The Audit Committee and Earnings Quality

Abstract

This paper provides empirical evidence on the association between audit committee formation and the quality of accounting earnings. The audit committee is responsible for overseeing the financial reporting and auditing process of the firm. This paper assesses the effectiveness of the audit committee in discharging these responsibilities by comparing the quality, or informativeness, of earnings reports before and after audit committee formation. For this paper, informativeness is measured by the extent to which the market reacts to the release of earnings reports. Economic theory predicts that the magnitude of the market's reaction to earnings is a nondecreasing function of earnings quality. The results show a significant increase in the market's reaction to earnings reports subsequent to the formation of the audit committee. Specifically, the reaction to earnings reports is more than 20 percent greater after the formation of the committee than before. These findings are robust to alternative variations in the research design. Overall, the evidence is consistent with the audit committee providing meaningful oversight of the financial reporting and auditing process.