In Brief

At the root of over a decade of regulation and best practices is the premise that the structure and independence of a company’s audit committee has a direct effect on the quality of its financial reporting. The empirical evidence to support this proposition, however, is scant. The author conducted a major research project that investigated the effects of audit committee size and independence standards on the quality of financial reporting by public companies.

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One of the backbones of the U.S. capital markets is investors’ access to unbiased and reliable financial reports. When the veracity of these statements is questioned, market participants often sell a company’s stock and avoid basing decisions on the accounting numbers generated by these reports. Think of the large declines in stock prices accompanying the announcement of revenue restatements (see Ming Wu, “Earnings Restatements: A Capital Market Perspective,” working paper, New York University, 2002,; and Paul Hribar and Nicole Thorne Jenkins, “The Effect of Accounting Restatements on Earnings Revisions and the Estimated Cost of Capital,” Review of Accounting Studies, 2004, Think of the bankruptcies following the accounting scandals of Enron and WorldCom.

After the Enron and WorldCom accounting scandals, Congress passed the Sarbanes-Oxley Act of 2002 (SOX), an extension to the Securities Exchange Act of 1934. SOX’s preamble states that its purpose is “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.” One of the ways it proposes to improve the reliability of financial statements is to require all companies with publicly traded securities to maintain audit committees that are “directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report” [SOX section 301(2)]. More pointedly, each board member serving on the audit committee must be independent of management and the company [SOX section 301(3)].

To date, however, it has not been established empirically if the fundamental requirements of audit committee independence produce their intended effects.

This author (with Seil Kim) recently examined whether shareholders of companies with less independent audit committees actually benefited from moving to full independence (“Did the 1999 NYSE and NASDAQ Listing Standard Changes on Audit Committee Composition Benefit Investors?” Accounting Review, November 2017, The research measured benefits in two distinct ways: stock market reactions surrounding the process leading to the adoption of a prior regulation requiring companies to maintain independent audit committees, and examination of changes in earnings manipulations and the number of egregious accounting restatements before and after the new requirement became effective. The findings throughout were consistent: there is no evidence that requiring companies to maintain independent audit committees benefits shareholders in terms of stock valuation or better financial reporting quality.

The regulation this research was based on involves changes in NYSE and Nasdaq listing standards on audit committee composition instituted by the SEC in December 1999, 18 months before SOX was passed, that required listed firms to maintain audit committees with at least three directors, “all of whom have no relationship to the company that may interfere with the exercise of their independence from management and the company.” Therefore, to remain listed, issuers had to change their audit committees to fulfill the new independence requirement. The authors chose to examine changes around this regulation instead of SOX because it is a stand-alone regulation, unlike SOX, which contains a multitude of changes (e.g., the founding of the PCAOB, CEO, and CFO certification of financial statements, increased auditing of the firm’s internal controls, an independent audit committee). The 1999 listing standards focus almost exclusively on firms maintaining “optimal” audit committees.

Although this rule change is more than 15 years old, today’s regulatory environment accepts the premise that this audit committee structure produces value-enhancing results for all companies. In 2002, Congress codified the 1999 audit committee full independence rule in SOX, thus making it the law of the land. More recently, the PCAOB’s website ties audit committees’ effectiveness to, among other things, the audit committee independence requirements imposed under SOX. To date, however, it has not been established empirically if the fundamental requirements of audit committee independence produce their intended effects.


On September 28, 1998, SEC Chairman Arthur Levitt delivered a speech at New York University expressing concern about the quality of financial reporting in the United States. His concerns included the use of “cookie jar” reserves to manipulate earnings and managements’ fixation on meeting or beating analysts’ earnings per share (EPS) forecasts. In his speech, Levitt announced that the “NYSE and NASD will sponsor an 11-member ‘blue ribbon’ panel drawn from the various constituencies of the financial community to make recommendations on strengthening the role of audit committees in overseeing the corporate financial reporting process.” Ultimately, the panel was cochaired by John Whitehead, a former deputy secretary of state and retired cochairman of Goldman Sachs, and Ira Millstein, a senior partner of the law firm Weil Gotshal & Manges. The remaining nine members were representatives from large corporations and the Big Four; the CEOs of the New York Stock Exchange, the National Association of Securities Dealers, and the TIAA-CREF Life Insurance Company; and a former U.S. controller general. The mandate of the panel was to issue a report within 90 days with a list of recommendations for improving audit committee effectiveness.

