Audit Committee Financial Experts: Leveraging Their Information Advantage in Accounting, Auditing, and Corporate Governance

Definition

To enhance financial reporting quality through increased oversight, the Sarbanes–Oxley Act (SOX) Section 407 mandates that firms disclose whether their audit committee includes a financial expert or explains the absence of such an expert. The definition of a financial expert has been broadened to encompass not only accounting knowledge but also finance or supervisory experience. Financial experts on audit committees possess an advantage in information access due to their role on the committee and an advantage in information processing because of their superior skills. This combination of skills and access to private information enables audit committee financial experts to achieve superior performance. We review articles that show audit committee financial experts leveraging their information advantage in accounting to improve financial transparency, in auditing to maintain audit integrity, and in corporate governance to enhance monitoring effectiveness.

1. Introduction

In this entry, we review research on audit committee financial experts. Financial experts on audit committees possess an advantage in information access due to their role on the committee and an advantage in information processing because of their superior skills [1]. Audit committee effectiveness has been a significant issue in corporate governance since the Blue Ribbon Committee (BRC) released its report in February 1999. The BRC recommended enhancing audit committee independence, improving their effectiveness, and increasing accountability among audit committees, outside auditors, and management. Specifically, audit committees should have at least three members, each financially literate, meaning that they can read and understand financial statements. Moreover, at least one member should possess accounting or financial management expertise, demonstrated through past employment, professional certification, or comparable experience, such as serving as a corporate officer with financial oversight responsibility [2,3].

These recommendations led to significant rule changes by the New York Stock Exchange (NYSE), National Association of Securities Dealers (NASD), American Stock Exchange (AMEX), Securities and Exchange Commission (SEC), and American Institute of Certified Public Accountants (AICPA); and were later incorporated into Section 407 of the Sarbanes–Oxley Act in 2002 [4]. SOX Section 407 mandates firms to disclose in periodic reports whether a financial expert serves on the firm’s audit committee and, if not, to explain why not. Audit committee members, responsible for reviewing financial statements, face civil and potentially criminal liabilities for violations of the Securities and Exchange Act of 1934 Section 10(b) and Rule 10b-5 [5]. They are more likely than other independent directors to be named as defendants in securities lawsuits [6].

The SEC defines a financial expert as an individual with an understanding of financial reporting and related internal controls [7]. A financial expert can be an accounting financial expert with experience as “a principal financial officer, principal accounting officer, controller, public accountant or auditor” [7]. A financial expert can also be a non-accounting financial expert with supervisory responsibilities (e.g., chief executive officer, president, or chairman of the board) or finance experience (e.g., a managing director, partner, or principal in venture financing, investment banking, or money management) [8,9]. Relative to their non-financial expert counterparts, audit committee financial experts profit more from insider purchases because they have not only an information access advantage but also superior information processing skills [1]. Initially, the definition of a financial expert was narrow, focusing on accounting-related experience. Critics argued that this would reduce financial reporting quality, as non-accounting financial experts are more likely to raise concerns about salient issues that receive press attention [10]. In response, the SEC broadened the definition to include individuals with supervisory or finance experience, thus expanding the scope beyond just accounting knowledge [7]. In support of this broader definition, Cohen et al. found that audit committee members with both accounting and industry expertise outperform those with only accounting expertise [11].

One caveat is that companies often do not designate all qualifying audit committee members as financial experts because such disclosure may expose designated financial experts to legal liabilities [12,13]. Exploring the link between litigation risk and the designation of financial experts, Krishnan and Lee found that firms facing higher litigation risk are more likely to appoint financial experts, especially when corporate governance is strong [14]. These studies underscore the complexity of the financial expert designation process, which is shaped by both the demand for expertise and the legal liabilities associated with the role.

The main objective of our entry is to provide readers with a comprehensive review of extant research evidence on how audit committee financial experts help improve financial transparency, maintain audit integrity, and enhance monitoring effectiveness. Specifically, we review the roles of audit committee financial experts in financial reporting, auditing, and corporate governance. This body of literature has significant implications for corporate stakeholders, regulators, and researchers.

