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Board Management: An Analysis of Investor Optimism,

Accounting Expertise of Board of Directors, and Financial

Restatements

Shantaram Hegde

Shantaram.Hegde@business.uconn.edu

School of Business

University of Connecticut

2100 Hillside Road Unit-1041

Storrs, CT 06269, U.S.A.

Phone: +1 (860) 486-5135

Tingyu Zhou

Tingyu.Zhou@concordia.ca

John Molson School of Business

Concordia University

1455 de Maisonneuve Boulevard West

Montreal, Quebec H3G 1M8, Canada

Phone: +1 (514) 848-2424, ext. 2459

November 27, 2017

Abstract

We document that investor optimism about industry-wide business prospects is associated with

a significant decrease in the firm-level appointment of directors with accounting expertise and

an increase in the incidence of accounting irregularities. In addition, a decrease in the

accounting expertise of the board is associated with a higher likelihood of both accounting

irregularities and errors. These findings are robust to alternative measures of investor optimism

and the accounting composition of the board. Our results highlight opportunistic board

management by incumbent management and directors as a novel channel through which

investor optimism influences the accounting composition of corporate boards and fin

restatements. (102 words)

Keywords: investor optimism; accounting expertise; financial reporting; restatements

JEL classification: M41; G30; K30

___________________________ * We appreciate insightful comments from Staurt Gillan, Johan Sulaeman, Jie Zhu, Assaf Eisdorfer,

Efdal Misirli, John Clapp, Joseph Golec, John Glascock and seminar participants at University of

Connecticut and the CFA-JCF-Schulich Conference on Financial Market Misconduct. We are very

grateful to Andrew J. Leone who generously shared the General Accountability Office (GAO) data on

classification of errors and irregularities.

PRELIMINARY – PLEASE DONOT QUOTE OR CITE

mailto:Shantaram.Hegde@business.uconn.edumailto:Tingyu.Zhou@concordia.ca

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Board Management: An Analysis of Investor Optimism, Accounting Expertise of Board

of Directors, and Financial Restatements

Abstract

We document that investor optimism about industry-wide business prospects is associated with

a significant decrease in the firm-level appointment of directors with accounting expertise and

an increase in the incidence of accounting irregularities. In addition, a decrease in the

accounting expertise of the board is associated with a higher likelihood of both accounting

irregularities and errors. These findings are robust to alternative measures of investor optimism

and the accounting composition of the board. Our results highlight opportunistic board

management by incumbent management and directors as a novel channel through which

investor optimism influences the accounting composition of corporate boards and fin

restatements. (102 words)

Keywords: investor optimism; accounting expertise; financial reporting; restatements

JEL classification: M41; G30; K30

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1. Introduction

An important consequence of the separation of ownership and control in corporations is the

conflict of interest between stockholders and managers over who controls the nomination and

election of board of directors. Although outside stockholders have formal control over board

structure under the standard one share – one vote system, the incumbent management has

strong incentives to dominate the board in order to strengthen their power over business

strategy and extract private benefits. The extant literature on corporate governance shows that

in practice investors have little power over director appointment. Instead, the incumbent

management and directors enjoy effective control over the election of corporate boards (Aghion

and Bolton, 1992; Hermalin and Weisbach, 1998; Cai et al. 2009 and 2017; Adams, Hermalin

and Weisbach, 2010). Another strand of literature on behavioral biases indicates that while

investors monitor directors and managers more intensely when they are pessimistic about the

overall business environment, they slacken their oversight over insiders when they feel very

optimistic about business conditions, contributing at times to increased likelihood of corporate

fraud (Shleifer and Vishny, 1997; Povel, Singh, and Winton, 2007; Wang, Winton, and Yu,

2010).

Corporate boards are facing increasing financial reporting complexity, broadly defined as

managers’ willingness and ability to properly (and truthfully) apply generally accepted

accounting principles and communicate the overall financial performance and health of a

company (SEC 2008, p. 18). A stronger accounting profile is likely to endow the board with

comprehensive and deeper knowledge and expertise needed to scrutinize and challenge the

financial reporting choices of the management and improve financial reporting quality. Prior

studies show that the accounting expertise of directors is associated with a lower likelihood of

financial misreporting (see, for example, Krishnan and Visvanathan 2008; Dhaliwal et al., 2010;

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Zhang et al., 2007; Carcello et al., 2009; Badolato et al., 2014).1 In light of the pivotal role

of accounting expertise of directors in determining the effectiveness of their monitoring and

advising roles, we focus on the how investor beliefs influence the accounting profile of the

board.2

It seems reasonable to expect that this environment creates opportunities for the incumbent

management and directors to manipulate the accounting composition of the board. Aware that

investors are monitoring the firm more closely during periods of low optimism, insiders may

strategically refrain from lowering the independence and accounting composition of the board.

However, when stockholders are very optimistic about macroeconomic conditions, they tend

to be less concerned with board performance in advising and monitoring of the management

over conflicts of interest. Insiders are more likely exploit this window of high investor

optimism to weaken the effectiveness of board monitoring by reducing the appointment of

independent directors with accounting expertise and manipulating financial statements.

Specifically, we investigate two hypotheses regarding the propensity of incumbent managers

and directors to opportunistically manage the accounting composition of corporate boards. The

Board Management Hypothesis posits that the appointment of directors with accounting

expertise decreases as investor optimism about the state of the economy increases. In addition,

the Accounting Misconduct Hypothesis claims that a decrease in the appointment of directors

with accounting expertise and an increase in investor optimism about business prospects are

both related positively to the incidence of accounting misconduct.

1 We use “accounting restatements” and “accounting misstatements” as interchangeable terms. Our sample includes some accounting-related fraudulent cases from SEC Accounting and Auditing Enforcement Releases (AAER) and Stanford Law

School’s Securities Class Action Clearinghouse (SCAC). As compared to GAO and AA databases, AAER and SCAC use a

fundamentally different way to identify accounting failures. Since we are interested in comparing intentional and unintentional

misstatements, we focus only on the GAO and AA datasets. We elaborate on our sample construction in Section 3, and thank

Stuart Gillan for his valuable comments on our sample construction.

2 A 2015 survey of U.S. corporations indicates that accounting/financial expertise is one of the top three backgrounds on their list of desired director attributes. About 24% of new board members in the S&P 500 are financial experts, although 54% of

boards report that they want new directors with financial expertise, https://www.spencerstuart.com/research-and-

insight/spencer-stuart-us-board-index-2015.

https://www.spencerstuart.com/research-and-insight/spencer-stuart-us-board-index-2015https://www.spencerstuart.com/research-and-insight/spencer-stuart-us-board-index-2015

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We use annual industry median EPS growth forecasts of analysts(based on the Fama-French

(1987) classification) to proxy for investor optimism, firm-level appointment of directors with

accounting expertise to corporate boards, and financial restatements over 1996-2012 to test

these hypotheses. Our proxies for financial misconduct are intentional accounting

misstatements (irregularities) and unintentional misreporting (errors), which are driven by

different underlying forces (Hennes et al., 2008).3 Our first main finding is that annual

appointment of directors with accounting expertise is negatively related to investor optimism

regarding business prospects as proxied by industry median EPS growth forecast, consistent

with our hypothesis that high optimism allows insiders to opportunistically weaken the

accounting composition of the board. This result is robust to multiple measures of director

accounting expertise (the presence or absence, number and proportion of directors with

accounting expertise among independent directors, audit committee members and all directors)

and industry-level Tobin’s Q as an alternative measure of investor optimism.

In addition, we find a strong positive association between investor optimism and the

likelihood of accounting restatements and a negative relation between director accounting

expertise and accounting misconduct. This result is in line with our argument that more

optimistic beliefs about business conditions lead to a higher likelihood of financial misconduct

by weakening the effectiveness of board oversight.

It is important to note that we treat investor optimism about macroeconomic conditions as

an exogenous variable, not affected by the propensity of firms’ management to engage in

misconduct. This treatment is consistent with the fraud model of Povel et al. (2007) and its

empirical testing in the context of fraud in initial public offerings by Wang et al. (2010). We

further emphasize that we are not examining investor optimism about an individual firm’s

3 Intentional misrepresentations are necessary but not sufficient conditions for classifying misconduct as accounting fraud. That is, an accounting fraud is an irregularity, but an irregularity is not necessarily a fraud. Hence, an analysis of irregularities

allows us to study a broader class of accounting misconduct.

