Discussion of “Audit committee financial expertise and earnings management: The role of status” by Badolato, Donelson, and Ege (2014)

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Discussion of “Audit Committee Financial Expertise and Earnings Management: The Role of Status” by Badolato, Donelson, and Ege (2014) Rachel M. Hayes

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Cite this article as: Rachel M. Hayes, Discussion of “Audit Committee Financial Expertise and Earnings Management: The Role of Status” by Badolato, Donelson, and Ege (2014), Journal of Accounting and Economics, http://dx.doi.org/ 10.1016/j.jacceco.2014.08.005 This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting galley proof before it is published in its final citable form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.

Discussion of “Audit Committee Financial Expertise and Earnings Management: The Role of Status” by Badolato, Donelson, and Ege (2014) Rachel M. Hayes1

Abstract Badolato et al. (2014) (BDE) examine the effectiveness of audit committee financial expertise. They find that financial expertise does not deter irregularities unless the audit committee also has high status. I review prior research on financial expertise to place the current study in the literature and for guidance in assessing the paper’s assumptions and empirical specifications. BDE’s conclusions run counter to many of the prior findings and to broad patterns in the data. I discuss how empirical research design choices and self-selection may affect the paper’s conclusions. Keywords: audit committees; earnings management; status; financial expertise

1 David Eccles School of Business, University of Utah. Thanks to Brian Cadman, Xiaoxia Peng, Marlene Plumlee, Chris Stanton, Alex Wells, and participants at the 2013 Journal of Accounting and Economics Conference for helpful discussions and comments.

Preprint submitted to Elsevier

August 22, 2014

Introduction The research question in Badolato et al.’s (2014) “Audit Committee Financial Expertise and Earnings Management: The Role of Status” is an intriguing one. Prior work has documented an increase in audit committee financial expertise and a decrease in the status of audit committee members following the Sarbanes-Oxley Act (SOX) of 2002. The authors extend this line of study to consider the joint effects of audit committee financial expertise and status on earnings management. In particular, the authors hypothesize that financial expertise alone does not deter earnings management; audit committees must have both expertise and high status to be effective. The paper’s findings are consistent with this hypothesis. The authors examine the empirical relation between accounting irregularities and audit committee financial expertise, both by itself and interacted with a measure of status. The only relation between financial expertise and the likelihood of irregularities appears through the interaction of expertise with status. Notably, financial expertise on its own is not associated with the likelihood of irregularities. Further analyses show that only the supervisory type of expertise (experience supervising individuals involved in financial reporting) combined with status is associated with deterrence of irregularities; neither accounting nor finance expertise (accounting experience and expertise using financial statements, respectively) combines with status to deter irregularities. The authors conclude that the push toward greater audit committee financial expertise might not have reduced misreporting as intended. I find the paper’s conclusions surprising. A large prior literature, using many different approaches, generally supports a positive view of audit committee financial expertise, and, further, that the accounting type of financial expertise is most valuable. The authors suggest that these prior results might not persist in the post-SOX time period because of the changes in audit committee membership in response to SOX. While audit committees have indeed changed on some measurable dimensions, such as increased financial expertise and decreased status (as measured in this analysis), the lack of association between financial expertise and accounting

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irregularities in the paper’s primary specifications raises questions, especially when one considers the steep decline in accounting irregularities over the time period. Although the authors are not explicitly investigating the cause of the post-SOX decline in misreporting, their conclusion that “the recent push for more audit committee financial experts may not have decreased accounting irregularities as intended” seems inconsistent with the broad patterns in the data. Departures from previous results or expectations can be valuable in moving the literature forward. But it is important to be confident that unusual findings aren’t simply the result of questionable research design choices. In the discussion that follows, I will comment on a number of the authors’ research design choices, both in the context of the current analysis and in relation to prior work. In my view, empirical choices in the definitions of some of the key variables raise more questions about the study’s conclusions. Further, even if the key variables are actually capturing the intended information, economic factors and findings in the prior literature suggest that self-selection could be a difficult issue to overcome in this setting. Overall, while I see this paper as an interesting and innovative addition to the literature, I believe its conclusions should be viewed with caution. In the discussion below, I will explain why. I begin by reviewing prior findings on audit committee financial expertise in order to place the current study in the literature. The prior work also provides some insight into assumptions and empirical specifications used in the current paper. I focus on some of those assumptions and specifications when I discuss the paper’s research design and how well the empirical constructs capture the underlying elements of the research question. Finally, and again building on findings from the prior literature, I discuss the potential for self-selection as an explanation. Even when setting aside my concerns about the empirical specifications, I am not convinced that the authors’ conclusions are the most plausible explanation for the results.

