ACCRUALS QUALITY, FIRM VALUATION AND AUDIT COMMITTEE ACCOUNTING EXPERT APPOINTMENTS

Transcription

1 ACCRUALS QUALITY, FIRM VALUATION AND AUDIT COMMITTEE ACCOUNTING EXPERT APPOINTMENTS Vic Naiker University of Auckland Doctoral Scholar Department of Accounting and Finance School of Business and Economics The University of Auckland January 2007 Preliminary version This paper is based on a chapter of my PhD dissertation at The University of Auckland. I would like to thank my dissertation advisors Dan Dhaliwal, Farshid Navissi and Jilnaught Wong for their advice and assistance. I also thank Robert Knechel, Divesh Sharma, Mike Bradbury, Steven Cahan, Donald Stokes, Philip Shane and seminar participants at the 2006 University of Auckland Auditing Conference and the 2006 Auckland Region Accounting Conference for their helpful comments and suggestions.

2 ACCRUALS QUALITY, FIRM VALUATION AND AUDIT COMMITTEE ACCOUNTING EXPERT APPOINTMENTS ABSTRACT Prior research indicates that accounting expertise in audit committees has a profound positive association with financial reporting quality. While these results suggest that accounting experts improve financial reporting quality, the results could also be attributed to the self-selection of accounting experts and firms with high financial reporting quality. This study employs the empirical setting of director appointments to the audit committee to provide support for the self-selection explanation. Specifically, I find that firms which already have high financial reporting quality are more likely to appoint accounting experts to their audit committee. The results also indicate that the propensity of high quality firms to make such appointments is more pronounced when they are undervalued, underlining the use of accounting expert appointments as a signaling mechanism. Additional tests provide further support for the signaling motivation by documenting pronounced positive abnormal stock returns for undervalued firms with high financial reporting quality who appoint accounting experts. Furthermore, the study documents that the positive association between audit committee accounting expertise and financial reporting quality, as documented in prior research, weakens in the year following the appointment year after controlling for self-selection bias. Keywords: Audit Committee, Accounting expertise, Self-selection Data Availability: Data are available from sources identified in the paper.

3 ACCRUALS QUALITY, FIRM VALUATION AND AUDIT COMMITTEE ACCOUNTING EXPERT APPOINTMENTS I. INTRODUCTION In July 2002, in response to high-profile cases, such as Enron and WorldCom, Congress enacted the Sarbanes Oxley Act (hereafter SOX), introducing additional standards for audit committees. One such requirement, introduced by section 407 of SOX, specifies the SEC to adopt rules mandating audit committees of public firms to include at least one member who is a financial expert. Although SOX proposed to classify individuals as financial experts if they had obtained education and experience in accounting and auditing only, critics believed that this definition was overly restrictive and severely limited the pool of qualified financial experts. In response, the SEC and the U.S. stock exchanges controversially adopted a broader definition of financial experts, under which financial expertise could include accounting expertise, or any experience in supervising employees with financial responsibilities and overseeing the performance of companies. The controversial circumstances surrounding the implementation of section 407 of SOX, has motivated numerous studies to evaluate whether the SEC and stock exchanges were justified in adopting a broadened definition of financial expertise, from the perspective of preserving financial reporting quality and shareholder wealth (DeFond, Hann and Hu 2005; Carcello, Hollingsworth, Klein and Neal 2006; Krishnan and Visvanathan 2006). These studies show that of the different types of 1

4 expertise currently included in the broad definition, accounting expertise in audit committees has the most significant positive association with financial reporting quality and shareholder wealth. These findings are based on the intuition that since audit committee members are responsible for tasks that require knowledge of accounting and auditing concepts, individuals with better understanding of technical accounting issues contribute more significantly to audit committee effectiveness (Kalbers and Fogarty 1993; McDaniel, Martin and Maines 2002; DeZoort 1997, 1998; McMullen and Raghunandan 1996). DeFond et al. (2005) state that if the goal of the SEC is to improve financial reporting quality, then it should adopt a narrower definition of financial expertise that only includes accounting expertise. However, to further understand the role that accounting experts play in ensuring high quality financial reporting, numerous important questions remain unanswered. One such question addressed in this study, is whether accounting experts and firms with high financial reporting quality self-select each other. Prior studies documenting a negative association between accounting expertise in audit committees and financial reporting irregularities have implicitly or explicitly concluded that having accounting experts on audit committees should improve financial reporting quality (monitoring hypothesis). 1 However, the findings of prior studies can also be partly attributed to accounting experts and high quality firms self-selecting each other (self-selection hypothesis). Given that accounting experts are more adept at scrutinizing financial results, the self-selection explanation suggests that accounting experts are more likely to chose and accept appointments in firms with high financial 1 For example, McMullen and Raghunandan (1996) find a negative association between financial reporting problems and firms with a CPA on the audit committee and conclude that having CPAs serve on audit committees should improve financial reporting quality. 2

