The Quality of Audit Committees Post Enron
Wednesday, 21 June 2006
School of Accountancy, Law and Finance
Unitec Institute of Technology
A number of empirical studies have considered the impact of the collapse
of Enron from a number of research perspectives. Logically, a number of these
studies are United States (US) based but the ramifications of the collapse were felt
worldwide. This study extends this area of research and examines one aspect of
the collapse of Enron from a New Zealand (NZ) perspective.
This study examines the effect of the Enron collapse on the composition of
audit committees of NZ listed companies. The research design includes a sample
that covers two periods. The first period covers balance dates from 1 January 2001
to 31 December 2001, the pre-Enron period. The second period covers balance
dates in the 2003 calendar year, the post-Enron period. In both periods, companies
listed on the New Zealand Exchange Limited (NZX) were not required to comply
with corporate governance best practices for audit committees and yet many did.
The results indicate that firms did voluntary improve the membership of
audit committees in response to the Enron collapse and subsequent calls for
improvements in corporate governance. The analysis indicates that the probability
of a firm meeting recommended membership criteria for audit committees
increased from 2001 to 2003., However, during this period not all listed
companies established audit committees and those that did still a high proportion
did not meet overseas best practice no doubt prompting regulatory changes from
the New Zealand Securities Commission (NZSC) and NZX.
Sincere thanks to my PhD supervisors and to Josefino San Diego, Shane Moriarity and Lyndon
Walker. Thanks to discussant (Chris van Stadem) and participants at the Auckland Region
Accounting Conference. Research support from Unitec and the New Zealand Institute of Chartered
Accountant is acknowledged.
Keywords: audit committees, corporate governance regulation, Enron collapse
This study examines the effect of the Enron collapse on the membership of
audit committees of NZ listed companies. Enron collapsed in December 2001
with subsequent investigations highlighting a number of corporate governance
and financial reporting issues. 2 These findings prompted legislators and regulators
in the US and internationally, to take action to restore confidence in capital
markets by suggesting improvements in the quality and monitoring of financial
reports of listed companies.3
In response to Enron’s collapse interested parties in NZ explored a range of
issues including the standard of corporate governance in the NZ business
environment.4 In May 2003, the New Zealand Stock Exchange (NZSE) (later
restructured to the New Zealand Exchange Limited (NZX)) released
recommendations for corporate governance. In announcing the changes, Mark
Weldon the NZSE CEO stated:
Corporate governance is widely recognised as an important tool for
improving accountability, transparency and certainty and if we are to be
successful in attracting foreign investment back into the New Zealand
market, we must be seen to uphold the appropriate standards (NZX, 2003a,
Investigations included the Special Investigative Committee of the Board of Directors of Enron
Corporation (2002) and the Permanent Subcommittee on Investigations of the Committee of
Government Affairs of the United States Senate (2002).
Overseas investigations included ones in the United Kingdom (Financial Reporting Council
(FRC) 2002), the European Union (European Commission 2002) and in Australia (Commonwealth
of Australia 2002).
The catalyst was the New Zealand Institute of Chartered Accountants (formerly the Institute of
Chartered Accountants of New Zealand (ICANZ)) which set up a working party to review
corporate governance issues for the NZ business environment arising from the Enron and
A final Corporate Governance Best Practice Code was included in NZ
listing requirements in October 2003 (NZX, 2003).
The New Zealand Securities Commission (NZSC) also considered that NZ
must take note of corporate governance practice internationally. The NZSC
chairman, Jane Diplock, commented that “for credibility in global markets, New
Zealand needs to be rigorously reviewing its own policies and practices - and to
be recognised as doing this” (NZSC, 2003, p.1). In 2004, the NZSC published
Corporate Governance Principles and Practice to “increase the integrity of the NZ
securities markets and make them more attractive to investors” (NZSC, 2004, p.1)
The NZX and NZSC codes imposed changes in the membership of audit
committees with the aim of improving the monitoring and quality of financial
reporting. This study investigates whether, during the period between the Enron
bankruptcy and the issuing of new regulations, NZ companies were influenced to
voluntarily improve corporate governance practices. In addition, the study
identifies the characteristics of companies that did improve their practices.
Specifically, the purpose of the study is to answer two questions:
(1) Did NZ listed companies voluntarily improve the membership of
audit committees to correspond with overseas recommendations,
subsequent to the collapse of Enron but prior to new regulation? and,
(2) If so, what were the characteristics of NZ listed companies that
improved the membership of audit committees, subsequent to the
collapse of Enron?
To answer these questions, the study uses pre- and post-Enron samples from
periods when there were no regulations in New Zealand regarding the formation
and composition of audit committees.
The results of the study show that the probability of firms changing audit
committee membership to meet overseas-recommended criteria, as reflected by
the NZSC (2004) principles, improved significantly, subsequent to the collapse of
Enron. Of the sample of listed companies, 25 of the 88 companies (28%) met
NZSC (2004) audit committee membership requirements in 2001 but in 2003 the
number of companies complying increased to 34 companies (38%).
Firms improving committee membership from 2001 to 2003, along
overseas lines, increased the size of the board of directors to facilitate the changes.
However, despite these improvements, the 15% of the total sample of
firms without audit committees and those with non-conforming audit committees
meant that 62% of the sample of NZ listed firms failed to voluntarily meet
international best practice standards. This probably contributed to the subsequent
regulatory moves by the NZX and NZSC.
The paper begins with a discussion of the Enron collapse and NZ
responses to it in Section 2.0 Section 3.0 summarises the literature relevant to the
research. Section 4.0 outlines the research design while the results are discussed in
sections 5.0 and 6.0. Section 7.0 summarises and concludes the paper.
