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Audit committee characteristics and restatements.


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.

We also contribute to the extant literature by providing, to the best of our knowledge, initial archival evidence on the impact of audit committee financial expertise on financial restatement, confirming the results of DeZoort and Salterio (2001) and Maines et al. (2002). We believe this to be an especially important finding given the recent public interest in the qualifications of audit committee members (Verschoor 2002; Lavelle 2002). Overall, our results provide support for BRC contentions regarding the importance of independent, knowledgeable, and diligent audit committee members.

The remainder of this paper is organized as follows: The next section reviews prior literature and develops hypotheses, followed by discussions of sample selection, methodology, results, and limitations. The final section details our policy implications and conclusions.


Prior Literature

Eilifsen and Messier (2000) identify four conditions that must be met for audited financial statements to be subsequently restated. First, a material misstatement occurs as a result of some type of inherent risk (e.g., management's aggressive accounting practices, misapplication of GAAP, personnel problems, etc.). Second, the misstatement is neither prevented nor detected by the company's internal controls. Third, the external auditor fails to detect the misstatement and the financial statements are issued. Last, the misstatement is subsequently discovered and, if deemed material, requires the correction, restatement, and reissuance of the original financial statements. A crucial requirement for restatement is a breakdown in the first three conditions of the financial reporting process identified above. We examine whether firms that adopted governance structures as subsequently recommended by the BRC experience fewer of these breakdowns and a subsequent decrease in likelihood of financial reporting restatements.

Empirical research on restatements is relatively limited (Palmrose et al. 2001; Kinney et al. 2003). One of the first studies in this area was that of Kinney and McDaniel (1989). These authors examined 73 "error" companies from 1976 to 1985 that had fourth-quarter restatements of a prior quarter(s) unaudited results and found these companies to be smaller, less profitable, slower growing companies with higher debt and more serious uncertainties. DeFond and Jiambalvo (1991) study 41 companies that restated their audited annual financial statements in the period 1977 to 1988 and found earnings errors consistent with managers responding to economic incentives arising because of deteriorating financial conditions. DeFond and Jiambalvo (1991) also find that restating companies were more likely to have an audit committee. Neither study examines the impact of audit committee characteristics on the incidence of restatement.

Note that the breakdowns in the first three conditions of financial restatements, mentioned above, are identical to those that give rise to financial statement fraud (Eilifsen and Messier 2000; Kreutzfeldt and Wallace 2000). For this reason, we also review the fraud literature related to audit committees. Research examining the impact of the audit committee on fraud is relatively more developed than the restatement literature. Although more extensive, this stream of research yields somewhat mixed results. For example, Beasley (1996) does not find that audit committee presence is significantly associated with the likelihood of financial statement fraud. Dechow et al. (1996) and McMullen (1996), however, document a significant negative relation between the presence of an audit committee and fraud. In general, these studies focus on the relation between audit committee presence and the incidence of financial statement fraud.

Abbott et al. (2000) (hereafter APP) test whether audit committee characteristics incremental to audit committee presence lead to effective discharge of audit committee duties. APP address audit committee effectiveness by examining a composite variable encompassing audit committee independence and activity. APP find that audit committees comprised entirely of outsiders that meet at least twice annually are negatively associated with fraud. Beasley et al. (2000) (hereafter BCHL) further this line of research by examining audit committee composition and activity separately. BCHL limit their study to three industries and find a significant negative (positive) univariate difference in audit committees comprised entirely of outsiders (that meet less often) for fraud than no-fraud firms.

Our study represents an extension of prior studies in two ways. First, we address the impact of individual audit committee characteristics on restatements in a multivariate setting. Second, we examine the impact of audit committee expertise--a key BRC recommendation.

BRC Recommendations and Hypotheses

The BRC recommendations focus on audit committee mechanisms that would affect "the large grey area(s) where discretion and subjective judgments bear on the quality of financial reporting" (BRC 1999). In the succeeding sections, we develop from these recommendations a series of empirically testable audit committee characteristics.


BRC recommendations 1 and 2 address the definition of director independence and requirements for independent audit committees. These recommendations are based upon the BRC's contention that independent directors are better able to objectively evaluate the propriety of management's accounting, internal control, and reporting practices. The BRC defines independence as the exclusion of current and former employees, relatives of management, and persons receiving compensation from the company (except directors' fees). The BRC also recommends excluding directors who are partners in, controlling shareholders, or executive officers of any for-profit business organization to which the corporation made or from which the corporation received significant payments in the last five years. Compensation committee interlocking directorships are also recommended for exclusion. In recommendation 2, the BRC states that all listed companies with market capitalizations greater than $200 million should have audit committees composed entirely of independent directors.

Prior literature suggests that audit committee director independence is associated with greater monitoring for two reasons. First, and most importantly, independent directors do not have economic or psychological ties to management that may interfere with their ability to question management (Carcello and Neal 2000, 2003; Baysinger and Butler 1985). Second, reputational capital preservation/development provides motivation for better monitoring unique to independent audit committee members. In particular, Beasley (1996) notes that outside directors use their directorships to signal to the external market for decision agents that they (1) are decision experts, (2) understand the importance of decision control, and (3) can work with such control (i.e., accounting) systems. Moreover, Abbott and Parker (2000) posit that although audit committee service may increase an independent director's reputation as a financial monitor, it also exacerbates the potential reputational damage should a financial misstatement occur while the director serves on the audit committee. (1) As such, it is posited that greater monitoring motivation should result in better monitoring on the part of independent audit committee directors (Lavelle 2002; Abbott and Parker 2000).

