Audit Committees, Corporate Governance, and the Quality of Financial Reporting: Evidence from Market Reactions to Earnings Announcements.

• In Event: Sox Compliance and Corporate Governance

Abstract

This empirical study provides further evidence regarding the relation between the effectiveness of the corporate financial governance process and the quality of financial reporting in a capital market setting. This study examines the relation between the audit committee effectiveness and the quality of financial reporting measured as the magnitude of market reactions to earnings announcements. For this study, I use 1241 firm-quarter observations representing 67 U.S. firms, which are publicly traded on the NASDAQ National Market System. In order to test relations between corporate financial governance characteristics and capital market reactions to earnings news, I first estimate firm-specific ERCs by regressing market adjusted abnormal returns on the unexpected earnings for each firm. I then regress firm-specific ERCs on corporate financial governance characteristics and control variables that have been found in previous research to be determinants of ERCs.

Empirical results show that the magnitude of market reactions to earnings announcements is significantly related to corporate financial governance characteristics, after controlling for previously known factors affecting market reactions. On the one hand, market reactions to earnings announcements increase (1) as audit committee directors have more stock ownership in their firms; (2) as audit committees meet more frequently; (3) as audit committees are composed of a higher percentage of directors with expertise in the financial reporting and auditing process; and (4) when the external auditor of a firm is a Big 4 audit firm. On the other hand, market reactions to earnings announcements tend to decrease when there are unaffiliated large block-holders. In addition, previously identified factors such as firm-specific risk and firm size are negatively associated with market reactions to earnings announcements, confirming the previous research findings.

Overall, the results of this paper provide empirical evidence in supporting the proposition that a firm with the effective audit committee will maintain a high quality financial reporting system and that capital markets respond more favorably to earnings news from such a firm. As such, these results support the public and professional efforts to improve the quality of financial reporting by strengthening the effectiveness of audit committees in their oversight role in the financial reporting and auditing process.

Author

• Young Park, University of the District of Columbia