Audit committee financial expertise and earningsmanagement: The role of status$

Audit committeesEarnings management

relative status are associated with lower levels of earnings management, as measured byaccounting irregularities and abnormal accruals. These results speak to benefits and

(SOX)y. Inentsit cosition

eporting becauseconflicting goals

Contents lists available at ScienceDirect

journal homepage: www.elsevier.com/locate/jae

Journal of Accounting and Economics

g Ai, Craig Chapman,, Shiva Rajgopal, John

Cao, Cory Cassell, Linda Myers, and Thomas Omer for sharing Fortune Most Admired List data. Patrick Badolato and Dain Donelson acknowledge supportfrom the Red McCombs School of Business. Matthew Ege acknowledges support from the Fisher School of Accounting and the Accounting Doctoral Scholars

Journal of Accounting and Economics 58 (2014) 2082300165-4101/& 2014 Elsevier B.V. All rights reserved.

http://dx.doi.org/10.1016/j.jacceco.2014.08.006

Program.E-mail addresses: Patrick.Badolato@mccombs.utexas.edu (P.G. Badolato), Dain.Donelson@mccombs.utexas.edu (D.C. Donelson),

Matthew.Ege@warrington.ufl.edu (M. Ege).Robinson, Jaime Schmidt, Bridget Stomberg, Jennifer Tucker, Laura Wang, Brian White, participants at the 2013 Journal of Accounting & EconomicsConference, and workshop participants at Northwestern University, the University of Florida, and the University of Texas at Austin. We appreciate thehelpful research assistance of Patrick Kielty. We thank Gerald Martin for sharing SEC and Department of Justice Enforcement Action data. We thank YingIndividuals with higher status are perceived to have higher ability, command more authority and obtain beThus, the decline in status could limit the ability of audit committees to constrain opportunistic financial rboth financial expertise and relative status are necessary to influence outcomes when parties are faced with(DAveni, 1990).

We appreciate comments and suggestions from Wayne Guay (editor), David Erkens (referee), Rachel Hayes (discussant), ChunronShuping Chen, Lisa De Simone, Alan Jagolinzer, Ross Jennings, Bill Kinney, Matt Lyle, Tom Lys, Bill Mayew, Brian Monsen, Jim Naughtonability to influence outcomes based on perceived skills, qualities and personal attributes (DAveni, 1990; Pollock et al., 2010).tter information.1. Introduction

The SarbanesOxley Act of 2002improving financial reporting qualitchanges to exchange listing requiremrequirements led to a decline in audhave been considered for director po& 2014 Elsevier B.V. All rights reserved.

stressed the importance of audit committee financial expertise with the goal ofaddition, with the goal of improving the effectiveness of the board, concurrentrequire boards to have a majority of independent directors (SEC, 2003a). These

mmittee status due to the appointment of individuals who would not otherwises (Erkens and Bonner, 2013; Linck et al., 2008). Status refers to an individual'sStatusFinancial expertise

limitations of financial expertise, which have been the focus of considerable debate.Patrick G. Badolato a, Dain C. Donelson a, Matthew Ege b

a University of Texas at Austin, Austin, TX 78712, USAb University of Florida, Gainesville, FL 32611, USA

a r t i c l e i n f o

Available online 28 August 2014

JEL classification:M41

Keywords:

a b s t r a c t

Regulatory pressure to increase both audit committee financial expertise and boardindependence has resulted in lower status for audit committees relative to management.This status differential is relevant because expertise and relative status are importantdeterminants of each party's ability to influence outcomes, particularly when parties faceconflicting goals. We find that audit committees with both financial expertise and high

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 209This study examines the joint effects of audit committee financial expertise and status on earnings management.Specifically, we test whether audit committee status, relative to management status, interacts with financial expertise toconstrain earnings management in the form of accounting irregularities and abnormal accruals. The relationship betweenmanagers and audit committees has the potential for significant conflict as managers have incentives to misreport, whileaudit committees have incentives to constrain opportunistic financial reporting due to career consequences (Srinivasan,2005) and negative publicity (Miller, 2006) when financial reporting problems occur. We expect that managers will beconstrained only when the audit committee has both financial expertise and the authority inherent in higher relative status.

There are at least two reasons that the relative status of the audit committee is likely to influence its effectiveness. First,audit committees need both ability and authority to gain the respect of managers in order to influence financial reportingoutcomes. Relative status directly influences how managers view the audit committee because status enhances perceivedability and commands authority and respect (DAveni, 1990; Pollock et al., 2010). Thus, managers would view higher statusaudit committees as more competent and authoritative, providing a disincentive to manipulate accounting numbers.Second, audit committees with higher relative status are likely to be more active monitors, acquire more comprehensiveinformation and be more willing to investigate potential problems because they would be less deferential to managementthan audit committees with lower relative status. As the SEC (2003b) states, Effective audit committee members must haveboth the ability and determination to ask the right questions. Overall, audit committees with higher relative status arelikely to be more effective in situations involving questionable financial reporting.

To investigate these issues, we gather a sample from BoardEx, a business network database with biographicalinformation and employment history for corporate directors and officers. To measure financial expertise, we follow SEC(2003b) rules by defining financial experts as individuals with experience creating, auditing, using or overseeing thecreation of financial reports. We create a measure of relative status by comparing audit committee status to managementstatus. This measure focuses on status indicators that are relevant in a corporate setting and includes the number of (1)contemporaneous public board directorships, (2) contemporaneous private board directorships and (3) degrees from eliteinstitutions (DAveni, 1990; Erkens and Bonner, 2013; Finkelstein, 1992; Pollock et al., 2010; Useem, 1979).

We find that the average number of audit committee members with financial expertise increased monotonically from 2001through 2008, driven by members with accounting and finance expertise. Audit committee status relative to managementdecreased over the same period. The percentage of independent directors also increased dramatically, while the workload fordirectors and audit committee members increased. These factors led to a fundamental shift in the market for corporatedirectors, resulting in previously unlikely candidates being named to boards (Engel et al., 2010; Linck et al., 2008).

Our primary measure of earnings management is accounting irregularities because irregularities objectively measuresevere earnings management. We identify irregularities based on settled, accounting-based securities class-action lawsuitsand SEC and Department of Justice enforcement actions claiming fraud or other intentional misconduct. In multivariate testsinvolving irregularity likelihood, the interaction between financial expertise and relative status is significantly negative.Firm-years with audit committees with financial expertise one standard deviation above the mean and that have highrelative status are 0.3 percentage points less likely to have an irregularity compared to those without high relative status.This represents 10.7 percent of the unconditional probability of an irregularity. These results support the notion thatsufficient audit committee financial expertise and relative status are necessary to deter irregularities.

A potential concern is that our results may be influenced by a selection bias in which high status directors either avoidaudit committee membership at firms with high financial reporting risk or leave the firm as soon as they detect anirregularity. This concern is somewhat tempered by our focus on relative rather than absolute status. In particular, firms withhigh financial reporting risk (or detected irregularities) are likely to have lower status managers, because these firms are lessattractive employment options. Therefore, even if these firms also attract or retain lower status audit committees, it is notclear that relative status would be affected.

We also address these concerns empirically by employing an instrumental variables approach as described inWooldridge (2010) to test for endogeneity. As instruments, we use whether a firm's headquarters is located within oneof the largest ten metropolitan statistical areas (for financial expertise) and the raw score from Fortune's Most AdmiredCompany List (for relative status). We find consistent results and do not find evidence of endogeneity. Additionally, for firmswith audit committee turnover, the change in relative audit committee status from t1 to t is unassociated with thepredicted probability of an irregularity for t1 (i.e., ex ante irregularity risk that should be observable to potential directorcandidates). These results are inconsistent with a selection bias in which relatively high status audit committees are affectedby high status directors either leaving firms before an irregularity begins or upon irregularity detection.

These results are robust to a host of additional tests aimed at addressing alternative explanations. For example,inferences remain the same when including controls for audit committee quality, social ties, board networks, and access toinformation flows, suggesting that our proxy for the relative status of the audit committee is distinct from these constructs.Results are also robust to using alternative definitions of our relative status proxy. Finally, in a falsification test, we find thatthe interaction between financial expertise and relative status is unrelated to error-based restatements (i.e., unintentionalmisapplications of U.S. GAAP).

As a secondary proxy for earnings management, we examine abnormal accruals. Abnormal accruals are a commonmeasure of within-GAAP earnings management (Zhao and Chen, 2008) and a potential indication of irregularities (Dechowet al., 2012). We focus on directional (raw) abnormal accruals because, similar to auditors, audit committees face greater riskof litigation and reputational damage when accruals increase income (Becker et al., 1998). We find corroborating results in

that the interaction of financial expertise and status is associated with lower abnormal accruals. This result is robust to usingfirm fixed effects to control for self-selection related to invariant firm characteristics.

This study makes two primary contributions. First, we provide insight into the ability of audit committees to constrainearnings management. We find evidence consistent with the proposition that audit committee financial expertise does notconstrain irregularities unless the audit committee also has high status. In addition, abnormal accruals are lower when theaudit committee has both high relative status and financial expertise. These results speak to benefits and limitations offinancial expertise, the focus of considerable debate. Notably, the results suggest that a combination of financial expertise

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230210and relative status is important for constraining earnings management.Second, this study extends the literature on corporate leader status. While surveys of individuals involved in financial

reporting have proposed that audit committee status can affect financial reporting quality (e.g., Turley and Zaman, 2007), wetest this with externally observable measures. This finding adds to research examining the conditions in which board ofdirector status can influence firm outcomes (DAveni, 1990; Pollock et al., 2010; Stuart et al., 1999). It also complements theemerging literature that suggests external auditor status is important for audit quality (Bennett and Hatfield, 2013).

Section 2 provides a review of related literature and develops the hypotheses. The sample selection and research designare described in Section 3. Sections 4 and 5 present the empirical results and additional analyses, respectively. Section 6contains the conclusion.

