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Journal of Accounting in Emerging EconomiesBoard characteristics, external auditing quality and earnings management : Evidence

from the Tunisian banksNeila Boulila Taktak Ibtissem Mbarki

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To cite this document:Neila Boulila Taktak Ibtissem Mbarki , (2014),"Board characteristics, external auditing quality and earningsmanagement ", Journal of Accounting in Emerging Economies, Vol. 4 Iss 1 pp. 79 - 96Permanent link to this document:http://dx.doi.org/10.1108/JAEE-10-2011-0046

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Board characteristics, externalauditing quality and

earnings managementEvidence from the Tunisian banks

Neila Boulila Taktak and Ibtissem MbarkiUnité de recherche DEFI – ESSECT,

Ecole Supé rieure de Sciences Economiques et Commerciales de Tunis,Tunis, Tunisia

Abstract

Purpose – The purpose of this paper is to examine the impact of board characteristics and externalaudit quality on earnings management among major Tunisian banks over the period 2003-2007.Design/methodology/approach – Multivariate regressions are employed to test the effect of boardstructure and external audit quality on discretionary provisions as a proxy for earnings management.Findings – Results indicate that among the characteristics of the board, CEO duality is associatedwith higher levels of discretionary provisions. However, the presence of directors affiliated to thelargest shareholder tends to constrain earnings management practices. The results reveal also thata co-audit belonging to the BIG 4 provides incentives to manage earnings while the capacity of theexternal auditor to disclose reservations impacts negatively the manager’s discretion.Practical implications – First, it is not desirable to appoint a co-audit both belonging to the BIG 4.Second, the presence of affiliated directors reduces the discretionary practices except in cases wheredirectors are affiliated to families. In this case, banks should strengthen the presence of independentdirectors. Finally, the delineation of the leeway left in the Tunisian accounting standards wouldprovide more transparent financial information.

Originality/value – This study contributes to the literature on governance and its impact onearnings management among Tunisian banks by introducing two variables that have not been testedbefore which are affiliated directors and co-audit. The paper will be of value to banks willing to complywith the Governance Good Practice Guide adopted recently in Tunisia.

Keywords Earnings management, Governance, Banks, Tunisia, Affiliated directors, Co-audit

Paper type Research paper

1. IntroductionTunisia is the first emerging economy from MENA region which has adopted a seriesof reforms in order to liberalize, modernize and adapt the financial sector to theinternational standards (adoption of Basel accord in 1999, universal banking model in

July 2001, enhancing the financial security in 2006). Given these changes, Tunisian banksare increasingly forced to provide better performance. However, the non-performingloans (NPL) ratio and loan loss allowances remain below the targets set by the TunisianCentral Bank. The overall provisioning rate averaged about 54 percent in 2006, far belowthe target level of 70 percent recommended by the International Monetary Fund (IMF).These efforts are still offset by the leeway offered by accounting and prudential rules forbank managers in the assessment of the credit quality.

In this context, it would be appropriate to examine the capacity of governancesystems to minimize opportunistic behavior of some managers. This recognition of theusefulness of governance in the delimitation of discretionary behaviors withinTunisian firms has led to the adoption of the Governance Good Practice Guide.

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/2042-1168.htm

Journal of Accounting in Emerg

Econom

Vol. 4 No. 1, 2

pp. 79

r Emerald Group Publishing Lim

2042-1

DOI 10.1108/JAEE-10-2011-0

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The objective of this research is to study the impact of governance mechanismson the discretionary[1] practices of loan loss provisions of the major Tunisian banksover the period (2003-2007). The results show that affiliated directors to the firstshareholder, which is the main feature of the board, affects significantly the

discretionary provisions. Particularly, it seems that affiliated directors to the State andinstitutions reduce the discretionary provisions compared to directors affiliated to thesame family members. The results show also that a dual auditors belonging to the BIG4 increases the discretionary provisions, while the capacity of the external auditor todisclose reservations impacts negatively the manager’s discretion.

The rest of the paper is structured as follows. The second section reviews literaturethat links the characteristics of the board and the quality of external audit to earningsmanagement, after which the hypotheses to be tested are developed. The third sectionpresents the methodology used. Empirical results and discussion are presented in thefourth section. The fifth section summarizes the main conclusions.

2. Literature review and hypotheses

2.1 Characteristics of the board 2.1.1 Size. Several studies have focussed on studying the effect of the board size onearnings management. Proponents of agency theory suggest that a large boardpromotes conflicts of interest between manager and shareholders, mainly because of difficulties of coordination and communication that may hinder consensus decisions( Jensen, 1993; Bushman et al., 2004; Kao and Chen, 2004). This allows the manager todominate the directors and use its managerial discretion to maximize his wealththrough the earnings management (Lipton and Lorsch, 1992; Abdul Rahman andMohamed Ali, 2006). Contrariwise, other authors support the hypothesis that a largeboard of directors reduces earnings management because such board usually allowsgetting profit from the various experiences of the different partners and boardmembers (Xie et al., 2003; Peasnell et al., 2005). This pattern is derived from the

resource dependence theory, which assumes that in an environment marked byconsiderable uncertainty, an expanded board of directors is an effective tool fordecision making as it allows benefiting from the specific knowledge of the variousdirectors ( Jian and Ken, 2004). In Tunisian banks, Omri et al. (2007) found that a largeboard of directors increases earnings management over the period (1998-2006).