Following a comment period and a public hearing on December 9, 1998, the panel released its Blue Ribbon Committee Report(BRC Report) on February 8, 1999. The BRC Report contained 10 separate recommendations, with the first seven asking for proposed changes in Nasdaq and NYSE listing requirements. Recommendations 2 and 3 provided for an independent audit committee of at least three directors, with independence being defined in Recommendation 1. The other recommendations included rules surrounding the audit committee charter, proposed discussions between the audit committee and the outside auditor about financial reporting issues, mandated disclosures from the audit committee about the audit process, and an auditor review of all 10-Q statements.

On September 2, 1999, the SEC obtained board approval to file proposed rule changes to audit committee standards for NYSE- and Nasdaq-listed companies, and on October 6, 1999, dual notices of filing of proposed changes for the NYSE and Nasdaq were made. On December 14, 1999, the SEC approved new audit committee standards for entities listed on the NYSE and Nasdaq. Most of the new guidelines reflected the sentiments and recommendations of the BRC Report (see SEC Release 34-42233), which described the audit committee’s “job” as “clearly one of oversight and monitoring” the firm’s financial reporting. With respect to the 100% independence standard, the SEC tied audit committee director independence to an ability to “objectively evaluate the propriety of management’s accounting, internal control, and financial reporting practices” (Release 34-42233). This reflected the sentiments of Eugene F. Fama and Michael C. Jensen, who suggested that outside board members are best placed to carry out tasks resolving agency problems between internal managers and shareholders (“Separation of Ownership and Control,” Journal of Law and Economics, 1992, As for the minimum three-director requirement, neither the BRC Report nor the SEC Releases offer a rationale for choosing this number. In a consent decree between Killearn Properties Inc. and the SEC, Killearn Properties agreed to form an audit committee of three outside directors (Brenda S. Birkett, “The Recent History of Corporate Audit Committees,” The Accounting Historians Journal, Fall 1986, The consent decree, however, is silent on how or why this number was reached.

Timeline of Changes Resulting from New Listing Standards

The phase-in period for compliance with the new listing standard was 18 months from December 14, 1999. Exhibit 1 shows how audit committee independence and audit committee size for companies listed on the S&P 1500 changed yearly from September 1998 (prior to Levitt’s speech) to September 2002 (a full year following the phase-in period). The last column presents p-values for differences between the 2002 and 1998 numbers. The p-values measure the probability that these two numbers are not different from each other—thus, a p-value less than 0.001 means that the probability that the number of audit committee members (or the percentages of independence) is the same for 1998 and for 2002 is less than 0.1%.


Audit Committee Changes Over Time

1998; 1999; 2000; 2001; 2002; p-value Audit Committee Size Number of members; 3.597; 3.580; 3.626; 3.667; 3.813; <0.001 Companies with at least three audit committee members; 82.7%; 82.8%; 85.7%; 91.2%; 95.9%; <0.001 Audit Committee Independence Percentage of independent directors on audit committee; 80.8%; 82.9%; 86.5%; 88.3%; 90.3%; <0.001 Companies with 100% independent audit committees; 52.1%; 55.9%; 63.9%; 67.3%; 70.8%;<0.001 Companies with an audit committee with at least three independent directors; 40.8%; 43.7%; 53.5%; 60.0%; 67.3%; 0.001

As Exhibit 1 shows, prior to Levitt’s speech, only 40.8% of audit committees were dually compliant with the new size and independence standard, and only 52.1% of all companies had a fully independent audit committee. By 2002, these percentages increased substantively to 67.3% and 70.8%; although these percentages indicate that full compliance was not reached in 2002, the p-values measuring the differences in compliance over time show large shifts in independence between 1998 and 2002.

Exhibit 2 shows that changes in audit committee independence size between 1998 and 2002 came primarily from entities that were out of compliance in 1998. Audit committees that were not fully independent in 1998 increased their percentage of independent directors by an average of 21.4%, whereas companies already in full compliance lowered their percentage of independent directors by an average of 4.5% (the new listing standards allowed some limited opt-out provisions, thus lowering the average percentage of independent directors). Audit committees with fewer than three members, on average, increased their size by 1.178 members, whereas audit committees that already had at least three members reduced their average size by 0.106 members. Therefore, it appears that the new listing standards had a tangible effect on audit committee composition.