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Audit Committee Financial Expertise Changes in Audit Committee Structure As discussed in Badolato et al. (2014) (BDE), regulatory pressure has led to changes in the structure of boards of directors and audit committees in recent years. In 1999, the Blue Ribbon Committee recommended that audit committees have at least one member with financial expertise. The Sarbanes-Oxley Act of 2002 and rules instituted by the major stock exchanges increased the independence requirements for boards and the disclosure requirements for audit committees. Audit committees must now consist entirely of independent directors, and firms must disclose whether the audit committee includes at least one member who is a financial expert. If the audit committee has no financial expert, the firm must explain why not. The SEC defined financial expertise broadly, and the literature commonly classifies financial expertise as accounting, finance, or supervisory expertise. Linck et al. (2008) study the effects of SOX and the related regulatory changes on the market for directors. They find that director workload and risk have increased, lowering the supply of directors, while the demand for outside directors is greater. These effects are exacerbated for directors that serve on audit committees, particularly those with financial expertise, because of the additional independence and disclosure requirements related to those committee members. Prior Work on Audit Committee Financial Expertise The regulatory focus on audit committee financial expertise has engendered considerable research on the topic. I discuss some of that literature here, with a focus on work that addresses key elements of the current paper: the benefits (real or perceived) of financial expertise, the effectiveness of the audit committee and of financial experts on that committee, differences following SOX, different types of financial expertise, and the selection of financial experts onto audit committees. I also elaborate on the first paper to link director status with financial expertise.

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Several papers examine the potential benefits of financial experts on audit committees, both before and after the passage of SOX. Defond et al. (2005) look at the market response to the appointment of an audit committee financial expert (FE) in the pre-SOX period. Using an event study, they find a positive market reaction to the appointment of an accounting FE, but no reaction to the appointment of a nonaccounting FE. Abbott et al. (2004) and B´edard et al. (2004) look at the relation between financial reporting outcomes and audit committee financial expertise prior to the passage of SOX. Abbott et al. (2004) find a significant negative association between restatements and an audit committee with at least one member that has financial expertise. Their findings are similar for fraud. B´edard et al. (2004) show that the presence of at least one audit committee member with financial expertise is associated with a lower likelihood of earnings management. Similar analyses have been done using data from the post-SOX period. Like the Defond et al. (2005) paper, Singhvi et al. (2013) use an event study methodology—in this case, to examine the market response to departures of FEs from audit committees. Their findings parallel those of the earlier paper: the market reaction to the departure of an audit committee accounting FE is significantly negative, while there is no market reaction to the departure of a nonaccounting FE or a member who does not have financial expertise. Dhaliwal et al. (2010) and Hoitash et al. (2009) examine the relation between financial reporting outcomes and audit committee financial expertise after SOX was passed. Dhaliwal et al. (2010) find that audit committee accounting expertise is positively associated with accruals quality, and the positive association is stronger when accounting FEs hold low levels of multiple directorships. They find the most positive effect when the audit committee has both accounting and finance expertise. They also find that accounting FEs prefer directorships in firms with higher accruals quality. Hoitash et al. (2009) document that more accounting and supervisory expertise on the audit committee is associated with a lower likelihood of material weakness disclosure under Section 404. Other work uses interviews to evaluate audit committees and financial expertise. Cohen et al. (2013) and Beasley et al. (2009) interview directors, while Cohen et al. (2002, 2010) interview 5

auditors. Of the 22 directors interviewed by Cohen et al. (2013), 89% believe that financial reporting improved after SOX, and 95% consider the audit committee to have sufficient power and authority from the board to resolve disagreements between management and the auditor. The authors note that their evidence suggests that SOX has had a positive impact on the monitoring role of the audit committee. Many of the surveyed directors stress the need for a “balanced portfolio of skills on the audit committee” (p. 75). Beasley et al. (2009) interview 42 directors serving on public company audit committees about audit committee oversight. The authors find that many of the responses vary with characteristics like the director’s accounting expertise and recency of appointment to the audit committee. The results indicate that audit committee members who are accounting FEs are more likely to have joined the audit committee post-SOX; to conduct numerous due diligence procedures before accepting position; to serve on a greater number of audit committees; and to state that the audit committee drives the content of the information packet, discusses alternative accounting treatments under GAAP, and discusses specific judgments, estimates, and assumptions involved in implementing a new accounting policy. Further, the audit committee members suggested that the audit committee chair is more likely to be an accounting expert, and was more likely to have had personal ties to management or other directors before joining the board. Cohen et al. (2002, 2010) conduct interviews with experienced auditors pre- and post-SOX. In the more recent survey, 96% of the auditor respondents say audit committees have become more effective in monitoring the financial reporting process. This contrasts with the authors’ earlier survey results, which found “auditors’ experiences indicated audit committees lacked both the expertise and the power to play an effective oversight role over management” (p. 768). Further, 96% of auditor respondents in the current study note that “audit committee members have sufficient power to confront management with respect to the financial reporting process” (p. 768). In addition, the auditors view some cross-section of expertise on the audit committee favorably. 6

