Corporate Governance, Auditing, and Reporting Distortions

Conventional wisdom suggests that independent boards limit earnings distortions and promote accurate reporting. In contrast, this study indicates that having insiders on boards enhances reporting integrity. The central result is that strengthening board independence curtails earnings overstatements but heightens the likelihood of understatements. This asymmetry occurs because reinforcing board independence on one hand limits the CEO's ability to overreport but on the other hand encourages the auditor to rely on the board's monitoring and consequently economize on effort. The reduced effort impairs the auditor's ability to verify high earnings and, because auditors favor conservative reports when in doubt, leads to increased incidence of conservative understatements.