Changes by Whether Firm’s Audit Committee Was Compliant or Noncompliant in 1998

Out of compliance with:; Change in Audit Committee Independence from 1998 to 2002 Compliant; Noncompliant; p-value Both Independence and Size; -4.1%; 16.9%; <0.001 Audit Committee Independence; -4.5%; 21.4%; <0.001 Audit Committee Size; 8.3%; 7.1%; 0.637 Change in Audit Committee Size from 1998 to 2002 Compliant; Noncompliant; p-value Both Independence and Size; 0.023; 0.110; 0.257 Audit Committee Independence; 0.249; -0.109; <0.001 Audit Committee Size; -0.106; 1.178;<0.001

Stock Market Reaction to New Listing Standards

The first analysis of whether the new audit committee standards benefited shareholders uses stock market reactions to the timeline surrounding the adoption of the new listing standards. In economic terms, the 1999 regulation is consistent with an entrenchment theory of corporate governance, which suggests that management seeks to insulate itself from oversight by maintaining smaller or less independent audit committees. Under this theory, the stock market will see the new listing standards as a net benefit for non-compliant firms, since the standards force companies with suboptimal audit committees to move to optimality.

A competing view is that audit committee composition is endogenously determined to maximize entity value. Under this scenario, companies trade off director independence, knowledge, and time constraints when composing their audit committees; these tradeoffs result in optimally creating committees that may not conform to the new regulation. If this view holds, the stock market sees the new listing standards as a net cost for noncompliant firms, since the standards force those with already optimal audit committees to move to suboptimal structures. A third view is that audit committee independence and size standards alone do not benefit or hurt shareholders, and therefore there is no net benefit or cost to being in or out of compliance with the new standards. In short, if stock prices rose on the days connected to the adoption of the new listing standard, then the market placed a positive net benefit on the new standard. Conversely, if stock prices dropped on the days connected to the adoption of the standard, the market placed a net cost on the standard.

Exhibit 3 contains the timeline of eight events used to measure abnormal returns. It begins with Levitt’s speech in 1998 and ends with the SEC final rule change approval in 1999. The abnormal returns are averaged over all companies with available data in the S&P 1500. To account for daily risk factors that may affect an individual stock return, returns related to size and book-to-market portfolios were removed (Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, 1992, The results are striking—on average, there was no stock market reaction to the announcements surrounding the passage of the new audit committee rules. In other words, the new standards elicited a “big yawn” from investors.


Timeline of Events and Abnormal Returns

Event; Description; Date; Average Abnormal Return #1; SEC Chairman Arthur Levitt announces formation of BRC; Sep. 28, 1998; −0.95% #2; SEC, NYSE, NASD announce who will be on BRC; Oct. 6, 1998; 0.44% #3; BRC announces request for public comment on recommendations; Nov. 4, 1998; −0.66% #4; Public hearing held on recommendations; Dec. 9, 1998; −0.15% #5; BRC Report released; Feb. 8, 1999; 0.11% #6; SEC obtains board approval to file proposed exchange rule changes; Sep. 2, 1999; −0.03% #7; SEC notices of filing amending audit committee requirements of listed companies on NYSE and Nasdaq; Oct. 6, 1999; −0.07% #8; Rule changes approved by SEC for NYSE and Nasdaq; Dec. 14, 1999; 0.28% All 8 events; 0.48% BRC =Blue Ribbon Committee NASD =National Association of Securities Dealers NYSE =New York Stock Exchange

Exhibit 4 examines subsamples of the S&P 1500 to see if the market reacted positively to those companies that, a priori, should have benefited from the new audit committee rules. Because the new listing standards affected only those companies out of compliance, the data are categorized as those already in and out of compliance. The first question is whether companies with audit committees that, in 1998, were out of compliance with 1) both size and independence, 2) size only, or 3) independence only earned significantly positive or negative abnormal returns across the eight events. No such price reaction was found.


