Audit committee characteristics and restatements.

INTRODUCTION

A financial restatement provides an explicit acknowledgement of material omissions or misstatements in prior financial statements. Increases over the past decade in the frequency of restatements have engendered a great deal of concern regarding the quality of financial reporting (Palmrose and Scholz 2000; Levitt 1998). In response to increases in restatements and at the behest of the Securities and Exchange Commission (SEC), the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD), the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (BRC) was formed. The BRC's purpose was to develop recommendations aimed at improving financial reporting by strengthening the audit committee's role as a financial monitor. In October 1999, the BRC issued its report, which included a set of ten recommendations (BRC 1999). The purpose of this study is to examine the efficacy of certain BRC recommendations in the context of restatements.

The BRC's recommendations address audit committee member independence, financial literacy and expertise, as well as audit committee size and authority over the appointment and compensation of the external auditor. The BRC also made several recommendations related to disclosures concerning audit committee charters and communications with the external auditor and shareholders. Although championed by various corporate governance advocates (e.g., National Association of Corporate Directors [NACD]; Institute of Internal Auditors [IIA]), the BRC's recommendations have not been uniformly incorporated into regulation. For example, the recently enacted Sarbanes-Oxley Act (U.S. Congress 2002) has incorporated the BRC's recommendation that all audit committee members be independent, but allows the NASDAQ and NYSE to define director independence differently. Thus, the BRC's recommendations currently represent an organized set of best practices that are expected to result in more effective audit committee oversight of the financial reporting process.

We investigate whether firms having audit committee structures consistent with certain BRC recommendations were less likely to experience restatement. More specifically, we examine 88 firms that restated annual financial statements (without an allegation of fraud by the SEC) in the period 1991 to 1999--i.e., the period before the issuance of the BRC's report. We construct a control set of firms matched upon exchange, industry, size, time, and auditor-type. We then study the association between certain BRC recommendations (audit committee independence, financial expertise, minimum audit committee size) and the likelihood of restatement. Further, since the BRC recommends audit committee oversight of the external auditor's quarterly financial statement review, we also investigate the impact of a threshold level of four audit committee meetings.

We find that audit committee independence and activity (whether the committee meets at least four times per year) exhibit a significant and negative association with the occurrence of restatement. We also find a significant, negative association between restatement and an audit committee that includes at least one member with financial expertise. To test the robustness of the results we also examine a sample of 44 fraud and no-fraud firms and find similar results.

Investigating the impact of audit committee characteristics on restatements is important to policymakers, academics, and practitioners for several complementary reasons. First, there is limited prior research on the incidence, characteristics, and causes of restatements (Palmrose et al. 2001; Kreutzfeldt and Wallace 2000). Second, restatements have exhibited a burgeoning increase in magnitude, as well as occurrence, as evinced by a 750 percent increase in incidence from 1992-1998 (SEC 2003; U.S. General Accounting Office 2002; Foster et al. 1999).

Finally, examining restatements allows for insights into the audit committee's ability to influence internal and external audit effectiveness in a setting different than that of fraud, which has been more heavily researched. Thus, restatements may imply an ineffective internal control system and/or external auditor. In contrast, explicit fraud may involve upper management's willful overriding of internal controls and concealment from the external auditor, making it unjustifiable to expect detection by either set of auditors using traditional audit procedures (Nieschwietz et al. 2000). As such, fraud may not be as informative about the audit committee's supervisory role over the internal and external audit functions.