Do Former Auditors on the Audit Committee Constrain Earnings Management? Evidence from the Banking Industry

Abstract

This paper examines whether former auditors on the audit committee constrain earnings management in the banking industry. Given the complexity and the size of banking organizations, it can be argued that the audit committees of large banks should possess a higher level of financial expertise than stipulated by the regulatory requirements in order to successfully monitor the financial reporting process. Using data on large publicly traded U.S. banks, we document a negative association between earnings management and the presence of audit committee directors with professional auditing experience. Specifically, our empirical findings indicate that banks with former auditors on the audit committee have lower levels of income-increasing as well as absolute discretionary loan loss provisions. We further document that the constraining effect of former auditors on earnings management is strongest for banks in which the former auditors on the audit committee have not been affiliated with the bank’s current audit firm. Overall, our results suggest that audit committee directors with professional auditing experience may improve financial reporting quality in the financial industry.

Keywords: Audit committees, former auditors, ex-auditors, discretionary loan loss provisions, earnings management, banks

JEL Classification: G20, G21, M40, M41, M42