2. Literature review and hypothesis development

2.1. Audit committees and accounting irregularities

Audit committees are intended to monitor the financial reporting process and constrain opportunistic managerialreporting. This role reflects the tenets of agency theory and the need to monitor managers to reduce their ability to extractrents from the firm (e.g., Beasley et al., 2009; Fama and Jensen, 1983). Due to this monitoring role, numerous regulators havehighlighted the importance of audit committees.1 For example, Arthur Levitt (2000), then the SEC Chairman, echoed theadvice of the Blue Ribbon Commission by stating that one of the most reliable guardians of the public interest is acompetent, committed, independent and tough-minded audit committee. Consistent with Levitt's advice, SOX requiresfirms to have fully independent audit committees. In addition, SOX effectively mandates financial expertise by requiring thatfirms disclose financial expertise. However, there is still substantial variation in audit committee composition and operation(Beasley et al., 2009; Cohen et al., 2010).

Several studies find that financial expertise limits routine earnings management as measured by accrual-basedvariables, including lower abnormal accruals and higher accrual quality, as well as more conservatism (Bdard et al., 2004;Carcello et al., 2006; Dhaliwal et al., 2010; Krishnan and Visvanathan, 2008; Xie et al., 2003). Financial expertise is alsoassociated with a lower likelihood of internal controls weaknesses (Krishnan, 2005) and is valued by market participants(Davidson et al., 2004; DeFond et al., 2005).

However, the primary goal of SOX was constraining financial reporting outside of GAAP (irregularities) rather thanroutine earnings management (Coates, 2007; Lucas, 2004). Constraining irregularities is a significant challenge for auditcommittees because managers hide fraud from monitors due to career consequences and other severe penalties forintentional GAAP violations (e.g., Larcker et al., 2007; Schrand and Zechman, 2012). Intentional obfuscation makes it difficultfor audit committees to detect and prevent irregularities.

Despite these difficulties, three prior studies find a negative relation between audit committee financial expertise andirregularities.2 Notably, these studies use sample periods prior to SOX, when choice of audit committee members was lessrestricted. It is unclear whether their results will continue to hold for at least two reasons. First, the intended result of therequirements of SOX is to increase the number of financial experts, which reduces the variation in the choice of financialexpertise. Second, audit committees now include lower status members. This is a consequence of placing financial expertson the audit committee who would not have previously been considered for directorships (Erkens and Bonner, 2013) andoverall shifts in the director market caused by the requirement for a majority of independent directors (Linck et al., 2008).

2.2. Status, audit committees and deterrence

The status of corporate leaders affects outcomes, especially in challenging settings involving uncertainty. For example,DAveni (1990) finds that top management teams with higher status are associated with a lower likelihood of bankruptcy for

1 These include the Treadway Commission of 1987, the Cadbury Commission of 1992, the Blue Ribbon Commission of 1999, the New York StockExchange's Corporate Governance Rules of 2004 and the Canadian Securities Administrators Audit Committee Rules of 2004, which all stress theimportance of audit committees.

2 Abbott et al. (2004) sample 44 fraud firms from 1991 through 1999 and find that audit committee financial expertise reduces the likelihood of fraud.Farber (2005) examines 87 firms with Accounting and Auditing Enforcement Releases detected through 1997 and finds a lower number of audit committeefinancial experts for fraud firms compared to control firms. Agrawal and Chadha (2005) find a negative association between financial expertise andrestatement likelihood in a sample of 159 public companies earnings restatements between 2000 and 2001 (including restatements that would beconsidered irregularities).

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 211troubled firms, and Pollock et al. (2010) find that the status of executives and directors at pre-IPO firms is positivelyassociated with IPO valuations. While financial expertise provides the knowledge needed to improve financial reportingquality (SEC, 2003b), it may not be sufficient to deter irregularities. The deterrent role of the audit committee is shaped byinteractions of managers and directors, and thus depends on status.

The primary role of status in manageraudit committee interactions involves a deterrence effect from being monitoredby a peer or higher status group versus a lower status group. Deterrence is based on management's perception of the auditcommittee's competence and willingness to confront managers over earnings management. This deterrent effect comesfrom two factors. First, audit committees with higher relative status will be viewed as more competent and authoritativebecause status enhances perceived ability and commands respect (DAveni, 1990; Pollock et al., 2010). Second, auditcommittees with higher relative status are likely to be more active monitors and acquire more comprehensive information.The SEC (2003a) stresses that audit committees must ask the right questions to gain information and be effective. Thewillingness to act on information, including confronting managers when necessary, is important in deterring irregularitiesgiven that some executives who violate GAAP are willing to engage in significant conflict with gatekeepers to achieve theirgoals (e.g., Byrne, 2003; Helyar, 2003).

2.3. Relative status

We focus on audit committee status relative to the top management team. Our design is based on the audit committee asa group as the Blue Ribbon Commission recommendations, exchange requirements and SEC regulations focus on theexistence, size, independence and other characteristics of the audit committee collectively (SEC, 2003a). Moreover, researchanalyzing corporate decisions shows that examining the groups responsible for decisions (rather than individuals) providesbetter explanatory power (Hambrick and Mason, 1984; Hambrick, 2007). For example, Carpenter et al. (2004, 768) cite 31studies between 1996 and 2003 examining top management teams and organizational outcomes and stress that, Clearlythe value of studying top executives in aggregateis not disputed.

For the management team, we include the CEO and the CFO because they have ultimate authority over the financialreporting process. For instance, SOX requires their personal certification of financial statements. In addition, CEOs and CFOsare named in most SEC enforcement actions dealing with accounting (Karpoff et al., 2008a; Feng et al., 2011), as well asnearly all accounting-based securities class actions (Klausner and Hegland, 2010).

Our focus on the status differential between the audit committee and management is logical because characteristics ofindividuals or groups, such as status, are not held in isolation. Relative status and the related concept of power are importantin many corporate settings, even when individuals have strong incentives to monitor. For instance, low power directorspaired with higher power managers allow such managers to extract higher compensation (Belliveau et al., 1996; Grinsteinand Hribar, 2004), even though it may cause the directors loss of reputation and negative career outcomes (Bebchuk et al.,2002). These studies focus on power attained through governance. Few choices remain regarding audit committeegovernance as full independence is required and financial expertise is essentially required by disclosure regulations.However, status, an aspect of power that is important to directors, is unregulated and displays substantial variationacross firms.

2.4. Primary hypothesis

Recent trends of increasing financial expertise and decreasing status of audit committees provide a strong reason toexamine the relation between financial expertise, status and accounting irregularities. As accounting irregularities involvefinancial reporting choices, we expect that financial expertise and independence are necessary, but not sufficient, to reducethe likelihood of accounting irregularities. Status often influences effectiveness in challenging business situations (DAveni,1990). Thus, managers are less likely to commit an irregularity due to deterrence provided by audit committees when theyhave the necessary combination of ability (i.e., financial expertise) and status. We propose that audit committee status,relative to management status, interacts with audit committee financial expertise to reduce the likelihood of accountingirregularities. We state our primary hypothesis in the alternative form:

H1. Relative audit committee status interacted with audit committee financial expertise decreases the likelihood of afinancial reporting irregularity.

2.5. Secondary hypothesis

Similar to the description above regarding accounting irregularities, audit committees with relatively higher statusshould help constrain other forms of earnings management, including those that fall within GAAP. That is, managers arelikely to more closely consider the commission of earnings management when faced with an audit committee that has thenecessary combination of ability and authority. Similar to prior studies that examine earnings management and auditors, wefocus on directional (raw) abnormal accruals in order to capture situations where audit committees will be most likely toconstrain or deter management actions. We propose that relative audit committee status interacts with financial expertiseto reduce the size of directional accruals. We state our secondary hypothesis in the alternative form:

H2. Relative audit committee status interacted with audit committee financial expertise decreases the level of abnormalaccruals.

3. Sample and research design

3.1. Sample

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230212We obtain our initial sample from BoardEx, a professional business network database that provides biographicalinformation and employment history for corporate directors and officers. We use the BoardEx data to measure auditcommittee financial expertise, the status of board members relative to management and other board characteristics. Givendata restrictions and allowing for sufficient time for irregularity revelation, our sample covers the years 2001 to 2008.During this period, boards were pressured to increase the financial expertise of the audit committee. We exclude all firm-year observations with CEO or CFO turnover, as it is unclear how to determine the proper status measures for these years.

To obtain our irregularity sample, we obtain SEC and Department of Justice enforcement actions that allege fraud or otherintentional financial reporting misconduct from the Federal Securities Regulation Database3 and settled securities class-actionlawsuits that allege violations of GAAP per RiskMetrics. IRREGULARITY is an indicator variable equal to one for years withalleged management misconduct. Specifically, it is set to one for either (1) violation years from SEC and Department of Justiceenforcement actions that establish intent under Section 17(a) of the Securities Act of 1933, or either Section 10(b) (includingRule 10b-5) or 13(b)(5) of the Securities Exchange Act of 1934 or (2) class period years related to the class-action lawsuits.

Our primary management misconduct model controls for incentives to manipulate the financial statements, corporategovernance variables and other determinants of misconduct. Data for these control variables come from Compustat, CRSPand Thompson Reuters. Our final sample includes 29,073 firm-year observations from 2001 to 2008.

3.2. Variable definitions

3.2.1. Financial expertiseWe classify audit committee members as having financial expertise if their biographical information in BoardEx includes

terms reflecting accounting experience, experience supervising the preparation of financial statements or expertise usingfinancial statements. We refer to these areas as accounting, supervisory and finance expertise, respectively (see Appendix Cfor a list of terms in each category). This is based upon the SEC (2003b) definition of financial expertise, which states thatfinancial expertise is evidenced by, (1) education and experience as a principal financial officer, principal accounting officer,controller, public accountant or auditor or experience in one or more positions that involve the performance of similarfunctions; (2) experience actively supervising a principal financial officer, principal accounting officer, controller, publicaccountant, auditor or person performing similar functions; (3) experience overseeing or assessing the performance ofcompanies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or (4) otherrelevant experience.

EXPERTISE is the percentage of audit committee members with financial expertise.4 The intuition is that higher levels offinancial expertise increase the likelihood that audit committees detect earnings management. The typical audit committeenow includes multiple financial experts, which provides cross-sectional variation in EXPERTISE. We also create moregranular expertise measures for accounting (ACCOUNTING_EXPERTISE), supervisory (SUPERVISORY_EXPERTISE) and finance(FINANCE_EXPERTISE) based on the percentage of audit committee members that have accounting, supervisory and financeexpertise, respectively.5 There is mixed evidence on which types of expertise affect financial reporting outcomes (Bdardand Gendron, 2010).

