13
Submitted: July 2002
Accepted: November 2003
AUDITING: A JOURNAL OF PRACTICE & THEORY
Vol. 23, No. 2
September 2004
pp. 13–35
The Effect of Audit Committee Expertise,
Independence, and Activity on
Aggressive Earnings Management
Jean Bédard, Sonda Marrakchi Chtourou, and Lucie Courteau
SUMMARY: This study investigates whether the expertise, independence, and activities
of a firm’s audit committee have an effect on the quality of its publicly released financial
information. In particular, we examine the relationship between audit committee charac-
teristics and the extent of corporate earnings management as measured by the level of
income-increasing and income-decreasing abnormal accruals. Using two groups of U.S.
firms, one with relatively high and one with relatively low levels of abnormal accruals in
the year 1996, we find a significant association between earnings management and
audit committee governance practices.
We find that aggressive earnings management is negatively associated with the
financial and governance expertise of audit committee members, with indicators of
independence, and with the presence of a clear mandate defining the responsibilities of
the committee. The association is similar for both income-increasing and income-de-
creasing earnings management, suggesting that audit committee members are con-
cerned with both types of earnings management and do not exhibit an asymmetric loss
function similar to that of auditors.
Keywords: audit committee; financial expertise; earnings management; abnormal
accruals.
Data Availability: The data used is from public sources identified in the manuscript.
INTRODUCTION
C

We investigate the relation between, on the one hand, the audit committee’s expertise (financial,
governance, and firm-specific expertise), independence, and activities and, on the other hand, ag-
gressive earnings management on a sample of 300 U.S. firms. The sample is composed of three
groups, one with aggressive income-increasing earnings management, one with aggressive income-
decreasing earnings management, and a third group of firms with low levels of earnings management
in the year 1996. Earnings management is measured as abnormal accruals estimated with a cross-
sectional version of the Jones (1991) model.
Controlling for specific motivations that firms may have to manage earnings, and for alternative
control mechanisms, as well as for variables that have been found to affect the reliability of abnormal
accruals measurement, we test whether recommended governance practices for audit committees are
associated with a lower likelihood that the firm be in one of the groups with high levels of earnings
management. A 1996 sample has the advantage of allowing us to examine firms that voluntarily
adopted the best governance practices before some of them were mandated by stock exchanges in
December 1999. Thus, we can test the effectiveness of these practices on a cross-section of firms
during the same period and increase the power of our tests by limiting the symbolic display of
conformity associated with mandatory rules (Kalbers and Fogarty 1998).
Our results suggest that an audit committee whose members have more expertise is more
effective in constraining earning management. Specifically, we find that the presence of at least one
member with financial expertise, which is now required by SOX, is associated with a lower likeli-
hood of aggressive earnings management, and so is the level of governance expertise in the commit-
tee. The association between the level of firm-specific expertise and the probability of earnings
management, however, is significant only for income-decreasing accruals.
Regarding independence, our results generally support the SOX requirement that all members of
the audit committee be independent. Contrary to Klein (2002) whose findings suggest that the
critical threshold for the number of independent directors on the audit committee is 50 percent rather
than 100 percent, we find no significant effect for a committee composed of 50-99 percent indepen-
dent members, but a significant reduction in the likelihood of aggressive earnings management when
100 percent of the members are independent. We also find that the percentage of stock options that
can be exercised in the short term by independent audit committee members is associated with a
higher likelihood of aggressive earnings management. This result provides some support for the

