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  • Jennifer M Mueller-Phillips
    The Effects of Prior Manager-Auditor Affiliation and PCAOB...
    research summary posted November 15, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.06 Board/Audit Committee Processes 
    Title:
    The Effects of Prior Manager-Auditor Affiliation and PCAOB Inspection Reports on Audit Committee Members’ Auditor Recommendations
    Practical Implications:

    This paper provides evidence indicating that audit committee members recognize the potentially harmful effects of a manager-auditor relationship on auditor independence. It also supplies insight into the audit committee’s auditor selection and audit quality assessment process. 

    Citation:

    Abbott, L. J. V. L. Brown and J. L. Higgs. 2016. The Effects of Prior Manager-Auditor Affiliation and PCAOB Inspection Reports on Audit Committee Members’ Auditor Recommendations.  Behavioral Research in Accounting 28 (1): 1-14. 

    Keywords:
    audit committees, auditor selection, PCAOB auditor inspections, audit affiliation and audit quality.
    Purpose of the Study:

    The authors of this paper investigated the extent to which audit committee members utilize Public Company Accounting Oversight Board (PCAOB) inspection reports and consider a prior manager-auditor affiliation in their auditor selection decisions when management has recommended an auditor. The audit committee is directly responsible for the appointment, compensation, an oversight of the external auditor. When performing this duty, audit committees are to annually assess the auditor’s qualifications, independence, and performance and to avail themselves of any information sources necessary to make that assessment. It is likely that audit committees utilize PCAOB inspection reports to assess auditor performance. Prior archival research has only examined the use of PCAOB reports indirectly, and the results were hampered by the confounding effects of auditor brand name, auditor switching costs, and attempts by the auditor to de-emphasize the PCAOB’s report findings. This behavioral setting has a unique benefit by eliminating these confounding effects, providing direct evidence about whether audit committee members find PCAOB inspection reports useful in the context of the auditor selection decision. 

    Design/Method/ Approach:

    The authors conducted an experiment with 118 financially literate participants, acting as surrogates for audit committee members. The study also utilizes a 2 x 2 research design with manipulated auditor competence and independence constructs. 

    Findings:
    • The authors find that auditors with unfavorable inspection reports receive less favorable hiring recommendations, and auditors with management affiliations also receive less favorable hiring recommendations.
    • The authors find that the impact of auditor affiliation on participants’ judgments is context specific: it manifests itself only when the auditor is deemed to be competent via a favorable inspection report.
    • The authors find that there does not appear to be an auditor affiliation effect in the presence of an incompetent auditor with an unfavorable inspection report. 
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Processes
  • Jennifer M Mueller-Phillips
    Serving Two Masters: The Association between Audit Committee...
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight, 13.06 Board/Audit Committee Processes, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Serving Two Masters: The Association between Audit Committee Internal Audit Oversight and Internal Audit Activities.
    Practical Implications:

    The results speak to the need for regulators to consider the incentives of the various stakeholders when determining policy. Should policy makers consider expanding or restricting specific oversight roles, they should consider the concomitant effects on the internal audit function, and the differential incentives faced by the audit committee and executive management. In addition, as audit committees and managers jointly work or oversee the work of internal auditors, the results suggest that these two oversight participants should consider how their respective incentives potentially bias the focus of the internal audit department away from a mix of activities that optimally address the greater business risks of the company. Likewise, as external auditors assess the organizational status of the internal audit department, they may also wish to consider the apparent focus of internal audit as a potential indication of oversight control.

    Citation:

    Abbott, L. J., S. Parker, and G. F. Peters. 2010. Serving Two Masters: The Association between Audit Committee Internal Audit Oversight and Internal Audit Activities. Accounting Horizons 24 (1): 1-24.

    Keywords:
    internal auditing, audit committees, best practices, internal auditors
    Purpose of the Study:

    This study examines the association between the activities performed by the internal audit function (hereafter, IAF) and the extent of audit committee oversight of the IAF. Two primary concerns motivate this study. First, relatively little regulatory or best practices guidance relates to the distribution of IAF activities, and virtually no current research has been done about these activities. The authors believe this topic to be important because current New York Stock Exchange listing rules require registrants to maintain an IAF, increasing the pervasiveness of internal audit. The second motivation concerns the relatively incomplete set of audit-committee related regulations. In particular, the Sarbanes-Oxley Act of 2002 (SOX) requires audit committee oversight of internal controls over financial reporting and also mandates reporting on a registrant’s internal controls. However, SOX is silent on internal audit, a key participant in both the financial reporting process and the internal control structure. Moreover, SOX does not address internal audit’s reporting relationship with the audit committee or the audit committee’s duties concerning internal audit resources.