3.2.2. StatusWe calculate raw status measures for audit committees, non-audit committee independent directors and management

(i.e., the CEO and CFO). We also calculate relative measures that capture the differential status between the auditcommittee and management and the differential status between non-audit committee independent directors andmanagement. We use the relative measure of differential status between the audit committee and management to testour main hypothesis. Our status measures are composite measures based upon prior literature (Finkelstein, 1992; Erkensand Bonner, 2013; Pollock et al., 2010) that include the number of (1) contemporaneous public board directorships, (2)contemporaneous private board directorships and (3) degrees from elite institutions.6

3 For more information on these data see http://www.fesreg.com/. These data were hand-collected by Gerald Martin and initially used in Karpoff et al.(2008a, 2008b).

4 In the multivariate analysis, the audit committee expertise measures are transformed such that the mean is zero for ease of interpreting theinteraction of expertise and status.

5 Inferences are unchanged if we use indicator variables for the presence of accounting, supervisory, and finance expertise instead of continuousmeasures.

6 Consistent with empirical studies that examine the entire board (e.g., Ferris et al., 2003) and the majority of audit committee studies recentlyreviewed (see Bdard and Gendron, 2010), we predict that having more directorships signals higher quality directors and better monitoring as opposed to

Numerous studies examine the role of status in other settings. Accordingly, while many other inputs have been usedwhen measuring status, we exclude inputs such as political connections, involvement in social clubs or fame because theseinputs are not necessarily related to the hypotheses we test. Rather, we follow prior studies that examine status andcorporate decision-making because they are the most directly analogous to the environment we study (DAveni, 1990;Finkelstein, 1992; Pollock et al., 2010; Stuart et al., 1999).

For audit committee status, we first determine the mean number of concurrent individual public boardappointments for each audit committee. Our variable, PUBLIC_BOARDS_INDICATOR_AC, equals one for each auditcommittee whose mean appointments is greater than the median for all audit committees, and zero otherwise.7

PRIVATE_BOARDS_INDICATOR _AC and ELITE_EDUCATION_INDICATOR _AC are defined similarly based on the meannumber of concurrent private board appointments and elite institution degrees, respectively. Elite institutions arenoted in Appendix B and are consistent with studies such as Useem and Karabel (1986) and Finkelstein (1992).STATUS_AC is an indicator that equals one if the sum of PUBLIC_BOARDS_INDICATOR _AC, PRIVATE_BOARDS_INDICATOR_AC and ELITE_EDUCATION_INDICATOR _AC is three, and zero otherwise. STATUS_AC measures raw audit committeestatus (i.e., not relative to management), and a value of one represents an audit committee with high status. Wecalculate similar measures for management status (STATUS_CEO/CFO) and independent, non-audit committee director

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 213status (STATUS_DIRECTOR).To calculate the relative status of the audit committee compared to management, we consider the same underlying

measures used to create our audit committee status measure, but we consider the differences in those measures for eachaudit committeemanagement pair.8 STATUS_DIFFERENTIAL is our measure of the status differential between auditcommittees and management, with values of one indicating instances where relative audit committee status is high.9 Forparsimony, detailed variable definitions are provided in Appendix A.

3.2.3. Major control variablesWe control for other board of director characteristics that affect governance and could affect the likelihood of an

irregularity. Specifically, we control for the relative status of independent directors not on the audit committee(STATUS_DIFFERENTIAL_DIRECTOR), audit committee size (AC_SIZE), board size (BOARD_SIZE), board independence (BOAR-D_INDEPENDENCE), CEO duality (CEO_IS_CHAIR), institutional ownership (INSTITUTIONAL_OWNERSHIP), firm size (LOG_MVE),growth prospects (BM and ROA), leverage (LEVERAGE) and debt and equity offerings (ISSUANCE).10

3.3. Descriptive statistics

Table 1 Panel A presents descriptive statistics by year for variables related to the board and audit committee. Auditcommittee average age (AGE_AC) has slightly increased over the sample period from 59.0 to 60.5 years old.Contemporaneous outside employment for audit committee members has decreased over the sample period. On average,audit committee members held 0.57 other positions outside of their independent directorships (OUTSIDE_EMPLOYMEN-T_AC) in 2001, which decreased to 0.49 in 2008. Notably, this includes any type of outside employment (most of whichappears to be in the form of part-time positions; for example, consulting or adjunct professor positions), not simplyexecutive positions. Very few audit committee members hold contemporaneous executive positions (EXECUTIVE_EM-PLOYMENT_AC), and this percentage has decreased from approximately 5% in 2001 to 2% in 2008. These trends could beconsistent with either audit committee membership becoming more demanding or a change in the type of individualsaccepting such appointments.

Average audit committee financial expertise (EXPERTISE) increases from a low of 48.8% in 2001 to a high of 59.5% in2008. In other words, in 2001 (2008) 48.8 (59.5) percent of audit committee members had financial expertise, which is,

(footnote continued)excessive busyness. Consistent with smaller sample surveys (e.g., Cohen et al., 2010), the audit committee members in our large sample serve on a mean(median) of 2.10 (2.67) total boards. The fact that more than half of these directors serve on fewer than two other boards provides additional evidence thatis inconsistent with directors being over-extended.

7 Median cutoffs for variables that compare audit committees and management are measured based on the median from the full sample period toallow for a constant basis of comparison and time trends to be observed.

8 For example, for relative audit committee status, we first determine the difference between the mean number of concurrent public boardappointments for each audit committeemanagement pair. That is, for each firm we take the mean number of concurrent public board appointments forthe audit committee and subtract the mean number of concurrent public board appointments for management (the CEO and CFO). Then,PUBLIC_BOARDS_INDICATOR_DIFFERENTIAL is an indicator that equals one for each audit committeemanagement pair whose mean appointments isgreater than the median for all audit committeemanagement pairs, and zero otherwise. PRIVATE_BOARDS_INDICATOR _DIFFERENTIAL and ELITE_EDUCA-TION_INDICATOR _DIFFERENTIAL are defined similarly based on the difference in mean number of concurrent private board appointments and eliteinstitution degrees, respectively. STATUS_DIFFERENTIAL equals one if the sum of PUBLIC_BOARDS_INDICATOR _DIFFERENTIAL, PRIVATE_BOARDS_INDICATOR_DIFFERENTIAL, and ELITE_EDUCATION_INDICATOR _DIFFERENTIAL is three, and zero otherwise.

9 In untabulated robustness tests, we find that inferences remain the same if we calculate relative audit committee status based upon audit committeestatus compared to only the CEO's status.

10 Inferences remain the same if we also control for the E-Index variable from Bebchuk et al. (2009). Including this variable significantly reduces thesample size.

Table 1Descriptive Statistics.

Panel A: Board of director variables of interest by year

Year No. of obs. No. of irregularities AGE_AC OUTSIDE_EMPLOYMENT_AC EXECUTIVE_EMPLOYMENT_AC

2001 1774 108 59.0 0.57 0.052002 1858 107 59.5 0.56 0.052003 3452 141 59.4 0.54 0.052004 4229 132 59.4 0.53 0.042005 4542 111 59.5 0.53 0.042006 4553 63 59.8 0.52 0.042007 4484 57 60.2 0.51 0.032008 4181 24 60.5 0.49 0.02

Year No. of obs. STATUS_AC PUBLIC_BOARDS_AC PRIVATE_BOARDS_AC ELITE_EDUCATION_AC

2001 1774 0.160 2.21 1.29 0.352002 1858 0.154 2.17 1.27 0.352003 3452 0.114 1.93 1.24 0.312004 4229 0.099 1.86 1.22 0.302005 4542 0.098 1.83 1.23 0.29

2006 4553 0.095 1.79 1.24 0.292007 4484 0.086 1.76 1.22 0.282008 4181 0.082 1.72 1.23 0.28

Year No. of obs. STATUS_CEO/CFO PUBLIC_BOARDS_CEO/CFO PRIVATE_BOARDS_CEO/CFO ELITE_EDUCATION_CEO/CFO

2001 1774 0.084 1.18 0.59 0.262002 1858 0.071 1.14 0.57 0.252003 3452 0.053 1.15 0.65 0.232004 4229 0.046 1.15 0.65 0.212005 4542 0.046 1.16 0.66 0.212006 4553 0.042 1.14 0.64 0.202007 4484 0.038 1.13 0.64 0.212008 4181 0.042 1.12 0.65 0.21

Year No. of obs. STATUS_DIFFERENTIAL PUBLIC_BOARDS_DIFFERENTIAL PRIVATE_BOARDS_DIFFERENTIAL ELITE_EDUCATION_DIFFERENTIAL

2001 1774 0.207 1.02 0.70 0.092002 1858 0.218 1.04 0.70 0.102003 3452 0.180 0.77 0.60 0.092004 4229 0.163 0.71 0.57 0.09

2005 4542 0.166 0.68 0.57 0.082006 4553 0.157 0.65 0.60 0.082007 4484 0.145 0.63 0.58 0.072008 4181 0.136 0.59 0.58 0.06

Year No. of obs. EXPERTISE ACCOUNTING_EXPERTISE SUPERVISORY_EXPERTISE FINANCE_EXPERTISE

2001 1774 0.488 0.186 0.299 0.2132002 1858 0.511 0.202 0.306 0.2312003 3452 0.511 0.244 0.275 0.251

2004 4229 0.533 0.278 0.274 0.2702005 4542 0.556 0.304 0.274 0.2922006 4553 0.572 0.324 0.280 0.3072007 4484 0.586 0.336 0.285 0.3202008 4181 0.595 0.346 0.285 0.331

Year No. of obs. AC_SIZE BOARD_SIZE BOARD_INDEPENDENCE CEO_IS_CHAIR

2001 1774 3.87 12.51 0.578 0.6552002 1858 3.97 12.52 0.579 0.6512003 3452 3.83 10.48 0.662 0.5822004 4229 3.80 10.06 0.689 0.5592005 4542 3.77 9.89 0.703 0.5242006 4553 3.77 9.84 0.714 0.4992007 4484 3.74 9.72 0.719 0.4892008 4181 3.76 9.75 0.724 0.482

This panel provides descriptive statistics regarding board composition and accounting irregularities by year. The sample period is from 2001 through 2008.We obtain measures of director age, current work appointments, independence, expertise, and status from BoardEx and an irregularity sample made up of(1) violation years from SEC and Department of Justice enforcement actions that establish intent under Section 17(a) of the Securities Act of 1933, or eitherSection 10(b) (including Rule 10b-5) or 13(b)(5) of the Securities Exchange Act of 1934 per the Federal Securities Regulation Database and (2) class periodyears related to settled securities class-action lawsuits that allege violations of Generally Accepted Accounting Principles per RiskMetrics. BoardEx does nothave age data for all directors. Thus, the AGE_AC data displayed in this table are based upon 1,774, 1,858, 3,449, 4,225, 4,538, 4,549, 4,478, and 4,174 obser-vations for years 2001 through 2008, respectively (i.e., 28 firm-years have no age information for audit committee members). Variable definitions areprovided in Appendix A.

