Does the SOX Definition of an Accounting Expert Matter?
The Association between Audit Committee Directors'
Accounting Expertise and Accounting Conservatism*
GOPAL V. KRISHNAN, Lehigh University
GNANAKUMAR VISVANATHAN, George Mason University
1. Introduction
The Sarbanes-Oxley Act (SOX) (U.S. Congress 2002) mandates the disclosure of
whether the audit committee includes a financial expert. ' However, the operationalization of who is a financial expert was and still is a controversial issue (Plitch
and Ceron 2003). Some have argued that effective audit committee members are
those who have general management experience rather than those who have an
accounting or financial background (Olson 1999). The Securities and Exchange
Commission (SEC) initially proposed a narrow definition to include only accounting financial experts — that is, directors with experience as a certified public accountant (CPA), auditor, chief financial officer (CFO), controller, or chief accounting
officer. Subsequently, the SEC defined financial expert broadly to include nonaccounting financial experts, such as directors with experience as a chief executive
officer (CEO) or president (SEC 2003).2 Was the SEC correct in defining financial
experts to include both accounting and nonaccounting experts? Do accounting
financial experts enhance the quality of financial reporting more than nonaccounting financial experts? These are important questions because the primary objective
of SOX was to restore credibility to the U.S. financial reporting system, which was
tarnished by several high-profile accounting scandals. Because the audit committee
is the ultimate monitor of the financial reporting process, the audit committee's
financial expertise is a key determinant of its effectiveness (Treadway 1987). We
contribute to this debate by separately examining the association between the audit
committee's accounting financial expertise and nonaccounting financial expertise
and several attributes of financial reporting quality.
Our primary measure of financial reporting quality is accounting conservatism. We focus on conservatism for several reasons. Several scholars recognize the
long-standing infiuence of accounting conservatism on accounting practice. For
example, Basu (1997) notes that conservatism has infiuenced accounting practice
for at least 500 years. Sterling (1970) rates conservatism as the most infiuential
principle of valuation in accounting. Ball (2001) argues that conservatism is a
*
Accepted by Peter Pope. We appreciate the helpful comments made by two anonymous referees,
Andrew Felo, Chris Jones, Peter Pope (associate editor), and the seminar participants at American
University, George Mason University, and the 2006 Annual Meeting of the American Accounting
Association. We thank Anya Zyuzina for help with data collection.
Contemporary Accounting Research Vol. 25 No. 3 (Fall 2008) pp. 827-57 © CAAA
doi:10.1506/car.25.3.7
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Contemporary Accounting Research
fundamental characteristic of financial reporting. Watts (2003a, b) emphasizes that
conservatism facilitates effective monitoring of managers and contracts by constraining overpayments to managers and other parties.3 Furthennore, the recent
accounting scandals in the United States and elsewhere, and a record number of
restatements of financial statements, have underscored the importance of conservative financial reporting. Despite the long history and the importance associated
with conservatism, surprisingly, there is limited empirical evidence of the relation
between the audit committee characteristics and conservatism.'* We also examine
the relation between the audit committee's financial expertise and the Q score
developed by Penman and Zhang 2002. Penman and Zhang refer to the Q score as
an "eamings quality indicator", and provide evidence that the Q score has predictive power for one-year-ahead retum on net operating assets (RNOA) incremental
to past RNOA.
Audit committee members with accounting financial expertise are expected to
enhance accounting conservatism through their better monitoring capability driven
by their knowledge base, job expectations as demanded by the audit committee charter, and economic incentives to mitigate the risk of litigation and protect their reputation capital.
We measure audit committee expertise in three ways: accounting financial
experts, nonaccounting financial experts, and nonfinancial experts (directors who
are neither accounting nor nonaccounting financial experts). We use multiple proxies
to capture conservatism. We use two accruals-based measures developed by Givoiy
and Hayn 2000, a measure that is derived from the book-to-market ratio (Beaver
and Ryan 2000), and a conservatism score developed by Penman and Zhang 2002
to capture unrecorded assets on the balance sheet. We also use Ball and Shivakumar's
2005 asymmetric loss recognition test, an altemative measure of conservatism.^
Our control variables include several other characteristics of the audit committee
and the board.
Our sample firms come from the Standard & Poor's (S&P) 500, and the total
number of firm-year observations is 929 (633 for the conservative score measure)
representing years 2000 through 2002. We find that, in general, accounting conservatism is not correlated with nonaccounting financial expertise or nonfinancial
expertise. However, accounting financial expertise is positively and significantly
correlated with all but one measure (book-to-market ratio) of conservatism.
Results based on the Q score indicate a positive and significant relation between
accounting financial expertise and the Q score. We also find that the accounting
financial experts on the audit committee are able to effectively perform their monitoring function and promote conservative accounting only when they are in boards
that are characterized by strong govemance. This finding holds for all four measures of conservatism. It appears that in weak boards the presence of accounting
financial expertise on the audit committee is ineffective in promoting conservative
accounting — that is, the effect of accounting financial expertise is undermined by
weak govemance mechanisms. We also consider the possibility that attributes of
corporate boards and govemance mechanisms may be endogenously determined.
When we control for endogeneity, results are significant for the book-to-market
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Does the SOX Definition of an Accounting Expert Matter?
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measure as well as for the other measures of conservatism. Overall, the findings
suggest that accounting financial expertise has a broader impact on financial
reporting beyond accounting conservatism.
We make several contributions. First, we contribute to the debate on the appropriate definition of a financial expert under SOX. By including both accounting
financial expertise and nonaccounting financial expertise in the same model, ours
is the first study that directly tests the relation between these two types of financial
expertise with accounting conservatism. We provide empirical evidence that is
consistent with the SEC's initial narrow definition to include only accounting
financial experts. This finding has implications for boards of directors and regulators in other countries who are considering measures to enhance the effectiveness
of audit committees.
Second, DeFond, Hann, and Hu (2005) consider two competing explanations
for the favorable market reaction to the appointment of experts to the audit committee: monitoring (i.e., the appointment of an expert improves the committee's oversight) and signaling (i.e., the appointment is a credible signal to the investors that
the firm takes financial reporting seriously. The two explanations are not mutually
exclusive and DeFond et al. (2005) interpret their evidence as consistent with the
monitoring explanation. Engel (2005), however, notes that the market reaction is
an expectation of value enhancement, not a direct measure of actual or ultimate
improvements associated with the appointment. Our finding that only accounting
financial expertise is associated with conservatism is consistent with the monitoring explanation. That differentiation is important because it opens up the "black
box" — that is, it contributes to our understanding of why the stock market reacts
favorably to the appointment of accounting experts but not nonaccounting experts
to the audit committee.
Third, we contribute to the growing literature on the consequences of the audit
committee's expertise on financial reporting quality (Xie, Davidson, and Bodealt
2003; Bedard, Chtourow, and Courteau 2004; Agrawal and Chadha 2005; J. Krishnan
2005).6 Whereas prior research implies that financial expertise will have a favorable impact on financial reporting quality for the average firm, we extend the literature by providing evidence that overall govemance quality accentuates the effect of
accounting expertise on conservatism. This finding has important implications for
the boards of directors, auditors, and investors.
Fourth, we also provide empirical evidence on the association between the Q
score, a measure of eamings quality, and the accounting expertise of the members
of the audit committee. Thus, by examining multiple measures of conservatism as
well as the Q score, we provide an analysis of the impact of the audit committee's
expertise on financial reporting that is more comprehensive than prior studies that
examined a single attribute of financial statements.
The rest of this paper is organized as follows. Section 2 reviews the related
research and develops the hypothesis. Section 3 describes the research method and
the sample selection process. Section 4 provides our results and conclusions.
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2. Hypothesis
Traditionally, the audit committee has oversight of financial reporting, including
the annual and quarterly financial statements, disclosures in regulatory filings,
eamings releases, pro forma information, and eamings guidance (Steinberg 2005).
The Blue Ribbon Committee (1999) notes that the audit committee is the ultimate
monitor of the financial reporting process. Recently, a survey by PricewaterhouseCoopers 2005 asked directors to rank seven dimensions of an effective board. The
audit committee's ability to monitor the accuracy of financial reporting was ranked
as the most important dimension. This finding underscores the significance of audit
committees as a govemance mechanism.
