Optimal versus suboptimal choices of accounting expertise on audit committees and earnings quality

Abstract

By employing a Heckman two-stage selection model, we identify whether employing a financial expert with or without accounting expertise on the audit committee is optimal and how earnings quality varies across these optimal and suboptimal choices. Using four earnings quality measures (informativeness, timely loss recognition, earnings persistence, and accruals quality), we find no differences in earnings quality between firms optimally choosing an expert with or without accounting expertise, consistent with Demsetz and Lehn (J Polit Econ 93:1155–1177, 1985) and others who argue that when firms optimize their choice (i.e., accounting expertise), there should be no difference across the characteristic (i.e., earnings quality) being examined. We do find, however, earnings quality is significantly higher for firms that optimally choose an accounting expert relative to firms that choose (with/without accounting expertise) suboptimally. Finally, firms suboptimally choosing an accounting expert exhibit no improvement, or even lower earnings quality, than firms that optimally choose no accounting expert. Our results provide important evidence of the impact accounting expertise has on earnings quality when considering the firm’s choice.