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  • Jennifer M Mueller-Phillips
    Board Independence and Internal Control Weakness: Evidence...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 01.04 Impact of 404, 07.03 Reporting Material Weaknesses, 13.01 Board/Audit Committee Composition 
    Title:
    Board Independence and Internal Control Weakness: Evidence from SOX 404 Disclosures
    Practical Implications:

    This study examines the effects on internal control weaknesses associated with an independent board of directors. A benefit of having an independent board is the timely remediation of ICWs. This is of high importance because the quicker a material weakness is resolved, the sooner a company can return to normal operations. Another contribution of this study is the discovery of implications regarding Auditing Standard No. 5. The standard changed internal control evaluation to become more holistic and less detailed. This provides the board of directors less tangible information on the status of internal controls.

    Citation:

    Chen, Yangyang, Robert. W. Kechel., V. B. Marisetty, C. Truong, and M. Veeraraghavan.2017. Board Independence and Internal Control Weakness: Evidence from SOX 404 Disclosures. Auditing, A Journal of Practice and Theory 36(21): 45-62.

    Keywords:
    internal control weakness; board independence; unitary versus dual leadership; SOX 404
    Purpose of the Study:

    An important role of corporate governance is its duty to manage various aspects of risk. One way to accomplish this goal is through oversight of management’s system of internal controls. This study examines how corporate governance structure affects management’s disclosure of material weaknesses in internal control over financial reporting. Specifically, the authors investigate how the board’s characteristics of independence and leadership style (a unitary leader versus separate CEO and chairman) influence the frequency of internal control weaknesses (ICWs) reported, the types of ICWs reported, and timeliness of ICW remediation. 

    Design/Method/ Approach:

    Reported ICWs were gathered from Audit Analytics, based on forms 10-K, 10-K/A, 20-F, and 40-F. Board demographics, including independence variables, were gathered from RiskMetrics. The final sample consisted of 2,048 firms and 11,226 observations, from 2004 – 2012.

    Findings:

    The authors find the following related to board independence:

    • Board independence is negatively associated with the disclosure of ICWs. The evidence suggests that higher board independence causes a lower probability of ICWs occurring.
    • There was lower number of both account-specific and company-level ICWs in boards with more independent directors.
    • Board independence is associated with timely remediation of ICWs.

     

    The authors also find:

    • The negative relation between board independence and ICWs is strongest in a company that has unitary leadership. This demonstrates that an effective board is based more on board independence rather than board leadership style.
    • The implementation of Auditing Standard No. 5 in 2007 somewhat weakened the effect of board independence on the disclosure of ICW’s.
    Category:
    Governance, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Board/Audit Committee Composition, Impact of 404, Reporting Material Weaknesses
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Board Interlocks and Earnings Management Contagion.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.05 Board/Audit Committee Oversight 
    Title:
    Board Interlocks and Earnings Management Contagion.
    Practical Implications:

    The evidence on the firm-to-firm spread of financial reporting behavior via board networks contributes to a little-studied area in accounting that should be important. The authors contribute to the corporate governance literature by offering evidence that contagion effects vary with board positions. They show that board supervision of management is important for ensuring high-quality financial reporting and that board linkages affect the success of this supervision. Regulators concerned about improving financial reporting quality should consider the board connectivity of companies.

    Citation:

    Chiu, P. C., S. H. Teoh, and F. Tian. 2013. Board Interlocks and Earnings Management Contagion. Accounting Review 88 (3): 915-944.

    Keywords:
    board interlocks, board networks, contagion, earnings management, governance, restatements, social networks
    Purpose of the Study:

    In the corporate world, behavior may spread through board of director networks. A board link exists between two firms whenever a director sits on both firms’ boards. A typical board in the sample has nine directors, and the median number of interlocks with other boards is approximately five. In this way, firms are widely connected by their board networks, which potentially serve as conduits for spreading behaviors from firm to firm.

