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  • Jennifer M Mueller-Phillips
    Can Big 4 versus Non-Big 4 Differences in Audit-Quality...
    research summary posted March 4, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual, 05.08 Impact of Office Size, 14.0 Corporate Matters 
    Title:
    Can Big 4 versus Non-Big 4 Differences in Audit-Quality Proxies Be Attributed to Client Characteristics?
    Practical Implications:

    The fact that the Big 4 effect is generally insignificant indirectly supports the argument that the Big 4 distinction may reflect client and not auditor characteristics. The results suggest that differences in these proxies between Big 4 and non-Big 4 auditors largely reflect client characteristics and, more specifically, client size. The study has not resolved the question, although it encourages other researchers to explore alternative methodologies that separate client characteristics from audit-quality effects.

    For more information on this study, please contact Alastair Lawrence.

    Citation:

    Lawrence, A., M. Minutti-Meza, and P. Zhang. 2011. Can Big 4 versus Non-Big 4 Differences in Audit-Quality Proxies Be Attributed to Client Characteristics? The Accounting Review 86 (1): 259-286. 

    Keywords:
    Big 4 versus non-Big 4 audit quality; discretionary accruals; ex ante cost-of-equity capital; analyst forecast accuracy; propensity-score matching; attribute-based matching
    Purpose of the Study:

    This study examines whether differences in proxies for audit quality between Big 4 and non-Big 4 audit firms could be a reflection of their respective clients’ characteristics.

    The question of Big 4 superiority is important, given that many studies rely on the Big 4 versus non-Big 4 distinction as an audit-quality proxy. Hence, it is prudent to confirm that this distinction does not simply reflect client characteristics. Furthermore, incorrectly classifying Big 4 auditors as superior to non-Big 4 auditors has unnecessary negative ramifications for smaller auditors, such as audit committee’s auditor selection bias and discriminatory clauses in loan and underwriting agreements, which could result in a loss of current and future clients.

    Design/Method/ Approach:

    In the research, the authors use three audit-quality proxies – discretionary accruals, the ex ante cost-of-equity capital, and analyst forecast accuracy – and employ propensity-score and attribute-based matching models in attempt to control for differences in client characteristics between the two auditor groups while estimating the audit-quality effects. Also, they use propensity-score matching models in an attempt to control for differences in client characteristics between the two auditor groups while estimating auditor treatment effects.

    Findings:

    Using the matching models and full samples, the authors find that the treatment effects of Big 4 auditors are insignificantly different from those of non-Big 4 auditors with respect to our three audit-quality proxies.

    Category:
    Audit Team Composition, Auditor Selection and Auditor Changes, Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Impact of Office Size, Industry Expertise – Firm and Individual
  • Jennifer M Mueller-Phillips
    Capital Structure, Earnings Management, and Sarbanes-Oxley:...
    research summary posted November 17, 2014 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Capital Structure, Earnings Management, and Sarbanes-Oxley: Evidence from Canadian and U.S. Firms
    Practical Implications:

    This study is important because an increase in a firm’s debt level also increases the probability that the firm goes bankrupt.  Thus, it behooves managers and auditors to understand the way that SOX and earnings management impact the percentage of one component of debt (here, long-term debt) in a firm.

    The result contained in the first bullet of the “Findings” section suggests that, even though SOX spurs managers to report more accurate financials, which tend to lower the cost of equity financing, managers still find it cheaper to use debt.  The result in the second bullet of the “Findings” section suggests that managers anticipate a higher cost of debt after SOX and acquire debt while it is relatively cheap.  This result is consistent with research papers that find that market participants rationally expect Congress to pass legislation (e.g., SOX) that protect investors and improves firm behavior in the aftermath of financial or accounting scandals.  Thus, managers rationally expect long-term debt to be more expensive after SOX and, accordingly, take on more of it before SOX. 

