ACCRUALS QUALITY, FIRM VALUATION AND AUDIT COMMITTEE ACCOUNTING EXPERT APPOINTMENTS

Vic Naiker

University of Auckland Doctoral Scholar

Department of Accounting and Finance

School of Business and Economics

The University of Auckland

+649 373 7599

January 2007

Preliminary version

This paper is based on a chapter of my PhD dissertation at The University of Auckland. I would like to thank my dissertation advisors Dan Dhaliwal, Farshid Navissi and Jilnaught Wong for their advice and assistance. I also thank Robert Knechel, Divesh Sharma, Mike Bradbury, Steven Cahan, Donald Stokes, Philip Shane and seminar participants at the 2006 University of Auckland Auditing Conference and the 2006 Auckland Region Accounting Conference for their helpful comments and suggestions.

ACCRUALS QUALITY, FIRM VALUATION AND AUDIT COMMITTEE ACCOUNTING EXPERT APPOINTMENTS

ABSTRACT

Prior research indicates that accounting expertise in audit committees has a profound positive association with financial reporting quality. While these results suggest that accounting experts improve financial reporting quality, the results could also be attributed to the self-selection of accounting experts and firms with high financial reporting quality. This study employs the empirical setting of director appointments to the audit committee to provide support for the self-selection explanation. Specifically, I find that firms which already have high financial reporting quality are more likely to appoint accounting experts to their audit committee. The results also indicate that the propensity of high quality firms to make such appointments is more pronounced when they are undervalued, underlining the use of accounting expert appointments as a signaling mechanism. Additional tests provide further support for the signaling motivation by documenting pronounced positive abnormal stock returns for undervalued firms with high financial reporting quality who appoint accounting experts. Furthermore, the study documents that the positive association between audit committee accounting expertise and financial reporting quality, as documented in prior research, weakens in the year following the appointment year after controlling for self-selection bias.

Keywords: Audit Committee, Accounting expertise, Self-selection

Data Availability: Data are available from sources identified in the paper.

ACCRUALS QUALITY, FIRM VALUATION AND AUDIT COMMITTEE ACCOUNTING EXPERT APPOINTMENTS

I. INTRODUCTION

In July 2002, in response to high-profile cases, such as Enron and WorldCom, Congress enacted the Sarbanes Oxley Act (hereafter SOX), introducing additional standards for audit committees. One such requirement, introduced by section 407 of SOX,specifies the SEC to adopt rules mandating audit committees of public firms to include at least one member who is a financial expert. Although SOX proposed to classify individuals as financial experts if they had obtained education and experience in accounting and auditing only, critics believed that this definition was overly restrictive and severelylimited the pool of qualified financial experts. In response, the SEC and the U.S. stock exchanges controversially adopted a broader definition of financial experts, under which financial expertise could include accounting expertise, or any experience in supervising employees with financial responsibilities and overseeing the performance of companies.

The controversial circumstances surrounding the implementation of section 407 of SOX, has motivated numerous studies to evaluate whether the SEC and stock exchanges were justified in adopting a broadened definition of financial expertise, from the perspective of preserving financial reporting quality and shareholder wealth(DeFond, Hann and Hu 2005; Carcello, Hollingsworth, Klein and Neal 2006; Krishnan and Visvanathan 2006). These studies show that of the different types of expertise currently included in the broad definition, accounting expertise in audit committees has the most significant positive association with financial reporting quality and shareholder wealth. These findings are based on the intuition that since audit committee members are responsible for tasks that require knowledge of accounting and auditing concepts, individuals with better understanding of technical accounting issues contribute more significantly to audit committee effectiveness(Kalbers and Fogarty 1993; McDaniel, Martin and Maines 2002; DeZoort 1997, 1998; McMullen and Raghunandan 1996). DeFond et al. (2005) state that if the goal of the SEC is to improve financial reporting quality, then it should adopt a narrower definition of financial expertise that only includes accounting expertise. However, to further understand the role that accounting experts play in ensuring high quality financial reporting, numerous important questions remain unanswered.

One such question addressed in this study, is whether accounting experts and firms with high financial reporting quality self-select each other. Prior studies documenting a negative association between accounting expertise in audit committees and financial reporting irregularities haveimplicitly or explicitly concluded that having accounting experts on audit committees should improve financial reporting quality (monitoring hypothesis).[1] However, the findings of prior studies can also be partly attributed to accounting experts and high quality firms self-selecting each other (self-selection hypothesis). Given that accounting experts are more adept at scrutinizing financial results, the self-selection explanation suggests that accounting experts are more likely to chose and accept appointments in firms with high financial reporting quality. Firms with high financial reporting quality may also have an incentive to recruit accounting experts, in order to signal that their existing financial reporting system passes the due diligence of an accounting expert. While prior studies have pledged support for the monitoring explanation, no prior study has formallyinvestigated the self-selection explanation.[2]

