AUDIT COMMITTEE COMPOSITION AND FUNCTIONING POST-ENRON

Abstract

The role of audit committees is crucial in the financial reporting process. I studied a sample of 288 S&P 500 firms from the period 2000-2002 and 2008-2009 to identify changes in audit committee composition. I found that directors with Audit/CPA and Accounting/Finance experience are sought after and most firms continue to add audit committee financial experts to their audit committees; in many instances, such additions happen in companies that already have multiple audit committee financial experts. This suggests that although it is challenging to find audit committee financial experts it is not impossible as some critics may have suggested in the past when the definition of who is an audit committee financial expert was under debate. I also examined the frequency of audit committee meetings in 2000-2002 and 2008-2009. It was important to look at changes in audit committee meetings in the post-Enron period because companies were likely to revert to reducing costs and reduce audit committee meetings. However, I found that the number of audit committee meetings has continued to increase, contrary to concerns that audit committees would become less diligent with the passage of time.

The first decade of the 21st century has witnessed some dramatic events that have significantly altered the landscape of corporate governance. The Enron and WorldCom failures, along with the failure of the Big 5 audit firm of Arthur Andersen, led to the enactment of the Sarbanes-Oxley Act (SOX) (2002), which brought sweeping reforms in the corporate governance structure of U.S. publicly held companies. SOX is deemed to be one of the most significant legislative actions related to the regulation of public companies since the Securities and Exchange acts of 1933 and 1934. SOX (2002) tightened the rules for audit committees of public companies and strengthened their roles.
One of the important changes brought forth by SOX was requiring companies to disclose in their proxy statements if the audit committee had an audit committee financial expert. The definition of “audit committee financial expert” was very controversial. The initial Security and Exchange Commission (SEC) rule proposal was quite narrow, and following a storm of criticism the SEC changed the definition by relaxing the requirements. As discussed in more detail below, many critics suggested that it would be very difficult to obtain qualified audit committee directors, particularly those willing to be characterized as an audit committee financial expert. Given such arguments, I examined the evolving composition of audit committees for selected years during the period 2000 to 2009. I limited my data to selected years because all the audit committee characteristics were hand-collected. Specifically, I examined the number of directors on audit committees as well as the proportion of audit committee directors who could be characterized as audit committee financial experts.
I also focused on a second topic of interest to regulators and other good governance advocates. Given the intense media focus on corporate governance in general, and audit committees in particular, in the immediate aftermath of Enron and WorldCom, it was natural that there would be significant changes in the functioning of audit committees. However, would the changes persist once the “bright lights” of the media and legislators dimmed with the passage of time? In other words, were the changes that occurred post-Enron and WorldCom merely temporary blips, or more permanent? I examined this issue by focusing on the frequency of audit committee meetings.