    In this study, the authors investigate whether financial reporting behavior spreads through interlocking corporate boards. The test design emphasizes contagion of bad financial reporting choices, specifically, earnings management that results in a subsequent earnings restatement, although it also allows for inferences about good reporting contagion. The authors use restatements to identify firms that have managed earnings and the period when the manipulation occurred. They refer to a firm that later restates earnings as contagious. The authors define the contagious period as starting in the first year for which earnings are restated and ending two years after. Any firm that shares an interlocked director with the contagious firm during the contagious period is therefore exposed to an earnings management infection via the board network. They consider a multiyear contagious period to allow the earnings management infection to incubate, which is analogous to an epidemiological setting for viral infections. The key test investigates whether an exposed firm is more likely to manage earnings during the contagious period as compared to an unexposed firm.

    Design/Method/ Approach:

    The authors use the U.S. Government Accountability Office’s (GAO) first release of restatements between January 1, 1997 to June 30, 2002 to identify contagious firms and their contagious periods. They keep only the earliest restatement within the sample period when a firm has multiple restatements. The authors obtain director names from Risk Metrics. In the 19972001 sample period the authors identify a sample of 118 observations.

    Findings:
    • The authors find strong evidence that a firm is more likely to manage earnings when exposed within a three-year period to earnings management from a common director with an earnings manipulator. The contagion effect is economically substantial.
    • The regression odds ratio suggests that a board link to a manipulator doubles the likelihood that the firm will manage earnings.
    • The authors also find evidence for good financial reporting contagion. A board link to a non-manipulator significantly decreases the likelihood of the firm being a manipulator.
    • Both bad and good accounting behaviors are contagious across board networks.
    • Earnings management contagion is stronger when the shared director has a leadership position as board chair or audit committee chair, or an accounting-relevant position as an audit committee member, in the exposed firm.
    • The contagion is also stronger when the linked director is the board chair or CEO of the contagious firm, but not when the linked director is the CEO of the exposed firm.
    • Earnings management contagion is exacerbated when the exposed firm is located within 100 miles of the contagious firm and shares a common auditor with the contagious firm.
    • The evidence supports the proposition that earnings manipulation spreads through board networks.
    Category:
    Accountants' Reporting, Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Oversight, Earnings Management, Earnings Management, Restatements
  • 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
    Busyness, Expertise, and Financial Reporting Quality of...
    research summary posted July 20, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.02 Board/Financial Experts, 13.05 Board/Audit Committee Oversight 
    Title:
    Busyness, Expertise, and Financial Reporting Quality of Audit Committee Chairs and Financial Experts
    Practical Implications:

    This research makes important contributions to understanding the factors associated with audit committee monitoring effectiveness in the post-SOX period. This study provides additional support for already existing research that both busy audit committee chairs and busy audit committee financial experts may result in overall lower financial reporting quality. These results are important for firms to consider in order to understand how the effectiveness of the audit committee can be affected by these key roles.

    For more information on this study, please contact Paul Tanyi.

    Citation:

    Tanyi, P. N. and D. B. Smith. 2015. Busyness, expertise, and financial reporting quality of audit committee chairs and financial experts. Auditing: A Journal of Practice and Theory 34 (2): 59-89.

    Keywords:
    Audit committee chairs, audit committee financial experts, audit committees, financial reporting quality
    Purpose of the Study:

    The audit committee chairman and financial experts hold important roles for audit committee oversight. This study investigates whether the number of other chairman or expert positions held by the individuals (“busyness”) negatively influences their ability to properly oversee financial reporting.  Previous research has shown that before the Sarbanes-Oxley Act there was a positive relationship between multiple audit committee directorships and monitoring quality. This study seeks to support the alternative hypotheses that financial reporting quality post-SOX is negatively associated with the number of audit committee chair positions and other audit committee financial expertise positions held by the audit committee chairman/financial experts.

    Design/Method/ Approach:

    The final data sample consisted of 6,535 firm-year observations from the period 2004 to 2008. The authors compare the busyness of the audit committee chairman and financial expert(s) to the quality of the public companies’ financial reporting. The authors determine the busyness of the chairman and financial experts using the number of other chair and financial expertise positions that they hold.  Financial reporting quality is measured by evaluating certain characteristics of the firms’ earnings and indicators of managerial earnings manipulation. The authors controlled for certain firm characteristics that might influence financial reporting quality—other governance characteristics, the nature of the firm’s business, the strength of internal controls over financial reporting, and auditor characteristics.

