The consequences of audit committee quality

Purpose - This study aims to examine the consequences when audit committees have different economic incentives (i.e. incentive-based compensation) to switch auditors. Design/methodology/approach - The author focuses on companies experiencing an auditor switching event (client-initiated dismissals) and uses Heckman’s (1997) two-stage estimation procedure to control endogenous bias. Audit committee quality is measured by the level of incentive-based compensation. Accrual quality and abnormal audit fees are examined over the periods of auditor switches. Findings - Using 1,087 US companies between 2006 and 2014, the author found that audit committees’ incentive-based compensation is negatively (positively) associated with accruals quality (abnormal audit fees) only when companies switch from Big 4 to non-Big 4 auditors or switch within non-Big 4 auditors. For companies that switch from non-Big 4 to Big 4 auditors, she found no evidence. Research limitations/implications - This study provides a detailed discussion of the consequences of audit committee quality. The findings also contribute to the literature by concluding that economic incentives are associated with ineffective oversight, particularly after auditor switches. Practical implications - Sarbanes–Oxley Act and its associated regulations significantly expanded the oversight role of audit committees. However, regulators bypassed restrictions on audit committee compensation. Accordingly, the author suggests that regulators focus on the issue of economic incentives to improve audit committee quality. Originality/value - Minimal research has been conducted on the role of audit committees when companies switch to a new external auditor. The author shows that when companies switch auditors, incentive-based compensation significantly affects the monitoring quality of audit committees.