Finally, I mention two other research methodologies that also provide insights into the effectiveness of audit committee financial expertise. Under the assumption that auditor pricing should reflect the effectiveness of the audit committee, Krishnan and Visvanathan (2009) examine the audit fees paid by S&P 500 firms from 2000 to 2002. They find that the financial expertise of audit committee members is negatively related to audit fees, but only when expertise is defined as accounting expertise. DeZoort et al. (2003, 2008) provide experimental evidence on the subject. The authors administered identical case materials to public company audit committee members both before and after the passage of SOX. They find that post-SOX audit committee member support for an auditor-proposed adjustment is significantly higher than pre-SOX support, and this finding is driven by whether there is a CPA on the committee. Post-SOX, audit committee members feel more responsible for the accounting issue and perceive that audit committee members have greater expertise to evaluate the issue. Collectively, these studies appear to provide a favorable view of audit committee financial expertise, especially accounting expertise. Financial expertise is associated with better financial reporting outcomes both before and after SOX. Audit committee accounting expertise is seen as valuable in the stock market, and audit fees are lower when there is an accounting FE on the audit committee. Further, the non-archival approaches reveal a perception that audit committee member effectiveness and power have increased post-SOX. While most of the financial expertise literature, like the studies above, aims to assess the value or effectiveness of financial experts on the audit committee, a few papers investigate the apparent reluctance of many firms to appoint an accounting FE to the audit committee. Bryan et al. (2013) argue that firms’ optimal choice of audit committee FEs (accounting or nonaccounting) varies with firm and board characteristics. Using a selection model, they find that when firms optimally choose FEs, there is no difference in earnings quality between firms with accounting FEs and firms with nonaccounting FEs. Krishnan and Lee (2009) examine the determinants of Fortune 1000 firms’ choice of FEs. They find that firms with higher litigation risk are more likely to have accounting FEs on their audit committee, although this relation 7

only occurs for firms with relatively strong governance. Erkens and Bonner (2013) examine the increased demand for FEs from a different perspective. Noting that many firms have not appointed an accounting FE despite the apparent benefits from doing so, Erkens and Bonner (2013) hypothesize that the lower status of accounting FEs makes them less attractive director candidates for high status firms. The authors examine the appointments of accounting FEs to the audit committees of S&P 1500 firms and find that the accounting FEs on average have lower director status than other audit committee appointees and directors in general. Further, while higher status firms are able to attract higher status accounting FEs, the higher status firms are also less likely to appoint accounting FEs to their audit committees and have the largest status gap between accounting FEs and other directors.

Research Design The BDE paper brings together ideas from the prior work on audit committee financial expertise. Much of the prior research is directed toward understanding the effectiveness of FEs on audit committees. Erkens and Bonner (2013), in contrast, start from the premise that firms without accounting FEs are more prone to financial problems, and they consider whether firms’ concerns about the status of accounting FEs have discouraged firms from appointing them. Their findings suggest that status-related concerns might lower the demand for accounting FEs, but Erkens and Bonner do not directly investigate the financial reporting consequences of status differences between accounting FEs and the firm or other directors. BDE follow on the Erkens and Bonner (2013) finding of a status gap between accounting FEs and other directors at the firm by considering how the gap in status might impact the effectiveness of the audit committee. Drawing on literature that suggests the status of a corporate leader affects organizational outcomes, BDE hypothesize that the reduction in the status of the audit committee could limit its ability to influence the firm’s financial reporting, because both status and expertise are necessary attributes of an effective audit committee. They test this hypothesis by examining the joint effects of financial expertise and relative status on earnings 8

management. The key elements of the paper’s research design are status, financial expertise and earnings management (in particular, the deterrence of earnings management). In the sections below, I focus on how well each of the authors’ empirical measures captures the related underlying construct. I then discuss whether the paper’s research design—even in the absence of specific variable measurement issues—enables us to answer the specific research question of whether financial expertise must be combined with high status to effectively constrain earnings management, as well as the broader question of whether the SOX requirement to disclose financial expertise is effective. Status Measuring an attribute like status is inherently difficult. This is particularly true when the measure must be quantifiable and is obtained using publicly available data. In evaluating the measure, it is useful to consider what characteristics and behaviors the measure is intended to capture. BDE state that the primary role of status in this context is a deterrence effect, and they provide two reasons why the status of the audit committee relative to management might influence the committee’s effectiveness. The first reason is that “status enhances perceived ability and commands authority and respect” (p. 2). As a result, a higher status audit committee would be viewed as “more competent and authoritative, providing a disincentive to manipulate accounting numbers” (p. 2). The second reason is that audit committees with higher relative status are “more likely to be more active monitors, acquire more comprehensive information and be more willing to investigate potential problems because they would be less deferential to management than audit committees with lower relative status” (p. 2). An ideal measure of status, then, would capture the audit committee’s willingness to monitor, gather information, and investigate potential problems, as well as management’s perception that the audit committee is competent and authoritative. The characteristics and behaviors that BDE want to capture with their status measure are