require adjustments to positive than negative accruals. Our results contradict both as we find almost
no significant difference in the association of committee characteristics with the two types of earn-
ings management. Third, our sample includes firms of various sizes. While Klein (2002) studies a
sample of firms from the S&P 500 for 1992 and 1993 (an average of 346 firms per year), our sample
includes 300 firms of different sizes for 1996. Our sample firms’ median assets are $51 million
whereas Klein’s (2002) smallest firm has assets of $179 million. Since the audit committee require-
ments apply to firms of all sizes, our sample allows us to test the effect of these requirements on
smaller firms, which have also been found to be more prone to earnings management.
Overall, our results lend support to the assumptions underlying the SOX requirements that both
expertise and independence are important characteristics for an audit committee to effectively moni-
tor the financial reporting and audit processes. They can be used by other regulators that are
contemplating similar rules. For example, in Canada the proposed rules on audit committees require
that all members of the committee be independent, but does not require financial expertise (Ontario
Securities Commission [OSC] 2003).
The remainder of the paper is organized as follow. The next section provides the motivation for
the predicted association between audit committee characteristics and earnings management. The
third section discusses sample selection and research design. Results are presented in the fourth
section and conclusions in the last section.
THE ROLE OF THE AUDIT COMMITTEE IN MITIGATING
EARNINGS MANAGEMENT
Earnings Management
Earnings management generally implies a “purposeful intervention in the external financial
reporting process, with the intent of obtaining some private gain” (Schipper 1989, 92). Although
management may intervene in the process to signal private information and make the financial
16 Bédard, Chtourou, and Courteau
Auditing: A Journal of Practice & Theory, September 2004
reports more informative for users, we concentrate on the negative aspect of earnings management,
i.e., “to mislead stakeholders (or some class of stakeholders) about the underlying economic perfor-
mance of the firm” (Healy and Wahlen 1999, 368).
The audit committee’s primary role is to help ensure “high quality financial reporting”

increasing accruals are more likely to result in auditor reporting conservatism. This greater attention
to income-increasing earnings management may be associated with professionally mandated skepti-
cism (Braun 2001) and auditors’ perception that litigation is more likely to occur when income is
overstated (Myers et al. 2003). In their study of auditor tenure, however, Myers et al. (2003) find that
if an auditor remains longer with a firm, then he or she is more likely to restrict management from
making extreme reporting decisions, both income-increasing and income-decreasing.
As in the case of auditors, it is possible that the audit committee restrains income-increasing to a
greater extent than income-decreasing earnings management because the members have an asym-
metric loss function: the likelihood of attracting media attention or being sued could be higher in
cases of income-increasing earnings management.
H4: The effect of audit committee characteristics is larger for income-increasing than
for income-decreasing earnings management.
The Effect of Audit Committee Expertise, Independence, and Activity on Earnings Management 17
Auditing: A Journal of Practice & Theory, September 2004
Audit Committee Expertise
In order to fulfill their responsibilities for monitoring internal control and financial reporting,
audit committee members should possess the necessary expertise. We examine three aspects of their
expertise: financial, governance, and firm-specific expertise.
First, based on the requirement by Section 407 of SOX, we investigate the effect of the presence
of at least one member with financial expertise. There is some empirical evidence that this require-
ment is effective for extreme events such as SEC violations and earnings restatement (e.g., McMullen
and Raghunandan 1996). While there is some experimental evidence that financial expertise is
associated with a higher likelihood that the committee support the auditor in an auditor-corporate
management dispute (DeZoort and Salterio 2001), greater focus on concerns that are critical for the
quality of financial reporting, and more structured discussion on reporting quality (McDaniels et al.
2002), to our knowledge there is no empirical evidence on the effectiveness of this requirement in
preventing less spectacular cases of earnings management.
Several authors suggest that the managerial labor market for outside directorships provides an
incentive to monitor effectively by rewarding effective outside directors with additional positions as
directors and disciplining those who have a record of poor monitoring performance (Fama and

