The Sarbanes-Oxley act of 2002 and the audit-committee : an examination whether SOX maximizes effectiveness of the audit-committee in the mitigation of earnings management

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The Sarbanes-‐Oxley Act of 2002 and The Audit-‐

Committee:

An examination whether SOX maximizes effectiveness of the audit-‐committee in the

mitigation of earnings management

ABSTRACT

This study examines whether SOX maximizes the effectiveness of the audit-‐committee in the mitigation of earnings management by determining the ideal framework to mitigate earnings management. Despite the induction of SOX, various cases of earnings management have come to light. Earnings management is viewed as undesirable, as it distorts the true underlying economic value of a firm. Based on a literature review, it can be concluded that an ideal audit-‐committee to mitigate earnings management will meet at least four times annually and will include at least four members, each of whom is both independent and a financial expert. Whereas a financial expert is defined as an individual who through both education and experience in either an accounting or auditing function encompasses the necessary attributes. SOX states that a committee member shall be a member of the board or independent and allows firms to decide whether an financial expert is included, whereas a financial expert encompasses the necessary attributes through experience. These findings suggest that SOX does not maximize effectiveness of the audit committee in the mitigation of earnings management. The main contributions to prior literature are the suggestions and propositions for future research stated in the final chapter of this chapter.

Name: Kareem Jamal Jaïr de Jong

Student number: 10361286

BSc Accountancy and Control

Faculty of Economics and Business, University of

Amsterdam

Supervisor:

mw. E.A. Duyster-‐Went RA

Date: 29/06/2015 Final Version

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Samenvatting

Dit literatuuronderzoek verkent of de Sarbanes-‐Oxley Wet (SOX) uit 2002 auditcommissies van beursgenoteerde bedrijven in staat stelt om, door formatie eisen te stellen aan de desbetreffende commissies, winststuring effectief matigen. In reactie op de geruchtmakende boekhoudschandalen bij onder andere Waste Management Inc. En Qwest Communications International Inc. Van het begin van het millennium is in 2002 (S0X) in het leven geroepen. Als gevolg van SOX moeten beursgenoteerde bedrijven in de Verenigde Staten publiekelijk rapporteren over de opzet en goede werking van de interne beheersing. Daarmee is tevens de rol van de auditcommissie, als interne toezichthouder, in zwaarte toegenomen. Ook na de invoering van SOX is gebleken dat beursgenoteerde bedrijven in de V.S. nog veelvuldig winststuring praktijken toepassen. De vraag is of SOX het functioneren van de auditcommissie in het voorkomen van winststuring optimaliseert.

Gebaseerd op literatuuronderzoek wordt in deze studie geconcludeerd dat ten behoeve van het voorkomen van winststuring de ideale auditcommissie enkel onafhankelijke financieel deskundige leden bevat. Hierbij wordt een financieel deskundige gedefinieerd als een individu die is opgeleid als een accountant of auditor en de nodige ervaring heeft opgedaan in een dergelijke functie. Tevens moet de auditcommissie minimaal vier keer per jaar samenkomen en uit minimaal vier leden bestaan.

SOX hanteert niet dezelfde formatie eisen als het op basis van het literatuuronderzoek geformuleerde ideale raamwerk. Deze bevindingen suggereren dat SOX de effectiviteit van auditcommissies in het matigen van winststuring niet optimaliseert. De voornaamste bijdrage van deze studie aan bestaande literatuur zijn de suggesties en proposities voor toekomstig onderzoek als vermeld in het laatste hoofdstuk van dit stuk.

Verklaring eigen werk

Hierbij verklaar ik, Kareem de Jong, dat ik deze scriptie zelf geschreven heb en dat ik de volledige verantwoordelijkheid op me neem voor de inhoud ervan.

