Audit Committee Indices, Firm Value, and Accounting Outcomes

Abstract

We investigate the relation between audit committee (AC, hereafter) quality indices derived from a principal component analysis (PCA) and firm value using a sample of 12,301 firms over the period 2002 to 2012. We also examine the usefulness of the indices in predicting the quality of a firm’s internal controls, financial reporting, and audit quality. We report a significant positive (negative) relation between ‘high’ (‘low’) AC quality firms and future firm value, measured as industry-adjusted Tobin’s q, supporting the view that AC characteristics have a significant impact on firm value. We show that low AC quality firms are significantly more likely to have internal control concerns disclosed by predecessor auditors, including accounting standard issues, financial restatements, audit opinion concerns, and deficiencies that undermine internal control effectiveness. We also show that low AC quality firms are more likely to manage earnings, be external auditor dependent with respect to non-audit tax services, and switch to a lower quality auditor. Further, they are also more likely to receive an audit report containing additional explanatory notes, consistent with a higher likelihood of future financial misstatements. Conversely, high AC quality firms are less likely to have accounting issues, dismiss an auditor after disagreements, have adverse restatements, and receive an audit report containing additional explanatory notes. Taken together, our findings support the view that the AC plays an important role in monitoring the financial reporting process. The results are robust to several econometric concerns primarily related to endogeneity, and to controls that capture broader firm-level governance characteristics, suggesting that AC quality has incremental value in driving better financial reporting, and internal control outcomes and, more importantly, firm value.

Keywords: Audit Committee, Firm Value, Internal Controls, Earnings Management, Principal Component Analysis

JEL Classification: M4, G3