Asia-Pacific Journal of Accounting & Economics

ISSN: 1608-1625 (Print) 2164-2257 (Online) Journal homepage: http://www.tandfonline.com/loi/raae20

Do financial expert directors affect the incidence

of accruals management to meet or beat analyst
forecasts?
Pei Hui Hsu
To cite this article: Pei Hui Hsu (2015) Do financial expert directors affect the incidence of
accruals management to meet or beat analyst forecasts?, Asia-Pacific Journal of Accounting &
Economics, 22:4, 406-427, DOI: 10.1080/16081625.2014.998244
To link to this article: http://dx.doi.org/10.1080/16081625.2014.998244

Published online: 03 Jan 2015.

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Date: 05 September 2016, At: 22:46

Asia-Pacic Journal of Accounting & Economics, 2015

Vol. 22, No. 4, 406427, http://dx.doi.org/10.1080/16081625.2014.998244

Do nancial expert directors affect the incidence of accruals

management to meet or beat analyst forecasts?
Pei Hui Hsu*
Department of Accounting and Finance, California State University, East Bay, Hayward, CA,
USA
(Received 9 January 2014; accepted 7 December 2014)
Evidence that rms adjust accruals to meet or beat analyst forecasts is pervasive.
However, the implications for earnings quality are not clear. Managers can use this
practice to mislead investors or to signal future earnings growth. Assuming boards
are concerned about providing higher quality nancial information, they should discourage managers from adjusting earnings to beat the target if adjustment diminishes
earnings quality. Consistent with this prediction, I nd a signicantly negative relation between the probability that a rm beats the target by adjusting accruals and
the presence of independent audit committee nancial expert for rms with poor
future performance.
Keywords: earnings management; corporate governance; board of director; nancial
experts; analyst forecasts
JEL classication: M40; M41; G34; G38

1. Introduction
Considerable research has been devoted to documenting and understanding the
importance of just meeting or beating the consensus analyst forecast.1 For example,
several studies document evidence that managers adjust accruals in order to beat consensus analyst forecast targets (Ayers, Jiang, and Yeung 2006; Burgstahler and Eames
2006), which is consistent with the evidence that managers have incentives to do so
(Cheng and Wareld 2005; Matsumoto 2002; Matsunaga and Park 2001; McVay,
Nagar, and Tang 2006).2 However, it is not clear whether adjusting accruals to beat the
target increases or decreases earnings quality. It is also not clear how the board views
such behavior or how board member characteristics inuence managements tendency
to use accruals to beat the target. To provide evidence on these issues, I examine
whether the presence of nancial experts on the audit committee affects the use of
accruals to beat analyst forecast targets conditional on the impact of accruals on the
earnings quality.
Using accruals to beat the analyst forecast target could either increase or decrease the
quality of earnings, depending on the nature of managements private information.
Adjusting accruals to beat the target would increase the information value of earnings
when managers use accruals to signal private favorable information about future performance. On the other hand, when managers have private information that the rm will not
*Email: pei-hui.hsu@csueastbay.edu
2014 City University of Hong Kong and National Taiwan University

Asia-Pacic Journal of Accounting & Economics

407

be able to sustain its performance in the future, adjusting accruals upward to beat the
target could provide an overly optimistic view of the rm and mislead shareholders.
Prior research suggests that board members monitor the nancial reporting process
and that higher quality boards increase earnings quality (Beasley 1996; Farber 2005).
This implies that the board should encourage or discourage accruals management to
beat analyst targets depending on whether the adjustment properly reects managements private information. Boards should allow rms to adjust accruals to beat the
analyst forecast if they expect future nancial performance to be good and object if
they expect poor future performance. This is consistent with boards protecting shareholders by monitoring the quality of nancial information presented by the rm.
However, this assumes that board members have sufcient knowledge and expertise
to evaluate managers private information, and there is evidence that the extent of
nancial expertise is not consistent across boards (Krishnan and Visvanathan 2008).
Regulators have expressed concerns regarding whether directors have sufcient knowledge to effectively monitor the nancial reporting process (Blue Ribbon Committee on
Improving the Effectiveness of Corporate Audit Cmmittees 1999; Sarbanes-Oxley Act
of 2002 [SOX] 2002). Academic research also supports this view by showing a positive
relation between appropriate expertise on the audit committee and the nancial reporting quality (Agrawal and Chadha 2005; Dhaliwal, Naiker, and Navissi 2010; Zhang,
Zhou, and Zhou 2007). As a result, in this paper, I argue that nancial expert director
is more likely to have sufcient knowledge to assess managers private information
about future performance.3
I rst expect an overall negative relationship between the likelihood that a rm will
adjust accruals to beat the analyst forecast and the intensity of nancial experts monitoring. Because audit committee members with nancial expertise are better able to
assess the quality of the information signaled by beating or missing the analyst forecast
target, managers in rms with more intensive monitoring by nancial experts would
only engage in accruals management when they have positive information about future
performance, while mangers in rms with less intensive monitoring by nancial experts
would always manage accruals to beat the target. I also expect to observe a differential
impact of nancial experts on the odds of using accruals to beat the target, contingent
upon future performance. When managers have negative information about future earnings, nancial experts on the audit committee are expected to discourage managers
from managing earnings upward to beat the analyst forecast because such adjustment
diminishes the information usefulness of earnings. Yet, when accruals adjustment
reveals managers private favorable information, nancial expert directors are expected
to allow managers to adjust accruals to beat the target.
Empirically, I identify 1460 rm-quarter observations that initially had earnings
before discretionary accruals below analyst forecasts by less than one cent. Of the 1460
observations, 1091 observations recognize enough amounts of positive discretionary
accruals and report earnings that are above analyst forecasts, while 369 observations do
not adjust earnings upward and therefore miss the target. I use next quarters earnings
surprises to capture rms future performance. Consistent with my expectation, I nd
that when there is at least one independent nancial expert on the audit committee,
rms are less likely to adjust earnings upward to beat the targets if rms next quarters
earnings fall below the analyst forecast.
While the prior results apply to nancial experts, I also investigate whether the
results are driven by accounting expertise on the audit committee. Consistent with the
argument that the effective audit committee members are those who have general