Watts (2003a) argues that the board of directors has at least two reasons to be
interested in conservatism: conservatism could restrain managers' ability to overcompensate themselves by aggressive accounting and conservatism could offset
managers' tendencies to report good news more than bad news. Although Watts's
arguments for the demand for conservatism are made from the overall board
perspective, there are several reasons why the members of the audit committee —
specifically the directors with accounting expertise — would promote conservatism. Our arguments for the audit committee directors with expertise derive from
the fact that they, among all board or audit committee members, have the best ability
to distinguish among accounting policies (as conservative or aggressive), and they
have incentives, more so than other directors, to promote conservatism. More specifically, audit committee members with accounting expertise could potentially
enhance conservatism for three reasons: (a) having accounting expertise provides
the ability to assess the nature and the appropriateness of the accounting choices
made by the managers; (b) provisions in audit committee charters frequently
require the members to examine the aggressiveness or conservatism of accounting
policies, thereby placing a demand on members' expertise; and (c) risk of litigation
and in particular the potential loss of reputation capital for those with accounting
expertise provide further incentives for such members to promote accounting conservatism. We elaborate on these reasons below.
Financial expertise
The Treadway Commission (1987) concluded that the experience and expertise of
the members of an audit committee are an important dimension of an audit committee's effectiveness. Audit committee members with accounting financial expertise can enhance conservatism by assessing the adequacy of provisions for matters
such as warranty obligations, lawsuits, and other contingencies, and appraise the
overall quality of financial reporting. Also, they can examine the reasonableness of
explanations provided by management, and in particular detect the nature of disagreements between management and the extemal auditor (DeZoort and Salterio
2001). There is a long and growing literature on the relation between an audit committee's financial expertise and attributes of financial reporting, and researchers
have begun to examine the effects of accounting versus nonaccounting financial
expertise.
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Kalbers and Fogarty (1993) examine whether an audit committee's power is
associated with its effectiveness. They argue that because audit committees are
composed of individuals, the members' personal attributes influence the committees' effectiveness. One dimension of power is "expert power"; that is, members
skilled in accounting and finance could contribute to the committee's effectiveness.
Kalbers and Fogarty find that expert power is highly associated with financial
reporting effectiveness. Similarly, McMuUen and Raghunandan (1996) provide
evidence that firms with financial reporting problems are less likely to have CPAs
on the audit committee.
McDaniel, Martin, and Maines (2002) conduct an experiment to study the
effects of financial expertise and financial literacy on financial reporting. They use
audit managers and Executive MBA graduates as surrogates for financial experts
and financial literates, respectively. Borrowing from research on cognitive psychology, McDaniel et al. (2002) argue that experts' episodic knowledge about
financial reporting quality represents both first-hand experiences (training and professional certification) with relevant problems and second-hand experiences — for
example, interactions with other experts. However, episodic knowledge of literates
is derived from second-hand information. McDaniel et al. point out that the secondhand exposure to a financial reporting issue is likely to be more limited and erode
over time because literates may not reinforce or further develop their framework
through practical experience. In other words, relative to the literates, experts possess experience-based and well-developed frameworks to raise concems regarding
treatment of items that may contribute to misstatement of financial statements or
poor reporting quality.'' Consistent with their predictions, McDaniel et al. find that
financial experts possess a framework for evaluating financial reporting quality
that is more consistent with the Financial Accounting Standards Board's (FASB)
conceptual framework. They conclude that having financial experts on the audit
committee is likely to bring a focus on issues that may receive a lower priority if
only financial literates were on the audit committee.
Several recent studies examine the relation between an audit committee's
financial expertise and eamings management, although the definition of financial
expertise varies. Xie et al. (2003) and Bedard et al. (2004) provide evidence that
the financial sophistication of the board and the audit committee is an important
factor in constraining the propensity of managers to engage in eamings management. Agrawal and Chadha (2005) find that the probability of restating financial
statements is significantly lower when the audit committee has an independent
financial expert. This finding is consistent with the notion that independent directors with financial expertise provide valuable oversight over financial reporting.
DeFond et al. (2005) conduct an event study for a sample of firms appointing
accounting and nonaccounting financial experts to their audit committees and find
a positive stock market reaction only for appointments of accounting experts. This
finding suggests that appointing a nonaccounting expert to the audit committee is
treated as a nonevent by the market participants. Conversely, appointing an accounting expert is expected to enhance corporate govemance through increased monitoring. Karamanou and Vafeas (2005) study several attributes of audit committees,
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Contemporary Accounting Research
including expertise, and find that firms with effective govemance mechanisms are
more likely to make or update a management forecast. This finding is stronger for
bad news when investors are at most risk of suffering wealth losses. Finally,
Zhang, Zhou, and Zhou (2007) provide evidence that firms are more likely to be
identified with an intemal control weakness under SOX if their audit committees
have less accounting financial expertise. Overall, the empirical evidence reviewed
here supports the notion that members of the audit committee with accounting
financial expertise possess experience-based and well-developed frameworks to
assess accounts' conservatism, and can evaluate the explanations provided by
management.
Expectations of the audit committee charter
The roles and responsibilities of the members of the audit committee are usually
described in the audit committee charter. We reviewed the audit committee charter
for several firms and generally found a high degree of consistency in terms of job
expectations, including reference to accounting conservatism.^ We provide two
examples from the audit committee charters below.
Ruby Tuesday:
As part of its oversight responsibility, the Committee shall provide for the
following to ensure the credibility offinancialreporting: ... Ensure that management and the Auditor discuss with the Committee their qualitative judgments
about the appropriateness, not just the acceptability, of accounting principles
andfinancialdisclosure practices used or proposed to be adopted by the Company and, particularly, about the degree of aggressiveness or conservatism of
its accounting principles and underlying estimates.
eBay:
The Audit Committee shall ... discuss with the independent auditors the
results of the annual audit, including the auditors' assessment of the quality
and conservatism [of accounting principles] ...
Thus, to fulfill the expectations of the audit committee charter, audit committee
members need to understand not only the accounting principles and estimates used
but also whether those principles and estimates are more conservative relative to
other principles and estimates. Though meeting the expectations of the audit charter applies to all audit committee directors, it is natural that directors who lack
accounting financial expertise would tum to directors with accounting expertise for
leadership on matters conceming financial reporting issues. This is the fundamental reason for recruiting a financial expert to serve on the committee in the first
place. Thus, the obligation to fulfill the expectations of the audit committee charter,
particularly with regard to conservatism, is greater for those directors with
accounting financial expertise relative to directors who lack such expertise.
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Economic incentives
Basu (1997) iu-gues that litigation risk against auditors is an important driver of
conservatism. We believe that the same argument also applies to the members of an
audit committee. Like auditors, members of the audit committee face an asymmetric loss function and bear significant reputation costs in the event of financial fraud
or a material misstatement of financial statements. For example, KPMG's Audit
Committee Institute (2006) surveyed 1,200 audit committee members in 17 countries and found that members of the audit committee felt that they are exposed to a
higher level of litigation risk and financial prosecution than any other members of
the board. Furthermore, this sentiment of greater exposure to lawsuits is highest in
North America. Do courts hold directors with financial expertise to a higher standard
than other directors? In a recent decision involving Emerging Communications,
Inc., where the shareholders sued the board for breach of fiduciary duty, the Delaware Chancery Court held one director to a higher standard than the other directors
because he had specialized financial expertise while several other directors were
not found liable (Cost and Miller 2005). This is an interesting development
because SOX provides a safe harbor for financial experts from additional liability
from the federal securities laws. However, fiduciary obligations are imposed on
directors by state law, and, thus, directors could be sued under the state law as in
the case of Emerging Communications, Inc. This example indicates that the risk
of litigation could be higher for directors who are financial experts relative to other
directors.