Finally, other studies estimate that the board size depends on a tradeoff between thebenefits of expertise related to the diversity provided by a large board and the benefitsof efficiency and control provided by a restricted board (Andres and Vallelado, 2008).This principle of arbitration between efficiency and diversity is one of the mainpreoccupations in Tunisian companies.

Thus, the Governance Good Practice Guide for Tunisian firms (2008)[2]recommends that firms should have “a board small enough to facilitate rapid

decision making and as wide as possible to get profit from the richness and diversity of skills and experiences of its members.” In this case, we cannot make a prediction of thesign of size variable. So our first hypothesis is as follows:

H1. There is a relationship between the board size and discretionary provisions.

2.1.2 CEO duality. Proponents of agency theory argue for the separation betweenCEO and chairman roles in a board of directors. Fama and Jensen (1983) stipulate thatthe separation of management and control functions enhances the effectiveness of the

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board decisions and reduces agency costs. In fact, the combination of these functionsincreases the manager’s authority by allowing him to satisfy his own interests overthose of shareholders (Jensen, 1993; Epps and Ismail, 2009). Splitting the roles of chairman and CEO is also favorable to make the board more independent (Coombes

and Wong, 2004). Proponents of stewardship theory, in contrast, argue that CEOduality enhances the firm’s performance as it avoids power dilution, reduces rivalryand provides more clarity in the business conduct (Bradbury et al., 2006). In addition,CEO duality facilitates decision making with a minimum board interference (Reshnerand Dalton, 1991; Lin, 2005).

Regarding the banking context, the results of previous studies addressing theimpact of this feature on earnings management are mixed. Cornett et al. (2009) foundthat the cumulative functions of management and control affects negatively earningsmanagement, particularly the level of discretionary provisions, contrary to Brickleyet al. (1997) and Anuchitworawong (2004) who found that CEO duality increases theprovisions adjustment. On a sample of Tunisian banks, Omri et al. (2007) found thatthe duality in the board appears to increase earnings management only in the presence

of institutional directors.The Governance Good Practice Guide for Tunisian firms (2008) recommends the

separation of management and control functions. It provides that “dissociationpromotes the right decisions, when the board decides the combination of the twofunctions; it has to justify to shareholders the reasons for this choice.” So the sign of CEO duality variable is expected to be positive. Hence, it is hypothesized that:

H2. There is a positive relationship between CEO duality and discretionaryprovisions.

2.1.3 Affiliation of directors. Theoretically, the relationship between the presence of affiliated directors in the board and its effectiveness is mixed. According to the agency

theory, the affiliated directors are cause of inefficiency or lack of control, becausethey are usually appointed by the manager and seek to maximize their revenues.Only independent directors can limit the manager discretionary practices(Anuchitworawong, 2004). In addition, affiliated directors seek to privilege theirprivate interests to the detriment of minority shareholders (Anderson et al., 2003;Schulze et al., 2003). On the other side, the resource dependence theory considers thatthe presence of affiliated directors in the board is equivalent to efficiency. They aremore familiar with the specificities of the company and its environment, as theymaintain business relationships with it.

Empirical results confirm that independent directors are more likely to reducediscretionary practices than affiliated ones. They can control and discipline moreeffectively the discretionary behavior of managers (Klein, 2002; Jaggi et al., 2007). Suchdirectors are known by their expertise and their ability to judge independently andobjectively the firm performance (Booth and Deli, 1996). It should be noted, however,that despite the high number of independent directors comprising the board of Enron,it was ineffective in its mission of control (Healy and Palepu, 2003). In fact, manystudies failed to find a significant relationship between board independence andearnings management (Park and Shin, 2004; Hashim and Devi, 2008).

The Tunisian system is characterized by the presence of strong blockholders oftenincluding families. In fact, 80 percent of total shares are held by the five largestshareholders (Omri, 2003), which explains the domination of affiliated directors in

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Tunisian boards against a weak presence of independent directors[3]. Outside directorsare usually appointed for expertise reasons rather than to save minority shareholders’interests (Boudriga et al., 2011). In this regard, the Governance Good Practice Guideencourages the Tunisian firms to appoint independent directors and recommends that

“at least one third of the board of directors must be independent.”It should be noted that the relationship between affiliated directors and earnings

management has not been tested before in the Tunisian context. This brings us to issue anon-directional hypothesis as we cannot make a prediction of affiliation variable’s sign:

H3. There is a relationship between affiliated directors and discretionary provisions.

2.1.4 Nature of directors. The ownership structure of a company often reflects thecomposition of his board, which allows us to distinguish several types of directors:State, foreigner and institutional.

Institutional directors. Theoretical studies dealing with the impact of the presenceof institutional directors (who are usually representatives of banks or insurances) on

the limitation of managers discretions report controversial points of view. Someauthors argue that their presence improves the efficiency of governance as they havebetter access to information and greater expertise in achieving performance (Jensen,1993). In contrast, other studies found that the presence of institutional directors has noeffect on the discipline of the opportunistic behavior of managers (Paquerot, 1997).