5 reporting quality. Firms with high financial reporting quality may also have an incentive to recruit accounting experts, in order to signal that their existing financial reporting system passes the due diligence of an accounting expert. While prior studies have pledged support for the monitoring explanation, no prior study has formally investigated the self-selection explanation. 2 This study employs the empirical setting of audit committee member appointments to investigate whether high-quality firms and audit committee accounting experts self-select each other. 3 Using a sample of 377 appointments consisting of 114 (263) accounting (non-accounting) expert appointments, logistic regression results indicate a positive relationship between the likelihood of firms appointing an accounting expert to the audit committee and a measure of financial reporting quality (based on discretionary accruals), from the year immediately prior to the year of appointment. This finding contributes to the extant literature by providing support for the self-selection explanation. The results also indicate that the likelihood of firms with high financial reporting quality appointing an audit committee accounting expert, becomes increasingly pronounced when they are undervalued. This finding is intuitive, since the motivation behind firms appointing audit committee accounting experts to signal their higher quality, must be eventually attributed to economic reasons, and prior research suggests that the resolution of firm undervaluation problems, constitutes one of the main objectives of signaling behaviour (Myers and Majluf 1984). Indeed, additional tests indicate significant 2 It is important to note that the monitoring and self-selection explanations are not necessarily mutually exclusive (DeFond, Hann and Xu 2005; Engel 2005). 3 Engel (2005) suggests that the empirical setting of audit committee member appointments has the potential of providing evidence that further clarifies the relationship between audit committee accounting expertise and financial reporting quality. 3

6 economic benefits (positive abnormal stock returns), around the appointment dates, accruing to undervalued firms with high financial reporting quality who appoint accounting experts. Hence, the study also contributes to the signaling literature, by providing empirical support for the use of audit committee accounting experts appointments as a signaling mechanism. Finally, the study develops predictions and provides evidence on numerous other economic determinants of accounting expert appointments to audit committees. Previous studies in this area have examined the association between the contemporaneous presence of financial experts on boards and firm characteristics (Agrawal and Chadha 2005). In contrast, this study specifically employs the empirical setting of audit committee member appointments and lagged measures of explanatory variables, to provide more direct evidence on firm attributes that drive the appointment of accounting experts to audit committees. The results indicate that the likelihood of firms appointing accounting experts is: (1) increasing in strength of audit committee governance, existing presence of accounting experts on audit committees, sales growth, leverage, capital intensity and age; and is (2) decreasing in firm size. My findings are insensitive to alternative measures of financial reporting quality and firm undervaluation. I also find that the study s explanatory variables are unsuccessful in predicting the appointment of nonaccounting experts to the audit committee, suggesting that the use of audit committee appointments for signaling reasons may only apply to the appointment of accounting experts. Moreover, using a two-stage treatment effects model (Heckman 1979; Lee 1979), the study illustrates the relevance of the self-selection issue, by documenting that the positive association between audit committee accounting expertise and 4

7 financial reporting quality, in the year following the appointment year, weakens after controlling for self-selection bias. This finding has important implications for future studies on how accounting expertise affects financial reporting quality, as the failure to control for self-selection may result in biased conclusions. The remainder of this study is organized as follows. Section II discusses the prior research and develops the hypotheses. Section III discusses the sample selection and data collection. Section IV explains the variable measurements and Section V discusses the research design. Section VI reports descriptive statistics while the empirical results are discussed in Section VII. The results from the additional tests are reported in Section VIII and Section IX concludes the study. II. PRIOR RESEARCH AND HYPOTHESES The central premise of this study is that high quality firms not only appoint accounting experts because they desire improvements in governance, but they also seek such appointments to signal that their existing financial reporting system passes the due diligence tests by an accounting expert. Another view is that accounting experts will also prefer appointments with high quality firms in order to preserve their reputational capital. From a firms perspective, the resolution of information asymmetry problems constitutes the objective of signaling behaviour (Spence 1973). Given that a firm is more fully informed about its current operations and growth prospects, the presence of asymmetric information between the firm and outsiders could lead to an undervaluation of the firm (Myers and Majluf 1984). The challenge facing high quality firms is to determine an effective way of signaling their true value so that the 5

8 wealth of existing shareholders is not threatened. Titman and Trueman (1986) apply this signaling behaviour to the appointment of experts and advisors, by proposing that the quality of advisors employed by a firm signals the quality of information within the firm. They argue that market participants recognize and value the services of the high quality experts, and such experts will therefore not seek employment with low quality firms in order to preserve their reputational capital. Conversely, low quality firms are less likely to recruit high quality experts, as in order to attract high quality experts, low quality firms would have to make substantial changes to provide investors with a more accurate portrayal of the firm s performance. Based on the above arguments, Titman and Trueman (1986) conclude that high quality firms and high quality experts will self-select each other. 4 While there is no prior evidence on the appointment of audit committee members as a signaling mechanism, a handful of studies provide supportive arguments and evidence on the viability of director appointments functioning as a signaling mechanism. Finkle (1998) finds that recruitment of directors with financial expertise enhances firms ability to raise additional capital, as such directors have considerably more expertise in investments, and their recruitment sends important signals to market participants. Certo, Daily and Dalton (2001) find that reputable outside directors assist firms in conquering information asymmetry problems that might otherwise deter potential investors and are associated with less underpricing 4 This finding has been subsequently confirmed in numerous other studies that have documented high quality firms and experts, such as underwriters and auditors, self-selecting each other to avoid problems related to firm undervaluation and reputational losses, respectively (Carter, Dark and Singh 1998; Chemmanur and Fulghieri 1994; Booth and Chua 1996; Nanda and Yun 1997; Chen and Mohan 2002; Datar, Feltham and Hughes 1991; Copley, Gaver and Gaver 1995). 6