    Findings:
    • The number of audit committee chair positions and other audit committee financial expertise positions held by the audit committee chairman is significantly negatively associated with financial reporting quality.           
    • The number of audit committee chair positions and other audit committee financial expertise positions held by the audit committee financial expert is significantly negatively associated with financial reporting quality.
    • Because the audit committee chairs and financial experts serve on multiple audit committees where they are considered audit committee chairpersons and financial experts, respectively, their over-commitment appears to limit the average amount of time they can devote to each audit committee, resulting in the previously stated negative associations.
    • Multiple audit committee directorships do not appear to be problematic for members who are not audit committee chairs or financial experts, likely because they face fewer burdens and expectations.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Oversight, Board/Financial Experts
  • Jennifer M Mueller-Phillips
    The Nominating Committee Process: A Qualitative Examination...
    research summary posted July 17, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.06 Board/Audit Committee Processes 
    Title:
    The Nominating Committee Process: A Qualitative Examination of Board Independence and Formalization.
    Practical Implications:

    The overall message of the interviews perhaps is best captured by one interviewee, who described a “strange little dance.” Throughout the interviews, the authors find evidence that the NC must “dance” through a complex decision landscape that includes potential CEO influence over the nomination process, consideration of formal versus informal processes, frequent previous ties between NC members and the CEO, a nearly pervasive focus on chemistry and comfort, and concerns about external legitimacy and board effectiveness. Such complexity offers the NC numerous opportunities to stumble or fall, and it demonstrates the need for multiple theoretical perspectives in interpreting the findings. Such complexity, or limited observability of NC-related outputs, also could serve to insulate the NC from scrutiny or regulation.

    Citation:

    Clune, R., Hermanson, D. R., Tompkins, J. G., & Ye, Z. 2014. The Nominating Committee Process: A Qualitative Examination of Board Independence and Formalization. Contemporary Accounting Research 31 (3): 748-786.

    Keywords:
    board of directors, CEOs, nominating committee, directors of corporations
    Purpose of the Study:

    This study examines the director nomination process employed by the nominating committee (NC), based on extensive interviews of U.S. public company NC members. The CEO’s influence over the director nomination process can range widely, from the CEO choosing the director candidates and using a mock search process, to the CEO being essentially uninvolved in a process that is handled independently by the NC. Likewise, the formality of the director nomination process can vary widely.

    The director nomination process is a setting where the characteristics of the board are established, and these characteristics have been examined in a growing body of accounting research. This study is designed to fill this void by examining the activities of corporate NCs, with particular focus on the director nomination process. In addition to providing insights for archival research examining director characteristics and offering implications for accounting practice and regulation, this study also extends the emerging interview-based accounting literature on board committee processes.

    Design/Method/ Approach:

    The authors interviewed 20 U.S. public company NC members to explore each company’s most recent outside director nomination process. Sixteen of the 20 interviewees were chairs of the committees, and all had been part of a recent director nomination process. The authors developed a 21-page interview script to guide the interviews with open-ended questions. The authors conducted the interviews from January through July of 2010, with nine of the interviews face-to-face and 11 via conference call.