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business prospects, which can be affected by misleading financial reports and earnings

management by the firm. The remaining two key variables – director accounting expertise and

financial misreporting are endogenous variables in our analysis.

It is plausible that accounting experts are less likely to work at firms with high financial

reporting risk, and firms that are more likely to commit accounting irregularities are less

inclined to select directors with accounting expertise. Further, our study of accounting

misconduct is subject to partial observability in that we cannot observe all irregularities and

errors but only those that are eventually disclosed (i.e., we do not have data on undetected

misstatements). These identification concerns indicate that our argument that stronger

monitoring by more accounting experts on the board is associated with lower likelihood of

financial misdeeds is subject to sample selection and endogeneity biases. We conduct a battery

of empirical tests including propensity-score matching, two-stage bivariate probit models and

instrumental variables to address concerns about observable and unobservable heterogeneity.

Results drawn from propensity-score matched samples based on investor optimism,

different types of board monitoring mechanisms and other observable firm attributes and

obtained from tests using binary, categorical and continuous treatments indicate that director

accounting expertise is associated with lower likelihood of both types of misconduct –

accounting irregularities and errors. Further, the likelihood of irregularities is positively related

to investor optimism about industry prospects but this relation rarely exists in errors. Our results

are robust to controls for executive compensation and other types of board monitoring

mechanisms such as board size, board independence, independence of audit committee, and

non-accounting financial expertise of directors.

To address the problem of partial observability of accounting misstatements, we examine a

bivariate probit model and find consistent results. Our results are also robust to two-stage

bivariate probit which uses predicted rather than actual measures of director accounting

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expertise. Moreover, we conduct an instrumental variable (IV) analysis to mitigate endogeneity

concerns by exploiting the role of the local labor market in supplying directors. Specifically,

we use the top metropolitan statistical areas with the largest number of headquarters of firms

and the population of the county where a firm’s headquarter is located as instruments for

director accounting expertise (Knyazeva et al., 2013; Badolato et al., 2014; Nguyen et al., 2015).

Both the instrumental variables are expected to correlate positively with board accounting

expertise but not with financial misreporting. In all these specifications, we control for board

monitoring such as board size, board independence and independence of audit committee.

These results confirm our original findings that monitoring by accounting experts on the board

is correlated with a reduction in the likelihood of both irregularities and errors even after

controlling for the level of investor optimism.

In our S&P 1500 sample, about 29% of our sample firm-years do not have any director

with accounting expertise. Our analysis shows that, all else equal, a one-standard-deviation

increase from the mean investor optimism is associated with a decrease in the likelihood of the

presence of accounting experts among independent directors of 3%. The corresponding figures

for all directors and audit committee members are 3% and 7%, respectively. In turn, the

predicted probability of irregularities (roughly) doubles for firms without any director with

accounting expertise as compared to firms with at least one director with accounting expertise

(holding other variables at their means) and the predicted probability of errors increases by 20%

for firms without director accounting expertise. In addition, although the increase in investor

optimism has a significant (positive but non-linear) impact on the likelihood of accounting

irregularities, the net effect of the positive impact of investor optimism and the negative impact

of board accounting expertise on the incidence of misstatements is statistically insignificant.

These results imply that investors, corporate boards and regulators can counteract the increased

likelihood of accounting restatements due to investor optimism by appointing more directors

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with accounting expertise.

This study makes the following noteworthy contributions First of all, this is the first paper,

to the best of our knowledge, to investigate whether investor optimism about the state of the

economy influences the probability of appointment of directors with accounting expertise to

the board, whether investor optimism increases the incidence of intentional misreporting, and

whether director accounting expertise mitigates the exacerbating effects of investor optimism

on the likelihood of financial misstatements.

The literature on earnings management indicates that firms may opportunistically shift

earnings from good to bad economic conditions, and report more negative discretionary

accruals during uncertain times (Stein and Wang, 2016). De Bondt and Thaler (1985) investors

tend to overreact to unexpected and dramatic news, driving stock valuations away from

fundementals. Benartzi and Thaler (1995) investors dislike losses more than they value gains.

Antoniou, Doukas, and Subrahmanyam (2016) indicate that high investor optimism lowers

investor monitoring intensity because it attracts unsophisticated (noise) investors, while

rational investors with greater monitoring effectiveness are more active in trading during

periods of investor pessimism. We contribute to the behavioral finance literature by showing

that investor overoptimism is associated with lower odds of appointment of directors with

accounting expertise, consistent with the notion that incumbent management and directors

attempt to biased corporate boards to be more ‘insider-friendly’ than ‘shareholder-friendly’.

Povel et al. (2007) predict that the probability of corporate fraud increases with investor

beliefs about the state of the economy because of weakened investor monitoring over

management (also see Shleifer and Vishny (1997), and Ball (2009)). But the incidence of fraud

drops when investors are over-optiomistic as managers are able to obtain unmonitored funding.

Supporting these predictions, Wang et al. (2010) find a hump-shaped relationship between

investor beliefs and firms’ propensity to commit fraud at initial public offerings. We extend this

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line of research and show that high investor optimism is associated with lower odds of

appointment of directors with accounting expertise and the resulting decrease in board

monitoring is related to an increase in the likelihood of accounting misconduct.

Gillan, Hartzell, and Starks (2006) suggest that an independent board can act as a substitute

for an active takeover market. Song and Thakor (2006) predict that the intensity of monitoring

of projects and strategies by corporate boards is greater when directors are pessimistic about

business conditions but weaker when times are good, and CEOs prefer less talented boards

during good times with higher probability of good investment projects. Ferreira, Ferreira, and

Raposo (2011) focus on adverse selection issues (about management quality) and find that

stock price informativeness acts as a substitute for board independence, particularly strong for

firms with better external and internal governance mechanisms. We contribute to this line of

research by highlighting that high investor optimism makes investors indifferent to board

oversight and allows for board management by insiders. Our results suggest that higher odds

of diminished board oversight and increased accounting misconduct during periods of high

investor optimism can lower earnings informativeness.

Cai, Garner, and Walking (2009) and Cai, Nguyen, and Walking (2017) find that

shareholders do not have much influence in the nomination, appointment, or removal of

directors, yet fewer shareholder votes result in lower abnormal CEO compensation and a higher

probability of removing poison pills, classified boards, and CEOs. Gal-Or, Hoitash, and

Hoitash (2016) report that shareholders offer more voting support in elections to directors who

serve on the audit committee of the board and hold them accountable for the quality of financial

reporting. Our analysis highlights opportunistic board management as a new channel through

which investor optimism influences the accounting composition of corporate boards and

financial restatements. It suggests that regulatory requirement on the minimum proportion of

directors with accounting expertise is warranted in order to strengthen board oversight during

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periods of high investor optimism.

We develop in Section 2 our hypotheses about the impact of investor optimism on the

proportion of directors with accounting-specific expertise and the effects of both of these

variables on the likelihood of irregularities and errors. Section 3 describes our sample. Sections

4 discusses our empirical tests and results, and Section 5 concludes the paper.

2. Hypotheses Development

A large body of literature on conflict of interest between stockholders and managers

highlights that incumbent management and directors have strong incentives to dominate board

nomination and election processes to gain the support of directors for their business strategy

and operating activities and dampen potential challenges to their attempts to extract private

benefits. Although in theory shareholders elect directors, there is widespread evidence that in

practice the director nomination and voting processes are biased in favor of insiders. (Aghion

and Bolton, 1992). Hermalin and Weisbach, 1998; Holmstrom and Tirole, 1993; Ferreira et al.,

2011; Adams, Hermalin and Weisbach, (2010) Cai et al. (2009 and 2017). Critics note that

many current board practices contribute to board entrenchment, lack of board refreshment,

inadequate director evaluation, term and age limits, succession planning, inadequate

managerial effort, empire building, private benefits extraction, lax board oversight, and lower

firm value (Manne, 1965; Jensen, 1988, 1993; Bebchuk and Cohen, 2005; Bebchuk, Cohen,

and Ferrell, 2009).

