Outside Directors' Expertise and Earnings Management

Abstract

The purpose of this research is to review the effectiveness of outside directors. This study examines the relationship between the quality of outside directors and earnings management. To explore this effect empirically, earnings management is captured by proxies as discretionary accruals that is estimated using the modified-Jones Model. The proportion of outside directors of the board of directors, the ratio of outside directors with financial expertise, the ratio of outside directors with CEO experience, and the ratio of outside directors with audit experience are defined as independent variables. This research empirically uses and analyzes the samples of 341 firm-year during the fourperiod from 2000 to 2003. The firms are listed in the Korean Stock Exchange and the Korean Securities Dealer’s Automated Quotation at the end of each year. There is, however, an exception for financial institutions, banks, and insurance companies which discretionary accruals were not able to be calculated since their accounting method was different. The results of this research can be summarized as follows: First, the proportion of outside directors of the board of directors has a negative relation with a manager’s earnings management. Second, the ratio of outside directors who are financially professional positively affects manager’s earnings management. Third, the ratio of outside directors who has current and/or past CEO experience is associated positively with manager’s earnings management. Lastly, the ratio of outside directors who has current and/or past audit experience is negatively related to manager’s earnings management. This research confirms the effects of outside directors’ expertise on earnings management, and provides implications to the design of boards.