    Design/Method/ Approach:

    The survey questionnaire was mailed to Fortune 1000 companies, after excluding banks. Consistent with much prior internal audit research, the survey was directed to CIAs. The first survey was sent in July 2006 and resulted in a total of 72 usable responses. A follow-up mailing was conducted in September 2006 and produced an additional 62 usable responses. This lead to the final sample size of 134 observations.

    Findings:

    The authors find that the percentage of the IAF budget devoted to internal-controls-based activities is positively related to the measure of the audit committee’s oversight. In particular, audit committees with greater IAF oversight are associated with larger percentages of IAF hours being allocated toward internal controls activities. Moreover, the results suggest that a significant number of Fortune 1000 companies have audit committees that appear to have little oversight of the IAF. This speaks to the relevance and timeliness of the recommendations of numerous parties concerning audit committee internal audit termination/hiring rights and budgetary controls.

    The authors also document significant differences in the allocation of IAF budgets across different activities, an area with very little prior research. They find that the majority of the IAF budget is devoted to internal controls activities, but the remainder, allocated to non-controls activities, is considerable. The evidence indicates that outsourcing arrangements are quite prevalent, but are also quite specific. In particular, the majority of outsourcing hours were spent on Section 404- related activities, with a lesser portion devoted to assisting the external auditor with the financial statement audit. The results suggest that an audit committee’s demand for better internal controls may lead to greater IAF focus on internal controls. 

    Category:
    Governance
    Sub-category:
    Board/Audit Committee Oversight, Board/Audit Committee Processes, Internal auditor role and involvement in controls and reporting
  • 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
    Corporate Governance Research in Accounting and Auditing:...
    research summary posted October 27, 2014 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.03 Board/Audit Committee Tenure, 13.04 Board/Audit Committee Compensation, 13.05 Board/Audit Committee Oversight, 13.06 Board/Audit Committee Processes 
    Title:
    Corporate Governance Research in Accounting and Auditing: Insights, Practice Implications, and Future Research Directions
    Practical Implications:

    First, the weight of evidence suggests that weak governance is associated with an increased likelihood of adverse financial reporting outcomes (in particular, fraud and restatements). Thus, perhaps the most fundamental practice implication is that the governance research findings to date are, on an overall basis, consistent with the focus on improved corporate governance (e.g., board independence, audit committee expertise) found in SOX and related regulatory reforms.

    Second, since the board and the audit committee are primary mechanisms for the internal monitoring of top management’s financial reporting behavior, and given that the CEO and/or CFO is involved in 89 percent of all public company accounting frauds (Beasley et al. 2010), external auditors need to very carefully examine corporate governance characteristics and processes in assessing the control environment.

    Third, research finds that auditor changes/dismissals are less problematic in the presence of good governance. That is, in the presence of good governance, the auditor change/dismissal may be justified by poor auditor performance or excessive fees. Since regulators do not have the resources to examine all auditor changes, even if limited to dismissals, regulators might want to consider the client firm’s governance characteristics when deciding whether to investigate an auditor dismissal.

    Fourth, research indicates that external auditors assess risk higher and plan more audit hours for firms with weak governance. However, whether auditors adequately adjust for weak governance has not been examined. In other words, adjustments of risk assessments and audit hours occur, but is there enough adjustment in light of the higher risk?

    Fifth, strong governance and strong auditing appear to be complements rather than substitutes—stronger boards and audit committees are associated with stronger auditing. Therefore, monitoring (both internal monitoring by the board and audit committee, and external monitoring by the auditor) is likely to be especially weak in firms with weak governance, for the quality of auditing is likely to be lower in the presence of weak governance.

    Sixth, a number of studies have demonstrated the importance of audit committee accounting expertise, as well as auditing expertise and industry expertise. Firms should strive to appoint audit committee members with specific accounting and auditing expertise given their apparently greater effectiveness and the positive stock market reaction to the appointment of accounting experts.

    Seventh, a growing line of research indicates that audit committee compensation methods can influence audit committee members’ judgments, and audit committee compensation methods are associated with the risk of restatement and with the handling of auditor adjustments. We encourage auditors, analysts, and shareholders to be cognizant of the potential risks involved if audit committee members are compensated primarily with short-term, incentive-based pay.

    Eighth, some audit committees appear to take their monitoring roles seriously, while others appear to be primarily ceremonial in nature. Auditors are in a unique position to evaluate the effectiveness of the audit committee process. Auditors should explicitly evaluate the effectiveness of the audit committee’s processes, and adjust their risk assessments, budgeted hours, and the nature, extent, and timing of audit testing, especially if effective audit committee processes seem to be attenuated by the intervention of a dominant CEO.