2.0 THE ENRON COLLAPSE AND NZ RESPONSES
2.1 The Enron Collapse
Enron was established in 1985 through the merger of two natural gas
pipeline companies creating a nationwide US gas pipeline network. Enron then
expanded, moving from distributing gas to also trading in natural gas futures. It
then extended its trading to other commodities such as power, steel, water, and
fibre optic capacity both within and beyond the US. The company grew rapidly in
the 1980’s and 1990’s acquiring businesses worldwide and entering new product
markets yet its profitability was declining. Enron obscured its true financial
position by transferring debt and non-performing assets off its balance sheet and
into special purpose entities. Disclosures of the complex related-party transactions
were insufficient for analysts and investors to understand the underlying substance
of the transactions (Special Investigative Committee of the Board of Directors of
Enron Corporation, 2002). But ultimately, analysts began to question the quality
of Enron’s financial reports.
In October 2001, asset write downs of $1.01 billion after tax were included
in a quarterly earnings announcement and the Securities and Exchange
Commission (SEC) commenced an informal enquiry. During October the
company set up a special committee to investigate the off-balance sheet related-
party transactions. In November 2001, accounting irregularities emerged that
resulted in restating prior years’ earnings downwards. The adjustments ranged
from around $96 million in 1997 to $250 million in 1999 (Chaney and Philipich,
2002). These events drove a collapse in the share price and the downgrading of
Enron’s debt. In December 2001, the company filed for bankruptcy (Palepu and
At the time of its collapse Enron had around 21,000 employees world-wide.
In the US, Enron was the seventh largest company in terms of revenue and it had
a market capitalisation of around $US 75 billion. The collapse of the company
resulted in job losses for its employees and investment losses for its shareholders.
About 70% of Enron’s shares were owned by institutional investors many of them
mutual funds, 18% of the shares were held by individual investors and 12% by the
company’s employee benefit plan which meant that some 12,000 of Enron’s
employees lost not only their jobs but their retirement savings. Creditors including
banks and insurers were exposed to substantial losses with Enron’s creditors
running to 54 pages on its website (Hill, McNulty and Robinson, 2001).
The size and rapid collapse of Enron along with its misleading financial
reporting resulted in a loss of confidence in capital markets. The New York Times
Securities markets are all about numbers, from sales and profits to debt
outstanding. If investors cannot believe the figures put out by public
companies, they will be much less willing to risk their money on
stocks.……Enron’s collapse has put that hard-won confidence at risk
(Berenson, 2002, p.4.1).
Joseph Berardino, the CEO of Anderson, Enron’s auditors, in his testimony
to the US Congress summed the situation up by stating:
I am here today because faith in our firm and in the integrity of the capital
market system has been shaken. There is some explaining to do (Committee
on Financial Services US House of Representatives, 2001, p.119).
The Comptroller General of the US considered that Enron’s failure
highlighted underlying problems in four areas: (a) corporate governance, (b)
independent audit of financial statements, (c) oversight of the accounting
profession, and (d) accounting and financial reporting issues, which were
fundamental for maintaining public confidence in capital markets (United States
General Accounting Office, 2002a).
A consequence of the loss in confidence in the capital markets resulted
in questions being asked about the quality of financial reporting of other
companies (The lessons learned from Enron, 2002). For example, Tyco’s share
price fell because investors became uneasy about corporate governance within the
company. General Electric had to defend comments about the transparency of its
financial reporting because investors were worried that the company was using
mergers to exaggerate its financial results (The good lay, 2002). The lack of
confidence was further shattered by corporate collapses of companies such as
Global Crossing and WorldCom and profit restatements of major listed companies
such as Waste Management and Xerox (United States General Accounting Office,
2002b). The lack of confidence depressed the US and world sharemarkets. By
mid-July 2002 global stock prices were 10% below the price levels after the
September bombing of the World Trade Centre5 (Gereben, Hull and Woodford,
The US government acted promptly to restore confidence in capital
markets by passing the Sarbanes-Oxley (SOX) Act of 2002. The Enron collapse
also prompted a number of overseas bodies including those in NZ to review their
After the 11 September 2001 bombing share prices on US markets dropped by 12% on average
(Gereben, Hull and Woodford, 2002).
Enron’s Audit Committee
Enron’s audit committee was accused of inadequate oversight of the
company’s financial reports and the independence of its auditors (Special
Investigative Committee of the Board of Directors of Enron Corporation, 2002;
US Permanent Subcommittee on Investigations, 2002).
The Audit and Compliance Committee was one of five committees
established by the Enron board. In 2001, the Enron board had 15 directors with
experience in business, finance and accounting. Six directors were appointed to
the Audit and Compliance committee.6 While all the audit committee members
were non-executive directors, not all them were independent. One the audit
committee members received consulting fees and Enron donated funds to
organisations with which two of the audit committee members were associated.7
Two audit committee members had financial expertise. The audit committee had a
charter; it approved the financial statements and liaised with the auditors.
The Enron board and its audit committee were considered responsible for
allowing the company to engage in high risk accounting. Evidence was presented
to the US Permanent Subcommittee on Investigations (2002) that Andersen had as
early as 1999, and on occasions during 2000 and 2001, informed the audit
The six directors included: (a) the chairperson Dr Jaedicke who was a former Dean of the
Stanford University Graduate School of Business (b) Mr Chan a billionaire and chairperson of a
Hong Kong property group and a director of Motorola and Standard Chartered PLC. (c) Dr
Gramm, an economist and director of a Regulatory Studies Programme at George Mason
University, (d) Dr Mendelsohn, President of the University of Texas M.D. Anderson Cancer
Centre, (e) Mr Pereira a Brazilian investment banker and Vice President of the Bazano Group and
(f) Lord Wakeham a member of the British Hose of Lords, a chartered accountant and a director of
a number of listed companies in the United Kingdom (Permanent Subcommittee on Investigations,
2002; Paredes, 2004).
Lord Wakeham received consulting fees from Enron. The cancer centre with which Dr
Mendelsohn was associated received donations from Enron. Similarly, the George Mason
University and its Mercatus Centre with which Dr Gramm was associated received Enron
donations (Permanent Subcommittee on Investigations, 2002).
committee about the nature of Enron’s accounting practices. Andersen informed
Enron that some of its accounting practices had a high risk of not complying with
generally accepted accounting practice were high risk because they were either
novel with no prior procedures to guide them or they relied significantly on
managers’ judgements. Anderson identified Enron’s high risk accounting
practices to include its (a) structured transactions, (b) merchant portfolio, (c)
commodity trading and project development activities, and (d) related party
transactions (US Permanent Subcommittee on Investigations, 2002).
