Does the Market Value Financial Expertise on Audit Committees of Boards of Directors?

Abstract

We examine three-day cumulative abnormal returns around the announcement of 702 newly appointed outside directors assigned to audit committees during a period before implementation of the Sarbanes-Oxley Act (SOX). Motivated by the SOX requirement that public companies disclose whether they have a financial expert on their audit committee, we test whether the market reacts favorably to the appointment of directors with financial expertise to the audit committee. In addition, because it is controversial whether SOX should define financial experts narrowly to include primarilyaccountingfinancial experts (as initially proposed) or more broadly to includenonaccountingfinancial experts (as ultimately passed), we separately examine appointments of each type of expert. We find a positive market reaction to the appointment ofaccountingfinancial experts assigned to audit committees but no reaction tononaccountingfinancial experts assigned to audit committees, consistent with accounting-based financial skills, but not broader financial skills, improving the audit committee's ability to ensure high-quality financial reporting. In addition, we find that this positive reaction is concentrated among firms with relatively strong corporate governance, consistent withaccountingfinancial expertise complementing strong governance, possibly because strong governance helps channel the expertise toward enhancing shareholder value. Together, these findings are consistent with financial expertise on audit committees improving corporate governance but only when both the expert and the appointing firm possess characteristics that facilitate the effective use of the expertise.