expenditures, or overproducing prod

expenditures, or overproducing products to lower cost of goods sold. His findings
indicate that managers usually take three types of real activities manipulation, namely,
sales manipulation, reduction of discretionary expenditures, and overproduction.
A number of high profile corporate scandals (e.g. Enron, WorldCom, and Tyco
International) raised public concerns on the integrity of accounting information
disseminated in capital markets and the ethics of accounting practice and financial
reporting. To address these concerns, the passage of the Sarbanes-Oxley Act (SOX) in
July 2002 mandated sweeping changes in corporate governance requirements of US
listed companies to improve financial reporting quality. Cohen et al. (2008) examine real
and accrual earnings management in the pre- and post-SOX periods. They find that the
level of real earnings management has increased after the passage of SOX, while the
level of accrual earnings management has declined at the same time period. Their results
suggest that firms may switch from accrual to real earnings management, as the latter is
viewed as harder to detect and constrain. The tendency of using real activities methods
to manage earnings is a challenge to corporate governance practices in the post-SOX
period and increases ethics concerns on managerial behavior.
Existing literature suggests that real earnings management may lower firms’
investment efficiency (Cohen and Zarowin, 2008). Cohen and Zarowin (2010) show that
seasoned equity offering (SEO) firms experience a more severe decline in post-SEO
performance due to real earnings management than due to accrual earnings
management. Real earnings management may also negatively affect future operating
performance (Gunny, 2005) and consequently shareholders’ interests. Since the
responsibility of boards of directors is to act as the shareholders’ representative in all
matters, the board should oversee managers to constrain their real activities
manipulation. Although audit committees play a key role in the oversight of financial
reporting process, it is unclear as to whether audit committees can effectively constrain
real earnings management.
The purpose of this study is to investigate the effectiveness of independent audit
committees in constraining real earnings management, an issue becoming more crucial
in the post-SOX period. Specifically, this study examines whether real earnings
management is affected by five audit committee characteristics including:
(1) accounting financial expertise;
(2) board tenure;
(3) additional directorships;
(4) block shareholdings; and
(5) committee size.
Following Roychowdhury (2006), we use abnormal cash flows from operations,
abnormal discretionary expenses, and abnormal production costs to measure real
earnings management. We run regressions based on a sample of firms that are likely to
manipulate real activities to avoid reporting annual losses for years 2007-2010. We
document that real earnings management, measured by abnormal cash flows from
operations, abnormal discretionary expenses, or abnormal production costs, is
positively associated with audit committee members’ additional directorships. These
results suggest that audit committee members’ busyness may impair their effectiveness