Stock option schemes may compromise committee members’ independence. While executive
stock options are designed to align the manager’s interests with those of the shareholders, they
18 Bédard, Chtourou, and Courteau
Auditing: A Journal of Practice & Theory, September 2004
sometimes have the opposite effect. For example, Safdar (2003) finds that executives manage
discretionary accruals prior to exercising substantial portions of their outstanding stock options.
Even if no research has examined the effect of stock options in the specific case of outside directors,
the U.K. Combined Code on Corporate Governance (FRC 2003) states that their remuneration
should not include stock options. We believe that such a practice is even more important for audit
committee members because it is their duty to monitor the quality of the financial reports. Hence, we
expect that outside directors with options that can be exercised currently or in the short run are less
effective in curtailing income-increasing earnings management, especially if the options are in-the-
money or at-the-money (i.e., the current stock price is higher than or equal to the exercise price of the
options). However, even if they can be exercised in the short term, Huddart and Lang (1996) show
that options are not necessarily exercised soon after their vesting date. If that is the case or if the
options are out-of-the-money, then it may be in the interest of committee members to allow income-
decreasing accruals in order to accumulate reserves to be used in subsequent years, when an increase
in earnings would enhance the value of the options.
Audit Committee Activity
Expertise and independence will not result in effectiveness unless the committee is active. We
examine three aspects of its level of activity: the duties it has to perform, the frequency of its
meetings, and its size. The duties of an audit committee can be classified into three categories
(Verschoor 1993; Wolnizer 1995): oversight of the financial statements, of the external audit, and of
the internal control system (including internal auditing). We focus on the first two because they are
the most relevant for income management. SOX (U.S. House of Representatives 2002, Section 2)
states that the purpose of an audit committee is to oversee the accounting and financial reporting
processes of the company as well as the audit of its financial statements. Furthermore, the BRC
(1999) recommends that the responsibilities should be memorialized in a formal charter approved by
the board of directors. A formal charter not only provides guidance to members as to their duties, but
it is also a source of power for the audit committee. Kalbers and Fogarty (1993) find that a formal

the highest income-decreasing abnormal accruals, and the 100 with the lowest abnormal accruals.
We categorize the first two groups as using “aggressive earnings management” (AEM) and the third
group as having “low earnings management” (LEM). Several studies indicate that all existing models
measure abnormal accruals with error (for example, Dechow et al. 1995). By including only firms
with high and low abnormal accruals in the sample, we seek to improve the power of our tests by
mitigating the measurement error problem.
1
Abnormal Accruals Estimation
Our sample is based on the complete set of firms on Compustat with a December 31, 1996 year-
end and complete accruals data for 1996. We exclude firms from the regulated (SIC 4000 to 4900),
financial (SIC 6000 to 6900), and government (SIC 9900) sectors because their special accounting
practices make the estimation of their abnormal accruals difficult. The abnormal component of total
accruals is estimated with the modified Jones (1991) cross-sectional model (DeFond and Jiambalvo
1994; Francis et al. 1999; Becker et al. 1998). This requires the estimation of a cross-sectional
regression for each industry (two-digit SIC codes), so we eliminate industries with less than ten
firms. These requirements leave 3,947 observations for the calculation of abnormal accruals.
Abnormal accruals (AbnAccruals) for each firm i in industry j are defined as the residual from
the regression of total accruals (the difference between cash from operations and net income) on two
factors that explain nondiscretionary accruals, the change in revenue and the level of fixed assets
subject to depreciation. All variables are deflated by total opening assets to reduce heteroscedasticity.
AbnAccruals
ijt =
TA C
ijt
/A
ijt–1
–[α
j
(1/A
ijt

(Compustat item 12);
PPE
ijt
= gross property, plant, and equipment for firm i from industry j in year t (Compustat
item 8);
α
j
,

β
1j
,
β
2
= industry-specific estimated coefficients from the following cross-sectional re-
gression:
TAC
ijt
/A
ijt–1
= α
j
(1/A
ijt–1
) + β
1j
(∆RE
ijt
/A
ijt–1

