Risk & Compliance

SEC Audit Committee Rule Is Worthless: Study

Investors gain no benefit from a 1999 rule requiring audit committees to have at least three members and be free of conflicting interests, research...
David McCannNovember 1, 2017
SEC Audit Committee Rule Is Worthless: Study

With the perennial issue of regulatory reform gaining renewed impetus from the Trump administration, some new research suggests a potential target: the Securities and Exchange Commission’s mandate spelling out the basic composition of audit committees.

Arthur Levitt

Arthur Levitt

The regulation has its roots in a landmark 1998 speech by then-SEC chairman Arthur Levitt, in which he trained his sights on manipulative earnings management and called for empowering the audit committee “as the ultimate guardian of investor interests and corporate accountability.”

About 15 months later, in December 1999, the SEC required audit committees to comprise no fewer than three members and to consist exclusively of directors having “no relationship to the company that may interfere with the exercise of their independence from management and the company.”

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Now, a study in The Accounting Review, a journal of the American Accounting Association, concludes that the 18-year-old rule (which was largely integrated into the Sarbanes-Oxley Act of 2002) has provided no discernible benefit for investors.

Before adoption of the regulation, there was no mandate on audit-committee size; independence was required of only a committee majority; and no definition of independence was provided, giving companies considerable leeway in how they met the requirement. The new mandate represented a marked change.

Yet, the new study says, the market placed no premium on companies being forced to comply with the rule. “Mandating a fully independent audit committee with at least three outside directors is not, on average, value enhancing,” write the authors, Seil Kim of the City University of New York and April Klein of New York University. The study’s findings are based on financial and governance information on 1,122 companies drawn from several large databases.

Given its lack of benefits and the fact that the market saw the regulation as imposing some costs, the professors believe that a simple enhanced disclosure requirement on audit committee composition would be more beneficial than the current independence standards.

Such new disclosure would go beyond current requirements to disclose whether the committee has a financial expert and whether members serve on the audit committees of more than three companies.

The researchers identify eight news events over a 15-month period, beginning with Levitt’s speech on Sept. 28, 1998. Other such events include announcement of appointments to a blue-ribbon committee to explore audit-committee reform options, release of the panel’s recommendations, and, finally, the SEC’s approval of the new regulation on December 14, 1999.

To gauge the impact of the forthcoming regulation, the authors measure market-adjusted returns for company shares on the event date and the day after.

If investors judged the reform to be of value, there should have been an extra share-price return following these events. That effect should have been particularly true for out-of-compliance firms with histories of subpar accounting quality, since investors might have anticipated that the regulation would spur improvement.

Yet, in extensive efforts to find evidence for such effects, the researchers turned up none that were statistically significant.

Investigating the possibility that the market underestimated the potential of the new regulation, the professors examine whether it enhanced accounting performance among previously out-of-compliance firms in the two years following its effective date.

They gauged this through three telltale indicators: number of corporate financial restatements: instances of fraud; and amount of manipulative earnings management. But again, virtually no significant association between the new regulation and the prevalence of these problems comes to light.

The authors see their findings as countering an entrenchment theory of corporate governance that has gained traction in recent decades. As applied to audit committees, the theory “suggests that management seeks to insulate itself from oversight by maintaining smaller and/or less independent audit committees [unless] regulation forces non-compliant firms to move to more optimal audit-committee structures.”

In contrast, the professors look upon their study’s results as consistent with a competing view — namely, that companies are well-equipped to compose their audit committees to maximize company value.

Meanwhile, audit committees are voluntarily disclosing more information about their selection of and relationship with their external auditors, according to the fourth annual Audit Committee Transparency Barometer by the Center for Audit Quality and Audit Analytics.

Among the evidence are the following data, drawn from the 2016 and 2017 proxy statements of Fortune 500 companies:

  • An increase from 31% in 2016 to 37% in 2017 in disclosing audit committee considerations in appointing the audit firm
  • An increase from 59% to 63% in disclosing length of audit-firm engagement
  • An increase from 17% to 20% in stating that the audit committee is responsible for fee negotiations
  • An increase from 34% to 38% in 2017 in discussing criteria considered when evaluating the audit firm
  • An increase from 19% to 21% in disclosing that an evaluation of the external auditor is at least an annual event
  • An increase from 43% to 49% in explicitly stating that the audit committee is involved in the selection of the audit engagement partner
  • An increase from 39% in 2016 to 46% in 2017 in stating the engagement partner rotates every five years

Photo: Wikimedia Commons, Flickr, CC BY 2.0