    Findings:
    • There is continuing recognition of CEO influence in the director nomination process, the level of which varies widely by company.  
    • The interviewees’ perceptions of CEO influence range from very little influence to virtually total control of the process. 
    • Greater CEO influence over the director nomination process is associated with more experienced interviewees, retired individuals serving on the NC, and larger companies/NCs.
    • The authors find considerable variability in the formalization of the director nomination process. Some interviewees discuss using a matrix/grid approach to assess director skill sets across the board, while others do not mention the use of such tools.
    • Some NCs use search firms to facilitate the process, while others do not, instead leveraging their own contacts to identify director candidates.
    • Overall, some nomination processes reflect very formal, structured approaches, while others are relatively informal and organic.
    • It does not appear that CEO influence and process formality are associated.
    • Many interviewees have professional or personal ties to the CEO and that nearly all of the NCs focus on chemistry and comfort in the director nomination process, where the often-stated goal is to enhance the board’s ability to function effectively and to reduce risk in the director nomination process.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Processes
  • Jennifer M Mueller-Phillips
    Market Reactions to Departures of Audit Committee Directors
    research summary posted February 16, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.03 Board/Audit Committee Tenure 
    Title:
    Market Reactions to Departures of Audit Committee Directors
    Practical Implications:

    The evidence indicates that the market values the presence of audit committee financial experts who have previous accounting experience on the board and reacts negatively if such directors leave the company. Furthermore, the results indicate a negative stock market reaction when a short-tenured audit committee director leaves the board. Departures of audit committee members could be early warning signals for larger problems in the long run.

    For more information on this study, please contact Meghna Singhvi (Meghna.Singhvi@LMU.EDU)

    Citation:

    Singhvi, M., D.V. Rama and A. Barua. 2013. Market reactions to departures of audit committee directors. Accounting Horizons 27(1): 113-128

    Keywords:
    Audit committee turnover, audit committee resignations, expert directors, director-tenure.
    Purpose of the Study:

    Audit committee composition has received significant attention from legislators and regulators in recent years. In this study, the authors study investor’s reaction to audit committee director departures, conditional on directors’ attributes, namely, types of expertise, tenure and busy-ness (i.e., number of other board appointments). SOX’s requirements about audit committee expertise were initially controversial and the SEC had to change the proposed definitions related to “audit committee financial expert.” Some suggest that long-tenured board members provide better oversight because of firm-specific knowledge that is acquired with experience, while others argue that long tenured directors are less likely to provide adequate oversight over management.  Similarly, there are divergent arguments about audit committee directors serving on multiple boards. The authors argue that market reactions provide empirical evidence about market perceptions related to different types of audit committee director departures. 

    Design/Method/ Approach:

    The data are from the years 2005-2008. This paper studies the cumulative abnormal return around the seven days surrounding the Form 8-K filing related to the departure of audit committee directors. The authors focus on single audit committee director departures and delete firms with (a) more than one audit committee director resignation and (b) other contemporaneous news. The final sample comprises of 107 audit committee director departures with available data for the analysis. 

    Findings:
    • The authors find that there is a negative market reaction when an audit committee financial expert who has an accounting background departs from the audit committee.
    • The authors find that there is a negative market reaction when a short-tenured (0-3years) audit committee director departs from the audit committee.
    • The market reaction does not differ between directors with and without multiple board memberships.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Audit Committee Tenure
  • Jennifer M Mueller-Phillips
    An Empirical Analysis of the Effects of Accounting Expertise...
    research summary posted December 1, 2014 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.02 Board/Financial Experts 
    Title:
    An Empirical Analysis of the Effects of Accounting Expertise in Audit Committees on Non-GAAP Earnings Exclusions
    Practical Implications:

    Given the Public Company Accounting Oversight Board’s (PCAOB) current proposal for auditors to provide assurance on non-GAAP information or earnings releases, the results of this study are important for regulators and boards of directors in their evaluation of the desirable attributes for audit committee financial experts. This study suggests that the audit committee financial expert designation is likely best held by a director who brings to the table more than just supervisory experience over the financial reporting function; lessons gained from actually performing financial accounting functions seem to enhance the audit committee’s ability to monitor management’s non-GAAP financial measures and rationale for excluding charges as infrequent, unusual or nonrecurring.

    For more information on this study, please contact Xu (Frank) Wang.

    Citation:

    Seetharaman, A., X. Wang, and S. Zhang. 2014. An Empirical Analysis of the Effects of Accounting Expertise in Audit Committees on Non-GAAP Earnings Exclusions. Accounting Horizons 28(1): 17-37.

