Abstract

     Prior evidence that firms adjust their board structure following accounting restatements suggests that firms expect the board to effectively monitor the firm’s financial accounting system. However, little is known about signals firms use to identify monitoring weaknesses or the types of individuals firms appoint to improve the quality of monitoring. We expand on Ghannam, Bujega, Matolcsy, and Spiropolous (2019)’s evidence that firms appoint directors with accounting experience after financial fraud by investigating whether firms that file restatements or issue highly inaccurate earnings forecasts appoint individuals with CFO experience (i.e., a subset of accounting experts) to their audit committee. We find that firms are more likely to appoint an outside director with CFO experience to the audit committee when they have recently restated earnings and when they have higher prior management forecast error. We also find that the appointment of a CFO outside director to the audit committee is followed by a lower likelihood of restatement and more accurate management forecast. Together, our results suggest that firms respond to accounting failures by appointing outside directors with CFO experience. Thus, we provide insight into the signals firms use to identify weaknesses in the monitoring of the accounting function and the types of expertise firms value in addressing those weaknesses.

Introduction

     Firms regularly release earnings reports and forecasts that are used by the investing public and other outside stakeholders to evaluate management performance, assess investing risk, and project future cash flows. Given the importance on such public disclosures, understanding how a firm adjusts its governance system to monitor its accounting system and ensure that the firm issues reliable earnings reports and forecasts is a key public policy issue. Farber (2005) documents changes to board structure and practices following restatements, Arthaud-Day et al. (2006) document increased turnover for CFOs and CEOs following restatements, and Srinivasan (2005) documents similar increases in turnover for board members. While these papers show that firms consider the board to be an important monitor of the financial reporting function, there is limited evidence regarding how boards identify monitoring weaknesses or the type of individual boards consider important in addressing those weaknesses. Ghannam et al. (2019) provide evidence on this question by showing that firms appoint directors with an accounting background, legal background or board experience following the revelation of fraud. In this study, we expand on their findings by considering whether earnings restatements (in general) or inaccurate forecasts are indicators that monitoring of the financial reporting function needs improvement and whether firms tend to appoint an outside director with Chief Financial Officer (CFO) experience to the audit committee to address that weakness.1 Our evidence provides additional insight into the way firms adjust their board structure to improve their monitoring effectiveness after issuing potentially misleading earnings reports or forecasts.

Conclusion

     A key public policy issue revolves around adjustments firms make to their governance structure following deficiencies in their financial reporting system that produced poor quality earnings reports and forecasts. Given the evidence that board turnover increases following earnings restatements and that boards appoint directors with accounting expertise following the revelation of fraud, it isn’t clear the types of signals firms use to identify weaknesses in their financial reporting system and the types of experience boards consider to be most important in improving the firm’s monitoring of the financial reporting function. In this paper, we provide insight into these issues by examining whether firms respond to earnings restate ments (both intentional and unintentional) and inaccurate forecast issuances by appointing an outside director with CFO experience to the audit committee and whether the appointment of such individual leads to a lower incidence of future restatements and improvements in forecast accuracy.

     We find that firms that have recently filed a restatement or issued inaccurate management forecasts are more likely to appoint an outside director with CFO experience to their audit committee. This evidence is consistent with firms appointing an individual with CFO experience to their board to address perceived weaknesses in their accounting systems. We also find evidence that appointing an outside director with CFO experience to an audit committee is associated with a lower likelihood of a restatement filing and more accurate management forecasts in the future. We also find that having an accounting background further improves a CFO outside director’s effectiveness regarding restatements, but not with management forecast error. Therefore, an accounting background appears to help more with monitoring compliance with GAAP than with projections of future earnings.