Empirically, the disciplinary authority of these institutions is generally testedaccording to their participation in the capital. If the share is low, institutionalinvestors[4] are more interested in maximizing their income in the short term, whichmake them less motivated to control managers. They may even encourage executivesto manage their results (Lang and McNichols, 1999). Contrariwise, if the share is high,these directors will instead seek to maximize the long-term value of the bank. As aconsequence, they will be more incited to monitor the managers’ behavior.

The exam of the ownership structure of the Tunisian banks over the period1998-2007 reveals that it is almost the same institutions that hold bank capital, whichmight suggest a negative relationship between institutional directors and discretionaryprovisions. In this case, the sign of this variable is expected to be negative:

H4-1. There is a negative relationship between the presence of institutionaldirectors in the board and discretionary provisions.

Foreign directors. The governance of banks by foreigners has been a subject of a limited number of studies (Beck and Levine, 2004), which show that banks with ahigh-foreign ownership have better access to capital markets and a greater capacity todiversify their risks. Moreover, such banks have better access to the best governance

practices compared to local ones. Therefore, the presence of foreign directors ensuresthe independence of the board and limits the manager’s opportunistic behavior. Thesign of this variable is expected to be negative:

H4-2. There is a negative relationship between the presence of foreign directors inthe board and discretionary provisions.

State directors. Most studies confirm that banks owned by the State suffer from a lackof effectiveness and efficiency (La Porta et al., 2002). Such banks are generally

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characterized by a high level of NPL, a weak competition and a lack of privatesupervision mechanisms (Barth et al., 2004). Therefore, compared to their privatecounterparts, they present to managers a propitious field to manage their results(Beatty et al., 2002). According to the agency theory, banks owned by the State are less

exposed than private ones to the disciplinary effect of financial market. Therefore,opportunistic behaviors of managers are promoted. In this case, the sign of thisvariable is expected to be positive:

H4-3. There is a positive relationship between the presence of State directors in theboard and discretionary provisions.

2.2 Characteristics of the external audit External auditing is another governance mechanism that can restrict the managerialdiscretionary practices. Based on the agency theory, an external audit reduces theinformation asymmetry between the principal and the agent and minimizes conflicts

of interest (Watts and Zimmerman, 1983). According to the literature, the quality of external audit is measured by the reputation of the auditor, his ability to disclosereservations and the presence of a co-audit.

2.2.1 Auditor’s reputation. Several studies have examined the relationship betweenearnings management and auditor’s reputation, generally measured by its membershipin “Big 4[5]” group (De Angelo, 1981). According to Rusmin (2010), BIG 4 audit firmshave more capital, human resources, technology and experiences which enable them toprovide higher quality audit. Furthermore, they typically have a large client base andinternationally recognized brand names, thus they have more incentive to maintainhigher quality audits.

The hypothesis related to the existence of a negative relationship between earningsmanagement and the auditor’s reputation has been validated only in the American

context, characterized by a significant legal risk (Becker et al., 1998). However, otherstudies conducted in other contexts invalidate the relevance of the auditor’s reputationin limiting earnings management (Piot, 2001; Kabir et al., 2011). In fact, since thebankruptcy of Enron the reputation of these networks has been called into question. Sothe sign of auditor’s reputation variable is expected to be negative:

H5. There is a negative relationship between the external auditor reputation anddiscretionary provisions.

2.2.2 Disclosure of reservations. De Angelo (1981) defines the quality of external auditas “the assessment by the market of the joint probability that an auditor discoverssimultaneously a significant anomaly in the accounting system of the company and

publishes this anomaly or this irregularity.” This definition highlights twofundamental aspects of external audit quality: the technical competence of theauditor represented by its ability to detect errors in the annual reports and hisindependence codified through revelation quality[6] (Lennox, 1999). Suchcharacteristics are essential for the delimitation of earnings management practices(Datar et al., 1991). So the sign of this variable is expected to be negative:

H6. There is a negative relationship between the disclosure of reservations anddiscretionary provisions.

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2.2.3 Co-audit . The co-audit is a specificity of the French law that allows companies toensure the independence of the auditor in expressing his opinion as many pressuresmay be exercised in the case of one auditor. Or, the manager cannot corrupt the twoauditors at the same time (Ebondo Wa Mandzilla, 2006). Piot and Janin (2007) suggest

that the co-audit provides two main advantages. In one hand, it offers the possibility of a reciprocal control of the auditor’s procedures which allows the comparison of theauditors’ opinions. On the other hand, it strengthens the independence of each of them,limiting any potential domination of the auditees. The co-audit can then enhance theaudit quality and therefore the reliability of financial reporting (Nôel et al., 2009).However, its main limitation lies in the asymmetry of information that links the twoauditors, which could affect the distribution of work between them. In fact, “Sometimesa BIG 4 is co-auditor with a small firm of audit. The latter lacks the same technical andphysical skills that are available to the BIG4. Consequently, the distribution can go upto a ratio of 20/80 between the two auditors, see 0/100. The asymmetry in the size of audit firms causes an imbalance of power relations between the two auditors that leadsto the dependence of one to the other” (Bennecib, 2004). In fact, when an auditor BIG

shares a co-audit mandate with a no BIG auditor, it gets usually benefit from suchsituation to allocate the whole work to their advantage to preserve their reputation incase of problem. The sign of co-audit variable is expected to be negative:

H7. There is a negative relationship between the co-audit and discretionaryprovisions.

