Does the Market Value Financial Expertise on Audit Committees of Boards of Directors?

Abstract

We examine 3-day cumulative abnormal returns (CARs) around the announcement of 850 newly appointed outside board members assigned to audit committees during 1993-2002, a period prior to the implementation of the Sarbanes-Oxley Act (SOX). Motivated by the SOX requirement that public companies disclose whether they have a financial expert on their audit committee, we test whether the market reacts favorably to the appointment of directors with financial expertise to the audit committee. In addition, because it is controversial whether SOX should define financial experts narrowly to include primarily accounting financial experts (as initially proposed), or more broadly to include non-accounting financial experts (as ultimately passed), we separately examine appointments of each type of expert.

We find significantly positive CARs around the appointment of accounting financial experts to the audit committee, but not around the appointment of non-accounting financial experts or directors without financial expertise. In addition, CARs are only positive when the newly appointed outside directors are independent (as opposed to affiliated), and when the appointing firms have relatively strong corporate governance prior to appointing the new directors. All of our findings hold in a multivariate test that includes several control variables, and are robust to several sensitivity tests.

Our findings are consistent with accounting financial expertise on audit committees improving corporate governance, but only when both the expert and appointing firm possess characteristics that facilitate the effective use of the accounting expertise. Thus, our findings suggest that while appointing financial experts to the audit committee may improve corporate governance, their ability to do so is contextual.

Keywords: Sarbanes-Oxley, Audit Committee, Financial Expert, Corporate Governance, Boards of Directors

JEL Classification: M41, M49, G34, G14, G18, K22