    Finally, given the severe reputational damage experienced by directors, especially audit committee members, in cases of financial reporting failures, and given the difficulty of monitoring a large entity on a part-time basis, audit committees might want to consider retaining permanent staff or consultants to the audit committee.

    For more information on this study, please contact Dana Hermanson.

    Citation:

    Carcello J. V., D. R. Hermanson, and Z. Ye. 2011. Corporate Governance Research in Accounting and Auditing: Insights, Practice Implications, and Future Research Directions. Auditing: A Journal of Practice & Theory 30 (3): 1-31. 

    Keywords:
    Corporate governance; board; audit committee; literature review.
    Purpose of the Study:

    Over the past two decades, the corporate governance literature in accounting and auditing has grown rapidly. We review this literature, primarily focusing on corporate board and audit committee issues.

    Design/Method/ Approach:

    We discuss 12 recent literature review or meta-analysis papers and summarize selected results (i.e., clusters of papers with new and interesting results) from recent empirical research papers, after reviewing the findings of over 250 studies. 

    Findings:

    We discuss the major insights from this literature and the practice implications of these findings. In addition, we identify a number of opportunities for future research. In particular, we make suggestions for: (1) improved research paradigms in corporate governance, (2) extensions of existing research, and (3) new or emerging lines of research.

    Category:
    Governance
    Sub-category:
    Board/Audit Committee Compensation, Board/Audit Committee Composition, Board/Audit Committee Oversight, Board/Audit Committee Processes, Board/Audit Committee Tenure
  • Jennifer M Mueller-Phillips
    Shareholder Voting on Auditor Selection, Audit Fees, and...
    research summary posted September 12, 2013 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 13.0 Governance, 13.06 Board/Audit Committee Processes 
    Title:
    Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality
    Practical Implications:

    The U.S. Department of the Treasury’s Advisory Committee on the Auditing Profession (ACAP) recently recommended that all publicly traded companies be required to have shareholder ratification of auditor selection. This study provides evidence of the potential implications of making a shareholder vote on auditor selection mandatory. The results of this study indicate that a shareholder vote on auditor selection is associated with higher audit quality and higher audit fees. These findings should be of interest to policy makers, auditors and public companies that might become subject to this policy change.


    For more information on this study, please contact Mai Dao.
     

    Citation:

    Dao, M., K. Raghunandan, and D. Rama. 2012. Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality. The Accounting Review 87 (1): 149-171.

    Keywords:
    auditor selection, shareholder voting, audit fees, audit quality.
    Purpose of the Study:

    The U.S. Department of the Treasury’s Advisory Committee on the Auditing Profession (ACAP) recommended in 2008 that all publicly traded companies be required to have shareholder ratification of auditor selection. ACAP justified this recommendation by citing the need for enhanced competition in the auditing industry. While the ACAP did not explicitly state what benefits increased competition may produce the authors espouse that the desired outcome would be reduced prices and increased quality. The authors point out that another potential benefit could come from a governance and accountability standpoint. They say that shareholder involvement may have a positive impact on the incentives of auditors and auditor independence. They argue that with shareholder voting there may be fewer opportunities for auditors to have a cozy relationship with management.
    This study informs this proposed policy choice. The authors look at audit fees and audit quality at firms that voluntarily engage in shareholder ratification of the auditor. By looking at these outcomes they hope to better understand the competitive and governance implications of making a shareholder vote on auditor selection mandatory.

     

    Design/Method/ Approach:

    The authors use data on publicly-traded companies in 2006 and compare audit fees and audit quality for companies that engage in shareholder ratification of auditors to those that do not. The authors also look at firms that switched from not having a shareholder vote on auditor selection in 2005 to having one in 2006 and compare them to firms that had a shareholder vote in 2005 and did not have one in 2006 to see if these firms had changes in audit fees relative to each other.

    Findings:
    • The authors find that within the 2006 sample shareholder involvement in auditor selection is associated with higher audit fees.
    • Additionally, they find that firms that switched from not having a shareholder vote on auditor selection in 2005 to having one in 2006 have, on average, higher audit fees than firms that stopped having a shareholder vote in 2006 but had one in 2005.
    • In their study of audit quality, the authors find that shareholder involvement in auditor selection is associated with a reduced probability of having a restatement that results in a negative effect on financial statements. 
    • Additionally, they document lower abnormal accruals for firms that have shareholder involvement in auditor selection.

    The authors claim that these findings are consistent with shareholder involvement in auditor selection being associated with higher audit quality and higher audit fees. They attribute these results to increased auditor effort requiring increased cost which is passed on to the client in the form of audit fees.