2. The Role of Audit Committee Financial Experts in Financial Reporting

Research consistently shows that audit committee financial experts enhance financial reporting quality. By conducting in-depth interviews with audit committee members from U.S. public companies, Beasley et al. found that audit committee members with financial expertise are more proactive in overseeing the financial reporting process [12]. They discovered that these financial experts conduct their due diligence before joining a board, keep up with the audit committee materials, and are diligent in fulfilling their audit committee responsibilities. Empirical studies support this notion, showing negative relationships between audit committee financial expertise and earnings management measures. For example, Bedard et al. found that audit committee expertise is associated with reduced levels of both income-increasing and income-decreasing abnormal accruals, indicating that audit committee financial experts are concerned with both types of earnings management practices [15].

While the sample periods of the aforementioned studies are prior to SOX, post-SOX studies also suggest that audit committee financial expertise improves accruals quality [16,17,18,19,20] and expand existing knowledge by focusing on more individual characteristics of the financial experts on the audit committee. For example, Dhaliwal et al. find that in periods immediately after SOX, audit committee financial expertise is associated with better accruals quality [19]. In addition, the authors document that this enhancing effect is the strongest when the audit committee financial experts are independent, have lower other directorship appointments, and have lower tenure [19]. Similarly, recognizing the importance of relative status of the audit committee, Badolato et al. found that an audit committee with greater financial expertise and higher status is more efficient in reducing earnings management [16].

In addition to accruals quality, other research indicates that audit committee financial expertise reduces financial reporting irregularities. Pre-SOX studies found a negative association between financial expertise and the likelihood of financial reporting fraud [21,22] and financial restatement [23]. These studies speak directly to the BRC recommendations, which aim at improving the financial expertise of the audit committee members in the pre-SOX era. Post-SOX studies found a lower likelihood of financial reporting misconduct associated with audit committee financial expertise [16], with additional corroborating evidence from other studies [17,24,25]. Particularly, subsequent studies further considered the interactions of corporate governance mechanisms and audit committee financial expertise and explored how such interactions play a role in the financial reporting processes. For example, Lisic et al. found that the effect of financial expertise on improving audit committee effectiveness decreases as CEO power increases [24]. The findings offer valuable insights for shareholders, regulators, accounting practitioners, and other stakeholders on how to maximize the financial reporting benefits derived from the audit committee’s financial expertise.

Additionally, audit committee financial expertise is linked to financial reporting timeliness [26,27], accounting conservatism [28], and internal control quality [9,29,30]. For example, Schmidt and Wilkins found that audit committee financial expertise reduces the reporting lag from the firm’s discovery of misrepresented financials to the actual restatement disclosure [27]. Their results illustrate that audit committee financial expertise generates benefits by facilitating quality financial information for the capital market. Other studies highlight the benefits of audit committee financial expertise in overseeing accounting policies, such as mitigating the upward bias of expected rates of return on pension assets [31].

Beyond financial reporting, audit committee financial expertise also influences firms’ tax reporting strategies [32,33]. Since audit committee members need to understand the risks and internal controls arising from tax strategies [34], Robinson et al. found that audit committee financial experts not only advise on tax planning but also monitor it to reduce risks [33]. In addition, Hsu et al. suggest that the impact of audit committee financial expertise on tax strategies varies based on the firm’s business strategy [32].

Research has also documented the impact of audit committee financial expertise on firms’ communications and interactions with the capital market. As the management discussion and analysis (MD&A) sections of firm disclosures communicate management’s perspectives on firm future performances, they are often subject to upward biases due to managerial opportunism. Focusing on MD&As, Lee and Park found that audit committee financial expertise reduces the upward bias in the tone of such sections in firms’ annual filings [35]. This indicates that audit committee financial experts are effective in reducing managers’ opportunistic behavior in firm disclosures. The market reacts positively to the appointment of accounting financial experts, but not to non-accounting financial experts [8,36]. Moreover, audit committee financial expertise helps improve the quality of financial analysts’ forecasts and facilitates transparency in the firm’s external information environment [37,38]. Das et al. showed that audit committee financial expertise mitigates the negative stock market consequences of financial restatement, reducing the probability of a CEO turnover [39]. However, the authors found that the results only pertain to accounting financial experts, and that non-accounting financial experts do not mitigate the negative consequences of a financial restatement.