population we use to estimate the abnormal accruals includes smaller firms (with median asset of
$82 million whereas Klein’s smallest firm has assets of $179 million), with lower profitability
(Klein’s average [median] earnings deflated by opening assets are 0.056 [0.048]) and generating
lower levels of cash flows from operations for each dollar of opening assets (Klein’s sample firms
have average [median] of 0.117 [0.107]).
While we take precautions (e.g., dropping outliers and firms with extreme earnings and cash
flows) to avoid known bias in the estimation of abnormal accruals, the possibility of measurement
error is always an issue in studies using the modified Jones model to measure discretionary accruals
in tests of earnings management. As noted by Klein (2002) any proxy for abnormal accruals yields
biased metrics if the measurement error in the proxy is correlated with omitted variables. Prior
studies suggest that the measurement error is correlated with current earnings, previous year’s
earnings, changes in earnings, current cash flows from operations, changes in cash flows, changes in
total accruals, firm size, and previous year’s return on assets (Kasznik 1999; Jeter and Shivakumar
1999; Klein 2002; Kothari et al. forthcoming).
Panel B of Table 1 reports the Spearman correlations of total and abnormal accruals with these
variables. The first two columns show that all variables are significantly correlated with the absolute
values of total and abnormal accruals, suggesting that the measure might be biased. We control for
this by including some of the possible omitted variables as control variables in the regression models
used to test the effect of the audit committee on the measure of abnormal accruals. Because we focus
on extremes (top and bottom deciles) in our analysis of the effect of audit committee characteristics,
our estimates of abnormal accruals are particularly vulnerable to the bias caused by cash flows and
earnings. For example, Jeter and Shivakumar (1999) show that the cross-sectional Jones model
yields systematically positive (negative) estimates of abnormal accruals for firms whose cash flows
are below (above) the industry median. Panel C shows that the possible correlated variables are
correlated to each other, suggesting that they capture much of the same processes. Consequently,
earnings and cash flows are included as control variables in the regression model used to test the
effect of audit committees on the measure of abnormal accruals, along with total assets and previous
year’s ROA. Because the top (bottom) decile of the abnormal accruals distribution is more likely to
contain firms with negative cash flows (earnings), we also include two indicator variables in the
regression models: one for the presence of negative cash flows and one for negative earnings.

CashFlows –0.029 0.337 0.062 –2.363 0.525 66
Total Assets (in millions) 1,504 9,407 82 0 272,402 100
Panel B: Spearman Correlations of Total and Abnormal Accruals with Possible Correlated Variables
Variable |Total Accruals||Abnormal Accruals|
|Earnings| 0.36 (<0.01) 0.29 (<0.01)
|Earnings
t–1
| 0.16 (<0.01) 0.16 (<0.01)
∆Earnings| 0.31 (<0.01) 0.28 (<0.01)
|CashFlows| 0.34 (<0.01) 0.07 (<0.01)
∆CashFlows| 0.28 (<0.01) 0.24 (<0.01)
∆Total Accruals| 0.39 (<0.01) 0.37 (<0.01)
Ln(Assets) –0.29 (<0.01) –0.32 (<0.01)
ROA –0.23 (<0.01) –0.16 (<0.01)
Panel C: Spearman Correlations Among Possible Correlated Variables
Variable |Earnings
t–1
||
∆∆
∆∆
∆Earnings||CashFlows||
∆∆
∆∆
∆CashFlows||
∆∆
∆∆
∆Total Accruals|
|Earnings| 0.564 0.420 0.523 0.304 0.308
|Earnings
t–1

population, except for the service industry which is overrepresented in the sample. The other statis-
tics show that the sample is different from the population. The sample firms are smaller and their
mean growth is lower but their median growth is larger suggesting that some of the firms in the
population have large growth rates.
4
The mean loss is larger for the sample, but the median earnings
are the same. Both the mean and median cash flows are lower in the sample than in the population.
Audit Committee Variables
All the audit committee characteristics are hand-collected from proxy statements for 1996. For
each committee member, we determine whether he or she holds a professional certification in
accounting (CPA) or financial analysis (CFA) or has experience in finance or accounting. Our
definition of financial expertise is more restrictive than that of the BRC in that it excludes prior
experience as a CEO. We consider that the CEO position provides financial literacy but not exper-
tise. FinExpertise is coded 1 if at least one audit committee member has accounting or financial
expertise, and 0 otherwise. The committee members’ competence is also measured by GovExpertise,
which is the average number of directorships held by nonrelated outside directors in unaffiliated
firms, and by FirmExpertise measured as the average number of years of board service for nonrelated
outside committee members.
Consistent with prior research and the requirements of SOX, we classify directors as executives,
4
Excluding two extreme observations from the population reduces the mean from 1.20 to 0.56.
FIGURE 1
Mean and Median Abnormal Accruals by Decile over the 3,451 Sample Firms
a
a
The population consists of 3,451 firms from Compustat with a December 31, 1996 year-end, complete accruals data
excluding the regulated, financial, and government sectors after the removal of firms with extreme income and cash
flows from operation and outliers. The deciles of the distribution are obtained by ranking the remaining firms on their
Abnormal Accruals. Abnormal Accruals is the abnormal component of total accruals estimated with the Jones cross-
sectional model (see Equation (1)).