This study employs the empirical setting of audit committee member appointments to investigate whether high-quality firms and audit committee accounting experts self-select each other.[3] Using a sample of 377 appointments consisting of 114 (263) accounting (non-accounting) expert appointments, logistic regression results indicate a positive relationship between the likelihood of firms appointing an accounting expert to the audit committee and a measure of financial reporting quality (based on discretionary accruals), from the year immediately prior to the year of appointment. This finding contributes to the extant literature by providing support for the self-selection explanation. The results also indicate that the likelihood of firms with high financial reporting quality appointing an audit committee accounting expert, becomes increasingly pronounced when they are undervalued. This finding is intuitive, since the motivation behind firms appointing audit committee accounting experts to signal their higher quality, must be eventually attributed to economic reasons, and prior research suggests that the resolution of firm undervaluation problems, constitutes one of the main objectives of signaling behaviour (Myers and Majluf 1984). Indeed, additional tests indicate significant economic benefits (positive abnormal stock returns), around the appointment dates, accruing to undervalued firms with high financial reporting quality who appoint accounting experts. Hence, the study also contributes to the signaling literature, by providing empirical support for the use of audit committee accounting experts appointments as a signaling mechanism. Finally, the study develops predictions and provides evidence on numerous other economic determinants of accounting expertappointments to audit committees. Previousstudies in this area have examined the association between the contemporaneous presence of financial experts on boards and firm characteristics (Agrawal and Chadha 2005). In contrast, this study specifically employs the empirical setting of audit committee member appointments and lagged measures of explanatory variables, to provide more direct evidence on firm attributes that drive the appointment of accounting experts to audit committees. The results indicate that the likelihood of firms appointing accounting experts is: (1) increasing in strength of audit committee governance, existing presence of accounting experts on audit committees, sales growth, leverage, capital intensity and age; and is (2) decreasing in firm size. My findings are insensitive to alternative measures of financial reporting quality and firm undervaluation. I also find that the study’s explanatory variables are unsuccessful in predicting the appointment of non-accounting experts to the audit committee, suggesting that the use of audit committee appointments for signaling reasons may only apply to the appointment of accounting experts. Moreover, using a two-stage “treatment effects” model (Heckman 1979; Lee 1979), the study illustrates the relevance of the self-selection issue, by documenting that the positive association between audit committee accounting expertise and financial reporting quality, in the year following the appointment year, weakens after controlling for self-selection bias. This finding has important implications for future studies on how accounting expertise affects financial reporting quality, as the failure to control for self-selection may result in biased conclusions.

The remainder of this study is organized as follows. Section II discusses the prior research and develops the hypotheses. Section IIIdiscusses the sample selection and data collection. Section IV explains the variable measurements and Section V discusses the research design. Section VI reports descriptive statistics while the empirical results are discussed in Section VII. The results from the additional tests are reported in Section VIII and Section IX concludes the study.

II.PRIOR RESEARCH AND HYPOTHESES

The central premise of this study is that high quality firms not only appoint accounting experts because they desire improvements in governance, but they also seek such appointments to signal that their existing financial reporting system passes the due diligence tests by an accounting expert. Another view is that accounting experts will also prefer appointments with high quality firms in order to preserve their reputational capital.

From a firms’ perspective, the resolution of information asymmetry problems constitutes the objective of signaling behaviour (Spence 1973). Given that a firm is more fully informed about its current operations and growth prospects, the presence of asymmetric information between the firm and outsiders could lead to an undervaluation of the firm (Myers and Majluf 1984). The challenge facing high quality firms is to determine an effective way of signaling their true value so that the wealth of existing shareholders is not threatened. Titman and Trueman (1986) apply this signaling behaviour to the appointment of experts and advisors, by proposing that the quality of advisors employed by a firm signals the quality of information within the firm. They argue that market participants recognize and value the services of the high quality experts, and such experts will therefore not seek employment with low quality firms in order to preserve their reputational capital. Conversely, low quality firms are less likely to recruit high quality experts, as in order to attract high quality experts, low quality firms would have to make substantial changes to provideinvestors with a more accurate portrayal of the firm’s performance. Based on the above arguments, Titman and Trueman (1986) conclude that high quality firms and high quality experts will self-select each other.[4]

While there is no prior evidence on the appointment of audit committee members as a signaling mechanism, a handful of studies provide supportive arguments and evidence on the viability of director appointments functioning as a signaling mechanism. Finkle (1998) finds that recruitment of directors with financial expertise enhances firms’ ability to raise additional capital, as such directors have considerably more expertise in investments, and their recruitment sends important signals to market participants. Certo, Daily and Dalton (2001) find that reputable outside directors assist firms in conquering information asymmetry problems that might otherwise deter potential investorsand are associated with less underpricing around initial public offerings.[5] Other studies that documentthe benefits firms gain by appointing reputable directors to signal their higher quality include Johnson, Daily and Ellstrand (1996), Mizruchi (1996), and Certo (2003). Deutsch and Ross (2003) advance this literature by formally modeling the signaling role of reputable directors, in which high quality firms“rent” the reputation of prestigious outside directors in order to distinguish themselves fromlow quality firms and attract stakeholders critical to their survival. However they warn that boards have various roles other than signaling so the hiring of individuals as a signaling mechanism should be restricted to a few individuals who possess the relevant reputational capital.

