The Effect of Audit Committee Expertise on Monitoring Financial Reporting

In our paper, The Effect of Audit Committee Industry Expertise on Monitoring the Financial Reporting Process, forthcoming in The Accounting Review, we examine the impact of audit committee (AC) industry expertise on the AC’s effectiveness in monitoring the financial reporting process. Despite the increased responsibilities, authority, independence, and financial expertise requirements placed on ACs by the Sarbanes-Oxley Act (SOX), ACs may, nonetheless, lack sufficient industry expertise to understand and thus properly monitor complex industry specific accounting issues. For instance, expertise in the retail industry may assist ACs to ensure that companies take an adequate write-down of inventory when their products face potential obsolescence. Similarly, revenue recognition, a prominent area of accounting manipulation (Beasley et al. 2000, 2010), entails an evaluation and understanding of the earnings process, which is tied to a company’s business processes that are often industry specific.

Practitioners recognize the importance of having individuals with industry expertise on the AC. For example, Olson (1999, 1108) argues that “the best qualified audit committee members will often be those who have practical management experience, and industry knowledge, as opposed to those with a financial or accounting background.” Similarly, in discussing best practices for ACs, Deloitte Development (2010, 2) recommended: “Because the audit committee is primarily responsible for addressing accounting and financial reporting risks, it is typical for a majority of the members to have finance, accounting, or legal backgrounds. Audit committees should consider including industry or other specialists to shed light on any complexities that may be unique to the company or the industry.”

Despite calls emphasizing the importance of industry expertise on the AC by practitioners and by academics (DeZoort et al. 2002; Bédard and Gendron 2010), there has been no prior research to our knowledge on the association between AC industry expertise and the effectiveness of the monitoring functions of the AC in ensuring high quality financial reports and overseeing the relationship with the external auditor. Therefore, the goal of this study is to fill this void in the literature by examining the impact of AC industry expertise on the performance of these critical duties of the AC.

Consistent with prior research, we use two measures of financial reporting quality: restatements; and earnings management using discretionary accruals. Additionally, consistent with prior studies, we use two measures that relate to AC’s direct responsibility for overseeing the auditor: the magnitude of audit fees; and the ratio of non-audit fees to total fees. We use a large and representative sample of 18,564 firm-year observations during 2001-2007, in which there are 1,103 “non-technical” restatements over 2,357 misstatement years and a sample of 16,693 firm-year observations for the discretionary accruals analyses. We also employ a sample of 18,567 firm-year observations for the audit and non-audit fees analyses.

We define an AC member to have industry expertise if s/he is currently or has previously been employed by another firm that has the same two-digit SIC code as the firm in which s/he now serves as an AC member. Next, consistent with prior literature (e.g., Krishnan and Visvanathan 2008), we measure AC member financial expertise as accounting or supervisory financial expertise, which we refer to as “accounting expertise” and “supervisory expertise”. We then aggregate measures of industry expertise with those of accounting and supervisory expertise at the individual level to obtain a measure of industry expertise at the AC level. We find that ACs with members who are industry experts as well as accounting experts consistently perform better than those with accounting experts alone as reflected by a lower likelihood of a financial restatement, a lower level of discretionary accruals, higher audit fees, and a lower ratio of non-audit fees to total fees.

Contrary to prior studies that do not report a significant association between supervisory expertise and financial reporting quality (Krishnan and Visvanathan 2008; Dhaliwal et al. 2010), we identify instances in which audit committee members with both industry and supervisory expertise are associated with higher financial reporting quality and more effective monitoring of the external auditor. Specifically, we find that they are associated with lower income-increasing discretionary accruals and lower non-audit fees as a proportion of total fees than members who are supervisory experts alone. Overall, our results suggest that in order to more effectively monitor the financial reporting process, it is beneficial for an audit committee member to have industry expertise in addition to accounting expertise.

The full paper is available for download here.