Ik bevestig dat de tekst en het werk dat in deze scriptie gepresenteerd wordt origineel is en dat ik geen gebruik heb gemaakt van andere bronnen dan die welke in de tekst en in de referenties worden genoemd. De Faculteit Economie en Bedrijfskunde is alleen verantwoordelijk voor de begeleiding tot het inleveren van de

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The Sarbanes-‐Oxley Act of 2002 and The Audit-‐Committee

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Table of contents

Samenvatting...2

1. Introduction………...4

2. Earnings Management………6

3. Sarbanes Oxley Act on the Audit-‐committee……….6

3.1 Definitions………...6

3.2 Composition………7

4. The Audit-‐committee Characteristics………..…8

4.1 Independence………8

4.2 Financial Expert……….11

4.3 Activity……….15

4.4 Size……….17

5. The Ideal Audit-‐committee Framework in the Mitigation of Earnings Management………..…19

5.1 Independence……….…19

5.2 Financial Expert……….…20

5.3 Activity……….…20

5.4 Size……….20

5.5 Conclusion……….20

6. The Sarbanes Oxley Act vs. the Ideal Audit-‐committee Framework………….………..21

7. Conclusion, Restrictions and Suggestions for Future Research………..……21

8. References………22

Appendix……….25

List of Tables Table 3.1 Review of SOX on the Audit-‐committee………...7

Table 4.1 Independence Articles……….11

Table 4.2 Expert Definitions………13

Table 4.3 Financial Expert Articles……….14

Table 4.4 Activity Articles……….16

Table 4.5 Size Articles……….19

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1. Introduction

The concept of an audit-‐committee began emerging around the 1940’s. During this period, the Securities and Exchange Commission (SEC) started recommending the establishment of such an audit-‐committee, not only to ensure auditor independence, but also to stress to the auditor his responsibilities to investors (1940). In the decennia that followed these first recommendations of the audit-‐committee, the position of the committee was further enhanced through several reforms. In 1987, for instance, the Treadway Commission recommended that all publicly listed companies be required to have audit-‐committees composed entirely of independent directors (NCFFR, 1987, p12). However, arguably the most important reform that impacted the audit-‐ committee position is the Sarbanes Oxley Act of 2002. Following the pattern of reorganizations after cases of accounting scandals, this reform was passed in response to various accounting scandals in the preceding years. Examples of accountings scandals that occurred in the applicable period include the following: Waste Management Inc. engaged in a systematic scheme to falsify and misrepresent its financial results; and Qwest Communications International Inc. fraudulently reported revenue and excluded expenses (SEC, 2002; SEC, 2004).

An often-‐occurring form of fraud is earnings management. Though earnings management can be legal in the form of aggressive accounting, the SEC still views it as highly inappropriate because it distorts the true financial performance of the company and threatens the overall credibility of financial reporting (Dechow and Skinner, 2000; SEC, 2000). According to Healy and Wahlen, the most common reasons for managers to engage in earnings management are stock-‐market reasons (1999). Through earnings management, organizations can influence short-‐term stock price performance and consequently meet the expectations of financial experts. Other motivations have to do with contracting, politics and taxation (Scott, 2003).

The Sarbanes-‐Oxley act (SOX) applies to publicly held companies and was designed to prevent financial-‐statement fraud, to make financial reports more transparent and to strengthen internal controls (SOX, 2002, Title I-‐XI). To enable organizations to attain the goals set forth by SOX, the act covers multiple aspects. One of those includes an enhancement of the role of the audit-‐committee. Despite the reformation, the primary function of the committee is still to monitor financial reporting processes and internal controls (SOX, 2002, SEC. Title I-‐XI).

Despite the induction of SOX, numerous accounting scandals of earnings management and other types

of fraud occurred in the following years. In 2008, Barnard L. Madoff Investment Securities LLC embezzled $65 million through a Ponzi scheme. In the same year, Diamond Inc. was caught boosting their earnings by $220 million (Wall Street Journal, 2009; SEC, 2014). These cases are just two out of many instances of financial fraud that occurred during this period. Both organizations are publicly traded firms in the U.S. (NYSE, 2015; NASDAQ, 2015) and are thus required by law to establish and maintain an audit-‐committee (SOX, 2002, SEC.1-‐5). The audit-‐committees in these cases therefore failed, or were ineffective at fulfilling their primary function as monitor of the financial process.

In terms of composition, multiple studies have identified four characteristics that enable the audit-‐ committee to function effectively: independence, financial expertise, activity and size (BRC, 1999; Vera-‐Munoz, 2005; Song and Widram, 2004). Researchers have criticized the fact that, so far as composition is concerned,

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SOX covers only the independence and financial-‐expert characteristics (SOX, 2000, SEC.407b-‐301 3A; Defond and Francis, 2005). Based on the pattern of reorganizations following accounting scandals, a new reform should be implemented in subsequent years to replace SOX. But the question is whether SOX is to blame for the ineffectiveness of the audit-‐committee.