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difficult to disentangle from ability or expertise. For example, behaviors such as “be more active monitors, acquire more comprehensive information and be more willing to investigate potential problems,” clearly involve expertise. BDE note that these behaviors derive from being “less deferential to management,” but that is not a direct link. These behaviors do not necessarily derive from higher status, nor will they necessarily be present when audit committee members do not defer to management. Thus, even the theoretical construct for status is murky. While the ideal empirical measure of status likely does not exist, several prior papers have developed measures of executive and director status. I discuss some of these measures here, focusing on those that were referenced in the current paper and the Erkens and Bonner (2013) paper. D’Aveni (1990) studies how top management prestige—defined as the property of having status—is associated with firm bankruptcy. He measures prestige using five status characteristics: membership in the political elite (which includes major law firms and Big 8 accounting firms), membership in the military elite, prestigious educational status, multiple board connections, and previous high-level business experience. These characteristics, in turn, were measured using multi-item scales, with all the items standardized based on the mean and standard deviation when all firms are pooled over the sample period. The status items are included in the regressions separately. The focus in Finkelstein (1992) is development and validation of objective measures of managerial power. He defines one dimension of power as “prestige power.” The source of prestige power is personal prestige or status, and it derives from a manager’s reputation in the institutional environment. The four indicators of prestige power are the number of corporate boards a manager sits on, the number of nonprofit boards a manager sits on, the average stock rating for all corporations where the manager is a board member, and elite education. Finkelstein (1992) standardizes each variable and then sums the normalized values to create his prestige power scale. He validates his measure by demonstrating its correlation with perceptual status measures. Belliveau et al. (1996) study the effects of social capital on CEO compensation. Like BDE, 10

they construct management-board pairs and consider relative measures of status for the pair. In the Belliveau et al. (1996) paper, the pair is the firm’s CEO and the chair of the compensation committee. They hypothesize that CEOs with higher social status than the compensation committee chairs will receive relatively higher compensation. Their social status measure includes four variables: the number of corporate board seats, the number of trusteeships, the number of social club memberships, and the prestige of the undergraduate institution attended. They standardize each variable because of differences in mean board seats and social club memberships for the two groups and sum the standardized measures to get an index for each person. The relative status variable is an indicator for whether the CEO’s status index is greater than compensation chair’s status index. In a more recent study, Pollock et al. (2010) consider the effects of prestige on IPO valuations. They measure the prestige of individuals with three credentials, including a tie (defined as current or former employment at a high level, or board membership) to a prominent firm in the same industry, a tie to a blue-chip corporation, and a degree from an elite educational institution. An executive or director is considered to be prestigious if he or she possesses one or more of those credentials. Finally, Erkens and Bonner (2013) create an index that includes the number of public board seats held by the director, the number of trusteeships, the number of social club memberships, and the prestige of the undergraduate institution attended. They standardize the four measures using data on all non-executive directors of S&P 1500 index firms from 1999-2008. Their director status variable is the sum of the four standardized measures. BDE create measures of status and relative status that include elements of this prior work, but they differ in important ways. Like the prior work, BDE’s status measures are a composite of underlying measures. The three underlying measures of status are the number of contemporaneous public board directorships, the number of contemporaneous private board directorships, and the number of degrees from elite institutions. The authors create “raw” status measures for the audit committee, the CEO and CFO, and the independent non-audit-committee directors, and a measure of relative status of the audit committee compared to the CEO/CFO. The measures 11