The Enron investigations concluded that the audit committee did not
comprehensively review the high risk accounting practices. The committee relied
on brief summaries and senior executive representations without requesting
supporting documentation or questioning the facts (Special Investigative
Committee of the Board of Directors of Enron Corporation, 2002; US Permanent
Subcommittee on Investigations, 2002).
Enron’s board and audit committee were also considered responsible for
not ensuring the independence and objectivity of Andersen. The audit committee
reviewed Andersen’s independence annually but the depth of review was
criticised. Internal audit and consulting engagements undertaken by Andersen
gave the audit committee reassurance. In the US Senate investigation none of the
Enron board members interviewed raised concerns that Andersen was auditing its
own work. Andersen’s fees for Enron work were substantial. For example, in
2000 Enron paid Anderson $US 27 million for consulting fees and $25 million in
audit fees. In its final report the US Senate investigation concluded that:
If it had dug deeper, the Enron Audit committee might have uncovered the
ongoing tension between the company and its auditor and the many
misgivings Andersen expressed internally while going along with Enron’s
high risk accounting (US Permanent Subcommittee on Investigations,
2.2 Audit Committee Regulation in New Zealand and Australia
Before the Enron collapse, NZ listed companies were required to disclose in
their annual report “a statement of any corporate governance policies, practices,
processes, adopted” (NZSE 2001, section 10.5.3). The New Zealand Institute of
Directors (1999) recommended that listed and widely held companies establish
audit committees, comprised of non-executive directors.
After the Enron collapse, the ICANZ (2002) took the initiative for change.
It setup a working party to review and recommend ways to improve standards of
financial reporting and corporate governance for NZ businesses. In its final
submission, ICANZ proposed only guidance for the operation of audit
committees, arguing that regulation was not appropriate as it would not guarantee
audit committee effectiveness. In addition, NZ issuers, being smaller on average
than overseas listed companies, would be less able to bear the cost of regulation
In direct contrast to ICANZ’s (2003) recommendations, the NZX (2003)
adopted a Corporate Governance Best Practice Code on 29 October 2003. It
requires issuers to establish audit committees consisting solely of non-executive
directors. Issuers are also required to disclose any corporate governance practices
different from those outlined in the Corporate Governance Best Practice Code
(NSX Listing Rule 10.5.3 (i)). Audit committees are to have charters and boards
are required to review the performance of the audit committee in terms of their
The NZSC (2003) consulted with NZ business stakeholders to achieve
consensus on appropriate corporate governance principles for NZ entities. It
published Corporate Governance in New Zealand Principles and Guidelines
(NZSC, 2004) in February 2004. There are nine principles. The principles do not
impose legal obligations but are standards that the NZSC “expects boards to
observe and report on to their investors and other stakeholders” (NZSC 2004, p.
One of the principles, (Principle Three) encourages boards of directors to
use committees if they enhance the operations of the board. The guidelines
recommend that audit committees of publicly owned8 companies should be
comprised solely of non-executive directors, a majority of whom are independent,
and have at least one director with financial expertise (such as a chartered
accountant). The committee chairperson should be an independent board member
and not be the board chairperson. The audit committee must report to the full
board. Audit committee responsibilities must be set out in a charter and disclosed
to investors, along with the membership composition.
Corporate governance developments also occurred in Australia, NZ’s major
trading partner and a country in which a number of NZ companies are also listed.
Publicly owned companies are companies with shareholders from the public and where the
spread of ownership is widely held (NZSC, 2004).
On 30 March 2003, the ASX Corporate Governance Council released Principles
of Good Corporate Governance and Best Practice Recommendations. ASX listed
companies must provide a statement in their annual report disclosing if these best
practices have been complied with and if they have not, to explain why not. The
best practice recommendations were effective for listed companies for financial
years commencing from January 2003.
3.3 Prior Literature and Hypothesis
3.3.1 Prior Literature
Regulatory bodies have focussed on audit committee membership
primarily in terms of the members’ independence and financial expertise.9
Regulators also specify the size of audit committee to ensure that sufficient
resources are dedicated to significant responsibilities.10
Non-executive directors free from management and other relationships
with the business are perceived to apply independent judgment to the quality of
financial reporting and internal controls (New York Stock Exchange and National
Association of Securities Dealers (Blue Ribbon Committee), 1999; Financial
Reporting Council, 2003). Empirical research suggests that firms with audit
committees that are more independent are less likely to have financial reporting
Other attributes of directors are considered important such as their work experience, leadership
and strategic thinking but independence and financial literacy are considered core attributes for
audit committees (Blue Ribbon Committee 1999). The Blue Ribbon Committee (1999) defined
financial expertise as financial sophistication obtained from past employment in accounting or
finance, professional certification or from financial oversight responsibilities such as a Chief
Executive or Financial Officer.
The London Stock Exchange Combined Code of Best Practice provides that audit committees
have at least three members and in the case of smaller companies two non-executive members.
Corporate governance rules set out in the New York Stock Exchange’s (NYSE) Listed Company
Manual requires that audit committees must have a minimum of three members.
failures (Abbott and Parker, 2000a; Beasley, et al. 2000; Abbot, et al. 2004;
Farber 2005). Research evidence also suggests that independent audit committees
can have a positive effect on external and internal audit functions: by appointing
specialist external auditors (Abbott and Parker 2000b), by reducing questionable
external auditor switches (Abbott and Parker 2002, Carcello and Neal 2003), by
monitoring the independence of external auditors (Abbot, et al. 2003) and by
interacting more with internal auditors (Scarbrough, et al. 1998, Raghunandan, et
Regulations requiring financial expertise on audit committees recognise
that audit committees must have appropriate skills and knowledge to oversee the
financial reporting, internal controls and audit functions of a firm. The importance
of financial expertise in monitoring financial reporting is supported in research by
Kalbers and Fogarty (1993). Firms with audit committee members with financial
expertise are less likely to be subject to censure for poor financial reporting
(McMullen and Raghunandan, 1996; Agrawal and Chadha, 2004; Farber, 2005)
and are more likely to support the external auditor in disputes with management
over technical and “substance over form” issues (DeZoort and Salterio, 2001).