    The result contained in the third bullet of the “Findings” section suggests that SOX requires managers who reported less transparent financial statements before SOX to report more transparent financials after SOX.  Since the more transparent financials are likely to be more volatile than and weaker than earlier financials, many managers will not be able to issue bonds to fund projects.  Thus, if those managers wish to take on projects, they will need to finance those projects by issuing equity, leading to lower long-term debt ratios.  Oppositely, SOX’s disclosure requirements will prompt managers who reported transparent earnings before SOX to continue to do so after SOX.  Thus, lenders will reward those managers by allowing them to take on additional long-term debt to finance the projects that the managers wish to undertake.

    For more information on this study, please contact Kelly E. Carter.

    Citation:

    Carter, K. 2013. Capital structure, earnings management, and Sarbanes-Oxley:  Evidence from Canadian and U.S. firms. Accounting Horizons 27 (2): 301-318.

    Keywords:
    Capital structure; earnings management; debt ratio; Sarbanes-Oxley.
    Purpose of the Study:

    The effect of the Sarbanes-Oxley Act (SOX) on earnings quality has been documented in the academic literature.  However, SOX’s effect on other aspects of firms is not known.  The purpose of this study is to document the effect of SOX and earnings quality on the capital structure of firms.  I measure earnings quality via accrual-based earnings management.  I measure capital structure via the ratio of long-term debt to assets (i.e., the long-term debt ratio).

    Design/Method/ Approach:

    This study uses quarterly data from 2000 to 2004, providing a relatively narrow window within which to investigate the effects of SOX’s announcement on capital structure.  Since SOX applies to firms that are listed on a U.S. exchange, the author segments firms by listing location.  Test firms include U.S. firms that are listed on a U.S. exchange as well as Canadian firms that are cross-listed in the U.S.  Control firms are Canadian firms that are listed in Canada.  The pre- versus post-SOX differences in the long-term debt ratios of test firms are compared to those of control firms.

    Findings:
    • SOX is associated with higher long-term debt ratios, as firms listed in the U.S. raise their long-term debt ratios by two to three percentage points.
    • The increase in long-term debt ratios occurs in the two quarters prior to SOX.
    • Firms that heavily manage earnings prior to SOX use less debt after SOX, while firms that lightly manage earnings prior to SOX use more debt after SOX. 
    Category:
    Corporate Matters
    Sub-category:
    Earnings Management
  • Jennifer M Mueller-Phillips
    CEO and CFO Equity Incentives and the Pricing of Audit...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 14.0 Corporate Matters, 14.01 Earnings Management, 14.07 Executive Compensation 
    Title:
    CEO and CFO Equity Incentives and the Pricing of Audit Services
    Practical Implications:

    Our study highlights the importance of taking into account executive incentive plans in improving the understanding of auditors’ risk assessment and pricing decisions, in support of the current professional audit standards. The findings that auditors respond to CEO and CFO equity incentives differently have significant implications for the corporate governance reforms and the design of optimal corporate executive compensation policies. Following the accounting scandals in the early 2000s, there has been increased regulatory and legislative scrutiny on corporate governance. Especially, regulators have recognized CFOs as the individuals bearing responsibilities for the integrity of financial information. Our paper lends support to the regulatory inclusion of CFOs as accountable individuals, and to concerns that firms should exercise caution in compensating CFOs using equity-based tools.

     

    For more information on this study, please contact Yonghong Jia.

    Citation:

    Billings, B. A., X. Gao, and Y. Jia. 2014. CEO and CFO Equity Incentives and the Pricing of Audit Services. AUDITING: A Journal of Practice & Theory 33 (2): 1-25

    Keywords:
    Audit fees; auditor risk assessment; equity incentive; accounting manipulation
    Purpose of the Study:

    The alleged perverse role of managerial incentives in accounting scandals and the distinctive role of auditors in identifying and intervening in attempted earnings manipulation, highlight the importance of explicitly considering executive incentive plans by auditors in the auditing process. However, there is little systematic evidence on auditors’ responses to the sizable holdings of equity by executives, a phenomenon that is particularly common in US public companies. In this paper, we investigate the association between executive equity incentives and auditors’ risk assessment and consequently audit pricing decisions. We examine auditors’ responses to equity incentives for CEOs and CFOs separately and jointly and inquire whether the responses are different.  