3. Methodology3.1 SampleThis research uses individual annual data of the ten major Tunisian banks[7] whichrepresent about 90 percent of the aggregate outstanding loans. All these banks are

listed on Tunisia Stock Exchange.Data on governance were collected manually from annual reports and banks web

sites covering a period of five years (2003-2007). The financial data used to estimate thediscretionary provisions were collected from BANKSCOPE database and banks’annual reports over a period of ten years (1998-2007). Indeed, the period before 2003 isessential to estimate the discretionary portion of provisions.

3.2 Variables measurement 3.2.1 Measurement of earnings management (dependent variable). We use thediscretionary provisions as a proxy of earnings management, measured by adoptingthe methodology of Elleuch-Hamza and Boulila-Taktak (2009) which is stronglyinspired from Cornett et al. (2007). It consists of three steps.

. Step 1: estimation of the regression’s parameters

The first step consists on estimating the coefficients of the model that identifies thenormal part of provisions (model 1) on the estimation period (1998-2002). The model isas follows:

LLP it =TC it 1 ¼ b0 þ b1 NPLit =TC it 1 þ b2 LLAit 1=TC it 1

þ b3COLLit =TC it 1 þ ULLP it ð1Þ

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where LLP it is the loan loss provisions of the bank i at date t ; NPLit the NPL of the banki at time t ; LLAit 1 the loan loss allowance of the bank i at date t 1; COLLit the totalcollaterals received by the bank i at date t ; TC it 1, the total credit of the bank i attime t 1. All model variables are standardized by total credit ( TC it 1 ) to avoid

heteroscedasticity problem; ULLP it , the error term of the equation representing thediscretionary portion of LLP of bank i in period t [8].

. Step 2: estimation of the non-discretionary component of loan loss provisions

The estimated coefficients b0, b1, b2 and b3 of regression (1) are used to calculate thepredicted values of loan loss provisions ( LLPND it ) over the period 2003-2007. Thiscomponent is calculated using the following equation:

LLPND it =TC it 1 ¼ b̂0 þ b̂1 NPLit =TC it 1 þ b̂2 LLAit 1=TC it 1

þ b̂3COLLit =TC it 1ð2Þ

. Step 3: estimation of the discretionary component of loan loss provisions

The last step consists on calculating the discretionary provisions ( LLPD ) given as thedifference between the actual amount of loan loss provisions ( LLP ) and thenon-discretionary portion of loan loss provisions estimated at the second stage ( LLPND ):

LLPD it ¼ LLP it LLPND it ð3Þ

3.2.2 Measurement of the independent variables. Two categories of independentvariables are tested in the paper. The first relates to the characteristics of the boardstructure (size, duality, affiliation and nature of directors) and the second is interestedto the characteristics of the external audit quality (co-audit, BIG 4, disclosure of

reservations).We also introduce in our model four control variables which can take into account

the practice of earnings management ( SMOOTH ), management of capital ( CAR ), size( SIZE ) and the concentration of ownership ( CONC ). Income smoothing is highlightedby the positive relationship between net income before provisions and tax on one handand discretionary provisions on the other hand (Jian and Ken, 2004). CAR variable isoften used to control for capital management practices. In fact, banks with capitaladequacy ratio below the required minimum will be incited to reduce their provisionsin order to maintain their CAR above the regulatory minimum (Kim and Kross, 1998;Ahmed et al., 1999). In the Tunisian regulatory framework, loan loss reserves areexcluded from regulatory capital and they are not counted either as tier 1 or as tier 2capital. The effect of the level of CAR on loan loss provisions is only considered,

indirectly, through net earnings (Boulila Taktak et al., 2010). The size variable isintroduced to take account of possible difference between large banks and those of small size. In fact, according to Cornett et al. (2009) larger banks are the most likelyto be monitored by industry analysts. As a consequence, they will be less incited toartificially increase income using discretionary accruals. Finally, we introduced theconcentration ownership variable ( CONC ) as the Tunisian system is characterized bythe presence of strong block holders including mainly state shareholders or families. Infact, 80 percent of total shares are held by the five largest shareholders (Omri, 2003).Table I presents measurements of variables and their expected signs.

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4. Results and discussion4.1 Descriptive statisticsTable II shows that the average of the discretionary provisions is positive andrepresents 0.43 percent of total loans, which proves that banks intentionally

underestimate provisions to manage upwards their results. This table shows also thatthe number of directors in the board is ranged from eight to 12 with an average of 11,against an average of seven for non-financial companies (Zéghal et al., 2006). It seemsthen, that the boards of Tunisian banks are large since the average is closer to themaximum limit of 12 directors prescribed by the regulation. Concerning directorsnature, results show that, on average, the proportion of State, foreign and institutionaldirectors is almost the same and varies from 25 to 28 percent.

Table III shows that in 64 percent of bank-year observations, the CEO combinesthe function of chairman of the board, against only 36 percent of cases of non-duality.