In addition to fines and damages awarded against the members of the audit
committee, outside directors with a poor track record of monitoring are disciplined
by the managerial labor market (Milgrom and Roberts 1992; Gerety and Lehn
1997). Srinivasan (2005) examines the loss in the number of other directorships
held by the director in the three years following the announcement of a restatement
of financial statements. He concludes that audit committee directors, on average,
lose more other directorships than do nonaudit committee directors. This is consistent with the notion that audit committee directors bear more responsibility for
financial reporting oversight relative to other directors. Furthermore, Srinivasan
finds that for a sample of firms with income-decreasing restatements, the coefficient on financial experts is positive and statistically significant. In other words,
financial experts lose more directorships than nonfinancial experts. Thus, in the
event of financial reporting failure, the market for directors appears to discipline
financial experts more than nonfinancial experts. Interestingly, the financial expert
coefficient is positive but not significant for firms with income-increasing restatements. This finding is consistent with the asymmetric loss function faced by the
members of the audit committee. Thus, members of the audit committee, particularly accounting financial experts, have incentives to enhance accounting conservatism to mitigate the risk of litigation and the consequential reputation loss.
In summary, the combination of the audit committee members' accounting
financial expertise, increasing expectations of the audit committee charter to
ensure the credibility of financial reporting — including maintaining conservatism
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— and the economic incentives of the members of the audit committee to mitigate
the risk of litigation and to protect their reputation capital is likely to enhance
conservatism through increased monitoring. This line of reasoning leads to the
following hypothesis (in altemative form):
The audit committee's accountingfinancialexpertise is positively
associated with accounting conservatism.
HYPOTHESIS.
3. Research design and sample
Measures of audit committee's expertise
Following DeFond et al. 2005, we measure expertise in three ways. Accounting
financial experts are directors with experience as a certified public accountant,
auditor, principal or chief financial officer, controller, or principal or chief accounting officer. Nonaccounting financial experts are directors with experience as the
chief executive officer or president of a for-profit corporation. Nonfinancial experts
are directors who are neither accounting nor nonaccounting financial experts.
Measures of conservatism
Conservatism is a multifaceted constmct. We use multiple proxies to capture conservatism. Our first measure of conservatism is an accrual-based measure. Givoly
and Hayn (2000) state that conservative accounting leads to persistently negative
accruals, in contrast with the expected pattern of accrual reversals. Following
Ahmed, Billings, Morton, and Stanford-Harris 2002, CONACRU equals income
before extraordinary items and discontinued operations plus depreciation expense
less operating cash flows deflated by total assets. CONACRU is averaged over a
three-year period centered at period t.^ We multiply CONACRU by — 1 so that it is
increasing in the amount of negative accmals.
Our second measure of conservatism is designed to address the issue that
accruals in any given period contain accmals of prior periods that reverse during
that period. To filter out effects of such reversals, Hui and Matsunaga (2004) use a
firm fixed-effect procedure by regressing current period accmals on lagged accmals for each of the prior six years. The coefficient on the lagged accmals would
capture the reversals of past accmals. The firm-specific intercept from this fixedeffect regression is thus at least partially free of the effect of past accmals that are
reversing. This firm-specific intercept multiplied by — 1 is our second measure of
conservatism designated as CONACRUF.
Our third measure comes from Ryan 1995 and Beaver and Ryan 2000. They
decompose the book-to-market ratio (BTM) into its bias and lag components. Bias
means that the book value is persistently lower (higher) than market value, so that
BTM is persistently below (above) one. Lag refers to the unexpected economic
gains and losses that are recognized in book value over time rather than immediately. Thus, the BTM is temporarily lower but tends to its mean over time. Both
bias and lag result from joint effects of the accounting process and the economic
environment. Beaver and Ryan estimate the firm-specific intercept, Xi, from the
following fixed-effect regression of book-to-market ratio (BTM) on current and six
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835
lagged (k = 0-6) annual stock retums (RET). We multiply the firm-specific intercept by — 1.
BTM¡, = x+Xi
+ Xt + ^hRETi, _ k
(1),
where i and t are firm and year subscripts; bias and lag are captured by Xi and 5^,
respectively. Beaver and Ryan show that the bias component is associated with
measures of accounting conservatism while lag is not. We refer to Xi as CONBM.
Penman and Zhang (2002) compute a conservatism index (C score) to capture
the effect of conservative accounting on the balance sheet. It is a measure of unrecorded reserves on the balance sheet. Following Penman and Zhang 2002, our final
measure of conservatism, CONCSCO, is the amount of LIFO (last-in, first-out)
reserve, research and development (R&D), and advertising reserves scaled by net
operating assets for firms that have one or more of the three reserves. LIFO inventory reserve equals LIFO reserve as reported in financial statements. R&D and
advertising reserves are calculated based on procedures described in Penman &
Zhang 2002. The advantage of this method is that it directly considers the role of
accounting policy choice in conservatism — unlike the other measures. A shortcoming, however, is that not all possible accounting choices are considered. Penman
and Zhang (2002) justify considering these three accounting policy choices in the
C score because, unlike most other accounting choices, these are either mandated
by regulators or changed only rarely.
Empirical model
We estimate the following empirical model:
CON = ao + aiAFINEXP + a^^AFINEXP + a^BSIZE + a^^^ODUAL
+ a^BIND + OLf/iCSIZE + a-jAClND + a^ACMEET + a^IZE
+ a^CFO + ai2RDADV + ay^SGROW + ai^LlTI
+ ai^NOWN + ui-jINSTOWN
(2).
We define the variables as follows:
CON
= one of the four conservatism measures (CONACRU, CONACRUF,
CONBM, and CONCSCO);
AFINEXP
= the proportion of audit committee directors who qualify as
accounting financial experts to the total number of directors in the
audit committee;
NÁFINEXP = the proportion of audit committee directors who qualify as nonaccounting financial experts to the total number of directors in the
audit committee;
BSIZE
= the log of total number of directors in the board;
NODUAL
= a dummy variable that equals 1 if the CEO is also not the chairman
of the board, and equals 0 otherwise;
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Contemporary Accounting Research
BIND
= the proportion of directors who are independent;
ACSIZE
= the log of total number of directors in the audit committee;
ACIND
= the proportion of independent directors in the audit committee;
ACMEET
= the number of meetings by the audit committee dudng the year;
SIZE
= the log of total assets;
DEBT
= long-term debt divided by total assets;
CFO
= cash now from operations, scaled by total assets;
RDADV
= research and development expense plus advertising expense, scaled
by sales;
SGROW
= the atinual percentage change in sales;
LITI
= a dummy variable that equals 1 for biotechnology, computers, electronics, and retailing industries and equals 0 for other industries
(Francis et al. 1994);
BIG4
= a dummy variable that equals 1 if the company's auditor is one of
the Big 4 audit firms and equals 0 for other auditors;
INOWN
= the percentage of common stock owned by all officers of the
corporation and directors as a group;
INSTOWN = the percentage of common stock held by institutions.
A positive coefficient for a^ is consistent with our hypothesis that accounting
financial expertise is associated with accounting conservatism. We do not offer a
prediction for a^ We also do not offer a prediction for «3 or «g because the prior
research is mixed. The literature on corporate governance generally suggests a
negative consequence arising from larger boards (Jensen 1993; Hermalin and
Weisbach 2003). However, Klein (2002b) finds that independent audit committees
are positively correlated with board size. Prior research finds that board independence, audit committee independence, and separation of CEO and chairman of the
board are indicative of good governance (Jensen 1993; Beasley 1996; Dechow,
Sloan, and Sweeney 1996; Klein 2002a). Therefore, a positive relation is predicted
for a^, a^, and aj. Prior research also finds that the frequency of audit committee
meetings is negatively associated with fraudulent reporting (Färber 2005). Thus, a
positive relation is expected for «g. Following Ahmed et al. 2002, we expect ag,
ajQ, 01 J, ai2, and 0)3 to be positive. We predict a positive relation for 014 and a j j .