Stock Market Reaction to Subsamples of S&P 1500 Firms

Out of compliance with:; Significant Market Reaction? Both Audit Committee Size and Independence?; No All companies; No Companies with earnings management; No Companies with fraudulent restatements; No Companies with small market cap; No Audit Committee Size Only?; No All companies; No Companies with earnings management; No Companies with fraudulent restatements; No Companies with small market cap; No Audit Committee Independence Only?; No All companies; No Companies with earnings management; No Companies with fraudulent restatements; No Companies with small market cap; No

The next step is to isolate out-of-compliance firms with poor financial reporting quality. The primary benefit articulated by SEC Chairman Levitt, the BRC Report, and the SEC in justification for mandating these changes was an improvement in financial reporting quality. In his 1998 speech, Levitt specifically pointed to earnings restatements and earnings management as two examples of poor financial reporting quality. The database compiled by Andrew Leone from the United States Government Accountability Office (“Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges,” 2002, was used by the authors to separate fraud-based restatements from error-based restatements and concentrate on companies that announced fraud-based restatements from 1996 through 1998. Again, no significant market price was found.

The results are consistent with the market perceiving that audit committees with full independence or a minimum of three directors provide no net benefit to existing shareholders.

Finally, companies that are out of compliance with small market capitalization were removed. Costs of compliance for these entities can be relatively high, as evidenced by the implementation of SOX section 404 and the passage of the Jumpstart Our Business Startups (JOBS) Act. If small-cap companies are expected to bear the high costs of implementing the new audit committee standards, significantly negative stock market reactions for small-cap companies out of compliance with the standards should result. No such price reaction was found.

The above results are consistent with the market perceiving that audit committees with full independence or a minimum of three directors provide no net benefit to existing shareholders. The market’s perception of the effectiveness of these new standards, however, might be incorrect. The market might be underestimating the effect that improved financial reporting quality may have on a stock’s value. The next set of empirical tests addresses these concerns.

Changes in Financial Reporting Quality

The author’s second analysis compared financial reporting quality measures between the period prior to and the period after the implementation of the 1999 audit committee listing standards. Put simply, can one find an actual improvement in reporting quality for companies forced into “improving” their audit committee composition? A difference-in-differences regression was used to examine 1) the earnings management measure described above, 2) egregious accounting restatements, and 3) all accounting restatements. A difference-in-differences regression uses data from the pretransition period and the posttransition period for the same set of companies to see if a variable changed over time. Because companies are expected to adjust their behavior even when anticipating new standards, the one- or two-year period prior to Levitt’s speech was used as the pretransition period. Because the transition period ended 18 months after the passage of the standard in December 1999, the one-year period after June 30, 2001, was used as the post-transition period.

As Exhibit 5 clearly demonstrates, there was no tangible change in earnings management and restatements (egregious or not) between the time periods before and after the implementation of the audit committee independence and size standards. Most pointedly, companies with audit committees out of compliance prior to 1998 showed no improvement in financial reporting quality.


Significant Changes in Financial Reporting Quality Between Pretransition and Posttransition Periods

Out of compliance in 1998 with:; Significant Reduction in Earnings Management?; Significant Reduction in Egregious Restatements?; Significant Reduction in All Restatements? Both audit committee size and independence; No; No; No Audit committee size only; No; No; No Audit committee independence only No; No; No

Other Factors

The authors also examined whether other regulated audit committee variables were related to stock returns or changes in financial reporting quality; specifically, whether having at least one audit committee financial expert or at least one “busy” audit committee member (both as defined by the SEC), had an impact on the results. These variables are included because companies are required to disclose these data in their annual proxy statements. Presumably, a financial expert should be a better monitor of the financial reporting process, and being busy spreads the audit committee member’s time more thinly, resulting in reduced monitoring. Somewhat surprisingly, there were no tangible effects of either characteristic.

The results strongly suggest that the current regulatory regime surrounding the composition of audit committees is not adequate in providing investors with high-quality financial reports.


The empirical results of this research strongly suggest that the current regulatory regime surrounding the composition of audit committees is not adequate in providing investors with high-quality financial reports. This conclusion is reinforced by the wave of financial frauds that followed the implementation of the 1999 listing changes (e.g., Enron, WorldCom, HealthSouth, AIG, Lehman Brothers).

These results should not, however, be interpreted as a negation of using an audit committee as a conduit between the auditor and the auditee in order to produce high-quality financial reporting. These findings merely confirm the view that independence, as defined by stock exchanges and the SEC, as well as the minimum size requirement, are not by themselves adequate to ensure financial statements free from fraud or error.

April Klein, PhD is a professor of accounting at the Stern School of Business at New York University, New York, N.Y.