    Design/Method/ Approach:

    We gather information on audit fees, non-audit fees, auditors, internal control information from AuditAnalystics, executive compensation data from ExecuComp, and financial variables from Compustat, for the years 2002 through 2009. We estimate standard audit fee regression models that include variables to capture executive equity incentives and control variables that are identified to be determinants of audit fees by prior studies. 

    Findings:

    Using different measures of executive equity incentives and following standard audit service pricing research designs, we document compelling evidence that auditors adjust the price of their audit services upward in response to CFO equity incentives, suggesting that auditors perceive heightened audit risk associated with CFO equity incentives. We find some evidence that auditors view CEO equity incentives as innocuous or even beneficial in term of audit risk. We further demonstrate that the presence of internal control problems augments the positive relation between CFO equity incentives and audit fees, suggesting particularly elevated risk concerning CFO equity incentives perceived by auditors when internal controls are flawed. 

    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Earnings Management, Executive Compensation
  • Jennifer M Mueller-Phillips
    CEO Equity Incentives and Financial Misreporting: The Role...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.01 Earnings Management, 14.10 CEO Compensation 
    Title:
    CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise.
    Practical Implications:

    The evidence documents an important role for financial statement verification in the way managers are incentivized. While the economic consequences of auditing have focused on improvements to the information environment and a lower cost of capital, this study broadens the role of auditing in the efficient functioning of firms. The link between auditor expertise and managerial incentives is an important one because CEO incentives have wide implications for managerial risk-taking.

    This study contributes to the CEO contracting-financial misreporting literature by providing an economic rationale for the inconsistent evidence in prior studies. The authors show that detection mechanisms such as auditor expertise mitigate the effect of equity incentives on misreporting by limiting the ability of managers to misreport financial statements.

    Citation:

    Jayaraman, S., & Milbourn, T. 2015. CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise. Accounting Review 90 (1): 321-350. 

    Keywords:
    auditor expertise, equity incentives, misreporting, earning management, CEO compensation
    Purpose of the Study:

    In the aftermath of accounting scandals at the turn of the century, many academics, regulators, and the media have questioned whether managerial compensation contracts are the culprits behind these acts of reporting transgressions. Greater equity incentives allegedly encourage managers to indulge in myopic acts aimed at maintaining stock prices and earnings at artificially high levels in the near term. A large literature in accounting and finance tests whether CEOs with equity-based incentives manipulate their financial statements. While the other studies differ in their research designs, empirical measures, and sample periods, none of them consider the role of detection mechanisms that would limit the ability of managers to successfully carry out any misreporting, assuming that equity incentives do indeed encourage misreporting. The authors posit effective auditing as one such mechanism, and argue that incorporating it in a CEO contracting-financial misreporting framework is likely to shed light on the preceding inconsistent findings. Following the auditing literature, the authors use auditor industry expertise to capture the effectiveness of auditing and examine how it affects the association between CEO equity incentives and financial misreporting.

    Design/Method/ Approach:

    The authors merged four databases: (1) data on lawsuits from1994 to 2004, (2) data on CEO equity incentives from ExecuComp, (3) data on auditor expertise from 2003 to 2007 from Audit Analytics, and (4) data on control variables from Compustat and IRRC. The final sample comprises 7,427 firm-year observations over the period 1994 to 2004, of which 201 firm-years of the sample involve a lawsuit concerning an accounting or other misreporting. These observations involve 87 unique firms.

    Findings:

    Controlling for previously identified determinants of CEO incentives, firms audited by an industry expert grant their CEOs an average of 14 percent more equity incentives than those audited by a non-expert. To further validate the inferences, the authors exploit variation across industries in the extent to which earnings matter for determining the stock price, and find that auditor expertise is positively associated with CEO incentives only in industries where earnings matter for stock price informativeness. Overall, these results are consistent with optimal contracting theories where equity-based incentives are, at least in part, granted by trading off the benefits of effort with the costs of financial misreporting.

