Audit Committee and Firm Value: Evidence on Outside Top Executives as Expert‐Independent Directors

• DOI: http://doi.org/10.1111/j.1467-8683.2008.00662.x
• Author: Kam C. Chan,Joanne Li
• Published date: 01 January 2008
• Date: 01 January 2008

Audit Committee and Firm Value:

Evidence on Outside Top Executives as

Expert-Independent Directors

Kam C. Chan and Joanne Li

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We examine the relation between independence of audit committee and f‌irm value with a sample

of Fortune 200 companies.

Research Findings/Insights: Using a sample of Fortune 200 companies and def‌ining top executives of other publicly traded

f‌irms as expert-independent directors and controlling for f‌irm specif‌ics, board features, and individual director character-

istics, we f‌ind the presence of expert-independent directors on board and in the audit committee enhances f‌irm value.

Theoretical/Academic Implications: We provide empirical evidence to show that by focusing on this restricted def‌inition

of independent directors (expert-independent directors), we are able to examine independence in both the board and audit

committee in a different light.

Practitioner/Policy Implications: We offer new insights to relate f‌irm value of the composition of audit committee. When

expert-independent directors are of majority control of audit committee, f‌inance-trained directors improve f‌irm value

almost f‌ive times to that of f‌irms with independent audit committee alone.

Keywords: Audit committee, f‌inancial performance, agency theory

INTRODUCTION

With the demise of Enron and debatable accounting

practices of Global Crossing, many are furious with

the monitoring provided by the board of directors, espe-

cially those in the audit committee. Along with the ongoing

heated debate on how to reform our corporate governance,

shareholder activists argue that catastrophes can be avoided

if we have a more vigilant audit committee.1TIAA-CREF’s

policy statement (1997) explicitly states thatthe board should

be composed of “qualif‌ied individuals who ref‌lect diversity

of experience.”2Lobbyists such as Robert Monks and Nell

Minow call for more diligence on the part of shareholders,

both private and institutional to ensure that directors elected

to the boards are performing their f‌iduciary duties (see

Monks and Minow [2004]). In a recent Blue Ribbon Panel’s

10 recommendations to the Securities Exchange Commis-

sion (SEC) and National Automated Securities Dealers,

f‌ive of them targeted at creating an independent and

accountable audit committee in corporations. These recom-

mendations ref‌lect conventional wisdom by seeking for a

more accountable and independent audit committee, to

increase the effectiveness of the board in the monitoring of

management. As more countries are converging toward an

Anglo-Saxon model of corporate governance, audit commit-

tees are widely accepted to establish conf‌idence in f‌inancial

markets (Collier and Zaman, 2005). Similar to the US, more

European authorities and regulators are emphasizing on the

independence of audit committee. With high-prof‌ile f‌inan-

cial fraud cases in recent years, academic and industry seek

for effective audit committees to provide sound monitoring.

DeZoort, Hermanson, Archambeault and Reed (2002) def‌ine

an effective audit committee as “[a body that] has qualif‌ied

members with the authority and resources to protect stake-

holder interests...”(p.41).

In addition to an effective audit committee, the New York

Stock Exchange proposes more drastic measure by calling

for more independent boards of directors. It requires listed

companies to have a majority of independent outside direc-

tors, and that companies have 2 years to comply after such

*Address for correspondence: Department of Accounting and Finance, Gordon Ford

College of Business, Western Kentucky University, Bowling Green, KY 42101. Tel:

(270) 745–2977; E-mail: Johnny.chan@wku.edu

16 CORPORATE GOVERNANCE

Volume 16 Number 1 January 2008 © 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd

doi:10.1111/j.1467-8683.2008.00662.x

rule is approved by the SEC on November 4, 2003.Although

the trend of increasing the number of independent directors

on boards is evident for the past 20 years, the def‌initions of

“independence” still widely vary. The most liberal def‌inition

of independent directors is to include those directors that

are not primarily served as employees. In a more restricted

def‌inition, directors who are former employees are not con-

sidered independent. Some go further to def‌ine indepen-

dent directors by excluding all outside directors who have

potential relationship with the f‌irm, such as consultants,

bankers, lawyers, and family members of employees. The

theory behind all these restrictions on independence is to

ensure independent directors’ objectivity while monitoring

the performance of management. The idea of having inde-

pendent directors make up the majority of the board has

become more popular in recent years as echoed previously

in The Sarbanes-Oxley Bill 2002 (SOX 2002) in the US and

Higgs Report (2003) in the UK. The majority independent

director membership does not guarantee directors’ willing-

ness to challenge the management, nevertheless. Some criti-

cize independent directors as uninterested and indifferent.

The incentives of these independent directors, hence, play a

signif‌icant role in successful corporate governance and

board monitoring.