are rather complicated, so I repeat many of the details here to facilitate comparisons with the previous status measures and insights of the prior work on audit committee effectiveness. To create the audit committee status variable, BDE first calculate the mean number of concurrent public board appointments for each audit committee. They define the variable PUBLIC BOARDS INDICATOR AC to equal one if the audit committee’s mean number of concurrent public board appointments is greater than the median for all audit committees, and zero otherwise. They define PRIVATE BOARDS INDICATOR AC and ELITE EDUCATION INDICATOR AC analogously. “Raw” audit committee status, STATUS AC, is an indicator variable that equals one if the sum of the three component indicator variables equals three, and zero otherwise. They calculate similar measures for CEO/CFO status and non-audit-committee independent directors. It is notable that the audit committee has higher status than the CEO/CFO on each of the three inputs as well as the overall raw status variable in all sample years. The relative status variable is still more complicated. For each of the three underlying status measures, BDE create an indicator variable related to the difference between the audit committee and CEO/CFO for that firm. For example, the variable PUBLIC BOARDS INDICATOR DIFFERENTIAL is an indicator that the mean number of audit committee concurrent public board directorships minus the mean number of CEO/CFO concurrent public board directorships is greater than the median difference for all audit committee-CEO/CFO pairs. PRIVATE BOARDS INDICATOR DIFFERENTIAL and ELITE EDUCATION INDICATOR DIFFERENTIAL are defined analogously. Relative audit committee status, STATUS DIFFERENTIAL, is an indicator variable that equals one if the sum of the three DIFFERENTIAL component indicator variables equals three, and zero otherwise. BDE’s main status measure, STATUS DIFFERENTIAL, differs from the prior work in several important ways. The authors note that in selecting inputs for their measure, they “follow prior studies that examine status and corporate decision-making because they are the most directly analogous to the environment we study” (p. 13). They list the D’Aveni (1990), Finkelstein (1992), and Pollock et al. (2010) papers discussed above, although they do not follow these 12

studies closely. It is unclear why the authors do not adhere to the previous approaches; while I do not think there is a “correct” measure of status, the authors do not provide a compelling reason for deviating from the earlier measures. Two of the inputs into their status measure, the number of public board seats and elite education, appear in various forms in all of the status measures cited. The third input, the number of private board seats, does not appear as a separate measure in any of this prior work, and several of the inputs to the other status measures, including previous high-level business experience, membership in the political or military elites, the number of nonprofit boards, the average stock rating for concurrent-board corporations, and ties to blue-chip or prominent industry firms, are omitted. BDE note that they exclude certain inputs from their measure of status because they “are not necessarily related to the hypotheses we test” (p. 13). This is a valid reason for deviating from previous work, but there is not enough support for the inputs they do include. Is a separate measurement of the number of private board seats more informative for this paper’s hypotheses than, for example, a measurement of ties to blue chip corporations? Erkens and Bonner (2013) and Belliveau et al. (1996) both include the number of social club memberships in their measures; how different is the current setting from the settings in these papers? Given that the findings in this paper are somewhat at odds with the earlier financial expertise literature, deviations from prior measures should receive additional scrutiny. Note too that D’Aveni’s (1990) measure lists partnership in a Big 8 accounting firm as an indicator of status, which reinforces the difficulty of disentangling status and expertise. BDE’s status measure also differs from the earlier work in its construction. As discussed above, most of the prior status measures are continuous measures whose inputs have been standardized. The exception is Pollock et al. (2010), whose measure defines prestige as the presence of any of the three credentials. BDE do not standardize the inputs into their measures; nor do they use a continuous measure. The lack of standardization likely has relatively little impact because of the use of indicators for whether the firm’s audit committee-CEO/CFO difference is greater than the median difference for all audit committee-CEO/CFO pairs. However, Bel13

liveau et al. (1996) note that they standardize because of differences between the CEOs and compensation committee chairs in their pairings, which is a factor in the BDE paper as well. It is not clear why the authors use an indicator variable—in fact, an indicator for the sum of other indicators—instead of a continuous measure, given the loss of information with the indicator. The conference version of the paper noted that some of the previous tests were run using the “sum of the underlying status measures to allow for greater variation.” I would expect this variation to be valuable in all of the tests. BDE do indicate that they repeat the irregularity analysis with several alternative definitions of relative status, including factor analyses, but the alternatives do not satisfy the concerns raised here. Several other aspects of the status measures raise questions. For example, does it make sense to compare the firm’s audit committee-CEO/CFO difference to the median values for all audit committee-CEO/CFO pairs when calculating the relative status measures? While this treatment is a form of standardization, it is not clear that this kind of standardization, particularly with the use of indicator variables, is desirable. If audit committee members having more directorships on average than management does indeed reflect higher status, then why compare the difference to the median audit committee-CEO/CFO difference? BDE’s description of relative status does not indicate that relative status is also relative to other firms’ relative status. In addition, the audit committee needs to be better than the CEO/CFO on all three underlying measures to have high status. This measure sharply contrasts with Pollock et al. (2010), who assume that prestige arises from the presence of any of their measures. BDE’s strict definition is unintuitive—would an audit committee whose members were directors at a number of blue-chip public companies but not at private companies, fit with the notion of low status? Note that a standardized continuous measure would be less susceptible to this criticism, since the public board measure could compensate for the private board measure. Another unintuitive aspect of the status measures is the use of the average, rather than the highest, status for each group. Is it necessary for the average audit committee member to have status, or is it enough for just one member to have status? An individual audit committee 14