Variables DefinitionsExpected

signs

LLPD The discretionary loan loss provisions

Ln-BD Log of the number of directors on the board þ / DUAL Binary variable equals to 1 if there is an overlapping of the functions of

chairman of the board and CEO and 0 otherwise þ DAFFIL Binary variable equals to 1 if the percentage of affiliated directors to the

first shareholder on the board exceeds 50% and 0 otherwise þ / DSTAT Percentage of State directors on the board þ DINST Percentage of institutional directors on the board DFORG Percentage of foreign directors on the board Co-Audit Binary variable equals to 1 if the bank is audited by two auditors and

0 otherwise BIG4_0 Binary variable that takes 0 if the auditor does not belong to a BIG4 þ BIG4_1 Binary variable that takes 1 if one of the two auditors belongs to a BIG4 BIG4_2 Binary variable that takes 1 if the two auditors belong to a BIG4 RESERV Binary variable equals to 1 if the auditor discloses at least one reservation

in its annual report, 0 otherwise SMOOTH Net income before tax and loan loss provisions reported to total assets þCAR Capital adequacy ratio (CAR) which is a measure of the amount of a bank’s

core capital expressed as a percentage of its risk-weighted asset SIZE Log of total assets /þCONC Percentage of the largest shareholder in the bank’s capital /þ

Table I.Variables definitionand expected signs

Variables Mean Median Minimum Maximum SD

LLPD 0.0043 0.002 0.012 0.0780 0.015 BD 11 11 8 12 1.293 DFORG 25.57 23.61 0.00 66.67 24.58 DSTAT 25.81 0.00 0.00 100.00 36.35 DINST 28 25.00 0.00 58.33 19.79

Notes: LLPD, discretionary loan loss provisions; BD, number of directors on the board; DFORG,percentage of foreign directors on the board; DSTAT, percentage of State directors on the board;

DINST, percentage of institutional directors on the board

Table II.Descriptive statistics of the dependent variableand governancevariables (continuousvariables)

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This result shows that the two functions remain associated despite the enactment of anew legislation in 2000 which provides the separation. Previous studies have shownthat duality is not specific to the Tunisian context; it is also expressed in US bankswhere 80 percent of managers combine the two functions (Cornett et al., 2009). Table IIIalso shows that boards of Tunisian banks are mainly characterized by the presence of affiliated directors with an average of 74 percent, which can influence the boarddecisions. This result does not comply with the Governance Good Practice Guide

which recommends that firms should have a minimum of 1/3 of independent directors.Regarding variables related to the quality of external auditing, it appears that

nearly the half of banks (52 percent) is audited by two auditors. This result shows thevoluntary adhesion of Tunisian banks to strengthen control since the requirement of adouble audit does not come into effect until 2007. Similarly, descriptive statistics showthat in 54 percent of cases, Tunisian banks are audited by an external auditorbelonging to one of the BIG 4 groups. Finally, the reservations revealed by the auditorsare about 66 percent over the study period.

Table IV, reporting the descriptive statistics of control variables, shows that theaverage of the variable measuring earnings smoothing coincides with its median

Variables Proportions (%)

DUAL 0 361 64

DAFFIL 1 740 26

Co-Audit 0 521 48

BIG4 0 461 402 14

RESERV 0 331 66

Notes: DUAL, binary variable equals to 1 if there is an overlapping of the functions of chairman of theboard and CEO and 0 otherwise; DAFFIL, binary variable equals to 1 if the percentage of affiliateddirectors to the first shareholder on the board exceeds 50 percent and 0 otherwise; Co-Audit , binaryvariable equals to 1 if the bank is audited by two auditors and 0 otherwise; BIG4_0 , binary variable

that takes 0 if the auditor does not belong to a BIG4; BIG4_1, binary variable that takes 1 if one of thetwo auditors belongs to a BIG4; BIG4_2 , binary variable that takes 1 if the two auditors belong to a

BIG4; RESERVE , binary variable equals to 1 if the auditor discloses at least one reservation in itsannual report, 0 otherwise

Table IProportions

governance variab(qualitative variabl

Variables Mean Median Minimum Maximum SD

SMOOTH 0.017 0.017 0.004 0.037 0.008CAR 10.406 10.400 1.800 19.870 4.054CONC 45.97 52 5.61 69 17.93SIZE 14.709 14.624 13.848 15.445 0.448

Notes: SMOOTH, net income before tax and loan loss provisions reported to total assets; CAR,capital adequacy ratio; CONC, percentage of the largest shareholder in the bank’s capital; SIZE, log of total assets

Table IDescriptive statist

of control variab

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(representing 1.7 percent of total assets). The banks in the sample are sufficientlycapitalized (with an average of 10.4 percent), far surpassing the regulatory minimumrequired of 8 percent. The table also reveals that the ownership structure is relativelyconcentrated since the largest shareholder holds on average 46 percent of the capital

with a maximum of 69 percent.

4.2 Multivariate analysis and results interpretationTo test the effect of board characteristics and the quality of external audit on thediscretionary provisions, we have introduced variables related to the nature of directorsone by one to avoid problems of correlation and multicollinearity[9]. Similarly, toaddress the endogeneity problem[10] that might exists between the characteristics of the board and the quality of external audit, each category of variables was testedseparately in two different models as suggested by Bhagat and Jefferis (2002).Accordingly, two regressions are estimated: first, LLPD ¼ f (board structure, controlvariables) and second, LLPD ¼ f (external audit quality, control variables).

