Women on audit committees and the relationship between related party transactions and earnings management

• Date: 01 May 2020
• Author: Bakr Al‐Gamrh,Akanksha Jalan,S. G. Badrinath
• Published date: 01 May 2020
• DOI: http://doi.org/10.1002/jsc.2337

RESEARCH ARTICLE

Women on audit committees and the relationship between

related party transactions and earnings management

Akanksha Jalan

1

| S. G. Badrinath

2

| Bakr Al-Gamrh

1

1

Department of finance and accounting,

Rennes School of Business, Rennes, France

2

Centre for Capital Markets and Risk

Management, Indian Institute of Management

Bangalore, Bangalore, India

Correspondence

Bakr Al-Gamrh, Department of finance and

accounting, Rennes School of Business, 2 Rue

Robert d'Arbrissel, 35065 Rennes, France.

Email: bakr.ali@rennes-sb.com

Funding information

NSE-IGIDR Corporate Governance Research

Initiative

Abstract

Our results indicate a negative relationship between related-party transactions (RPT)

and earnings management, but a significantly positive relationship between discre-

tionary accruals and the presence of a woman chairing the audit committee. While

we observe a positive relationship between RPT volume and earnings quality, we fail

to find any relationship between other audit committee characteristics and the latter.

One significant result in the article is the positive relation between promoter pres-

ence on the audit committee and poor earnings quality. This article documents, for

the first time, such a relationship from the perspective of an audit committee, at least

in the Indian context.

1|INTRODUCTION

Related-party transactions (RPT) continue to be rated as the biggest

threat to Indian corporate governance today (OECD, 2014). Under

Indian Accounting Standard–18 on Related-Party Disclosures, parties

are said to be related if “if at any time during the reporting period one

party can control the other party or exercise significant influence over

the other party in making financial and/or operating decisions.”While

RPTs are looked upon with skepticism globally, the unique ownership

structure of Indian firms makes them more vulnerable to abuse. The

presence of family firms mainly characterizes the Indian corporate

sector, often organized in the form of business groups. Pyramidal

structures are employed to create a divergence between voting and

cash flow rights and retain ownership in the hands of the ultimate

owner. The Satyam scandal in India highlighted the severe inadequa-

cies in the regulation of RPTs in India and prompted reform in that

area. While regulators recognize the fact that RPTs could be

employed for several reasons, including genuine business ones, the

difficulty in their identification and the determination of arms-length

values makes them a more significant cause for concern for listed

Indian firms.

The relationship between the use of RPTs and earnings manage-

ment objectives of corporate managers is a well-researched area. In

its most common meaning, earnings management refers to the act of

opportunistically reporting accounting numbers with a view to either

smooth income over time or to achieve specific targets such as meet-

ing analyst expectations, receive import relief, earn performance

bonus. (Healy & Wahlen, 1999). Interestingly, papers have found evi-

dence of “tunneling”in Indian business groups, which is also consis-

tent with the use of RPTs to achieve earnings management (Bertrand,

Mehta, & Mullainathan, 2002). Tunneling is a specific form of RPT that

involves the transfer of profitability from a low-cash flow to a higher

cash-flow right business group firm, in order to maximize cash flows

for the majority shareholder, at the expense of the minority.

We extend the RPT-earnings management argument by introduc-

ing the dynamics of gender diversity to the relationship for Indian

firms, where the use of RPTs is rampant and recent regulatory reform

has mandated the induction of an at least one-woman director on the

boards of listed companies. Usman, Farooq, Zhang, et al. (2018) find

that lenders offer a better cost of debt for firms led by female CEOs.

In our study, we choose to study gender diversity on audit commit-

tees, rather than at the board-level because the provisions of the new

Companies Act, 2013 onerous cast responsibility on the audit com-

mittee, in terms of identification and approval of RPTs that the man-

agement may wish to undertake. The audit committee is a specialized

committee of the board, which is entrusted with the responsibility of

overseeing the quality of the overall financial reporting process within

the firm. Starting April 1, 2014 (also the start of our sample), no RPT

can be initiated unless approved by this committee, granting it abso-

lute power over such transactions. This is in contrast to its erstwhile

JEL classification codes: G30, G32, G34, O16.

DOI: 10.1002/jsc.2337

Strategic Change. 2020;29:389–406. wileyonlinelibrary.com/journal/jsc © 2020 John Wiley & Sons, Ltd. 389

powers, which included a mere review of the firm's RPTs, once they

had taken place.

Gender studies document higher moral standards (Bernandi &

Arnold, 1997), greater risk-aversion (Barber & Odean, 2001; Estes &

Hosseini, 1988), and higher sensitivity to ethical concerns

(Gilligan, 1977) for women, on an average, when compared to their

male counterparts. There exists well-developed literature on the rela-

tionship between women directors and earnings management

(Srinidhi, Gul, & Tsui, 2011; Thiruvadi & Huang, 2011) and between

women directors and greater accounting conservatism (Francis,

Hasan, Park, & Wu, 2015; Peni & Vahamaa, 2010). Most of these

studies document that women directors are associated with lower

accrual-based earnings management.

