October 23, 2007
What Are Experts To Do?
Posted by Lawrence Cunningham

            People seem to agree that directors who are accounting experts serving on audit committees (ACAEs) should police “accounting earnings management” (like manipulation of accruals).  But people disagree about whether ACAEs should police “real earnings management” (substantive business decisions designed to achieve accounting results, like accelerating or delaying buying new a plant).  What’s the correct answer?

            The number of ACAEs rose dramatically after Sarbanes Oxley’s requirement to have one or disclose why not and exchange rules requiring them.  Empirical studies show they are effective in reducing accounting earnings management.  The empirical evidence is mixed about whether they are good at preventing real earnings management.

            Whether ACAEs influence real earnings management may depend on whether they believe that is their responsibility.  After all, no legal or accounting authority specifies what their duties are.  SOX and the exchanges only suggest or require expert presence without saying anything about its purpose. 

            Authoritative silence on the purpose of expertise leads to two competing views in the literature.  One sees audit committees only as monitors and enforcers, whose presence is solely to assure compliance with law and accounting regulations.  So accounting earnings management is their bailiwick, but real earnings management is not. 

            Under the other view, ACAEs are there to direct as well as monitor the management of the enterprise, including decisions about resource allocation.  That role includes understanding whether those decisions are driven by substantive business judgments on long-term value enhancement or short-term accounting results.

            To me, the latter view seems stronger: (1) committee experts are directors too and directors are not excused from understanding, reviewing or even controlling internal firm resource allocations; (2) the distinction between accounting earnings management and real earnings management is ultimately superficial since both are artificial; and (3) evidence is strong that the post-SOX reduction in accounting earnings management has increased managerial appetite and resolve to pursue real earnings management. 

            Saying ACAEs should police accounting earnings management but not real earnings management would produce a policy backfire.  The backfire would be as serious as the problem of accounting earnings management, although the problems differ.  The problem with accounting earnings management is that investors are misled into sub-optimal capital allocation that could result in investment losses.  The problem with real earnings management is that managers deliberately commit to sub-optimal capital allocation that almost certainly, although stealthily and indirectly, inflict investment losses on investors. 

            So, in my view, the expectations and duties of ACAEs should include controlling real earnings management just as much as accounting earnings management.  But, no doubt, I could be wrong.

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