Terry L. Neal

CEO Involvement in Selecting Board Members, Audit Committee Effectiveness, and Restatements

Research finds independent audit committees and audit committee financial experts are generally effective in monitoring the financial reporting and auditing processes. However, not all audit committees that appear in form to be independent are in fact actually independent, and not all financial experts with similar backgrounds and credentials are equally effective. CEO involvement in the board selection process can affect whether an audit committee substantively functions as an independent one. We use financial statement restatements to examine whether the benefits of having an independent and expert audit committee are diminished, or even eliminated, when the CEO is involved in the selection of board members. Our results provide some evidence that the monitoring benefits of having an independent and expert audit committee are only maintained when the CEO is not formally involved in selecting board members, although our proxy for CEO involvement in the director selection process is likely subject to some measurement error. Further, we find that these results appear to be driven by the more severe restatements, including misstatements in conjunction with fraudulent financial reporting. In addition, we find that our results continue to apply in the post-SOX period, a period where we have a more exact measure of CEO involvement in the director selection process. Finally, we find that the stock market’s negative reaction to a restatement is mitigated only when the audit committee is independent and the CEO was not involved in selecting board members.

Audit Committee Financial Expertise, Competing Corporate Governance Mechanisms, and Earnings Management

A prime objective of the Sarbanes-Oxley Act and recent changes to stock exchange listing standards is to improve the quality of financial reporting. We examine the associations between audit committee financial expertise and alternate corporate governance mechanisms and earnings management. We find that both accounting and certain types of non-accounting financial expertise reduce earnings management for firms with weak alternate corporate governance mechanisms, but that independent audit committee members with financial expertise are most effective in mitigating earnings management. Importantly we find that alternate corporate governance mechanisms are an effective substitute for audit committee financial expertise in constraining earnings management. Finally, we find either no association or a positive association between financial expertise and real earnings management. Our results suggest that alternate governance approaches are equally effective in improving the quality of financial reporting, and that firms should have the flexibility to design the particular set of governance mechanisms that best fit their unique situations.

Audit Committee Independence and Disclosure: choice for financially distressed firms

This study examines the relation between audit committee independence and disclosure choice for financially distressed US firms. The tenor of both the financial statement notes and Management Discussion and Analysis (MD&A) is considered. For firms experiencing financial distress, there is a significant positive relation between the percentage of affiliated directors on the audit committee and the optimism of the going-concern discussion in both the notes and the MD&A. These results add to the growing body of literature documenting a relation between audit committee independence and financial reporting quality.

CEO Power, Internal Control Quality, and Audit Committee Effectiveness in Substance Versus in Form†

During the past decade, new regulations have been adopted to improve audit committee effectiveness. Prior research has generally provided evidence in support of these regulations and suggests that a more independent and expert audit committee is more effective. We posit that CEO power reduces or even eliminates the improvements in audit committee effectiveness resulting from independent and financially expert committee members. Thus, CEO power may result in an audit committee that appears effective in form but is not in substance. We construct a composite index for CEO power by combining ten CEO characteristics and employ the incidence of internal control weaknesses as a proxy for audit committee monitoring quality. Since all the firms in our sample have completely independent audit committees, we use financial expertise to examine the impact of CEO power on audit committee effectiveness. We find that, when CEO power is low, audit committee financial expertise is negatively associated with the incidence of internal control weaknesses. However, as CEO power increases, this association monotonically weakens. When CEO power reaches a sufficiently high level, this association is no longer negative. The moderating effect of CEO power on audit committee effectiveness is more prominent when the CEO extracts more rents from the firm through insider trading. Our results are not driven by the CEOs involvement in director selection. Our paper suggests that more expert audit committees in form do not automatically translate into more effective monitoring. Rather, the substantive monitoring effectiveness of audit committees is contingent on CEO power.