408

P.H. Hsu

management experience as well as those who have an accounting or nancial

background (Dhaliwal, Naiker, and Navissi 2010; Zhang, Zhou, and Zhou 2007), I nd
that the presence of both independent accounting experts and independent nonaccounting nancial experts is related to lower possibility of using accruals to beat the target
for rms with negative earnings surprises in quarter t + 1.
I perform several additional tests. I address potential endogenous issue by using
lagged nancial expert variables as an instrument (Hermalin and Weisbach 1991) and a
two-stage least squares estimation (2SLS). All results remain quantitatively similar. In
addition, in order to make sure that missing rms have ability to adjust accruals but
they chose not to do so, I match beating rms to missing rms by year, industry, and
prior year net operating assets (NOAs). I also examine the overall predictive ability of
accruals. Consistent with the prediction that nancial expertise is associated with highquality accruals, I nd that when rms have independent audit committee nancial
expert, the current quarters accruals are more closely related to next quarters earnings.
My study contributes to literature in several ways. First, my study is of interest to
academic researchers, who study earnings management around analyst forecast. While
there is considerable research which documents that managers have incentives to use
accruals to beat the analyst forecast, less attention is paid to the rms that fail to beat
the target. In particular, the reasons why managers would choose not to adjust accruals
and miss analyst forecasts when they are capable of doing so is not well understood. I
provide evidence that monitoring by nancial experts deters managers from adjusting
earnings upward to beat analyst forecast and leads to when management has negative
private information regarding future nancial performance.
Second, I contribute to the literature that examines the role of the board in determining earnings quality. Prior studies generally assume that accruals management
reduces information value of earnings, so that effective boards should prohibit the use
of accruals management (Klein 2002; Xie, Davidson, and DaDalt 2003). I extend this
stream of literature by arguing that accruals management is not necessarily harmful to
shareholders. If board members have sufcient nancial expertise, they will discourage
the recognition of accruals when it diminishes the information value of the earnings
and allow managers to adjust accruals to improve the decision usefulness of earnings.
Third, I contribute to the literature regarding the impact of accruals to beat the targets on earnings quality. Although prior studies document the tendency of rms to use
accruals to beat the analyst forecast, it is not clear whether the use of accruals to beat
the target increases or decreases the quality of earnings. My analyses suggest that when
managers are closely monitored by nancial experts, accruals might be used to signal
future strong performance and result in higher earnings quality.
This study also has implications for standard setters. I nd that nancial experts are
better able to preserve a high-quality nancial reporting, supporting the SECs intention
to push for additional nancial experts on the audit committee. I also contribute to the
controversy about the denition of nancial expertise. My evidence suggests that both
accounting and nonaccounting nancial experts are able to contribute to the effectiveness of the board. This supports the SECs wide-ranging denition of nancial
expertise.
The remainder of the paper is organized as follows. Section 2 discusses the related
literature and hypotheses development. Section 3 discusses my sample selection, variable denitions, and provides summary statistics. In Section 4, I outline the research
design and present empirical results. Section 5 discusses the role of accounting-specic
expertise. Section 6 provides additional tests, and Section 7 concludes.

Asia-Pacic Journal of Accounting & Economics

409

2. Literature review and hypotheses development

Prior studies provide evidence that managers have strong incentives to avoid negative
earnings surprises. The benets that managers enjoy from avoiding negative earnings
surprises include maximizing the value of their stock-based compensation (Cheng and
Wareld 2005; McVay, Nagar, and Tang 2006), increasing their cash bonus (Matsunaga
and Park 2001), and avoiding litigation risk (Matsumoto 2002).4 Consistent with managers incentives to beat the analyst forecast, prior studies have shown that managers
adjust accruals to produce earnings that beat the target. Burgstahler and Eames (2006)
nd that managers manage earnings upward through accruals in order to avoid reporting negative earnings surprises. Ayers, Jiang, and Yeung (2006) document a signicant
positive association between discretionary accruals and beating the analyst forecast
benchmark.
Adjusting accruals to avoid negative earnings surprises can either increase or
decrease the information value of earnings, depending on the nature of managements
private information. If managers have negative private information regarding future
earnings performance, adjusting accruals to beat the analyst forecast target provides a
misleadingly optimistic picture of the nancial success of the rm that allows managers
an opportunity to increase their personal wealth. For example, Cheng and Wareld
(2005) nd that high equity incentives motivate managers to engage in earnings management to beat analyst forecasts in order to increase the value of the shares. However,
on the other hand, if managers have favorable information regarding future earnings
performance, adjusting accruals to beat the analyst forecast reveals managers private
information and provides a more timely measure of a rms future performance. In this
case, the earnings number becomes more informative and shareholders are able to make
better-informed decisions. Subramanyam (1996) suggests that managerial discretion
improves the ability of earnings to reect economic value. Xue (2003) also nds that
rms with high growth opportunities are more likely to adjust accruals to signal future
performance.
Assuming that the interests of shareholders and the board are properly aligned,
directors should respond to investors demands for higher quality nancial information.5 As a result, when managers have unfavorable information regarding future performance, the board should deter managers from adjusting earnings upward to beat the
analyst forecast because such adjustment might be driven by managers self-interest
incentives and diminishes the information value of earnings. Conversely, when managers have positive information regarding future earnings, the board should allow managers accruals adjustment to beat the target, since such adjustment signals strong future
performance and improves the decision usefulness of earnings.
However, this assumes that board members should have enough expertise to
understand managements private information regarding future earnings. Prior research
suggests that lack of appropriate expertise may reduce directors ability to monitor the
nancial reporting process. Krishnan and Visvanathan (2008) nd that the proportion
of nonaccounting nancial experts on the audit committee is unrelated with accounting
conservatism, while the proportion of accounting nancial experts is signicantly
positively correlated with conservatism. Regulators also emphasize the importance of
nancial expertise on the audit committee. Section 407 of SOX requires rms to disclose whether at least one of the audit committee members is a nancial expert. The
NYSE and the NASDAQ also have similar requirement regarding nancial expert
directors.

410

P.H. Hsu

In addition, academic research generally supports the regulatory view that audit
committee nancial expertise is related to higher quality nancial reporting. Agrawal
and Chadha (2005) nd that the odds of restating nancial statements are signicantly
lower when the audit committee has an independent nancial expert on the audit committee. Farber (2005) nds that rms subject to an SEC enforcement action have fewer
nancial experts on their audit committees than a control group of similar rms.
Dhaliwal, Naiker, and Navissi (2010) document nancial expertise as positively associated with accruals quality. Zhang, Zhou, and Zhou (2007) nd that rms are more
likely to be identied with an internal control weakness if their audit committees have
less nancial expertise. As a result, in this paper, I focus on audit committee nancial
experts as dened by Section 407 of the SOX Act. I argue that these directors are better able to monitor nancial reporting and disclosure issues through their knowledge
base, educational background, or prior working experience.6
Since audit committee nancial expertise are better able to evaluate managers private information regarding future performance and to assess the quality of the information signaled by beating or missing the analyst forecast target. Managers in rms with
more intensive monitoring by nancial experts would only engage in accruals management when they have positive information about future performance, while mangers in
rms with less intensive monitoring by nancial experts would always manage accruals
to beat the target. This leads to an overall negative relationship between the unconditional likelihood that a rm will adjust accruals to beat the analyst forecast and the
intensity of nancial experts monitoring.
Hypothesis 1: The presence of an independent nancial expert on the audit committee is
negatively related to the odds of beating analyst forecasts by adjusting accruals.

