Audit Committee Elections

The following post comes to us from Ronen Gal-Or and Udi Hoitash, both of the Accounting Group at Northeastern University, and Rani Hoitash of the Department of Accountancy at Bentley University.

In our paper, Audit Committee Elections, which was recently made publicly available on SSRN, we examine whether and in what ways shareholder votes in the elections of directors who sit on the audit committee (AC) are associated with the effectiveness of the audit committee. Within the board, the audit committee is responsible for monitoring the financial reporting process. This process involves oversight over the external auditor, internal controls and overall quality of the financial reports. Aside from voting in director elections, shareholders can do very little to influence or signal their satisfaction to the AC. Yet, research examining director elections does not generally focus on the AC. In this study we aim to fill this void.

To conduct our examination, we use a large and representative sample of AC member elections between the years 2004 and 2010 that includes elections of over 40,000 directors. In contrast to previous studies, our sample, by design, includes only independent directors. Further, to examine shareholders’ independent evaluations of directors, we neutralize the strong documented influence of Institutional Shareholder Services (ISS), a proxy advisor, from our analyses by removing firms with directors that receive negative recommendations from ISS. This distinction in sample construction is important as it yields different results from prior studies and provides implications for future research. Particularly, we find that compared to other independent directors, AC members tend to receive a higher approval rate from shareholders. Studies that do not perform their analyses within independent directors only, obtain contradictory results. The results have important implications as they suggest that shareholders appreciate the additional work and personal risk taken by AC members.

Previous research also examined whether financial mishaps effect voting patterns and generally find that shareholders “penalize” the entire board for financial statement restatements. We refine these results by showing that shareholders assign the accountability over the financial reporting process to the AC and less so to non-AC independent directors. This refinement is important as it suggests that shareholders vote consciously and distinguish between directors based on their specific fiduciary duties.

Our results also contribute to the extensive literature on financial expertise on the AC. This literature demonstrates the value of having accounting experts on the AC. However, aside from DeFond et al. (2005), we are not aware of other studies providing evidence on shareholder sentiment towards directors with financial expertise. Our results demonstrate that shareholders prefer to see the AC populated with accounting experts and specifically an AC chair who is qualified for the position. While shareholders differentiate between AC members based on their qualifications, we do not find that they hold specific AC members more accountable for financial reporting mishaps. Yet, our results show that boards do hold the accounting experts more accountable and are more likely to replace experts following low AC approval rates.

Finally, and perhaps most importantly, we provide evidence that although shareholders’ votes are not binding, there is an association between votes and subsequent changes to the composition of the AC as well as improvements in financial reporting quality and audit pricing. Consequently, our results suggest that shareholders can influence the future quality of financial reporting through the director election process.

The full paper is available for download here.

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