9 around initial public offerings. 5 Other studies that document the benefits firms gain by appointing reputable directors to signal their higher quality include Johnson, Daily and Ellstrand (1996), Mizruchi (1996), and Certo (2003). Deutsch and Ross (2003) advance this literature by formally modeling the signaling role of reputable directors, in which high quality firms rent the reputation of prestigious outside directors in order to distinguish themselves from low quality firms and attract stakeholders critical to their survival. However they warn that boards have various roles other than signaling so the hiring of individuals as a signaling mechanism should be restricted to a few individuals who possess the relevant reputational capital. From the directors perspective, they also have incentives to select appointments in high quality firms. Certo et al. (2001) argue that reputable individuals would be hesitant to accept directorships in low quality firms; as such a choice may damage their reputation as decision experts. Gilson (1989) documents this reputational damage by showing that over 50 percent of financially distressed firms experience management and director turnover. Moreover, none of the departing officers are able to secure similar positions with exchange-listed firms during the three years following their departure. Other studies that document adverse consequences for officers and directors of poor performing firms include Kaplan and Reishus (1990), Hambrick and D Aveni (1992), and Srinivasan (2005). Consistent with these findings, Finkelstein and Hambrick (1996) state that reputable individuals are cautious in accepting directorships, as directors of poor performing firms may 5 Mace (1986) and Herman (1981) contend that independent directors are valued not for their monitoring capabilities, but for their ability to solidify business relationships, and to signal that the company is performing well. Director independence would be a useful signaling mechanism, as independent directors have been argued to utilize board memberships to enhance their reputations as expert decision makers (Fama and Jensen 1983). 7

10 threaten their own status in the elite. 6 This implies that appointment of reputable directors are costly to imitate for low quality firms, as reputable directors will be less likely to accept directorships with poor performing (low quality) firms. Given that the audit committee is a sub-committee of the entire board, the supportive arguments on the self-selection of high quality firms and reputable directors, sets the stage for an examination of self-selection between reputable audit committee members and firms with high financial reporting quality. Prior research suggests that an important component of audit committee member reputation is the level of accounting expertise they possess to carry out the audit committees primary responsibility of overseeing the financial reporting process. These studies argue that financial reporting issues involve the highest level of technical detail among audit committee effectives areas (Kalbers and Fogarty 1993; Green 1994), and that ideal audit committee members should have knowledge of accounting concepts and the auditing process, to help them better understand the financial reporting process, recognize problems, ask probing questions of the management and auditor, and make leadership contributions to audit committees (McDaniel et al. 2002; Libby and Luft 1993; Bull and Sharp 1989; Lipman 2004; Scarpati 2003). Prior archival studies show that audit committee accounting expertise is: (1) negatively associated with SEC enforcements and restatements (McMullen and Raghunandan 1996; Agrawal and Chadha 2005) and suspicious auditor switches (Archambeault and DeZoort 2001), and (2) positively associated with firm credit ratings (Ashbaugh-Skaife, Collins and LaFond 2004), shareholder wealth (DeFond et 6 This is because the reputations of firms and their leaders are entangled, and tainted corporate performance creates difficulties for leaders as individuals (Sutton and Callahan 1987). 8

11 al. 2005), financial reporting quality (Carcello et al. 2006; Krishnan and Visvanathan 2006), and likelihood of supporting and agreeing with auditors in financial reporting disputes with management (DeZoort and Salterio 2001). While these findings could support the view that the presence of accounting experts on audit committees helps improve the financial reporting quality (monitoring explanation), the results of these studies could also infer that accounting experts are being more selective and choosing appointments in high quality firms and vice-versa (self-selection explanation). While prior studies have pledged support for the monitoring explanation, to the best of my knowledge, no prior study has examined whether accounting experts and high financial reporting quality firm self-select each other. Engel (2005) outlines this self-selection scenario for accounting experts appointed to the audit committee, under which firms nominate or invite potential audit committee members, who following their nomination, conduct due diligence on the firm s financial reporting environment in deciding whether to accept or decline the nomination. By virtue of their superior knowledge of accounting and auditing concepts, accounting experts are more likely to accurately assess the quality of financial reporting prior to accepting appointments and have the luxury of being particular about which firms to join. Failure to do so increases the exposure of accounting experts to problems, ranging from reputation damaging publicity to time consuming legal entanglements (King 2003). Srinivasan (2005) shows that, in comparison to other directors, directors who serve as audit committee members are more likely to bear significant reputational losses in the period following an earnings restatement. While Srinivasan (2005) does not separately consider the reputational 9