In summary, studies in both the pre- and post-SOX eras document better financial reporting quality associated with audit committee financial expertise. While confirming the effectiveness of SOX, this line of research also sheds light on other factors that potentially enhance or mitigate the effect of audit committee financial expertise.

3. The Role of Audit Committee Financial Experts in Auditing

Audit committee financial experts play a crucial role in auditing, resulting in a reduction in both financial fraud and internal control weaknesses. For example, Farber examined the impact of corporate governance mechanisms on restoring trust following incidences of financial fraud and found that the presence of financial experts on the audit committee significantly reduces the likelihood of financial fraud [22].

In addition, Zhang et al. found that audit committees with financial experts are more effective in identifying and mitigating internal control weaknesses [9]. Similarly, Hoitash et al. showed that audit committees with financial experts significantly reduced the incidence of internal control deficiencies, highlighting the importance of financial expertise in ensuring compliance and control [29]. Nevertheless, Lisic et al. found that the substantive monitoring effectiveness of audit committees is contingent on CEO power [24], whereas Lisic et al. showed that CFO influence over the audit committee negates the increased likelihood of adverse internal control opinions when internal control material weaknesses likely exist [40]. Finally, Hansen et al. found that audit committee accounting experts can reduce instances of auditor strategic behavior by limiting auditors’ ability to over-audit and under-audit and reducing the information asymmetry between the auditor and the client [41].

While audit committee financial experts add significant value to auditing, their effectiveness in monitoring nonetheless faces certain limitations. For instance, Lisic et al. cautioned that merely increasing the number of financial experts on audit committees did not automatically lead to higher audit quality [24]. While financial expertise on the audit committee can help reduce audit fees by ensuring better oversight, independence in the audit committee may increase audit fees due to more intensive auditing processes. These findings underscore the importance of understanding the nuanced effects of audit committee characteristics on audit outcomes.

Additionally, while SOX Section 407 mandates the inclusion of financial experts in audit committees, this requirement has had unintended consequences on the other characteristics of the board. For example, Erkens and Bonner found that SOX Section 407 led to the appointment of individuals such as CFOs and retired audit partners, who would not have been considered for board seats prior to SOX [42]. The appointments of CFOs and retired audit partners could potentially undermine the independence of the audit committee, as these individuals might have existing ties to the firm that could influence their decision-making. Focusing on the relative status of audit committee financial experts, Badolato et al. found that the reduced status of financial experts undermines their ability to deter financial irregularities effectively [16]. This suggests that status and credibility are critical factors for the success of financial experts on audit committees.

To summarize, the presence of financial experts in audit committees generally strengthens the auditing process by reducing fraud and internal control weaknesses. However, the mere presence of these experts is insufficient to ensure effectiveness. The quality, credibility, and status of these experts, as well as their ability to actively engage in monitoring, are key determinants of success. Regulatory interventions, such as SOX Section 407, have introduced new dynamics that can dilute the perceived authority of audit committees, thereby mitigating their effectiveness in monitoring the financial reporting process. This body of literature highlights the nuanced role of audit committee financial experts and the importance of balancing regulatory requirements with the practical aspects of expertise and effectiveness.

4. The Role of Audit Committee Financial Experts in Corporate Governance

In addition to financial reporting and auditing outcomes, audit committee financial experts also enhance oversight over financial reporting by strengthening corporate governance practices. For example, Raghunandan and Rama found that audit committees with financial experts work more diligently, as evidenced by the positive association between the number of financial experts and audit committee meetings [43]. However, they did not find such an association between the non-financial expert members and audit committee meetings. Moreover, Raghunandan et al. found that the financial experts on audit committee help improve internal audit functions by having longer meetings with internal auditors, providing more access to internal auditors, and reviewing internal audit proposals and results [44].