Prior research suggests that audit committee independence, by way of greater monitoring, can reduce the likelihood of restatement in two ways. First, the independence and effectiveness of the internal audit function are strengthened when it reports directly to an audit committee that does not include a current or former member of management (Raghunandan et al. 2001; Raghunandan et al. 1998; Scarbrough et al. 1998; IIA 1993). Independence allows internal auditors to audit and assess individuals more objectively within the company, since internal audit's independence is its most critical characteristic in reducing misstatement magnitude (Wallace and Kreutzfeldt 1991). Second, independent audit committees may demand greater external audit scope to avoid being associated with financial restatement, increasing the likelihood the external auditor will detect the misstatement (Abbott et al. 2003a). These results suggest audit committee independence can strengthen a firm's internal control structure and increase the effectiveness of the external audit, thereby reducing the likelihood of misstatements. These expectations lead to our first hypothesis (stated in alternative form):

H1: The presence of an audit committee comprised entirely of independent directors is associated with a lower incidence of restatement.

Audit Committee Size and Expertise

The BRC notes that the complexity of the accounting and financial matters facing audit committees merits the commitment of considerable director resources. As such, the BRC's third recommendation requires (except for small firms) a minimum of three audit committee directors, each of whom is financially literate and at least one of whom has accounting or related financial management expertise. The audit committee size recommendation is consistent with a desire to elevate the organizational status of the audit committee (Braiotta 2000). Similarly, Kalbers and Fogarty (1993) propose that audit committee effectiveness can be perceived as a function of audit committee power. Larger audit committees are legitimized by a meaningful designation from the board of directors and are thus more likely to be acknowledged as an authoritative body by the external and internal audit function (Kalbers and Fogarty 1993).

The IIA (1993) asserts that the goals and objectives of the audit committee and internal audit function are essentially intertwined. Consequently, the increased organizational status and power of the audit committee may enhance the status of the internal audit function (Quarles 1994). It may also deflect cost control pressures from management who may view internal audit as a cost center (Rittenberg et al. 1999; Quarles 1994; Raghunandan and McHugh 1994; IIA 1994; Treadway Commission 1987). The increase in internal audit status, combined with the reduction in cost containment pressures from management, assists in the implementation of additional internal controls that may subsequently prevent or detect material misstatements (Raghunandan and McHugh 1994). Collectively these forces are expected to reduce the likelihood of subsequent restatements and leads to our second hypothesis (stated in alternative form):

H2: The presence of an audit committee with at least three directors is associated with a lower incidence of restatement.

The BRC's expertise recommendation is a response to increasingly complex accounting and auditing issues facing audit committees. To be effective, audit committee members need to understand the various financial and operational issues confronting the company's management (PricewaterhouseCoopers/IIA 2000). The BRC defines financial literacy as the ability to read and understand fundamental financial statements. The BRC also states that accounting or financial management expertise may be demonstrated by employment experience in finance or accounting, a CPA certification or comparable experience, or a position as a CEO or other senior officer with financial oversight responsibilities.

The BRC's assertion that effective audit committees should include at least one member who possesses financial expertise is consistent with previous research on accounting knowledge. Audit committee members may come from a wide variety of backgrounds and may not have the experience or technical knowledge needed for effective accounting and auditing oversight (Kalbers and Fogarty 1993). Likewise, the audit committee's oversight role may be discounted by the external auditor if the auditor believes the audit committee does not possess the knowledge necessary to understand technical auditing and financial reporting matters (Cohen et al. 2002; Knapp 1987). Finally, knowledgeable audit committees are better equipped to understand auditor judgments and discern the substance of disagreements between management and the external auditor (DeZoort and Salterio 2001; DeZoort 1998).

Prior research suggests that audit committee expertise can reduce the incidence of financial restatement in a variety of ways. First, an audit committee with at least one member with financial expertise is more likely to comprehend the internal audit program and results thereof (Raghunandan et al. 2001; Scarbrough et al. 1998; IIA 1993). This, in turn, ensures that mechanisms are in place to assure corporate responsibility and increase the effectiveness of internal controls in preventing or detecting material misstatement. Second, audit committee expertise also allows for a better understanding of auditing issues and risks, as well as the audit procedures proposed to address and/or detect these issues and risks (DeZoort and Salterio 2001). Consequently, audit committee expertise may manifest itself in the form of greater external audit scope to adequately address and detect material misstatements (Abbott et al. 2003a). Finally, audit committee expertise increases the likelihood that detected material misstatements will be communicated to the audit committee and corrected in a timely fashion (DeZoort and Salterio 2001; Knapp 1987). Collectively, such evidence suggests audit committee expertise reduces the probability of breakdowns in the first three conditions that give rise to restatement, leading to our third hypothesis (stated in alternative form):

H3: The presence of an audit committee with at least one director possessing financial expertise is associated with a lower incidence of restatement. (2)

Other BRC Recommendations

The age of our sample and consequent data limitations preclude us from addressing all of the BRC recommendations directly. (3) However, we indirectly investigate the diligence of the audit committee by observing the impact of audit committee meeting frequency. Kalbers and Fogarty (1993) posit that audit committee effectiveness is likely a function of diligence, or the persistence with which audit committee members execute their duties. Meeting frequency may indirectly provide information on the audit committee's diligence and, as it is disclosed in the proxy statement, is often used as a proxy for diligence (DeZoort et al. 2002; Menon and Williams 1994). Moreover, the only way an effective audit committee can be apprised of recent audit developments and issues on a timely basis is to meet frequently with both the internal and external auditors (PricewaterhouseCoopers/IIA 2000; Raghunandan et al. 1998).

Prior research suggests that an audit committee that meets frequently can reduce the incidence of financial restatement in two ways. First, by meeting frequently with the internal auditor, the audit committee will remain informed and knowledgeable about accounting and auditing issues (Raghunandan et al. 1998). Should a material accounting or auditing issue arise, the audit committee can then influence and direct the appropriate level of internal audit resources to address the matter in a timely fashion (Raghunandan et al. 1998; IIA 1993). This likely applies to communications with the external auditor as well. Second, an audit committee that meets frequently can proactively direct additional external audit resources toward a particular auditing issue in a timely fashion (Abbott et al. 2003a). This can reduce year-end audit time pressures that can potentially compromise external audit quality (Public Oversight Board 2000) and can thereby reduce the likelihood of subsequent restatements by bolstering the process of detecting and correcting misstatements prior to the issuance of the financial statements. The expectations above lead to our fourth hypothesis (stated in alternative terms):

H4: An audit committee that meets frequently is negatively associated with the probability of restatement.