Firms operating in industries where the risk of litigation is high have incentives to
adopt conservative financial reporting. Similarly, Big 4 auditors have greater marketbased incentives than non-Big 4 auditors to protect their reputation capital and
therefore enhance eamings conservatism (Basu, Hwang, and Jan 2000). Finally,
we predict ajg to be positive following Warfield, Wild, and Wild 1995, who find
that managerial ownership is associated with the informativeness of eamings. We
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
837
predict a negative sign for a]7 consistent with prior research that institutional
investors may emphasize short-term performance and, thus, greater likelihood of
eamings management (Bushee 2004; Kury 2006). When conservatism is defined as
CONCSCO, we do not include RDADV in (2).
Sample and univariate analyses
Our search for sample firms begins with firms that are included in the S&P 500 for
the years 2000 through 2002. Like DeFond et al. 2005, our sample period mostly
predates SOX. We limit our sample to the pre-SOX period because more variation
in audit committee appointments can be expected during the pre-SOX period. Our
focus on larger firms is motivated by prior research (Klein 2002b; Karamanou and
Vafeas 2005). Furthermore, the likelihood of data availability on attributes of
boards of directors and attributes of audit committees' expertise is higher for larger
firms than for smaller firms, particularly before SOX. A search on COMPUSTAT
for the S&P 500 firms yielded 389 firms or 1,167 firm-years (389 X 3 years). We
exclude 194 firm-years in financial services industries (Standard Industrial Classification [SIC] codes 6000-6900) because accruals of these firms are likely to be
different from accruals of firms in other industries. Next, we exclude 44 firm-years
for which either the financial data or the govemance data are unavailable. We handcollect data on the qualifications and experience of the members of the audit committee from proxy statements, 10-K reports, company websites, and other publicly
available sources. Thus, the total number of firm-years available to estimate CONACRU, CONACRUE, and CONBM is 929 (310 firms). Finally, we exclude 296
firm-years where data are unavailable for any of the three reserves (LIFO inventory, R&D expense, and advertising expense) needed to estimate our final measure
of conservatism, CONCSCO (633 firm-years or 211 firms).
Industry distribution for the sample appears in Table 1. Business equipment,
manufacturing, and retail industries collectively represent 48 percent of the total
firm-years for conservatism measures CONACRU, CONACRUE, and CONBM and
61 percent for the CONCSCO measure.
Information conceming the presence of financial experts on the audit committee for the sample firms is summarized in Table 2. It appears that the proportion of
firms with at least one accounting financial expert has been gradually increasing
over time. Panel B reports the proportion of experts as a percentage of audit committee. For the first year of SOX, accounting experts constitute a little more than a
fourth of the audit committees of the sample firms with an accounting expert. It is
clear that there are more nonaccounting financial experts than accounting financial
experts on the audit committees of the sample firms.
Descriptive statistics for the pooled sample are in Table 3. The median value
for the CONCSCO measure of 0.13 is comparable to the median value reported by
Penman and Zhang 2002 for the entire COMPUSTAT sample over the period
1975-97 of 0.11. About 21 percent of the firm-years have at least one accounting
financial expert. Only 6 percent of the total audit committee directors qualify as
accounting financial experts. The proportion of audit committee directors who are
neither accounting financial experts nor nonaccounting financial experts is 36.2
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Contemporary Accounting Research
percent. The mean and median values oi ACIND (audit committee independence) are
higher than those oí BIND (board indepetidence). The tnean value for NODUAL is
0.21, indicating that for 79 percent of the firm-years, the CEO and the chairman of
the board are the same individual. About 87 percent of the total firm-years are
audited by the Big 4 auditors. The mean percentages of common stock held by
insiders and institutions are, respectively, 3.70 percent and 66.5 percent.
Untabulated correlation coefficients indicate that, as expected, CONACRU and
CONACRUE are highly correlated. The correlations between CONCSCO and other
measures of conservatism are positive and significant at the 0.01 level. However,
CONBM is not significantly correlated with CONACRU or CONACRUF. Turning
to the variable of interest, AFINEXP is positively and significantly correlated at the
0.01 level (for a two-tailed test) with all proxies for conservatism except CONBM.
The correlation between AEINEXP and CONBM is positive but not significant at
the 0.10 level. Also, the correlations between the proxies for conservatism and
NEINEXP (the proportion of audit committee directors who are nonfinancial
experts) are negative but not significant. Similarly, the correlations between
NAEINEXP and the proxies are negative except for CONBM, and only the correlation between NAEINEXP and CONCSCO is significant at the 0.10 level. Overall,
these results are consistent with the hypothesis that accounting financial expertise
of the audit committee is positively associated with conservatism.
TABLE 1
Industry distribution
Firm-years
Industry
Consumer nondurables
Consumer durables
Manufacturing
Energy
Chemicals and allied products
Business equipment
Telephone and telephone transmission
Utilities
Shops
Health care
Other
For conservatism
measures other
than CONCSCO
For CONCSCO
measure
75
33
157
42
,47
160
34
79
129
73
100
929
46
24
143
21
47
151
20
0
90
63
28
633
Note:
Industry classification is based on 11 Fama and French industries excluding money and
finance (see http://mba.tuck.dartmouth.edu/pages/faculty/ken.french).
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
839
Next, we examine whether differences in mean and median values of the various
conservatism measures between accounting and nonaccounting financial experts
are significant. Those results are reported in Table 4. AFINEXD equals 1 for firmyears with at least one accounting financial expert and 0 for firm-years with only
nonaccounting or nonfinancial experts. Both mean and median values of conservatism are higher for firm-years with at least one accounting financial expert relative
to firm-years that have only nonaccounting financial experts for all measures
except CONBM. Furthennore, the differences in mean and median values are significant at the 0.01 level. These results suggest that greater conservatism is associated with accounting financial experts.
4. Results
Multivariate results
Results of the multivariate model are reported in Table 5. To control for industryspecific effects, we include 10 industry-dummy variables based on Fama-French
industry classifications (excluding money and finance — see Table 1). We also
TABLE 2
Presence of financial experts on the audit committee for sample firms
Panel A: Proportion of firms (as a percentage of total sample)
Year
financial
2000
2001
2002
With at least
one accounting
expert
19.75
21.40
23.10
With at least one
nonaccounting
financial expert
96.50
95.90
97.10
With at least one
nonfinancial
expert
83.75
84.30
84.60
Panel B: Proportion of experts as a percentage of audit committee in firms that have at least
one financial expert
Year
2000
2001
2002
financial
Accounting
expert
28.50
28.00
27.20
Nonaccounting
financial expert
45.60
47.60
47.10
Nonfinancial
exjjert
25.90
24.40
25.70
Notes:
Following DeFond et al. 2005, members of the audit committee are classified into three
categories. Accounting financial experts are directors with experience as a certified
public accountant, auditor, principal or chief financial officer, controller, or principal
or chief accounting officer. Nonaccounting financial experts are all directors with
experience as the chief executive officer or president of a for-profit corporation.
Nonfinancial experts are directors who are neither accounting nor nonaccounting
financial experts.
CAR Vol. 25 No. 3 (Fall 2008)
840
Contemporary Accounting Research
include two year-dummy variables that equal 1 for years 2001 and 2002, respectively, and 0 otherwise to control for time-specific effects (coefficients for the
industry-dummy variables and the year-dummy variables are not tabulated).'^
The i-statistics in Table 5 are based on Huber-White standard errors that correct for
clustering and are robust to heteroscedasticity and serial correlation (Huber 1967;
White 1980; Rogers 1993). 11
The variable of interest AFINEXP is positive for all four measures of conservatism and significant at the 0.05 level or better (for a one-tailed test) for CONACRU,
CONACRUF, and CONCSCO. On the other hand, the sign for NAFINEXP is mixed
and insignificant for all the four proxies of conservatism. These results are consistent with our hypothesis and indicate that only accounting financial expertise is
significantly associated with conservatism. Thus, the broader definition of an
accounting expert that is currently in place under SOX appears to weaken accounting conservatism. When we replace NAFINEXF with NFINEXF (nonfinancial
expert), it is not significant. Turning to control variables that measure other aspects
TABLE 3
Descriptive statistics
Variable
Mean
Median
Standard
deviation
Minimum
Maximum
CONACRU
CONACRUF
CONBM
CONCSCO
AFINEXD
AFINEXP
NAFINEXP
NFINEXP
BSIZE
NODUAL
BIND
ACIND
ACSIZE
ACMEET
SIZE
CFO
DEBT
RDADV
SGROW
LITI
BIG4
INOWN
INSTOWN
0.010
0.014
0.350
0.172
0.214
0.060
0.579
0.362
2.380
0.209
0.696
0.902
1.430
5.696
9.045
0.110
0.226
0.050
0.083
0.305
0.867
3.698
66.464
0.006
0.008
0.387
0.131
0.000
0.000
0.600
0.333
2.398
0.000
0.714
1.000
1.386
5.000
9.053
0.105
0.227
0.023
0.038
0.000
1.000
0.710
68.100
0.038
0.111
0.300
0.180
0.410
0.123
0.241
0.237
0.224
0.407
0.154
0.167
0.284
2.444
1.180
0.071
0.142
0.072
0.388
0.461
0.339
8.661
15.227
-0.153
-0.369
-1.910
0.001
0.000
0.000
0.000
0.000
1.609
0.000
0.143
0.000
0.000
1.000
6.287
-0.213
0.000
0.000
-0.788
0.000
0.000
0.000
0.000
0.412
0.688
0.950
1.115
1.000
0.667
1.000
1.000
3.044
1.000
0.938
1.000
2.398
17.000
13.263
0.503
0.756
0.753
7.110
1.000
1.000
0.830
99.000
(The table is continued on the next page.)