member who is viewed as competent, can “ask the right questions,” and has the “willingness to act on information, including confronting managers when necessary” (p. 8) would seem to be an effective deterrent to misreporting. Further, consider a high relative status audit committee that adds another financial expert, increasing the committee size and lowering the mean audit committee status on one of the underlying variables to the point where the committee no longer has higher average status than the CEO/CFO. Under the paper’s assumption that both expertise and relative status are needed to influence financial reporting outcomes, the audit committee is expected to have less ability to influence financial reporting outcomes than it did before. This prediction does not seem plausible. The use of summed indicators derived from mean values of the underlying measures also runs counter to the sentiments expressed by directors and auditors in the interview studies discussed above. The respondents view financial expertise favorably, but they also indicate a need for a cross-section of skills on the audit committee. The measure is not flexible enough to reflect the existence of diverse skills on the committee. Overall, the relative status measure has a number of weaknesses, both conceptually and empirically, in my view. The attributes of status described by the authors are closely tied to expertise, a point reinforced by D’Aveni’s (1990) inclusion of Big 8 partnership (which would qualify an audit committee member as an accounting financial expert) as a past indicator of prestige. The empirical implementation of status deviates on several important dimensions from prior measures, and the deviations are not well supported. For example, the authors do not explain why membership on private boards, in addition to membership on public boards, is necessary for high status. In addition to being different from prior measures, the underlying inputs are aggregated differently and in a manner that discards information. The definition of relative status is so strict—for example, requiring that the audit committee have higher status on all three dimensions—that it seems likely to over-classify audit committees as low status. The authors note in the paper that relative status has decreased over the sample period, but the raw status measures all point to the average audit committee’s status remaining higher than that of the CEO/CFO during that time. 15

Finally, it is worth noting the similarity of the status measures to measures of social ties or centrality, which are not always viewed favorably for firm governance. For example, Hwang and Kim (2009) find that social ties between conventionally independent directors and the CEO affect how the directors monitor and discipline the CEO. They note that many boards classified as independent are substantively not independent. Other work (for example, Larcker et al. (2013)) finds that connections are value-increasing. When are board connections and social ties beneficial or harmful to the firm? Where does ability fit? While BDE conduct robustness tests relating to centrality and board interlocks, I would like to be informed conceptually about what distinguishes the effects of status from the effects of these other measures. Financial Expertise Financial expertise is another important element of the BDE paper. The authors review biographical information in BoardEx and classify audit committee members as having financial expertise based on the SEC’s definition. In contrast to the status measures, EXPERTISE is a continuous variable, defined as the percentage of audit committee members with financial expertise. The authors also create measures for the three types of expertise. ACCOUNTING EXPERTISE, SUPERVISORY EXPERTISE, and FINANCE EXPERTISE are the percentage of audit committee members that have accounting, supervisory, and finance expertise, respectively. The authors’ classification of financial experts seems to correspond with the SEC’s definition of financial expertise. Further, since the paper’s research question centers on whether the regulatory actions that define financial expertise are effective, the empirical classifications are appropriate for the research question. My primary question about the EXPERTISE variable is whether the percentage of audit committee members having financial expertise is the best measure of expertise for this study. The authors assume that “higher levels of financial expertise are beneficial to audit committees” (p. 12). Prior research provides some guidance in this area. As noted above with respect to status, directors and auditors both suggested that diverse skills are valuable on audit committees.

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Some of the empirical analyses found that specific combinations of expertise (for example, both accounting and finance expertise in Dhaliwal et al. (2010)) were most highly associated with low likelihood of financial misreporting. Several other studies found better financial reporting outcomes when the audit committee had “at least one” financial expert. Collectively, these findings suggest that the presence of at least one financial expert, or the presence of multiple types of expertise, might be more appropriate measures. An indicator for the presence of financial expertise is also consistent with the regulatory language: both the Blue Ribbon Committee and SOX refer to “at least one” audit committee member with financial expertise. Deterrence of Earnings Management BDE use two measures of earnings management. Their primary measure is IRREGULARITIES, an indicator for years with alleged management misconduct. Misconduct is defined as either SEC and Department of Justice enforcement actions that allege fraud or other intentional financial reporting misconduct, or settled securities class-action lawsuits that allege violations of GAAP. The other measure is signed ABNORMAL ACCRUALS, calculated using the modified Jones model. BDE provide few details about the accruals measure—there are no descriptive statistics, correlations, or yearly averages presented—which makes evaluation more difficult. The authors focus on the irregularities model because “irregularities objectively measure severe earnings management” (p. 3), so I will focus on irregularities here. As noted earlier, BDE suggest that the primary role of status in the interactions between the audit committee and management is deterrence. Consequently, an ideal measure would reflect the deterrence of misreporting throughout the financial reporting process. The IRREGULARITIES variable provides information about misreporting that becomes publicly known, either by SEC/Department of Justice enforcement actions or through settled class-action lawsuits. This measure implicitly assumes that misreporting was deterred at the firms where no irregularity became publicly known, and not deterred at those where an irregularity became publicly known. Recall that the paper’s hypothesis is that status interacts with financial expertise to increase

