Following corporate governance failures like Enron and WorldCom, the role of the board of directors has come under increased scrutiny. Audit committee effectiveness has become increasingly important following the financial scandals and has been the focus of regulatory changes in recent years. A major concern raised post Enron is that individuals hold too many directorships, as a result of which “they do not have the time to do their job” (Dougherty, 2002). Corporate reformers, likewise, have advocated reforms to prevent poor governance resulting from overcommitted directors. For instance, the Council of Institutional Investors suggests that individuals with full time jobs should not serve on more than two boards. An alternative view is that directors with more outside board seats may be more experienced and prove to be better monitors.
This study examines the phenomenon of multiple directorships of audit committee members by investigating its effect on financial reporting quality. As audit committees are specifically charged with overseeing firms’ financial reporting quality, this study provides a stronger test of monitoring effectiveness in comparison with studies that examine overall board effectiveness. Multiple directorships among audit committee members is common among big firms in the Unites States. However, its effect on financial reporting quality has yet to be rigorously explored in the literature. Since the regulation change has make certain audit committee characteristics, such as audit committee independence and financial expertise somewhat uniformed across firms, it is more important to examine other characteristics of audit committee (DeFond and Francis 2005), such as audit committee multiple directorships. In this study, I extend research in
multiple directorships on audit committees. My study examines whether the multiple directorship characteristics of audit committees or their key members are associated with a firm’s financial reporting quality. I also examine whether SOX has changed the
incidence of multiple directorships as well as moderated the effects of multiple directorships on financial reporting quality.
Existing theories (agency theory and labor market theory) predict that audit committee multiple directorships can affect the financial reporting quality in two competing ways. Agency theory predicts that audit committees with high multiple directorships might be subject to time constraints, which could adversely affect their financial reporting quality. In contrast, labor market theory implies that audit committees (or audit committee members) with high multiple directorships might work more
diligently because of the reputation concern, and might transfer their knowledge and experience across firms. As a result, high audit committees multiple directorships might be positively associated with good monitoring outcomes like higher financial reporting quality.
Using data from S&P 500 companies during the period 1997–2005, I find that high multiple directorships on audit committees as a whole does not have a significant effect on firms’ financial reporting quality. Instead, what appears to be important is who on the audit committee is “busy,” as multiple directorships of audit committee chairs and financial experts are positively associated with a firm’s financial reporting quality. The results are consistent with the labor market theory, suggesting audit committee focal points with high multiple directorships might work diligently as they have a higher reputational capital at stake, and might transfer their knowledge and experience across
firms. Further, additional analysis suggests that the positive association between AC chair with high MD and FRQ is driven by the scenario in which the AC chair is also a financial expert. In addition, I find there is an inverted U-shape relation between the percentage of AC member with MD and FRQ, with the optimal level around 47%, suggesting that while some degree of multiple directorships at the audit committee level is beneficial from a monitoring perspective, beyond a certain point, the costs of multiple directorships outweigh its benefits.
I also investigate the effects of SOX on multiple directorships. In the audit committee level, I find that an audit committee as a whole tends to have lower MD post- SOX. For the key audit committee members, perhaps due to its more stringent
requirements relating to qualifications of audit committee members, SOX has
significantly increased the incidence of multiple directorships for audit committee chairs and financial experts. However, further analysis shows that only the key members with low multiple directorships in the pre SOX period are more likely to increase their number of directorships post SOX, suggesting that the regulation change potentially marks a significant shift in the equilibrium number of additional directorships of audit committee members. Finally, when financial reporting quality is proxied for by performance
matched abnormal accruals, the effects of multiple directorships of audit committee focal points on financial reporting quality changes from a positive association pre SOX to a negative association post-SOX, indicating that the costs of multiple directorships post- SOX might be greater than the benefits, which is reinforced by my finding that the number of audit committee meetings significantly increases post SOX.
My study contributes to the literature on multiple directorships and audit
committee effectiveness. This study adds to the stream of audit committee effectiveness research by focusing on the multiple directorships issue, an issue extensively examined in the management and finance literature but yet to be fully explored in accounting
literature. My results also speak to regulators’ and shareholders’ concern that high AC- MD could lead to ineffective monitoring. Generally, my findings do not validate their concerns. As I discuss in the paper, there is a trade off between costs of MD induced by time commitment and the reputational and experiential benefits of MD. While regulators such as the NYSE have expressed concern over AC-MD, my results indicate that on average the benefits of AC-MD outweigh the costs of AC-MD in terms of improved financial reporting quality.
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