    The authors find that AA firms audited by an expert auditor in the post-period experience an average of 17 percent larger increase in CEO incentives as compared to AA firms audited by a non-expert in the post-period. Overall, these time-series tests performed complement the cross-sectional inferences on the important effect of auditor expertise on CEO equity incentives.

    Category:
    Corporate Matters
    Sub-category:
    CEO Compensation, Earnings Management
  • Jennifer M Mueller-Phillips
    CEO Financial Background and Audit Pricing
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience 
    Title:
    CEO Financial Background and Audit Pricing
    Practical Implications:

     The findings of this study suggest that the training and functional expertise of the CEO can affect the auditor’s perception of engagement risk, observed through a reduction in audit fees. They add to the growing literature of CEO characteristics which highlight how top managers influence firm outcomes.

    Citation:

     Kalelkar, R., S. Khan. 2016. CEO Financial Background and Audit Pricing. Accounting Horizons 30 (3): 325-339.

    Keywords:
    CEO financial expertise; audit fees
    Purpose of the Study:

     Theory suggests that the audit pricing decision is a function of a client’s audit risk and business risk. Recent literature has suggested that CEO characteristics can affect how auditor’s perceive the firm’s audit risk and the resulting audit pricing decision. This paper addresses how the financial expertise of Chief Executive Officer influences audit fees. The authors hypothesize that a CEO’s financial expertise can affect the level of audit fees through two channels:

    • Reducing the firm’s business risk through greater performance and profitability and

    • Reducing the firm’s audit risk by improving the quality of the firm’s financial reporting.

    Specifically, they suggest that a CEO’s financial expertise will lower both the firm’s audit risk and business risk resulting in lower audit effort and a corresponding reduction in audit fees.

    Design/Method/ Approach:

    The authors use a sample of firms with changes in CEO financial expertise between 2004 and 2013.  Specifically, they look at firms that switched from a CEO with financial expertise to a CEO with no financial expertise and vice versa, resulting in a sample of 77 firms and 81 changes in financial expertise.

     

    Alternatively, to address the unobservable characteristics of the firm which may influence both accounting outcomes and CEO selection, the authors utilize an instrumental variables two-stage model.  They use the local density of financial firms as an instrument for the financial expertise of the focal firm.  The location of the firm can influence the financial expertise of the board of directors.  When the board holds greater financial expertise this can limit the demand for a CEO with similar functional expertise within the firm.

    Findings:
    • The authors find that audit fees for firms with a financial expert CEO are lower by 8.5 percent, or $310,000.  The results are robust to controlling for CEO voluntary turnover, the simultaneous turnover of the CFO, firm fixed effects, as well as an instrumental variables approach.
    • Consistent with their predictions, results suggest that a CEO’s financial expertise results in lower audit fees, potentially due to decreased audit risk and lower audit effort.
    Category:
    Corporate Matters, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, CEO Tenure & Experience
  • Jennifer M Mueller-Phillips
    CEO Power, Internal Control Quality, and Audit Committee...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    CEO Power, Internal Control Quality, and Audit Committee Effectiveness in Substance versus in Form
    Practical Implications:

     The findings of this paper have significant policy implications and are important to shareholders. While regulators have set rules to improve audit committee effectiveness, the reforms may not change the substantive effectiveness in certain cases, one case being that the CEO has too much power. The authors provide empirical evidence showing that the negative association between audit committee financial expertise and internal control weaknesses becomes weak when the CEO is powerful. The result implies requiring audit committee to possess certain characteristics, such as financial expertise and fully independence, may not be sufficient to strengthen the underlying substance of monitoring effectiveness. The findings are consistent with evidences from survey and interview studies that argue top management ultimately determine the effectiveness of audit committee. The authors also show a powerful CEO can affect the substantive effectiveness even though he/she is prohibited from selecting audit committee members under the SOX Act. Finally, the findings raise concerns over the common practice of CEO duality in the U.S. A CEO, being the chairman of the board at the same time, can adversely affect audit committee effectiveness.

