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  • Jennifer M Mueller-Phillips
    A Post-SOX Examination of Factors Associated with the Size...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 05.0 Audit Team Composition, 05.04 Staff Hiring, Turnover and Morale, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    A Post-SOX Examination of Factors Associated with the Size of Internal Audit Functions
    Practical Implications:

    This study provides insights that should be useful for CAEs and boards of directors (or audit committees) in discussions related to (1) internal audit philosophy regarding its potential contributions to an organization, (2) alternative staffing models, (3) resource allocation, and (4) embracement of audit technology. The study could also help guide external auditors’ evaluation of client internal audit functions. The authors find that the mission of internal audit functions differs from organization to organization. Additionally, the results suggest that internal audit functions used for leadership development purposes (i.e., a rotational staffing strategy) are larger, presumably because the staff have less experience and staff are rotating in and out of the department more frequently. Finally, these findings help illustrate the importance of internal audit proving that it is ‘‘value added’’ to the organization. Management and audit committees are often looking for more than financial statement compliance, and those internal audit functions that have responded to these greater needs are rewarded with more resources, likely because they are perceived to deliver more value.

    For more information on this study, please contact Karla Johnstone.
     

    Citation:

    Anderson, U. L., M. H. Christ, K. M. Johnstone, and L. E. Rittenberg. 2012. A Post-SOX Examination of Factors Associated with the Size of Internal Audit Functions. Accounting Horizons 26(2): 167-191

    Keywords:
    Internal Audit; resource allocation; budgeting; staffing.
    Purpose of the Study:

    Internal auditing is a key element of an organization’s governance, risk management, and internal control structure. However, many organizations struggle to know if the investments they make in the internal audit function are appropriate and use size benchmarking data (e.g., firm assets, revenues, number of employees) to determine if internal audit is appropriately sized. However, benchmark data fails to incorporate other factors that influence internal audit size such as the effectiveness and efficiency of an internal audit function, the scope of the internal audit mission, or internal audit objectives and staffing strategies. Therefore, the objectives of the study include the following:

    • Develop and test a conceptual model that articulates the factors associated with internal audit size in the contemporary post-SOX era. The model includes four determinants of internal audit size: (1) audit committee characteristics, (2) internal audit characteristics and mission, (3) assurance activities performed by others (including internal audit outsourcing providers and assurance provided by other functions within the organization), and (4) organization characteristics.
    • Conduct an examination using contemporary post-SOX data in order to extend earlier related research on internal audit sizing by considering a variety of previously unexamined characteristics that differentiate internal audit functions from one another.
    • Examine the state of internal audit staffing in the post-SOX environment.
       
    Design/Method/ Approach:

    The authors collected data with which to test their model by first conducting field interviews with a variety of chief audit executives across a broad range of industries. The authors then distributed a survey to chief audit executives that are members of the Institute of Internal Auditors. The survey includes questions related to each of the four determinants of internal audit size (as mentioned above), as well as internal audit size based on number of internal audit personnel. The field interviews were conducted between August 2006 to November 2006 and the survey was conducted from August 2007 and October 2008.

    Findings:

    The authors find that internal audit size is positively associated with:

    Audit Committee Characteristics:

    • the size of the audit committee;
    • the frequency of audit committee meetings with the CAE
    • audit committee review and approval of the internal audit budget.

    Internal Audit Characteristics and Mission:

    • CAE tenure in the organization;
    • performance of IT auditing;
    • the use of a staffing model in which internal audit is used for rotational leadership development
    • the use of sophisticated audit technology.

    Organization Characteristics:

    • the total assets of the organization
    • the number of foreign subsidiaries that the organization possesses.


    Further, the authors find that internal audit size is inversely associated with:

    Internal Audit Characteristics and Mission:

    • the percent of audit staff designated as Certified Internal Auditors.

    Internal Audit Activities Performed by Others:

    • the extent of internal audit activities outsourced to a third party.
    Category:
    Audit Team Composition, Governance, Standard Setting
    Sub-category:
    Board/Audit Committee Composition, Impact of SOX, Staff Hiring - Turnover & Morale
  • 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
    Associations between Internal and External Corporate...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance 
    Title:
    Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements
    Practical Implications:

    Prior studies’ conflicting results regarding the association between corporate governance measures and restatements are explained (at least partially) by the time period in which the relationship is examined. The relationship is different before and after Sarbanes Oxley (2002). However, this paper cannot determine whether the change in relationship was caused by Sarbanes Oxley or whether it happened for another reason.

    For more information on this study, please contact William R. Baber.
     

    Citation:

    Baber, W. R., L. Liang, and Z. Zhu. 2012. Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements. Accounting Horizons 26 (2): 219-237.

