Boards, Audit Committees, Earnings Management and Shareholder Returns in MBO's

Abstract

We relate the agency issues inherent in management buyouts and in earnings management. Income-reducing earnings management occurs prior to management buyouts. When insiders own small amounts of stock, outside monitoring mechanisms such as institutional ownership and Big Six audit firms reduce the level of earnings management. However, when insiders own large amounts of stock, the outside monitors have very little effect and inside monitors become more important. In these cases, smaller and more active audit committees reduce the level of earnings management. MBO firm earnings management does not appear to fool the stock market because the level of earnings management does not influence announcement-period abnormal returns. In a post-hoc examination of these issues in the years following Sarbanes-Oxley, we find that the pre-MBO earnings management becomes insignificant. This change may be due to the improvement in board and audit committee structure that we find in MBO firms following Sarbanes Oxley.