Another strand of studies highlights that investors intensify monitoring over management

when they are less optimistic about macroeconomic conditions but slacken it when they feel

very optimistic. PSW (2007)and WWY (2010) note that the probability of corporate fraud

increases initially with investor optimism but decreases when investors are overoptimistic

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because investors are willing to provide unmonitored funding. De Bondt and Thaler (1985)

point out that investors tend to overreact to unexpected and dramatic news, driving stock

valuations away from fundementals. In Benartzi and Thaler (1995), investors dislike losses

more than they value gains. Song and Thakor (2006) predict that the intensity of monitoring of

projects and strategies by the board of directors is higher when directors are pessimistic about

business conditions but weaker when times are good and CEOs prefer less able boards during

economic upturns when there are many good investment projects to choose from.

Antoniou, Doukas, and Subrahmanyam (2016) focus on the effects of investor optimism

on the relation between systematic risk (beta) and stock returns. They suggest the monitoring

effects of stock prices is lower when investor optimism is high because overoptimism attracts

unsophisticated investors, leading to overvaluation and less informative stock prices. By

contrast, rational investors are more active in trading during periods of investor pessimism,

which increases monitoring effectiveness. IO provides the management with the opportunity

to manage board composition.

Against this backdrop, we focus on how investor optimism influences the accounting

composition of the board of directors. Financial statements have become increasingly complex

over time, and accounting misconduct is very costly to stockholders (Agrawal and Chadha,

2005; Kedia and Philippon, 2009; Bhattacharya, U. and C.D. Marshall, 2012).4 We expect that

less optimistic investors view board accounting expertise as a natural, first-order remedy for

curbing managerial propensity to manipulate financial reports. Similar to venture capitalists

and investment banks in the context of IPOs (WWY, 2010), a board equipped with more

specialized financial expertise, knowledge and experience in accounting and auditing should

face lower monitoring costs, have the courage to scrutinize and challenge the financial

reporting choices of top executives, monitor managers more effectively, prevent and detect

4 In addition, managers and directors face substantial loss of reputation and legal costs if the firm engages in fraudulent behavior (Srinivasan, 2005; Helland, 2006; Fich and Shivdasani, 2007).

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accounting misconduct, and improve financial reporting quality (see Guner et al., 2008; Duchin

et al., 2010; Badolato et al. 2014). Thus, a higher proportion of directors with AE is likely to

strengthen the authority, competence and willingness of the board to confront managers over

questionable accounting practices and enhance the deterrence effect of their monitoring on the

likelihood of irregularities. This argument suggests that incumbent management and directors

have a strong propensity to dampen the accounting composition of the board in order to pursue

private benefits.5

As prior studies show, low investor optimism about business conditions intensifies

investor monitoring through a variety of channels including takeover threats, increased

informativeness of stock prices, activist campaigns for more independent directors, industry

expertise of directors, limits on board tenure, director age limits, more scrutiny of individual

director’s and board performance. Despite the fact that shareholders have limited influence

over director nomination and election, poorly performing firms may face mounting pressure

from activist investors to restructure their operations and are more likely concede a board seat

in order to avoid the distraction of a potential proxy fight.6 Even when proxy fights and

campaigns by activist and institutional investors fail to gain board seats in director elections,

they push the incumbent management to not only take a hard look at their existing strategies

and policies but also refrain from weakening board oversight. Therefore, we anticipate that

intense monitoring and mounting pressure for improved firm performance constrains insider

attempts to weaken the accounting profile of the board of directors during periods of low

investor optimism.

However, when investors are very optimistic, their indifference and lax monitoring allows

5 Studies on corporate governance discuss many other attributes that influence board advising and monitoriing effectiveness, such as, board independence, size, age limit, tenure, CEO-chairman duality, staggered boards, busy boards, and so on (Adams, et al. (2010). Wang, Xie, and Zhu (2016) find that relevant industry expertise improves independent directors’ monitoring effectiveness. 6 For example, faced with a sharp decline in stock price, General Electric Co. bowed to mounting pressure from activist investor Trian Fund Management and agreed to give the fund a seat on its board. http://www.foxbusiness.com/features/2017/10/10/ge-adds-activist-to-board-as-stock-slumps-wsj.html

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insiders a window of opportunity to dampen the appointment of directors with accounting

expertise, turn the board around to be more ‘management-friendly’ and insulate themselves

from market discipline.

These arguments lead us to formulate the following hypothesis regarding the impact of

the exogenous investor optimism on the accounting profile of the board:

Board Management Hypothesis: The appointment of directors with accounting expertise decreases as investor optimism about the state of the economy increases.

xxxxxxxxxxxx

In early 2000, there was significant debate among regulators, investors, and researchers

whether only individuals with direct accounting knowledge should be considered as ‘‘financial

experts.’’ The SEC defined a financial expert as one who has direct accounting knowledge or

experience (SEC, 2002). Its final rule broadened the definition to allow persons with either

accounting (‘‘accounting financial expert’’) or non-accounting financial expertise

(‘‘supervisory financial expert’’) to be designated as a ‘‘financial expert” (SEC, 2003). Recent

literature suggests that the SEC 2003 definition does not capture the essential monitoring power

of accounting expertize as well as its original narrow definition (Carcello et al. 2009; Zhang et

al. 2007; Krishnan and Visvanathan, 2008). Defond et al. (2005) find positive market reaction

to the appointment of accounting financial experts but no reaction to non-accounting financial

experts assigned to audit committees. Krishnan and Visvanathan (2008) find that accounting

conservatism is positively related to accounting financial expertise but not related to non-

accounting financial expertise and nonfinancial expertise. Guided by these studies, we follow

the narrow definition in SEC (2002) and define accounting experts as ‘‘accounting financial

experts.’’

The SOX mandates that a firm must disclose whether at least one member of the audit

committee is a financial expert. If not, the firm has to explain why. Further, the listing stock

exchanges, such as NYSE and NASDAQ, require that at least one member of the audit

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committee have accounting or related financial management expertise and/or experience

(Krishnan and Visvanathan, 2008). These rules suggest that investors may be able to influence

how many additional directors with accounting expertise, over and above the minimum set by

the regulatory and listing provisions, are appointed to the board depending on their optimistic

beliefs.

Prior studies point out that the presence of accounting experts on the board improves a

firm’s financial reporting quality. For example, Agrawal and Chadha (2005) and Carcello et al.

(2011) find that independent audit committees and audit committee financial experts are

generally effective in monitoring the financial reporting and auditing processes, thus lowering

the incidence of restatements. Badolato et al. (2014) find that audit committees with both

financial expertise and high status relative to top management lead to lower levels of earnings

management, as measured by accounting irregularities and abnormal accruals. As optimistic

investor beliefs about macroeconomic prospects dampen the likelihood of appointment of

directors with accounting expertise, we expect the combination of high optimism and lower

accounting expertise to increase the probability of accounting misconduct, leading us to

advance the following hypothesis:

Accounting Misconduct Hypothesis: A decrease in the appointment of directors with accounting expertise and an increase in investor optimism about business prospects are both related positively to the incidence of accounting misconduct.

As highlighted earlier, it is important to note that investor optimism about booms or busts

is an exogenous variable that cannot be affected by an individual firm’s actions (see in the

context of Povel et al. (2007) and WWY (2010)). By contrast, the accounting composition of

the board and financial misreporting are endogenous variables that the management can

influence.

3. Data and Sample Construction

3.1 S&P 1500 and COMPUSTAT-CRSP Merged Samples

Given our focus on the impact of investor optimism about business prospects on accounting

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composition of the board and financial misconduct, we select a sample of financial restatements

from 1996 to 2012 from three different sources: General Accountability Office (GAO, 2002

and 2006), and Audit Analytics (AA).7 The GAO (2002, 2006) database contains accounting

restatements announced between January 1996 and September 2005. We extend this sample by

including additional accounting restatements identified by AA from October 2005 to December

2012.8 Since we only observe accounting mistakes that are committed and then detected, we

need to collect information on both the year of commission (the first misstated period) and the

year of detection (or announcement) for each restatement to address partial observability.