12 losses experienced by audit committee members who have accounting expertise, it is plausible that accounting experts will ultimately bear greater reputational losses given that their professional development has an intimate connection to the financial reporting environment. Accounting experts are therefore more likely to conduct thorough due diligence before accepting their nominations, and are more likely to accept appointments in firms with high financial reporting quality. 7 This view is supported by Agrawal and Chadha (2005) who also state that the selection of accounting experts is more likely in better managed firms which are less prone to accounting problems. Hence, firms may appoint accounting experts to their audit committee to signal their high financial reporting quality and provide stakeholders with assurances about the firms financial reporting and ethical responsibilities. Conversely, firms with low financial reporting quality are more likely to appoint nonaccounting experts either due to an accounting expert uncovering low quality financial reporting in the due diligence process and declining the nomination, or the firm, recognizing its low quality financial reporting and not nominating an accounting expert (Engel 2005). This leads to the first hypothesis (stated in alternative form): H 1 : Firms with high financial reporting quality are more likely to appoint accounting experts to the audit committee. 7 Some documented cases on the range of due diligence activities conducted by accounting experts help illustrate the level of vigilance exercised by accounting experts prior to accepting committee memberships. For example, prior to joining the audit committee of LaCrosse Footwear Stephen Loughlin, a chief financial officer stated that, he thoroughly investigated the integrity and competence of the existing management by interviewing the board members, meeting twice with the management group, interviewing the financial analysts that covered the firm and talking to acquaintances who knew the management team (Norton 2003). His due diligence process stretched to a length of nearly four months before he finally accepted the invitation to join LaCrosse. Michael Bernstein, CPA went even further before accepting an appointment as the audit committee chairman of Bradley Pharmaceuticals. Bernstein s investigation involved interviewing Bradley s auditor Grant Thornton on its opinion of the capabilities and integrity of Bradley s financial officers. 10

13 The likelihood of high financial reporting quality firms appointing accounting experts to their audit committee for signaling reasons may however be ultimately driven by economic motivations. As discussed earlier, prior literature suggests that the resolution of firm undervaluation problems constitutes the objective of signaling behaviour by firms. Hence, it is plausible to expect this motivation to hold for the current study s setting. Specifically, the appointment of accounting experts may be more likely in high quality firms who are also undervalued. This is because such firms have an additional incentive of addressing their undervaluation, which can be partially accomplished by resolving any information asymmetry problems with respect to their financial reporting quality. Indeed, DeFond et al. (2005) find that the market value of firms significantly increases in response to the appointment of audit committee members with accounting expertise, while in comparison; firms appointing audit committee members with non-accounting expertise experience no significant changes in firm value. This leads to the second hypothesis (stated in alternative form): H 2 : The likelihood of firms with high financial reporting quality appointing accounting experts to their audit committee becomes more profound when these firms are undervalued. III. SAMPLE SELECTION AND DATA Table 1 outlines the sample selection procedure. The original sample is based on firms covered by the IRRC directors database. <<< INSERT TABLE 1 ABOUT HERE >>> 11

14 As of 1998, the IRRC database extended its data coverage to include, among other items, the appointment year of directors. The 1998 database lists 6,431 audit committee members serving on the boards of 1,766 firms. Using this database, I identify a preliminary sample of 1,962 audit committee members who were appointed during the period I then eliminate appointments of directors who were employees or held close economic ties with the appointing firms. This reduced the sample to 1,623 appointments. Next, I eliminate 471 appointments made by firms without Compustat financial data necessary to complete the empirical analysis. Similar to previous studies, I use the industry membership of firms from Compustat to exclude director appointments by banks, financial institutions, utilities, and firms in regulated industries. 8 This reduces the sample size to 955 director appointments. Next, I delete 415 appointments that involved recruitment of multiple directors. Such a restriction eliminates the chance of any due-diligence collaboration between directors from affecting the likelihood of directors accepting or declining appointments. I then further reduce the sample to 495 appointments, by requiring the appointed directors to serve on the appointing firm s audit committee in the initial year of their appointment. Finally, in order to compute firm valuation, I require the appointing firms to have relevant stock price data on CRSP and analyst forecast data available on I/B/E/S. This reduces the sample to 321 appointments. At this point, the type of financial expertise possessed by each director being appointed is determined using the: proxy statements of all firms that these directors serve on, biographical information of directors on the Hoovers database, and director 8 These firms often have incentives to report earnings levels linked to regulatory oversight or linked economic benefits flowing to regulators. To focus on cases without these complications I exclude from the sample, firms with SIC codes between 4400 and 5000 and between 6000 and

