Audit Committees, Corporate Governance, and the Quality of Financial Reporting: Evidence From Market Reactions to Earning Announcements

Abstract

This empirical study examines the relation between the audit committee effectiveness and the quality of financial reporting measured as the magnitude of market reactions to earnings announcements. Results show that market reactions increase (1) as audit committee directors have more stock ownership in their firms; (2) as audit committees meet more frequently; (3) as audit committees are composed of a higher percentage of directors with expertise in the financial reporting and auditing process; and (4) when the external auditor of a firm is a Big 4 audit firm. Market reactions decrease when there are unaffiliated large block-holders. Results provide empirical evidence in supporting the proposition that a firm with the effective audit committee will maintain a high-quality financial reporting system and that capital markets respond more favorably to earnings news from such a firm. As such, these results support the public and professional efforts to improve the quality of financial reporting by strengthening the effectiveness of audit committees in their oversight role in the financial reporting and auditing process.