    Citation:

    Lisic, L. L., T. L. Neal, I. X. Zhang, and Y. Zhang. 2016. CEO Power, Internal Control Quality, and Audit Committee Effectiveness in Substance versus in Form. Contemporary Accounting Research 33 (3): 1199–1237.

    Keywords:
    CEO power, audit committee, financial expertise, internal control
    Purpose of the Study:

     Since the passage of SOX Act of 2002, regulators have implemented several changes to strengthen audit committees’ oversight of public companies’ financial reporting, such as requiring a completely independent audit committee and a disclosure on whether the firm has at least one financial expert on the committee. A stream of academic research shows that financial expertise improves audit committee effectiveness. However, there is an ongoing debate on whether these requirements can truly enhance audit committee’s monitoring effectiveness. Some argue the reforms merely represent a change in form rather than substance. To add additional insights to the debate, the authors examine whether top management can exert detrimental influence on audit committee effectiveness. Specifically, the authors investigate the effect of CEO power on the substantive effectiveness of audit committee, as measured by the firm’s internal control quality. The authors expect a powerful CEO reduces the positive effect of financial expertise on audit committee effectiveness. They also expect this moderating effect of CEO power is stronger when the CEO behaves in a way to benefit him/herself at the expense of the shareholders (i.e., extract rents from the firm).

    Design/Method/ Approach:

    The initial sample comes from public companies’ firm-years without CEO changes between 2004 and 2010. The final sample consists of 7,217 firm-years at the intersection of three databases: COMPUSTAT for financial information and ExecuComp and Corporate Library Directors Databases for information on CEOs and directors. Most CEO characteristics and audit committee financial expertise data are hand-collected by the authors from proxy statements. Audit opinions on internal control effectiveness are obtained from Audit Analytics.

    Findings:
    • The authors find CEO power has a moderating effect on audit committee effectiveness. When CEO power is low, audit committee financial expertise, a measure of audit committee effectiveness, is negatively related to the incidence of internal control weaknesses. However, this relationship is monotonically weakened by increasing CEO power. When CEO power reaches to a high state, audit committee financial expertise is no longer negatively associated with the incidence of internal control weaknesses. This result is not driven by potential indirect involvement by CEO in selecting audit committee members.
    • Consistent with the authors’ expectation, the moderating effect of CEO power is stronger when the CEO extracts more rents from the firm through profitable insider trading.
    • Supporting the main findings, the results also show when CEO power is high, audit committee hold fewer meetings and financial misstatements are more frequent. Both relationships are stronger when internal controls are weaker.
    • The authors also demonstrate the structure and expert dimensions of CEO power are most closely associated with the moderating effect. Specifically, the sources of power of a powerful CEO come from being the chairman of the board at the same time, receiving compensation much higher than other executives, and taking more management positions in the firm before becoming the CEO. 
    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts
  • Jennifer M Mueller-Phillips
    Chief Audit Executives Assessment of Internal Auditors’ P...
    research summary posted February 17, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Chief Audit Executives Assessment of Internal Auditors’ Performance Attributes by Professional Rank and Cultural Cluster
    Practical Implications:

    These results suggest that a generic profile for internal auditors, regardless of industry, may be in order. However, for a small minority of the attributes for which industry may have effects, industry-specific guidance may be appropriate. This conclusion suggests future studies of industry-specific effects for the purpose of developing industry-specific guidance. The IIA’s (2009) Internal Auditor Competency Framework has no industry-specific guidance, and it has indicated that such information will be added when available.

    An interesting finding in the study is that attributes such as financial analysis, research skills, and statistical sampling that have theoretical appeal to the practice of internal auditing were not selected by the CAEs as most important attributes. This result may be an artifact of limiting the selection of the attributes to the top five from each category of behavioral, technical, and competencies. The differences may also be due to the effects of culture.