In addition, I expect to observe a differential impact of nancial experts on the odds of

using accruals to beat the target, contingent upon future performance. When managers
have negative information about future earnings, nancial expert directors on the audit
committee are expected to discourage managers from managing earnings upward to
beat the analyst forecast because such adjustment diminishes the information usefulness
of earnings. On the other hand, when the accruals adjustment reveals managers private
favorable information and reduces the information asymmetry between managers and
shareholders, nancial expert directors are expected to allow managers to adjust accruals to beat the target.
Hypothesis 2A: The presence of an independent nancial expert on the audit committee is
negatively related to the odds of beating analyst forecasts by adjusting accruals when the
manager has unfavorable information regarding future nancial performance.
Hypothesis 2B: The impact of an independent nancial expert on the odds of beating analyst forecasts by adjusting accruals is stronger when the manager has unfavorable information regarding future nancial performance than when the manager has favorable
information regarding future performance.

3. Data description and summary statistics

3.1. Sample selection
The sample starts with all rms with available quarterly data from COMPUSTAT,
covering the years from 2004 to 2011. I restrict my sample to post-2004 data because
the SOX provision regarding nancial experts is effective in 2003. The sample is

Asia-Pacic Journal of Accounting & Economics

411

restricted to pre-2011 data because I need to examine earnings performance in

subsequent quarters. I/B/E/S summary le provides quarterly analyst forecast data.
Board data are obtained from the Corporate Library database for 20042008, and from
RiskMetrics for 20092011 because the nancial expert data is missing in Corporate
Library after 2008.
I drop observations that have missing total assets or SIC code in COMPUSTAT. I
also delete all rms with Standard Industry Classication (SIC) codes from 44005000
(utility industry), 60006999 (nancial services), and 90009999 (nonclassiable establishments). I require all observations to have sufcient board and audit committee data
from Corporate Library or RiskMetrics and sufcient forecast data from I/B/E/S. I also
require each rm to have quarterly earnings data for all four quarters for the given year.
Finally, to reduce the effects of extreme observations, I truncate rm-quarter observations in the top and bottom one percent of distributions of all continuous variables.
3.2. Accruals management to beat the target
I rst identify rms that use accruals management to beat the target. Discretionary
accruals estimated from the cross-sectional adaptation of the modied Jones model
(Balsam, Bartov, and Marquardt 2002; Dechow, Sloan, and Sweeney 1995) are used as
the primary measure of earnings management (see Appendix 1 for accruals measures).
For each rm-quarter observation, I rst calculate nondiscretionary EPS (NDEPS),
which I dene as:
NDEPSitq Actual EPSitq  DACitq per share
Following Davis, Soo, and Trompeter (2009), I compute an adjusted forecast error
(AdjFE) as the difference between NDEPS and median consensus analyst forecasts.
Essentially, AdjFE represents the difference (in dollar amount) between analysts estimated EPS and the EPS that managers would report if no discretionary accruals were
recorded. Stated differently, AdjFE represents the deciency in earnings that managers
would have to eliminate through discretionary accruals in order to exceed the consensus
earnings forecasts. Assuming that rms just missing the analyst EPS forecast by one
cent are able to adjust accruals to beat the target, I construct a sample of 1460 rmquarter observations that have earnings before discretionary accruals initially below the
analyst forecast target by less than one cent (0.01 < AdjFE < 0). Among 1460 observations, I further identify 1091 rm-quarter observations that have earnings before discretionary accruals initially just below the forecast (0.01 < AdjFE < 0), but report
sufcient positive discretionary accruals that allow earnings to beat analyst forecasts
(FE = [EPS median consensus analysts forecast] 0) as the earnings management
sample. The rest of the 369 rm-quarter observations still report earnings that miss analyst forecasts (FE < 0). I consider these 369 observations as rms that chose not to
adjust accruals to beat the analyst target.
3.3. Variable measures
I hypothesize that nancial experts will discourage or encourage accruals management
to beat the target depending on future performance. By using next quarters earnings
surprises to capture rms future performance, I create a dummy variable (BadNEWS)
that equals one if a rm has next quarters earnings less than the analyst forecast, and
zero otherwise. In order to make sure that the analyst forecast in quarter t + 1 is not

412

P.H. Hsu

affected by the earnings surprise in quarter t, I use the latest consensus forecasts before
quarter ts earnings release to calculate the earnings surprises in quarter t + 1.
Section 407 of the SOX Act mandates rms to disclose whether there is at least one
nancial expert on the audit committee. Following Section 407, I create a dummy variable (FEDIR1) that equals one when there is at least one independent nancial expert
on the audit committee, and zero otherwise.7
3.4. Summary statistics
Table 1 provides descriptive statistics. Panel A shows that, relative to all Compustat
rms, my sample includes rms that are larger in size (log market value) and total
assets, and are more protable. Panel B shows the summary statistics for rms that
have earnings before discretionary accruals below analyst forecast by less than one
cent. As expected, the mean value of discretionary accruals (DAC) of rms that
beat the forecast is signicantly larger than the value of rms that miss the forecast.
On average, rms that beat the forecasts through accruals have signicantly less
negative adjusted forecast error (AdjFE) than rms that miss the forecast, implying
that it might be easier for those managers to adjust accruals to beat the target. The
actual forecast error (FE) of rms that beat the target is 0.001, which is signicantly larger than that of rms that miss the target. There is no signicant
difference in board composition between rms that beat the target and rms that
miss the target.
Panel C presents the distribution of independent nancial experts in my sample. Of
rms that beat the target by adjusting accruals, 10.26% do not have any independent
nancial expert on the audit committee; while of rms that choose to miss the target,
only 6.82% do not have any independent nancial expert on the audit committee. Panel
D shows the distribution of independent accounting experts on the audit committee. On
average, 85% of rms do not have any independent accounting expert on the audit
committee. This statistic is similar to prior studies. For example, Krishnan and
Visvanathan (2008) show that about 20% of rms have at least one accounting
nancial expert on the audit committee for the period 20002002.
4. Research design and empirical results
Hypothesis H1 predicts that the monitoring imposed by nancial experts reduces the
unconditional tendency to use accruals to beat the analyst forecast. To test this prediction, I estimate a logit model and predict a negative relation between the presence of a
nancial expert on the audit committee and the possibility of unconditional accruals
management to beat analyst forecast targets.
ProbJUSTBEATi;t;q 2 0; 1 logit a0 b FEDIRi;t;q c CONTROLi;t;q ni;t;q (1)

Following Matsumoto (2002), I include various control variables that might correlate with earnings surprises. I control for market value (SIZE), book-to-market ratio
(BTM), the number of outstanding shares (SHARES), the number of analysts
(NUM_ESTIMATE), dispersion of individual forecast (CV_AF), and a downward revision dummy (DOWN_REV). I also control for board characteristics. I include
BOARD_SIZE to capture the number of directors on the board and number of independent directors (BOARD_IND) to control for the independence of the board. The Blue

Descriptive statistics.

