CEO Involvement in Selecting Board Members and Audit Committee Effectiveness

Abstract

Research finds independent audit committees are generally effective in monitoring the financial reporting and auditing processes. However, not all audit committees that appear in form to be independent are in fact actually independent. CEO involvement in the board selection process can affect whether an audit committee substantively functions as an independent one. We use financial statement restatements to examine whether the benefits of having an independent audit committee are diminished, or even eliminated, when the CEO is involved in the selection of board members. Our results indicate that the monitoring benefits of having an independent audit committee are only maintained when the CEO is not formally involved in selecting board members. Further, we find that these results appear to be driven by the more severe restatements, including misstatements in conjunction with fraudulent financial reporting. Thus, our evidence suggests that the diminishment in audit committee effectiveness with CEO involvement in selecting directors is associated with real economic costs to the firm. Finally, or results provide support for various post-SOX changes, which enhanced audit and nominating committee independence.