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the likelihood of deterrence. To understand how well the IRREGULARITIES variable measures the deterrence of misreporting, consider what would be observable at various stages in the ideal experiment. Ideally, we would observe all opportunities for irregularities, as well as all irregularities that were not deterred at this stage. Next, we would observe whether the audit committee learned about the irregularity, and, if so, whether the audit committee challenged management. Finally, we would observe whether the irregularity became publicly known. According to BDE’s characterization of status, higher status should affect the first four stages of the observational process. Higher status audit committees should deter irregularities where those opportunities exist, because managers view these committees as more competent and authoritative. Higher status audit committees should be more likely to learn about irregularities because they are more active monitors who gather information and investigate problems, and they should be more likely to challenge management because they are less deferential. At the same time, it seems likely that all five stages are affected by expertise, as this was presumably the intent of the SOX FE disclosure requirement. While the paper predicts a complementary relation between status and expertise, it is difficult to separately identify the effects of the two variables. The influence of the audit committee’s status on the public revelation of an irregularity is less clear. As the authors observed in the conference version of the paper, higher status directors may have more to lose in terms of reputation and wealth. But when it comes to financial malfeasance, this exposure could work both ways. In theory, the potential costs of enforcement actions or class-action lawsuits should encourage deterrence, but in practice they could also deter revelation of financial misreporting. As Srinivasan (2005) notes, audit committees monitor the system within which the irregularities are both committed and detected, so a publicly disclosed irregularity does not necessarily imply audit committee ineffectiveness. Relatedly, prior work on social ties suggests that ties between the CEO/CFO and the audit committee are associated with greater earnings management (see Krishnan et al. (2011) and Hwang and Kim (2012), for 18

example). Both of these factors confound the association between status and public revelation of an irregularity. One additional aspect of IRREGULARITIES stands out. Table 1, Panel A shows the number of irregularities by year during the sample period. There were 108 irregularities in 2001, the first year of the sample period. The number of irregularities peaked at 141 in 2003, then steadily decreased, with only 24 in 2008. The number of observations increased considerably after the 1,774 and 1,858 firm-years in 2001 and 2002, and then ranged between 4,181 and 4,553 over the final five years. Because of the increase in sample size, the percentage of observations with an irregularity decreased even more dramatically over this period—from 6.08% to 0.57% from 2001 to 2008. This decrease coincides with a monotonic increase in EXPERTISE and its accounting and finance components, as well as a monotonic decrease in both STATUS AC and STATUS CEO/CFO. The decreases in status appear to be driven by declines in the number of public board seats and elite education. While explaining the decrease in irregularities is not the goal of BDE’s analysis, the more-than-tenfold decrease in the probability of an irregularity is hard to ignore, particularly since it accompanies an increase in financial expertise. Without more investigation into the cause of this decrease, the paper’s analysis is incomplete.

Self-selection The authors argue that status has an influence on audit committee effectiveness, where effectiveness is evaluated using irregularities. However, any observed association between relative status and the likelihood of irregularities could instead be due to a reverse causal relation. That is, high status audit committee members might be choosing to avoid firms with high financial reporting risk. Some of the prior research on accounting financial expertise is consistent with this possibility. Several papers suggest that accounting FEs can be selective in the audit committees they join. For example, Beasley et al.’s (2009) interviews with audit committee members reveal that accounting FEs are likely to conduct numerous due diligence procedures before accepting a 19