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230214

Panel B: Descriptive statistics

IRREGULARITY1 (n743) IRREGULARITY0 (n28,330) Differences

Mean Std dev Median Mean Std dev Median Mean Median

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 215Expertise variablesEXPERTISE 0.570 0.266 0.667 0.553 0.283 0.600 0.017* 0.067*

ACCOUNTING_EXPERTISE 0.270 0.227 0.250 0.294 0.235 0.333 0.024*** 0.083**SUPERVISORY_EXPERTISE 0.321 0.261 0.333 0.281 0.266 0.250 0.039*** 0.083***

FINANCE_EXPERTISE 0.284 0.240 0.333 0.288 0.248 0.286 0.003 0.048Status variablesSTATUS_AC 0.176 0.381 0.000 0.101 0.301 0.000 0.075*** 0.000***

STATUS_DIFFERENTIAL 0.219 0.414 0.000 0.163 0.369 0.000 0.057*** 0.000***

STATUS_DIFFERENTIAL_DIRECTOR 0.152 0.359 0.000 0.142 0.349 0.000 0.010 0.000

Control variablesAC_SIZE 3.795 1.090 4.000 3.794 1.076 4.000 0.002 0.000BOARD_SIZE 11.304 3.809 11.000 10.231 3.667 10.000 1.073*** 1.000***

BOARD_INDEPENDENCE 0.622 0.137 0.615 0.689 0.139 0.667 0.067*** 0.051***CEO_IS_CHAIR 0.610 0.474 1.000 0.535 0.490 1.000 0.076*** 0.000***

INSTITUTIONAL_OWNERSHIP 0.387 0.365 0.387 0.379 0.346 0.333 0.008 0.054LOG_MVE 7.280 1.761 7.137 6.173 1.916 6.138 1.107*** 0.999***

BM 0.483 0.496 0.389 0.571 0.637 0.471 0.088*** 0.082***LEVERAGE 0.232 0.213 0.204 0.211 0.215 0.160 0.021*** 0.044***

ISSUANCE 0.388 0.488 0.000 0.350 0.477 0.000 0.038** 0.000**

ROA 0.012 0.218 0.023 0.042 0.637 0.022 0.030*** 0.001

This panel provides descriptive statistics. The sample period is from 2001 through 2008. We obtain an irregularity sample made up of (1) violation yearsfrom SEC and Department of Justice enforcement actions that establish intent under Section 17(a) of the Securities Act of 1933, or either Section 10(b)(including Rule 10b-5) or 13(b)(5) of the Securities Exchange Act of 1934 per the Federal Securities Regulation Database and (2) class period years related toon average, 1.9 (2.2) members per audit committee. It appears that this increase in financial expertise is driven by anincrease in accounting and/or finance expertise, as the percent of audit committee members with accounting expertise(ACCOUNTING_EXPERTISE) or finance expertise (FINANCE_EXPERTISE) monotonically increases from 2001 through 2008,while the percent of audit committee members with supervisory expertise (SUPERVISORY_EXPERTISE) stays relativelysteady.

In contrast to financial expertise, average audit committee status (STATUS_AC) and average relative audit committeestatus (STATUS_DIFFERENTIAL) decrease over the sample period. The size of the audit committee (AC_SIZE) is fairly constant,so it appears that firms replaced high status members with accounting or finance experts rather than adding accounting orfinance members to the audit committee.11 Finally, the percentage of independent board members increases over time, andthe instances of CEO duality decrease over the sample period. These trends seem consistent with pressure to increase boardindependence from regulators and shareholder advocates. Table 1 Panel A also shows that years 2003 and 2004 (2007 and2008) have the highest (lowest) number of irregularities within the sample period.

Table 1 Panel B presents descriptive statistics for the irregularity and control samples. Panel B provides evidence thatthere is a significant difference between the irregularity and control samples with respect to a number of variables.Specifically, audit committee accounting expertise is higher in the control sample. The percentage of audit committeefinancial expertise and supervisory expertise is higher in the irregularity sample. Additionally, the status and relativestatus of the audit committee are higher in the irregularity sample. These correlations are likely the result of larger firmshaving an increased likelihood of both irregularities and the ability to attract high status directors (Table 2 showspositive and significant correlations between LOG_MVE and EXPERTISE, SUPERVISORY_EXPERTISE, STATUS_AC andSTATUS_DIFFERENTIAL).

settled securities class-action lawsuits that allege violations of Generally Accepted Accounting Principles per RiskMetrics. We obtain measures of directorindependence, expertise and status from BoardEx. *, ** and *** represent two-tailed statistical significance at the 10%, 5% and 1% levels, respectively. Variabledefinitions are provided in Appendix A.

11 In a sample of S&P 1500 firms, Erkens and Bonner (2013) report that firms that added accounting expertise to the audit committee during 1999 to2008 did so by adding an accounting expert to the board rather than replacing a board member. In our sample, which includes more than the S&P 1500firms, audit committee size is relatively constant over the entire sample period and board size is relatively stable once our sample size stabilizes in 2004.

Table 2Pearson correlations for variables in main regression.

Variables 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

1 IRREGULARITY2 EXPERTISE 0.0103 ACCOUNTING_EXPERTISE 0.016 0.5774 SUPERVISORY_EXPERTISE 0.023 0.633 0.0625 FINANCE_EXPERTISE 0.002 0.601 0.592 0.1346 STATUS_AC 0.039 0.056 0.034 0.079 0.0497 STATUS_DIFFERENTIAL 0.024 0.091 0.006 0.098 0.058 0.3538 STATUS_DIFFERENTIAL_DIRECTOR 0.004 0.094 0.035 0.101 0.066 0.052 0.2389 AC_SIZE 0.000 0.049 0.117 0.068 0.088 0.080 0.008 0.00710 BOARD_SIZE 0.046 0.033 0.048 0.118 0.023 0.107 0.075 0.167 0.52111 BOARD_INDEPENDENCE 0.076 0.045 0.048 0.083 0.002 0.046 0.095 0.011 0.092 0.23212 CEO_IS_CHAIR 0.024 0.011 0.044 0.010 0.018 0.018 0.037 0.035 0.039 0.065 0.16313 INSTITUTIONAL_OWNERSIHP 0.004 0.180 0.078 0.168 0.135 0.072 0.062 0.080 0.091 0.213 0.161 0.04814 LOG_MVE 0.091 0.174 0.007 0.225 0.092 0.167 0.119 0.162 0.328 0.654 0.304 0.128 0.38815 BM 0.022 0.061 0.012 0.086 0.022 0.056 0.065 0.049 0.004 0.050 0.083 0.010 0.060 0.25616 LEVERAGE 0.016 0.042 0.042 0.019 0.086 0.024 0.000 0.036 0.054 0.122 0.042 0.077 0.056 0.113 0.05517 ISSUANCE 0.013 0.056 0.050 0.004 0.076 0.010 0.010 0.020 0.108 0.118 0.036 0.012 0.003 0.036 0.066 0.32118 ROA 0.007 0.004 0.013 0.013 0.005 0.006 0.004 0.001 0.059 0.094 0.060 0.029 0.082 0.156 0.039 0.020 0.068

This table provides Pearson correlation coefficients for primary variables. The sample period is from 2001 through 2008. We obtain measures of director independence, expertise and status from BoardEx and anirregularity sample made up of (1) violation years from SEC and Department of Justice enforcement actions that establish intent under Section 17(a) of the Securities Act of 1933, or either Section 10(b) (includingRule 10b-5) or 13(b)(5) of the Securities Exchange Act of 1934 per the Federal Securities Regulation Database and (2) class period years related to settled securities class-action lawsuits that allege violations ofGenerally Accepted Accounting Principles per RiskMetrics. Variable definitions are provided in Appendix A. Bolded coefficients are significant at the 10 percent level.

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P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 2173.4. Results audit committee status and status differential

3.4.1. Audit committee statusWe begin by investigating the role of audit committee financial expertise in explaining audit committee status. In this

initial model, we include controls for executive and independent director (non-audit committee) status. We also include ourcontrol variables from our main model of interest, Eq. (3), which is presented later. Model 1 is specified:

ProbSTATUS_ACt 1 F01 EXPERTISEt2 STATUS_CEO=CFOt3 STATUS_DIRECTORt4 AC_SIZEt5 BOARD_SIZEt6 BOARD_INDEPENDENCEt7 CEO_IS_CHAIRt8 INSTITUTIONAL_OWNERSHIPt9 LOG_MVEt10 BMt11 LEVERAGEt12 ISSUANCEt13 ROAtYear Fixed Ef f ects Industry Fixed Ef f ects 1

The dependent variable, STATUS_AC, is set to one for firm-years with high audit committee status. Results for Eq. (1) arepresented in the first two columns of Table 3. Column (1) reveals that the percentage of audit committee financial expertise(EXPERTISE) is positively associated with audit committee status (STATUS_AC). However, the negative and significantcoefficient in column (2) on ACCOUNTING_EXPERTISE is consistent with accounting experts lowering audit committee status.Additionally, the positive and significant coefficients in column (2) on SUPERVISORY_EXPERTISE and FINANCE_EXPERTISEsuggest that supervisory and finance experts raise audit committee status. The results are also consistent with the status ofexecutives and other independent directors being positively associated with audit committee status, evidenced by positiveand significant coefficients on STATUS_CEO/CFO and STATUS_DIRECTOR. Thus, the same firms attract both high statusdirectors and executives.