Sample Selection

We began our sample selection of firms issuing restated financial statements by searching the Dow Jones Interactive Database for the term "restatement" appearing in the lead paragraph or headline of articles from the Wall Street Journal, Barron's, the Dow Jones Corporate Filings Alert, Dow Jones Business News, Dow Jones News Service, and PR Newswire between January 1, 1991 and December 31, 1999. We further screened sample firms to locate those restatements applying to annual financial statements, filed between January 1, 1991 and December 31, 1999, for domestic firms and not caused by routine events, such as mergers and acquisitions, divestitures, stock- or tax-related changes, changes in accounting principles, or related restatements of financials contained in a registration statement for an initial public offering. (4,5)

We limited our sample to those firms with restatements of annual reports to better control for variation that might exist in the degree of external audit scrutiny received by the sample and control firms. In particular, during the sample period, SEC registrants were not required to have a timely review of interim statements by their external auditors. (6) Consequently, it would be difficult to make predictions as to the potential effectiveness of the audit committee in monitoring the interim, quarterly financial reporting process when there may have not been any external auditor involvement in the reporting of these results. This enables us to focus more narrowly on the role of the audit committee as overseer of the annual financial reporting process. Our sample selection methodology resulted in a final sample of 88 firms, as summarized in Table 1. (7)

Control Firms Selection

Consistent with prior research, we match each sample firm with a control firm on the same exchange with a market value of equity within 30 percent of the sample firm in the year preceding the fraud or misstatement. We also match on the basis of Big 5 (Big 6) or non-Big 5 (Big 6) auditor. We select the control firm from among those meeting the above criteria in the same four-digit SIC code whenever possible. In cases in which we are unable to locate a control firm from the corresponding four-digit SIC code, we select from firms matching at the three-digit or two-digit level. (8) In all cases, we ensured that none of the control firms were identified as having financial misstatements in the period from 1991 to February 2003.

Table 1, Panel B shows 53 of our restatement firms were matched with a corresponding control firm at the four-digit level, 20 restatement firms were matched at the three-digit level, and the remaining 15 restatement firms were matched at the two-digit level. Panel C shows that approximately 50 percent of our observations are from four "high-tech" industries: 35xx (computers), 36xx (electronic components), and 38xx (instruments) and 73xx (software and computer programming). Panel D shows the sample observations, by year, with the majority of the restatements occurring in the later years of the sample period.

Research Design

Test Variables

Our test variables are obtained solely from publicly available sources. We obtain information on the board and audit committee from the firm's proxy statement for the period covering the restated year. (9) For each director serving on the audit committee during the target year, we determine consistent with the BRC recommendations, whether the director was a current or former employee of the firm (acceptable under NASDAQ and AMEX regulations during the sample period) or had any other disclosed affiliation with the company or its management, other than board service. INDEP is coded 1 if the audit committee consists entirely of independent auditors (per the BRC's independence definition), and 0 otherwise. In terms of the BRC's audit committee size recommendation, MINSIZE is coded 1 if the audit committee consists of at least three directors, and 0 otherwise.

We believe the BRC's requirement that every member possess basic financial literacy is impossible to evaluate from the currently available public information, since such literacy may be associated with a wide variety of backgrounds and qualifications. However, the BRC requirement that at least one member possess "financial expertise" is more precisely stated and testable using archival data. We code EXPERT as 1 (0 otherwise) if the audit committee includes at least one director who is (or has been) a CPA, investment banker or venture capitalist, served as CFO or controller, or has held a senior management position (CEO, President, EVP, SVP, VP) with financial responsibilities. (10,11)

Our meeting frequency variable, MINMEET, is coded 1 if the audit committee met at least four times during the first misstatement year, and 0 otherwise. We base this meeting threshold upon a review of the BRC. Report (1999) and recommendations of other corporate governance institutions. In particular, while the BRC did not make a specific meeting frequency recommendation, it implied that audit committees should meet at least quarterly. That is, the BRC recommends that all publicly held firms have their interim quarterly financial statements reviewed by the external auditor on a timely basis and that the audit committee discuss the results of the quarterly reviews with the external auditors, resulting in four meetings. The four meeting minimum is also recommended by the NACD (1999), as well as PricewaterhouseCoopers/IIA (2000).

Control Variables

Due to the relative lack of prior restatement literature, there does not yet exist a standard restatement firm profile. As such, in choosing our control variables, we reviewed both the restatement and fraud literature. We note substantial overlap in the control variables used in both restatement and fraud studies. Some common constructs include ownership diffusion, firm size, auditor, and management ownership. Given these factors, we use Beasley (1996)--a prominent fraud study--as a benchmark in generating our control variables since Beasley's set of control variables essentially subsumes those used in prior restatement literature (e.g., Kinney and McDaniel 1989; DeFond and Jiambalvo 1991). Additionally, the breakdowns in the first three conditions of the financial reporting process are necessary for both restatement and fraud. Consequently, restatements and fraud often reflect similar financial reporting conditions--namely, materially misstated financial statements have been issued to investors (Eilifsen and Messier 2000; Kreutzfeldt and Wallace 2000). Borrowing from the Beasley (1996) and Loebbecke and Willingham (1988) taxonomy, we categorize our control variables as relating to oversight mechanisms, management incentives, and management characteristics.