86,834
86,834
86,834
86,834

N
5.33***
5.13***
0.08***
0.010**

Mean
2.40
2.67
0.41
0.16

SD

Compustat sample

5.37
5.30
0.005
0.0004

Median

1091
1091
1091
1091
1091
1091
1091
1091
1091
1091
1091
1091
1091

Accruals measures
Discretionary accruals (DAC)
Nondiscretionary EPS (NDEPS)
Actual EPS (ACTUAL)
Consensus analyst forecast (MEDEST)
Forecast error adjusted for DAC (AdjFE)
Forecast error (FE)

Board characteristics
BOARD_SIZE
BOARD_IND
AC_SIZE
# of Financial expert
# of Independent nancial expert
# of Accounting expert
# of Independent accounting expert

11.18
7.42
3.68
1.62
1.55
0.14
0.13

0.003***
0.352**
0.356***
0.354**
0.001***
0.001***

Mean

4.02
2.86
0.88
1.97
1.08
0.38
0.36

0.008
0.306
0.306
0.306
0.002
0.007

SD

10.00
7.00
3.00
1.00
1.00
0.00
0.00

0.001
0.299
0.310
0.300
0.000
0.000

Median

Panel B: Firms with earnings before discretionary accruals below forecast by less than one cent
Beat the target

Panel A: Compustat sample and test sample

SIZE
LOG_ATQ
EARN
Discretionary accruals (DAC)

Table 1.

369
369
369
369
369
369
369

369
369
369
369
369
369

1460
1460
1460
1460

N
1.33
1.31
0.03
0.10

SD

11.34
7.52
3.78
1.61
1.56
0.13
0.13

0.000
0.302
0.300
0.310
0.007
0.009

Mean

4.14
3.00
0.99
1.09
1.07
0.36
0.36

0.002
0.303
0.302
0.302
0.303
0.004

SD

Miss the target

7.55
7.24
0.01
0.001

Mean

Test sample

(Continued)

10.00
7.00
4.00
1.00
1.00
0.00
0.00

0.000
0.240
0.240
0.250
0.000
0.010

Median

7.42
7.20
0.01
0.0003

Median

Asia-Pacic Journal of Accounting & Economics

413

Table 1. (Continued).

1091

Total rms
100

%
10.26
50.97
38.77
369

#
27
204
138

1091

Total rms
100

%
85.62
13.01
1.37

369

#
316
49
4

Miss the target

Miss the target

100

%
85.63
13.27
1.10

100

%
6.82
55.28
37.40

Notes: The descriptive statistics are based on 1460 rm-quarter observations in the period 20042011 excluding rm that do not have quarterly earnings data for all quarters of
the given year. I delete all rms with Standard Industrial Classication (SIC) codes from 44005000 (utility industry), 60006999 (nancial services), and 90009999 (unclassible
industry). One thousand and ninety-one rm-quarter observations have earnings before discretionary accruals initially below forecasts by less than one cent but reports sufcient
positive discretionary accruals that allow earnings to beat analyst forecasts. Three hundred and sixty-nine rm-quarter observations have earnings before discretionary accruals initially below forecasts by less than one cent and report earnings that is below analyst forecasts. See Appendix 1 for variable measures.
***p < 0.01; **p < 0.05; *p < 0.1.

#
934
142
15

Independent accounting expert = 0

Independent accounting expert = 1
Independent accounting expert >1

Panel D: Accounting Experts on Firms with earnings before discretionary accruals below forecast by less than one cent
Beat the target

#
112
556
423

Independent nancial expert = 0

Independent nancial expert = 1
Independent nancial expert >1

Beat the target

Panel C: Financial experts on Firms with earnings before discretionary accruals below forecast by less than one cent

414
P.H. Hsu

Asia-Pacic Journal of Accounting & Economics

415

Ribbon Committee suggests that audit committees should have at least three members,
implying that larger audit committees are more likely to have a wider knowledge base
on which to draw and are better able to perform their oversight duty. Thus, number of
audit committee members (AC_SIZE) is included to control for the size of the audit
committee.
Table 2 reports the results. As expected, there is a signicantly negative relation
between the measure of audit committee nancial expertise and the odds of unconditional accruals adjustments to beat the analyst forecast target. The coefcient on
FEDIR1 is 0.687 (with p value < 0.01), suggesting that the possibility of beating the
analyst forecast is lower for rm that has at least one independent nancial expert
director on the audit committee. Regarding the control variables, the coefcient on
NUM_ESTIMATE is signicantly positive, suggesting that rms are more likely to beat
the target by adjusting accruals when they have more analysts following. The signicant negative coefcient on BOARD_SIZE suggests that rms with larger boards are
less likely to use accruals to beat the target.
I then empirically test Hypothesis 2 by partitioning my sample based on rms
future nancial performance and estimating the following equation:
Prob(JUSTBEATi;t;q 2 0; 1 logit a0 b0 FEDIRi;t;q b1 BadNEWSi;t;q
 FEDIRi;t;q b2 BadNEWSi;t;q c CONTROLi;t;q ni;t;q

(2)

In Equation (2), control variables are the same as Equation (1). 0 captures the
effect of the presence of at least one independent nancial expert on the odds of

Table 2. The effect of the presence of at least an independent nancial expert on the odds of
beating analyst forecast by accruals.

FEDIR1t
SIZEt
BTMt
SHARESt
NUM_ESTIMATEt
CV_AFt
DOWN_REVt
BOARD_SIZEt
BOARD_INDt
AC_SIZEt
Observations
Pseudo R2
Year & quarter xed effect
Industry xed effect

()
()
(+)
(+)
()
(+)

JUSTBEAT

2 statistics

0.687***
0.040
0.272
0.000
0.045***
0.359
0.273
0.446*
0.001
0.122

[5.069]
[0.323]
[1.316]
[0.365]
[3.604]
[1.163]
[1.160]
[1.759]
[0.0276]
[0.393]

1460
0.101
Yes
Yes

Notes: The dependent variable is JUSTBEAT, which equals one when a rm whose earnings before discretionary accruals is initially below forecasts by less than one cent but reports sufcient positive discretionary accruals that allow earnings to beat analyst forecasts, and zero, when a rm whose earnings before discretionary
accruals is initially below forecasts by less than one cent and reports earnings that is still below analyst forecasts. See Appendix 1 for variable measures. The regression is estimated with an intercept included but the
intercept is not reported. 2 statistics shown in brackets are based on robust standard errors cluster by year.
***p < 0.01; **p < 0.05; *p < 0.1.