3.4.2. Status differentialBecause our main interest is how relative audit committee status interacts with financial expertise in deterring

irregularities, we also investigate whether financial expertise and the types of financial expertise affect relative auditcommittee status. To do this, we replace the status measures in model (1) with our relative status measures. Model 2 isspecified as follows:

ProbSTATUS_DIFFERENTIALt 1 F01 EXPERTISEt2 STATUS_DIFFERENTIAL_DIRECTORt3 AC_SIZEt4 BOARD_SIZEt5 BOARD_INDEPENDENCEt6 CEO_IS_CHAIRt7 INSTITUTIONAL_OWNERSHIPt8 LOG_MVEt9 BMt10 LEVERAGEt11 ISSUANCEt12 ROAtYear Fixed Ef f ects Industry Fixed Ef f ects 2

The dependent variable, STATUS_DIFFERENTIAL, is set to one for firm-years where relative audit committee status is high.Results from Eq. (2) are presented in the third and fourth columns of Table 3. The results are consistent with accountingexperts decreasing relative status, and supervisory and finance experts increasing relative status. The positive, significantcoefficient on STATUS_DIFFERENTIAL_DIRECTOR suggests that companies where the relative status of independent, non-auditcommittee directors is high also have high relative audit committee status. This is consistent with the same firms attractinghigh status directors both on the audit committee and for other board positions.

3.4.3. Changes in audit committee status and status differentialFinally, we confirm that status differential decreased based on the increase in both the percentage of independent

directors and accounting experts over the sample period. Specifically, we regress the difference in STATUS_DIFFERENTIALbetween the final firm-year versus the initial firm-year on the difference between the final firm-year versus the initial firm-year in BOARD_INDEPENDENCE, ACCOUNTING_EXPERTISE, SUPERVISORY_EXPERTISE and FINANCE_EXPERTISE. The coefficientson the difference in BOARD_INDEPENDENCE and ACCOUNTING_EXPERTISE are negative and significant, both with one-tailedp-values of less than 0.04 (untabulated). This is consistent with increased director independence and audit committeeaccounting expertise lowering the relative status of the audit committee.

4. Empirical results

4.1. Accounting irregularities, financial expertise and status differential

4.1.1. Accounting irregularitiesWe next examine the relation between financial expertise, relative audit committee status and irregularities. The model

controls for major incentives for managers to misreport financial results, including debt and equity offerings, size, growthprospects and leverage (see Dechow et al., 2011; Kim and Skinner, 2012), as well as corporate governance variables related

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230218Table 3Effect of audit committee financial expertise on audit committee status and relative status.

Logistic regressions, dependent variable is STATUS_AC for (1) and (2) and STATUS_DIFFERENTIAL for (3) and (4)

Independent variables Predicted sign (1) (2) (3) (4)

EXPERTISE ? 0.2352* 0.5073***

(0.134) 0.1055ACCOUNTING_EXPERTISE 1.1767*** 0.6767***

(0.203) (0.161)SUPERVISORY_EXPERTISE 0.1876* 0.3519***to monitoring the financial reporting process (see Dechow et al., 2011; Dechow et al., 1996; Klein, 2002). Model 3 is specifiedas follows:

ProbIRREGULARITYt 1 F01 EXPERTISEt2 EXPERTISEtnSTATUS_DIFFERENTIALt3 STATUS_DIFFERENTIALt4 STATUS_DIFFERENTIAL_DIRECTORt5 AC_SIZEt6 BOARD_SIZEt7 BOARD_INDEPENDENCEt8 CEO_IS_CHAIRt9 INSTITUTIONAL_OWNERSHIPt10 LOG_MVEt11 BMt12 LEVERAGEt13 ISSUANCEt14 ROAtYear Fixed Ef f ects Industry Fixed Ef f ects 3

(0.135) (0.112)FINANCE_EXPERTISE ? 1.1810*** 0.7973***

(0.169) (0.145)STATUS_CEO/CFO 0.3484*** 0.3094***

(0.109) (0.109)STATUS_DIRECTOR 0.4697*** 0.4438***

(0.074) (0.074)STATUS_DIFFERENTIAL_DIRECTOR 1.305*** 1.300***

(0.060) (0.060)AC_SIZE 0.1727*** 0.1666*** 0.085*** 0.071***

(0.031) (0.031) (0.028) (0.028)BOARD_SIZE ? 0.0282* 0.0234 0.0189 (0.016)

(0.015) (0.015) (0.012) (0.012)BOARD_INDEPENDENCE ? 0.1425 0.1637 1.4101*** (1.400)***

(0.292) (0.293) (0.234) (0.234)CEO_IS_CHAIR 0.0422 0.0512 0.2907*** (0.295)***

(0.070) (0.070) (0.058) (0.058)INSTITUTIONAL_OWNERSHIP 0.1612* 0.1398 0.0902 0.086

(0.114) (0.114) (0.093) (0.093)LOG_MVE 0.2731*** 0.2654*** 0.1125*** 0.109 ***

(0.027) (0.028) (0.021) (0.022)BM ? 0.0252 0.0276 0.0862* (0.088)*

(0.065) (0.066) (0.052) (0.052)LEVERAGE ? 0.2598 0.2414 0.0002 0.000

(0.173) (0.173) (0.144) (0.144)ISSUANCE ? 0.1227** 0.1161** 0.0704 0.072

(0.055) (0.055) (0.046) (0.046)ROA ? 0.0673 0.0629 0.0133 (0.009)

(0.049) (0.042) (0.020) (0.021)

Year Fixed Effects? Yes Yes Yes YesIndustry Fixed Effects? Yes Yes Yes YesObs. where STATUS_AC/STATUS_DIFFERENTIAL1 2,988 2,988 4,770 4,770Total obs. 29,073 29,073 29,073 29,073Pseudo-R2 0.10 0.11 0.13 0.13

This table reports the results of a logistic regression examining the effect of audit committee expertise on the likelihood of high audit committee status orrelative status based on the following model:

ProbSTATUS_ACt=STATUS_DIFFERENTIALt 1 F1EXPERTISEt0CONTROLS

STATUS_AC is an indicator variable that is set to one when the audit committee has high status, and zero otherwise. STATUS_AC is the dependent variable forcolumns (1) and (2). STATUS_DIFFERENTIAL is an indicator variable that is set to one when relative audit committee status is high, and zero otherwise.STATUS_DIFFERENTIAL is the dependent variable for columns (3) and (4). Columns (1) and (3) include EXPERTISE, which includes accounting, supervisoryand finance expertise. Columns (2) and (4) include ACCOUNTING_EXPERTISE, SUPERVISORY_EXPERTISE, and FINANCE_EXPERTISE, which measure the percentof the audit committee with accounting, supervisory and finance expertise, respectively.

The sample period is from 2001 through 2008. We obtain measures of director independence, expertise and status from BoardEx. Variable definitions areprovided in Appendix A. Standard errors clustered by firm are in parentheses. Pseudo-R-square is the max re-scaled R-square from SAS (also known asCragg & Uhler's pseudo-R-square). *, ** and *** represent statistical significance at the 10%, 5% and 1% levels, respectively, using a one-tailed test where thecoefficient sign is consistent with the predicted direction.

The dependent variable, IRREGULARITY, is set to one for firm-years associated with an irregularity (i.e., the years of theclass period for a class-action lawsuit and the violation years associated with SEC and Department of Justice EnforcementActions). The first two columns of Table 4 Panel A present results of Eq. (3). In column (1), the insignificant coefficient onEXPERTISE suggests financial expertise on its own is not associated with irregularities. However, in column (2) theEXPERTISEnSTATUS_DIFFERENTIAL coefficient is negative and significant. To put these results in economic perspective, theresults from column (2) suggest that firm-years with audit committees that have high relative status and audit committeefinancial expertise one standard deviation above the mean are 0.3 percentage points less likely to have an irregularitycompared to those with audit committee financial expertise one standard deviation above the mean but without highrelative audit committee status. This represents approximately 10.7 percent of the 2.6 percent unconditional probability of

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 219an irregularity.12

One potential measurement problem in this study deals with the intersection of audit committee status and quality.Status enhances quality by empowering the group based on the respect of others, while financial expertise andindependence are components of audit committee quality. Although these constructs are different, it is possible that ourmeasure of relative status serves as an indirect proxy for quality. Our sub-measures of status (elite education and number ofpublic and private board memberships) likely reflect higher ability, reinforcing concerns that we capture audit committeequality. This is one reason for our focus on the relative rather than absolute status of the audit committee. By comparing theattributes of the audit committee to the firm's management (rather than other audit committees), we measure the statusdifferential between the audit committee and management, rather than the raw ability or quality of the audit committee.

Nevertheless, our design does not perfectly control for quality as status differential may be correlated with raw auditcommittee status. To provide evidence that our relative status measure is not simply capturing quality, we use our measureof high status audit committees (STATUS_AC) in addition to our measure of relative audit committee status (STATUS_DIFFER-ENTIAL). STATUS_AC should reflect audit committee quality because high quality members would likely hold more boardseats and have more elite education.