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
841
TABLE 3 (Continued)
Notes:
CONACRU = mean total accruals (net income before extraordinary items plus
depreciation less cash flow from operations) scaled by total assets,
averaged over three-year period centered on the year of interest and
multiplied by - 1 (Givoly and Hayn 2000);
CONACRUF = fixed-effect measure of total accruals estimated as the firm-specific
intercept from a fixed-effect regression of current accruals on lagged
accruals for each of the prior six years (Hui and Matsunaga 2004). The
firm-specific intercept is multiplied by — 1 ;
CONBM
= firm-specific intercept, a,, from the following fixed-effect regression of
book-to-market ratio (BTM) on current and six lagged (k = 0-6) annual
stock retums (RET) (Beaver and Ryan 2000), multiplied by - 1 :
RTA4
= V -I- V + V
ajMj,
— X ^ Xi ^ Xt
where i and t are firm and year subscripts;
CONCSCO = amount of inventory, R&D, and advertising reserves scaled by net
operating assets for firms that have one or more of the three reserves
(Penman and Zhang 2002);
AFINEXD
= a dummy variable that equals 1 if the audit committee has at least one
accounting financial expert, and 0 otherwise;
AFINEXP
= proportion of audit committee directors who qualify as accounting
financial experts to the total number of directors in the audit committee;
NAFINEXP = proportion of audit committee directors who qualify as nonaccounting
financial experts to the total number of directors in the audit committee;
NFINEXP
- proportion of audit committee directors who qualify as nonfinancial
experts to the total number of directors in the audit committee;
BSIZE
= log of total number of directors in the board;
NODUAL
= a dummy variable that equals 1 if the CEO is also not the chairman of the
board, and equals 0 otherwise;
BIND
= proportion of directors that are independent in the board of directors;
ACIND
= proportion of directors that are independent in the audit committee;
ACSIZE
= log of total number of directors in the audit committee;
ACMEET
= number of meetings by the audit committee during the year;
SIZE
= log of total assets;
CFO
= cash flow from operations, scaled by total assets;
DEBT
= long-term debt divided by total assets;
RDADV
= R&D plus advertising expense, scaled by sales;
SGROW
= annual percentage change in sales;
LITI
= a dummy variable that equals 1 for biotechnology, computers, electronics,
and retailing and equals 0 for other industries;
(The table is continued on the next page.)
CAR Vol. 25 No. 3 (Fall 2008)
842
Contemporary Accounting Research
TABLE 3 (Continued)
BIG4
= a dummy variable that equals 1 if the company's auditor is one of the Big 4
auditfirmsand equals 0 otherwise;
INOWN
= percentageofcommonstockownedby all officers of the corporation and
directors as a group (Karamanou and Vafeas 2005);
INSTOWN = percentage of common stock held by institutions (Karamanou and Vafeas
2005).
of corporate govemance, the sign for BSIZE is mixed and significant at the 0.10
level in two cases. NODUAL, as predicted, is positive except for CONBM and significant for two measures of conservatism. BIND is positive in all four cases and
significant in three cases. ACSIZE and ACMEET are not significant in any of the
cases. This is consistent with Bedard et al. 2004, who find that size of the audit
committee and the frequency of the meetings are not associated with the likelihood
of earnings management. The sign for ACIND is mixed and not significant.
INSTOWN is negative, as predicted, and suggests that institutions have a preference for more positive eamings.
Does strong governance enhance the relation between accounting financial
expertise and conservatism?
DeFond et al. (2005) report that the positive investor response to accounting financial
experts on the audit committee is conditional upon the firm's corporate govemance
— that is, accounting expertise is more effective when other govemance mechanisms are already in place. This finding motivates us to examine whether our
results are also conditional upon the strength of govemance for the sample firms.'2
Following DeFond et al. 2005, we construct a measure of strong governance
{SGOV) that equals 1 if GOV is greater than or equal to the sample median, and 0
otherwise.
We define the variables as follows:
GOV
= a summary measure of corporate govemance that is equal to the sum
of the following six dichotomous govemance variables: LBSIZE,
HBIND, H ACSIZE, H ACIND, LGINDEX, and HINSTOWN;
LBSIZE
= a dummy variable that equals 1 if the board size is less than the
sample median, and 0 otherwise;
HBIND
= a dummy variable that equals 1 if the proportion of outside directors
is greater than 60 percent, and 0 otherwise;
H ACSIZE
= a dummy variable that equals 1 if the proportion of the number of
directors on the audit committee to the total number of directors
on board is greater than the sample median, and 0 otherwise;
H ACIND
= a dummy variable that equals 1 if the audit committee is composed
of solely independent directors, and 0 otherwise;
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
0
843
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. 25 No. 3 (Fall 2008)
844
Contemporary Accounting Research
TABLE 5
OLS regressions of conservatism measures on audit committee's financial expertise and
control variables
Conservatism measures
Predicted
sign
Intercept
?
AFINEXP
+
NAFINEXP
?
BSIZE
?
NODUAL
-1-
BIND
+
ACSIZE
7
ACIND
+
ACMEET
-1-
SIZE
-1-
DEBT
-1-
CFO
+
RDADV
+
SGROW
+
LITl
+
B1G4
+
INOWN
+
CONACRU
Coefficient§
(/-statistic)
CONACRUF
Coefficient^
(i-statistic)
0.029
(1.10)
0.022
(L73)t
0.001
(0.20)
-0.008
(-0.92)
0.009
(2.36)*
0.006
(0.57)
0.003
(0.46)
0.002
(0.27)
-0.001
(-0.75)
-0.002
(-0.79)
0.012
(1.04)
0.114
(3.52)*
0.100
(3.15)*
-0.007
(-1.68)t
0.001
(0.15)
0.003
(0.70)
0.001
(0.83)
0.102
(1.40)
0.082
(1.94)t
0.002
(0.13)
-0.053
(-1.99)t
0.026
(2.60)*
0.059
(1.66)t
0.012
(0.63)
-0.007
(-0.23)
-0.002
(-1.07)
0.003
(1.43)
0.029
(0.79)
0.296
(3.54)*
0.254
(2.75)*
-0.012
(-1.21)
0.010
(0.44)
0.007
(0.60)
0.001
(0.93)
CONBM
Coefficient?
(i-statistic)
CONCSCO
Coefficient?
(r-statistic)
0.149
(1.02)
0.001
(0.30)
-0.016
(-0.39)
0.090
(1.83)*
-0.022
(-0.85)
0.121
(1.37)*
-0.003
-0.104
(-0.78)
0.162
(1.78)t
-0.028
(-0.88)
0.010
(0.21)
0.007
(0.38)
0.181
(2.73)*
-0.039
(-1.27)
0.052
(1.25)
0.003
(1.03)
0.007
(0.82)
-0.124
(-1.85)t
0.060
(1.58)*
(-0.10)
-0.110
(-1.23)
-0.002
(-0.57)
-0.004
(-0.41)
0.133
(1.60)*
0.983
(6.26)*
0.177
(1.36)*
-0.048
(-1.32)*
0.017
(0.40)
-0.067
(-1.29)
-0.001
(-0.90)
-0.056
(-1.74)t
0.040
(1.60)*
0.023
(1.16)
0.001
(0.17)
(The table is continued on the next page.)
