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Review of Accounting Studies

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01.12.2013

Optimal versus suboptimal choices of accounting expertise on audit committees and earnings quality

verfasst von: Daniel Bryan, M. H. Carol Liu, Samuel L. Tiras, Zili Zhuang

Erschienen in: Review of Accounting Studies | Ausgabe 4/2013

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Abstract

By employing a Heckman two-stage selection model, we identify whether employing a financial expert with or without accounting expertise on the audit committee is optimal and how earnings quality varies across these optimal and suboptimal choices. Using four earnings quality measures (informativeness, timely loss recognition, earnings persistence, and accruals quality), we find no differences in earnings quality between firms optimally choosing an expert with or without accounting expertise, consistent with Demsetz and Lehn (J Polit Econ 93:1155–1177, 1985) and others who argue that when firms optimize their choice (i.e., accounting expertise), there should be no difference across the characteristic (i.e., earnings quality) being examined. We do find, however, earnings quality is significantly higher for firms that optimally choose an accounting expert relative to firms that choose (with/without accounting expertise) suboptimally. Finally, firms suboptimally choosing an accounting expert exhibit no improvement, or even lower earnings quality, than firms that optimally choose no accounting expert. Our results provide important evidence of the impact accounting expertise has on earnings quality when considering the firm’s choice.

Vorheriger Artikel Textual risk disclosures and investors’ risk perceptions

Nächster Artikel Stock option grant vesting terms: economic and financial reporting determinants

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Demsetz and Lehn (1985) and Himmelberg et al. (1999) focus on managerial ownership and find that by controlling for its determinants, which are endogenously determined by the contracting environments, there is no significant relationship between managerial ownership and firm performance.

Although Section 407 of the SOX is a disclosure requirement on audit committee financial expertise, NYSE and NASDAQ require the listed companies to include a financial expert on the audit committee. In the post-SOX era, therefore, it is uncommon that the audit committee does not employ a financial expert. From this standpoint, our study literally tests whether selecting an accounting expert provides incremental benefit to a non-accounting financial expert on the audit committee.

See Tucker (2010) for more discussions on the methodology to control for endogeneity.

Since the number of accounting experts serving on the board could also be a supply factor related to the choice of an accounting expert on the audit committee, we randomly test 400 firms (1,620 firm-years) from our sample to identify the influence of additional accounting experts on the board. We find, however, only eight-percent of the firms tested have an accounting expert serving on the board that is not serving on the audit committee. As such, the number of accounting experts on the audit committee overlaps substantially with the number of accounting experts on the board, resulting in a ‘quasi-complete separation of values’ issue. Consequently, the number of accounting experts on the board does not load as a significant additional determinant in our first-stage test.

Heckman (1979, p. 156) demonstrates the following properties of \( W_{i,t}^{k} \):

\( \lim_{\Upphi (\beta \prime Z) \to 1} W^{1} = 0,\lim_{\Upphi (\beta \prime Z) \to 0} W^{1} = \infty \), where W ¹ = φ(β′Z)/Ф(β′Z); and \( \lim_{\Upphi (- \beta \prime Z) \to 1} W^{0} = 0,\lim_{\Upphi (- \beta \prime Z) \to 0} W^{0} = - \infty \), where W ⁰ = −φ(β′Z)/(1 − Ф(β′Z)), and Ф(−β′Z) = 1 − Ф(β′Z).

Due to lack of theoretical guidance on the cutoff value for the optimal and suboptimal choices, we use the median of \( W_{i,t}^{1} \) and \( W_{i,t}^{0} \) to group our sample. Using alternative cutoff values, including 40th and 60th percentiles, the top and bottom quartiles and quintiles, does not alter our results.

We also test the differences in earnings quality by dichotomizing the inverse Mills ratio, where a dichotomous variable is set to one when the firm is classified as optimally choosing an accounting expert or choosing no accounting expert, and zero otherwise. While dichotomizing allows for a test in the difference across firms in the optimal and suboptimal groups, it results in a loss of information about the impact of different degree of deviation from the optimal choice. Nonetheless, the results of our earnings quality tests substantially hold, suggesting that dichotomizing the inverse Mills ratio does not alter our inferences in any significant way.

An alternative four-factor model (Carhart 1997) produces similar results.

Ball and Shivakumar (2006) adopt a similar model specification to test the role of accruals in the asymmetrically timely recognition of gains and losses.

While the notion of optimality is not expressed in the extant literature, the literature nonetheless strictly assumes that an accounting expert will always improve earnings quality over no accounting expert. Thus our first set of hypotheses can be viewed as testing the underlying assumption of the extant literature for these set of firms.

For the same reason as the predicted sign on our variables of interest in our H2a and H2b, we predict the sign to flip across our variables of our interest in the test between Opt AEXP = 0 and Sub AEXP = 0 and between Opt AEXP = 0 and Sub AEXP = 1.

We focus on the post-SOX period (2003–2008) in our tests to avoid the possibility that changes in the regulatory environment and governance structures would contaminate our results.

The results are robust to deleting top and bottom one-percent of the values deemed as outliers.

For ease of exposition, we only report the coefficient on the variables of our interest.

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Titel: Optimal versus suboptimal choices of accounting expertise on audit committees and earnings quality
verfasst von: Daniel Bryan
M. H. Carol Liu
Samuel L. Tiras
Zili Zhuang
Publikationsdatum: 01.12.2013
Verlag: Springer US
Erschienen in: Review of Accounting Studies / Ausgabe 4/2013
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-013-9229-8

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