This study examines if boards of directors voluntarily changed their
behaviour and made changes to the composition of audit committees in response
to financial reporting and governance issues arising from the Enron collapse. This
leads to the following hypothesis:
H1: Subsequent to the Enron collapse, and before the introduction of
corporate governance code regulations, the independence and financial expertise
of audit committees of NZ listed companies improved.
If firms did voluntary improve audit committee composition what were the
characteristics of firms that made changes? Prior research shows that firms that
voluntarily form audit committees have a higher proportion of non-executive
directors (Pincus et al., 1989; Menon and Williams, 1994; Collier 1993). Firms
with more independent audit committees are more likely to be larger firms with
bigger and more independent boards of directors (Beasley and Salterio, 2001;
Klein, 2002a; Menon and Williams 1994). This leads to the second hypothesis
H2: NZ listed companies that voluntarily improved the independence and
financial expertise of audit committee membership were larger, had larger boards
and a higher percentage of independent directors compared with other companies.
This study extends prior literature in the following ways. The study
compares audit committee composition before and after the collapse of Enron in a
voluntary regulatory environment. It extends empirical research on pre- and post-
Enron effects to countries outside the US and is one of the first studies to examine
the impact of the Enron collapse in the NZ business environment.
4.0 RESEARCH DESIGN
4.1 Sample Selection
The population examined is companies listed on the NZ stock exchange.
The sample selection covers two periods. The first period covers balance dates
from 1 January 2001 to 31 December 2001, the pre-Enron period. As outlined in
section 2.0 the demise of Enron commenced in October 2001 when earnings
restatements rapidly led to the company’s bankruptcy on 2 December 2001
(Chaney and Philipich, 2004).
The second period is for balance dates from 1 January 2003 to 31
December 2003, the post-Enron period. During this period publicity about Enron
was vast and a number of overseas corporate governance investigations and
recommendations were published. In New Zealand, the NZICA published its
discussion document Corporate Transparency Making Markets Work Better in
August 2002. On 31 July 2002, the NZX (2002) released a set of rule changes to
make markets more transparent. Its proposals included strengthening corporate
governance aspects of the listing rules in order to align with international best
practice. On 13 August 2003, the NSX issued the approved corporate governance
rules. 11 The new rules were effective from 29 October 2003 although issuers were
allowed a 12 month transitional period to comply.12
Developments also occurred at a similar time in Australia. The Corporate
Economic Reform Programme 9 (Commonwealth of Australia, 2002)
recommended mandatory audit committees for the top 500 listed companies to be
enforced by the ASX. In August 2002, the ASX established the ASX Corporate
The audit committee is to be comprised solely of non-executive directors. An audit committee
charter is to set out the committee’s authority duties and responsibilities and the board has to
evaluate the performance of the committee against the charter (NZX 2003)
Listed companies had twelve months to comply with the new rules from the 29 October , 2003
or twelve months from the conclusion of the issuer’s annual meeting (NZX, 2003).
Governance Council which published Principles of Good Corporate Governance
and Best Practice in March 2003. In accordance with ASX Listing Rule 4.10
issuers are required to state the extent to which they have followed the best
practice recommendations. The rules were made effective for balance dates
beginning on 1 January 2003.
Thus in 2002, changes in corporate governance were being proposed in
NZ and Australia but no regulatory changes were in place. In 2003, listed
companies in both countries were in transition to comply with new corporate
governance rules. Only dual listed companies on the NZX with December 2003
balance dates would have had to comply with the ASX regulatory changes.
Changes in board and board committee composition would also require
shareholder approval at an annual general meeting held subsequent to balance
date. Thus, listed companies would be unlikely to change audit committee
composition as a direct effect of the listing rules until 2004.
The sample comprises listed companies on the NZX in 2001 and excludes unit or
property trusts which have different governance structures. Using the 2001
companies as a base, data for the 2001 and 2003 years is collected. There are 109
companies in the 2001 population but the sample is reduced to 88 companies with
the requirement that the companies must have be listed in both pre- and post-
Enron periods. Table 1 summarises the sample selection.
4.2 Research Model
Two models are used to test the research hypotheses. Hypothesis 1 is
tested using the observations in 2001 and 2003 of the model variables. Hypothesis
2 is tested by observing the changes in the model variables between 2001 and
Model to Test Hypothesis 1
A pooled logit regression is used to test if the probability of a firm meeting
recommended audit committee membership criteria improved between 2001 and
The logit model is:
Logp ACt = b 1 +b2 Y2003+ b3 LEVt + b4 EXDIRSHt + b5 BLOCKt + b6 BSIZEt
+ b7 BINDt + b8 EXCHt + b9 SIZEt (1)
Where p ACt is the probability that a firm has an audit committee meeting
recommended membership criteria in 2001 and 2003. A dichotomous variable for
year (Y2003 ) is included in the regression. Y2003 is coded 1 for observations for
2003 and coded 0 for 2001 observations. The Y2003 variable enables a comparison
of the empirical model for years 2001 and 2003. The intercept of the regression
for 2001 is b 1 and for 2003 (b 1 + b 2 ) (Gujarati 2003). If the differential intercept
for b 2 is significant and positive this means that the audit committee attributes, as
defined, improved between 2001 and 2003.
Model to Test Hypothesis 2
A logit regression is also used to test the characteristics of firms that
voluntarily improved audit committee membership between 2001 and 2003.
The logit model is:
Logp AC2003-2001 = b1 + b2 ∆LEV2003-2001 + b3 ∆EXDIRSH2003-2001 +
b4 ∆BLOCK2003-2001 + b5 ∆BSIZE2003-2001 + b6 ∆BIND2003-2001 +
b7 ∆EXCH2003-2001 + b8 ∆SIZE2003-2001 (2)
Where p AC2003-2001, is the probability that a firm improved the membership of
the audit committee consistent with overseas recommended criteria from 2001 to
2003. For each of the variables, the change from 2001 to 2003 is determined by
taking the difference in the observations of each variable at the two points in time,
i.e. observation in 2003 less the observation in 2001, for each company.
Audit Committee Membership Variables
Four measures of audit committee membership are used. The first
definition is labelled ACNZSC and measures whether the composition of an audit
committee meets the standard as set out in Principle Three: Board Committees of
the NZSC’s Corporate Governance in New Zealand Principles and Guidelines
(2004). ACNZSC recommends that an audit committee be comprised of all non-
executive directors, the majority of which are independent, has at least one
member who is a chartered accountant13 and whose chairperson is independent
but not the board chairperson.
Audit committees with a majority of independent directors and an
independent chartered accountant are coded ACINDEXP which is the second
audit committee measure
The third measure of audit committee membership is audit committee
independence (ACIND). Firms are coded 1 if the audit committee is comprised of
Principle Three refers to a chartered accountant or other recognised form of financial expertise.
Only a member of a professional accounting organisation such as the New Zealand Institute of
Chartered Accountants was specified as an expert.
a majority of independent directors, and 0 if not. An independent director is
defined as not being employed or closely affiliated with a company.
Audit committee financial expertise (ACFINEXP) is the final audit committee
measure. Firms with an audit committee having a member with a professional
accounting qualification are coded 1 and 0 otherwise.14
The models includes a number of factors other than the timing of the Enron
collapse that may influence the composition of an audit committee. These include
leverage (LEV), executive ownership (EXDIRSH), board independence (BIND) and
board size (BSIZE).
Empirical research suggests that managers make accounting choices to affect the
calculations used to determine compliance with debt covenants (Healy and Whalen
1999, Fields, Lys, and Vincent, 2001; Graham, Campbell, and Rajgopal, 2005). It is
expected that as debt increases there will be greater external demand for monitoring by
the board to ensure compliance with debt covenants. Such a specialist function may be
delegated to an audit committee that is perceived to be objective and which has the
expertise to re-assure debtholders.
Ownership structure can also impact the level of monitoring required. Executive
director share ownership aligns the interests of managers and shareholders, thus
reducing agency costs and the level of monitoring required (Jensen and Meckling, 1976;
Rosenstein and Wyatt, 1997). In addition, owners with a substantial shareholding have
the incentive to directly access information to monitor management (Shleifer and
Vishny, 1997) thus reducing the need for audit committee monitoring. Empirical work
Other recognised forms of financial expertise (NZSEC, 2004) were considered but lack of information
provided in annual reports on the background of directors meant a narrower definition had to be used. The
NZICA website was used to identify audit committee members with a professional accounting
supports that the existence of a blockholder on the board of directors reduces the level
of audit committee independence observed (Wright, 1996; Beasley and Salterio, 2001;
Cotter and Silvester, 2003).
Independent board members are considered to play a monitoring role by
reducing conflicts between owners and mangers and reducing manager opportunism
(Fama and Jensen 1983). Firms with a higher percentage of independent board directors
are less likely to have financial reporting problems (Beasley, 1996, Dechow, et al. 1996,
Beasley et al. 2000, Song and Windram, 2000, Peasnell, et al. 2001, Farber, 2005).
Research also shows that as the proportion of independent directors on the board
increases, it is more likely for the audit committee to include independent directors
(Menon and Williams, 1994; Beasley and Salterio, 2001; Klein, 2002).
Board size is likely to be related to monitoring by an audit committee. It is
argued that large boards are less effective than small boards because directors can free
ride (Jensen 1993). However, large boards can utilise the greater pool of knowledge and
expertise by appointing appropriate directors to subcommittees to undertake specialist
tasks. Klein (2002) finds that audit committee independence increases with board size.
In addition, Beasley and Salterio (2001) find that firms with larger boards are more
likely to establish audit committees with members that exceed minimum legal
requirements for independence and financial expertise.
Each of the above factors is measured as follows. LEV is the ratio of total
liabilities to total assets. EXDIRSH is the cumulative percentage of shares held by
executive directors as a percentage of the total shares issued. BLOCK is the percentage
of shares issued to shareholders who own at least 5% of the issued shares of a company.
BDSIZE is the number of individuals serving on the board of directors and BDIND is
the percentage of independent board directors.
A control variable for exchange listing is included to control for the influence of
overseas regulatory authorities for NZ companies that are cross- listed. The exchange
control variable (EXCH) is set to 1 if a firm is listed on an overseas exchange and 0 if
not. Consistent with prior studies on audit committee composition, firm size (SIZE) is
included as a control variable and is measured as total assets.
5.1 Descriptive Statistics
Table 2 summarises the changes in audit committee formation and membership
between 2001 and 2003 for the sample of 88 companies that are listed in both years
(refer to Table 1). The audit committee of each company is coded 0, 1, 2 or to 3 for each
year. A company is coded 0 if it does not have an audit committee. A company is coded
1 if it has an audit committee but its composition does not meet the criteria for coding 2
or 3. A code of two is given to a company with an audit committee with all non-
executive directors, the majority of which are independent and at least one member with
a professional accounting qualification. A code of three is given to a firm that has an
audit committee that meets the NZSC best practice requirements of having 100% non-
executive directors, a majority of which are independent, at least one audit committee
members has a professional accounting qualification and the chairperson is independent
and not the board chairperson.
Table 2, Panel A summarises the profile of audit committees in 2001 and
2003. Changes in audit committee composition are listed in Panel B with the
changes plotted in Panel C. The rows in Table 2, Panel C record the scores for
2001 and the columns record the scores for 2003. Each cell records the number of
companies meeting the respective codes in 2001 and 2003. The shaded cells on
the diagonal reflect no change in audit committee composition. Cells to the right
of the shaded diagonal show an improvement in audit committee composition.