The purpose of this study is to determine if whether, in terms of composition, SOX maximizes the

effectiveness of the audit-‐committee of public listed firms to mitigate earnings management, by identifying the ideal audit-‐committee framework. Throughout this study, the framework will refer to the composition of the audit-‐committee. The stated purpose of this study will be reached by answering the following two questions:

“What is the ideal audit-‐committee framework to mitigate earnings management?”

“Does this framework correspond to the Sarbanes-‐Oxley Act of 2002?”

This study will be conducted through a literature review. This format is chosen because prior studies have subjected each characteristic of the audit-‐committee to extensive empirical research. Therefore, existing literature will be used as a foundation.

Whereas prior studies have studied each characteristic of the audit-‐committee individually, this paper discusses the four characteristics collectively. This applies also to the connection made to SOX: prior studies have discussed each characteristic but neglected the overall assessment. This study can, furthermore, be used as an indicator of which areas should be further subjected to empirical research.

In SOX it is stated that each member of the audit-‐committee shall be a member of the board of directors or be independent. An organization shall furthermore state whether at least one financial expert is included in the committee and if not, the reasons therefore shall be stated. SOX defines a financial expert as an person who encompasses through experience the necessary attributes. The findings of this study, on the other hand, suggest that to mitigate earnings management, the audit-‐committee should meet at least four times annually and include at least four members, each of whom is an independent financial expert. A financial

expert is defined as an individual who possesses the necessary attributes through education and experience in

an accounting or auditing function.

This paper is split into eight chapters. The following chapter provides a definition for the term,

earnings management. Chapter three will briefly specify the Sarbanes-‐Oxley act on the audit-‐committee. The

fourth chapter will discuss the studies that have been conducted on each characteristic and will provide an analysis of the results of each study. Chapter five provides an answer to the following question: What is the ideal audit-‐committee framework to mitigate of earnings management. In the sixth chapter, an answer is provided to the following question: does the ideal audit-‐committee framework correspond to SOX? Chapter seven will draw a conclusion, and the final chapter provides a reference list.

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2. Earnings Management

Earnings management has been a specific area of concern for the SEC. Various studies have defined the term,

earnings management. The definitions frequently cited are those by Scott (2003) and Healy and Wahlen (1999).

This subchapter will consider both definitions and compare them.

According to Scott, earnings management is the decision by a manager of accounting policies to

achieve some specific objective (2003, p.369). He adds that the choice of accounting policy is interpreted quite broadly. In his research however, Scott divides the choice of accounting policies into two categories: (1) the choice of policies per se, such as straight-‐line versus declining balance; and (2) discretionary accruals, such as provisions for credit losses and inventory costs (2003).

Healy and Wahlen, on the other hand, offer a broader definition for the term. They state that earnings

management occurs when managers use judgment in financial reporting and in structuring transactions to alter

financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers (Healy and Wahlen, 1999, p.368).

These two definitions clarify the essence of earnings management. Comparing the definitions suggests

that earnings management is an intentional choice made by a manager of an organization. Both definitions state that the deliberate choice will affect financial reports; Healy and Wahlen specify this explicitly, whereas Scott articulates the choice of accounting policies that consequently affect the financial report. Whereas Scott refers to a nondescript objective, Healy and Wahlen specify this objective. These objectives are, (1) to mislead stakeholders about the underlying economic performance of the company, and (2) to influence contractual outcomes that depend on reported net income. Thus, organizations that use earnings management mislead and influence the users of the financial statement and thereby threaten the overall credibility of financial reporting, as the SEC warned.

3. Sarbanes Oxley Act on the Audit-‐committee

To protect investors, the Sarbanes Oxley Act (SOX) of 2002 covered multiple aspects. In this chapter, an exposition of these is provided to describe the main subject of this research: the audit-‐committee. The audit-‐ committee is accounted for mainly in sections 2, 301 and 407 of the act (SOX, 2002). To facilitate comprehension, the sections will be divided into two categories: definitions and composition. This chapter will describe each category.

3.1 Definitions

Sections 2-‐a3 and 407b of SOX each describe definitions of terms that are applicable to the audit-‐committee:

audit-‐committee and financial expert. In this section, each definition will be examined.