Restatements prior to 1996 are excluded to minimize the confounding effects of the passage of

the Private Securities Litigation Reform Act in 1995 which might affect a firm’s incentives to

engage in fraudulent behavior. Since the median length of the misstated period (from

commission to detection) in our sample is about two years, we exclude cases with commission

dates after 2010 to mitigate data truncation. We follow Hennes et al. (2008) and classify each

case of restatements into either an irregularity or an error.9 Our comprehensive (merged)

restatement sample consists of 868 cases of irregularity and 4,730 cases of errors spanning 15

years.

We hand-collect data on director accounting expertise from proxy statements. As manual

data collection is quite time-consuming, we focus on S&P1500 firms (for which data on board

characteristics are available in RiskMetrics) to gather a reasonable sample on the appointment

7 Earlier studies that use a combined sample of GAO and AA include Badertscher et al. (2011), Ettredge et al. (2012) and Files (2012). 8 We cross-check the overlapping cases in both GAO and AA as the latter (AA) database covers misstatements from January 2000. As one case might be associated with more than one event (restatement), we carefully investigate each case and keep

only the earliest event. 9 The GAO data on the classification of errors versus irregularities are generously provided by Professor Andrew J. Leone (http://sbaleone.bus.miami.edu/). In the AA database, there are two variables which help us distinguish irregularity from errors.

One is “Res_fraud”, which equals 1 if the restatement identified financial fraud, irregularities and misrepresentations. The

other is “Res_sec_investigation”, which equals 1 if the restatement disclosure identified that the SEC, PCAOB or another

regulatory body is investigating the registrant. Including “Res_sec_investigation” is consistent with the procedure to

distinguish irregularities from errors employed by Hennes, Leone and Miller (2008), where the first step is self-disclosure of

irregularity or fraud, the second step is SEC investigation and the third step is non-SEC investigation (Hennes et al. 2008,

p.1494). Badertscher (2011) applies a similar method to identify irregularities in AA.

http://sbaleone.bus.miami.edu/

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and departure of directors with accounting expertise. This choice significantly reduces our

restatement sample to 193 irregularities and 922 errors for which firm-level data on director

accounting expertise are available as of the beginning date (commission) of misstatements. The

existing literature has documented a significant industry effect in the accounting expertise of

directors due to the complexity of accounting practice in some industries (Bills et al., 2013).

We exploit this evidence to relax the data constraint due to firm-level board accounting

expertise, estimate median values of board A accounting expertise for the Fama and French

(1997) 49 industry categories and use them in the bivariate Probit analysis. This yields a

broader restatement sample of 737 irregularities and 3,997 errors with non-missing values of

industry-level accounting expertise.10

Our control sample for testing the relation between director accounting expertise and

likelihood of accounting misstatements includes all firm-years in the COMPUSTAT-CRSP

merged database except firms that are in the restatement sample. Also we delete shell holding

companies and acquisition vehicles (SIC code 99) because the characteristics of these firms

change dramatically after acquisition. The initial control sample includes 96,667 firm-year

observations. After merging it with our measures of firm-level board accounting expertise, the

control sample drops to 20,907 observations. As a large set of control variables in regression

analyses imposes further reduction in sample size, we provide a detailed description on sample

construction in Appendix T.1B.

3.2 Measures of Investor Optimism and Director Accounting Expertise

As emphasized earlier, investor optimism about the state of the economy is an exogenous

variable in our setting. Following Wang et al. (2010), we use median annual earnings per share

(EPS) consensus growth forecasts of analysts for a firm’s industry (Indus. EPS Growth) based

10 Bivariate Probit analyses further reduce the sample size because of additional control variables and the requirement of data availability at both commission and disclosure of misconduct (see Appendix 1B for details on sample construction).

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on Fama-French 49 industry categories as our primary proxy for investor optimism.11 Greater

accounting expertise of the board of directors should lower their own monitoring costs while

strengthening the confidence of investors in the delegated monitors’ capabilities. We define a

member of the board of directors as an accounting expert if the individual is a CPA and/or has

experience as a public accountant, auditor, principal or chief financial officer, controller, or

principal or chief accounting officer. This definition is the same as that of accounting financial

experts in the original SEC proposal in 2002 (SEC 2002). As emphasized earlier, recent

literature concludes that this measure is more effective in capturing monitoring effectiveness

than the revised definition in SEC’s final ruling (SEC 2003).12

To conduct a comprehensive analysis, we use six firm-level measures (three binary and

three continuous) and three industry-level measures (continuous) of accounting expertise of

directors summarized in Appendix T.1A. The six firm-level measures include (a) the presence

and the proportion of accounting experts among independent directors (Firm_AE_IndDir_D

and Firm %AE_IndDir), (b) the presence and the proportion of accounting experts among all

directors on the board (Firm_AE_AllDir_D and Firm %AE_AllDir), (c) the presence and the

proportion of accounting experts on the audit committee (Firm_AE_AuditDir_D and

Firm %AE_AuditDir). Firm_AE_IndDir_D is a dummy variable equal to one if there is at least

one director with accounting expertise among independent directors. Firm%AE_IndDir is the

number of independent directors with accounting expertise divided by the total number of

independent directors. Accounting expertise measures of all directors and audit committee

members are defined in an analogous fashion.

11 To mitigate endogeneity concerns, we exclude firms with misstatements when computing industry median proxies for investor optimism. 12 “Proposed Rule: Disclosure Required by 404, 406 and 407 of the Sarbanes-Oxley Act of 2002. U.S. Securities and Exchange Commission, 2002” (SEC 2002) originally proposed that accounting financial experts are individuals who have knowledge of GAAP that has been obtained through direct experience in accounting and/or auditing positions, which would have only

included individuals with experience as a public accountant, auditor, principal or chief financial officer, controller, or principal

or chief accounting office. In the “Final Rule: Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of

2002. U.S. Securities and Exchange Commission, 2003” (SEC 2003), it relaxed the range and allowed for individuals who

have obtained knowledge of GAAP by supervising or otherwise monitoring the performance of others who are directly engaged

in accounting and/or auditing functions to qualify.

18

By far the most important accounting expertise measure we use is Firm%AE_IndDir as this

measure combines board independence as well as the depth of its accounting expertise, thus

making it a strong instrument of board monitoring. We also construct Firm%AE_AllDir

because boards may not have many independent accounting experts. Since previous studies

focus on the effects of audit committee on accounting misreporting, we include

Firm%AE_AuditDir. In bivariate probit analyses, we construct industry-level accounting

expertise measures by using the industry median %AE of firms in a given year. Similar to firm-

level accounting expertise measures, we construct Indus.%AE_IndDir, Indus.%AE_AllDir and

Indus.%AE_AuditDir.13

4. Empirical Results

4.1. Summary Statistics

Panel A of Table 1 presents the distribution of number of directors with accounting expertise

in our S&P 1500 sample over 1996-2010. Of the total of 22,022 firm-year observations, 6,362

firm-years (29% of total) have no directors with accounting expertise.14 In untabulated results

we find that the mean and median numbers of directors per firm are 9.47 and 9. Of these, the

mean and median numbers of independent directors are 6.51 and 6, and the corresponding data

for the audit committee members are 3.14 and 3. Roughly 46% of independent directors and

55% audit committees in the overall sample have no directors with accounting expertise. The

minimum and maximum number of directors with accounting expertise per board (or firm) are

0 and 7, respectively. The number of directors with accounting expertise per board varies from

1 to 3 for the majority (15,017 out of 22,022) of firm-years. Column (2) indicates that the

number of firms with no director with accounting expertise decreases from 705 in 1996 to 165

13 We construct only Indus. %AE because a dummy variable for the industry-level DAE has no practical meaning. 14 The entries in the “Total” column vary from 1,500 because (1) our sample is based on RiskMetrics, which includes a few additional large-cap companies in earlier years or (2) missing data on DAE. In addition, the gap reflects the additions and

deletions of firms from the index.

19

in 2010, while the next three columns show that the number of firms with 1 to 3 accounting

experts on the board has increased over our sample period, especially after SOX.

In column (1) of Panel B, we find that the average annual industry-level analyst EPS growth

forecast is 11.11%, varying from -24.06% to 16.38%. Column (2) shows our S&P 1500 sample

has 1.2092 accounting experts per firm on average, increasing from 0.6235 in 1996 to 1.7833

in 2010. The grand mean proportion of independent directors with accounting expertise among

all independent directors is 11.49%, which also increases from 5.72% to 20.38%, see the last

column.