Oversight mechanisms. Beasley (1996) and others argue that the effectiveness of the company's oversight mechanisms may vary with factors such as the presence of blockholders, the board's size, the percentage of outsiders on the board, and the ownership percentage of outsiders on the board. Similar to Beasley (1996) and Dechow et al. (1996), we define BLOCK as the cumulative percentage of outstanding common stock shares held by 5 percent (or greater) blockholders unaffiliated with management. Since blockholders can serve as an additional monitoring mechanism (Beasley 1996; Dechow et al. 1996), we expect a negative relation between BLOCK and the incidence of restatement.

BOARDSIZE is defined as the number of board members. Dechow et al. (1996) posit that larger boards may result in ineffectual monitoring due to a proclivity toward communication breakdowns and inefficiencies. Thus, we expect a positive relation between BOARDSIZE and the incidence of restatement. Beasley (1996) posits that outside directors have reputational capital incentives to more actively monitor management and minimize management actions that require subsequent restatement. We define %OUTSIDER as the percentage of outside directors serving on the board and expect a negative relation between %OUTSIDER and restatement. Finally, Dechow et al. (1996) argue that higher equity ownership on the part of outside directors provides them with economic incentives for greater monitoring of management. We define OUTOWN as the cumulative percentage of common stock held by outside directors and expect a negative relation between OUTOWN and restatement.

Management incentives. In studies involving financial errors and fraud, Kreutzfeldt and Wallace (1986), Loebbecke and Willingham (1988), and DeFond and Jiambalvo (1991) find a positive association between management financial incentives and the risk of financial error, restatement, or fraud. Borrowing from this previous literature, we control for the impact of these incentives by including the following variables.

AGEPUB measures the length of time a firm's common stock has been publicly traded. Beasley (1996) reasons that new public companies may encounter difficulty with SEC-enforced reporting requirements and may not have commensurate financial reporting controls established. Thus, we expect a negative relation between AGEPUB and restatement. TROUBLE measures the financial distress of the firm. Loebbecke et al. (1989) and Bell et al. (1991) note that poor financial performance often increases the likelihood that management will engage in actions that will require subsequent restatement. We base the TROUBLE variable on the Altman Z score in the year prior to misstatement (Altman 1968). (12) We expect a positive relation between TROUBLE and restatement.

FINANCE captures the need for additional financing per Dechow et al. (1996). The need for financing is calculated as:

(Operating [Cashflow.sub.t]--Average Capital [Expenditures.sub.t-3-t-1])/Current [Assets.sub.t-1].

Firms with scores less than -0.5 are expected to need external financing within two years, which provides an incentive to manage earnings and assets in an attempt to qualify for lower cost financing (Dechow et al. 1996). FINANCE is coded 1 for these firms, and 0 otherwise. (13) We expect a positive relation between FINANCE and restatement.

Finally, the firm's rate of growth can negatively impact the ability of a firm's internal control structure and accounting system to properly record and value a firm's transactions (Beasley 1996; Bell et al. 1991). GROWTH is the average growth rate of total assets in the two years preceding the misstatement. We predict a positive relation between GROWTH and the incidence of financial restatement.

Management characteristics. Prior research has found that certain management characteristics impact the degree of monitoring to which management is willing to subject itself. Beasley (1996) and Dechow et al. (1996) argue that when the CEO is also chairman of the board, this reduces the effectiveness of the board's monitoring function and eliminates an additional monitoring mechanism--that of an independent overseer of the CEO. We control for this with a dichotomous variable CEOCHAIR, which is coded 1 in instances where the two positions are combined, and 0 otherwise. We expect a positive relation between this variable and the incidence of restatement.

The extent of management ownership can have differing effects on the likelihood management will engage in actions that require subsequent restatement (Beasley 1996). Higher management stock ownership could motivate management to increase firm value, eliminating some of the inherent agency conflict between management and shareholders. However, Loebbecke et al. (1989) note that management stock ownership can provide motivation for management to artificially inflate stock values by engaging in actions that may require subsequent restatement. As in Beasley (1996), we control for this using MGROWN, or the cumulative ownership percentage of the firm held by management that serves on the board. Due to these countervailing effects, we do not provide a directional prediction for this variable.

Finally, Dechow et al. (1996) document less accountability to the board when CEOs are also company founders. This is due to the founder's large informational advantage about the company's control systems, as well as the founder not having been subject to an independent monitoring function prior to the firm's publicly held status. A company founder may not appreciate the value of incremental monitoring functions and thus may be unwilling to expend significant resources on these functions. FOUNDER is coded dichotomously, with a value of 1 when the CEO and/or chair is also the company's founder, and 0 otherwise. We expect a positive relation between FOUNDER and the incidence of restatement.

Regression Model

Our research design is similar to that used in Beasley (1996) and Dechow et al. (1996). Our regression model is:

RESTATEMENT = [alpha] + [[beta].sub.1]INDEP + [[beta].sub.2] MINSIZE + [[beta].sub.3]NOEXPERT + [[beta].sub.4]MINMEET + [[beta].sub.5]BLOCK + [[beta].sub.6]BOARDS1ZE + [[beta].sub.7]%OUTSIDER + [[beta].sub.8]OUTOWN + [[beta].sub.9]AGEPUB + [[beta].sub.10]TROUBLE + [[beta].sub.11]FINANCE + [[beta].sub.12]GROWTH + [[beta].sub.13]CEOCHAIR + [[beta].sub.14]MGROWN + [[beta].sub.15]FOUNDER + [epsilon]

where the variables are as described previously.


Descriptive Statistics and Univariate Analysis

Table 2 presents the means, medians, and standard deviations for the restatement firms and their matched control firms. The restatement and control firms differ significantly (p < .01) in the independence of the audit committee, absence of an expert, and whether the committee meets at least four times per year. The mean number of restatement (control) firms with fully independent audit committees is 50 percent (72 percent). Seventy-six (92) percent of the restatement (control) firms had an audit committee possessing at least one financial expert. Finally, 15 percent (38 percent) of the restatement (control) firms' audit committees met at least four times during the year. With respect to the control variables, the restatement and control samples differ only in the levels of management ownership---restatement firms have significantly (p-value < .10) higher levels of ownership (26 percent) than control firms (14 percent). The size difference was insignificant, indicating the matching process was successful with respect to size.

