An audit committee with financial expertise is expected to strengthen the firms' internal control system, and consequently, contribute to reliable and relevant financial reporting. The controversial definition of financial expert was intensively commented on before the Securities and Exchange Commission (SEC) stipulated the final rules. In this study, the author examines whether the impact of audit committee's financial expertise on earnings quality as measured by returns-earnings relation varies with the way the financial expert is defined.The results indicate that the firms with an accounting-literate professional serving on the audit committee are more likely to have high quality of reported earnings than others without such an expert. In addition, the size of the audit committee with accounting-related expertise has a positive impact on earnings quality. In contrast, the presence of a financial expert under SEC final definition is not significantly related to earnings quality. The results are robust with other influential factors, such as earnings growth, persistence, firm size, and industry specificity, taken into account.

In response to the catastrophic accounting problems at Enron, WorldCom and other giant firms, the US Congress passed the Sarbanes-Oxley Act (SOX) in January 2002. This act has been called the most comprehensive legislation ever affecting the accuracy of financial reports (DeFond et al., 2005). In Section 407, SOX requires a public company to disclose whether or not it has at least one audit committee member who is a financial expert. If the committee has no financial expert, the company must explain the reason. The Securities and Exchange Commission (SEC), subsequently proposed rules (hereafter, SEC rules) to implement the SOX legislation and required all the US public companies to comply with the new disclosure requirements. However, the proposed definition of the financial expert in SEC rules proved to be the most controversial aspect of the proposal, as more practitioners commented on it than any other topic addressed by the proposed rules. The requirements to become an expert were criticized as stringent. The recruitment of such a financial expert may be challenging for many firms. In response to the criticism, the SEC broadened the definition in its final rules.

As implied by the SEC rules, a financial expert in an audit committee could ensure a good system of internal control and consequently contribute to reliable and relevant financial reporting and high quality financial statements. However, there is little empirical evidence that the audit committee financial expertise is related to earnings quality. Given that there is a relationship between audit committee financial expertise and earnings quality, another unresolved issue is that whether this relationship varies with the way such a financial expert is defined. The primary purpose of this study is to empirically examine the impact of two types of financial expertise under the SEC’s initial and final definition respectively on earnings quality.

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