Corporate Governance, Auditing, and Reporting Distortions

Abstract

Conventional wisdom suggests that hiring independent boards limit earnings manipulations and promote accurate reporting. In contrast, this study indicates that hiring some insiders to the board facilitates the integrity of the reporting process. The central result is that strengthening board independence curtails earnings overstatements, but heightens the likelihood of understatements. This is because, reinforcing board independence limits the CEO's ability to over-report, but also encourages the auditor to economize on effort. The reduced effort impairs the auditor's ability to verify high earnings and, because auditors tend to favor conservative reports when in doubt, leads to increased incidence of conservative under-reporting.

The effect of firm-specific litigation risk on independent director conservatism

“…Such cognitive biases may lead to the overestimate of out-of-pocket liability and, thus, magnify independent directors' concerns about their liability risk. Ramanan (2014) performs theoretical analysis to assert that high board independence can reduce earnings overstatements but tolerate earnings understatements, implying that independent directors are conservative in reporting earnings. This theoretical inference is consistent with the argument that independent directors are concerned about liability risk arising from aggressive financial reporting.…”

“…Further research indicates that independent directors may be more concerned about earnings overstatements than earnings understatements because of the higher likelihood of lawsuits for overstatement activities (Heninger, 2001). Ramanan (2014) develops a theoretical model to assert that independent directors intend to constrain earnings overstatements but tolerate earnings understatements, suggesting that they are conservative in the oversight of financial reporting so as to mitigate liability risk.…”

The Adverse Effect of Information on Governance and Leverage

“…Pae and Yoo (2001) analyze the interaction of internal audit systems with auditor effort as a function of the auditor's liability in the event that its reports prove to be incorrect. Ramanan (2014) shows that improved governance (via a more diligent board) can reduce external auditors' incentives to monitor the audit report. We assume that auditors cannot verify the information that headquarters learns from an information system and headquarters can lie about the outcome of its information system.…”

Determinantes das Republicações no Mercado Brasileiro: Uma Análise a partir dos Incentivos ao Gerenciamento de Resultados

“…Nesse contexto, Ramanan (2014) observa ainda que a auditoria assume importante papel na estrutura de governança das empresas. A Auditoria Interna busca reduzir os riscos relativos aos processos críticos, estruturando, revisando e monitorando o devido cumprimento dos controles internos e políti-cas definidas pelas empresas, buscando mitigar a ocorrência de erros e fraudes.…”