Table 3 shows the correlations between the regression variables. We find numerous significant correlations (p < .05) between the corporate governance-related variables, which appear primarily to function as complements. While some of these correlations are significant (between INDEP, NOEXPERT, MINMEET, and %OUTSIDER), none is greater than 0.25. (14)

Multivariate Results

Table 4 shows the regression results. Significance levels for our coefficient estimates are one-tailed if the estimate is in the predicted direction, two-tailed otherwise. The results for the restatement sample support H1, H3, and H4, but do not support H2. More specifically, our coefficient estimates for the presence of a completely independent audit committee (INDEP) and committee meeting frequency (MINMEET) are significantly, negatively related to restatement (p-value < 0.01). In addition, a committee possessing at least one member meeting the BRC definition of expert (EXPERT) is significantly, negatively related to the incidence of restatement (p-value < 0.05). A committee of at least three members (MINSIZE) is not significantly related to the incidence of restatement. We also find the likelihood of restatement is higher for firms with larger boards (BOARDSIZE). Among the additional control variables, there are significant negative associations between the presence of blockholders (BLOCK) and the number of years the firm has been publicly traded (AGEPUB) and the incidence of restatement.

BRC Recommendations and the Incidence of Fraud

While we are the first study (to our knowledge) to examine the relation between audit committee factors and restatements, prior research has examined similar corporate governance variables in a fraud setting (APP 2000; BCHL 2000). However, these prior fraud studies do not examine the impact of individual audit committee characteristics on the incidence of fraud using multivariate analysis. Moreover, the BRC suggests that the adoption of their recommendations should also result in a decreased incidence of fraud. Thus, for purposes of comparison with these prior studies and to test the BRC fraud assertions, we test our hypotheses using a set of fraud firms.

Consistent with prior research, we relied upon SEC Accounting and Auditing Enforcement Releases (AAERs) that allege fraud to objectively identify 44 fraud companies during the period 1991-1999 (Bell and Carcello 2000; Palmrose and Scholz 2000; Beasley 1996). We then constructed a size-, exchange-, industry-, and auditor-matched control sample of no-fraud firms. Using the regression model found in Table 4, we found that audit committee expertise and independence are negatively related to the incidence of fraud, supporting our restatement sample findings.

However, we failed to document a statistically significant relation between our audit committee meeting frequency variable (MINMEET) and fraud. Our lack of results for this variable does not necessarily imply that meeting frequency is not an important element of audit committee effectiveness. Although its coefficient was in the predicted direction, the relative low number of observations may have diminished the power of our test for this variable. Therefore, we believe it remains an empirical question as to whether meeting frequency is systematically related to the incidence of fraud.

Sensitivity Analyses

Sensitivity analyses address three primary issues: sample selection, alternative test variable definitions, and potentially omitted correlated variables. With respect to sample selection, we test for the possibility that undiscovered restatements exist in our control sample. As of February 2003, we did not note any restatements occurring within our control sample. A second sample selection issue concerns firm size. In particular, since the BRC recommendations exempt small firms (those with market capitalization under $200 million) from certain requirements for audit committee independence, we examine the results with such small companies omitted. Our results are qualitatively unchanged.

In terms of alternative definitions of our test variables, we test different threshold levels of audit committee size and meeting frequency. We tested five alternative definitions of our MINMEET variable (e.g., meetings greater than or equal to 1, 2, 3, 5, 6 times annually). The same set of procedures was used for audit committee size, although in terms of size, there is the potential for an audit committee to become too large and unwieldy to be effective. Our tests failed to document a statistically significant relationship between restatement and any of the alternative threshold measures for audit committee size or meeting frequency. (15)

With regard to potentially correlated omitted variables, we also test other board-related characteristics including average tenure of outside directors, the number of directorships held by outside directors, percentage of nonemployee directors, and whether the board had a simple majority of outside directors. None of these variables are significant at conventional levels, nor do they impact the results reported. We also add a variable coded 1 if the firm's proxy statement discloses the presence of an internal audit function. The internal audit variable is not significant. This may be due to our inability to accurately identify all firms with internal audit functions, or to assess the effectiveness of those functions. Finally, we included other variables found to be related to the incidence of restatement such as leverage and the ratio of income-increasing GAAP alternative procedures used to the total available for use by the firm (DeFond and Jiambalvo 1991). Coefficient estimates for these two explanatory variables were statistically insignificant and the results were qualitatively unchanged.


In interpreting the findings, it is necessary to consider several important limitations of the study. First, because we wish to provide timely information that may be of interest to policymakers, we test our hypotheses in a historical sample of firms. This precludes the more complete test of BRC recommendations that would be possible using a survey instrument to obtain nonpublic information. This is especially true for the area of financial literacy. It is not certain to what extent literacy and expertise may be substitutes. Second, these same limitations also force us to adopt a piecemeal approach to evaluating the efficacy of certain recommendations--even though the BRC report stresses that its recommendations should be adopted in their entirety. Third, our meeting frequency threshold is only one measure of audit committee activity and may be relatively crude.

A final potential limitation of our paper relates to the fourth condition of financial reporting process as described by Eilifsen and Messier (2000). No control system or external auditor is capable of preventing or detecting 100 percent of misstatements. As such, if material misstatements are discovered and communicated to audit committees in subsequent annual audits, an effective audit committee could be more likely to demand restatement. We believe that in order to properly test this conjecture, a researcher would need to observe not only the restatements that occurred and the corresponding audit committee characteristics, but also instances in which misstatements were reported to the audit committee, but no restatement was issued. This provides an interesting avenue for future research.


