Lead independent director and earnings management

• Published date: 01 January 2024
• Author: Yuan‐Teng Hsu,Cheng‐Few Lee,Chih‐Yung Lin,Ning Tang
• Date: 01 January 2024
• DOI: http://doi.org/10.1111/eufm.12404

DOI: 10.1111/eufm.12404

ORIGINAL ARTICLE

Lead independent director and earnings

management

Yuan‐Teng Hsu

1

|Cheng‐Few Lee

2

|Chih‐Yung Lin

3

|

Ning Tang

3

1

Research Center of Finance, Shanghai

Business School, Shanghai, China

2

Finance and Economics, Rutgers

University, Newark, New Jersey, USA

3

Department of Information

Management and Finance, National

Yang Ming Chiao Tung University,

Hsinchu City, Taiwan

Correspondence

Ning Tang, Department of Information

Management and Finance, National

Yang Ming Chiao Tung University,

No. 1001, Daxue Rd. East Dist., Hsinchu

City 300093, Taiwan.

Email: klayt.mg07@nycu.edu.tw

Abstract

In this study, we examine the effects of lead independent

directors (LIDs) on firms' earnings management. On the

basis of US firms from 2000 to 2018, those with LIDs

managed earnings less, as reflected by the absolute value

of discretionary accruals. Specifically, we find the effect is

likely to be more prominent among firms with less

disclosure transparency, weaker corporate governance and

higher risk. In addition, we find that firms with LIDs tend

to increase R&D and capital expenditures, reduce

leverages and enhance firm values. Overall, the findings

indicate the monitoring of LIDs can effectively reduce

firms' earnings management and enhance firm values.

KEYWORDS

corporate governance, disclosure transparency, earnings

management, firm riskiness, lead independent director,

G32, G34, M41

1|INTRODUCTION

Boards of directors play a major role in corporate governance since they have monitoring and

advisory roles (Adams et al., 2010; Bebchuk et al., 2009; Core et al., 1999; Fama & Jensen, 1983;

Weisbach, 1988). In particular, Schwartz‐Ziv and Weisbach (2013) find that boards took at least

Eur Financ Manag. 2024;30:3–54. wileyonlinelibrary.com/journal/eufm © 2022 John Wiley & Sons Ltd.

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We thank John Doukas (the editor) and two anonymous referees for very helpful comments and suggestions that

greatly improved the paper. We also thank I‐Hsuan Ethan Chiang, Yi‐Jie Tseng, Chi‐Yang Tsou, and Yin‐Hua Yeh for

their insightful comments and encouragement. Seminar participants at National Yang Ming Chiao Tung University,

and 2022 Taiwan Finance Association Conference provided many valuable comments. The authors are listed in

alphabetical order and contributed equally to the manuscript.

one supervisory action or did not vote in line with the chief executive officer (CEO) in 63% of all

meetings. Li and Srinivasan (2011) argue that boards with a founder who is a director improve

board efficiencies, especially in terms of CEO turnover. In contrast, Fich and Shivdasani (2006),

Fracassi and Tate (2012) and Coles et al. (2014) find that busy or connected directors on the

board weaken their monitoring role, which leads to inefficiency.

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Therefore, how to improve

the efficiencies of boards is a vital issue in the corporate governance literature.

Recently, Krause et al. (2017) initiate the theory of compromise in the board's leadership

structure. They find that a lead independent director (LID) can balance the power on the board

and that it can be beneficial under proper conditions. A LID is responsible for calling separate

meetings of the independent directors, determining the agenda and serving as chairperson of

meetings of independent directors, reporting to the chairman of the board regarding feedback

from executive sessions, serving as spokesperson for the corporation as requested, and

performing other such responsibilities as may be designated by a majority of the independent

directors from time to time.

2

That is, LIDs can improve board monitoring without reducing the

operational freedom of the CEO. Thus, LIDs contribute to corporate performance in at least

three key areas: (1) taking responsibility for improving board performance, (2) building a

productive relationship with the CEO and (3) providing leadership in crises.

The role of a LID has recently become more prevalent in US‐listed firms. Nonetheless, few

studies examine the importance of LIDs to corporate decisions. For example, Lamoreaux et al.

(2019) find that firms with LID are more likely to terminate poorly performing CEOs. Rajkovic

(2020) shows that a LID on the board is positively associated with investment efficiency and is

negatively associated with overinvestment. Complementarily to these studies, we investigate the

effect of LID on earnings management that is the most important topic in the accounting literature.

Although board structure has been extensively studied in the prior literature, firms were

supposed to increase board independence after the enactment of the Sarbanes–Oxley Act

(SOX). However, almost 20 years after the enactment of SOX, we still see some cases of surplus

management occurring (e.g., Adu‐Gyamfi, 2016; Chung, 2021; Hamilton, 2020; Ivanova, 2017;

Khan, 2004; Surowiecki, 2016). For example, Healthsouth Corporation, one of the top publicly

traded healthcare companies in the United States, was found to have overstated its profits by

more than $1.8 billion in 2003. The CEO, Richard Scrushy, was indicted on 36 counts of

accounting fraud.