From thedirectors’ perspective, they also have incentives to select appointments in high quality firms. Certo et al. (2001) argue that reputable individuals would be hesitant to accept directorships in low quality firms;as such a choice may damage their reputation as decision experts. Gilson (1989) documents this reputational damage by showing that over 50 percent of financially distressed firms experience management and director turnover. Moreover, none of the departing officers are able to secure similar positions with exchange-listed firms during the three years following their departure. Other studies that document adverse consequences for officers and directors of poor performing firms include Kaplan and Reishus (1990), Hambrick and D’Aveni (1992), and Srinivasan (2005). Consistent with these findings, Finkelstein and Hambrick (1996) state that reputable individuals are cautious in accepting directorships, as directors of poor performing firms may threaten their own status in the elite.[6] This implies that appointment of reputable directors are costly to imitate for low quality firms, as reputable directors will be less likely to accept directorships with poor performing (low quality) firms. Given that the audit committee is a sub-committee of the entire board, the supportive argumentson the self-selection of high quality firms and reputable directors, sets the stage for an examination of self-selection between reputable audit committee membersand firms with high financial reporting quality.

Prior research suggests that an important component of audit committee member reputation is the level of accounting expertise they possess to carry out the audit committees’ primary responsibility of overseeing the financial reporting process. These studies argue that financial reporting issues involve the highest level of technical detail among audit committee effectives areas (Kalbers and Fogarty 1993; Green 1994), and that ideal audit committee members should have knowledge of accounting concepts and the auditing process, to help them better understand the financial reporting process, recognize problems, ask probing questions of the management and auditor, and make leadership contributions to audit committees (McDaniel et al. 2002; Libby and Luft 1993; Bull and Sharp 1989; Lipman 2004; Scarpati 2003). Prior archival studies show that audit committee accounting expertise is: (1) negatively associated with SEC enforcements and restatements (McMullen and Raghunandan 1996; Agrawal and Chadha 2005) and suspicious auditor switches (Archambeault and DeZoort 2001), and (2) positively associated with firm credit ratings (Ashbaugh-Skaife, Collins and LaFond 2004), shareholder wealth (DeFond et al. 2005), financial reporting quality (Carcello et al. 2006; Krishnan and Visvanathan 2006), and likelihood of supporting and agreeing with auditors in financial reporting disputes with management (DeZoort and Salterio 2001). While these findings could support the view that the presence of accounting experts on audit committees helps improve the financial reporting quality (monitoring explanation), the results of these studies could also infer that accounting experts are being more selective and choosing appointments in high quality firms and vice-versa (self-selection explanation). While prior studies have pledged support for the monitoring explanation, to the best of my knowledge, no prior study has examined whether accounting experts and high financial reporting quality firm self-select each other.

Engel (2005) outlines this self-selection scenario for accounting experts appointed to the audit committee, under which firms nominate or invite potential audit committee members, who following their nomination, conduct due diligence on the firm’s financial reporting environment in deciding whether to accept or decline the nomination. By virtue of their superior knowledge of accounting and auditing concepts, accounting experts are more likely to accurately assess the quality of financial reporting prior to accepting appointments and have the luxury of being particular about which firms to join. Failure to do so increases the exposure of accounting experts to problems, ranging from reputation damaging publicity to time consuming legal entanglements (King 2003). Srinivasan (2005) shows that, in comparison to other directors, directors who serve as audit committee members are more likely to bear significant reputational losses in the period following an earnings restatement. While Srinivasan (2005) does not separately consider the reputational losses experienced by audit committee members who have accounting expertise, it is plausible that accounting experts will ultimately bear greater reputational losses given that their professional development has an intimate connection to the financial reporting environment. Accounting experts are therefore more likely to conduct thorough due diligence before accepting their nominations, and are more likely to accept appointments in firms with high financial reporting quality.[7] This view is supported by Agrawal and Chadha (2005) who also state that the selection of accounting experts is more likely in better managed firms which are less prone to accounting problems. Hence,firms may appoint accounting experts to their audit committeeto signal their high financial reporting quality and provide stakeholders with assurances about the firms financial reporting and ethical responsibilities. Conversely, firms with low financial reporting quality are more likely to appoint non-accounting experts – either due to an accounting expert uncovering low quality financial reporting in the due diligence process and declining the nomination, or the firm, recognizing its low quality financial reporting and not nominating an accounting expert (Engel 2005). This leads to the first hypothesis (stated in alternative form):