Subject to the limitations previously discussed, our results support the BRC's contentions regarding audit committee independence, expertise, and meeting frequency. We believe our study contributes to an area that has become increasingly important in recent years, as investor losses from high-profile financial restatements continue to mount.

Three factors suggest that our evidence remains timely and relevant. First, current research suggests that corporate audit committees had yet to attain the standards suggested by the BRC. In particular, in a study from the 2001 proxy statement season, Abbott et al. (2003b) find that of a sample of over 500 firms, only 74 percent of audit committees were comprised entirely of outsiders, only 57 percent met at least four times annually, and 79 percent possessed a member with financial expertise. An even smaller proportion of audit committees (38 percent) simultaneously achieved these three recommendations. Second, recent regulation such as the Sarbanes-Oxley Act and proposed NYSE listing requirements still allow for exceptions (per review of the SEC) to their definitions of audit committee member independence. Third, highly publicized restatements and frauds, combined with the speed at which the Sarbanes-Oxley Act was created, suggest that the role of the audit committee in the financial reporting process will continue to be a very important issue facing regulators, professionals, and academics.
Sample Selection Results

Panel A: Restatement Sample Selection

Number of restatement articles found per initial
  article search                                       3033
 Less: Duplicate references to same restatement       (1425)
 Less: Non-financial statement restatements           (358)
 Less: Foreign Firms                                  (153)
 Less: Non-sample period restatements                  (46)
 Less: References to quarterly statements             (553)
 Less: Registration statements and restatements
  due to mergers, etc.                                (236)

  Total unique annual restatement references found     262

Sample firm losses due to additional sample
 selection criteria:                                  Number     %

Initial annual restatement sample                      262      100
 Less: SEC has alleged fraud                           (27)    (10.3)
 Less: Financial Institutions                          (22)    (8.4)
 Less: Compustat information not available             (72)    (27.5)
 Less: Proxy statement not available                   (18)    (6.9)
 Less: No control firm located                         (18)    (6.9)
 Less: Not on NYSE, AMEX/NASDAQ, or other reasons
   for non-inclusion                                   (19)    (7.3)

  Total firms dropped                                  176      67.3

Sample firms located from initial article search        86       --
Add: Restatement firms located via AAERs
  (without an allegation of fraud)                       2       --

  Total restatement firm sample                         88       --

Panel B: Control Firm Matches by SIC Codes

Four-digit SIC code   53   Three-digit   20   Two-digit   15
                            SIC code          SIC code

Panel C: Restatement Sample observations by Two-Digit SIC Code

28xx--Chemicals and Allied Products, Pharmaceuticals            3
35xx--Industrial Machinery, Computers                           9
36xx--Electronic Components & Other Electrical Equipment        5
38xx--Instruments                                               9
49xx--Electric, Gas, Sanitary Services                          5
50xx--Durable Goods                                             3
59xx--Miscellaneous Retail                                      4
73xx--Business Services, Computer Programming & Software       19
80xx--Health Services                                           5
Two-digit SIC codes with less than 3 observations              26

 Total                                                         88

Panel D: Restatement Sample Observations by Year

1991     3   1994      4     1997   22
1992     2   1995     10     1998   23
1993     3   1996      8     1999    3

Univariate Results

                      Restatement Firms
                           (n = 88)

Variable Name     Mean     Median    Std. Dev.

INDEP             0.500     0.500        0.503
MINSIZE           0.614     1.000        0.489
EXPERT            0.761     0.000        0.429
MINMEET           0.147     0.000        0.357
BLOCK             0.128     0.085        0.137
BOARDSIZE         6.988     7.000        2.619
%OUTSIDER         0.609     0.600        0.158
OUTOWN            0.042     0.005        0.092
AGEPUB            6.591     7.000        3.307
TROUBLE           0.342     0.000        0.477
FINANCE           0.215     0.000        0.892
GROWTH            1.111     0.401        2.695
CEOCHAIR          0.784     1.000        0.414
MGROWN            0.258     0.124        0.694
FOUNDER           0.318     0.000        0.468
TOTAL ASSETS    989.3     129.2       1788.2

                        Control Firms
                          (n = 88)
                                                 Diff. in    Mann-
Variable Name     Mean     Median    Std. Dev.    Means     Whitney

INDEP             0.716     1.000        0.453     -0.216    8.95 ***
MINSIZE           0.727     1.000        0.448     -0.113    2.58
EXPERT            0.921     0.000        0.272      0.160    8.64 ***
MINMEET           0.375     0.000        0.486     -0.210   12.47 ***
BLOCK             0.162     0.139        0.164     -0.034    2.23
BOARDSIZE         7.375     7.000        2.488     -0.387    1.01
%OUTSIDER         0.629     0.633        0.152     -0.024    0.77
OUTOWN            0.029     0.009        0.054      0.013    1.37
AGEPUB            7.473    10.000        3.028     -0.882    1.44
TROUBLE           0.278     0.000        0.451      0.064    0.73
FINANCE           0.093     0.000        0.355      0.122    1.44
GROWTH            0.892     0.152        3.068      0.219    0.25
CEOCHAIR          0.705     1.000        0.458      0.079    1.46
MGROWN            0.144     0.084        0.159      0.114    2.72 *
FOUNDER           0.238     0.000        0.429      0.080    1.38
TOTAL ASSETS   1067.5     126.2       1972.4       78.2      0.56

*, **, *** Significant at p-value < .10, .05, .01, respectively.