Since 1978, the New York Stock Exchange has required

its member companies to have audit committees entirely

made up of independent directors. Although this total inde-

pendent audit committee is not a norm for countries in the

world, there is an obvious trend toward tighter independ-

ence requirements (see DeZoort et al. [2002]). The indepen-

dence of audit committee is widely accepted as a must for

good governance and internal control for assessing risks.

However, little is known about the “quality” of these inde-

pendent directors in the audit committee. Thus, our study

is attempting to f‌ill this gap by providing one aspect of

“qualif‌ied” members. We def‌ine directors who are top

executives of other publicly traded f‌irms among all outside

directors as “expert-” independent directors. Similar to the

argument of Keys and Li (2005), we believe that these direc-

tors have more corporate experience and more exposure to

strategic operations of their own f‌irms. Their incentive to

monitor is that their performance as director is tied in with

their reputational capital in the market. By focusing on this

restricted def‌inition of independent directors (expert-

independent directors), we are able to examine indepen-

dence in both the board and audit committee in a different

light.

This study examines the relation between the indepen-

dence of the audit committee and f‌irm value for Fortune 200

companies in the year 2000, with two thresholds of indepen-

dence for boards – 50 and 35 per cent or more expert-

independent director membership, respectively.3We use a

full information maximum likelihood (FIML) estimation

method to examine f‌irm value of these 200 f‌irms. Firm spe-

cif‌ics, board features, and director characteristics, are col-

lected to control any contemporaneous events. This paper

contributes to the emerging literature in three ways. First,we

focus on expert-independent directors among all outside

directors to further our understanding on independence in

board and audit committee. Second, we explicitly analyze

the makeup of the audit committee and its relation with f‌irm

value. Third, because we use a simultaneous equation

method, we are able to consider the endogeneity problem

that could exist between board structure (audit committee

structure) and f‌irm value.

The SOX 2002 mandatescorporate boards to include direc-

tors with f‌inancial expertise on their audit committees.

Empirically, it is impossible to distinguish the intention of

companies that put in place or restructure a board post-SOX

which is truly to improvemonitoring or merely comply with

the laws. We suspect a post-SOX sample provides a bias,

because companies might have the intention to “dress up”

their boards. Thus,we argue our choice of a pre-SOX sample

provides a better judgment on auditcommittee composition,

and how it relates to f‌irm value by imposing a condition that

f‌irms voluntarily choose to bring expertise in their audit

committees. Our empirical study with the pre-SOX data

allows us to identify if audit committee composition, inde-

pendent of laws and regulations, has a relation with f‌irm

performance. The empirical results of this paper also better

our understanding on the relation between the indepen-

dence of board (proxied by the top executives of other pub-

licly traded f‌irms) and f‌irm value. Thus, we attempt to

investigate if f‌inance-trained directors serving on audit com-

mittees have any impact on f‌irm value.

Our f‌indings indicate that the independence of audit com-

mittee results in higher f‌irm value when a majority of expert-

independent directors serve on board.While we fail to f‌ind if

f‌inance-trained directors serving on audit committee have

any impact on f‌irm value, our empirical results indicate that

f‌inance-trained directors serving on audit committee are

related to positive f‌irm value, when expert-independent

directors are a majority in the audit committee. In fact, we

f‌ind that f‌inance-trained directors serving on an expert-

independent audit committee impact f‌irm value almost f‌ive

times as much as that of the independence of audit commit-

tee alone. We also f‌ind that directors who serve on all three

crucial committees (audit, nominatings, and compensation)

are related to a higher probability of having an independent

audit committee. However, the presence of chief executive

off‌icers (CEOs) who are also Chairmen of the board is

related to negative f‌irm value.

AUDIT COMMITTEE AND INDEPENDENCE

There are two strands of studies on audit committee inde-

pendence. The f‌irst strand of literature studies the relation

between audit committee composition and specif‌ic account-

ing issues. Carcello, Hermanson, Neal and Riley Jr. (2002)

examine board characteristics and audit fees. Their results

suggest that board independence and audit fees are posi-

tively correlated. They argue that independent boards, in

general, demand higher audit quality beyond normal stand-

ards and, hence, auditors need to charge higher fees. In

similar studies, Carcello and Neal (2003) and Felo, Krishna-

murthy and Solieri (2003) document a positive relation

between audit committee independence and f‌inancial

reporting quality. In general, for boards with less independ-

ent directors, it is likely that their auditors only issue

unmodif‌ied reports on going-concern issues. Xie, Davidson

and DaDalt (2003) examine the role of the audit committee

AUDIT COMMITTEE AND FIRM VALUE 17

Volume 16 Number 1 January 2008© 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd