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Univ. of Toledo College of Law

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Sunday, October 28, 2007

Cunningham on Board Expertise

Rediscovering Board Expertise: Legal Implications of the Empirical Literature, by LAWRENCE A. CUNNINGHAM, George Washington University Law School, was recently posted on SSRN.  Here is the abstract:

This paper reviews and draws insights from recent empirical research in financial accounting on the value of director expertise for financial reporting quality. Among important consequences of Sarbanes-Oxley is an increase in the percentage of accounting experts on boards of directors, particularly on audit committees.

The research reviewed here documents the value of this expertise in promoting financial reporting quality measured in terms of “accounting earnings management” (artificial bookkeeping manipulations). These findings contrast with well-known evidence showing little value arising from director independence.

The research holds numerous implications and raises important questions, including the following:

1. It shows that accounting expertise is more valuable than other kinds of financial expertise, suggesting that the SEC should reconsider its definition of this concept.

2. Although accounting earnings management has declined since SOX, real earnings management (substantive business decisions taken to achieve accounting results, like delaying or accelerating investment in a new plant) may be rising. Do audit committee financial experts have a role to play in policing the latter?

3. What role do such experts have in determining the degree of conservatism that a firm uses in its financial reporting, demand for which may differ as among shareholders, bondholders, employees and others?

4. It is customary to see independence and expertise as trade offs. This may be correct when expertise arises from insider status, but incorrect when the expertise is substantive knowledge in a discipline, such as accounting.

5. Law has traditionally encouraged director independence and discouraged expertise but, this research suggests, that may be backwards and certainly requires reconsideration.

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