Corporate governance: why independent audit committees matter

Corporate governance has been a hot topic for many years in the US and Europe as corporations, whether in finance or the hospitality industry, grapple with their supervisory structures.

Since 2000, the audit committee has been put forward as an effective mechanism to limit fraudulent financial reporting. Following financial scandals such as Enron and WorldCom, the US Congress issued the Sarbanes-Oxley Act (SOX) in 2002 to protect investors by improving the accuracy and reliability of corporate disclosures.

Sarbanes-Oxley requires publicly traded companies to have:

• the CEO and CFO certifying the financial statements;
• an effective internal control system put in place and maintained;
• an audit committee in charge of the oversight of the financial reporting process and of the engagement of the external auditor. The audit committee must be wholly composed of independent members sitting on the board of directors.

In Europe, the audit committee’s composition rule is different. The European Commission (EC) mandated in 2006 that each ‘public-interest entity’ should have an audit committee with at least one independent member. In 2014, the EC amended this regulation by mandating companies should be at least 50 percent comprised of independent members.

In a recent article in the Journal of Accounting Literature, we examine whether the percentage of independent members sitting on audit committees, in different institutional settings, has an impact on the credibility of earnings.

For this study, we examined a large sample of 7,656 earnings announcements by 1,420 listed companies in 15 European countries during the period 2006-2014.

To measure the strength of the institutional setting, we used an index developed by Brown et al. (2014), which – in our view – is able to explain differences in earnings management across countries.

We also used the World Bank’s Governance Indicators to control for potential limitations of the index.

Our key findings were as follows:

• Stock market reaction to earnings announcements is greater when firms have more independent members sitting on the audit committee;
• The percentage of independent members sitting on the audit committee very significantly affects investors’ reaction in countries with weaker legal protection of shareholders’ interests (i.e. weak institutional setting), but not in the case of stronger legal protection.

Thus, our results suggest that the institutional setting does have an impact on the effectiveness of the audit committee. In weak institutional contexts, managers have more incentives to distort financial information to acquire private benefits, and investors may therefore rely on the independence of the audit committee to assess the credibility of earnings.

Overall, by highlighting the impact of the institutional context on the independence of the audit committee, our results are particularly interesting for European regulators. They should also be interesting for boards of directors, which are in charge of the oversight of the financial reporting.

As for the hospitality industry in Europe, we would encourage boards of listed hotel firms to opt for fully independent audit committees.

Access the full study:

Audit committees’ independence and the information content of earnings announcements in Western Europe. Journal of Accounting Literature. Poretti, C., Schatt, A., & Bruynseels, L. (2018).