    For more information on this study, please contact Mohammad J. Abdolmohammadi

    Citation:

    Abdolmohammadi, M.J. 2012. Chief Audit Executives Assessment of Internal Auditors’ Performance Attributes by Professional Rank and Cultural Cluster. Behavioral Research in Accounting 24(1): 1-23.

    Keywords:
    internal auditor attributes; professional rank; culture
    Purpose of the Study:

    This study explores chief audit executives’ perceptions of the most important performance attributes of internal auditors by professional rank and cultural cluster. Specifically, I investigated the following research questions:

    1. What are the most important performance attributes of internal auditors?
    2. Does the importance of performance attributes differ by internal auditors’ professional rank?
    3. Does the importance of performance attributes of internal auditors differ by cultural cluster?
    Design/Method/ Approach:

    The source of data for this study is the IIA’s CBOK (2006) database. This database contains responses from internal auditors of varying ranks practicing in over 100 countries. The IIARF developed this database in 2006 as a comprehensive study of the current state of the internal auditing profession worldwide. The data collected range from personal attributes of internal auditors (e.g., education), to the characteristics of their organizations (e.g., number of employees), to the internal and external quality assessment of the internal audit function. Included are data on 43 performance attributes of internal auditors.

    I identified 19 countries that could be classified into five distinct cultural clusters for investigation. Specifically, two criteria were used to select countries for the current study. First, the country to be selected had to be clearly identifiable with a specific cultural cluster. Second, to be included, a cultural cluster had to be represented by at least ten observations in the CBOK (2006) database so as to have sufficient data for statistical analysis. The resulting sample used in this study consists of 1,497 responses from CAEs in 19 countries classified into five distinct cultural clusters. The Anglo-Saxon cluster has the largest number of CAE responses with 913 observations, while the East-European cluster has only 58 responses. Within various clusters, Venezuela, with seven responses, has the smallest sample size, and the U.S., with 760 responses, has the largest sample size.

    Findings:

    The results show that while leadership attributes increase in importance by professional rank, technical skills generally decrease in importance by professional rank. The results also indicate that importance of performance attributes differs by cultural cluster. Robustness of the main results were confirmed through various multivariate analyses, where significant interaction effects between cultural cluster and professional rank were found. However, industry-specific analysis indicated no pattern of industry differences for the vast majority of performance attributes.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Internal auditor role and involvement in controls and reporting
  • Jennifer M Mueller-Phillips
    Chief Financial Officers as Inside Directors.
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 14.0 Corporate Matters, 14.06 CFO Tenure and Experience 
    Title:
    Chief Financial Officers as Inside Directors.
    Practical Implications:

    These results have implications for boards when deciding on the appointment or replacement of insiders to the board. Specifically, since only a few non-CEO executives can be granted a board seat, the board should carefully consider which executive would enhance the effectiveness of the board. The results demonstrate that the CFO can enhance board effectiveness with respect to the quality of the financial reports. Yet, the results also show that CFOs who serve on the board are more entrenched. Therefore, boards should carefully consider whether the benefits of appointing the CFO to their board outweigh the costs.

    Citation:

    Bedard, J. C., Hoitash, R., and Hoitash, U. 2014. Chief Financial Officers as Inside Directors. Contemporary Accounting Research 31 (3): 787-817.

    Keywords:
    chief financial officers (CFO), organizational structure, board of directors, financial statements
    Purpose of the Study:

    Chief financials officers possess specialized knowledge and play a key role in the current economic and regulatory environment. This is the first study to distinguish a specific board insider, the CFO, from other insiders based on that officer’s specific knowledge and role within the corporate hierarchy. The authors investigate the association between the inclusion of a company’s chief financial officer on its board of directors with financial reporting quality and with CFO entrenchment. They examined first how financial reporting quality is affected by board membership of the CFO based on two contrasting perspectives. The first is consistent with the agency theory that a board seat provides officers with power and influence; thus, there could be negative consequences from reduced board independence associated with officer appointments. With CFOs on the board, the authors could observe lower financial reporting quality among companies making this choice. On the other hand, the CFO can positively contribute to board effectiveness by improving mutual advice and collaboration. Companies should perform better in those areas relating to CFO functions. The second concern is the risk of entrenchment at the cost of investors.