15 appointment announcements on the Factiva and HighBeam Research database. This process indicates that the preliminary sample consisted of 58 appointments of directors who possessed accounting expertise, while the remaining 263 appointments concerned directors who did not have any accounting expertise. Consistent with prior research (DeFond et al. 2005; Carcello et al. 2006; Krishnan and Visvanathan 2006), I assign accounting expertise to appointed audit committee members if they have work experiences as certified public accountants, chief financial officers, vice president of finance, financial controllers, or any other major accounting positions. In an attempt to increase the accounting experts sub-sample, which may be beneficial for some of the study s additional analyses, I include additional appointments of accounting experts during the sample period, identified using keyword searches on the Factiva and HighBeam databases and quarterly announcements of director appointments from Directors & Boards. These observations were subject to the same sample selection criteria leading up the 321 earlier-identified sample firms. The final sample consists of 377 appointments made up of 114 (263) accounting (non-accounting) experts appointments. 9 I test the sensitivity of my results to the inclusion of the accounting expert appointments from the Factiva and HighBeam databases, later in the paper. IV. VARIABLE MEASUREMENT I employ a logistic cross sectional regression analysis to test the study s hypotheses, where the dependent variable is an indicator variable, APPOINT, that is coded 1 if a sample firm appoints an accounting expert to the audit committee in year t and 0 if a sample firm appoints a non-accounting expert to the audit committee. The 9 The 377 appointments are made by 371 firms. While there are six firms that make two appointments in our sample, these appointments are made in different years. The study s conclusion remains robust when these six firms are excluded from the sample. 13

16 measurement of the independent variables employed in this study is discussed in detail below. Financial Reporting Quality The main independent variable of interest is financial reporting quality. Similar to numerous prior studies, I employ performance-adjusted discretionary accruals as a proxy for financial reporting quality (Cahan and Zhang 2006; Ecker, Francis, Kim, Olsson and Schipper 2005; Francis, Lafond, Olsson and Schipper 2005; Menon and Williams 2004). Kothar Leone and Wasley (2005) state that the process of performance matching will remove the component of discretionary accruals that is motivated by firm performance and the resulting performance-adjusted discretionary accruals represents the best specified measure of discretionary accruals across a wide variety of simulated event conditions. I employ signed performance-adjusted discretionary accruals rather than their absolute (unsigned) values for two reasons. First, in order to protect their reputational capital, reputable directors would prefer appointments in firms that are less exposed to litigation threats. Prior studies show that auditors are conservatively biased towards income-decreasing accruals (DeFond and Jiambalvo 1993; Kinney and Martin 1994; Wright and Wright 1997; Nelson, Elliot and Tarpley 2001) because lawsuits are rarely filed for recording accruals to reduce earnings (St. Pierre and Anderson 1984; Becker, DeFond, Jiambalvo, and Subramanyam 1998; Barron, Pratt and Stice 2001; Chung and Kallapur 2003). Hence, it is plausible that accounting experts will prefer appointments in firms that report less aggressive (more conservative) discretionary accruals. Second, Hribar and Nichols (2006) show that signed discretionary accruals are a better measure of 14

17 financial reporting quality than the absolute or unsigned value of discretionary accruals. I test the sensitivity of my results to alternative measures of discretionary accruals, including unsigned discretionary accruals, later in the paper. The process of deriving the performance-adjusted discretionary accruals is initiated, by employing the modified-jones (Dechow, Sloan and Sweeny 1995) model to compute the unadjusted discretionary accruals of the sample firms. The model is estimated using the entire population of Compustat firms for each two-digit SIC industry-year combination represented in my sample with at least 20 or more firms: TA ASSET j 1 = 1 j 1 j 1 ( REV AR ) ( PPE ) j α + α 2 + α 3 + ε ASSET ASSET ASSET where TA j is total accruals of firm i in the year j, REV j is the change in revenue of firm i in year j (Compustat item 12), AR j is the change in accounts receivable of firm i in year j (Compustat item 2), PPE j is the net property, plant and equipment of firm i in year j (Compustat item 7), and ASSETS j-1 is the total assets of firm i in year j-1 (Compustat item 6). 10 The residuals from the equation (1) represent unadjusted discretionary accruals. Next, I partition the firms within each industry-year combination into deciles based on their return on assets (ROA) in year j-1. Performance-adjusted discretionary accruals are calculated as the difference between the unadjusted discretionary accruals of firm i in year j and the median unadjusted discretionary accruals of firm s industry- ROA decile in year j, where the median calculation excludes firm i. For use in the j 1 j j j 1 j (1) 10 Consistent with Kothari et al. (2005), total accruals (TA j ) employed in the above equation is measured as change in non-cash current assets (Compustat item 4 - Compustat item 1) minus the change in current liabilities (Compustat item 5) excluding the current portion of long-term debt (Compustat item 34), minus depreciation and amortization (Compustat item 14), scaled by lagged total assets (Compustat item 6). 15