The cells to the left of the shaded diagonal show a worsening position.
The overall trend is a modest improvement in audit committee composition.
In 2001, 27% (24 firms) of the sample of 88 firms meet the NZSC requirements
and 38% (33 firms) in 2003. However, as at 2003, 15% (13 firms) of the sample
of 88 listed firms did not have an audit committee while 47% of the sample (42
firms) had audit committees but did not meet NZSC best practice.
Table 3, Panel A shows firm, board and audit committee characteristics for
the sample of 88 firms in 2001 and 2003. The mean firm size drops from of $749
million of total assets to $678 million. Average gearing for the sample of
companies increases from 46.77% to 63.39% but is not statistically significant.
There is a statistically significant increase in executive and blockholder
The average size of the board of directors decreases from 6.25 to 5.93
members. The mean number of independent directors decreases from 3.13 to 3.06
members but the percentage of independent directors increases from 49.60% in
2001 to 51.39% in 2003 but the change is not significant.
To investigate improvement in audit commit membership between 2001 and
2003 the sample of 88 companies was reduced by 23 companies that met NZSC
requirement in both 2001 and 2003.15 Two firms that were not trading and with
high levels of debt were also excluded leaving a sample of 63 companies.Table 3:
Panel B records the descriptive statistics and the Wilcoxon Signed Ranks test for
the reduced sample. Mean firm size and executive shareholding increases between
2001 and 2003, while the average level of debt, blockholder shareholdings and the
percentage of companies listed on offshore exchanges decreases. The average size
of the board of directors and the mean number of independent directors decreases
significantly. While the proportion of independent directors increases from 42.03%
to 44.43%, the change is not significant. Thirty- nine of the 63 companies (62%)
had audit committees. The average size of audit committee did not change between
2001 and 2003 but the number of independent directors increased from an average
of 1.87 members in 2001 to 2.11 members in 2003, increasing the percentage of
independent directors significantly from 60.69% to 66.62% in 2003.
Table 4 reports chi-square results for each audit committee membership variable
(ACIND, ACFINEXP, ACINDEXP and ACNZSC) for the reduced sample of 63
companies. An additional variable representing an independent audit committee
chairperson (ACINDCHR) is included in this analysis.
Improvements in audit committee composition between 2001 and 2003 are
statistically significant. In 2001, 18 firms have audit committees with over 50%
independent directors (ACIND) which increases to 29 firms in 2003.Eleven firms
improved audit committee financial expertise (ACEXP) as well as appointing an
Table 2 shows that in 2001 24 audit committees met the NZSC (2004) audit committee
membership criteria but only 23 of these companies met this criteria in 2003.
independent chairperson (ACINDCHR). Overall, the number of audit committees
meeting NZSC composition principles increases from 1 firm in 2001 to 13 firms
in 2003. This change is strongly significant. However, the 13 firms complying
with NZSC principles of best practice only represents 20% of the total sample of
63 firms and 15% of the original sample of 88 companies.
5.2 Multivariate tests
Table 5 presents the results of pooled logit regressions for four audit
committee membership variables. The audit committee dependent variables are as
defined in section 4.2.2. The explanatory power of the models is reasonable with a
pseudo R2 ’s of over 30% for all models except the logit regression for
ACFINEXP which is 18.7%. Table 5 also records the models’ coefficients and p-
Firms with audit committees that meet independence membership criteria
are more likely to have a higher proportion of independent directors on the board.
This result is consistent with prior research (Beasley and Salterio 2001, Klein
Firms with financial expertise on the audit committees also have a higher
proportion of independent directors compared with other firms but also a larger
board size (BSIZE). Firms with financial experts on the audit committee are more likely
to have higher agency costs as executive director shareholding are lower for these firms
compared with other firms. The negative relation between audit committees with
financial expertise and blockholder shareholders (BLOCK) suggests that these
shareholders act as a substitute for a financial expert.
The variable of primary interest in the logit regressions is the Year 2003 (Y2003 )
variable. The coefficients for the Y2003 variable are positive and strongly significant for
all audit committee dependent variables. These results support hypothesis H1, that in
comparison to 2001, audit committee membership in 2003 improved in terms of NZSC
principles. The result indicates that in the aftermath of Enron, the probability of New
Zealand listed companies adjusting the membership of audit committees to meet overseas
recommendations significantly increased from 2001 to 2003.
Table 6 reports the logit regression of the changes in audit committee
membership regressed on changes firm and board characteristics with the purpose of
identifying the type of firms that voluntary improved audit committee membership in
line with recommended practice. Firms that made improvements to audit committee
membership were coded 1 while firms that made no changes or made changes contrary to
NZSC (2004) principles were coded 0. Table 6 also records the mean change for each
explanatory variable for those firms that did or did not make audit committee changes.
The results show that NZ listed companies that voluntarily improved audit
committee membership were more likely to be have increased in size and increased the
size of the board of directors. This results are consistent with H2 except that
improvements in audit committee membership were not significantly related to changes
in board independence as predicted.
6.0 ADDITIONAL ANALYSIS
The analysis was also repeated for 2002. Table 7, Panel A shows that in 2001, 28%
(24 firms) of the sample of 88 firms met the NZSC requirement which increases to 29%
of the sample (25 firms) in 2002. Consistent with the previous analysis the 23 firms that
met NZSC audit committees requirements were excluded from subsequent analysis. In
the reduced sample of 63 firms there is modest change in the membership of the audit
committees. Table 7, Panel B shows that four companies improved independence
(ACIND), eight firms improved audit committee expertise (ACEXP) and nine firms
introduced an independent audit committee chairperson (ACINDCHR). Overall, five
companies improved the audit committee membership sufficiently so that they met the
The pooled logit is repeated using 2001 and 2002 data for each of the sample of
companies and shown in Table 8. The results for the dependent variable ACNZSC show
that NZ listed companies did significantly improve the composition of audit committees
in order to be consistent with overseas best practice (p- value of the Y2002 intercept is 0.03
one-tailed).The pooled logit using changes in the variables shows that firms making
improvements to the audit committee did so by increasing the size of the board.