When applied to the audit committee set, it could indicate that

gender-diverse audit committees (with one or more women onboard)

could reflect greater conservatism in approving RPTs, particularly

those that appear, prima facie, more prone to earnings management,

in their opinion. We expect such behavior to alter the RPT-earnings

management relationship.

To the best of our knowledge, the role of gender diversity in

explaining the RPT-Earnings management relationship has not been

investigated at least in the Indian context. We believe that the results

of this article contribute significantly to policymaking in several ways.

First, it empirically examines the role of gender diversity in the quality

of corporate reporting. This is particularly relevant in light of the

recent SEBI requirement that mandates the presence of at least one

woman director on the boards of all listed firms, with effect from

March 31, 2015. Second, in addition to the gender diversity dimen-

sion, we also control for the presence of promoter directors on the

audit committee. Given the rampant Type-II agency problem due to

concentrated ownership in India, this is critical to the understanding

of corporate behaviour and incentives to manage earnings.

We test our hypotheses on financial and governance data for

236 listed Indian firms for the financial years ended 2014 and 2015,

using multivariate fixed-effect regressions. Our results indicate a neg-

ative relationship between RPT volume and earnings management,

suggesting that on average, firms in our sample do not seem to be

using RPTs for earnings management purposes. What is interesting in

that in the presence of a woman in the audit committee, this relation-

ship weakens. This fact seems to suggest that women on the audit

committee may be acting too conservatively in terms of RPT approval,

weakening the RPT-earnings management relationship. Another inter-

esting finding is the positive relationship between the presence of a

promoter director of the committee and earnings management. Ours

is the first article that document the effects of women's presence in

audit committes in the Indian context. We also find a positive relation-

ship between larger audit committees and earnings management.

This article is organized as follows: Section 2 discusses the litera-

ture review. Section 3 discusses the hypotheses development. Sec-

tion 4 discusses the data sources and empirical methodology.

Section 5 presents the univariate statistics and empirical results. Sec-

tion 6 concludes.

2|LITERATURE REVIEW

2.1 |Women directors and earnings quality/

conservatism

In the last decade or so, gender diversity and its impact on earnings

quality have gained considerable attention in the accounting research

arena. Such evolution has had to do, in part, with the global attempt

toward breaking the “glass ceiling”by making gender representation

mandatory on corporate boards. Interestingly, results about the

impact of the presence of women on earnings quality have been

largely skewed in favor of higher risk aversion and better earnings

quality for either female-led firms or firms whose boards have women

directors.

Using a sample of listed American firms over the period

2001–2007 and discretionary accruals as their measure for earnings

management, Srinidhi et al. (2011) find that the presence of female

directors on the board results in both better reporting discipline and

earnings quality. The results are more pronounced when women

directors occupy positions in the firm's audit committee. Using a sam-

ple of 175 firms out of the S&P 500 over the period 2003 to 2005,

Sun, Liu, and Lan (2011) focus their attention on the presence of

women on fully independent audit committees. Using the Jones (1991)

discretionary accruals as their measure of earnings management, they

find no association between the proportion of women on the audit

committee and the degree of earnings management. Thiruvadi and

Huang (2011) investigate the link between gender diversity on the

audit committee and earnings management using 320 of the S&P

600 firms. They find that the female presence on the audit committee

is associated with both higher income-decreasing accruals and meet-

ing frequency of the audit committee, implying both better financial

reporting and corporate governance outcomes.

Francis et al. (2015) examine the impact of CFO gender on

accounting conservatism in the context of S&P 1500 firms. They

focus on firms that experience CFO changes from male to female over

the period 1988–2007 and compare the degree of accounting conser-

vatism in the pre and post-transition periods. They find that female

CFOs are more risk-averse than male CFOs, which in turn results in

them adopting more conservative accounting policies. Further, higher

risk-aversion in female CFOs also manifests itself in less equity-based

compensation, a lower dividend payout, lower firm risk, and higher

tangibility levels. Peni and Vahamaa (2010) examine the association

between earnings management and the gender of the firm's execu-

tives (in particular, the firm's CEO and CFO) for the S&P 500 firms

over 2003–07. They find that female CFOs are associated with more

conservative financial reporting. They find no results with female

CEOs. Vahamaa (2014) examines the link between CFO turnover and

earnings management. For the S&P 1,500 firms over the period

2004–06, they find that firms that move from a male to female CFO

tend to adopt more conservative financial reporting practises, as mea-

sured by the Dechow and Dichev (2002) measure of accruals. Specifi-

cally, discretionary accruals tend to become more negative if a female

390 JALAN ET AL.