416

P.H. Hsu

beating the analyst forecast target by adjusting accruals. By interacting BadNEWS

dummy with FEDIR1, 1 captures the incremental effect of the presence of at least one
independent nancial expert on the odds of beating the analyst forecasts by adjusting
accruals for rm that has negative earnings surprise in the following quarter; and
0 + 1 is the total effect of the presence of independent nancial expert on the odds of
beating target for rm, whose earnings fall below analyst forecasts in quarter t + 1.
Hypothesis 2A predicts that nancial experts monitor will discourage managers from
adjusting accruals to beat forecasts when rm has poor future performance, i.e. 0 + 1
is predicted to be negative. Hypothesis 2B predicts that the impact of independent
nancial expert on the odds of beating the targets by adjusting accruals is greater when
future performance is poor than when future performance is strong. Thus, 1 is predicted to be negative.
Table 3 shows the results. Consistent with Hypothesis 2A, the sum of 0 + 1 is signicantly negative (see last row of Table 3), suggesting that independent nancial
experts discourage managers from adjusting accruals to beat analyst forecasts when
rms have a negative earnings surprise in quarter t + 1. In addition, consistent with
Hypothesis 2B, the coefcient on FEDIR1*BadNEWS is signicantly negative
(1 = 0.808; p < 0.01), suggesting that there is an incremental negative effect of the
presence of independent nancial expert on the odds of beating targets for rms with a
negative earnings surprise in the next quarter. Results for the control variables are consistent with those reported in Table 2.

Table 3. The effect of the presence of at least an independent nancial expert on the odds of
beating target by accruals contingent on future earnings surprises.

Constant
FEDIR1t
BadNEWSt*FEDIR1t
BadNEWSt
SIZEt
BTMt
SHARESt
NUM_ESTIMATEt
CV_AFt
DOWN_REVt
BOARD_SIZEt
BOARD_INDt
AC_SIZEt
Observations
Pseudo R2
Year & quarter xed effect
Industry xed effect
Coefcient on 0 + 1

(+)
()
()
(+)
(+)
()
(+)

0
0
1
2

JUSTBEAT

2 statistics

0.870
0.280
0.808***
0.397***
0.026
0.290
0.000
0.047***
0.369
0.231
0.416
0.008
0.076

[1.360]
[4.351]
[2.784]
[0.201]
[1.388]
[0.417]
[3.989]
[1.128]
[1.004]
[1.506]
[0.362]
[0.237]
[0.695]

1460
0.105
Yes
Yes
1.088***

Notes: The dependent variable is JUSTBEAT. BadNEWS is a dummy variable that equals one if a rm fails
to beat analyst forecasts in the following quarter, and zero otherwise. See Appendix 1 for variable measures.
2 statistics shown in brackets are based on robust standard errors cluster by year.
***p < 0.01; **p < 0.05; *p < 0.1.

Asia-Pacic Journal of Accounting & Economics

417

5. Accounting expertise on audit committee

In this paper, I also focus on accounting expertise on the audit committee. The SECs
original proposal adopts a denition of nancial expertise that focuses on whether the
director has prior accounting experience with nancial reporting and suggests that such
directors will have work experience as a public accountant, auditor, principal nancial
or accounting ofcer, or controller. However, narrowly dening nancial expertise as
accounting-related expertise has been widely criticized. Critics of the denition argue
that its narrow focus on accounting-related expertise is unnecessarily restrictive and
limits the pool of qualied directors. In its nal version of the SOX provision, the SEC
compromised by broadening the denition of nancial expertise (Defond, Hann, and
Hu 2005). The nal rule gives board members wide latitude to qualify a director as a
nancial expert by suggesting that directors may gain such expertise through experience
supervising employees with nancial reporting responsibilities, overseeing the performance of companies, and other relevant experience. Essentially, the nal rule logically
extends the eld of qualied experts to encompass company presidents and CEOs.
Because of the controversy surrounding the SECs denition of nancial expertise,
the denition of what constitutes a nancial expert has given rise to academic research
on the effects of accounting and nonaccounting nancial expertise on nancial reporting quality. The result of whether nonaccounting expertise is benecial to the effectiveness of audit committees is mixed. Although Krishnan and Visvanathan (2008) nd

Table 4. The effect of the presence of at least an accounting expert on the odds of beating
analyst forecast by accruals contingent on future earnings surprises.

ACCDIR1t
BadNEWSt*ACCDIR1t
NonACC_FEDIR1t
BadNEWSt*NonACC_FEDIR1t
BadNEWSt
SIZEt
BTMt
SHARESt
NUM_ESTIMATEt
CV_AFt
DOWN_REVt
BOARD_SIZEt
BOARD_INDt
AC_SIZEt
Observations
Pseudo R2
Year & quarter xed effect
Industry xed effect

0
1
2
3
()
(+)
(+)
()
(+)

JUSTBEAT

2 statistics

0.152
0.687**
0.246
0.533**
0.293*
0.042
0.325***
0.001
0.045***
0.408
0.109
0.507
0.001
0.157

[0.654]
[2.012]
[1.590]
[2.260]
[1.750]
[0.276]
[2.666]
[0.487]
[3.043]
[0.996]
[0.363]
[1.538]
[0.0526]
[0.427]

1106
0.125
Yes
Yes

Notes: The dependent variable is JUSTBEAT. ACCDIR1 is dummy variable, which equals one when there is
at least one independent accounting expert on the audit committee, and zero otherwise. NonACC_FRDIR1 is
dummy variable, which equals one when there is at least one independent nonaccounting nancial expert on
the audit committee, and zero otherwise. See Appendix 1 for variable measures. The regression is estimated
with an intercept included but the intercept is not reported in 2 statistics shown in brackets based on robust
standard errors cluster by year.
***p < 0.01; **p < 0.05; *p < 0.1.

418

P.H. Hsu

that accounting conservatism is not correlated with nonaccounting nancial expertise,

Zhang, Zhou, and Zhou (2007) nd that both accounting and nonaccounting nancial
experts affect the possibility of internal control weakness. Similarly, Dhaliwal, Naiker,
and Navissi (2010) nd that the mix of accounting and nonaccounting expertise
provides the most positive impact on accruals quality.
In order to test whether my results are driven by accounting expert, I re-estimate
Equation (2) and replace FEDIR1 by ACCDIR1 and NonACC_FEDIR1 (see Appendix
1 for variable measures).8 Table 4 shows the result that the presence of both independent accounting expert and nonaccounting nancial expert negatively affects the possibility of adjusting accruals to beat the target for rm that has negative earnings
surprises in quarter t + 1. This nding is consistent with the argument that both
accounting and nonaccounting experts are able to contribute to the effectiveness of the
board.