position on the audit committee and to have turned down board opportunities. According to Beasley et al. (2009), while accounting experts serve on a greater number of audit committees, they are very careful about which boards they join; the most common reason they cite for declining a position is concern about the integrity of the firm’s management. Krishnan and Lee (2009) note that while firms with high potential litigation risk will have a higher demand for accounting FEs, accounting FEs may be less willing to join the audit committees of such firms. Their finding that a positive association between litigation risk and the appointment of an accounting FE holds only for the firms with already existing good governance is broadly consistent with Beasley et al.’s (2009) interview results. Finally, as discussed earlier, Dhaliwal et al. (2010) find that accounting FEs self-select into firms with higher accruals quality. While these findings do not specifically address status, it seems likely that more desirable directors (with desirability presumably correlated with status) would have more opportunities to choose between positions. The authors are aware that their results might reflect self-selection by high status directors. They address this concern two ways: by explaining how the research design mitigates the selfselection problem, and through the use of instrumental variables to test for endogeneity. The authors argue that their use of relative status—that is, the status of the audit committee relative to management—tempers the concern that high status directors are selecting away from firms with high financial reporting risk. They reason that firms with high financial reporting risk, being less attractive employment options, are also likely to have lower status managers. This argument is unconvincing for two reasons. First, potential audit committee members and managers are not necessarily selecting based on the same factors. For example, a manager might prefer less board oversight than does a prospective member of the audit committee. Relatedly, the interview results suggest that when accounting FEs decline positions, it is most frequently because of concerns about management integrity. Concerns about the integrity of the CEO and CFO in place might therefore be a factor that influences firm selection by the accounting FE but not by the CEO/CFO. Further, it seems likely that the items that lead accounting FEs to 20

have concerns about CEO/CFO integrity could also increase financial reporting risk. Second, the authors reason that firms with high financial reporting risk are less attractive employment options for managers, so they are likely to have lower status managers. While this argument may seem intuitive, the descriptive statistics suggest that it may be flawed. The firms with IRREGULARITY = 1 are significantly larger than the firms with IRREGULARITY = 0. Given the long line of literature demonstrating the relation between firm size and executive compensation (see, for example, Murphy (1985, 2012)), and the related literature on managerial empire-building (e.g., Jensen (1986)), it is unlikely that the firms with irregularities tend to attract managers with lower status. BDE also address the self-selection using a test for endogeneity. They instrument for EXPERTISE with MSA, an indicator for whether the firm’s headquarters is located within the ten largest metropolitan statistical areas. They reason that there are likely to be more financial experts in large metropolitan statistical areas. ADMIRED, the score from Fortune’s Most Admired Company List, is used to instrument for STATUS DIFFERENTIAL. The authors argue that this list likely reflects executive status but is less relevant for director status, “which is obtained from outside sources such as the number of concurrent board seats” (p. 23). The difference in relevance suggests the executives gain status from their association with the firm, but the directors do not, although the director and executive status in this paper are measured using the same outside sources. The authors also note that they use the product of MSA and ADMIRED as an instrument for the joint effect of relative status and expertise. The authors do not discuss the properties of their instruments, so it is difficult to evaluate whether the instruments are valid. We can observe in the first-stage regression that both MSA and ADMIRED are partially correlated with their endogenous regressors, although MSA*ADMIRED is not. None of the test statistics is as large as the values recommended in Stock et al. (2002) and cited in Larcker and Rusticus (2010) to rule out a weak instrument. MSA is also partially correlated with relative status, which makes interpretation difficult. BDE do not discuss whether their instruments satisfy the exclusion restrictions; for example, is ADMIRED 21

uncorrelated with IRREGULARITY other than through its correlation with relative status? The weak instruments—in particular, the lack of correlation between the interaction term and its instrument—along with the challenges of interpreting a model with two endogenous regressors, make the endogeneity test inconclusive in my view.

Conclusion Badolato et al. (2014) add to the large literature on the effectiveness of audit committee financial expertise with a creative research question. The increased demand for independent directors and financial experts has changed the characteristics of audit committees. BDE investigate whether a change in one of those characteristics—status—has adversely affected audit committees’ influence over financial reporting. Examining the joint effects of financial expertise and status on accounting irregularities, the authors find that financial expertise does not deter misreporting unless the audit committee also has high status. They conclude that regulators’ push toward greater audit committee financial expertise may not have decreased misreporting as intended. While the paper’s conclusions are somewhat provocative, I believe they are premature. As detailed above, the paper’s findings, as well as certain assumptions used to guide the empirical specifications, are at odds with much of the prior literature. Further, it is difficult to ignore the dramatic decrease in irregularities over the sample period. This decrease coincides with the implementation of SOX and the increase in financial expertise on audit committees. While the negative correlation between irregularities and financial expertise need not imply that audit committee FEs have been effective, the authors’ conclusion that lower status has rendered audit committees less effective is hard to reconcile with the tenfold decrease in misreporting. Coupled with my concerns about the empirical choices and the inconsistencies with prior findings, the unexplained decrease in misreporting suggests that more research is needed before we conclude that status limits the effectiveness of audit committees. This paper takes the analysis of financial expertise on the audit committee in an interesting 22

direction. Future work will likely continue to incorporate such difficult-to-quantify but relevant attributes as status into more traditional research settings. With the challenges of measuring these attributes, it will be increasingly important to consider how the assumptions and findings relate to prior work and the economic environment.

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