The estimation method used is the “Panel Corrected Standard Errors” (PCSE) which

can provide unbiased coefficients by correcting problems of autocorrelation andheteroscedasticity in micro-panels (Beck and Katz, 1995, 1996). Indeed, based onestimations of Monte Carlo, Beck and Katz (1995, 1996) show that the PCSEspecification provides a more reliable error structure than that produced by the methodof generalized least squares considered too confident.

Table V reports the results of the first model testing the effect of boardcharacteristics on earning management. It shows that combining the functions of chairman and CEO increases significantly the discretionary provisions (panels 1, 2and 3 of Table V) according to the agency theory perspective which supports interests

(1) (2) (3) (4) LLPD LLPD LLPD LLPD

DUAL 0.00690*** (3.72) 0.00467* (1.65) 0.00457*** (3.68) 0.00372 (1.29)

Ln-BD 0.00500 (0.49) 0.00291 (0.25) 0.0104 (0.89) 0.00951 (1.01)

DAFFIL 0.0352*** ( 4.54) 0.0339*** ( 5.16) 0.0413*** ( 4.75) 0.0290*** ( 5.41)

DFORG 0.0129** ( 2.22)

DSTAT 0.00709 (1.62)

DINST 0.0209** ( 2.89)

SMOOTH 0.462** (2.52) 0.289* (1.88) 0.622*** (3.97) 0.282** (2.05)

CAR 0.00103** ( 2.34) 0.00132*** ( 3.99) 0.000429 ( 1.09) 0.00104** ( 2.65)

SIZE 0.00288 ( 1.59) 0.00923*** ( 4.18) 0.00705 ( 1.49) 0.0120*** ( 5.49)

CONC 0.000357*** (3.82) 0.000433*** (4.11) 0.000225** (2.24) 0 .000415*** (4.23)

Constant 0.0435* (2.31) 0.148** (3.25) 0.0282134 (0.32) 0.1839176*** (2.35)

n 50 50 50 50

R 2 66% 66.17% 68% 71%

Notes: LLPD , discretionary loan loss provisions; DUAL, binary variable equals to 1 if there is an overlapping of the

functions of chairman of the board and CEO and 0 otherwise; Ln-BD , log of the number of directors on the board;

DAFFIL, binary variable equals to 1 if the percentage of affiliated directors to the first shareholder on the board

exceeds 50 percent and 0 otherwise; DFORG , percentage of foreign directors on the board; DSTAT , percentage of State

directors on the board; DINST , percentage of institutional directors on the board; SMOOTH , net income before tax and

loan loss provisions reported to total assets; CAR , capital adequacy ratio; SIZE , log of total assets; CONC , percentage

of the largest shareholder in the bank’s capital. ***, **, *Significance at 1, 5 and 10 percent levels, respectively

Table V.Panel regression of theboard characteristicson discretionaryprovisions

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conflicts (Jensen, 1993). However, duality does not impact the provisioning policy inthe presence of institutional directors on the board (panel 4 of Table V). These findingssupport, on the one hand, the recommendations of the Governance Good PracticeGuide which is in favor of the separation of management and control functions. On the

other hand, they confirm the mixed results of earlier researches. Results also showthat whatever the specification used, boards dominated by affiliated directors affectnegatively the discretionary provisions because of the intensity of coalition betweenthe first shareholder who exercise the control (or officer of the bank) and directors. Thiscounter-intuitive result confirms the notion that boards dominated by such directors,control and discipline more effectively discretionary behavior of managers (Jian andKen, 2004; Cornett et al., 2009). Another plausible explanation for this result lies in thefact that banks with a large number of affiliated directors are those least provisioned.This is particularly about the two State banks (STB and BNA) and a private familybank (Amen bank). These banks are required to increase their provisioning policy toachieve the target of 70 percent by the end of 2009 required by IMF.

Regarding the nature of directors, results show that the presence of foreign and

institutional directors on the board reduces the discretionary practices. The first allowsbanks to access to the best practices of governance through their knowledge andexpertise. The latter seek to maximize long-term value of the bank as they maintain asubstantial stake. On the other side, the results show that the board size has no effecton the discretionary practices of Tunisian banks confirming the findings of Cornettet al. (2009) on a sample of American banks.

Eventually, concerning the control variables, the coefficient associated with( SMOOTH ) variable is positive and significant, which emphasizes the practice of earnings management through provisions in Tunisian banks (Boulila Taktak, 2008).The capital adequacy ratio has a significant and negative impact on discretionaryprovisions. The highly capitalized banks are those that handle to lower thediscretionary provisions (Dewatripont and Tirole, 1994). Finally, results also show the

variable ( CONC ) is significant and positive in all specifications showing that bankswhich are heavily concentrated are those that manipulate the most their provisions.

