Audit Committee Characteristics and Accounting Conservatism

• Author: Nigar Sultana
• Date: 01 July 2015
• Published date: 01 July 2015
• DOI: http://doi.org/10.1111/ijau.12034

Audit Committee Characteristics and Accounting Conservatism

Nigar Sultana

School of Accounting,Curtin University

This study examines the association between four pivotal audit committee characteristics and accounting

conservatism. Using a sample of 7,668 Australian firm-year observations from 2004 to 2012, a positive association

is found between accounting conservatism and: (a) a director with financial expertise on the audit committee; (b)

an experienced director on the audit committee; and (c) frequency of audit committee meetings. Within an

agency theoretical framework, results suggest that audit committees act as effective monitoring mechanisms in

restricting management’s opportunistic behaviour and overstatement of earnings. Results also suggest that

regulators (and other stakeholders) should pay greater attention to the financial expertise, experience of

members and meeting frequency of the audit committee when judging the committee’s value.

Key words: Corporate governance, audit committee, conservatism, agency theory

INTRODUCTION

Audit committees have received growing attention in

the corporate governance literature over the past two

decades, after a series of global corporate accounting

scandals (e.g., Enron, WorldCom, HIH) and major

financial crises (e.g., Asian Financial Crisis, Global

Financial Crisis). Although the board of directors

continues to be recognised as having the ultimate

responsibility for a firm’s financial reporting system,

following the financial crises and a high number of

international accounting scandals, the day-to-day

responsibility and accountability for the financial

reporting process within a firm is increasingly delegated

to the audit committee. Regulators and institutional

authorities internationally have recognised this

delegation, and reinforced the sub-committee’s

importance via the introduction (and subsequent

revision/s) of corporate governance codes and best

practices (Cadbury Report, 1992; Securities and Exchange

Commission, 1999; ASX Corporate Governance Council,

2003). One role of an audit committee considered pivotal

by researchers, regulators and institutional stakeholders

worldwide, is the oversight of the quality of reported

earnings with a particular emphasis on constraining

earnings management and the prevention of adopting

policies that misrepresent earnings (Klein, 2002a).

This study examines the associationbetween four audit

committee characteristics and accounting conservatism1

using a sample of 7,668 Australianfirm-year observations

between 2004 and 2012. Frequently cited in prior

literature (Klein, 2002a; Abbott, Parker & Peters, 2004;

Dhaliwal, Naiker & Navissi, 2010) as instrumental to

audit committee effectiveness, the four specific

components examined are: (1) committee independence;

(2) financial expertise of members; (3) experience of

members; and (4) the committee’s meeting frequency. To

extensively test the audit committee/accounting

conservatism linkage, this study uses two different

measures of accounting conservatism: (1) timeliness of

earnings to news (Basu, 1997); and (2) accrual-based loss

recognition (Ball & Shivakumar, 2005). The first measure

is market-based while the second one is an accounting

-based measure of conservatism.

The Australian capital market and the time period

selected provide a suitable setting for the analyses.

Although a topic of interest in Australia since the early

1970s, it is only recently (since the introduction of the

Australian Securities Exchange (ASX) Corporate

Governance Council (ASX CGC) Recommendations in

2003) that audit committees have become an established

component of the corporate governance structure within

Australian publicly listed firms.2Although a number of

prior studies in Australiahave examined the effectiveness

of an audit committee as a monitor of financial reporting

process, a prominent focus of prior empirical research

is directed towards the impact of audit committees on

firm performance and earnings quality, particularly

earnings management (Goodwin,2003; Stewart & Munro,

2007; Christensen, Kent & Stewart, 2010; Kent, Routledge

& Stewart, 2010; Aldamen et al., 2012). For example,

Christensen et al. (2010) and Aldamen et al. (2012)

investigated the association between audit committee

characteristics and firm performance while Davidson,

Goodwin-Stewart and Kent (2005) and Kent et al. (2010)

focused on audit committees’ effect on accruals

quality. None of the past studies, however, examine the

linkage between audit committee characteristics and

conservatism in any comprehensive way. Only two

studies (Lim, 2011; Ahmed & Henry, 2012) incorporated

audit committee features while investigating

the corporate governance/accounting conservatism

linkage. However, given the main focus of these studies

was overall corporate governance structure, they

examined only a single attribute of an audit committee

(i.e., existence and independence, respectively). By

examining only the existence and independence of

the audit committee, it is not possible to properly

Correspondence to: Nigar Sultana, Curtin University, GPO Box U1987,

Bentley 6845, Perth, Western Australia, Australia. Email:

N.Sultana@curtin.edu.au

International Journal of Auditing doi:10.1111/ijau.12034

Int. J. Audit. 19: 88–102 (2015)

© 2015 John Wiley & Sons Ltd ISSN 1090-6738