Section 2 of SOX provides a list of definitions that apply throughout the act. In section 2-‐sub a-‐3, the term audit-‐committee is described as follows:

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purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer; and (B) if no such committee exists with respect to an issuer, the entire board of directors of the issuer” (SOX, 2002, SEC. 2-‐a-‐3).

Section 407b reviews the definition of the term, financial expert. The SEC amended this section in 2003. The SOX amendment defines an financial expert as a person who has the following attributes: (1) an understanding of generally accepted accounting principles and financial statements; (2) experience in (A) the preparation or auditing of financial statements of generally comparable issuers, and (B) in the application of such principles in connection with the accounting for estimates, accruals, and reserves; (3) experience with internal accounting controls; and (4) an understanding of audit-‐committee functions. Under the final rules, a person must have acquired such attributes through one or more of the following: (1) education and experience in either an accounting or auditing function; (2) experience actively supervising an accountant or auditor or experience performing similar functions; (3) experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or (4) other relevant experience (SEC, 2003, G3). The applicability of this term will be further discussed in chapter 3.2.

3.2 Composition

The composition requirements of the committee are stated in section 301-‐3 and 407a of SOX. Subsection 301-‐ 3A of title III describes the independence of the committee members. In this subsection, it is stated that each member of the audit-‐committee shall either be a member of the board of directors or be independent. That is, if someone other than a member of the board is appointed to the audit-‐committee, that person has to be independent (SOX, 2002). In order to be independent, an individual may not, other that in his or her capacity as member of the audit committee, or any other board committee (1) accept any consulting, advisory, or other compensatory fee from the applicable firm, or (2) be an affiliated person of the applicable firm of which the audit-‐committee is a part or any subsidiary thereof (SOX, 2002, SEC 301-‐3).

The residual part of the composition requirement is detailed in section 407a. In this subsection, it is

stated that an organization shall disclose whether or not the audit-‐committee is comprised of at least one member who is a financial expert. If no financial expert is given a position on the committee, the reasons for this lack should be stated (S0X, 2002).

Table 3.1 provides a summary of this chapter.

Table 3.1 Review of SOX on the audit-‐committee

Component Subject Section Content

Definitions Audit-‐committee 2-‐a3 A committee established by and among the board of directors

for the purpose of overseeing the financial process and audits of the financial statements of the applicable firm

Financial Expert 407b _{understanding
of
GAAP
and
financial
statements;
(2)
experience}A person who encompasses the attributes of: (1) an

in the preparation or auditing of financial statements and the

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application of accounting principles; (3) experience with internal _{accounting
controls;
(4)
and
an
understanding
of
audit-‐} committee functions

a person must have acquired such attributes through any one or

more of the following: (1) education and experience in either an accounting or auditing type function; (2) experience actively

supervising an accountant or auditor or performing similar functions; (3) experience overseeing or assessing the performance of companies or public accountants; or (4) other

relevant experience

Composition Independence 301 3A Each member of the audit-‐committee shall be a member of the

board of directors and shall otherwise be independent

Independence Criteria

301 3B A committee member may not accept any consulting, advisory,

or other compensatory fee from the applicable firm, or (2) be an affiliated person of the applicable firm or any subsidiary thereof

Financial Expert 407a An organization shall disclose whether or not the audit-‐

committee is comprised of at least one member who is a financial expert. If no financial expert is appointed, the reasons

for this lack shall be stated

4. Audit-‐committee Characteristics

The initial recommendations of the audit-‐committee made by the SEC (1940) state that the audit-‐committee should consist of non-‐officer board members who nominate auditors and arrange details of engagement. In the years following the initial recommendations, the initial formation requirements were replaced by others which were viewed as prerequisites for an effective audit-‐committee. The Blue Ribbon Committee (BRC) published a report in which the characteristics were identified and listed (1999). This report is one of the two regulatory reforms initiated in this century that have impacted corporate governance and enhanced the position of the audit-‐committee (Vera-‐Munoz, 2005). The BRC report has been cited as a reference for both the characteristics and responsibilities of the audit-‐committee. These responsibilities, however, are beyond the scope of this paper. The four characteristics identified in the BRC report are the following: independence, financial expert, activity and size. This chapter provides a description of each characteristic and a specification of certain articles about each characteristic

4.1 Independence

In the BRC report, it is stated that a member of the audit-‐committee shall be considered independent if he or she has no relationship to the corporation that may interfere with the exercise of his or her independence from management and the corporation (1999). Examples of non-‐independent members include the following: a director who is a partner in or a controlling shareholder or an executive officer of any for-‐profit business organization, and a director who is employed by the corporation or any of its affiliates for the current year or any of the past five years. A director with personal ties to management is less able to objectively evaluate the

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financial process of an organization than a director with no personal ties (BRC, 1999). The BRC therefore recommends that the audit-‐committee should consist solely of independent members (1999). Empirical research has been conducted on independence as a characteristic of the audit-‐committee, as it is most frequently cited as a prerequisite to effective audit-‐committee functioning (Abbot, Park and Parker, 2000; Klein, 2000; Xie, Davidson and DaBalt, 2002; Bedard, Chtourou and Courteau, 2004; Agrawal and Chadha, 2005).

Multiple studies have applied earnings management as a proxy to examine the effects of audit-‐ committee member independence (Klein, 2000; Xie et al., 2002; Bedard et al., 2004; Agrawal and Chadha, 2005). Klein (2002) studied 692 US publicly traded firms to determine whether committee independence is related to the magnitude of abnormal accruals, which is a proxy for earnings management. Klein’s results suggest a negative relationship between independent committee members and abnormal accruals. They furthermore suggest a significant negative relationship between abnormal accruals and an audit-‐committee that is comprised of a majority of independent directors: i.e., a committee with an independent proportion between 51% and 99%. Klein found no relationship, however, between abnormal accruals and audit-‐ committees with an independent member proportion of 100%. Klein thus rejected the view that the committee should be compromised solely of independent members and suggested that the threshold of audit-‐committee independence should be 50%.

Bedard et al. (2004) sampled 200 aggressive-‐earnings-‐management (AEM) firms and 100 low-‐earnings-‐ management (LEM) firms to determine whether firms with an independent audit-‐committee are less likely to engage in aggressive earnings management. The results indicate no significant effect for a committee comprised of a majority of independent members, contrary to Klein (2002),. The findings of Bedard et al. also suggest a significant reduction in the likelihood of aggressive earnings management when the audit-‐committee is fully independent. Xie et al. (2002), on the other hand, examined the relation between earnings management and discretionary accruals. Their findings suggest a negative relationship between audit-‐committee independence and the level of earnings management, partially confirming the results of Bedard et al. (2004).

A notable difference in the above findings is the contradictory results of Klein (2002) and Bedard et al. (2004). This contradiction may be explained by the different methods the studies used for accrual-‐error adjustment. Several studies indicate that biased results result when studies use a proxy to measure abnormal accruals rather than the true measure (Dechow, Sloan and Sweeney, 1995; Kasznik, 1999). To mitigate the measurement error, Klein applied the matched-‐portfolio technique described by Kasznik (1999), whereas Bedard et al. sampled only aggressive-‐earnings management firms and low-‐earnings management firms to mitigate the measurement error. Since the findings of Bedard et al. are in line with the majority of studies conducted in this area (Xie et al., 2003; Beasley et al., 2000; Abbott et al., 2000), it is most likely that the method used to mitigate the measurement of accruals in this study is more effective.

Agrawal and Chadha (2005) examined the relation between audit-‐committee independence and the likelihood of earnings restatements in a sample of 159 US public companies that restated earnings. The results suggest that there is no relation between the independence of the committee and the probability that a company will restate earnings. Compared to other studies covered in this subchapter, the results of Arguwal

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and Chadha (2005) stand out: it is the only study that found no relationship between independence and earnings management. This difference in results may be explained by the variance in earning management proxies applied. Arguwal and Chadha apply cases of earnings restatements as a proxy for earnings management whereas the other studies applied accruals (Klein, 2002; Xie et al., 2003; Bedard et al., 2004). Restatements of earnings occur only when the management of earnings has been discovered and reported either internally or externally. If the restatement is initiated internally, it is most likely that the audit-‐committee influenced the discovery either indirectly or directly. Given the primary function of the audit-‐committee as monitor of the financial process, an earnings restatement is therefore not necessarily undesirable for an effectively functioning committee. It is therefore questionable whether earnings restatements are appropriately used proxies for earnings management and audit-‐committee effectiveness if the sample for a majority consists of firm-‐initiated restatements. This is applicable to the study of Arguwal and Chadha (2005), as 119 of the 159 firms sampled initiated the restatement. The results of this study are thus insignificant when it comes to assessing audit-‐committee independence.