18 empirical tests, I take my measure of financial reporting quality (performanceadjusted discretionary accruals) from the year immediately prior to the appointment year (hereafter year t-1). This decision is based on the intuition that if accounting experts are likely to be selective about the firms they join, then they are likely to closely scrutinize recent corporate information and the annual reports statements relating to year t-1 would constitute the most recent financial information. 11 Consistent with prior literature, firms with more positive performance-adjusted discretionary accruals are expected to have lower financial reporting quality. As discussed later, the variable capturing financial reporting quality is interacted with a variable that captures firm undervaluation to test the study s second hypothesis. To ease the interpretation of the interaction term, I multiply the raw performanceadjusted discretionary accruals by -1 before it s inclusion in the empirical tests. Under this inverted performance-adjusted discretionary accruals measure (INVPADA) larger positive INVPADA values signal higher financial reporting quality. Firm Undervaluation The results from numerous studies lend strong support for the use of price to residual value ratio (P/V) as an indicator of market misvaluation (Dong, Hirshleifer, Richardson and Teoh 2006; Lee, Myers and Swaminathan 1999; Frankel and Lee 1998; D Mello and Shroff 2000). For example, Frankel and Lee (1998) and Al Hwang and Trombley (2003) find that P/V can significantly predict future returns, an attribute that makes P/V an attractive index of mispricing (Dong et al. 2006). Dong et al. (2006) state that the benefits of using residual income value instead of book value 11 As discussed later, a large number of the remaining independent variables used in the empirical tests are also constructed using financial and governance information from the year t-1. 16

19 is that residual income is less likely to be affected by any biases in accounting treatments and more likely to incorporate future performance expectations as reflected in analysts forecasts of future earnings. Accordingly, I employ the ratio of price (P t ) to residual value (V t ), computed using stock price and I/B/E/S forecast data from month -1 relative to the month in which the director is appointed, to identify undervalued firms in my sample. Pi, t PVRATIO t = (2) V t where residual income is estimated using the valuation approach of Lee et al. (1999) and Dong et al. (2006) (see Appendix A for a detailed explanation of how residual value is computed for each firm). Consistent with prior research (e.g., D Mello and Shroff 2000), I then construct an independent variable (UDVALUE) that is coded 1 for firms with a P/V ratio less than 1, and 0 otherwise. In other words, UDVALUE is coded 1 for firms that are undervalued. Control Variables As discussed earlier, there has been no prior research on the determinants of accounting expert appointments to audit committees. However, descriptive statistics reported in DeFond et al. (2005) suggest that firms with stronger governance and prior audit committee accounting expertise are more likely to value accounting experts on their audit committees, and/or that accounting experts are more willing to serve on the audit committee of firms with such characteristics. 12 I control for governance 12 However, it is important to acknowledge that a counter argument can be applied to this expectation under which accounting expertise in audit committees may act as a substitute for other internal monitoring mechanisms. Hence, firms with strong governance may not feel the immediate need for alternative monitoring, making them less likely to appoint accounting experts to their audit committees. 17

20 environment strength, by employing commonly used audit committee and board characteristics to construct two summary measures that capture the strength of a firm s audit committee (ACGOV) and board (BDGOV) environment (see Appendix B for a detailed explanation of how the summary measures are computed for each sample firm). To control for the prior presence of accounting experts on audit committees (PRIORACCTG), I include an independent variable that captures the number of accounting experts on the audit committee in the year immediately prior to the appointment year (year t-1). Furthermore, another possible motivation for firms appointing accounting experts is not to signal but rather to replace any outgoing audit committee accounting expertise. To control for appointments made with the intention of replacing accounting experts who have departed, I include an independent variable (ACCTGDEP) that is coded 1 if an accounting expert departs from the audit committee of the sample firm in year t-1. Another possible explanation for the appointment of accounting experts is that the appointed director is a past employee of the firm s external auditor who is likely to be familiar with the firm s financial reporting systems. Accordingly, an additional independent variable (PASTAUD) is included that is coded 1 in instances where the new director is a past employee of a firm s current auditor. I also control for the total compensation offered to the new directors (DIRCOMP), as prior literature suggests that directors with better reputations are likely to demand higher compensation (Deutsch and Ross 2003) Consistent with prior research (Roulstone 2003), total compensation is measured as the sum of cash salary, other annual cash compensation and incentive payouts, and value of stock options and restricted stock granted. I value stock grants by multiplying the number of shares by the closing stock price and stock options are valued using the Black-Scholes model, adjusted for dividend payouts, assuming stock options are issued at the money with a ten-year maturity. 18

21 Hence, it is possible that accounting experts are selecting appointments in firms that offer higher levels of compensation. The next group of control variables are derived from Agrawal and Chadha (2005) who argue that certain firm attributes demand greater financial needs, which in turn increases the need for firms to possess directors with accounting expertise. Following Agrawal and Chadha (2005), I expect the appointments of audit committee accounting experts to be more likely in firms that: are smaller in size; are experiencing high growth; are more highly levered; have more volatile stock returns; are more capital intensive and are younger in age. I employ the log of total assets in year t-1 to control for firm size (SIZE). To control for firm growth (GROWTH), I employ the mean sales growth over years t-5 through to t-1. Leverage (LEVERAGE) is controlled by ratio of long-term debt to firm value (market capitalization) in year t- 1, while stock volatility (STOCKVOL) is captured as the standard deviation of daily stock returns over years t-2 through to t-1. Capital intensity (CAPINT) is represented by the ratio of total assets to number of employees, while firm age (AGE) is defined as the age of the firm from the date of listing on CRSP. The next set of control variables are derived from the extant literature on auditor selection, which has established associations between various firm characteristics and the demand for higher audit quality in the form of brand-name auditors. The heightened emphasis on internal corporate governance in recent years suggests that the same firm characteristics could influence the demand for accounting 19