    Keywords:
    corporate governance; governance regulation; accounting restatements
    Purpose of the Study:

    Prior studies have found conflicting results as to whether corporate governance characteristics are related to accounting restatements. Some of these prior students examine restatements prior to Sarbanes Oxley (2002), and some examine restatements afterwards. This study seeks to reconcile the findings of previous research and determine whether the relationship between corporate governance and accounting restatements has changed over time.

    Design/Method/ Approach:
    • Authors examine corporate governance data from 1997 and 2005 to compare differences in governance over time.
    • Corporate governance characteristics are divided between factors that affect internal governance (defined as characteristics that presumably govern the efficacy of board of director oversight of management) and factors that affect external governance (defined in terms of the ability of shareholders to intervene in decisions by both management and the board of directors)
    • Investigate the association between 1997 corporate governance and the probability that financial statements from 1995-1999 are restated; also investigate the association between 2005 corporate governance and the probability that financial statements from 2003-2007 are restated.
       
    Findings:
    • There is a substantial increase in internal governance during the period when changes were imposed by stock exchanges and by the U.S. Congress in the Sarbanes-Oxley Act (2002). The change in internal governance is offset by a less substantial, yet statistically significant, decrease in external governance which is consistent with the observation that shareholder oversight is recently declining.
    • In 1997, internal and external governance characteristics are substitutes for each other (firms tend to do one or the other); in 2005, however, internal and external governance is not related.
    • Corporate governance characteristics in 1997 (prior to Sarbanes Oxley) are unrelated to the probability of financial statement restatements, whereas the correlation between corporate governance characteristics and restatements is statistically significant in 2005 (after Sarbanes Oxley).
      • Thus, the cross-sectional relationship between governance characteristics and restatement changed between 1997 and 2005.
    • The relationship between corporate governance measures in 2005 and restatements in 2003-2007 is not significant if interactions between internal and external governance measures are omitted from the model.
       
  • Jennifer M Mueller-Phillips
    Assuring a New Market: The Interplay between Country-Level...
    research summary posted August 31, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance 
    Title:
    Assuring a New Market: The Interplay between Country-Level and Company-Level Factors on the Demand for Greenhouse Gas (GHG) Information Assurance and the Choice of Assurance Provider
    Practical Implications:

     The results from this study highlight the complexity of assurance-related decisions and the interplay between macro-level and micro-level institutional factors. The results also reveal the diversified nature of this particular emerging assurance market, which should prove to be a rich source of future research.

    Citation:

     Zhou, S., R. Simnett, and W. J. Green. 2016. Assuring a New Market: the Interplay between Country-Level and Company-Level Factors on the Demand for Greenhouse Gas (GHG) Information Assurance and the Choice of Assurance Provider. Auditing: A Journal of Practice and Theory. 35 (3): 141-168.

    Keywords:
    greenhouse gas assurance, stakeholder theory, legal environment, corporate governance.
    Purpose of the Study:

    Recently there has been a dramatic increase in the public reporting and assurance of broad ranging sustainability information covering multiple nonfinancial elements. In addition to this, there has been greater public reporting of organizations’ single element greenhouse gas (GHG) emissions. The growth of GHG reporting ultimately resulted from the heightened awareness of global warming among investors, stakeholders, and regulators, as well as the growing number of countries mandating the reporting of GHG emissions. As more and more companies publish this information, it follows that there is a growing reliance on independent assurance of these nonfinancial reports; consequently, two major types of publicly available assurance engagements have evolved: assurance on the broad-ranging subject matter of sustainability reporting and assurance of an organization’s report of their GHG emissions. Many studies have examined the assurance of the broader sustainability subject matter; however, there is limited research examining the more defined and specific GHG emissions assurance engagements, as this paper does.

    Design/Method/ Approach:

    The authors analyzed information about GHG emissions assurance from a sample of 32 countries that comprise corporate responses to the Carbon Disclosure Project’s annual questionnaires. These data were gathered within the period of 2008-2011

    Findings:
    • The authors find that just over 40 percent of disclosing companies purchase third-party assurance services, and that just over half of these purchase these services from accounting firm providers; however, this purchasing behavior differs significantly between countries.
    • The authors find that assurance is more likely to be purchased by companies in stakeholder-oriented countries and less likely to be purchased as the strength of the legal enforcement system increases. However, further analysis reveals that these relationships are moderated by the strength of company-level corporate governance mechanisms.
    • The authors find that the business culture (stakeholder versus shareholder orientation) of a country significantly affects the choice of accounting firms as assurance providers.
    • The authors find a low adoption rate for U.S. assurance of GHG reports, which is consistent with previous findings regarding the U.S. adoption rate of sustainability reports.
    Category:
    Governance
  • Jennifer M Mueller-Phillips
    Attracting Applicants for In-House and Outsourced Internal...
    research summary posted April 18, 2016 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 05.04 Staff Hiring, Turnover and Morale, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Attracting Applicants for In-House and Outsourced Internal Audit Positions: Views from External Auditors.
    Practical Implications:

    This study offers insights into why internal auditing is experiencing a shortage of qualified job candidates and offers a potential solution to the problem. The authors find that external auditors have negative perceptions about internal auditing, and these negative perceptions are associated with a (1) decreased desire to apply for internal auditing positions, (2) lower likelihood of recommending an in-house internal auditing career to high-performing students, and (3) higher likelihood of recommending an in-house internal auditing career to mediocre students. Internal auditors can try solving this problem by improving perceptions about internal auditing via a media campaign that raises awareness about the true internal audit career path.