3

If you look at recent examples, in 2016, Valeant Pharmaceuticals

International was revealed to have misbooked $58 million of its books, leading to a subsequent

plunge in its share price.

4

On 2 April 2020, Luckin Coffee Inc. announced that an internal

investigation found that its chief operating officer, Jian Liu, had fabricated the company's 2019

sales by “around RMB2.2 billion”(US$310 million). It is more valuable in the stock price

crashing and several executives being fired.

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The SEC is continuing to crack down on

companies that manipulate earnings numbers to meet expectations. Consequently, the function

of independent directors needs to be fully considered in accordance with SEC standards. The

role of LID as a governance mechanism is still largely unexplored. Therefore, as a complement

to these studies, we examine the impact of LID on earnings management under the lens of

board independence to further explore its role and motivations.

1

Connected directors are those appointed by a powerful CEO to the board.

2

https://www.lawinsider.com/dictionary/lead-independent-director.

3

https://www.nbcnews.com/id/wbna21027918.

4

https://www.cbc.ca/news/business/valeant-pharmaceuticals-pershing-1.4023893.

5

https://sevenpillarsinstitute.org/case-study-luckin-coffee-accounting-fraud/.

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HSU ET AL.

Firms are given discretion and judgement in preparing financial statements under the

standards of the Generally Accepted Accounting Principles. Managers may have an incentive to

communicate selfish messages and mislead stakeholders by choosing specific reported

accounting methods and estimates that do not accurately reflect their firm's underlying

economics. Therefore, practitioners perceive earnings management to be a pervasive phenome-

non. This perception has been the subject of several studies in the accounting field in the past two

decades (e.g., Bartov et al., 2002; Brown, 2001; Brown & Caylor, 2005; Franz et al., 2014;Kama&

Weiss, 2013; Lopez & Rees, 2002; Matsumoto, 2002).

Other studies have pointed out that the critical protective mechanism to reduce the

incidence of earnings manipulation is corporate governance (Beasley & Salterio, 2001; J. Cohen

et al., 2002; Doyle et al., 2007; Engel et al., 2010). As shown by Klein (2002), Be'dard et al.

(2004) and Cheng et al. (2005), board independence and earnings management have a negative

association. Most of these studies have focused on the level of independent directors and their

ability to not only reduce the practice of earnings management but also improve the quality of

financial reporting (e.g., Beasley, 1996; Dechow et al., 1996; Klein, 2002; Peasnell et al., 2005).

We attempt to further study earnings management issues through recently developed

theories, such as the classical organizational theory and the agency theory (Fama &

Jensen, 1983; Fayol, 1949). The classical organization theory posits that a LID with considerable

experience in the corporate world may be the primary mentor for the CEO and funnel

recommendations from other directors without the appearance of the directors ganging up on

the CEO. Accordingly, the LID plays a good advisory role for the CEO and facilitates their focus

on the long‐term value that abates discretionary accruals. The agency theory posits that a LID

takes responsibility for monitoring and improving board performance and often makes valuable

contributions in times of crisis, which is essential to effective monitoring of management and to

constraining earnings management. We, therefore, expect a LID's presence to be associated

with a decline in earnings management.

However, the literature divides earnings management into two parts: accruals and real

earnings management. Gunny (2010) finds that managers may prefer accruals management

rather than real earnings management. The reasoning is that accruals management can occur

after the fiscal year‐end when the need for earnings management is the most certain, while real

earnings management must occur before fiscal year‐end. Therefore, we focus on accruals

management rather than real earnings management in this study.

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To examine how LIDs influence firms' earnings management, we collect data from BoardEx

over the period from 1999 to 2016 that covers 49,206 observations for 5668 individual firms. The

empirical results are consistent with our prediction. We find that a LID's presence on the board

is associated with an economically meaningful reduction in the absolute discretionary accruals.

For example, in the model (4) of Table 3, the coefficient of LID is 0.0056. As the average

earnings management is 0.1201, a decreasing effect of LID leads to an average decrease of 4.66%

(0.0056/0.1201) in earnings management. The results hold after we remove the observations

before 2004 (2006) to eliminate the effects of the SOX.

Additionally, the results are potentially subject to some endogeneity issues. We conduct

various sensitivity analyses to reduce potential endogeneity problems by using a difference‐in‐

differences (DiD) setting as well as a selection model. First, we use a change in 2009 to the

6

We obtain no results when earnings management is estimated by real activities manipulation (Roychowdhury, 2006).

The results are presented in Appendix C.

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