    Keywords:
    Non-GAAP Earnings, Accounting Expertise, Audit Committee Composition, Financial Experts.
    Purpose of the Study:

    U.S. stock exchanges and lawmakers rely on audit committees to help safeguard the accuracy and reliability of corporate GAAP and non-GAAP financial information. However, there are gaps in our knowledge of how audit committees perform, especially with respect to companies’ non-GAAP financial information.

    An important motivation of this paper is that unlike companies’ GAAP-based financial measures, non-GAAP numbers are unaudited and not well-defined. These numbers are therefore subject to the discretion of the managers who may or may not have their interests aligned with those of the stakeholders of the companies. In this study, the authors address these concerns by focusing on the audit committee’s role in monitoring companies’ non-GAAP financial disclosures.   

    The authors examine the association between audit committee appointments of accounting experts (relative to appointments of nonaccounting experts) and the company’s non-GAAP earnings numbers. Specifically, the authors investigate whether the appointment of an audit committee accounting expert, in contrast to the appointment of a nonaccounting expert, would improve the quality of non-GAAP earnings while reducing the magnitude of potential misuse.

    Design/Method/ Approach:

    The research evidence is collected from data of publicly traded companies in the 1998-2005 time period.  The authors identify audit committee appointments as either an accounting expert appointment or a nonaccounting expert appointment, which in turn is further classified into two sub-groups: (1) supervisory expert appointment, and (2) other appointment. Each appointment is a deliberate intervention that helps shed light on the differential effects of one type of appointment from another in terms of monitoring the quality of non-GAAP earnings numbers. 

    Findings:
    • The authors find a larger decline in non-GAAP earnings exclusions following the appointment of accounting (rather than nonaccounting) experts to audit committees.
    • The authors find that accounting experts are associated with higher-quality post-appointment non-GAAP earnings exclusions.
    • The authors find that accounting expert appointments are associated with higher quality non-GAAP earnings exclusions than supervisory expert appointments.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Financial Experts
  • Jennifer M Mueller-Phillips
    The Audit Committee: Management Watchdog or Personal Friend...
    research summary posted November 17, 2014 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.05 Board/Audit Committee Oversight 
    Title:
    The Audit Committee: Management Watchdog or Personal Friend of the CEO?
    Practical Implications:

    The results of this study shed light on some unanticipated effects of the SOX mandate for “independent” audit committee members. While the growth in board and audit committee size that followed this mandate has led to improvements in audit committee expertise, CEOs might still appoint or maintain directors from their personal network of friends to build an audit committee that is sympathetic to their reporting choices.

    Furthermore, the evidence is informative for shareholders, nomination and governance committees. Such parties might refrain from appointing a director in the audit committee who is too closely connected to the CEO. Additionally, it may be important to require more disclosure about the nature and type of social connections between audit committee members and the CEO.

    For more information on this study, please contact Liesbeth Bruynseels.

    Citation:

    Bruynseels, L. and E. Cardinaels. 2014. The Audit Committee: Management Watchdog or Personal Friend of the CEO? The Accounting Review 89 (1): 113-145.

    Keywords:
    social ties; financial reporting quality; audit committee; monitoring.
    Purpose of the Study:

    To ensure that audit committees provide sufficient oversight over the auditing process and quality of financial reporting, legislators have imposed stricter requirements on the independence of audit committee members. Yet audit committee members who are fully independent according to SOX may still be connected to executives in many ways. They may serve together as directors on the board of another company, they may have worked together in the past as directors or employees, or they may have earned their MBA from the same university. Other connections may be formed outside professional or educational networks, such as those between committee members and executives attending the same business club, playing in the same golf club, working for the same charity, or other non-profit organization. This latter category of non-professional social ties is labeled as CEO-audit committee “friendship” ties.

    The study predicts that connections may enable the CEO to appoint directors who are “friendly” to his or her reporting policies. This may have an impact on the audit committee’s primary task to offer sufficient oversight over the reporting quality and audits of the financial statements.

