Audit committee financial expertise: mitigation of real earnings management

Abstract

The paper examines whether and in what contexts the education and experience dimensions of audit committee financial expertise lower the propensity for real earnings management. We separate financial expertise into financial education and financial experience components and test the impact of each on three real earnings management metrics for a sample of Australian firm-years. Financial expertise is negatively related to abnormal cash flows from operations (CFO) and abnormal production costs, suggesting audit committee financial expertise mitigates real earnings management activities. Abnormal discretionary expenses are higher for firms with greater financial expertise, consistent with downward earnings management or conservative reporting. Financial experience is negatively related to abnormal CFO and production but both experience and education are positively related to abnormal discretionary expenses. Our results are largely driven by the experience dimension of financial expertise and for profitable firm-years in less profitable periods of time. Profitable firms with financial expertise exhibit unusually low CFO and production costs but unusually high discretionary expenses, consistent with prudent financial management rather than upward earnings management.