22 expertise within a firm s internal governance environment. 14 Accordingly, I expect the appointments of audit committee accounting experts to be more likely in firms that: have longer operating cycles, issue additional equity securities, are not reporting significant losses, have higher asset turnover, and have larger current ratios. Operating cycle (OPCYCLE) is controlled by sum of days inventory and days accounts receivable in year t-1 divided by To control for issues of equity securities (ISSUE), I employ an indicator variable, which is coded 1 if the sample firm issues equity in year t equal to or greater than 10 percent of its beginning equity capital. An additional indicator variable is employed to control for reporting of significant losses (LOSS). This variable is coded 1 if firms have both negative earnings in year t-1 and a change in absolute value of earnings from year t-2 exceeding 10 percent. Asset turnover (ASSETTURN) and current ratio (CURRENT) are measured by dividing total sales and current assets from year t-1 by total assets of year t-1, respectively. I also control for the impact of industry characteristics by introducing industry dummies (INDUSTRY) representing the major economic divisions. 16 Braswell and Mauldin (2004) use a similar scheme to control for industry membership and document lower presence of audit committee accounting experts in firms operating in the manufacturing and exploration industries. Finally, consistent 14 Further, there is some overlap between the intuition and explanatory variables employed by Agrawal and Chadha (2005) and studies in the auditor selection literature. An example of a commonality is the intuition that higher leverage signals higher presence of asymmetric information (agency problems), and firms with higher leverage may prefer to select superior experts (auditors / internal accounting experts) to reduce exposure to agency costs. Hence it seems worthwhile extending the analysis to include additional variables from the auditor-selection literature, to evaluate whether they are just as successful in predicting the appointments of accounting experts to audit committees. 15 Specifically, days inventory = 365 x (average of beginning and closing inventory / cost of goods sold), and days accounts receivable = 365 x (average of beginning and closing accounts receivable / sales). 16 The major economic divisions are represented by 1 digit SIC codes 20

23 with Himmelberg, Hubbard and Palia (1999), I also introduce time dummies (YEAR) to control for any unobserved variation in the contracting environment of the firm. V. RESEARCH DESIGN I employ the following logistic regression model to formally test the hypotheses of the study: APPOINT t = β + β INVPADA β PRIORACCTG + β SIZE t 1 + β CAPINT t β ASSETTURN t 1 t 1 + β GROWTH 14 t β AGE + β UDVALUE t 1 t β CURRENT t + β ACCTGDEP t 1 t 1 + β LEVERAGE + β OPCYCLE + β BDGOV t 1 t 1 t 1 + β PASTAUD β INVPADA t t β STOCKVOL + β ISSUE + β ACGOV 8 t 1 17 t 1 + β DIRCOMP. UDVALUE t 1 + β LOSS t t t 1 + n j= 1 β INDUSTRY j j + n k = 1 γ YEAR k k + ε t () 3 Given that more positive values of INVPADA signals higher financial reporting quality, a significant positive coefficient for INVPADA, when the regression is run without the interaction term (INVPADA x UDVALUE), would indicate that appointments of accounting experts are more likely in firms that have higher financial reporting quality (Hypothesis 1). When the regression is run after including the interaction term, a significant positive coefficient for the interaction term (INVPADA x UDVALUE) would provide support for the hypothesis that the likelihood of firms with high financial reporting quality appointing accounting experts to their audit committee becomes more profound when these firms are undervalued (Hypothesis 2). VI. DESCRIPTIVE STATISTICS Panel A of Table 2 reports descriptive statistics for the continuous independent variables, for the full sample and then separately for firms appointing non-accounting 21

24 (NOEXP sample), and accounting (ACEXP sample) experts. I also report results from a parametric (non-parametric) analysis that tests the difference in the mean (median) values across the two sub-samples. <<< INSERT TABLE 2 ABOUT HERE >>> The mean inverted performance-adjusted discretionary accruals (INVPADA) of the NOEXP sample (-0.003) is negative whereas the mean INVPADA of the ACEXP sample is positive (0.039), implying higher financial reporting quality in the ACEXP sample. Parametric and non-parametric test confirm the difference between the INVPADA of the two samples to be significant (p-value < 0.01). While this finding implies higher financial reporting quality for firms appointing accounting experts and is consistent with the first hypothesis, the result should be interpreted cautiously given that it is obtained from a univariate analysis that does not control for the effects of the control variables. The remaining summary statistics from panel A of Table 2 indicates that ACEXP firms: have stronger audit committee governance (ACGOV), have higher prior presence of accounting expertise in audit committees (PRIORACCTG), are smaller in size (SIZE), experience higher growth (GROWTH), have more volatile stock returns (STOCKVOL), have lower asset turnover (ASSETTURN), and have more current assets as a proportion of total assets (CURRENT). The above differences are significant with p-value < I also find some weaker evidence (p-value < 0.10) indicating that ACEXP firms have stronger board governance (BDGOV), and are younger in age (AGE). Panel B of Table 2 reports descriptive statistics for the discrete independent variables. The only noteworthy result indicates that ACEXP are more likely to appoint former employees 22

