Board Monitoring, Audit Committee Effectiveness, and Financial Reporting Quality: Review and Synthesis of Empirical Evidence

Although financial reporting quality (FRQ) is not directly observable, prominent commentators claim that they know it when they see it and vigorously assert its importance as a mainstay of modern capital markets. Arthur Levitt, former chairman of the United States Securities and Exchange Commission (SEC), says “high quality accounting standards …improve liquidity [and] reduce capital costs”1 and claims that “quality information is the lifeblood of strong, vibrant markets. Without it, liquidity dries up. Fair and efficient markets cease to exist.”2 Easley and O’Hara [2004] show that the market exacts a premium to compensate investors for such information risk, lending conceptual support to Levitt’s claim. Consensus as to qualitative factors that can reduce FRQ is also emerging. The Senate of Canada [2003, p. 2] says “analysts generally agree that the financial scandals appearing almost daily for months in the media were the result of some combination of at least three factors: failed corporate governance; lax auditing and accounting standards and oversight; and the incentives, at times perverse, provided by executive compensation systems. ” To date, however, the measurement of FRQ has eluded both researchers and those charged with improving it (See Appendix A, Figure 1)