Panel C shows the distribution of accounting expertise (# for numbers and % for percentage)

among independent directors, all directors, and directors serving on audit committees, sorted

by the deciles of investor optimism measured by industry median annual EPS growth forecast.

As shown in column (3), the average % and number (#) of independent DAE in the first decile

of investor optimism are 0.1626 and 1.1052, respectively, per firm. They drop to 0.1133 and

0.6548 in the last decile of investor optimism. The t- and z-statistics in the bottom rows show

that the mean decreases in both DAE measures are highly significant across all measures. The

negative correlation between investor optimism and DAE is confirmed by additional tests on

whether the mean and median DAE are lower for firm-years associated with high (above

median) investor beliefs relative to low optimism, see Appendix T.2. This preliminary evidence

offers strong support for our Board Management Hypothesis that investor optimism is

negatively related to the accounting makeup of the board.

Our first objective is to study how investor optimism about the state of the economy

contributes to this variation in the number of accounting experts serving on the board. In the

U.S. nominating committees appointed by the top management and incumbent boards put

together a roster of candidates for director election or reelection. It is typical to hold annual

election for all board members, but some firms have staggered (i.e., classified) boards in which

20

only a fraction of the board members is elected each year. For example, directors may serve

three-year terms, so only a third of the board is up for election each year. Classified boards are

unpopular with many institutional and activist investors, and a large majority of boards have

been declassified over time.15

To probe the time-series and cross-sectional variation in directors with accounting expertise,

we present the distribution of annual turnover among independent directors with accounting

expertise in Table 2. The sample is drawn from S&P 1500 firms over 1996-2010 (with complete

data on all control variables used in regression analysis in Table 4). Panel A shows the annual

change in the number of independent DAE ranges from -2 to +3. We define the annual change

as number of independent DAE in year t minus those in year t-1. For example, “0” in the Annual

Change row means no change in DAE from the past year. Entries within the table show the

number of firms experiencing the reported annual turnover by year. The last row of Panel A

indicates the net annual change in the number of independent DAE is zero for 5,386 out of

6,379 firm-years (84% of observations). Net annual additions of one-to-three directors occur

in 749 firm-years, while 244 firm-years are marked by net decreases of one-to-two directors.

Panel B (Panel C) tabulates the distribution of number of independent directors with accounting

expertise added to (i.e., appointment) and removed from (i.e., departures) corporate boards by

year. In Panel B, annual appointment of one-to three independent DAE occurs in 11% of firm-

years, while in Panel C about 9% of firm-years exhibit annual departure of one-to-three (or

more) independent DAE. Overall, these board renewal through annual elections patterns are

consistent with the widely documented evidence of low turnover among directors, but show

(considerable) entry and exit of DAE in 20% of our sample observations.16

15 Only about 50 of the S&P 500 companies still have staggered boards, one-sixth of the number just 15 years ago, http://www.wsj.com/articles/twitter-takeover-defenses-may-fly-out-the-window-1454463255 (last access: March 7, 2016). 16 Our estimates are in line with the continued low turnover in board seats. For instance, 255 boards included in the S&P 500 index elected 376 new independent directors during the 2015 proxy year (about 7% of total board members), with 91 boards

welcoming more than one director, see https://www.spencerstuart.com/research-and-insight/spencer-stuart-us-board-index-

2015 (last access: March 7, 2016).

http://www.wsj.com/articles/twitter-takeover-defenses-may-fly-out-the-window-1454463255https://www.spencerstuart.com/research-and-insight/spencer-stuart-us-board-index-2015https://www.spencerstuart.com/research-and-insight/spencer-stuart-us-board-index-2015

21

Columns (1) and (2) of Panel A of Table 3 report the annual frequency of accounting

irregularities and errors in the full (COMPUSTAT-CRSP merged) sample, both measured as of

the year of commission. Our sample covers in aggregate 868 accounting irregularities and

4,730 errors. There is a declining trend in the incidence of both irregularities and errors after

2000, but the drop-off appears more pronounced in intentional misstatements.

Turning to the influence of investor optimism about business conditions on managerial misconduct, we

find in the first row of Panel B of Table 3 that our COMPUSTAT-CRSP merged sample has 737 firm-year

observations on irregularities, 3,997 on errors and 96,667 firm-years in the control sample. The mean and

median industry EPS growth forecasts for the irregularities sample are 11% and 14%, respectively (column

(2)), and those for the error sample are 9% and 12% (column (3)). The univariate t statistics (t-stat) for mean

differences and Wilcoxon z statistics (z-stat) for median differences in the last two columns in Appendix T.3

show that accounting irregularities are typically associated with significantly higher levels of investor

optimism as compared to errors. Similarly, estimates in columns (1) and (2) and the related tests in Appendix

T.3 indicate that on average higher investor optimism accompanies irregularities relative to the control firm-

years with no reporting issues. These univariate tests are consistent with our Accounting Misconduct

Hypothesis regarding the positive relation between investor beliefs and accounting restatements. Moreover,

in line with the falsification of this argument, the estimates (and tests in Appendix T.3) reported in the

columns (1) and (3) suggest that the impact of investor optimism on errors (median of 12%) is not

significantly different from that on the control sample (median of 11%).

The remaining comparisons in Panel B indicate that, on average, firms reporting irregularities have

significantly smaller number and proportion of DAE relative to those in the no-restatement and error samples

in both the COMPUSTAT-CRSP merged sample and S&P 1500 sample. Further, firms committing errors

have significantly less DAE relative to the no-restatement sample. For example, in the S&P 1500 sample 36%

of firms in the irregularity sample have independent DAE, compared with 48% in the error sample and 54%

in the no-restatement sample. Mean percentage accounting expertise among independent directors is 8% in

the irregularity sample, compared with 11% in the error sample and 12% in the non-restatement sample.

Tests on the differences in means and medians between the sub-samples reported in Appendix T.3 are

supportive of our Accounting Misconduct Hypothesis that firms with more accounting experts on

22

corporate boards commit fewer accounting misstatements, especially irregularities.

Pairwise correlations between alternative measures of board accounting expertise and

investor optimism are negative and highly significant (see Appendix T.4). Similarly,

correlations between DAE and restatements (both irregularities and errors) are negative and

highly significant and that between investor optimism and irregularities is positive and

significant. All of these correlation estimates are supportive of our two hypotheses.

4.2. Investor Optimism and Board Accounting Expertise

The Board Management Hypothesis predicts that the proportion of directors with

accounting expertise decreases with optimistic investor beliefs. To test this prediction, we

estimate the following probit regressions on the presence of director accounting expertise and

ordinary least squares (OLS) regressions on the proportion of DAE:

Director Accounting Expertise = β0 + β1 Indus. EPS Growth + β2 Board Size + β3 Board

Independence + β4 Audit Committee Independence + β5 G Index + β6 Capital Intensity + β7

Prior ROA + β8 Leverage + β9 Earning Volatility + β10 Sales Growth + β11 Age + β12Log

Assets + β13 SOX + Industry/Firm fixed effect + ε (1)

The dependent variable is one of the six measures of firm-level board accounting expertise

discussed in Section 3.2 (three binary measures in the probit regressions in Models (1), (3) and

(5) and three continuous measures in OLS regressions in Models (2), (4) and (6)). The test

variable is the contemporaneous industry median EPS growth forecast, Indus. EPS Growth, our

proxy for investor optimism. In all models, we lag firm characteristics, control for industry or

firm fixed effect, and cluster standard errors at the firm level.17

Following prior studies, we add a number of regressors, as summarized in Appendix T.1A,

17 Coefficient estimates of Indus. EPS Growth in probit regressions with the firm-fixed effect are still statistically significant (at 5% for Firm AE_IndDir_D, 10% for Firm AE_IndDir_D and 1% for Firm AE_AuditDir_D). However, imposing the firm-

fixed effect in probit regressions reduces the number of observations to 2,319 with 261 firms due to collinearity. Alternatively,

coefficients estimates of Indus. EPS Growth using linear probability models with the firm-fixed effect are statistically similar.

