In today’s rapidly evolving corporate governance landscape, the role of audit committees in overseeing financial reporting has never been more important. Recent regulations, such as the updated Compliance & Disclosure Interpretations (“C&DIs”), have emphasized the need for audit committees to ensure the integrity of both GAAP and non-GAAP disclosures. In a recent study, I explore the relationship between the quality of non-GAAP disclosures and the number of external directorships held by a firm’s independent audit committee chair (ACC).

The Importance of Non-GAAP Disclosures

Non-GAAP disclosures are financial measures not defined by generally accepted accounting principles (GAAP) and have gained prominence as companies seek to provide more relevant information to investors. These measures often exclude items deemed non-recurring, infrequent, or unusual, aiming to present a clearer picture of a company’s performance. However, the discretion involved in defining non-GAAP earnings can lead managers to exclude important information, potentially misleading investors.

The Influence of Audit Committee Chairs

The ACC plays a pivotal role in the committee’s effectiveness, acting as a liaison among the board, management, and auditors. Research suggests that ACCs who serve as directors on multiple boards may bring a wealth of experience and reputational capital, motivating them to enforce stricter oversight and enhance disclosure quality. My study examines how the number of external directorships held by ACCs influences the quality of non-GAAP disclosures.

Key Findings

My analysis reveals that firms with ACCs who hold more external directorships tend to provide higher quality non-GAAP disclosures. The study measures the quality of these disclosures by examining their persistence – less persistent exclusions of information are considered higher quality. The findings indicate that non-GAAP exclusions are more transitory (of higher quality) when the ACC has at least one director serving on another company’s board. Additionally, these firms are less likely to engage in aggressive reporting, with smaller non-GAAP exclusions that are more closely aligned with those endorsed by analysts.

The Reputation Cost Perspective

The results of the study are consistent with the reputation-cost perspective. ACCs who serve on multiple boards face greater risks to their reputation, which gives them an incentive to enforce strong monitoring and high-quality disclosures. This perspective is grounded in agency theory, which posits that independent directors seek to build reputations as effective monitors to secure additional directorships. The enhanced scrutiny and effort these ACCs bring to their roles help ensure that non-GAAP measures are used appropriately, thereby protecting their reputational capital.

Practical Implications for Corporate Governance

My findings have significant implications for corporate governance practices and policymaking. For companies, appointing ACCs with multiple external directorships can be a strategic move to enhance the quality of financial disclosures and bolster investor confidence. For regulators, understanding the dynamics of ACCs’ external directorships can inform policies that encourage high-quality non-GAAP reporting.

Moreover, the study suggests that there is a diminishing return to the benefits of external directorships. While having one or two external directorships significantly enhances non-GAAP disclosure quality, additional directorships beyond this point do not confer the same benefits and may even lead to the ACC being overextended, aligning with the “busyness” perspective.

This post comes to us from Professor Cheng-Hsun Lee at National Kaohsiung University of Science and Technology, Taiwan. It is based on his recent paper, “Non-generally accepted accounting principles disclosures and audit committee chairs’ external directorships,” published in the Journal of Business Finance & Accounting and available here.