Other studies linked financial experts on audit committee to capital market outcomes such as the cost of capital. For example, Dhaliwal et al. found that audit committees with financial experts are associated with a lower cost of equity capital, which suggests that investors perceive these firms as having more transparent and reliable financial reporting [19]. Focusing on specific corporate governance provisions, Zhang and Zhou explore how financial experts influence the voluntary adoption of clawback policies in the pre-Dodd–Frank period [45]. Clawback policies provide firms with the ability to recoup incentive-based compensation in the event of a financial fraud. The authors find that companies with audit committees that have a higher proportion of members with financial expertise are more likely to voluntarily adopt clawback policies. These studies suggest that audit committee financial experts are associated with better corporate governance quality.

One stream of literature focuses on audit committee networks, formed when audit committee members serve on the board of multiple companies. Investigating the association between busy financial experts and financial reporting quality, Tanyi and Smith documented a negative association between the number of outside positions held by the audit committee financial experts and the quality of financial reporting, which suggests that individuals who serve on multiple boards may have limited time and attention for overseeing financial reporting [46]. The results imply that the mere presence of financial experts on the audit committee is not sufficient to guarantee quality financial reporting.

Besides reporting outcomes, financial experts could also shape corporate governance practices by changing the executives’ compensation design. Different from the negative workload effect, Omer et al. found that firms with well-connected audit committees have a positive network effect and are less likely to have financial reporting problems [47]. Nevertheless, this director network serving as the channel of information diffusion may also lead to unintended outcomes. For example, Dharwadkar et al. documented that the initiation of audit committee interlock is associated with contagion in reported special items, a specific channel through which firms may manage their earnings [48]. Moreover, Dharwadkar et al. showed that audit committee interlocks can facilitate the dissemination and contagion of both accrual-based earnings management (AEM) and real earnings management (REM) [49]. These studies indicate that audit committee networks are conduits through which financial experts can share their know-how and exert their influence.

5. Conclusions

To conclude, our review of the accounting and auditing literature suggests that although SOX Section 407 aims to enhance the quality of audit committees by requiring the inclusion of financial experts, several mitigating factors may limit its effectiveness. First, SOX Section 407 focuses more on “appearance” than “substance”. While audit committee accounting experts can mitigate strategic auditor behavior [41], simply increasing the number of financial experts does not automatically create an effective audit committee [24]. The presence of financial experts alone does not guarantee that the audit committee will function effectively. It is essential that these experts actively engage in the oversight process and contribute meaningfully to discussions and decisions.

Second, SOX Section 407 has led to the appointment of individuals, such as CFOs and retired audit partners, who might not have been considered for director positions otherwise. This can reduce the audit committee’s status and perceived independence [42]. When individuals with prior ties to the firm are appointed, their ability to remain impartial and objective may be compromised. This diminished status makes audit committee financial expertise less effective in deterring irregularities [15]. The effectiveness of financial experts is closely tied to their credibility and independence, which can be undermined by prior relationships with the firm.

Third, financial experts on audit committees may engage in rent-seeking behaviors, obtaining higher abnormal returns from insider trading than non-financial experts [1]. As this behavior can erode trust in the audit committee’s ability to provide effective oversight, the requirement of audit committee financial expertise does not necessarily lead to higher market value or better financial reporting quality [50].

Our entry has practical implications that regulators may consider to alleviate these unintended consequences related to SOX Section 407. The emphasis on having financial experts as a checkbox requirement may not translate into tangible improvements in financial reporting quality or market performance. SOX Section 407 requires firms to disclose in their periodic financial reports whether their audit committee includes at least one financial expert. In contrast, SOX Section 404 mandates that firms and their auditors certify the effectiveness of internal controls, while SOX Section 906 requires CEOs and CFOs to certify the accuracy and completeness of financial statements. To further enhance the quality of audit committees, regulators could consider adopting more stringent certification requirements, similar to those required by SOX Section 404 and SOX Section 906 [51].

In summary, the effectiveness of audit committee financial experts depends on their active engagement, independence, and credibility. Regulatory requirements should balance the need for expertise with practical considerations to ensure that audit committees can effectively monitor financial reporting processes, facilitate high-quality audit, and contribute to overall corporate governance. In addition to the existing evidence in this field, future research should consider recent trends and perspectives. For example, exploring the role of audit committee financial experts in Environmental, Social, and Governance (ESG) or Information Technology (IT) audits should offer novel insights for extant research. Furthermore, other studies should also extend the evidence in this area by utilizing data and specific regulations from different countries.