Audit Committee Financial Expertise Mitigation of Real Earnings Management

We examine whether and in what contexts the education and experience dimensions of financial expertise on the audit committee lowers the propensity for real earnings management. We find that 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. In contrast, we find that abnormal discretionary expenses are higher for firms with greater financial expertise, which is more consistent with downward earnings management or more conservative reporting. We separate financial expertise into financial education (finance or accounting degree, and CPA, CMA or CFA qualifications) and financial experience (finance or accounting work experience) components. Financial experience is negatively related to abnormal CFO and production but both experience and education are positively related to abnormal discretionary expenses. We find these results are largely driven by profitable firm-years in less profitable periods of time. Our evidence suggests that profitable firms with financial expertise exhibit unusually low CFO and production costs but unusually high discretionary expenses which is more consistent with prudent financial management than upward earnings management.