Other studies used general financial-‐statement fraud to assess audit-‐committee independence (Abbot et al., 2000; Beasley, 1996; Beasley et al., 2000). Beasley (1996) sampled 75 fraud and 75 no-‐fraud firms to determine whether the proportion of independent directors is lower for firms that suffer financial-‐statement fraud. His results suggest that fraud firms have a significantly lower percentage of outside directors than no-‐ fraud firms. However, the negative relationship between board independence and financial-‐statement fraud applied to the board of directors and not the audit-‐committee per se. To examine audit-‐committee independence effects, Beasley created a subsample of 26 fraud and 26 non-‐fraud firms. The results generated from analysing the subsample indicate that audit-‐committee independence has an insignificant negative effect on the likelihood of fraud. The results thus suggest that audit-‐committee independence may influence the likelihood of fraud, partially supporting the findings of Bedard et al. (2004) and Xie et al. (2002). The results of Beasley (1996) also suggest that board composition plays a greater role than audit-‐committee presence or composition in reducing the likelihood of financial-‐statement fraud. It should be noted that the sample Beasley examined is both relatively small (only 52 firms) and rather outdated (dating from 1980-‐1991). The significance of the results is therefore questionable, as it is most likely not representative of current issues.

The results of Beasley, Carcello, Hermanson and Lapides (2000) indicate that a lower percentage of audit-‐committees are composed entirely of independent directors in no-‐fraud firms than in fraud firms. These results suggest that the likelihood of fraud is significantly lower when an audit-‐committee is comprised entirely of independent members. Beasley et al. (2000) generated these results by analysing a total of 66 firms: 25 technology companies, 19 health-‐care companies, and 22 financial-‐services firms. Because of the small sample size, the possibility exists that the results are caused in part by coincidence rather than by facts. The significance of these findings is therefore debatable. The findings of Abbott et al. (2000) corroborate the results of Beasley et al. (2000). Abbott et al. (2000) sampled 156 publicly listed US firms, with an equal portion of sanctioned and non-‐sanctioned firms, to examine the relation between committee independence and the likelihood of fraud or aggressive accounting. The results of the study advocate a negative relationship between independence and the likelihood of financial-‐statement fraud or aggressive financial-‐statement actions.

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Table 4.1 provides a review of the independence articles covered in this subchapter.

Table 4.1 Independence Articles

Author Sample Independence

Measure Used Proxy Findings

Klein (2002) 629 US public listed firms

from Earnings Management Abnormal Accruals Negative relationship. Also Significant negative

relationship majority

independent. No relationship 100% independent

1992 to 1993

Xie et al (2003) 282 firms S&P 500 1992, 1994 and 1996 Earnings Management Discretionary current accruals Negative relationship Bedard et

al. (2004) 300 firms listed on Compustat. 200 Aggressive

Earnings management, 100 Low Earnings Management 1996

Earnings

Management Abnormal Accruals Negative relationship. Also no significant effect for a

committee composed majority-‐ independent

Agrawal and Chadha (2005)

159 U.S. Public companies that restated earning 2000 or 2001

Earnings

Management Cases of earnings

restatements

No relationship

Beasley

(1996) 150 U.S. public listed firms. Equal portion of fraud and

non-‐fraud 1980-‐1991 Financial-‐ statement fraud Cases of Accounting and Auditing Enforcement Releases No relationship Beasley et

al. (2000) 66 Firms alleged by SEC in health-‐care, financial-‐

service and technologies markets Financial-‐ statement fraud Cases of Accounting and Auditing Enforcement Releases Negative Relationship January 1987-‐ December 1997 Abbott et al. (2000)

156 Firms. Equal portion of sanctioned and non-‐ sanctioned firms for aggressive accounting or fraud.

Corporate fraud

Firms

sanctioned by the SEC for fraud or aggressive accounting Negative relationship 1980-‐1960 4.2 Financial Expert

Financial expert refers to the proportion of financial experts on the audit-‐committee. In fulfilling the primary

function, the audit-‐committee has a need for a person with accounting/financial expertise: i.e., a financial expert. The BRC, however, argues that it is important for a board member to be able to ask probing questions

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about the financial process of an organization and to intelligently evaluate the answers to these questions. The ability to ask and evaluate questions hinges on both the personal competence of the member and whether the member is able to read and understand fundamental financial statements. Thus, a basic understanding of fundamental financial statements—i.e., financial literacy—is needed rather than financial expertise for an effective audit-‐committee. Based on this, the BRC (1999) recommends that each member of the audit-‐ committee should be financially literate, whereas at least one member should be an expert.