We measure the three dimensions of audit committee activity as follows. The presence of a clear
mandate defining the responsibilities of the audit committee is measured with the indicator variable
Mandate, which is coded 1 if the proxy statement indicates that the committee is responsible for the
5
In order to be considered as independent for purposes of SOX, an audit committee member may not accept any
consulting, advisory, or other compensatory fee from the firm or be affiliated to the firm or any of its subsidiaries in any
other way (SOX 2002).
TABLE 2
Descriptive Statistics for the Population and the Sample
Panel A: Industry Composition
Population
b
Sample
c
Variable n % n %
SIC Code
10 Mining 312 9 26 9
20 Construction 722 21 50 17
30 Manufacturing 1269 37 106 35
50 Wholesale and Retail Trade 377 11 28 9
70–80 Services 771 22 90 30
Total 3451 100 300 100
Panel B: Financial Characteristics
Variable
a
Population
b
Sample
c
Mean Median Mean Median

year’s return on assets (ROA). Second, we control for the fact that some of the sample firms may be
in a situation that gives them particular incentives to manage earnings that have nothing to do with
the quality of their corporate governance practices. It has been shown that firms have a tendency to
use income-increasing accruals before an initial public offering (Teoh et al. 1998), so we control for
this with an indicator variable (IPO) that equals 1 if the firm had an IPO in 1996. Third, we control
for two monitoring mechanisms that decrease the need for an efficient audit committee: Big6 is an
indicator variable that captures the effect of a Big 6 auditor on earnings management and BlockHolders
indicates the presence of outside shareholders owning at least 5 percent of the firm’s shares and who
are in a position to monitor the financial reporting process.
Empirical Model
We examine the relation between aggressive earnings management and governance characteris-
tics by estimating the coefficients in the following multinomial logit regression model:
EarnMan = β
0
+ β
1
FinExpertise + β
2
GovExpertise + β
3
FirmExpertise + β
4
50-99%Ind
+ β
5
100%Ind + β
6
StockOptions + β
7
Mandate + β

The first nine independent variables measure audit committee characteristics and they constitute
our test variables, the next eight control for omitted variables in the estimation of abnormal accruals,
and the last three control for specific earnings management situations and other monitoring mechanisms.
RESULTS
Univariate Analysis
Table 3 provides descriptive statistics, by earnings management category, for the financial vari-
ables, audit committee characteristics, and control variables in the sample. The first three columns
present the mean and median of each variable for each of the three subsamples (AEM+, AEM–, LEM),
and the last three present the results of tests of differences among them using t-tests on the means and
Kruskal-Wallis tests on the medians for continuous variables, and Chi-square tests for dichotomous
variables.
6
The BRC does not suggest a minimum number of meetings. Menon and Williams (1994) suggest that an audit committee
needs to hold a minimum of two meetings per year, while the Canadian Institute of Chartered Accountants (1981)
suggests that at least three meetings are required for the committee to perform its duties effectively.





 −+
=
)(Prob
),(Prob
log
LEM
AEMAEM
EarnMan
.
The Effect of Audit Committee Expertise, Independence, and Activity on Earnings Management 25

Abnormal Accruals Mean 0.32 –0.38 0.00 *** *** ***
Median 0.29 –0.29 0.00 *** *** ***
Panel B: Audit Committee Characteristics
AEM+ AEM– AEM+
Variable Name
a
AEM+
b
AEM– LEM versus versus versus
Number of Observations 100 100 100 LEM
c
LEM AEM–
Expertise
FinExpertise Mean 10% 18% 26% ***
GovExpertise Mean 0.98 1.19 1.92 *** ***
Median 0.00 0.58 1.50 *** ***
FirmExpertise Mean 4.50 3.97 6.75 *** ***
Median 3.00 3.33 5.83 *** ***
Independence
50-99%Ind Mean 81% 33% 22% * **
100%Ind Mean 42% 35% 65% *** ***
StockOptions Mean 0.31 0.40 0.28 ***
Median 0.13 0.26 0.17
Activity
Mandate Mean 57% 82% 93% *** ** ***
Meetings Mean 1.47 1.58 2.30 *** ***
Median 1.00 1.00 2.00 *** ***
Members>2 Mean 55% 64% 67% *
(continued on next page)