    Design/Method/ Approach:

    The authors used a sample of 7,034 firm year observations. The study sample is based on companies included in the Audit Analytics governance database for 2004 through 2007. The main results are reported using two-stage models. The first stage addresses factors associated with the presence of the CFO on the board, and the second stage tests the association of CFO board membership with financial reporting quality, CFO compensation, and turnover.

    Findings:
    • Companies with CFOs on the board have more effective internal control over financial reporting, higher accruals quality, and lower likelihood of restatements.
    • The results showed a 4.28 percentage point reduction in material weakness (MW) disclosure likelihood.
    • This suggests that suggest that these CFOs are more likely to share information with other board members about the status of the financial reporting function and secure sufficient resources to invest in the establishment, documentation, and testing of internal controls.
    • The results implied that CFOs are more aligned with shareholder interests.
    • CFOs who serve on their own boards receive 26.9 (36.3) percent higher cash (total) compensation.
    • Further, CFOs serving on their own boards are less likely to face turnover following poor corporate performance. However, the authors also find that board membership does not protect the CFO from turnover when poor performance relates specifically to financial reporting quality.
    • These results suggest that serving on the board generally enables CFOs to gain more resources from the company and avoid penalty in times of difficulty, unless that difficulty is related to their direct responsibility.
    Category:
    Corporate Matters, Governance
    Sub-category:
    Board/Audit Committee Composition, CFO Tenure & Experience
  • Jennifer M Mueller-Phillips
    Corporate Governance Reform and Executive Incentives:...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.10 CEO Compensation 
    Title:
    Corporate Governance Reform and Executive Incentives: Implications for Investments and Risk Taking.
    Practical Implications:

    The evidence speaks to the debate on how corporate governance regulation interacts with firms' and managers' incentives, and ultimately affects corporate operating and investment strategies. The evidence contributes to the literature on the economic effects of the governance regulations in SOX on CEOs’ compensation contracts and corporate investment strategies. The evidence also contributes to this literature by documenting how the period after SOX is associated with changes in stock- and option-based compensation. The authors find evidence that the changes in investments are related to lower operating performances of firms, suggesting that these changes were costly to investors.

    Citation:

    Cohen, D. A., Dey, A., & Lys, T. Z. 2013. Corporate Governance Reform and Executive Incentives: Implications for Investments and Risk Taking. Contemporary Accounting Research 30 (4), 1296-1332.

    Keywords:
    corporate governance, executive compensation, investments, risk-taking, executives
    Purpose of the Study:

    In response to a series of corporate scandals beginning with Enron, the U.S. Congress enacted the Sarbanes-Oxley Act (SOX) in 2002 aimed at regulating the governance of firms. While this has resulted in a large and growing body of research, the overall consequences of regulating firms’ governance structures is not yet well understood. For instance, one of the questions still under assessment is to what extent corporate governance regulation interacts with firms’ and managers’ incentives and ultimately affects corporate operating and investment strategies. The authors objective is to investigate how governance regulations in SOX and the exchanges are associated with chief executive officers’ (CEOs) incentives and risk-taking behavior. While there are no direct mandates in SOX regarding executive compensation, two provisions in SOX motivate the analyses. First, SOX requires that a majority of board members of all publicly traded companies be independent, thus increasing the role of independent directors. Second, SOX increases the liability of corporate officers and directors, including expanding the scope of their legal obligations by requiring CEOs and CFOs to certify financial statement information and increasing the penalties associated with violations of securities acts. The authors discuss how these requirements are likely to affect incentive compensation and risk-taking behaviors of executives.