To verify the financial literacy claim made by the BRC (1999), McDaniel et al. (2002) used an

experiment to determine whether and how judgments related to financial-‐reporting quality differ between financial literates and financial experts. Participants evaluated the quality of financial reporting of a fictive textile company. Audit managers represented the financial experts, and executive MBA graduates represented the financial literates. The findings of McDaniel et al. suggest a difference in how these groups assess the quality of reporting. The researchers consequently identified two relevant aspects of evaluation. First is the framework for evaluating reporting quality. The results generated by McDaniel et al. (2002) indicate that a financial expert incorporates some of the three quality characteristics that are generally viewed as prerequisite for proper evaluation of reporting quality into his or her framework. These quality characteristics are relevance, reliability and comparability. Financial literates, on the other hand, do not include these characteristics consistently. The second aspect of evaluation is the identification and evaluation of reporting concerns. In the experiment, financial experts identified as areas of concern those issues that their experiences would suggest are related with reporting quality. Financial literates, however, identified issues that are non-‐recurring in nature or other issues that have less important implications for the quality of reporting. The results of McDaniel et al. thus indicate that financial experts are better audit-‐committee members than financial literates. An inclusion of a financial expert over a financial literate improves the consistency of assessment of overall reporting quality. Financial experts are more likely to focus on areas of concern, whereas financial literates tend to focus on areas of lesser concern (McDaniel et al., 2002).

Whether or not the results generated by McDaniel et al. are representative is, however, questionable

for several reasons. First, because the study utilized a non-‐random sampling method, it is possible that human judgment affected the sampling process, making some members of the population more likely to be selected. Second, the sample utilized in the study is rather specific: it consisted of big-‐5 audit managers and MBA graduates. It is likely that the framework of audit managers differs from accounting managers and other levels of auditing/accounting type functions. For these reasons, it is debatable whether the results are representative.

In 2003, the SEC passed a SOX amendment that broadened the definition of financial expert. Whereas

the definition1 once included only individuals who acquired the necessary attributes2_{through
education
and}

experience (SOX, 2002, SEC. 407a), the new definition includes individuals who gained the necessary attributes solely through experience. (SEC, 2003, G3). Multiple studies (Defond, Hann and Hu, 2002; Krishan and Visvanathan, 2008; Carcello, Hollingsworth, Klein and Neal, 2006) examined the effects of the different definitions by distinguishing between financial and non-‐financial experts. The studies also divided financial

1_{A
description
of
the
old
definition
is
provided
in
the
Appendix}

2_{The
attributes
one
should
possess
to
be
considered
a
financial
expert
are
given
in
chapter
3.1}

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₁₃

experts into two subcategories: accounting experts and non-‐accounting experts. Accounting experts include those who were considered financial experts under the initial SOX definition. Non-‐accounting experts, on the other hand, include those who are considered financial experts under the SOX amendment but are excluded from being termed a financial expert under the initial definition. Examples of a non-‐accounting expert include company directors and CEO’s. Non-‐financial experts are furthermore considered the same as financial literates (Defond et al., 2005; Krishan and Visvanathan, 2008; Carcello et al., 2006). A review of the discussed expert definitions is provided in table 4.2

Table 4.2 Expert Definitions

Financial Expert Non-‐Financial expert

Accounting Expert Non-‐Accounting Expert (Financial Literacy)

Individuals who acquired the necessary attributes through education and experience