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
845
TABLE 5 (Continued)
Conservatism measures
Predicted
sign
INSTOWN
Adj. /?2
CONACRU
Coefficient^
(i-statistic)
CONACRUF
Coefficient^
(i-statistic)
-0.002
(-1.91)t
0.16
-0.001
(-1.74)t
0.24
CONBM
Coefficient^
(i-statistic)
CONCSCO
Coefficient^
(/-statistic)
-0.002
(-2.93)i
0.26
-0.001
(-1.92)t
0.46
Notes:
Data are for the years 2000 through 2002. Total number of firm-year observations is 929 for
all measures of conservatism except CONCSCO. For CONCSCO, it is 633. Variables
are as defined in Table 3. Each model includes, but does not tabulate, 10 industry
dummies based on 11 Fama-French industries (see Table 1) and two year dummies
that equal 1 for years 2001 and 2002, respectively, and 0 otherwise. For the
CONCSCO measure, no observations are available in the utilities industry and thus
that model uses only 9 industry dummies.
Significances below are for one-tailed tests where predicted signs are specified and for twotailed tests otherwise.
*
Significant at the 10 percent level.
1'
Significant at the 5 percent level.
i
Significant at the 1 percent level.
§
/-statistics (indicated within parentheses) are computed based on Huber-White robust
standard errors that correct for serial correlation among multiple-year observations.
LGINDEX
= a dummy variable that equals 1 if the GINDEX is below the sample
median, and 0 otherwise; GINDEX, developed by Gompers, Ishii,
and Metriek 2003, measures the strength of a firm's governance
system and is constructed based on a simple counting of 24 corporate govemance provisions — a low (high) GINDEX means that
a firm has a strong (weak) govemance system;
HINSTOWN = a dummy variable that equals 1 if the percentage of institutional
ownership (¡NSTOWN) is greater than the sample median, and 0
otherwise.
We interact SGOV with AFINEXP and NAFINEXP to test whether the relation
between accounting financial expertise and conservatism is accentuated by strong
govemance. Because SGOV includes a variety of govemance variables that we
separately consider in the prior analysis, we do not include these other govemance
variables in this analysis. Results are reported in Table 6. Recall that SGOV is a
dummy variable that equals 1 for strong governance and 0 otherwise; thus, the
CAR Vol. 25 No. 3 (Fall 2008)
846
Contemporary Accounting Research
coefficients on AFINEXP and NAFINEXF in this model represent the coefficients on
these expertise variables for firms with weak govemance, and the sum of the coefficients for AFINEXP and AFINEXP*SGOV (NAFINEXP and NAFINEXP*SGOV)
represents the coefficients on expertise for firms with strong govemance. We report
the significance testing for the combined coefficients at the bottom of Table 6.
Results show that neither AFINEXP nor NAFINEXP is significant for three of
the four conservatism measures. Thus, for firms with weak govemance mechanisms, audit committee members' accounting financial expertise does not appear to
enhance conservatism. For CONBM, the AFINEXP and NAFINEXP variables are
negative and significant, implying that the presence of such experts is associated
with lower conservatism in firms with weak govemance. In contrast, the incremental effect of strong govemance captured by AFINEXP*SGOV is positive for all four
measures of conservatism and statistically significant for three of the four measures.
The coefficient on NAFINEXP*SGOV, the incremental effect of nonaccounting
financial expertise, is not significant for any of the conservatism measures, nor is
the sum of the coefficients NAFINEXP and NAFINEXP*SGOV (not reported).
Note that the sum of the coefficients AFINEXP and AFINEXP*SGOV reported at
the bottom of the table represents the coefficients for firms with strong govemance
and it is positive and significant for all four measures of conservatism, including
CONBM. These results indicate that accounting financial experts on the audit
committee are able to effectively perform their monitoring function and promote
conservative accounting only when they are in boards that are characterized by
strong govemance. It appears that in weak boards the presence of financial expertise on the audit committee is ineffective in promoting conservative accounting —
that is, the effect of accounting financial expertise is undermined by weak govemance mechanisms. Also, it appears that even in the presence of strong govemance,
nonaccounting financial experts are not able to enhance conservatism. 13 in summary, our results corroborate the findings in DeFond et al. 2005 and underscore the
contextual nature of the relation between audit committees' accounting financial
expertise and accounting conservatism.
Sensitivity ehecks
We conduct a variety of sensitivity checks to assess the robusmess of our results to
outliers, altemative variables, and model specifications. We describe our sensitivity
checks as follows. When (2) is estimated annually for the years 2000, 2001, and
2002, the untabulated results show that for CONACRU, AFINEXP is positive
and significant at the 0.05 level or better for all the three years. When CONACRUF
is the dependent variable, AFINEXP is positive and significant at the 0.10 level for
the years 2000 and 2002 and significant at the 0.01 level in 2001. When CONCSCO
is the dependent variable, AFINEXP is positive and significant at the 0.10 level for
2000 and significant at the 0.01 level for 2001 and 2002. On the other hand,
NAFINEXP is negative for all four measures in 2000 and positive for all measures
except CONBM in 2001 and positive in 2002 for all measures except CONACRU.
However, NAFINEXP is not significant for any of the conservatism measures except
for CONCSCO, where it is marginally significant for 2000. Overall, these results
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
847
TABLE 6
OLS regressions of conservatism measures on audit committee's financial expertise and
control variables conditioned on the role of govemance
Conservatism measures
rVedicted
sign
Intercept
?
AFINEXP
+
AFINEXP*SGOV
?
NAFINEXP
?
NAFINEXP*SGOV
?
SGOV
+
SIZE
+
DEBT
+
CFO
+
RDADV
+
SGROW
+
UTl
+
BIG4
+
INOWN
+
Adj. ^2
/-statistic for
AFINEXP
+ AF1NEXP*SGOV
CONACRU
Coefficient?
(/-statistic)
CONACRUF
Coefficient?
(/-statistic)
CONBM
Coefficient?
(/-statistic)
CONCSCO
Coefficient?
(/-statistic)
-0.003
(-0.19)
0.010
(0.55)
0.008
(0.32)
-0.007
(-0.71)
0.009
(0.80)
-0.005
(-0.70)
-0.001
(-0.74)
0.011
(1.13)
0.137
(3.46)*
0.107
(3.25)*
-0.006
(-1.70)t
0.001
(0.19)
0.001
(0.27)
0.001
(1.89)t
0.16
0.007
(0.18)
0.001
(0.03)
0.102
(1.74)*
-0.019
(-0.76)
0.046
(1.28)
-0.023
(-1.03)
0.002
(0.58)
0.002
(0.08)
0.345
(3.48)*
0.309
(2.77)*
0.003
(0.38)
0.010
(0.83)
0.006
(0.60)
0.001
(1.54)*
0.24
0.256
(2.37)t
-0.553
(-2.18)t
0.719
(2.39)t
-0.134
(-1.69)*
0.219
(1.38)
-0.159
(-1.25)
0.001
(0.07)
0.142
(1.77)t
0.967
(4.15)*
0.104
(0.58)
-0.047
(-1.71)t
0.017
(0.50)
-0.076
(-1.19)
-0.001
(-1.08)
0.26
-0.075
(-1.09)
0.001
(0.06)
0.211
(2.06)t
0.032
(0.76)
-0.066
(-1.32)
0.057
(1.80)*
0.011
(2.02)t
-0.173
(-1.99)t
0.070
(1.78)t
(2.05)t
(3.01)*
(1.50)*
(3.49)*
-0.064
(-1.94)t
0.039
(1.80)t
0.027
(1.44)*
-0.001
(-0.22)
0.46
(The table is continued on the next page.)