After controlling for audit committee status, the coefficient on the interaction between relative audit committee statusand financial expertise remains negative and significant as reported in columns (3) and (4) of Table 4 Panel A. Additionally,the coefficient on audit committee status is insignificant, and, in column (4), the coefficient on the interaction of auditcommittee status and audit committee financial expertise is insignificant. These results are consistent with statusdifferential, rather than absolute status (which is likely to be reflective of quality), being an important influence onfinancial reporting outcomes. This is consistent with our measure of relative audit committee status having constructvalidity with results not being driven by audit committee quality. This supports H1 and is consistent with the propositionthat relative audit committee status interacts with financial expertise to deter accounting irregularities.13

4.1.2. Falsification test error-based restatementsTo rule out the potential for false positives, we investigate the relation between financial expertise, relative audit

committee status and error-based restatements. Error-based restatements reflect unintentional misapplications of U.S. GAAPas opposed to intentional misapplications (see Hennes et al., 2008). Such technical financial reporting errors are unlikely tobe caught by the audit committee if the external auditor did not find the error. Thus, relative audit committee status wouldnot be expected to interact with financial expertise to deter error-based restatements. The model is identical to Eq. (3) withthe exception of the dependent variable. Model 4 is specified as follows:

ProbERRORt 1 F01 EXPERTISEt2 EXPERTISEtnSTATUS_DIFFERENTIALt3 STATUS_DIFFERENTIALt4 STATUS_DIFFERENTIAL_DIRECTORt5 AC_SIZEt6 BOARD_SIZEt7 BOARD_INDEPENDENCEt8 CEO_IS_CHAIRt9 INSTITUTIONAL_OWNERSHIPt10 LOG_MVEt11 BMt12 LEVERAGEt13 ISSUANCEt 14 ROAtYear Fixed Ef f ects Industry Fixed Ef f ects 4

The dependent variable, ERROR, is set to one for firm-years with an accounting misstatement identified as an error byAudit Analytics. The fifth and sixth columns of Table 4 Panel A presents results of Eq. (4). Column (5) reveals that thecoefficient on EXPERTISE is insignificant. In column (6), the coefficient on EXPERTISEnSTATUS_DIFFERENTIAL is negative andinsignificant.14 This suggests that audit committee financial expertise as well as relative audit committee status interacted

12 Marginal effects are computed using the average of discrete or partial changes over all observations (Bartus, 2005), but the interaction effect isadjusted as described in Norton et al. (2004). Norton et al. (2004) suggest a correction for examining interaction effects of non-linear models by consideringthe cross-partial derivative of the expected value of the dependent variable. Using the Norton et al. (2004) correction, the marginal effect ofEXPERTISEnSTATUS_DIFFERENTIAL is 0.025 with a one-tailed p-value less than 0.08.The 0.3 percent marginal effect for column (2) of Table 4 Panel Awas computed by adding the marginal effect of STATUS_DIFFERENTIAL (0.004) to the marginal effect of EXPERTISEnSTATUS_DIFFERENTIAL (0.025)multiplied by 0.283 (i.e., the standard deviation of EXPERTISE).

13 Year Fixed Effects are included to control for the time trend in both STATUS_DIFFERENTIAL and IRREGULARITY. If Year Fixed Effects are omitted, thecoefficient of interest becomes more negative and more statistically significant. Additionally, results are robust when separately estimating Eq. (3), with andwithout Year Fixed Effects, for years 2001 through 2005 and for years 2006 through 2008.

14 Firm-years where IRREGULARITY1 are removed from this analysis. However, inferences remain the same if we include these firm-years.

Table 4Panel A: Effect of the interaction of audit committee financial expertise and relative status on irregularities and errors.

Logistic regressions, dependent variable is IRREGULARITY for (1) through (4) and ERROR for (5) and (6)

Independent variables Predicted sign (1) (2) (3) (4) (5) (6)

EXPERTISE ? 0.0323 0.1522 0.1531 0.1424 0.3087 0.2236(0.243) (0.253) (0.253) (0.262) (0.271) (0.281)

EXPERTISE*STATUS_DIFFERENTIAL /? 0.9240** 0.9149** 0.9625** 0.5792(0.532) (0.530) (0.476) (0.756)

STATUS_DIFFERENTIAL ? 0.1443 0.1681 0.1111 0.1128 0.0324 0.0147(0.140) (0.139) (0.141) (0.139) (0.224) (0.225)

STATUS_DIFFERENTIAL_DIRECTOR ? 0.2056 0.2078 0.1961 0.1959 0.2346 0.2324(0.159) (0.158) (0.158) (0.158) (0.234) (0.234)

AC_SIZE ? 0.0712 0.0724 0.0761 0.0761 0.0780 0.0770(0.063) (0.063) (0.063) (0.063) (0.082) (0.082)

BOARD_SIZE ? 0.0412 0.0403 0.0398 0.0399 0.0548 0.0546(0.029) (0.029) (0.029) (0.029) (0.034) (0.034)

BOARD_INDEPENDENCE /? 1.2596** 1.2407** 1.2524** 1.2514** 0.2607 0.2602(0.552) (0.549) (0.548) (0.548) (0.708) (0.707)

CEO_IS_CHAIR /? 0.0553 0.0570 0.0548 0.0545 0.0873 0.0874(0.135) (0.134) (0.134) (0.134) (0.163) (0.163)

INSTITUTIONAL_OWNERSHIP /? 0.3739** 0.3841** 0.3835** 0.3819** 0.6672** 0.6624**(0.221) (0.220) (0.220) (0.220) (0.306) (0.306)

LOG_MVE /? 0.3922*** 0.3908*** 0.3854*** 0.3855*** 0.0844 0.0848(0.050) (0.050) (0.050) (0.050) (0.061) (0.061)

BM ? 0.3208*** 0.3183*** 0.3168*** 0.3168*** 0.0249 0.0249(0.111) (0.112) (0.112) (0.112) (0.092) (0.092)

LEVERAGE ? 0.6057** 0.6016** 0.5916** 0.5936** 0.1066 0.1061(0.296) (0.296) (0.296) (0.296) (0.441) (0.440)

ISSUANCE ? 0.2808*** 0.2784*** 0.2767*** 0.2765*** 0.0422 0.0402(0.104) (0.104) (0.104) (0.104) (0.150) (0.150)

ROA ? 0.0269 0.0264 0.0243 0.0242 0.0173 0.0182(0.036) (0.038) (0.041) (0.042) (0.123) (0.126)

EXPERTISE*STATUS_AC ? 0.132(0.632)

STATUS_AC ? 0.171 0.167(0.157) (0.158)

Year Fixed Effects? Yes Yes Yes Yes Yes YesIndustry Fixed Effects? Yes Yes Yes Yes Yes YesObs. where IRREGULARITY/ERROR 1 743 743 743 743 273 273Total obs. 29,073 29,073 29,073 29,073 28,330 28,330Pseudo-R2 0.12 0.12 0.12 0.12 0.03 0.03

This table reports the results of a logistic regression examining the effect of the interaction of audit committee financial expertise and relative auditcommittee status on the likelihood of an irregularity or error based on the following model:

ProbIRREGULARITYt=ERRORt 1 F1 EXPERTISEt2 EXPERTISEtnSTATUS_DIFFERENTIALt3 STATUS_DIFFERENTIALt0CONTROLS

We obtain an irregularity sample made up of (1) violation years from SEC and Department of Justice enforcement actions that establish intent underSection 17(a) of the Securities Act of 1933, or either Section 10(b) (including Rule 10b-5) or 13(b)(5) of the Securities Exchange Act of 1934 per theFederal Securities Regulation Database and (2) class period years related to settled securities class-action lawsuits that allege violations of GenerallyAccepted Accounting Principles per RiskMetrics. IRREGULARITY is the dependent variable for columns (1) through (4). ERROR is an indicator variableequal to one for misstated years where Audit Analytics identifies the associated restatement as resulting from an error. ERROR is the dependentvariable for columns (5) and (6), and for these columns we exclude firm-years where IRREGULARITY1. We obtain measures of directorindependence, expertise and status from BoardEx.

The sample period is from 2001 through 2008. Variable definitions are provided in Appendix A. Standard errors clustered by firm are in parentheses.Pseudo-R-square is the max re-scaled R-square from SAS (also known as Cragg & Uhler's pseudo-R-square). *, ** and *** represent statisticalsignificance at the 10%, 5% and 1% levels, respectively, using a one-tailed test where the coefficient sign is consistent with the predicted direction.

Panel B: Effect of the interaction of audit committee financial expertise and relative status on irregularities test of endogeneity

OLS regression, where dependent variable is Logistic regression, where dependentvariable is

Independent variables PredictedSign STATUS_DIFFERENTIAL EXPERTISE

STATUS_DIFFERENTIAL*

EXPERTISEIRREGULARITY

MSA ?/ /? 0.0221*** 0.0253*** 0.0029(0.008) (0.007) (0.002)

ADMIRED /?/? 0.0088*** 0.0005 0.0007(0.003) (0.003) (0.001)

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230220

Table 4 (continued )

Panel B: Effect of the interaction of audit committee financial expertise and relative status on irregularities test of endogeneity

OLS regression, where dependent variable is Logistic regression, where dependentvariable is

Independent variables PredictedSign STATUS_DIFFERENTIAL EXPERTISE

STATUS_DIFFERENTIAL*

EXPERTISEIRREGULARITY

MSA*ADMIRED ?/?/? 0.0031 0.0025 0.0011(0.005) (0.004) (0.001)

EXPERTISE ? 0.1384(0.253)

EXPERTISE*STATUS_DIFFERENTIAL 0.9107**(0.536)

STATUS_DIFFERENTIAL ? 0.1507(0.140)

STATUS_DIFFERENTIAL_DIRECTOR /?/?/? 0.2294*** 0.0288*** 0.0154*** 3.7691(0.012) (0.007) (0.004) (4.117)

AC_SIZE /?/?/? 0.0107*** 0.0158*** 0.0007 0.4552(0.003) (0.003) (0.001) (0.485)

BOARD_SIZE ? 0.0017 0.0014 0.0001 0.0402(0.001) (0.001) (0.000) (0.040)

BOARD_INDEPENDENCE ?/?/?/ 0.1603*** 0.0472* 0.0027 1.8571(0.029) (0.026) (0.009) (3.043)

CEO_IS_CHAIR /?/?/ 0.0363*** 0.0123** 0.0038* 0.5644(0.007) (0.006) (0.002) (0.664)

INSTITUTIONAL_OWNERSHIP ?/?/?/ 0.0150 0.0694*** 0.0032 0.5005(0.013) (0.010) (0.004) (1.349)

LOG_MVE /?/?/ 0.0168*** 0.0340*** 0.0037*** 0.5729**(0.003) (0.002) (0.001) (0.298)

BM ? 0.0040 0.0105*** 0.0005 0.5907(0.004) (0.004) (0.001) (0.422)

LEVERAGE ? 0.0072 0.0901*** 0.0124** 1.4496(0.018) (0.016) (0.006) (0.956)