    This study explores:

    • the extent and type of social ties observed between CEOs and audit-committee members
    • whether such ties reduce the quality of audit committee monitoring.
    Design/Method/ Approach:

    This study uses a large dataset of U.S.-listed companies and focuses on the 2004 to 2008 post-SOX period. A distinction is made between fully independent audit committees and firms whose audit committee members have social ties with the CEO through either employment (e.g., shared current directorships or past employment/directorships), past education (e.g., graduating from the same school), or other non-professional activities (e.g. shared memberships in leisure clubs, charities, country clubs, industry associations etc).  The authors assess the effect of these three types of CEO-audit committee social ties on various output variables that proxy for the oversight quality of the audit committee. 

    Findings:

    The sample of all firm-year observations shows that on average 17 percent of audit committee members share ties with their CEO, mainly through employment. On average in 39 percent of all firm-year observations, the audit committee includes at least one socially connected audit committee member.

    The results show that:

    • Friendship ties between CEOs and the audit committee may reduce the quality of the audit committee’s oversight (proxied by financial reporting quality and levels of audit effort).
    • Consistent with weaker oversight of the audit process, auditors are also less likely to issue going-concern opinions for firms in distress when friendship ties are present.
    • Fewer internal control weaknesses are disclosed in the SOX 404 reports of firms with friendship ties. This presumably occurs because audit committees with such ties to the CEO offer the auditor less support when he or she disagrees with management over the type of internal control report to issue. Further analysis indeed suggests that firms with friendship ties are more likely to subsequently amend initially clean reports because of weak internal controls.
    • Finally, professional and educational ties do not seem to produce negative effects on oversight quality.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Compensation, Board/Audit Committee Oversight
  • Jennifer M Mueller-Phillips
    Voluntary Adoption of More Stringent Governance Policy on...
    research summary posted November 12, 2014 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Voluntary Adoption of More Stringent Governance Policy on Audit Committees: Theory and Empirical Evidence
    Practical Implications:

    The findings in this study have important policy and practical implications. First, the study provides empirical evidence that firms have incentives to adopt more stringent governance mechanisms voluntarily if doing so is beneficial. The OSC Policy to exempt smaller issues is both effective and efficient in that it encourages the voluntary adoption and it avoids imposing unnecessary compliance costs associated with a one-size-fits-all mandatory compliance policy. Second, the findings in this study provide strong evidence that adopting more stringent audit committees can generate tangible economic benefits in the form of increased firm valuation, lower cost of capital, and improved investment efficiency. It appears that managers in some TSX listed firms may have overlooked these benefits and did not adopt the more stringent audit committee voluntarily before the mandatory adoption date. Finally, the findings in this study provide corroborating evidence that fully independent and financially literature audit committees are more effective than the less stringent ones in monitoring firm investments and in enhancing the quality of accounting information, as implied in our findings. Investors and policy makers should advocate the adoption of more stringent audit committees.

    For more information on this study, please contact either Feng Chen or Yue Li.

    Citation:

    Chen, F., and Y. Li. 2013. Voluntary Adoption of More Stringent Governance Policy on Audit Committees: Theory and Empirical Evidence. The Accounting Review 88 (6): 1939-1969.

    Keywords:
    Independent audit committees; corporate governance; voluntary compliance; investment efficiency; firm valuation; cost of capital
    Purpose of the Study:

    The Ontario Securities Commission (OSC) issued Multilateral Instrument 52-110 (MI 52-110) policy in June 2003. This policy, which became effective on January 1, 2004, requires securities issuers listed in the Toronto Stock Exchange (TSX) to set up an audit committee with at least three independent and financially literate board members. One unique feature of this policy is that it exempts small issuers such as companies listed on the TSX Venture Exchange in favor of voluntary compliance by these firms due to concerns about compliance costs. . The policy only requires small issuers to disclose whether they have an audit committee, the names of its members, and whether the members are independent.