Median 0.07 0.08 0.19 *** ***
*, **, *** Significant beyond the 10 percent, 5 percent, and 1 percent levels, respectively.
a
All financial variables except Ln(Assets) are scaled by total assets. Earnings, |Earnings|, CashFlows, |CashFlows|,
Total Accruals , Abnormal Accruals, Ln(Assets), and ROA are described in Table 1. GrowthSales is the growth in Net
Sales from 1995 to 1996. The other variables are defined as follow:
FinExpertise = indicator variable coded 1 if at least one member has financial expertise;
GovExpertise = average number of directorships held by nonrelated outside members in unaffiliated firms;
FirmExpertise = average years of board service of nonrelated outside members;
50-99%Ind = indicator variable coded is coded 1 if the committee is composed of more than 50 percent and less
than 100 percent of nonrelated outside directors;
100%Ind = indicator variable coded 1 if the audit committee is composed solely of nonrelated outside directors;
StockOptions = Ratio of stock options that can be exercised in the 60 days following fiscal year end to the sum of
options and stocks held by nonrelated outside committee members;
Mandate = indicator variable coded 1 if the 1996 proxy statement contains a clear mandate stating the
committee’s responsibility for the oversight of both the financial statements and the external audit;
Meetings = number of committee meetings in 1996;
Members>2 = indicator variable with the value of 1 if the audit committee has at least three members;
Loss = indicator variable coded 1 if Earnings is negative;
NegCF = indicator variable coded 1 if Cash Flows is negative;
Debt = long-term debt deflated by lagged total assets;
IPO = indicator variable coded 1 if the firm made an IPO in 1996;
Big6 = indicator variable coded 1 if the auditor is a BIG 6 audit firm; and
BlockHolders = cumulative percentage of outstanding common shares held by block holders holding at least 5 per-
cent of the firm’s shares and who are not affiliated with management.
b
The sample consists of three groups of 100 firms each based on their level of abnormal accruals for the year 1996.
AEM+ is the group with the highest positive (income-increasing) accruals, AEM– is the group with the highest nega-
tive (income-decreasing) accruals, and LEM is the group with the accruals closest to 0.
c

(Panel B of Table 3). Audit committees of LEM firms, on average, have more financial, governance,
and firm-specific expertise than those of AEM firms, a significantly larger percentage of them have
only independent members (100%Ind), and they are more active (Mandate, Meetings). Hypothesis 4
does not seem to be supported, however, since only two variables (Mandate and 50-99%Ind) are
significantly different between the two groups of AEM firms.
Multivariate Analysis
Table 4 presents the results of the multinomial logit regression model used to test the relation
between aggressive earnings management and audit committee characteristics. The column titled
“AEM+, AEM– versus LEM” presents the joint test of the effect of the independent variables for
both groups of aggressive earnings management (AEM+, AEM–) while allowing the coefficients to
be different between the two AEM groups. The column titled “AEM+ versus LEM” presents the
effect of independent variables on the likelihood of aggressive positive earnings management (AEM+),
the column titled “AEM– versus LEM” presents the effect of independent variables on the likelihood
of aggressive negative earnings management, and the last column presents the test of the equality of
these two effects. The model is highly significant with a χ
2
statistic of 437 (p < 0.001) and a pseudo
R
2
of 0.77.
Expertise
For the presence of a member with financial expertise (FinExpertise), the results of the multino-
mial regression in Table 4 support H1. The coefficients for AEM+ and AEM– are negative (–2.817
and –1.361) and significant at the 0.01 and 0.03 levels, respectively. The p-value in the first column
(0.01) indicates that the effect is significant in the joint test of AEM+ and AEM– versus LEM.
28 Bédard, Chtourou, and Courteau
Auditing: A Journal of Practice & Theory, September 2004
TABLE 4
Multinomial Logit Model of Aggressive Earnings Management Categories on Audit Committee
Characteristics