ISSUANCE ? 0.0078 0.0181*** 0.0017 0.5449(0.006) (0.005) (0.002) (0.660)

ROA ? 0.0013 0.0068 0.0001 0.1241(0.003) (0.005) (0.001) (0.168)

ERROR_TERM_1ST_COLUMN ? 16.9207(27.807)

ERROR_TERM_2ND_COLUMN ? 14.5590(12.482)

ERROR_TERM_3RD_COLUMN ? 46.1276(143.400)

Year Fixed Effects? Yes Yes Yes YesIndustry Fixed Effects? Yes Yes Yes YesTotal obs. 29,073 29,073 29,073 29,073Joint Test of ERROR_TERM_1ST_COLUMNERROR_TERM_2ND_COLUMNERROR_TERM_3RD_COLUMN0Chi-square 3.510p-Value 0.320

This table reports the results of testing for endogeneity for a logistic regression examining the effect of the interaction of audit committee financialexpertise and relative audit committee status on the likelihood of an irregularity. To test for endogeneity we use OLS regressions and instrumental variables(MSA, ADMIRED andMSA*ADMIRED) as suggested byWooldridge (2010). These regressions are captured in columns (1) through (3). Then, in column (4), thefollowing equation is estimated with the error terms from columns (1) through (3) as control variables:

ProbIRREGULARITYt 1 F1 EXPERTISEt2 EXPERTISEtnSTATUS_DIFFERENTIALt3 STATUS_DIFFERENTIALt0CONTROLS

MSA is an indicator that is equal to one if a firm's headquarters is located within the largest ten metropolitan statistical areas based upon the number offirms for year t, and zero otherwise. ADMIRED is the raw score from Fortune's Most Admired Company List, and zero if the firm-year is for a firm not on thelist for year t.

We obtain an irregularity sample made up of (1) violation years from SEC and Department of Justice enforcement actions that establish intent underSection 17(a) of the Securities Act of 1933, or either Section 10(b) (including Rule 10b-5) or 13(b)(5) of the Securities Exchange Act of 1934 per the FederalSecurities Regulation Database and (2) class period years related to settled securities class-action lawsuits that allege violations of Generally AcceptedAccounting Principles per RiskMetrics. We obtain measures of director independence, expertise and status from BoardEx.

The sample period is from 2001 through 2008. Variable definitions are provided in Appendix A. Standard errors clustered by firm are in parentheses.Pseudo-R-square is the max re-scaled R-square from SAS (also known as Cragg & Uhler's pseudo-R-square). *, ** and *** represent statistical significance atthe 10%, 5% and 1% levels, respectively, using a one-tailed test where the coefficient sign is consistent with the predicted direction.

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 221

with audit committee financial expertise are unrelated to accounting errors and only affect intentional intervention in theearnings process.

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 2082302224.1.3. EndogeneityIt is possible that our results are due to the self-selection of audit committee members at firms with high financial

reporting risk. Due to personal risks in terms of reputation and legal liability, high status individuals may be unlikely toaccept an audit committee role in a firm where management has a questionable reputation or may leave a firm when anaccounting irregularity is detected (Beasley et al., 2009). Thus, low status audit committees may be matched with managerswho are more likely to commit an irregularity, leading to our results.

This concern is tempered by our focus on relative rather than absolute audit committee status. Before an irregularity,firms with high financial reporting risk likely have lower status managers because they are less attractive employmentoptions. Thus, even if these firms attract lower status audit committees, it is not clear relative status would be affected. Inaddition, after an irregularity, managers lose their positions at a very high rate (Karpoff et al., 2008a) and thus the status ofthe executives is likely to fall. Thus, even if high status audit committee members leave a firm after an irregularity, it is againunclear that relative status would be affected.

As this concern relates to the selection of audit committee members at firms, adding firm fixed effects would helpaddress the issue because this would control for any firm characteristic that did not change over our sample period(Bebchuk et al., 2009). Given our eight-year sample period (due to data constraints), it seems unlikely that firmcharacteristics would change substantially. Unfortunately, we cannot perform this analysis for irregularities due toinsufficient variation in the dependent variable. Instead we utilize an instrumental variable approach, with the cautionthat instruments are difficult to identify (see Larcker and Rusticus, 2010).

We address this concern empirically by testing for endogeneity following Wooldridge (2010). We first identifyinstrumental variables for EXPERTISE, STATUS_DIFFERENTIAL and EXPERTISEnSTATUS_DIFFERENTIAL. Our first instrument,MSA, is an indicator that is equal to one if a firm's headquarters is located within the largest ten metropolitan statisticalareas based upon the number of firms in Compustat for year t, and zero otherwise. MSA serves as an instrument forEXPERTISE, as there are likely more financial experts (for example, former chief financial officers who would be qualified asindependent directors) in large metropolitan statistical areas (see Knyazeva et al., 2013). Our second instrument, ADMIRED,is equal to the raw score from Fortune's Most Admired Company List, and zero if the firm-year is for a firm not on the list.ADMIRED serves as an instrument for STATUS_DIFFERENTIAL, as being on the Fortune Most Admired List likely reflectsexecutive status, but is less relevant for director status, which is obtained from outside sources such as the number ofconcurrent board seats. We interact MSA and ADMIRED to instrument for EXPERTISEnSTATUS_DIFFERENTIAL.

Results are presented in Table 4 Panel B. In the first three columns, we estimate ordinary least squares regressions for thethree potentially endogenous variables and capture the error term. We then include the error terms in Eq. (3) as controlvariables. In column (4), the coefficient on EXPERTISEnSTATUS_DIFFERENTIAL remains negative and significant. Additionally,we perform a joint test of whether the three error terms from the first stage regressions equal zero. We find that the threeerror terms are insignificantly different from zero, indicating that the residuals are not related to the dependent variable,suggesting that unobservable characteristics do not drive our results.

In additional (untabulated) tests, we investigate the correlation between the change in audit committee status upon anaudit committee turnover event with year t1 financial reporting risk. These turnover events include either the addition ofa new board member to the audit committee or a member of the audit committee leaving the board. We use the prior year'sfinancial reporting risk because this informationwould be available to a prospective audit committee member at the time heor she made the decision to join or leave the committee. If self-selection explained our results, we would expect to find anegative relation between relative audit committee status change and financial reporting risk because higher statusindividuals would refuse to work at (or would leave) high risk firms, while lower status directors would not have betteralternatives and would therefore be more likely to accept or retain such positions.

Instead, we find an insignificant association between relative audit committee status change and financial reporting risk(which we measure using model (3) without the relative audit committee status-related variables) from the year prior to anaudit committee turnover event. This is inconsistent with a self-selection story based on high relative status auditcommittee members avoiding high irregularity risk firms.15

4.2. Abnormal accruals, financial expertise and status differential

To provide evidence complementary to our irregularity results, we examine the relation between financial expertise,relative audit committee status and signed, abnormal accruals. We use signed abnormal accruals because we expect auditcommittees to function similarly to external auditors with respect to their concern about signed accruals. External auditorsand management tend to disagree about income-increasing rather than income-decreasing earnings management and

15 We also find a positive association between the change in audit committee financial expertise that accompanies audit committee member turnoverand ex ante financial reporting risk. This is consistent with risky firms seeking director candidates with financial expertise when there is an open positionon the audit committee.

auditors generally require their clients to adjust earnings downward rather than upwards (Lennox and Li, 2012, 167). Wecalculate abnormal accruals using the modified-Jones model with an intercept (Kothari et al., 2005). We measureABNORMAL_ACCRUALS as the error term for firm i in year t as measured by the following equation estimated by year andtwo-digit Standard Industrial Classification code (requiring ten firm-year observations per industry):

TOTAL_ACCRUALSit 01n1=ASSETSit12nREVitARit3nPPEit 5

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 223After calculating abnormal accruals, we use the following model, based upon prior literature (e.g., Ashbaugh-Skaife et al.,2008; Dhaliwal et al., 2010; Doyle et al., 2007; Prawitt et al., 2009) to test whether the status differential between auditcommittees and management interacts with audit committee financial expertise to lower signed abnormal accruals:

ABNORMAL_ACCRUALSt 01 EXPERTISEt2 EXPERTISEtnSTATUS_DIFFERENTIALt3 STATUS_DIFFERENTIALt4 STATUS_DIFFERENTIAL_DIRECTORt5 AC_SIZEt6 BOARD_SIZEt7 BOARD_INDEPENDENCEt8 CEO_IS_CHAIRt9 INSTITUTIONAL_OWNERSHIPt10 STDEV_CFOt11 STDEV_SALESt12 FOREIGN_SALESt13 LOG_SEGMENTSt14 EXTREME_GROWTHt15 MERGERt16 RESTRUCTURINGt17 LOG_ASSETSt18 AGGREGATE_LOSSt19 SHUMWAYt20 BIG4t21 LEVERAGEt22 BMt23 ROAtYear Fixed Ef f ects Industry Fixed Ef f ects 6

Table 5 presents the results of Eq. (6), where the dependent variable is ABNORMAL_ACCRUALS. In column (1), thecoefficient on EXPERTISE is negative and significant, suggesting the percentage of audit committee members with financialexpertise limits abnormal accruals. In column (2), the coefficient on EXPERTISEnSTATUS_DIFFERENTIAL is negative andsignificant. This supports H2 and suggests that the relative status of the audit committee compared to management furtherassists the audit committee in constraining opportunistic financial reporting.16 As an additional test, in column (3) weprovide results after including firm fixed effects. The coefficient on EXPERTISEnSTATUS_DIFFERENTIAL remains negative andsignificant, providing additional support that results are not due to self-selection related to invariant firm characteristics(Bebchuk et al., 2009).17

5. Additional analyses and results

5.1. Specific types of audit committee expertise

Relative audit committee status may interact with specific types of audit committee expertise to deter irregularities. Were-estimate Eq. (3), but replace EXPERTISE with measures of audit committee accounting, supervisory and finance expertise(untabulated). Coefficients on the interactions of accounting and finance expertise with relative status are insignificant.However, the coefficient on the interaction of supervisory expertise and relative status is negative and significant. Thissuggests past experience in a supervisory role (i.e., CEO or president), combined with high relative audit committee status,influences irregularity deterrence. This is consistent with financial literates (such as CEOs) being better than experts (i.e.,accountants) at identifying non-recurring accounting issues (McDaniel et al., 2002).