Table 5. The effect of the presence of at least an independent nancial expert on the odds of
beating analyst forecast by accruals contingent on future earnings surprises: two-stage least
squares.
FEDIR1 Dummya
(1)
FEDIR1
^ t
FEDIR1
^ t *BadNEWSt
FEDIR1
BadNEWSt
SIZEt
BTMt
SHARESt
NUM_ESTIMATEt
CV_AFt
DOWN_REVt
BOARD_SIZEt
BOARD_INDt
AC_SIZEt
COMPANY_AGE
FCFt
R&Dt
SEGMENTt
CEO_TENUREt
LEVERAGEt
Observations
Pseudo R2
Year & quarter xed effect
Industry xed effect
Coefcients on 0 + 1

0.031**
0.063**
0.000
0.001
0.019
0.038
0.098
0.010*
0.079
0.034
0.012
0.006
0.002
0.001
0.033

2 statistics

[2.696]
[2.859]
[0.843]
[0.382]
[0.581]
[1.839]
[1.376]
[1.945]
[0.809]
[1.773]
[1.210]
[0.643]
[0.533]
[0.981]
[1.586]

JUSTBEAT
(2)
BEAT

2 statistics

2.981
1.174**
0.884**
0.166
0.596
0.000
0.039
0.088
0.131
1.040***
0.010
0.005

[1.398]
[2.101]
[1.994]
[0.675]
[1.620]
[0.004]
[1.627]
[0.200]
[0.544]
[2.991]
[0.174]
[0.010]

796
0.404

796
0.148

Yes

Yes
4.155***

Notes: Logistic regression of rst-stage model is estimated with FEDIR1 as the dependent variable (= 1 for
rms with at least one independent nancial expert, and zero otherwise). See Appendix 1 for variable measures.
All regressions are estimated with an intercept included but the intercept is not reported. 2 statistics shown in
brackets are based on robust standard errors cluster by year.
***p < 0.01; **p < 0.05; *p < 0.1.
a

Asia-Pacic Journal of Accounting & Economics

419

6. Additional tests
6.1. Control for endogenous
One concern regarding the prior results is the possibility of a reverse causal relation.
This would occur if nancial experts with knowledge about the rms accounting systems systematically opt out of serving on boards of rms with low nancial reporting
quality. I address this endogeneity problem using two approaches. First, I estimate
simultaneous equations in the odds of beating targets by adjusting accruals and number
of nancial experts using 2SLS regressions. My rst-stage model captures the determinants of board structure, including monitoring and advising costs, information asymmetry, and business complexity (Coles, Daniel, and Naveen 2008).
Table 5 reports the parameter estimates. Column (1) presents the results on the
determinants of the presence of nancial expert director. FEDIR1 is positively related
to BOARD_IND. In addition, larger rms and rms with higher book-to-market ratio
are more likely to have at least one nancial expert on the audit committee. In the second stage, I replace FEDIR1 with the predicted value from the rst-stage model. I continue to nd a negative total effect of (predicted) FEDIR1 and the odds of beating
target by accruals when the rms have negative earnings surprise in quarter t + 1 (see
last row of Column (2) Table 5). In addition, the signicant negative coefcient on 1
suggests a signicant incremental effect of nancial experts on the odds of beating target for rms with negative earnings surprises.
While my results are qualitatively similar under 2SLS, this method could be subject
to specication error. Thus, following Hermalin and Weisbach (1991), I use lagged
(instead of contemporaneous) values of number of nancial experts in regressions of
the odds of beating analyst forecast targets, and all the results are unchanged.
6.2. Mangers exibility in using accruals to beat the target
Although managers have strong incentive to manage earnings to beat the target, prior
studies suggest that managers are not always able to do so (Barton and Simko 2002;
Hunt, Moyer, and Shevlin 1996). By assuming that rms with unmanaged earnings just
below forecasted target are more capable in adjusting accruals, my main results are
based on observations with earnings before discretionary accruals below analyst forecasts by less than one cent (Davis, Soo, and Trompeter 2009).9 Yet, one cent is an
arbitrage cut-off. In order to examine whether my results are sensitive to the choice of
cut-off, I construct samples based on rms with unmanaged earnings below analyst
forecasts by less than two cents, three cents, and four cents, respectively. Untabulated
results are robust when using alternative cut-offs.
Although above results show that my ndings are not sensitive to different cut-offs,
it is still possible that rms missing forecasts by less than couple cents are not able to
adjust accruals. In order to address such concern, I relax my assumption that managers
in rms with unmanaged earnings just below forecasted target are able to adjust accruals and construct a matched sample. Ideally, matching procedure yields control observations (rms do not use accruals to beat the target) that are identical to treatment
observations (rms with unmanaged earnings below the target but use accruals to beat
the target) in respect of the exibility in adjusting accruals. I conduct a two-step matching procedure. First, an observation can be selected as control observation when it has
discretionary accruals initially below forecast and reports earnings that is still below
analyst forecasts. I then match control observations with treatment observations based

420

P.H. Hsu

on year, prior-quarter NOAs, and industry (two-digit SIC code) (Barton and Simko
2002).10 Untabulated results from matched sample are consistent with my main
ndings.
6.3. Predictive ability of accruals
In order to make my results more generalizable, following prior study (Chang et al.,
2012), I examine whether independent audit committee nancial expert improves the
association between accruals component and future earnings. By arguing that rms with
more intensive nancial expert monitoring are more likely to use accruals to signal
future performance, the accrual component should better predict future earnings when
rms have nancial expert on the audit committee. Following Sloan (1996), I estimate
following Equation (3):
EARNi;t;q1 a b1 CFOi;t;q b2 ACCRi;t;q b3 CFOi;t;q  FEDIRIi;t;q
b4 ACCRi;t;q  FEDIRIi;t;q ni;t;q

(3)

The results of estimating Equation (3) are shown in Table 6. Consistent with prior
studies, the coefcients on 1 and 2 are signicantly positive (Sloan 1996). As
expected, I nd a signicantly positive 4, suggesting that the relation between the current periods accruals component and the following periods earnings is stronger when
the rm has at least one independent nancial expert on the audit committee.
6.4. Does board independence matter?
The key variable (FEDIR1) is dened as the presence of at least one independent
nancial expert on the audit committee. Since prior studies have documented a positive
relation between board independence and earning quality (Beasley 1996; Farber 2005),
it is not clear whether my prior ndings are driven by independent directors monitoring or by their nancial background. To address such concern, I examine whether independent non-nancial directors affect the odds of using accruals to beat analyst
Table 6. The effect of the presence of at least a nancial expert on the predictive ability of
accruals.
EARNt
CFOt
ACCRt
CFOt*FEDIR1t
ACCRUALt*FEDIR1t
Observations
Adjusted R2
Year & quarter xed effect
Industry xed effect

(+)
(+)
(+)

1
2
3
4

+ 1

0.582***
0.315***
0.053
0.159**

t-statistics
[12.81]
[11.55]
[1.071]
[2.800]

14,658
0.381
Yes
Yes

Notes: The dependent variable is EARNt + 1. See Appendix 1 for variable measures. The regression is
estimated with an intercept included, but the intercept is not reported. t-Statistics shown in brackets are based
on robust standard errors cluster by year.
***p < 0.01; **p < 0.05; *p < 0.1.

