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    Audit Committee Financial Expertise, Litigation Risk, and...
    research summary posted April 23, 2012 by The Auditing Section, last edited May 25, 2012, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.02 Board/Financial Experts 
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    Title:
    Audit Committee Financial Expertise, Litigation Risk, and Corporate Governance
    Practical Implications:

    Based on the positive relation between litigation risk and the likelihood of appointing an accounting financial expert, this study suggests that firms with a demand for accounting financial experts are able to obtain accounting financial experts for their audit committees.  However, this relation is only present in the presence of good governance.  The authors suggest that this follows because either (1) only firms with good corporate governance seek to appoint accounting financial experts or (2) only firms with good corporate governance can attract accounting financial experts.

    Citation:

    Krishnan, J., and J.E. Lee. 2009. Audit Committee Financial Expertise, Litigation Risk, and Corporate Governance. Auditing: A Journal of Practice and Theory 28 (May): 241-261.

    Keywords:
    audit committee; financial expert; litigation risk; corporate governance.
    Purpose of the Study:

    Policy makers believed that financial expertise on audit committees would “enhance the effectiveness of the audit committee in carrying out is financial oversight responsibilities” (SEC 1999). While it was generally acknowledged that financial expertise on the audit committee would be beneficial, the definition of financial expertise (and what qualifies as financial expertise) was not widely debated until SOX Section 407 was proposed.  The SEC’s initial definition of audit committee financial expertise included a very narrow definition of expertise, including essentially accounting and auditing expertise only.  However, after many comment letters opposing the narrow definition, the SEC adopted a broader definition of expertise.  The broader definition allows those with experience in evaluating financial statements or actively supervising those who prepare, audit, analyze, or evaluate financial statements to be designated as financial experts. The initial narrow definition was motivated by the assumption that accounting/auditing financial experts would provide better monitoring than non-accounting financial experts. 

    Previous academic research has found that firms who appoint accounting financial experts (based upon the original narrow definition proposed by the SEC) have higher measures of financial reporting quality and that investors have reacted favorably to the appointments.  However, few firms actually appoint accounting financial experts to the audit committee; not all accounting experts are designated as audit committee financial accounting experts; and many audit committee financial experts do not have prior accounting expertise.  The authors set out to examine the determinants of appointing an accounting expert versus a non-accounting expert.

    Design/Method/ Approach:

    The authors construct a measure of litigation risk (a proxy for the demand for an accounting financial expert) and gather corporate governance quality measures for the Fortune 1000 firms as of 2004.  The authors then classify audit committee members as accounting or non-accounting financial experts by gathering biographical information on the audit ommittee members using proxy statements and 10-Ks.

    Findings:
    • Of the 3,218 audit committee members identified in the study, only 572 (17.8%) have accounting financial expertise as originally defined by the SEC.  The authors indicate this is a relatively low ratio. 
    • Well-governed firms with higher litigation risk have a greater likelihood to appoint an accounting financial expert.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Financial Experts
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