    Category:
    Auditor Selection and Auditor Changes, Governance
    Sub-category:
    Board/Audit Committee Processes
  • The Auditing Section
    On the Constitution of Audit Committee Effectiveness
    research summary posted May 3, 2012 by The Auditing Section, tagged 13.0 Governance, 13.06 Board/Audit Committee Processes, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    On the Constitution of Audit Committee Effectiveness
    Practical Implications:

    The results of this study are important for regulators when considering corporate governance processes and governance disclosures.  This study also provides insight into the importance of small events surrounding audit committee meetings, such as members’ style of questioning and insistence on managers swiftly adopting corrective measures to solve problems highlighted in internal audit reports.  The results provide insights into the process with which audit committee attendees define their effectiveness.  The results call into question the effectiveness of recent regulatory attempts to strengthen formal disclosures.

    Citation:

    Gendron,Y., and J. Bédard. 2006. On the constitution of audit committee effectiveness. Accounting, Organizations and Society 31(3):
    211-239.

    Keywords:
    Audit committee effectiveness, social constructivist
    Purpose of the Study:

    Corporate stakeholders increasingly rely on the audit committee to constrain managers’ self-interested behavior.  Previous practitioner and academic recommendations for audit committee effectiveness have focused on the composition and responsibilities of the audit committee, as well as the expertise and independence of audit committee members.  This paper examines the meaning of audit committee effectiveness through the eyes of individuals who attend meetings: corporate managers, auditors and audit committee members.  The authors attempted to understand the process by which audit committee effectiveness is internally developed and sustained by audit committee meeting attendees.  The authors use sociological techniques to examine: 

    • how the activities of audit committees are perceived by attendees.
    • how the perceptions of audit committee effectiveness are influenced by both the symbolic and substantive layers of meaning. 
      The symbolic ceremonies and rituals of audit committee meetings include agenda items and best practices.  The substantive processes include one’s line of questioning, both during and outside of meetings, in order to become comfortable with their company’s financial reports and internal controls.   
    • how members’ backgrounds (expertise and independence) influence perceptions of audit committee effectiveness.
    Design/Method/ Approach:

    The authors collected their evidence via interviews with the CEO, CFO, internal auditor, audit partner, and audit committee members associated with 3 Canadian corporations.  Interviewees were asked to describe the process of a typical audit committee meeting, the role of the audit committee, and difficult issues faced by the committee.  The interviews were conducted primarily in 2000 and 2001 and updated for post-Enron insights in 2004. 

    Findings:
    • The authors suggest there is a heterogeneity in audit committee participants’ emotions, which varies from confidence to hopefulness to anxiety.  Attendees appeared to be comfortable with reviewing the financial statements and reviewing internal control systems and less comfortable with auditor dismissal.  This heterogeneity influences attendees’ configurations of the meaning of effectiveness, both from an intra- and between-individual perspective.
    • The authors find that audit committee members perceive extensive financial and accounting background as significant in making their audit committee effective.  Formal competencies appear to generate feelings of confidence in committee members, managers, and auditors. 
    • The ceremonial features of meetings contribute to perceptions of effectiveness among audit committee members, managers and auditors.  The “ideal” ceremonial and symbolic features include: structured and well-organized meetings, consistent and orderly agendas, and best practice suggestions from the audit firm.
    • The substantive features of meetings also contribute to perceptions of effectiveness.  Interviewees imply that demonstrations of toughness by the internal auditor and tensions and divergences between the internal auditor and corporate managers are indications of independence and effectiveness.  Committee members perceive their relevant and challenging questions as
      key to demonstrating their effectiveness and establishing their self-confidence.  Attendees expect auditors to keep them informed regarding accounting standards and governancepractices.  Thus, the effectiveness appears to be linked with the extent that the audit committee is able to require management and auditors to account for their positions on potentially sensitive topics. 
    • The meaning of audit committee effectiveness develops in large part through the interactions and ongoing reflections of attendees concerning the many small events and relatively unremarkable actions that take place within and around meetings.  Thus, regulator efforts at making corporate governance more transparent through the disclosure of input and process measures, are fundamentally limited due to the nature of activities that surround audit committee meetings. Moreover, the emotional heterogeneity that characterizes members’ effectiveness meanings are not easily translated into formal disclosures and detailed indicators of effectiveness. Because of these, the authors argue that several aspects of corporate governance may be doomed to remain in the shadows.
    Category:
    Governance, Corporate Matters
    Sub-category:
    Board/Audit Committee Processes, Audit Committee Effectiveness
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