Abstract
This study examines the association between the quality of audit committees on financial reporting quality and external audit fees in an environment where the formation of audit committees was unregulated. The study uses a sample of 87 New Zealand firms in 2001 when no regulations or listing rules existed for audit committees. The results show no significant association between the quality of an audit committee and the quality of financial reporting. These results are robust to alternative measures of earnings quality. Similarly, the quality of audit committees has little impact on the level of fees paid to external auditors. The results suggest that the benefits of ‘best practice’ audit committees may be less than anticipated by regulators and policymakers.
1. Introduction
We examine firms that voluntarily adopt a high quality audit committee in an environment, New Zealand, where prior to 2003, the formation of audit committees was completely unregulated. Thus, compared to other countries such as the US where New York Stock Exchange (NYSE) listing requirements have long required audit committees and the UK where the high profile Cadbury Code published in 1992 strongly recommends audit committees with ‘at least three non-executive directors’, prior to 2003, New Zealand companies had considerable leeway in deciding whether an audit committee should be formed and its composition if one was formed. Thus, in the pre-2003 environment, the existence and composition of audit committees in New Zealand varied widely, providing a unique opportunity to examine the benefits that might accrue to firms that adopted what now would be considered ‘best practice’ audit committees. Since audit committee formation was voluntary, the strength of the audit committee should be closely related to the expected benefits associated with the audit committee as a firm would have no incentive to create a best practice audit committee unless it was the optimal choice. As a result, our setting differs from the settings used in most prior studies where regulations or strong encouragement through corporate codes could force firms to adopt best practice audit committees as a second-best option.
6. Conclusion
The corporate collapses in the early 2000s prompted regulators to improve the quality and oversight of financial reporting by improving the effectiveness of audit committees. For example, best practice recommendations issued by the NZSC in 2004 affirm that audit committees should be structured with all non-executive directors, a majority of them being independent, and include a director with financial expertise. However, before these recommendations were released, some New Zealand firms already had audit committees that satisfied these best practice guidelines. The purpose of this study is to examine the financial reporting quality and audit fees for firms that voluntarily formed high quality audit committees.