23

to control for corporate governance and firm characteristics. We include Board Size because

larger boards are more likely to include a board member of any type. Previous studies (such as

Defond et al. 2005; Erkens and Booner 2013) document the impact of board independence and

audit committee independence on board structure, including the appointment of accounting

experts on the board. Following Beasley (1996), Klein (2002), and others, we use the

percentage of outside directors on the board and on the audit committee as proxies for Board

Independence and Audit Committee Independence, respectively. G Index, developed by

Gompers, Ishii and Metrick (2003), measures the strength of a firm’s governance system and

is constructed based on a simple counting of 24 corporate governance provisions. It proxies for

a firm’s exposure to the discipline of the market for corporate control (Ferreira et al., 2011).18

Since the data on G Index is not available after 2008, we use the 2008 index data for 2009 as

well 2010 – the last two years in our sample period. A low (high) G Index is associated with a

strong (weak) governance system. Previous literature (see, for example, DeFond, et al., 2005

and Krishnan and Visvanathan, 2008) suggests a negative relation between the appointment of

a financial expert and the G Index.19

Agrawal and Chadha (2005) predict that firms that are more capital intensive are likely to

have a greater need for financial expertise on the board. We measure Capital Intensity as total

assets scaled by number of employees. We include Leverage and Prior ROA because more

leveraged and poorly performing firms are likely to have a greater need for external financing

and boardroom financial expertise. Following Agrawal and Chadha (2005), and Krishnan and

Visvanathan (2008), we include Earnings Volatility, measured as the standard deviation of

earnings per share including extraordinary items for the past five years, Sales Growth,

measured as annual percentage change of sales, firm age (Age) and Log Assets (defined as the

18 Ferreira et al.(2011) find both %institutional ownership and institutional ownership insignificant in their tests on board independence. 19 We find similar results by replacing G Index with BCF Index, developed by Bebchuk et al. (2009).

24

logarithm of book value of total assets). To control for regulatory changes, we include the SOX

dummy (that equals one for misstatements committed in 2002 or after and zero otherwise).

The estimates in Panel A of Table 4 show a significantly negative relation between investor

optimism and all the six director accounting expertise measures. The associated marginal

effects indicate that, all else equal, a one-standard-deviation increase in investor optimism

(Indus. EPS Growth) from the mean is associated with a decrease in the likelihood of the

presence of director accounting expertise (Firm AE_IndDir_D, Firm AE_AllDir_D and Firm

AE_AuditDir_D) of 3%, 3% and 7% (respectively). Further, a one-standard-deviation increase

in Indus. EPS Growth is associated with a 10% decrease in the proportion of audit committee

members with accounting expertise (Firm %AE_AuditDir). These results seem economically

significant, especially in the case of audit committee accounting expertise, and indicate that

investor optimism regarding the state of the economy is one of the major drivers of the

accounting composition of the board. They offer strong support for our Board Management

Hypothesis that higher optimistic beliefs are associated with lower investor monitoring through

the appointment of accounting experts to the board. The coefficient estimates on control

variables indicate that board accounting expertise increases in general with firm size, firm age,

board size, board independence, better corporate governance, poor prior performance and

lower sales growth, although they are not significant in all the models. All proxies for

accounting expertise tend to increase significantly after SOX.

In Figure 1, we plot the median predicted values of the proportion of independent directors

with accounting expertise (based on Model (2) in Panel A of Table 4, shown on the vertical

axis) for the ten deciles of industry EPS growth forecast (horizontal axis). The solid line

connects the 10 predicted median values, and the dashed line is a fitted line. The observed trend

is consistent with our novel prediction that the predicted proportion of independent directors is

declining in investor optimism about business prospects.

25

To explore whether investor optimism affects other mechanisms (attributes) of board

monitoring, we conduct separate regressions (similar to the one in Panel A of Table 4) for each

of the following dependent variables: board independence, audit committee independence and

G Index. In unreported results, we find that the coefficient estimates on our test variable,

Industry median EPS growth (-0.062, -0.043, and 0.745, respectively, with p-values of 0.349,

0.675, and 0.392) are all insignificant. These results indicate that investor optimism has

negligible influence on other widely used board monitoring mechanisms.

Investor optimism decreases dramatically during the periods surrounding the recession in

2001 and the global financial crisis in 2008 in our sample period. On the other hand, director

accounting expertise increases almost monotonically, especially after the passage of SOX in

2002. A potential concern is that our results with respect to the impact of investor optimism on

board accounting expertise are driven by these events. To mitigate this concern, we exclude the

data over 2001-2002 (roughly the period of economic slowdown and recession as identified by

the National Bureau of Economic Research’s Business Cycle Dating Committe) and 2008-

2010 (covering global financial crisis and thereafter). In untabulated results, we find the

negative relation between EPS growth and direct accounting expertise remains intact. For

example, the coefficient estimates of EPS growth based on Model (1) in Panel A of Table 4 is

-0.158 with p-value of 0.036. The coefficient estimates of EPS growth based on Model (2) is -

0.038 with p-value of 0.049. The estimates for the remaining measures of board accounting

expertise are similar to those based on the full sample, suggesting that our results are not driven

only by these two major events.

To address potential concern that the time-series and cross-sectional variations in the

proportion of directors with accounting expertise are driven by the changes in board size

instead of the number of directors per se, we replace %AE with the absolute number of

accounting experts in the three continuous measures and still find negative coefficient estimates

26

of Indus. EPS Growth (except for the number of accounting experts among all directors). In

untabulated results, the coefficient estimates on the number of independent directors (number

of audit committees) with accounting expertise is -0.183 (-0.459) with a p-value of 0.078

(0.005).

The six measures of board accounting expertise used as dependent variables in Panel A are

in levels – either the presence (or absence) of accounting experts or the proportions of

accounting experts. Given the relatively low rate of director transition in our panel data, these

variables are persistent over time. Our first hypothesis posits that investors elect more directors

with accounting expertise to the board when they are less optimistic about macroeconomic

conditions. But investors do not care much about the accounting composition of the board when

they are optimistic. This indifference allows opportunistic managers to reduce the number of

accounting watchdogs on the board. To scrutinize this prediction, we present additional tests in

Panel B that focus on director turnover as dependent variable. We estimate director transition

as the annual change in the number and proportion of directors with accounting expertise

among independent directors, all directors and audit committee members. These six annual

board refreshments capture the election or exit of accounting experts. Five of the six estimates

of coefficients on Indus. EPS Growth are negative and significant at 10% or better. These

robustness tests based on turnover of accounting experts on the board provide more compelling

evidence that high investor optimism is associated with fewer accounting experts on the board.

4.3 Appointment and Departure of Directors with Accounting Expertise

The annual DAE turnover analysis presented in Panel B of Table 4 is based on net changes

(the difference between appointment and departure of DAE). Our arguments underlying the

Board Management Hypothesis indicate that the negative relation between investor optimism

and turnover of DAE is less likely come from the departure of DAE because it is unlikely that

investors as well as insiders would actively remove sitting directors with accounting expertise

27

regardless of high or low investor optimism. Therefore, we expect to find that investor

optimism plays an insignificant role in explaining the departure of DAE. On the other hand,

opportunistic management is more likely to appoint fewer DAE during times of high investor

optimism, but refrain from doing so when investors are pessimistic and more likely to question

board oversight over incumbent management. If is even possible that management would bow

to mounting pressure from activist shareholder campaigns and grant some board seats to avoid

the distraction form proxy fights, especially when poor firm performance coincides with lower

investor optimism about business prospects. These arguments suggest a negative relation

between appointment of DAE and high optimism, but no relation, or even a positive relation,

between appointment of DAE and low investor optimism.

To examine the above arguments, we specify a Poisson model to analyze the likelihood of

appointment and departure of DAE in Table 5. Our dependent variables include the number of

accounting experts added to (removed from) independent directors (in Model (1)), the number

of accounting experts added to (removed from) all directors on the board (in Model (2)), and

the number of accounting experts added to (removed from) audit committee (in Model (3)). In

Panel A, our test variable is high investor optimism that takes value of one if Indus. EPS Growth

forecast exceeds the 67th percentile of forecasts in a given year, and zero otherwise. We add

additional controls based on the existing literature (such as Hermalin and Weisback, 1988;

Farrell and Hersch, 2005). The likelihood of appointment of a DAE to a board should be higher,

the lower the existing representation of DAE. To control for this assertion, we include the lgged

percentage DAE among independent directors (Lagged %AE) as well as the number of

accounting experts on the board in the preceding year who left the board (DAE Departure). A

new addition or departure of a director is more likely when a board vacancy occurs, which is

closely related to CEO turnover or insiders leaving in the preceding year. CEO Turnover equals

one if the firm experiences a CEO turnover in the preceding year. Insider Departure is the

28

number of directors leaving the board in the preceding year.