Asia-Pacic Journal of Accounting & Economics

421

forecast target. Financial expertise is argued to be crucial for directors to distinguish

accruals management to signal future performance from accruals management that misleads the shareholders. Thus, independent non-nancial director might be less capable
in understanding managers accruals practice and will unconditionally encourage the
adjustment of accruals to beat the target because beating targets boosts stock price,
which seems to be benecial to the shareholders. This leads to an overall positive relation between the monitoring imposed by independent non-nancial directors and the
odds of beating target by adjusting accruals.
Empirically, I use the number (and the percentage) of independent non-nancial
directors to proxy for their monitoring and re-estimate (Equation (1)). Untabulated
result shows a marginally positive relation between the percentage of independent
non-nancial directors and the odds of using accruals to beat the target, which rules
out the possibility that my main ndings are driven by independent nancial experts
independent status.
6.5. Other future performance measurements
In the main section, I use next quarters earnings surprise to measure future nancial
performance. However, there is concern that managers adjust accruals to beat analyst
forecasts for consecutive quarters when they believe the rm will perform well several
quarters later. In this case, the next quarters earnings (t + 1) or/and the quarter after
next quarters earnings (t + 2) are also managed. In order to address such concern, I
rst argue that it is less likely for managers to consistently use accruals to adjust earnings upward for a long period of time. Because of the reversing nature of accrual
accounting, prior studies nd that managers biased estimates and judgments in one
period reduce their ability to make similarly biased estimates and judgments in subsequent periods (Barton and Simko 2002; Hunt, Moyer, and Shevlin 1996).
Empirically, I use various alternative proxies to capture future performance. Since
managers are less capable of consistently managing accruals, longer term performance
might better capture rms nancial performance. I classify a rm with poor future performance if it has negative earnings surprises in future two quarters (t + 1 and t + 2)
and future three quarters (t + 1, t + 2, and t + 3), respectively. I also use I/B/E/S analysts long-term forecast (FPI = 0) to proxy for future performance. Results using various future long-term performance measures all remain consistent with our main
ndings.
6.6. Real earnings management
Real earnings management has been examined extensively. Recently, studies suggest
that managers make choices between real activities manipulation and accrual-based
earnings management and managers treat the two strategies as substitutes (Cohen and
Zarowin 2010; Zang 2011). In this section, I examine whether nancial experts are able
to detect managers real earnings management to beat the target when managers have
less exibility in adjusting accruals.
Following Roychowdhury (2006) and Zang (2011), I use two proxies to capture
real activities manipulation: RMPROD and RMDISX. See Appendix 1 for variable measures. Since prior studies suggest that NOAs (i.e. the smaller the prior period NOA, the
greater the exibility for accruals management) and/or the length of operating cycles
(i.e. the longer the operating cycles, the greater the exibility for accruals management)

422

P.H. Hsu

restricts managers ability to use accruals, I focus on rms that have beginning NOAs
above the median of the corresponding industry-year-quarter NOAs or/and rms with
beginning length of operating cycle below the median of the corresponding industryyear-quarter operating cycle (Barton and Simko 2002; Zang 2011). I then re-estimate
Table 3 using RMPROD or/ RMDISX to substitute for discretionary accruals.
The results from using real earnings management as an alternative way to beat the target are similar to my main ndings. Untabulated results show a negative impact of nancial experts on the odds of using overproduction or/ cutting discretionary expenditures to
beat the target by when future performance is poor. In addition, I also nd that impact of
independent nancial experts on the odds of beating the targets by decreasing cost of
goods sold (inventory overproduction) is greater when future performance is poor.
7. Conclusion
Although prior evidence suggests that managers adjust accruals to beat the analyst forecast, the implication of accruals adjustment on earnings quality is not clear. When managers have negative information regarding future earnings performance, accruals
adjustment mislead shareholders and result in lower quality of nancial reporting. However, accruals signal strong future earnings growth and thereby improve the decision
usefulness of earnings. In this study, I examine whether the monitoring imposed by
nancial experts on the audit committee affect managers accruals adjustment to beat
analyst forecasts conditional upon future performance.
I argue that audit committee nancial experts who have sufcient nancial knowledge are better able to assess and understand managers private information and are
more capable of overseeing the nancial reporting process. Thus, when future performance is poor, they would intervene in accruals adjustment to beat the target when
future performance is poor. Consistent with my predictions, I nd that the presence of
at least one independent nancial expert on the audit committee is negatively related to
the use of accruals to beat analyst forecasts when the rm has next quarters earnings
below analyst forecasts. In addition, the negative effect of nancial experts on the odds
of beating the target by adjusting accruals is greater for rms with negative earnings
surprises than for rms with positive earnings surprises in quarter t + 1.
I also examine the impact of accounting experts on the quality of accruals and nd
that the presence of both accounting and nonaccounting expertise on the audit committee is associated with higher quality of accruals. This evidence is consistent with prior
studies and suggests that the SECs wide-ranging denition of nancial expertise may
not be a compromise to allay public criticism, but rather reects the need for broader
expertise on the board.
Notes
1.
2.
3.

Hereafter, I use beat the consensus analyst forecast to refer to just meet or beat the analyst forecast target.
Firms can also guide analyst forecasts downward to avoid missing targets (Matsumoto
2002). Expectation management is excluded from my analysis because it is a reporting strategy and does not affect earnings quality.
Following SEC, a nancial expert director has an understanding of generally accepted
accounting principles (GAAP); has the experience in preparing, auditing, analyzing, or evaluating nancial statements; and has the ability to access the accounting principle or has an
understanding of internal controls and procedures for nancial reporting (SEC 2003).

Asia-Pacic Journal of Accounting & Economics

423

4.