*, **, *** Significant beyond the 10 percent, 5 percent, and 1 percent levels, respectively.
a
Results are from a Multinomial Logit of earnings management categories (AEM+, AEM– , LEM) on audit committee
characteristics and control variables. The model χ
2
statistic is 437 (p < 0.001) and the pseudo R
2
= 0.77.
The sample consists of three groups of 100 firms each based on their level of abnormal accruals for the year 1996.
AEM+ is the group with the highest positive (income-increasing) accruals, AEM– is the group with the highest nega-
tive (income-decreasing) accruals, and LEM is the group with the accruals closest to 0. The independent variables are
defined in Table 3.
b
The column titled “AEM+, AEM– versus LEM” presents the joint test of the effect of the independent variables for
both group of aggressive earnings managements (AEM+, AEM–), the column entitled “AEM+ versus LEM” presents
the effect of independent variables between firms that display aggressive positive earnings management and low earn-
ings, the column titled “AEM– versus LEM,” the effect of independent variables between firms that display aggressive
positive earnings management and low earnings, and the last column presents the test of the equality of the effect audit
committee characteristics between positive and negative earnings management.
c
Test statistics are one-tailed when the expected sign is positive or negative, and two-tailed otherwise.
Hence, financial expertise seems to decrease the likelihood of both positive and negative earnings
management. While the coefficient is lower and less significant for AEM–, as predicted in H4, the
test of difference between the two coefficients is not significant (p = 0.11). Thus, the presence of at
least one audit committee member with financial expertise required by SOX seems to reduce the
likelihood that a firm will use aggressive earnings management.
The Effect of Audit Committee Expertise, Independence, and Activity on Earnings Management 29
Auditing: A Journal of Practice & Theory, September 2004
The average number of other directorships of independent committee members (GovExpertise)
also has a significant effect on earnings management (p = 0.05). The regression coefficients on this

and stocks held by nonrelated outside committee members (StockOptions) increases the probability
that a firm will be in either the AEM+ or the AEM– groups. The coefficients for AEM+ and AEM–
are positive (1.748 and 2.196) and significant at the 0.03 and 0.00 levels, respectively, which
suggests that, as predicted, stock options may reduce directors’ monitoring of earnings management
to increase either current earnings (positive earnings management) or those of future years (negative
earnings management). These results seem to support the U.K. Combined Code’s (FRC 2003)
provision that directors’ remuneration should not include stock options.
These results on the importance of audit committee independence not only support H2 and are
consistent with those of previous studies (Klein 2002; Wright 1996), but they also provide a clearer
picture of the effect of independence on earnings management. It seems that, consistent with the
SOX requirements, a majority of outside members is not sufficient to decrease the likelihood of
aggressive earnings management and that 100 percent is the critical threshold and that participation
of committee members to stock option schemes decreases their monitoring effectiveness by aligning
their interests with those of management rather than those of shareholders.
7
To examine the potential negative effect of long tenure, we replace FirmExpertise with a dichotomous variable that takes
the value of 1 if tenure is longer than 5 years, and 0 otherwise. The results (not shown in a table) still indicate a
significantly negative effect for AEM+ and AEM– (–0.955 and –0.877, p < 0.01) when tenure is larger than five years.
30 Bédard, Chtourou, and Courteau
Auditing: A Journal of Practice & Theory, September 2004
Activity
A clear indication in the proxy statement about the responsibility of the audit committee in the
financial reporting and audit processes (Mandate) constitutes our first measure of committee activ-
ity. The regression coefficients on Mandate are negative and significant both for the AEM+ (–2.352,
p < 0.00) and the AEM– groups (–1.065, p = 0.06) and the effect is significantly larger for AEM+
than for AEM– firms (p = 0.02). The presence of a clear mandate seems to provide the audit
committee with the necessary authority to reduce the probability of aggressive earnings manage-
ment, which is consistent with the BRC’s assertion and with Kalbers and Fogarty’s (1993) survey
findings.
The univariate tests (Table 3, Panel B) indicate that audit committees of LEM firms meet