TABLE 7: Audit Committee Changes 2001 to 2002
Panel A: Audit Committee Profile (N=88)
Code* 2001 2002
3 24 (28%) 25 (29%)
2 10 (12%) 17 (20%)
1 36 (42%) 32 (36%)
0 16 (18%) 12 (15%)
Sample 88 (100%) 88 (100%)
3 = a company with an audit committee comprising all non-executive directors, with a majority (greater than 50%)
of independent directors and a director with a professional accounting qualification, and an independent AC chair.
2 = a company with an audit committee with a majority of independent directors and a director with a professional
accounting qualification 1=a company with an audit committee that does not meet the criteria 2 or 3. 0 = a company
with no audit committee. Cells record the number of companies meeting the audit committee criteria.
Panel B: Changes in Audit Committee Composition 2001 to 2003 (N=63)
ACIND ACFINEXP ACINDCHR ACINDEXP ACNZSC
No Yes No Yes No Yes No Yes No Yes
2001 45 18 35 28 36 27 54 9 62 1
2003 41 22 27 36 27 36 48 15 57 6
c2 = 0.02 c2 = 0.03 c2 = 0.03 c2 = 0.01 c2 = 0.03
c = chi square (p-value one-tailed). ACIND is 1 if a company has an audit committee, greater than 50%
independent directors, 0 otherwise. ACFINEXP is 1 if a company has an audit committee with a director with a
professional accounting qualification, 0 otherwise. ACINDCHR is 1 if a company has an independent audit
committee chairman, 0 otherwise. ACINDEXP is 1 if a company has an audit committee with a majority (greater
than 50%) of independent directors and a director with a professional accounting qualification, 0 otherwise.
ACNZSC is 1 an audit committee with all non-executive directors, with a majority (greater than 50%) of
independent directors and a director with a professional accounting qualification, and an independent AC chair, 0
7.0 SUMMARY AND CONCLUSION
This study examines the changes in the membership of audit committees made
voluntarily by boards of New Zealand listed companies in response to the Enron
collapse. Following the collapse overseas regulatory bodies made calls to improve the
independence and financial expertise of audit committees with the aim of enhancing
their performance. Audit committee membership did significantly improve in line with
overseas recommendations in the first two years subsequent to the Enron collapse. In
2003, 33 firms out of 88 firms (38%) met the NZSC requirements for audit committee
composition. Although there was significant improvement in audit composition in 2003,
42 firms of the 88 firms (48% of the sample) did not meet the membership criteria for a
high quality audit committee. In addition, there were still companies in 2001-2003 that
did not have audit committees.
The results suggest that calls for improved audit committee effectiveness in
monitoring the quality of financial reports did motivate a significant number of New
Zealand boards to make voluntary changes to the composition of audit committees.
However, the fact that not all listed companies established audit committees or
structured them in terms of overseas best practice suggests that moves by the NZX and
the NZSC to improve corporate governance practices and in particular the composition
of audit committees were appropriate.
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TABLE 1: Sample Selection Summary
Initial sample 109
Less unit trust 1
Less companies delisted 19
Less outlier 1 16
Final Sample 88
Based on a scatter plot one firm was excluded
TABLE 2: Audit Committee Composition Changes 2001 to 2003 (N=88)
Panel A: Audit Committee Profile
No (%) No(%)
3 24 (27%) 33 (38%)
2 10 (11%) 11 (12%)
1 37 (42%) 31 (35%)
0 17 (20%) 13 (15%)
Panel B: Summary of Changes 2001 to 2003
Changes No (%) Location on Plot
No Change 65 (74%) The shaded diagonal
Change for the To the right of the shaded
Change for the To the left of the shaded
Panel C: Plot of Audit Committee Changes 2001 to 2003
Row=2001 0 1 2 3
3 0 1 0 23 3
2 0 1 7 2 2
1 3 25 1 8 1
0 10 4 3 0 0
0 0 1 2 3
3 = a company with an audit committee comprising all non-executive directors, with a majority (greater
than 50%) of independent directors and a director with a professional accounting qualification, and an
independent AC chair. 2 = a company with an audit committee with a majority of independent directors
and a director with a professional accounting qualification 1=a company with an audit committee that
does not meet the criteria 2 or 3. 0 = a company with no audit committee. Cells record the number of
companies meeting the audit committee criteria.
Table 3 Panel A: Descriptive Statistics 2001 and 2003 (N=88)
Panel A: Full Sample
Firm size 749,181,592 678,432,640 -11.51 (0.00)
Leverage 46.77% 63.397% -1.26 (0.21)
Executive director shareholding 2.41% 2.70% -7.72 (0.00)
Blockholder shareholding 42.08% 43.15% -11.12 (0.00)
Number of directors 6.25 5.93 -11.54 (0.00)
Number of independent directors 3.13 3.06 -10.86 (0.00)
Percentage of independent directors 49.60% 51.39% -0.11 (0.92)
Panel B: Reduced Sample (N=63)
Firm size 351,918,069 378,277,844 -9.74 (0.00)
Leverage 46.33% 39.83% -1.97 (0.05)
Executive director shareholding 2.9% 3.3% -6.57 (0.00)
Blockholder shareholding 45.25% 44.89% -9.47 (0.00)
Overseas exchange 16% 14% -5.50 (0.00)
Number of directors 5.83 5.62 -9.78 (0.00)
Number of independent directors 2.43 2.44 -8.95 (0.00)
Percentage of independent directors 42.03% 44.43% -1.66 (0.10)
Audit committee characteristics (N=39)
Number of members 3.10 3.10 -7.75 (0.00)
Number of independent directors 1.87 2.11 -7.06 (0.00)
Percentage of independent directors 60.69% 66.62% -2.43 (0.02)
Wilcoxon Signed Rank Test (p-value two-tailed). Firm size is total assets, leverage is the ratio of total
liabilities to total assets, and executive director shareholding is the total number of shares held by
executive directors as a percentage of the total shares issued. Blockholder shareholding is measured as
the percentage of shares owned by a shareholder with more that a 5% of the firms’ issued shares and
represented on the board of directors.