Individuals who acquired the necessary attributes through experience

An person who has a basic understanding of fundamental financial statements

Defond et al. studied 702 announcements of newly appointed audit-‐committee members to determine whether market participants reacted favourably when firms announced the appointment of either a financial expert or a non-‐financial expert (2005). In this study, the reactions of market participants were used as a measure based on the assumption that a financial expert on the audit-‐committee will enhance the ability of the board to protect shareholders interests and thereby increase shareholder value. Enhancing the ability of the board to protect shareholders will consequently strengthen corporate governance. Defond et al. (2005) made several findings of consequence. First, the market reacted positively to the appointment of an accounting financial expert, whereas no reaction to the appointment of a non-‐accounting expert was discovered. These results suggest that stakeholders prefer the appointment of accounting financial experts over non-‐accounting experts. Second, the benefits of a financial expert are contextual. That is, appointing a financial expert to the audit-‐committee only improves the corporate governance when that expert has accounting experience and the corresponding firm has strong corporate governance. Defond et al. thus reject both the broader definition of the SOX amendment and the financial-‐literacy view of the BRC, as only the appointment of accounting financial experts affect shareholder’s value.

However, to use market reactions as a measure of audit-‐committee effectiveness is, in the view of the author, controversial. Fluctuations in the share value after an announcement indicate only the preference of the stakeholders and not the effect that such an appointment will have on the overall effectiveness of the audit-‐committee. It is thus debatable whether the results of Defond et al. (2005) are significant to the assessment of audit-‐committee effectiveness.

Following Defond et al. (2005), both Carcello et al. (2006) and Krishan and Vishvanathan (2008) distinguish between accounting, non-‐accounting and financial experts. Krishnan and Vishvanathan (2008) analysed the association between audit-‐committee expertise and accounting conservatism for a sample of 211 firms listed on S&P 500. Their results indicate a positive relationship between accounting expertise and conservatism. However, their findings suggest no significant associations for both non-‐accounting experts and

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non-‐financial experts. These findings of Krishnan and Vishvanathan are supported by Carcello et al. (2006). Carcello et al. examined the relation between financial expertise and earnings management. Their findings indicate a significantly negative relation between accounting experts and abnormal accruals, and no significant association between the amount of abnormal accruals and both non-‐accounting and non-‐financial experts. Krishnan et al. (2008) and Carcello et al. (2006) therefore confirm the findings of Defond et al. (2005), and again reject the broader SOX definition and the BRC literacy view.

Other studies likewise used earnings management to assess the influence of financial experts on audit-‐ committee effectiveness (Xie et al., 2003; Bedard et. al. 2004; Agrawal and Chadha, 2005), consistent with Krishnan and Vishvanathan (2008) and Carcello et al. (2006). The results of Xie et al. (2003), among other things, suggest that the proportion of financially literate audit-‐committee members is negatively associated with discretionary current accruals. Their results thus suggest that, to mitigate earnings management, it is not necessary for an audit-‐committee member to be a financial expert, as financial literacy is sufficient. Of all the studies that empirically investigated the financial-‐literacy claim (Defond et al., 2005; Krishan and Visvanathan, 2008; Carcello et al. 2006), Xie et al. (2003) thus emerges as the only study that suggests a significant relationship. The difference in findings may result from the definition of financial literate each study uses. In the studies of Defond et al., Krishan and Visvanathan and Carcello et al., a financial literate is a person who is excluded from the definition of financial expert. Xie et al. narrow the definition by including only individuals with corporate or investment-‐banking backgrounds. This may suggest a significant relationship between individuals with corporate and investment backgrounds and audit-‐committee effectiveness rather than a significantly negative association with financial literates.

Other studies verified the effect of the proportion of financial experts on the audit-‐committee. Benard et al. (2004) and Agrawal and Chadha (2005) indicate that the proportion of financial experts is positively related to the containment of earnings management.

A review of the articles described in this subchapter is provided in table 4.3.

Table 4.3 Financial Expert Articles

Author Sample Measure Proxy Findings

McDaniel et

al. (2002) Experiment: 20 audit Big 5 Managers and 18

executive MBA graduates Quality of Financial Reporting Judgments Evaluation reporting quality fictive textile company

Inclusion of a financial expert over a financial literate improves

the consistency of judgment. Financial experts will also more likely focus on areas of concern whereas financial literates tend to

focus on areas of lesser concern

Defond et al.

(2005) 702 announcement newly appointed audit-‐

committee member 1993 to 2002 Market reaction on appointment announcement Stock returns form the Center for Research in Security Prices

Positive reaction appointment accounting expert and the benefits of a financial expert are

contextual

The Sarbanes-Oxley act of 2002 and the audit-committee : an examination whether SOX maximizes effectiveness of the audit-committee in the mitigation of earnings management