results indicate that of the five audit committee characteristics that have a significant effect on the
probability of AEM, four have a coefficient that is larger in absolute value for AEM+ than for AEM–
(FinExpertise, GovExpertise, 100%Ind, Mandate) and only the coefficient for StockOptions is smaller.
However, in the last columns of both Table 3 and Table 4, only for Mandate is the difference between
the two groups significant.
8
To examine the possibility that there could be a threshold in the number of meetings for the committee to be efficient, we
replace Meetings with an indicator variable coded 1 if the committee met at least twice in 1996, but the results are similar
to those presented in Table 4.
The Effect of Audit Committee Expertise, Independence, and Activity on Earnings Management 31
Auditing: A Journal of Practice & Theory, September 2004
Overall, these results do not support H4 that the effect of audit committee characteristics is more
important in preventing income-increasing than income-decreasing aggressive earnings manage-
ment. This result may be explained by the fact that for audit committee members the perceived threat
of liability is lower than for auditors or that it is equivalent for both types of earnings management.
Both possibilities would result in a level of monitoring that is similar for positive and negative AEM.
Control Variables
In Table 4, the first eight control variables are included in an effort to ameliorate the measure-
ment errors that may occur in the estimation of abnormal accruals and, consequently, in the classifi-
cation of our sample firms into the low or aggressive earnings management groups.
9
The first column
of the table shows that all these control variables, except Ln(Assets) and GrowthSales have a
significant effect on the classification of firms as AEM or LEM, although not all coefficients are
significant in the multinomial logit regression.
The next variable, IPO, controls for a specific motivation to manage earnings. Consistent with
previous research, it seems that the occurrence of an IPO significantly increases the probability that a
firm will be in one of the AEM groups. What is more surprising is that it is the case for both accruals
groups. One would expect that firms try to increase, not decrease, their earnings before going public.
It is possible that firms considering an IPO start managing earnings at least one year prior to the issue

p-value of 0.07 and FirmExpertise, which becomes more significant with a p-value of 0.06. Moreover, all of the
coefficients that are statistically significant in Table 4 keep the same sign and are of similar magnitude. Thus, most of our
results continue to hold with a smaller sample size (281 firms instead of 300) classified on the basis of adjusted rather
than unadjusted abnormal accruals.
32 Bédard, Chtourou, and Courteau
Auditing: A Journal of Practice & Theory, September 2004
accounting and financial reporting processes as well as the audit of the financial statements. Specifi-
cally, we find that the presence of a financial expert on the audit committee, a committee composed
solely of nonrelated directors, and a clear mandate to oversee the financial reporting processes and
the audit are negatively related with the likelihood of aggressive earnings management. Our results
also indicate a negative association between governance expertise and the likelihood of aggressive
earnings management. Finally, we find support for the Cadbury Committee’s (1992) assertion that
share option schemes for directors reduce their independence in that the percentage of stock options
held by nonrelated outside committee members that can be exercised in the short term is positively
associated with the likelihood of aggressive earnings management. We find no significant associa-
tion between either the size of the committee, the frequency of its meeting, or the firm-specific
expertise of its members with the likelihood of aggressive earnings management. While the effect of
audit committee characteristics is generally larger on income-increasing than on income-decreasing
earnings management, we find the difference to be statistically significant only for the presence of a
clear mandate defining the oversight responsibilities of the committee.
This study is subject to a number of limitations. First, our results demonstrate an association, not
a causal link, between audit committee characteristics and the level of earnings management. Sec-
ond, our measure of earnings management is subject to measurement errors. We have taken precau-
tions to limit the effect of measurement errors in the estimation of abnormal accruals by (1) using a
categorical variable rather than the magnitude of abnormal accruals as the dependent variable, (2)
excluding firms with extreme earnings and cash flows, (3) including in the regression control vari-
ables possibly correlated with omitted variables, and (4) adjusting our estimated abnormal accruals
with a matched-portfolio approach similar to Kasznik’s (1999). Nevertheless, we are unable to
control for all variables potentially correlated with accruals, so there remains a possibility that our
results are caused by a bias in the measurement of abnormal accruals related to some other omitted

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