25 of its external auditor (PASTAUD). This difference is significant (p-value < 0.01) but highly expected since the mechanical construction of the sub-samples only allows firms appointing accounting experts (ACEXP sample) to make such appointments. VII. EMPIRICAL RESULTS Correlation Matrix Table 3 reports the Spearman and Pearson correlation among the independent variables. <<< INSERT TABLE 3 ABOUT HERE >>> For sake of brevity, correlation coefficients for the time and industry dummies are not reported. On the whole, although there are a few large correlation coefficients, the coefficients are not large enough to prohibit the use of a multivariate logistic regression analysis. 17 Logistic Regression Results Table 4 presents the results from the logistic regressions of type of expertise possessed by the appointed audit committee member (APPOINT) on the inverted measure of performance-adjusted discretionary accruals (INVPADA), the firm undervaluation variable (UDVALUE), the variable that captures the interaction between INVPADA and UDVALUE, and the control variables. Coefficients for time and industry dummies are not reported. <<< INSERT TABLE 4 ABOUT HERE >>> The first model examines the association between INVPADA and APPOINT, without considering the interaction effect between INVPADA and UDVALUE. The 17 I also compute and examine the variance inflation factors for the independent variables but find no signs of any independent variable being collectively correlated with the other independent variables. 23

26 results from this model (Model 1), reported in the third and fourth columns of Table 4, show that APPOINT is positively and significantly related to INVPADA (at the 1 percent level). This result supports the first hypothesis by suggesting that appointments of accounting experts are more likely in firms that have higher financial reporting quality. Several of the control variables are also significantly associated with APPOINT. Consistent with expectations, the results indicate that the likelihood of an accounting expert being appointed to the audit committee is increasing in the strength of the audit committee (ACGOV), and the number of accounting experts serving the audit committee, prior to the appointment (PRIORACCTG). The result for ACGOV and PRIORACCTG are significant at the 1 and 5 percent levels, respectively. It is noteworthy that the prior board governance strength (BDGOV) is not significant in predicting the type of expert appointed to the audit committee. Turning to the results for the remaining control variables, I find that the likelihood of an accounting expert appointment is: (1) increasing in sales growth (at the 1 percent level), leverage (at the 5 percent level), capital intensity (at the 5 percent level), and age (at the 5 percent level); and (2) is decreasing in firm size (at the 1 percent level). With the exception of firm age, the results for the preceding control variables are all consistent their predicted effects on the likelihood of an accounting expert appointment. 18 Overall, Model 1 is significant and the max-rescaled R 2 is I further assess the accuracy of the classification of Model 1, by assuming that an accounting expert is appointed, if the probability of appointing an accounting expert is greater than A possible explanation of the unexpected sign of firm age (AGE) is that AGE is highly correlated with two other independent variables: SIZE and STOCKVOL. When the analysis is replicated after excluding SIZE and STOCKVOL, I find that the significant positive relationship between AGE and APPOINT (as reported in Table 4) changes to a negative relationship, which is not statistically significant. 24

27 percent. Based on this cut-off, when the results of the logistic regression is used to classify the type of appointment (accounting or non-accounting), the classification is accurate, on average, 78 percent of the time. Model 2 extends Model 1 by including an additional independent variable that captures the interaction effect between INVPADA and UDVALUE. The results from this regression, reported in the last two columns of Table 4, show that INVPADA is positively related to APPOINT but this time only at the 5 percent level. This finding suggests that the stronger results observed for INVPADA in Model 1 were being driven by firms with higher financial reporting quality who were also undervalued. Indeed, the parameter estimate of the interaction term, INVPADA *UDVALUE, is significantly positive at the 5 percent level, implying that the likelihood of firms with higher financial reporting quality appointing accounting experts becomes more profound when they are undervalued. This finding supports the study s second hypothesis. The results for the control variables are qualitatively similar to those reported for Model 1 with two exceptions: the statistical significance of PRIORACCTG decreases to the 10 percent level, whereas UDVALUE becomes statistically significant for the first time, albeit at the 10 percent level. The maxrescaled R 2 of Model 2 is and its classification accuracy remains at 78 percent. Robustness Tests Alternative Discretionary Accruals Measures Prior studies have employed other approaches in computing discretionary accruals. To check whether my results are robust to alternative measures of discretionary accruals (DISCACC), I repeat the analyses in Table 4 after considering 25