Although managers also have incentive to lower earnings in order to miss the target, the
evidence is rare. The only explanation is that CEOs consider their stock options to more
likely miss targets. Missing targets can reward a CEO with option grants that are pegged to
a lower stock price (McAnally, Srivastava, and Weaver 2008).
5. Rather than being completely aligned with the interests of shareholders, boards interests
can be aligned with managers interests (i.e. the board consists of individuals assumed to be
beholden to the CEO). I address this concern by examining independent nancial experts in
my empirical tests. Independent directors who are concerned about their reputation are less
likely to align with managers (Byrd and Hickman 1992).
6. An audit committee nancial expert is a person who has an understanding of GAAP; experience in preparing, auditing, analyzing, or evaluating nancial statements; and the ability to
understand the accounting principle or to understand internal controls and procedures for
nancial reporting (SEC 2003). Find more information in SOX Section 407.
7. The focus on the independence of nancial experts is based on several reasons. First, prior
studies generally suggest that the interests of independent directors are more likely to be
aligned with shareholders due to concerns about their reputation (Byrd and Hickman 1992).
In addition, Section 301 of the SOX Act mandates the SEC to direct the national securities
exchange to require the listing company to have all independent audit committee members.
Even though not all reporting companies are listed on a national securities exchange or
association, Section 407 of the SOX Act explicitly requires a company to disclose whether
the nancial expert is independent of management because the SEC believes that investors
in these companies would be interested in knowing whether the audit committee nancial
expert is independent of management.
8. A nancial expert is classied as an accounting expert if the director has experience as a
public accountant, auditor, principal or chief nancial ofcer, controller, or principal or chief
accounting ofcer (Defond, Hann, and Hu 2005). Because RiskMetrics does not provide
information regarding nancial experts prole, the sample period for this test is restricted
from 2004 to 2008, the period covered by Corporate Library. This subsample consists of
1106 rm-quarter observations.
9. Prior research shows that the distributions of earnings surprises contain an unusually high
frequency of small positive surprises and an unusually low frequency of small negative surprises (Degeorge, Patel, and Zeckhauser 1999), implying that managers boost earnings
upward from just-miss-target to just-beat-target. Other studies also show that managers use
various accounting choices to achieve small positive earnings surprises (Burgstahler and
Eames 2006). Following these prior studies, Davis, Soo, and Trompeter (2009) directly
focus on rms with unmanaged earnings that just miss the forecast by less than one cent
and argue that such stricter metric is more likely to capture accruals management.
10. Prior studies also suggest that the length of operating cycle restricts managers exibility in
adjusting accruals (Zang 2011). I matched control observations with treatment observations
based on year, prior-quarter length of operating cycle, and industry. The results are consistent with the results when using NOA as matched factor.

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Accrual-Based Earnings Management. The Accounting Review 87 (2): 675703.
Zhang, Yan, Jian Zhou, and Nan Zhou. 2007. Audit Committee Quality, Auditor Independence,
and Internal Control Weaknesses. Journal of Accounting and Public Policy 26 (3): 300327.

Log (1 + Number of directors on the board)

Log (1 + Number of independent directors on the board)
Log (1 + Number of audit committee members)
Log (1 + Number of independent audit committee members)
Dummy variable equals one if there is at least one independent nancial expert on the audit committee, and zero otherwise
Dummy variable equals one if there is at least one independent accounting expert on the audit committee, and zero otherwise
Dummy variable equals one if there is at least one independent nonaccounting expert on the audit committee. and zero otherwise
Number of independent nonnancial director on the board, which is measured as log value of (1 + Number of independent
directors on the board Number of independent nancial expert on the audit committee)
Percentage of independent nonnancial director on the board, which is measured as number of independent non nancial
directors on the board divided by number of independent directors on the board

Actual earnings per shares from I/B/E/S

Total accruals for rm i year t quarter q, which is measured as income before extraordinary items (IBCY) minus cash
ow from continuing operations (XIDOCY + OANCFY), scaled by total assets (ATQ) for rm i year t quarter q 1
Forecast error adjusted for discretionary accrual for rm i year t quarter q, which is dened as the difference
between nondiscretionary EPS (Dene below) and median consensus analyst forecasts from I/B/E/S
Discretionary accrual for rm i year t quarter q. The estimation exactly followed Modied Jones Model
Forecast error for rm i year t quarter q, which is dened as the difference between actual EPS and median consensus analyst
forecast from I/B/E/S
Nondiscretionary earnings per share for rm i year t quarter q, which is measured as actual EPS before recognizing discretionary
accruals
Median value of consensus analyst forecast from I/B/E/S

Measures

Real earnings management

RMPROD
Abnormal level of production costs for rm i year t quarter q. The estimation of is RMPROD exactly followed
(Roychowdhury 2006; Zang 2011)
RMDISX
Abnormal level of discretionary expenditures for rm i year t quarter q. The estimation of RMDISX is exactly followed
(Roychowdhury 2006; Zang 2011)

% INDEP NON-FEDIR

Board measurements
BOARD_SIZE
BOARD_IND
AC_SIZE
AC_IND
FEDIR1
ACCDIR1
NonACC_FEDIR1
# INDEP NON-FEDIR

MEDEST

NDEPS

DAC
FE

AdjFE

Accruals measurements
ACTUAL
ACCR

Variables

Appendix 1. Variable measures

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P.H. Hsu

SEGMENT
SIZE
SHARES

R&D

OPERATING CYCLE

NUM ESTIMATE

NOA

EARN

DOWN_REV

LEVERAGE

COMPANY_AGE
CV_AF

Other variables
CEO_TENURE
CFO

Log (Number of years that current CEO serves in company) for rm i year t quarter q
Cash ows from continuing operations for rm i year t quarter q, measured as extraordinary items and discontinued
operations (Statement of Cash Flows) plus operating activities (XIDOCY + OANCFY), scaled by total assets (ATQ)
for quarter t 1
Log (Number of years company has been in business) for rm i year t quarter q
Coefcient on variation of the consensus forecast used to calculate earnings surprise for rm i year t quarter q, which is dened
as standard deviation scaled by the mean
Dummy variable equals one if long-term debt (DLTTQ) for rm i year t quarter q, scaled by total assets (ATQ) for quarter t 1,
is greater than the median value pooled over the sample period, and zero otherwise
Analyst downward revision for rm i year t quarter q, which equals one if at least one of the rms analysts revised his or her
forecast downward in the three months prior to the earnings announcement for quarter t, and zero otherwise
Earnings for rm i year t quarter q, which is measured as income before extraordinary Items (IBCY), scaled by total assets
(ATQ) for quarter t 1
Net operating assets for rm i year t, which is measured as shareholders equity (CEQQ) less cash and marketable securities
(CHEQ) plus total debt (DLCQ + DLTTQ), scaled by sales (SALEQ)
Number of analysts for rm i year t quarter q, which is measured as number of analysts whose forecasts are included in the
consensus forecast used to calculate earnings surprise
The operating cycle for rm i year t quarter q, which is computed as the days receivable plus the days inventory less the
days payable
Dummy variable equals one when the R&D expenditure (XRDQ) for rm i year t quarter q is less than industry median
for a given year, and zero otherwise
Log (Number of business segment and geographic segments) for rm i year t quarter q
Size of the rm for rm i year t quarter q, which is measured as natural logarithm of market value (PRCCQ*CSHOQ)
Number of common shares (CSHOQ) outstanding for rm i year t quarter q

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