Audit Committee Formation at the IPO: Existence and Financial Expertise

Abstract

This study investigates the determinants of designated audit committee formation and of narrowly defined financial expertise on the audit committee at a unique point in time: the initial public offering (IPO). Importantly, the U.S. Securities and Exchange Commission (SEC) and major exchange rules do not require firms to have designated audit committees until one year after IPOs. Even when audit committees are formed, there is no requirement for any member to have narrowly defined financial expertise. Such expertise is known to make audit committees more effective compared to broadly defined expertise. We propose two hypotheses explaining audit committee formation and expertise at the IPO. One is that the IPO firm’s complexity and scope of operations are positively associated with committee formation and expertise. The other hypothesis is that committee formation and expertise are driven by the CEO’s incentives and power, and by powerful outside monitors such as independent board members, venture capitalists, and highly reputable underwriters. We find evidence to support both hypotheses.