Auditor independence, corporate governance and aggressive financial reporting: an empirical analysis
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Auditor independence, corporate governance and aggressive financial reporting: an empirical analysis Ahmed M. Abdel-Meguid • Anwer S. Ahmed Scott Duellman
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Published online: 13 April 2011 Ó Springer Science+Business Media, LLC. 2011
Abstract This paper seeks to provide empirical evidence on the efficacy of three important governance mechanisms (auditors, directors, and institutional shareholders) in constraining aggressive financial reporting, proxied by abnormal accruals. It also examines the effects of the Sarbanes–Oxley Act (SOX) on their efficacy. Using a sample of US firms audited by the Big 5 (4) auditors between 2000 and 2004, we document a positive relation between abnormal accruals (our proxy for financial reporting aggressiveness) and auditors’ economic dependence on their clients. Furthermore, we find that this relation is driven by firms with weak nonauditor governance mechanisms before and after the enactment of SOX. The results suggest that aggressive financial reporting occurs only when multiple governance mechanisms ‘fail’. More specifically, such type of reporting requires that a highly dependent auditor operates in a ‘poor’ governance setting. Thus, the paper underscores the importance of strong governance in constraining aggressive financial reporting. Moreover, our results suggest that governance regulation (such as SOX) is not a substitute for strong governance mechanisms and thus caution against the over reliance on SOX-type legislation in other parts of the world.
A. M. Abdel-Meguid (&) Department of Accounting, The School of Business, The American University in Cairo, New Cairo, Cairo 11835, Egypt e-mail: [email protected] A. S. Ahmed Mays Business School, Texas A&M University, College Station, TX 77843-4353, USA e-mail: [email protected] S. Duellman John Cook School of Business, Saint Louis University, Davis-Shaughnessy Hall, 111, 3674 Lindell Ave., St. Louis, MO 63108, USA e-mail: [email protected]
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Keywords Corporate governance Auditor independence Outside directors Institutional shareholders Aggressive financial reporting The Sarbanes–Oxley Act (SOX)
1 Introduction The last decade has witnessed a number of major governance failures of firms and drastic responses by regulators to prevent such failures from recurring. Perhaps the most famous example of these failures is the case of Enron where a poorly thought out business strategy together with weak monitoring mechanisms resulted in one of the biggest bankruptcies in the history of the US (see for example Coffee 2002; Healy and Palepu 2003; McLean and Elkin 2004). The Sarbanes–Oxley Act of 2002 (SOX) was passed in response to the accounting scandals at Enron, WorldCom and several other large corporations. It includes sweeping measures dealing with the oversight of the accounting profession, financial reporting, corporate governance, and other provisions affecting the business environment (Romano 2005). An important presumption underlying SOX was that in the pre-SOX period governanc
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