5.2. Alternative definitions of status differential

We repeat our irregularity analysis with several alternative definitions of status differential. First, we use a variable with arange of zero to three based on the number of status differential sub-measures above the median in favor of the auditcommittee. Results are robust to this specification (one-tailed p-value of 0.006). Second, we add a fourth measure of statusbased on the size decile rank of the largest firmwhere the individual is an officer or director. The logic of this measure is thatit is more prestigious to be associated with larger firms (Boeker, 1997). We then create an alternate indicator variable that isset to one when three of the four sub-measures of status are above the median in the audit committee's favor. Results areagain robust (one-tailed p-value of 0.024). Finally, we perform three sets of factor analyses. We use the status indicatorvariable components that are based upon a median split, decile rankings of the raw status measures and the raw statusmeasures. These analyses produce a negative coefficient on the variable of interest with one-tailed p-values of 0.005, 0.058,and 0.081, respectively.

16 The coefficient on EXPERTISEnSTATUS_DIFFERENTIAL is insignificant if we use absolute abnormal accruals as the dependent variable.17 In untabulated tests, we find that the coefficient on EXPERTISEnSTATUS_DIFFERENTIAL is significant in column (2) if we performance-match accruals

based upon year t return on assets. When we add firm fixed effects to the performance-matched model, the coefficient is insignificant. However, Dechowet al. (2010) note that matching on year t return on assets may result in low power tests because the match is influenced by discretionary accruals. Whenwe match on year t cash-flow performance, the coefficient on EXPERTISEnSTATUS_DIFFERENTIAL is significant regardless of whether we include firm fixedeffects.

Table 5Effect of the interaction of audit committee financial expertise and relative status on abnormal accruals.

OLS regressions, dependent variable is ABNORMAL_ACCRUALS

Independent variables Predicted sign (1) (2) (3)

EXPERTISE 0.0139*** 0.0096** 0.0145*(0.005) (0.005) (0.010)

EXPERTISE*STATUS_DIFFERENTIAL 0.0322*** 0.0406***(0.011) (0.015)

STATUS_DIFFERENTIAL ? 0.0044 0.0034 0.0003(0.003) (0.003) (0.004)

STATUS_DIFFERENTIAL_DIRECTOR ? 0.0042 0.0043 0.0023(0.003) (0.003) (0.005)

AC_SIZE ? 0.0023* 0.0023* 0.0016(0.001) (0.001) (0.002)

BOARD_SIZE ? 0.0010 0.0010 0.0011(0.001) (0.001) (0.002)

BOARD_INDEPENDENCE 0.0167* 0.0164* 0.0093(0.011) (0.011) (0.031)

CEO_IS_CHAIR 0.0033 0.0033 0.0035(0.003) (0.003) (0.005)

INSTITUTIONAL_OWNERSHIP 0.0202*** 0.0204*** 0.0187(0.004) (0.004) (0.013)

STDEV_CFO 0.0024 0.0026 0.0981**(0.040) (0.040) (0.055)

STDEV_SALES 0.0019 0.0017 0.0227(0.010) (0.010) (0.018)

FOREIGN_SALES ? 0.0028 0.0027 0.0057(0.004) (0.004) (0.010)

LOG_SEGMENTS ? 0.0031 0.0032 0.0010(0.003) (0.003) (0.007)

EXTREME_GROWTH 0.0101** 0.0101** 0.0136***(0.005) (0.005) (0.005)

MERGER ? 0.0120** 0.0121** 0.0056(0.006) (0.006) (0.010)

RESTRUCTURING 0.0181 0.0185 0.0221(0.021) (0.021) (0.027)

LOG_ASSETS 0.0134*** 0.0134*** 0.0463***(0.002) (0.002) (0.009)

AGGREGATE_LOSS ? 0.0173*** 0.0174*** 0.0340***(0.004) (0.004) (0.006)

SHUMWAY 0.0021** 0.0021** 0.0038***(0.001) (0.001) (0.001)

BIG4 0.0095** 0.0099** 0.0112(0.005) (0.005) (0.009)

LEVERAGE 0.0613*** 0.0616*** 0.1261***(0.012) (0.012) (0.031)

BM ? 0.0080*** 0.0080*** 0.0095***

(0.002) (0.002) (0.003)ROA 0.0467*** 0.0467*** 0.0742**

(0.018) (0.018) (0.034)

Year Fixed Effects? Yes Yes YesIndustry Fixed Effects? Yes Yes NoFirm Fixed Effects? No No YesTotal obs. 19,807 19,807 19,807R2 0.04 0.04 0.33

This table reports the results of an ordinary least squares regression examining the effect of the interaction of audit committee financial expertise andrelative audit committee status on signed abnormal accruals. The model is

ABNORMAL_ACCRUALSt 01 EXPERTISEt2 EXPERTISEtnSTATUS_DIFFERENTIALt3STATUS_DIFFERENTIALt0CONTROLS

We calculate signed abnormal accruals using the modified-Jones model with an intercept. We obtain measures of director independence, expertise andstatus from BoardEx.

The sample period is from 2001 through 2008. Variable definitions are provided in Appendix A. Standard errors clustered by firm are in parentheses. *, **

and *** represent statistical significance at the 10%, 5% and 1% levels, respectively, using a one-tailed test where the coefficient sign is consistent with thepredicted direction.

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230224

5.3. Relative audit committee chair and independent director status

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230 225A potential limitation is that we can only observe exposed irregularities. Some irregularities may go unrevealed, althoughmany studies assume material frauds are eventually discovered (e.g., Dyck et al., 2010). The possibility that someirregularities go unrevealed could influence results if, for example, higher status audit committees work with managementto cover up an irregularity rather than blowing the whistle or if such audit committees are able to detect fraud earlier andstop it such that SEC or private enforcement is avoided.

We believe this is unlikely for two reasons. First, higher absolute status audit committees have more reputational andfinancial capital at risk than do lower status audit committees, and are likely more skilled as well. However, these argumentsapply more directly to STATUS_AC (which measures absolute audit committee quality) rather than to STATUS_DIFFERENTIAL(which measures the audit committee relative to management). As shown earlier, STATUS_DIFFERENTIAL drives our results.

18 For example, Turley and Zaman (2007) and Bdard and Gendron (2010) discuss the importance of the audit committee chair in ensuring financialreporting quality.Finally, we investigate whether status differential could be a proxy for social ties, board networks or better access toinformation flows. Boards with more connections have more centrality, a concept linked to status. As Davis (1991, 592)states, In addition to providing social capital, centrality indicates a firm's status and the degree to which it is integrated intothe corporate elite. By definition, a more central board is composed of directors who sit on numerous other boards.Centrality could be a concern because our audit committee status measure includes the number of public boardmemberships as a sub-measure (although it is only indirectly incorporated in our measure of status differential becauseof the comparison to the management team).

We examine the effect of access to information based on centrality as measured by the total number of boardconnections the audit committee has to other firms (see Davis, 1991). Audit committees with access to more informationmay be better able to contribute to value-adding corporate policies (e.g., Larcker et al., 2013). In a monitoring context, Omeret al. (2014) find that firms with more board connections experience fewer irregularities. Controlling for the total number ofpublic board connections, we find that higher connections are associated with fewer irregularities (one-tailed p-value lessthan 0.06) and that the interaction between financial expertise and relative status remains negative and significant (one-tailed p-value less than 0.04).

Second, we consider whether the board had an opportunity to learn about accounting irregularities through priorexperience at other firms. The information contagion perspective predicts that directors exposed to specific types ofinformation at one firm are more likely to spread related information or their perspective to other boards on which theyserve. For example, Chiu et al. (2013) find that earnings management is higher when the firm has board members connectedto other firms that engage in earnings management. Thus, we examine the extent to which the audit committee's pastexperience at firms with irregularities influences the likelihood of an irregularity at the focal firm. For this test, we examinewhether an audit committee member sat on the board of an irregularity firm during the prior three years. Our results for theinteraction of audit committee financial expertise and relative status remain robust (one-tailed p-value less than 0.07), andaudit committees that have a member on the board from a prior irregularity firm are positively associated with thelikelihood of an irregularity (one-tailed p-value less than 0.01).

Third, we consider whether management and audit committee members have other ties outside their relationship at thefocal firm. A common theme in the governance literature is that grey directors with ties to management are less intensemonitors (see Duchin et al., 2010). For this test, we examine whether the CEO or CFO sits on the board of another firm withany director who sits on the audit committee of the manager's firm. Our results for the interaction of audit committeefinancial expertise and relative status remain robust (one-tailed p-value less than 0.05), and the presence of at least onemanageraudit committee link is not associated with the likelihood of an irregularity.

5.5. Irregularity detection versus irregularity occurrenceAs we find evidence that relative audit committee status improves the ability of financial experts to constrainirregularities, we also investigate whether relative audit committee chair or non-audit committee independent directorstatus provide similar benefits. As the chair is the leader of the audit committee, the chair's status may matter most indeterring irregularities.18 Similarly, it is possible that high status independent directors who do not sit on the auditcommittee could support the audit committee when confronting management about possible irregularities. In untabulatedresults, we find no evidence that relative audit committee chair status or relative independent, non-audit committeedirector status interact with audit committee financial expertise to deter irregularities. These results provide evidence thataudit committee status as a whole, as compared to audit committee chair or non-audit committee independent directorstatus, is most important in assisting audit committee financial experts in reducing irregularities.

5.4. Status, social ties, networks and information flows

P.G. Badolato et al. / Journal of Accounting and Economics 58 (2014) 208230226Second, the abnormal accrual results provide additional comfort. Even if irregularities were being covered up or detectedearly, some evidence of their presence would likely be apparent in abnormal accruals (see Dechow et al., 2012).

6. Conclusion

This study examines the importance of the interaction of relative audit committee status and financial expertise inconstraining earnings management. Our results suggest that the presence of both relative status and financial expertisedeters earnings management. Thus, our findings imply that increasing audit committee financial expertise is insufficientwithout considering status. In particular, the recent push for more audit committee financial experts may not havede