TABLE 4 Changes in Audit Committee Composition 2001 to 2003 (N=63)
ACIND ACFINEXP ACINDCHR ACINDEXP ACNZSC
No Yes No Yes No Yes No Yes No Yes
2001 45 18 35 28 36 27 54 9 62 1
2003 34 29 24 39 25 38 43 20 50 13
c2 = 0.02 c2 = 0.03 c2 = 0.03 c2 = 0.01 c2 = 0.00
c = chi square (p-value one-tailed). ACIND is 1 if a company has an audit committee, greater than 50%
independent directors, 0 otherwise. ACFINEXP is 1 if a company has an audit committee with a director
with a professional accounting qualification, 0 otherwise. ACINDCHR is 1 if a company has an
independent audit committee chairman, 0 otherwise. ACINDEXP is 1 if a company has an audit committee
with a majority (greater than 50%) of independent directors and a director with a professional accounting
qualification, 0 otherwise. ACNZSC is 1 an audit committee with all non-executive directors, with a
majority (greater than 50%) of independent directors and a director with a professional accounting
qualification, and an independent AC chair, 0 otherwise.
Table 5: Audit Committee Composition 2001 and 2003 (N=63)
ACIND ACFINEXP ACINDEXP ACNZSC
Coeff Coeff Coeff Coeff
(p-value) (p-value) (p-value) (p-value)
-4.69 -2.25 -5.72 -7.93
(0.00) (0.02) (0.00) (0.00)
0.97 0.85 1.24 3.10
Year 2003 +/-
(0.02) (0.02) (0.01) (0.00)
-0.20 0.02 -0.65 0.67
(0.41) (0.49) (0.25) (0.31)
-1.11 -3.75 -0.82 -2.75
(0.34) (0.07) (0.39) (0.26)
0.01 -0.02 0.00 -0.00
(0.12) (0.04) (0.39) (0.41)
0.03 0.40 0.18 0.40
(0.42) (0.00) (0.13) (0.02)
7.47 1.32 6.06 2.37
(0.00) (0.07) (0.00) (0.06)
1.12 -0.49 -0.16 -0.50
(0.08) (0.22) (0.42) (0.32)
0.00 0.00 0.00 0.00
(0.15) (0.41) (0.32) (0.40)
Pseudo R2 45.9% 18.7% 34.5% 30.3%
-2 Log 155.14
114.80 103.83 67.13
% Predicted 65.1%
79.4% 82.5% 86.5%
Coefficients (p-values one-tailed). ACIND is 1 if a company has an audit committee, greater than 50% independent
directors, 0 otherwise. ACFINEXP is 1 if a company has an audit committee with a director with a professional
accounting qualification, 0 otherwise. ACINDCHR is 1 if a company has an independent audit committee
chairman, 0 otherwise. ACINDEXP is 1 if a company has an audit committee with a majority (greater than 50%)
of independent directors and a director with a professional accounting qualification, 0 otherwise. ACNZSC is 1 an
audit committee with all non-executive directors, with a majority (greater than 50%) of independent directors and
a director with a professional accounting qualification, and an independent AC chair, 0 otherwise LEV is the
ratio of total liabilities to total assets. EXDIRSH is the cumulative percentage of shares held by executive
directors as a percentage of the total shares issued. BLOCK is the percentage of shares issued to shareholders who
own at least 5% of the issued shares of a company. BDSIZE is the number of individuals serving on the board of
directors. BDIND is the percentage of independent board directors. EXCH is 1 is the company is listed on an
overseas exchange , 0 otherwise. SIZE is total assets.
Table 6: Changes in Audit Committee Composition from 2001 to 2003
No AC Changes AC Changes ACNZSC2003-2001
Sign Mean 2003-2001 Mean2003-2001 Coeff (p value)
(N=50) (N=13) (N=63)
Constant -1.96 (0.00)
∆LEV2003-2001 + -0.05 -0.11 -1.91 (0.10)
∆EXDIRSH2003-2001 – 0.01 -0.02 -11.05 (0.05)
∆BLOCK2003-2001 – -0.78 1.24 0.03 (0.26)
∆BSIZE2003-2001 + -0.34 0.31 1.04 (0.02)
∆BIND2003-2001 + 0.01 0.07 3.10 (0.11)
∆EXCH2003-2001 + 0.00 0.00 17.59 (1.00)
∆SIZE2003-2001 + -3,541,243 14,133,692 0.00 (0.06)
Pseudo R2 33.1%
-2 Log likelihood 49.18
% Predicted correct 77.8%
Coefficients (p-values one-tailed). ∆ is the variable in 2003 less the variable in 2001. Refer to Table 5 for definitions
Table 8: Logit Regression Audit Committee Changes 2001 to 2002 (N=63)
Sign Coeff (p value) Coeff (p value)
Constant -7.47 (0.00) Constant -3.22 (0.00)
Year 2002 + 2.20 (0.03)
LEV – -3.11 (0.13) ∆LEV2003-2001 -0.38 (0.46)
EXDIRSH – -3.94 (0.28) ∆EXDIRSH2003-2001 -4.48 (0.37)
BLOCK + -0.00 (0.49) ∆BLOCK2003-2001 0.11 (0.23)
BSIZE + 0.63 (0.01) ∆BSIZE2003-2001 1.75 (0.01)
BIND + 1.74 (0.16) ∆BIND2003-2001 3.97 (0.13)
EXCH + -18.11 (0.50) ∆EXCH2003-2001 *
SIZE 0.00 (0.25) ∆SIZE2003-2001 0.00 (1.00)
Pseudo R2 35.7% 34.4%
-2 Log likelihood 37.29 24.96
% Predicted correct 95.2% 93.7%
Coefficients (p-values one-tailed). ∆ is the variable in 2002 less the variable in 2001. Refer to Table 5 for definitions
* ∆EXCH is excluded as there was no change