CAR Vol. 25 No. 3 (Fall 2008)
848
Contemporary Accounting Research
TABLEÓ (Continued)
Notes:
Data are for the years 2000 through 2002. Total numher of firm-year ohservations is 929 for
all measures of conservatism except CONCSCO. For CONCSCO, it is 633. Variables
are as defined in Table 3. Each model includes, but does not tabulate, 10 industry
dummies based on 11 Fama-French industries (see Table 1) and two year dummies
that equal 1 for years 2001 and 2002, respectively, and 0 otherwise. For the
CONCSCO measure, no observations are available in the utilities industry and thus
that model uses only 9 industry dummies.
SGOV
= a dummy variable that equals 1 if GOV is greater than or equal to the sample
median, and 0 otherwise;
GOV
= a summary measure of corporate govemance that is equal to the sum of the
following six dichotomous govemance variables: LBSIZE, HBIND,
HACSIZE, HACIND, LGINDEX, and HINSTOWN;
LBSIZE
= a dummy variable that equals 1 if the board size is less than the sample
median, and 0 otherwise;
HBIND
= a dummy variable that equals 1 if the proportion of outside directors is
greater than 60 percent, and 0 otherwise;
HACSIZE
= a dummy variable that equals 1 if the proportion of the number of members
on the audit committee to the total number of directors on the board is
greater than the sample median, and 0 otherwise;
HACIND
= a dummy variable that equals 1 if the audit committee is composed of solely
independent directors, and 0 otherwise;
LGINDEX
= a dummy variable that equals 1 if the GINDEX is below the sample median,
and 0 otherwise; GINDEX, developed by Gompers et al. 2003, measures the
strength of a firm's govemance system and is constmcted based on a simple
counting of 24 corporate govemance provisions — a low (high) GINDEX
means that a firm has a strong (weak) govemance system;
HINSTOWN = a dummy variable that equals 1 if the percentage of institutional ownership
(¡NSTOWN) is greater than the sample median, and 0 otherwise.
Significances below are for one-tailed tests where predicted signs are specified and for twotailed tests otherwise.
*
Significant at the 10 percent level.
t
Significant at the 5 percent level.
*
Significant at the 1 percent level.
§
i-statistics (indicated within parentheses) are computed based on Huber-White robust
standard errors that correct for serial correlation among multiple-year
observations.
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
849
once again support the hypothesis that only accounting financial expertise is associated with accounting conservatism. Furthermore, the results indicate that the results
based on the pooled model do indeed persist for each of the sample years examined. •'*
We also define ACMEET, ACSIZE, and ACIND as categorical variables rather
than as continuous variables as in Abbott, Parker, and Peters 2004 and our results
are consistent with the results in Table 5. G. Krishnan (2005) finds that auditors'
industry expertise is associated with conservatism. When we include auditors'
industry expertise and auditor tenure in (2), they are not significant. We follow procedures recommended by Belsley, Kuh, and Welsch 1980 in identifying outliers
and our results are not sensitive to the exclusion of outliers.
Q score
The CONCSCO measure is based on Penman and Zhang's 2002 C score conservatism index. They also offer a measure of conservatism that impacts the income
statement, designated as the Q score. It is a combination of the change in the
C score and the industry (median) adjusted C score. Penman and Zhang (2002)
refer to the Q score as an "eamings quality indicator". The Q score can be thought
of as the unexpected C score and captures the effects of past conservatism. Penman
and Zhang provide evidence that the Q score has predictive power for one-year
ahead retum on net operating assets (RNOA) incremental to past RNOA. We use
the Q score as an altemative measure of conservatism and estimate (2). The untabulated results indicate that the coefficient on AFINEXP is 0.112 and significant at
the 0.05 level. NAFINEXP is negative and insignificant.'^
Control for Arthur Andersen and exchange listing
Next, we examine whether our results are driven by former clients of Arthur
Andersen or firms not listed on the NYSE. We use a dummy variable that equals 1
for former Arthur Andersen clients and 0 for non-Andersen clients. We interact the
dummy with AFINEXP and NAFINEXP. Untabulated results show that neither
interaction is significant. The dummy variable is also insignificant. However,
AFINEXP is positive and significant for CONACRUF, CONCSCO, and CONACRU.
NAFINEXP is not significant. These results indicate that our results are not sensitive
to former Andersen clients. A similar test indicates that our results are not sensitive to
exchange listing.
Asymmetric loss recognition test
We also use Ball and Shivakumar's 2005 asymmetric loss recognition test, an alternative measure of conservatism. We run a regression of total accruals over total
assets at the beginning of the year on positive cash flows, a dummy variable that
equals 1 for negative cash fiows and 0 for positive cash fiows, and include AFINEXP
and NAFINEXP as main effects and interact both variables with positive and negative cash fiows. The untabulated results indicate that although the interaction
between NAFINEXP and negative cash fiows is insignificant, the interaction between
AFINEXP and negative cash fiows is positive and significant at the 0.01 level,
indicating that timely recognition of losses via accruals is greater, that is, more
CAR Vol. 25 No. 3 (Fall 2008)
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conservative for accounting financial experts. In short, these results are consistent
with the notion that higher conservatism is associated with accounting financial
expertise but not nonaccounting expertise.
Control for endogeneity
Prior research recognizes that attributes of corporate boards and govemance mechanisms are endogenously determined (Klein 2002b). Building on a model developed
by Agrawal and Chadha 2005, we examine whether our results persist after controlling for endogeneity. For firm performance we use an accounting measure
(ROA) rather than stock retums. Similarly, for volatility we measure eamings volatility because one of our proxies for conservatism, CONBM, is highly correlated
with any stock-related measure. We also add the GINDEX as of the beginning of
the year. A high (low) GINDEX implies weak (strong) govemance. DeFond et al.
(2005) find that the market reactions to the appointment of a financial expert to the
audit committee are contingent upon existing govemance structure as measured by
the GINDEX. Thus, we estimate the following model:
FINEX = ßo + ßiSIZE + ß2PR0A + ß^DEBT + ß^SGROW + ßßSIZE
+ ß(,AEMF + ß^GINDEX -H ß^EVOL + ßgAGE
(3),
where FROA is the prior three-year average retum on assets; AEMP is a measure of
capital intensity, computed as total assets divided by number of employees; EVOL
is eamings volatility for the past six years; and AGE is the age of the firm from the
date of listing in number of years. Other variables are the same as defined before.
Following Agrawal and Chadha 2005, we predict a negative sign for ßi and ß^ and
a positive sign for ß2, J83, ß^, ß^, ß^, and ßg. A negative relation is expected for ßj
because a low GINDEX is consistent with good governance, including having
experts on the audit committee.
We run two specifications. Model (3A) does not include eamings volatility
and firm age because both are strongly correlated with the book-to-market ratio.
Model (3B) is the full model. Untabulated results indicate that, with the exception
of DEBT and AEMF, signs for all the variables are in the expected direction. SIZE,
PROA, BSIZE, GINDEX, EVOL, and AGE are significant at the 0.10 level or better. The pseudo R^for the full model is modest, but higher than the R^in Agrawal
and Chadha 2005.16
Next, we replace AFINEXD with FFINEX, the predicted probability of having
a financial expert on the audit committee and estimate (2). PFINEX is estimated
using model (3B) for CONACRU, CONACRUF, and CONCSCO. For CONBM, we
use both models (3A) and (3B). The untabulated results indicate that FFINEX is
positive and significant at the 0.01 level for the accmal-based measures of conservatism and significant at the 0.10 level for CONCSCO. More importantly, results are
significant at the 0.05 level for CONBM when earnings volatility and age are
excluded in the first stage. NAFINEXF is not significant except for CONBM, where
it is negative and significant at the 0.10 level. Overall, these findings are consistent
with our hypothesis and alleviate concems that the reported results are driven by
the endogenous relationship between conservatism and board attributes.