The results in Panel A of Table 5 confirm our expectation that higher investor optimism is

associated with lower likelihood of appointment of DAEs. All coefficient estimates of High

Indus EPS Growth dummy are negative and significant. The negative effect is most pronounced

among the appointment of audit committee members. Negative and significant coefficients of

Lagged %AE suggest that a firm is more likely to appoint a DAE to the board when the existing

representation of DAE is low.

In sharp contrast, the low investor optimism dummy, which takes a value of one if Indus.

EPS Growth is below the 33rd percentile of forecasts of a given year and zero otherwise, is

positive and significant in all three models, see Panel B. This finding suggests that when

investors are pessimistic about general economic conditions, insiders are more likely to appoint

DAE to the board, consistent with our prediction.

Estimates in Panels C and D indicate that the odds of departure of DAE are unrelated to investor

optimism, which is also consistent with our expectation.20

4.4. Accounting Restatements, Investor Optimism and Board Accounting Expertise -

Propensity Score Matching (PSM)

Now we turn to more detailed tests on our second hypothesis which predict that (a) investor

optimism raises the likelihood of accounting irregularities, and (b) the likelihood of

misstatements (both irregularities and errors) decreases as the proportion of directors with

accounting expertise increases. Our research design centers on estimating variants of the

following basic model:

Prob (Accounting Misstatement = 1) = β0 + β1 Accounting Expertise +β2 Indus. EPS

20 The spline tests (untabulated, for brevity) offer strong support for our revised argument that insiders behave opportunistically by (a) exploiting investor overoptimism to weaken the accounting expertise of the board, and (b) refraining from dampening DAE and independent directors) when investor optimism is at a normal level. However, at lower levels of investor optimism (first and second quintile), the coefficients on Indus EPS Growth forecast are positive but not significant at 5%.

29

Growth + β3 Indus. EPS Growth Squared + β4 ROA + β5 Leverage + β6 External Financial

Need + β7 Insider Ownership + β8 Big N Auditors +β9 M&A Expenditure + β10 CAPX + β11

R&D Expenditure + β12 Log Assets + β13 Analyst Coverage + β14 SOX + ε

(2)

Prob (Accounting Misstatement = 1) represents either the likelihood of committing

irregularities or errors. It equals one for firms committing irregularities or errors firms and zero

for control firms with no restatements. Our test variables are Accounting Expertise and Indus.

EPS Growth, both measured prior to the first misstated year. Similar to Equation (1), we use

three accounting expertise (DAE) measures of independent directors, all directors and audit

committee members. To test potential non-linear relation between investor beliefs and the

likelihood of misstatements documented in Wang et al. (2010), we include Indus. EPS Growth

Squared.

The (ex-ante) control variables are measured prior to the year of commission to minimize

spurious relationship with the outcome variable. We use return on assets (ROA) to measure

accounting performance because previous studies find that manipulating firms have strong

financial performance prior to the misstatements (see Beasley, 1996; Crutchley et al., 2007;

Dechow et al.,2010; Kinney and McDaniel, 1989; Summers and Sweeney, 1998; Erickson et

al. 2006).21 We control for Leverage based on the debt covenant hypothesis (DeFond and

Jiambalvo; 1994, Sweeney, 1994; Dichev and Skinner, 2002).22

High external financing needs affect earnings management as well as the commission of

accounting misstatements (Dechow et al., 1996; Teoh et al., 1998; Wang, 2013; Wang and

Winton, 2014). We follow Dechow et al. (1996) and define Ext. Fin. Need as a dummy variable

21 Beasley (1996) finds that companies reporting repeated losses are more likely to engage in financial fraud. Kinney and McDaniel (1989) find that less profitable companies are more likely to misreport. But Summers and Sweeney (1998) find a

positive association between misstatements and profitability, and Erickson, Hanlon and Maydew (2006) find insignificant or

mixed evidence. 22 However, empirical evidence on the impact of leverage is mixed (DeAngelo et al., 1994; Dechow et al. 1996; DeFond and Jiambalvo, 1991; Dechow et al. 2011).

30

equal to one if the firm’s free cash flow is less than –0.5 and zero otherwise.23 Free cash flow

is defined as cash from operations minus average capital expenditures during the previous three

years and then divided by prior year current assets. Cash from operations equals earnings minus

accruals. Accruals are changes in current assets minus changes in current liabilities minus

changes in cash/cash equivalents plus changes in debt included in current liabilities, and minus

depreciation and amortization expense.

Warfield et al. (1995) find that greater Insider Ownership is associated with greater earnings

informativeness and better accruals quality. However, Goldman and Slezak (2006) and Denis

et al. (2006) suggest that a positive relation between firm performance and insiders’

compensation can induce misreporting. Previous studies (such as Bhattacharya and Marshall,

2012; Agrawal and Cooper, 2014) indicate mixed results. We construct this proxy using the

percentage of shares owned by insiders.24 We control for M&A expenditure. Kinney et al.

(2004) suggest that acquisitions may increase the probability of misstatement because of new

accounting issues and possible business integration problems. In addition, we add capital

expenditure (CAPX), R&D Expenditure, Log Assets, the SOX dummy, and Analyst Coverage

as controls (Wang (2013) and Wang and Winton (2014)). We include a dummy variable for big

4 or big 5 auditors to control for audit firm quality (Big N Auditors).25 In robustness tests

discussed in Section 4.8, we add controls for additional board monitoring mechanisms, such as

board and audit committee independence, governance quality, board size and executive

compensation, which also could affect the incidence of accounting failures.

Since the accounting profile of directors, like many other board attributes and corporate

arrangements, is not randomly assigned (Adams, Hermalin, and Weisbach, 2010), tests of the

monitoring impact of directors with accounting expertise are vulnerable to sample selection

23 While Wang (2013) and Wang and Winton (2014) focus on accounting fraud, we study accounting restatements. 24 We construct Fama-French 49 industry medians for each fiscal year and replace missing observations with industry medians. 25 Since some firms might restate their accounts only once in our sample period, we cannot control for firm fixed effect with accounting misstatement as our binary dependent variable.

31

and endogeneity biases. The propensity score matching methodology models the investors’

choice of directors with accounting expertise as a treatment variable. This matching method

allows us to construct a counterfactual (weighted) control sample with observable firm

characteristics virtually identical to those of the treatment sample except for board accounting

expertise.26 It provides reasonable assurance that our test results on the link between the

likelihood of restatements and board accounting expertise are not attributable to observable

heterogeneity between firms with directors with accounting expertise and those without, but it

does not control for unobserved heterogeneity. To conduct rigorous analyses, we begin with

binary treatment under propensity score matching and supplement it with:, categorical

treatment and continuous treatment (see Appendix T.6). Under binary treatment, firm-years

with at least one director with accounting expertise are included in the treatment sample, while

firms without any director with accounting expertise are assigned to the control sample.27 We

use the predicted probabilities (propensity scores) from the probit regressions in Models (1),

(3) and (5) of Table 4 to match each firm-year observation on a firm with accounting expertise

to that on a firm without accounting expertise such that the absolute value of the difference in

propensity scores between the treated and control groups based on the nearest neighborhood

matching technique with replacement is minimized (Rosenbaum and Rubin, 1983).28

26 Propensity score matching does not allows us to control unobservable characteristics. In later sections we provide a battery of tests using other empirical strategies including bivariate Probit regressions, two-stage bivariate Probit regressions and

instrumental variables to mitigate this concern. 27 As a diagnostic test, we report in Appendix T.5 univariate comparisons of key observable firm characteristics between

those with accounting expertise among independent directors and their matched peers. The covariate balance between the

matched pairs show that most of the differences in observable firm attributes are trivial and are not significantly different

from zero, which suggests that the propensity score matching process has formed a control group of closely-matched firms

with director accounting expertise which are highly similar to firms with director accounting expertise. In particular, the lack

of significance of both the mean and median difference tests shows that the treated (i.e., firms with at least one accounting

expert on the board) and control samples are very similar in other types of board monitoring mechanisms such as board size,

governance mechanisms, board and audit committee independence. This covariate balancing process should strengthen our ability to identify a relation between director accounting expertise, our test variable, on financial misreporting. In

untabulated analyses, we obtain similar results for firms with director accounting expertise among all directors and audit

committee members. 28 We repeat our tests using (1) nearest neighbor 1:1 with replacement, (2) nearest neighbor 1:4 without replacement and (3) a sample including all firms within the region of common support of their propensity scores. Results are quite similar except

that the coefficient estimates are more significant when using nearest neighbor 1:4 and common support due to a larger sample

size. In unreported results, we test average treatment effects of having DAE on board on the outcome of irregularity by using

different matching methods including nearest neighbor 1:1, nearest neighbor 1:4 and Kernel weighting. In all the methods, the

coefficient estimates of DAE are negative and statistically significant with t-statistics greater than 2.