    INDEP = 1 if all audit committee members are independent by BRC
            definition, else 0;

  MINSIZE = 1 if the audit committee consists of at least three
            members, else 0;

   EXPERT = 1 if audit committee includes at least 1 director with
            financial expertise per the BRC's definition, else 0;

  MINMEET = 1 if audit committee meets at least four times annually
            during the sample year, else 0;

    BLOCK = the cumulative percentage of outstanding common stock
            shares held by 5 percent + blockholders not affiliated
            with management;

BOARDSIZE = the number of directors on the board;

%OUTSIDER = percentage of the board members who are nonemployee

   OUTOWN = the cumulative percentage of stock held by outside

   AGEPUB = the number of years the company has been publicly

  TROUBLE = indicator variable equal to 1 if the firm is financially
            distressed, based on the Altman Z-score in the year
            preceding misstatement, else 0;

  FINANCE = 1 if the firm is expected to need external financing
            within two years, else 0;

   GROWTH = average percentage change in total assets for the two
            years ending before the year of the misstatement;

 CEOCHAIR = 1 board chairman holds the managerial positions of CEO
            or president, else 0;

   MGROWN = the cumulative ownership percentage in the firm held by
            insiders (e.g. managers) who serve on the board; and

  FOUNDER = 1 if the firm's founder retains the post of either CEO
            or Chair, else 0.

Correlation Matrix

Variable      Indep      Minsize      Expert    Minmeet    Block

Indep          1.00
Minsize       -0.12        1.00
               0.12        0.00
Expert         0.16        0.24        1.00
               0.03        0.00        0.00
Minmeet        0.08        0.17        0.08      1.00
               0.29        0.02        0.28      0.00
Block          0.08       -0.04       -0.01     -0.09      1.00
               0.31        0.63        0.88      0.22      0.00
Boardsize      0.05        0.25        0.34      0.27     -0.15
               0.49        0.00        0.00      0.00      0.04
%Outsider      0.20        0.18        0.17      0.19      0.17
               0.00        0.02        0.02      0.01      0.02
Outown         0.08       -0.07       -0.13     -0.08     -0.02
               0.32        0.37        0.09      0.27      0.78
Agepub         0.07        0.26        0.14      0.06      0.03
               0.33        0.00        0.07      0.41      0.72
Trouble       -0.06       -0.13       -0.09      0.07      0.02
               0.47        0.09        0.29      0.37      0.77
Finance       -0.08       -0.11       -0.13     -0.13     -0.09
               0.27        0.15        0.09      0.08      0.23
Growth        -0.15       -0.04       -0.02      0.00     -0.02
               0.04        0.60        0.83      0.98      0.79
Ceochair       0.01       -0.08       -0.03     -0.13     -0.07
               0.90        0.30        0.69      0.10      0.38
Mgrown         0.01        0.03       -0.03     -0.10     -0.07
               0.94        0.66        0.72      0.19      0.33
Founder       -0.18       -0.05       -0.08     -0.11     -0.05
               0.02        0.51        0.31      0.15      0.49

Variable     Boardsize   %Outsider    Outown    Agepub    Trouble






Boardsize      1.00
%Outsider      0.22        1.00
               0.00        0.00
Outown        -0.13        0.11        1.00
               0.08        0.16        0.00
Agepub         0.39        0.21       -0.03      1.00
               0.00        0.01        0.72      0.00
Trouble       -0.16       -0.08        0.21     -0.21      1.00
               0.05        0.29        0.01      0.01      0.00
Finance       -0.09       -0.04        0.06     -0.07     -0.05
               0.22        0.58        0.41      0.33      0.20
Growth        -0.16       -0.02        0.02     -0.41     -0.05
               0.03        0.81        0.76      0.00      0.31
Ceochair       0.03        0.00       -0.07     -0.15     -0.16
               0.73        0.95        0.36      0.05      0.05
Mgrown        -0.05        0.02       -0.06     -0.04     -0.07
               0.52        0.80        0.43      0.62      0.42
Founder       -0.13       -0.24       -0.15     -0.23     -0.14
               0.08        0.00        0.05      0.00      0.08

Variable      Finance     Growth     Ceochair   Mgrown    Founder











Finance        1.00
Growth         0.07        1.00
               0.36        0.00
Ceochair      -0.01        0.06        1.00
               0.89        0.41        0.00
Mgrown         0.03       -0.01        0.05      1.00
               0.69        0.89        0.47      0.00
Founder        0.10        0.16        0.25      0.09      1.00
               0.17        0.04        0.00      0.24      0.00

Note: Independent variables are defined in Table 3.
(p-values listed below correlation coefficients).

Logistic Regression of Financial Restatements on
Audit Committee Characteristics and Control Variables

Regression Model:

RESTATEMENT = [alpha] + [[beta].sub.1]INDEP + [[beta].sub.2]MINSIZE +
[[beta].sub.3]NOEXPERT + [[beta].sub.4]MINMEET + [[beta].sub.5]BLOCK +
[[beta].sub.6]BOARDSIZE + [[beta].sub.7]%OUTSIDER +
[[beta].sub.8]OUTOWN + [[beta].sub.9]AGEPUB + [[beta].sub.10]TROUBLE +
[[beta].sub.11]FINANCE + [[beta].sub.12]GROWTH +
[[beta].sub.13]CEOCHAIR + [[beta].sub.14]MGROWN +
[[beta].sub.15]FOUNDER + [epsilon]

                                         Coefficient        Wald
Independent Variable     Expected Sign    Estimate      [chi square]

Intercept                                    0.179      0.051
INDEP                          -            -0.909      6.011 ***
MINSIZE                        -            -0.507      1.498
EXPERT                         -            -1.074      3.973 **
MINMEET                        -            -1.232      8.301 ***
BLOCK                          -            -2.007      2.892 **
BOARDSIZE                      +             0.093      2.566 **
%OUTSIDER                      -            -1.635      1.556
OUTOWN                         +             2.551      1.061
AGEPUB                         -            -0.115      2.673 **
TROUBLE                        +            -0.016      0.018
FINANCE                        +             0.019      0.054
GROWTH                         +             0.020      0.174
CEOCHAIR                       +             0.295      0.523
MGROWN                       None            0.553      0.793
FOUNDER                        +             0.153      0.133
Observations                                  176
Adjusted [R.sup.2]                           0.25
Model [c.sup.2]                             54.76 ***

*, **, *** = p-value < .10, .05, .01, respectively, one-tailed if in
predicted direction, two-tailed otherwise.