Table VI presents the results regarding the effect of the external audit’s quality ondiscretionary provisions. It shows that the more auditors disclose reservations aboutthe reliability of financial information conveyed through the financial statements of thebank, the more the intention to manipulate provisions declines. This result highlightshow much it is important that the external auditor must maintain its independencetoward his client (Lennox, 1999). Indeed, the ability of revelation is essential to limitearnings management in banks. Another result that seems very interesting is thepositive effect associated with the variable Co-Audit . This result interpellates theusefulness of the implementation of the new law on financial security that providesincreased control through the appointment of two auditors. Moreover, the affiliation

between two BIG 4 auditors increases accounting manipulations. The co-audit isworking properly only in the presence of a single member belonging to the BIG 4. Thisresult is consistent with researches conducted in European countries (Piot, 2001;Vander Bauwhede, 2005) and contradicts the conclusions of the Anglo-Saxon studies(Becker et al., 1998), supporting the theory of “deep pockets” developed by De Angelo(1981). According to this view, only large firms are able to compensate for any lossescaused by an incorrect certification because of the significant financial resources attheir disposal. Indeed, the ineffectiveness of BIG 4 auditors in the reliability of accounting data seem to be attributed to the fragility of the legal and discipline system

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of auditors in Tunisia. The civil and criminal liability of auditors is much lesspronounced in the Tunisian context than in the USA.

4.3 Discussion and policy implicationsThe results of the previous regressions showed that among the characteristics of the board, the presence of affiliated directors ( DAFFIL ) impacts negatively andsignificantly the discretionary provisions. This result, which we thought, a priori,

counter-intuitive, led us to run further investigations by distinguishing betweendifferent categories of affiliated. We consider four types of affiliation: AFFILSTAT if the directors on the board are affiliated with the largest shareholder who is the State;AFFIFORG if the directors on the board are affiliated with the largest shareholderwho is foreign; AFFILINST if the directors on the board are affiliated with the largestshareholder who is institutional and finally AFFILFAM if the directors affiliated tothe largest shareholder are mainly members of the same family. The results reportedin Table VII show that the effect of affiliation variable changes depending on itsnature. In fact, for directors affiliated to State and institutions, the effect isstill negative and significant. Their presence reduces the discretionary portionof provisions; this is explained by the fact that these banks are characterized bythe lowest provisioning rate in the industry. So, they have interest to reduce

manipulation to achieve the provisioning target of 70 percent. However, if thedirectors are affiliated with a leading shareholder composed of the same familymembers, the manager manipulate upward the reserves primarily to lower incomeand therefore to distribute lower dividends.

By controlling the nature of affiliation, the coefficient relative to the size of the boardbecomes significant in two regressions. It seems then that it is difficult in a large boardof directors to be influenced by the decisions of managers. Large boards can usuallytake advantage of the different experiences of the members which impacts negativelyearnings management (Jian and Ken, 2004). Finally, concerning control variables, the

(1) (2) (3) LLPD LLPD LLPD

RESERV 0.00807*** ( 3.55) 0.00730*** ( 3.35) 0.00648*** ( 3.59)Co-Audit 0.00407** (2.35)

BIG4_1 0.000574 ( 0.20) BIG4_2 0.0135*** (4.29)SMOOTH 0.166 (1.18) 0.102 (0.70) 0.190 (1.45)CAR 0.00218*** ( 4.57) 0.00209*** ( 4.09) 0.00191*** ( 4.29)SIZE 0.00666** ( 2.26) 0.00557* ( 1.89) 0.00530* ( 1.89)CONC 0.0000275 (0.61) 0.00000838 ( 0.23) 0.0000633 ( 1.34)Constant 0.253614** (2.94) 0.115** (2.58) 0.2219685** (2.70)n 50 50 50

R 2 51% 48% 51%

Notes: LLPD , discretionary loan loss provisions; RESERVE , binary variable equals to 1 if the auditordiscloses at least one reservation in its annual report, 0 otherwise; Co-Audit , binary variable equals to 1if the bank is audited by two auditors and 0 otherwise; BIG4_1, binary variable that takes 1 if one of

the two auditors belongs to a BIG4; BIG4_2 , binary variable that takes 1 if the two auditors belong to a BIG4; SMOOTH , net income before tax and loan loss provisions reported to total assets; CAR , capitaladequacy ratio; SIZE , log of total assets; CONC , percentage of the largest shareholder in the bank’scapital. ***, **, *Significance at 1, 5 and 10 percent levels, respectively

Table VI.

Panel regression of theexternal audit qualityon discretionaryprovisions

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results remain unchanged even after controlling for the nature of affiliation whichconfirms the robustness of our results.

5. Conclusion

The objective of this research is to provide a better understanding of the consequencesof the codification of governance practices on discretionary practices. It aims to testthe impact of the board characteristics and the quality of external audit on theprovisioning policy of Tunisian banks. To do this, we used a sample of ten Tunisianbanks listed on Tunisia Stock Exchange and representing over 90 percent of total bankassets over the period (2003-2007).

The results show that among the characteristics of the board of directors, thecombination of management and control functions contributes to the ineffectiveness of the decisions of the board by increasing the discretionary practices of provisions.However, the affiliation variable, which measures the degree of affiliation of directors tothe largest shareholder, affects significantly and negatively the discretionary provisions.Further analysis reveals that directors affiliated to the State and institutions behave

differently than those affiliated to the same family members. Our results reveal also that aco-audit belonging to the BIG 4 increases the discretionary provisions while the capacityof the external auditor to disclose reservations impacts negatively the manager’sdiscretion. Finally, the Tunisian banks use loan loss provisions to manage their resultsand those heavily capitalized have less intention to manipulate their provisions.

