Do Former Auditors on the Audit Committee Constrain Earnings Management? Evidence from the Banking Industry

This paper examines whether former auditors on the audit committee constrain earnings management in the banking industry. Given the complexity and the size of the entities, it can be argued that the audit committees of large banks should possess a higher level of financial expertise than stipulated by the regulatory requirements in order to successfully monitor the financial reporting process. Using data on large publicly traded U.S. banks, we document a negative association between earnings management and the presence of former auditors on the audit committee. Specifically, our empirical findings indicate that banks with ex-auditors on the audit committee have lower levels of income-increasing as well as absolute discretionary loan loss provisions. We further document that the constraining effect of ex-auditors on earnings management is strongest for banks in which the former auditors on the audit committee have not been affiliated with the bank’s current audit firm. Overall, our results suggest that audit committee members with professional auditing experience may improve financial reporting quality in the financial industry.