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
851
5. Conclusions
In response to several well-publicized accounting scandals and increases in restatements of financial statements, the U.S. Congress passed the Sarbanes-Oxley Act to
enhance corporate govemance mechanisms and restore investor confidence in
financial reporting. One aspect of corporate govemance that has received considerable attention is improving the effectiveness of the audit committee, the ultimate
monitor of the financial reporting process. The SOX mandates the disclosure of
whether at least one member of the audit committee is a financial expert. However,
the final version of the rule adopted by the SEC defined experts to include both
accounting and nonaccounting experts. Did the SEC do the right thing? Are the
nonaccounting experts just as competent as the accounting experts in enhancing the
quality of financial reporting? We examine the composition of the audit committees
for a sample of S&P 500 firms and our results suggest that an audit committee's
accounting financial expertise is positively associated with conservatism, a fundamental property of financial statements. This finding does not hold for nonaccounting
financial experts or nonfinancial experts. We also find that the audit committee's
financial experts are able to effectively perform their monitoring function and promote conservative accounting only when they are in boards that are characterized
by strong govemance. In other words, the effect of accounting financial expertise is
undermined by weak govemance mechanisms. The results are robust to altemative
measures of conservatism iind controls for other characteristics of boards of directors. We also find that only accounting financial expertise is positively associated
with Penman and Zhang's 2002 Q score, a measure of eamings quality. Overall,
our findings are consistent with the notion that accounting expertise contributes to
greater monitoring by the members of the audit committee, which in tum enhances
multiple attributes of financial reporting quality.
Our findings add to the growing literature on the relation between audit
committee's expertise and other measures of financial reporting quality, such as
accmals-based eamings management and eamings restatements (Klein 2002a; Xie
et al. 2003; Bedard et al. 2004; Agrawal and Chadha 2005). Our findings have
implications for regulators, corporate boards, and the accounting profession. Findings from concurrent research and this study suggest that adopting a narrower definition of a financial expert is likely to enhance the audit committees' effectiveness.
Our findings are also relevant to regulators in other countries who are considering
adopting measures to enhance corporate govemance, particularly the effectiveness
of audit committees. The implication for boards of directors is that merely appointing an accounting expert to the audit committee without improving the overall
govemance quality is not likely to enhance the effectiveness of the audit committee. Finally, our findings document an association rather than causation between an
audit committee's expertise and conservatism. Our sample does not permit us to
examine whether firms that replace nonaccounting experts with accounting experts
exhibit greater conservatism. When more data become available, future research
could examine whether and how our results change in the post-SOX period.
CAR Vol. 25 No. 3 (Fall 2008)
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Endnotes
1. In contrast, the NYSE requires that at least one member of the audit committee have
accounting or related financial management expertise and that all members of the audit
committee be financially literate or become financially literate within a reasonable
period of time after their appointment to the audit committee. Similarly, the NASDAQ
rules require that all members of the audit committee be able to read and understand
financial statements at the time of their appointment. Furthermore, companies must
certify whether at least one member of the audit committee has past employment
experience in finance or accounting, requisite professional certification in accounting,
or any other comparable experience or background that results in the individual's
financial sophistication, including being or having been a CEO, CFO, or other senior
officer with financial oversight responsibilities (NYSE 2004; NASDAQ 2004).
2. Dennis Beresford, a former chairman of the Financial Accounting Standards Board,
expresses concern that a large number of companies may have appointed
nonaccounting experts to the audit committees. He further cautions that most CEOs do
not have specific knowledge of generally accepted accounting principles, SEC
regulations, or Public Company Accounting Oversight Board auditing standards and
must depend heavily on the finance executives and auditors of the companies on whose
boards they sit (Beresford 2005).
3. There is a growing literature on accounting conservatism (Ball, Kothari, and Robin
2000; Givoly and Hayn 2000; Bushman and Piotroski 2006; Givoly, Hayn, and
Natarajan 2007; Lobo and Zhou 2006).
4. Beekes, Pope, and Young (2004) find evidence that U.K. firms with a higher proportion
of outside directors tend to recognize bad news in eamings on a timely basis. The
authors do not examine audit committee characteristics, such as independence, number
of meetings, and members' accounting expertise.
5. We use Ball and Shivakumar's 2005 asymmetric loss recognition test (conditional
conservatism) because it is less controversial than Basu's 1997 reverse regression
framework. Following Givoly, Hayn, and Natarajan's 2007 suggestion, we use multiple
proxies to measure conservatism.
6. Our study differs from prior research in many ways. Xie et al. (2003) do not distinguish
between accounting and nonaccounting financial expertise. Unlike Bedard et al. 2004,
we include board independence and CEO duality in our models to tease out the
incremental effect of the audit committee's expertise. Also, both Xie et al. (2003) and
Bedard et al. (2004) do not address endogeneity issues in board characteristics and
govemance mechanisms. Furthermore, Bedard et al. (2004) focus on a sample of 200
firms with extreme positive and negative abnormal accruals and caution that their
results may not be generalizable for firms with lower levels of eamings management.
Agrawal and Chadha (2005) also do not distinguish between accounting and
nonaccounting financial expertise. Also, they study only firms restating their financial
statements. Thus, it is not clear whether their findings are generalizable to firms that
are not involved in aggressive forms of financial reporting. A focus on firms that do not
restate financial statements but might otherwise engage in less aggressive financial
reporting is important because those firms are representative of the population of firms.
CAR Vol. 25 No. 3 (Fall 2008)
Does the SOX Definition of an Accounting Expert Matter?
853
Finally, J. Krishnan (2005) focuses only on firms that changed their auditors. We do not
impose such a restriction.
7. This argument is consistent with evidence from behavioral research that individuals
with significant financial experience have knowledge of misstatement occurrences in
financial statement accounts and underlying causes of misstatements (Libby 1985;
Ashton 1991; Solomon, Shields, and Whittington 1999).
8. Carcello, Hermanson, and Neal (2002) analyze disclosures in audit committee charters
and find that about half of the audit committee charters examined disclose that the
audit committee reviews or approves accounting changes, indicating that audit
committees attempt to infiuence financial reporting quality. Furthermore, Statement on
Auditing Standards (SAS) No. 90, Audit Committee Communications, requires that the
auditor discuss with the audit committee the auditor's judgement about the quality, not
just the acceptability, of the company's accounting principles employed in its financial
reporting and encourages a three-way discussion among the auditor, management, and
the audit committee.
9. Ahmed et al. (2002) average over a six-year period. We use a three-year period because
we do not have COMPUSTAT data for all firms for the year 2005.
10. See Petersen 2007 for a discussion of year dummies.
11. The Huber-White i-statistic is lower than the OLS unadjusted /-statistic for AFINEXP.
For example, when the dependent variable is CONACRU, the unadjusted i-statistics
and White t for AFINEXP are, respectively, 2.25 and 2.20 (compared with the HuberWhite/of 1.73).
12. We thank an anonymous referee for this suggestion.
13. We also consider altemative cutoff values to provide some evidence on the sensitivity
of our results to specific thresholds. We remeasure SGOV with the following
modifications. For BSIZE and ACSIZE, instead of the median we use a 66 percent
cutoff; for BIND we change the cutoff from 60 percent to 50 percent or 70 percent; for
GINDEX and INSTOWN we use 66 percent instead of the median cutoff. The results
are not sensitive to these modifications. Finally, without modifying the individual
components of SGOV, we modify the cutoff for SGOV from the median to 66 percent.
Again, the results are similar. These findings provide some assurance that the results
reported in Table 6 also hold when altemative cutoff values are used.
14. We also attempt to examine the association between the changes in an audit
committee's expertise and the change in conservatism. However, the ability to do this
analysis is limited by the small number of changes in members of the audit committee,
specifically members who are accounting financial experts. We find that all
conservatism measures, except CONACRUF, register a higher increase for firms that
appoint a new director with accounting financial expertise as compared with firms that
let go of such directors. Although this is consistent with expectations, the differences
are not statistically significant.
15. We also conduct tests of real eamings management (Roychowdhury 2006) and find
that only accounting financial expertise consu-ains real eamings management. Those
results are not reported for the sake of brevity.
16. The percentage correctly classified by the model is 79 percent for model (3 A) and
80 percent for model (3B).
CAR Vol. 25 No. 3 (Fall 2008)
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Contemporary Accounting Research
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