These results have implications for both stakeholders and policy makers. First, itis not desirable to appoint a co-audit both belonging to the BIG 4. Second, the effectof affiliated directors on accounting manipulations is favorable. Generally, the presenceof affiliated directors on the board reduces the discretionary practices except in cases

(1) (2) (3) (4)

LLPD LLPD LLPD LLPD

DUAL 0.00448 ( 1.57) 0.000971 (0.40) 0.00974** ( 2.58) 0.00522* ( 1.67)

Ln-BD 0.0158 ( 1.58) 0.0417* ( 1.97) 0.0155 ( 1.07) 0.0362* ( 2.34)

AFFILFORG 0.00230 (0.35)

AFFILSTAT 0.0155** ( 3.28)

AFFILINST 0.0250*** ( 5.22)

AFFILFAM 0.0152*** ( 4.21)

SMOOTH 0.547* (1.89) 0.449* (1.75) 0.179* (0.97) 0.442* (1.77)

CAR 0.00197*** ( 5.03) 0.0028*** ( 5.41) 0.000947* ( 2.27) 0.00238*** ( 5.33)

SIZE 0.00167 (0.24) 0.0139* (1.81) 0.0187*** ( 3.29) 0.00174 (0.36)

CONC 0.0000662* ( 1.85) 0.0000465 (0.52) 0.000174* (1.73) 0.000082** ( 2.54)

Constant 0.0339 (0.32) 0.0907304 ( 0.89) 0.333*** (3.52) 0.0875 (1.26)

n 50 50 50 50

R 2 48% 59% 60% 52%

Notes: LLPD , discretionary loan loss provisions; DUAL, binary variable equals to 1 if there is an overlapping of the

functions of chairman of the board and CEO and 0 otherwise; Ln-BD , log of the number of directors on the board;

AFFIFORG , percentage of directors affiliated with the largest shareholder who is foreign; AFFILSTAT , percentage

of directors affiliated with the largest shareholder who is the State; AFFILINST , percentage of directors affiliated

with the largest shareholder who is institutional; AFFILFAM , percentage of directors affiliated with the largest

shareholder who are mainly members of the same family; SMOOTH , net income before tax and loan loss provisions

reported to total assets; CAR , capital adequacy ratio; SIZE , log of total assets; CONC , percentage of the largest

shareholder in the bank’s capital. ***, **, *Significance at 1, 5 and 10 percent levels, respectively

Table VPanel regressi

of affiliation natuon discretiona

provisio

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where directors are affiliated to families. In this case, banks should strengthen thepresence of independent directors. Finally, the delineation of the leeway left in theTunisian accounting standards would provide more transparent financial information.

Notes

1. Although the estimation of provisions is intended by accounting standards, it stills in partsubject to the subjective assessment of the manager. Thus, the constitution of provisionsincludes an objective part set by the banking regulation and a discretionary part thatmanagers can use to manage their results upwards or downwards depending on the outcomethey want to achieve.

2. Available at: www.ecgi.org/codes/documents/guide_tunisia_2008_en.pdf

3. According to the descriptive statistics, in 74 percent of cases, the percentage of affiliateddirectors to the largest shareholder exceeds 50 percent.

4. The percentage of shareholders (or investors) in a bank does not match the percentage of directors in the board. For example, if a bank is held by foreign investors, the proportion of foreigners in the board will be high but not equal to the percentage of foreign shareholders.

However, the voting right of foreign directors is proportional to the number of shares held.

5. The “BIG 4” are the four largest international firms of accounting and professional services.They audit the majority of listed companies. The “Big 4” includes Pricewaterhouse Coopers,KPMG, Ernst & Young and Deloitte Touche Tohmatsu.

6. A qualified opinion report is issuedwhen the auditor encountered one of two types of situationswhich do not comply with the financial reporting framework, however, the rest of the financialstatements are fairly presented. An auditor gives a clean or unqualified opinion when he doesnot have any significant reservation in respect of matters contained in the financial statements.

7. Amen Bank (AB), Arab Tunisian Bank, Attijari Bank, Bank of Housing, International ArabicBank of Tunisia, the National Agricultural Bank (BNA), Bank of Tunisia, Tunisian Society of banks (STB), Banking Union for Trade and Industry and the International Union of Banks.

8. The method of panel data with individual effect is used to estimate the coefficients over1998-2002 used later in the calculation of theoretical provisions. The Hausman test is used tospecify the heterogeneous nature of the model either fixed or random. Similarly, using themethod of “PCSE,” considered more appropriate for micro panels, gives similar results.

9. Correlation test of Pearson between explanatory variables show that correlation problemsappear between governance variables related to the nature of directors. The highestcorrelation coefficient is the one that connects institutional directors to foreigners (86percent). In fact, foreign directors are usually representatives of foreign banks. Similarly,applying the Variance Inflation Factor (VIF) test, the VIF values exceed the critical values of ten for the foreign directors and institutions (21.65 and 16.18 percent).

10. This endogeneity problem is due to the fact that users of financial statements do no longerperceive the principal role of the auditor consisting in protecting the rights of the company

against any abuse by the manager. In fact, a board that does not favor the control is requiredto appoint an accomplice auditor. The auditors deemed by their qualities can be appointedonly by independent boards of directors (Sakka, 2009).

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Externauditin

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Boulila Dan Mbarki