32

Table 6 presents results regarding the impact of investor optimism and board accounting

expertise on the likelihood of irregularities (Panel A) and of errors (Panel B). Models (1), (2)

and (3) are estimated using three firm-level binary measures of director accounting expertise.

For example, in Model (1) of Panel A, there are 2,088 firm-year observations with at least one

independent director with accounting expertise (treatment sample), which are matched with

2,088 firm-year observations with no independent director with accounting expertise (control

sample). In all models the estimated coefficients on board accounting expertise are negative

and significant, suggesting the presence of accounting experts on the board is associated with

a reduction in the likelihood of accounting misreporting. In unreported results, the predicted

probability of irregularities in firms with accounting expertise among independent directors is

1.2% while that of firms without accounting expertise is 2.4%, holding other variables at their

means (based on Model (1)). This is a huge difference (marginal effect) because the predicted

probability of firms without accounting expertise is twice as large as the probability of firms

with DAE.29 For unintentional misstatement (errors), the predicted probability of errors in

firms with director accounting expertise is 8% while that of firms without DAE is 10%, holding

other variables at their means (based on Model (1)). The difference is economically significant,

though not quite as large as that in irregularities. Further, we typically observe a positive

relation between investor optimism and the likelihood of accounting misstatements, both

irregularities and errors. Results on control variables are consistent with prior studies. We find

similar results with categorical and continuous treatments in Appendix T.6.

As accounting failures shake investor trust in capital markets and institutions, they are very

costly not only to the firm but also to the economy at large. Our analyses thus far indicate that

29 We note that board accounting expertise in Table 5 is a binary variable. The marginal effect is calculated as the difference in the predicted probability of firms with director accounting expertise and that of firms without director accounting expertise.

The predicted probability of irregularity for firms with accounting expertise among all directors is 1.7% given that all predictors

are set to their mean values, while that of firms without DAE is 2.7%. The corresponding numbers for DAE among audit

committee members are 1.2% and 2.6%, respectively. Note that, it is difficult to compare the marginal effect of Indus. EPS

Growth with that of DAE because the former is a categorical variable while the latter is a binary variable. See our discussion

on Table 8 for the comparison of the effect on investor belief and that of DAE on the likelihood of accounting misstatements.

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while investor optimism is correlated with a decrease in the proportion of accounting experts

on the board and an increase in the incidence of misstatements, DAE is associated negatively

with the probability of misconduct. Is the weakened monitoring intensity of DAE sufficiently

strong to offset the increased likelihood of irregularities and errors due to investor optimism?

To explore this question, we repeat the tests in Panel A of Table 6 by interacting the three binary

measures of DAE with Indus. EPS Growth. The results presented in Panel C suggest that all

the interaction coefficient estimates are negative and two out of three are significant. All the

three net effects (sum of the negative coefficient estimate of DAE dummy and positive estimate

of Indus. EPS Growth) of DAE and investor beliefs are insignificant (with p-values of 0.932,

0.874, and 0.501). Following Ai and Norton 2003; Norton, Wang, and Ai 2004; Cornelißen and

Sonderhof 2009), we estimate the marginal effects of investor optimism on the likelihood of

irregularity. Our tests indicate these effects are insignificant in the presence of board accounting

expertise, holding other control variables at their means. But the marginal effects of investor

optimism are positive and significant in the absence of DAE. These results imply that investors,

boards and regulators could help counteract the increased likelihood of accounting restatements

due to investor optimism by appointing more directors with accounting expertise.

4.5. Bivariate Probit Model

Investors are unaware of financial misstatements at the time when they are actually

committed, and they typically come to learn about the beginning of misconduct at a later time

when the misstatements are disclosed. Therefore, the occurrence of accounting mistakes is only

partially observable to investors. We use a bivariate probit model to address the partial

observability (incomplete detection) concern. There are two latent (indicator) variables,

whether there is a mistake in accounting statements (M) and whether the misstatement is

disclosed or detected (D). We only observe misstatements that have been committed and

restated, for which both M and D equal one. In addition, the probability of observed

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misstatements is different from the probability of committed misstatements if the

detection/disclosure process is not perfect.

Our bivariate probit model includes (a) an equation of misstatement commission, (P(M=1),

and (b) an equation of misstatement disclosure, P(D=1|M=1). Equation P(M=1) has the same

specification as in Equation (2), with the latent dependent variable equal to one if a firm

committed an accounting misstatement, zero otherwise. The ex-ante explanatory variables are

measured prior to the year of commission. In equation P(D=1|M=1), the dependent variable is

a latent variable equal to one if a firm committed an accounting misstatement and then restated

or got caught, zero otherwise. We include a set of ex-ante disclosure/detection factors

(measured prior to the disclosure of reporting failures) as well as a set of ex-post

disclosure/detection factors (measured as of the year of disclosure) as follows:30

Prob (Disclosure of Accounting Misstatement = 1 | Commission of Accounting

Misstatement = 1) = β0 + β1 Abnormal Restatement Risk +β2 Disastrous Stock Return + β3

Abnormal Volatility + β4 Abnormal Turnover + β5 M&A Expenditure + β6 CAPX + β7 R&D

Expenditure +β8 Log Assets +β9 Analyst Coverage + β10 SOX + ε (3)

Our ex-ante determinants of misstatement disclosure include M&A Expenditure, R&D

Expenditure, CAPX, Analyst Coverage, Log Assets and SOX dummy. 31 For the ex-post

determinants of misstatement disclosure, we add a proxy for restatement risk (defined as the

logarithm of the sum of market value of restated firms in an industry) to control for industry

restatement intensity. Abnormal Restatement Risk is the yearly deviation from the industry

average restatement intensity. Regulators and investors pay more attention to a particular

industry which has more misstatements. Firms that experience large negative returns, high

30 For robustness, we also test our model by constructing ex post disclosure/detection factors as of one year after the first misstated period and find similar results. 31 Wang (2013) suggests that R&D investment, capital expenditure and mergers and acquisitions tend to affect the likelihood of detection. Dyck et al. (2010) suggest that analysts are important external monitors of firms. Accordingly, we include Analyst Coverage as the number of stock analysts that follow an industry. Following Wang et al. (2010) and Wang (2013), we include

firm size and the SOX dummy.

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stock turnover and high return volatility are more likely to be watched by investors and

shareholders. Disastrous Stock Return is an indicator variable equal to one if the firm’s stock

return is in the bottom 10% of all the firm-year return observations in the COMPUSTAT-CRSP

merged database.32 Abnormal Return Volatility is the difference between the yearly standard

deviation of the firm’s returns and its time-series average. Similarly, Abnormal Stock Turnover

is the difference between the monthly share turnover of the firm and its time-series average.

Panel A (irregularities) and Panel B (errors) of Table 7 report bivariate probit regression

results. For both irregularities and errors, coefficient estimates of the three DAE measures are

negative and typically significant at 1%, consistent with our previous results using propensity

score matching. In addition, the probability of committing irregularities is significant and

positively related to the level of investor optimism, but it is significant and negatively related

to the squared optimism term. This hump-shaped relation between investor optimism and the

incidence of irregulariti