Audit committee financial expertise

Audit committee financial expertise and properties of analyst earnings forecasts☆
John L. Abernathy a,⁎, Don Herrmann a,1, Tony Kang a,2, Gopal V. Krishnan b,3
a Spears School of Business, Oklahoma State University, Stillwater, OK 74078, United States b Kogod School of Business, American University, Washington, DC 20016, United States a r t i c l e i n f o a b s t r a c t
Keywords:
Audit committees
Financial expertise
Analyst earnings forecasts
An important role of financial accounting information is to aid financial statement users in forming expectations about the firm's future earnings. Prior research finds that accounting financial expertise of the audit committee is associated with higher financial reporting quality. We extend this literature by examining the association between audit committee financial expertise and analysts' ability to anticipate future earnings.
We find a significant association between accounting financial expertise on the audit committee and analyst earnings forecasts that are more accurate and less dispersed. In contrast, we do not find a significant association between non-accounting financial expertise (i.e., supervisory expertise) and forecast accuracy or forecast dispersion. These findings contribute to our understanding of the benefits of accounting expertise in audit committees by demonstrating an association between accounting financial expertise and improvements in analyst earnings forecasts. © 2012 Elsevier Ltd. All rights reserved.
1. Introduction
Prior research provides evidence that having accounting financial experts on the audit committee is associated with higher financial reporting quality (e.g., DeFond, Hann, & Hu, 2005; Dhaliwal, Naiker, & Navissi, 2010; Krishnan & Visvanathan, 2008).We extend this research to examinewhether improved financial reporting quality fromsuch expertise is associated with the ability to anticipate future earnings. The Financial Accounting Standard Board (FASB) (1978) notes in the Statement of Financial Accounting Concepts No. 1 that “financial reporting should provide information that is useful to present and potential investors and creditors and other users inmaking rational investment, credit and similar decisions.”While prior studies suggest that audit committee expertise is associated with improved financial reporting quality, there is little empirical evidence on the association between audit committee's financial expertise and decisions of financial statement users. We examine an important aspect of users' investment decisions, i.e., their ability to anticipate future earnings. Specifically, we investigate the association between audit committee financial expertise and financial analysts' ability to predict future earnings. We focus on analyst earnings forecasts for several reasons. First, Schipper (1991) suggests that analyst behavior can provide insight into the activities and beliefs of investors that cannot be observed directly.
Analysts, as sophisticated users of financial reporting information, provide
direct evidence about whether users incorporate improvements in
financial reporting into their decision-making process. Second, as
Kothari (2001) states, “almost all models of valuation either directly or
indirectly use earnings forecasts.” Thus, given analysts' role as a key
provider of information to the capital markets, empirical evidence on
whether audit committee financial expertise relates to analysts' forecasting
ability is useful to investors in firm valuation. Kecskes, Michaely,
andWomack (2010) find evidence that analysts' earnings-based recommendation
changes are more informative than discount rate-based
recommendations, supporting the notion that the value of analysts' recommendations
is primarily linked to how well they can discern a firm's
future earnings. Finally, while prior research has documented a link between
accounting expertise on the audit committee and financial
reporting quality, prior research has not explored a direct link with
users of financial statement information.We address this gap in the literature
in examining the association between audit committee financial
expertise and analysts' ability to anticipate future earnings.
The Sarbanes–Oxley Act of 2002 required the Securities Exchange
Commission (SEC) to issue rules mandating that the audit committee
of every public company have a designated financial expert; and that
the name of that financial expert be disclosed (Sarbanes–Oxley Act of
2002). The SEC suggests that having at least one financial expert on
Advances in Accounting, incorporating Advances in International Accounting 29 (2013) 1–11
☆ We thank Wayne Thomas and seminar participants at Chulalongkorn University,
OklahomaStateUniversity, SingaporeManagement University and the 2012AmericanAccounting
Association Annual meeting for helpful comments and suggestions. Dr. Krishnan
gratefully appreciates the financial assistance fromthe Joseph R. Perella and AmyM. Perella
Professorship.
⁎ Corresponding author. Tel.: +1 405 744 6349; fax: +1 405 744 1680.
E-mail addresses: john.abernathy@okstate.edu (J.L. Abernathy), don@okstate.edu
(D. Herrmann), tony.kang@okstate.edu (T. Kang), krishnan@american.edu (G.V.Krishnan).
1 Tel.: +1 405 744 8602; fax: +1 405 744 1680.
2 Tel.: +1 405 744 8631; fax: +1 405 744 1680.
3 Tel.: +1 202 885 6460; fax: +1 202 885 1992.
0882-6110/$ – see front matter © 2012 Elsevier Ltd. All rights reserved.
http://dx.doi.org/10.1016/j.adiac.2012.12.001
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Advances in Accounting, incorporating Advances in
International Accounting
journal homepage: www.elsevier.com/locate/adiac