Dependent Variable = 1 if financial restatement is present, 0

Independent variables are defined in Table 3.

We express our sincere thanks to two anonymous reviewers and to Arnie Wright and Jane Mutchler for numerous helpful comments and suggestions. We also thank Dana Hermanson, participants of the 2001 American Accounting Association Auditing Section Meeting, and workshop participants at the University of Oregon. Professor Parker gratefully acknowledges the financial support of the Ernst & Young Accounting Faculty Research Fellowship and the Dean Witter Foundation.

(1) An audit failure entails greater reputational damage to an independent audit committee director since (s)he was specifically assigned to the audit committee's financial reporting oversight role because of their independence. The external market for decision agents is likely to react more negatively in these instances for independent directors (Booker 2002).

(2) Note that because of the difficulty of developing a measure of literacy (which is defined in terms of skills, rather than professional background) from public information, we confine this hypothesis to addressing the effect of the presence of financial experts on the audit committee. Our measure of expertise is similar to that adopted by the NASDAQ, but not to that of the NYSE, which allows the board substantial discretion.

(3) Recommendations 6-10 deal (either directly or indirectly)with the responsibilities and activities of the audit committee, requiring the committee to be responsible for the selection and retention of the external auditor (number 6), evaluate auditor independence (number 7), to discuss accounting quality with the auditor (number 8), and to hold similar discussions with management and the auditor (number 9). Recommendation 10 requires interim reviews, and also discussion of these review-related issues with the auditor.

(4) Firms listed on the three major domestic exchanges were required to have audit committees during the time frame considered. The AMEX regulations had not yet taken effect in 1991; however, our sample from that year consists only of NASDAQ and NYSE firms. We eliminated restatements related to registration statements since companies are not required to form audit committees at the time the registration documents are filed.

(5) We ensured sample restatements did not result from fraud by employing the methodology of Palmrose and Scholz (2000). These authors define a fraud-related restatement as one satisfying any of three criteria: (1) an Accounting and Auditing Enforcement Releases (AAER) alleging fraud at the restating company was issued by the SEC; (2) criminal charges were brought against company management connected to the restatement; (3) an admission of fraud on the part of company management. A search of AAERs and WSJ articles confirms that none of our sample firms met any of these three criteria.

(6) We do not include quarterly restatements in our sample for two interrelated reasons. First, many quarterly restatements are corrected before the end of the fiscal year--often after discovery by the external auditor (Palmrose and Scholz 2000). Second, during our sample period, SAS No. 71 required auditors to review quarterly results. However, under the provisions of SAS No. 71, external auditors could either perform a timely review of quarterly results or perform a retrospective review of quarterly results during the year-end audit. Consequently, a quarterly restatement does not necessarily indicate that an error went undetected by both the internal control system and the external auditor. Since the audit committee must rely upon the internal and external audit functions in discharging its duties, including quarterly restatements in our sample may introduce variation in our dependent variable unrelated to our test variables of interest.

(7) We compared our sample selection results to Palmrose and Scholz (2000). After eliminating restatements as described in our sample selection process, we observe 184 restatements for the 1995-1999 period. This compares reasonably to the annual restatement sample of 204 for a similar period in Palmrose and Scholz (2000), although they use a more exhaustive search methodology and include AAERs alleging fraud.

(8) Four sample firms were matched on a basis of total assets because no equity-value matching firm could be located in the same two-digit industry.

(9) Our procedure entails examining the proxy statement issued during the year following the restated year. For example, consider a firm whose 12/31/97 annual financial statements were restated during the year 1999. We retrieve audit committee data from the 1998 proxy statement that describes the audit committee's activities and composition that occurred during 1997. We focus on determining which members served on the audit committee at the end of the first restatement year, through the annual meeting date. We do this on the assumption that those directors were present during the most critical period of the external audit (from year-end to the issuance of the report), and thus were most responsible for the oversight of that year's financial reporting process. This approach is consistent with that of prior research (Beasley 1996; Abbott et al. 2000).

(10) We thank an anonymous reviewer for assistance in appropriately operationalizing this variable. Our data are limited in that SEC regulations require biographical information in the proxy for only the preceding five-year period.

(11) The recently enacted Sarbanes-Oxley Act of 2002 requires a firm to disclose whether or not, and if not, the reasons therefore. The Act's definition of "financial expert" is substantially similar to the one adopted in this paper.

(12) For the 20 firms for which an Altman Z cannot be constructed from Compustat data, we use an indicator variable with the value 1 if the firm has experienced losses in three of the preceding six years. Our results are not sensitive to the exclusion of these 20 firms.

(13) For 30 firms for which we are unable to obtain enough information to calculate the external financing need, we examine whether the firm registered a securities offering (based on notice in the Investment Dealers' Digest) or received additional debt or equity financing in the first year of misstatement or the succeeding year.

(14) We also note negative correlations between audit committee independence and growth, and audit committee independence and the presence of a founder as CEO. The largest correlation between control variables is 0.41 (years publicly traded and growth). Regression diagnostics on the multivariate results reported in the succeeding section do not indicate the presence of multicollinearity among the explanatory variables.

(15) The most significant alternative MINMEET variable was for audit committees meeting greater than or equal to five times during the year (p = .1260, two-tailed). We attribute this lack of significance to the small percentage of firms attaining this level of meeting frequency, thus reducing the variation in this measure.


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Lawrence J. Abbott is an Assistant Professor at the University of Memphis, Susan Parker is an Assistant Professor at Santa Clara University, and Gary F. Peters is an Assistant Professor at the University of Arkansas.

Submitted: March 2001

Accepted: November 2003
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Author:Abbott, Lawrence J.; Parker, Susan; Peters, Gary F.
Publication:Auditing: A Journal of Practice & Theory
Date:Mar 1, 2004
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