    The OSC’s policy on audit committees is unique in that it allows TSX Venture-listed firms to adopt a more stringent governance mechanism voluntarily. This policy creates a desirable regulatory setting to investigate the costs and benefits associated with voluntary adoption of a more stringent audit committee.  Within this Canadian regulatory setting, we examine the following research questions: (1) What economic factors would affect TSX Venture firms’ decisions to adopt the more stringent audit committee voluntarily? (2) What are the likely economic benefits from adopting more stringent audit committees by TSX Venture firms and from mandatory compliance by TSX listed firms? 

    Design/Method/ Approach:

    The researchers first develop a parsimonious analytical model to analyze controlling shareholders’ (or management) incentives to adopt the more stringent audit committee policy voluntarily. The model provides interesting and intuitive predictions. First, firms with low compliance costs will be more likely to adopt the more stringent audit committee voluntarily. Second, firms with high future financing needs will also be more likely to adopt the more stringent audit committee voluntarily. Finally, the adoption of the more stringent audit committee will lead to higher firm valuation due to improvement in investment efficiency.           

    They then test the predictions of the model empirically by using archival data from a sample of 376 firms listed on the TSX Venture Exchange during the 2003-2004 period. They also analyzed whether the adoption of the more stringent audit committee would lower the cost of capital and improve the investment efficiency for both the TSX Venture firms and TSX listed firms. 

    Findings:
    • Consistent with the predictions of the model, the researchers find that compliance costs negatively affect the TSX Venture firms’ decisions to adopt the more stringent audit committee policy voluntarily.
    • They also find that firms that adopted the more stringent audit committees voluntarily were more likely to raise capitals and to migrate to the Toronto Stock Exchanges during the three year period immediately following the adoption decision.
    • The study also finds that companies that adopted the audit committee policy voluntarily experienced a high firm valuation measured in Tobin's Q, lower costs of capital, improved investment efficiency after the voluntary adoption.
    • Finally, the study finds that TSX listed firms also experienced increased firm valuation, lower cost of capital, and improved investment efficiency immediately following the mandatory adoption of more stringent audit committees.
    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Audit Committee Composition
  • Jennifer M Mueller-Phillips
    The Effect of Audit Committee Industry Expertise on...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    The Effect of Audit Committee Industry Expertise on Monitoring the Financial Reporting Process
    Practical Implications:

    The findings indicate that audit committee members who have industry knowledge enhance financial reporting quality and external audit oversight beyond what is provided by members with only financial expertise. Therefore, standard setters and regulators such as the SEC should consider revisiting this issue and recommend that audit committees include member(s) who possess a combination of industry specific knowledge and financial expertise. Finally, since companies commonly have members with industry experience on their boards, they should consider appointing these members to serve on the audit committee.

    For more information on this study, please contact Jeffrey Cohen.

    Citation:

    Cohen, J., Hoitash, U., Krishnamoorthy, G., and Wright. 2014. The Effect of Audit Committee Industry Expertise on Monitoring the Financial Reporting Process. The Accounting Review (January): 243-273

    Keywords:
    Corporate governance, Industry expertise, Financial expertise, Audit committees, Restatements, Discretionary accruals, Audit fees, Non-audit fees.
    Purpose of the Study:

    Calls from practice suggest that audit committee members with industry expertise can improve audit committee effectiveness. Nevertheless, regulators have focused on the financial expertise of the audit committee. We expect that audit committee industry knowledge is valuable because accounting guidance, estimates, and oversight of the external auditor are often linked to a company’s operations within a particular industry. 

    Design/Method/ Approach:

    Using publically available data from 2001-2007 for a large and representative sample of over 18,000 observations from public companies, we examine two measures of financial reporting quality (financial restatements and earnings management) and two measures of external auditor oversight (audit and non-audit fees).

    Findings:

    As predicted, we find that audit committee members who are both accounting and industry experts are associated with higher financial reporting quality than those with only accounting expertise. We also find that in certain instances, supervisory experts (i.e., those who have gained financial expertise by supervising preparers of financial reports such as CEOs) who are also industry experts are associated with higher financial reporting quality than supervisory experts alone. Overall, these results suggest that industry expertise, when combined with financial expertise, can improve the effectiveness of the audit committee in monitoring the financial reporting process.

    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition

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