    Design/Method/ Approach:

    The sample consists of industrial companies from the COMPUSTAT annual industrial and research files and ExecuComp and covers the period 19922006. For the analyses with board independence, the authors merge the above sample with RiskMetrics. This results in a sample of 1,158 firms and 12,486 firm-year observations. The final sample represents only firm-year observations where data for all variables included in the analysis are available.

    Findings:
    • The authors find that there were significant shifts in executive compensation to packages that have less incentive-based compensation.
    • The sample firms significantly reduced investments in risky projects in the period following SOX.
    • While the authors find a decline in incentive-based compensation, they also find that CEOs’ responses to risk-inducing incentives declined significantly in the post-SOX period. Therefore, the reductions in investments are not only the consequence of changes in incentive contracts but also the consequence of increased personal costs perceived by CEOs in the period after SOX.
    • Furthermore, the authors find evidence indicating that these changes in investments were, indeed, associated with reduced operating performance of the sample firms and that these changes are correlated with firm-specific stock price changes at the SOX events.
    • The authors find evidence that the changes in investments are related to lower operating performances of firms, suggesting that these changes were costly to investors.
    • The changes in investments were in part due to changes in executive compensation contracts and in part related to increased executives' personal costs of engaging in risky activities.
    Category:
    Corporate Matters
    Sub-category:
    CEO Compensation, Earnings Targets & Management Behavior
  • Jennifer M Mueller-Phillips
    Corporate Sustainability Reporting and Stakeholder Concerns:...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 15.0 International Matters, 15.05 Sustainability Services 
    Title:
    Corporate Sustainability Reporting and Stakeholder Concerns: Is There a Disconnect?
    Practical Implications:

    Sustainability is important to the accounting industry. Accountants have a responsibility to help integrate sustainability into areas such as budgets, resource allocations, and capital expenditure decisions. The evidence from this study indicates what CS activities consumer find important. Management can use this information in developing their business strategies related to CS. 

    Citation:

    Bradford, Marianne, J. B. Earp, D. S. Showalter, and P. F. Williams. 2017. “Corporate Sustainability Reporting and Stakeholder Concerns: Is There a Disconnect?”. Accounting Horizons. 31 (1): 83-102.

    Keywords:
    corporate sustainability; Global Reporting Initiative; sustainability reporting; stakeholder theory; content analysis; survey; factor analysis
    Purpose of the Study:

    There has been an increasing number of companies reporting their corporate sustainability (CS) in recent years. Traditionally, CS refers to measures companies take against environmental issues. However, in recent years it is often viewed as the balance between environmental, social, and economic outcomes, also known as the triple bottom line. This expanded definition of CS has caused companies to emphasize different outcomes, and subsequently to have vastly different CS reports. The current guidelines for CS reporting, the Global Reporting Initiative (GRI) framework, is consistently updated to account for this expanded view. Additionally, consumers are increasingly being viewed as primary stakeholder groups. This study examines whether the CS information being reported through the GRI framework is adequately addressing consumer stakeholder interests.

    Design/Method/ Approach:

    The sample contained 505 participants that responded to an online survey in 2013. The link to the survey was posted on the Institute of Management Accountants (IMA) website and also onto North Carolina State University’s website. The participants assumed the role of consumers and took the survey which contained 40 scale items and 6 demographic items.

    Findings:

    The authors find the following:

    • There is a disconnect between the dimensions that consumer stakeholder groups view as important and the GRI dimensions. The GRI based framework is broad, and therefore the reported measures may not satisfy the precise concerns that all stakeholder groups have.
    • Specifically, consumer stakeholder group consider Risk and Compliance to be of high importance. The stakeholders are concerned with the company’s ethical behavior, accountability standards, audits, and accounting policies. On the other hand, Economic activities were viewed as less important.
    Category:
    Corporate Matters, International Matters
    Sub-category:
    Sustainability ServicesTraining & General Experience

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