    Citation:

    Bartlett, G.D., J. Kremin, K.K. Saunders, and D.A. Wood. 2016. Attracting Applicants for In-House and Outsourced Internal Audit Positions: Views from External Auditors. Accounting Horizons 30 (1): 143-156.

    Keywords:
    internal audit, hiring decisions, outsourcing, external auditors
    Purpose of the Study:

    The internal audit function can help organizations strengthen their risk management and corporate governance, yet the demand for qualified candidates to fill internal audit job openings exceeds the supply of interested applicants. Consequently, the internal audit function may find itself short-staffed and/or staffed with lower quality candidates, which may limit its ability to add value to the organization. In order to correct this problem, it is important to fully understand its scope and its root cause(s). Prior research attempting to gain this understanding has focused on investigating how accounting students’ beliefs about internal audit impact their interest to pursue an internal audit career. The authors of this paper extend this research by:

    • Investigating how external auditors’ beliefs about internal audit impact (1) their interest to pursue an internal audit career and (2) their recommendations to students about pursuing an internal audit career,  
    • Investigating differences in external auditor’s perceptions of in-sourced versus out-sourced internal audit, and
    • Asking external auditors to suggest what needs to be done to improve their perceptions of internal audit.
    Design/Method/ Approach:

    The authors use data from three sources. First, the authors performed an experiment using experienced external auditorsmostly seniors or associateswho were asked whether they would apply for a job described as either an accounting, in-house internal audit, or outsourced internal audit position. Second, the authors performed another experiment using experienced external auditorsmostly managers or directorswho were asked whether they would recommend that a high-performing (mediocre performer) student pursue an external audit, in-house internal audit, or outsourced internal audit career. Third, the authors surveyed high-ranking former/current external auditors who never worked in internal audit about what would make internal auditing a more appealing career for them.

    Findings:
    • When the same job opening is labeled as either accounting, in-house internal auditing, or outsourced internal auditing, the accounting label is likely to attract two times as many external auditor applicants as the other two labels.
    • External auditors are equally willing to apply for in-house internal auditing or outsourced internal auditing positions.
    • External auditors have more negative perceptions of in-house internal auditors than outsourced internal auditors.
    • External auditors have negative perceptions of the internal auditing profession. They believe that (1) others have negative stereotypes about the profession, (2) business professionals do not respect internal auditors, and (3) internal auditors do boring work.
    • Those less interested in applying for internal audit jobs have negative perceptions of internal auditing.
    • The average external auditor willing (unwilling) to apply for an internal audit position would want to receive at least 124% (149%) of his current salary before being willing to switch from his current external audit job to an internal audit job.  
    • External auditors will be most likely to recommend that top-performing students work in external audit and mediocre students work in in-house internal audit.
    • External auditors will equally recommend that top-performing students and mediocre students should consider outsourced internal audit as a second best career path.
    • External auditors have more negative perceptions of outsourced internal auditing than external auditing on most dimensions, except in regards to work-life balance. They believe that work-life balance is better for outsourced internal auditors.
    • Current and former external auditors believe that internal auditing could become more appealing if internal auditors do more interesting work, receive more respect, perform value-added tasks, receive better compensation, and have better promotion opportunities. Because internal auditors appear to already be following these suggestions, internal auditors may benefit from giving others a better understanding of internal audit careers.
    Category:
    Audit Team Composition, Auditing Procedures - Nature - Timing and Extent, Governance
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Reliance on Internal Auditors, Staff Hiring - Turnover & Morale
  • Jennifer M Mueller-Phillips
    Audit Committee Compensation, Fairness, and the Resolution...
    research summary posted February 16, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.04 Board/Audit Committee Compensation 
    Title:
    Audit Committee Compensation, Fairness, and the Resolution of Accounting Disagreements
    Practical Implications:

    When selecting members of the audit committee, our results suggest the need for the nominating committee to pursue individuals who place great emphasis on issues of fairness to shareholders. Beyond such initial screening, one way to improve the quality of the financial reporting process could be to educate audit committee members to explicitly consider outcome fairness to shareholders of the financial statement presentation, especially in matters that involve ambiguous accounting issues. This education process should help to emphasize that audit committee members need to consider stakeholders, such as current and prospective shareholders, above the potentially parochial views of management. Moreover, regulatory bodies may consider emphasizing the nature of the monitoring role of the board and how examining decisions through the lens of fairness may enhance the ability of the board to fulfill its monitoring role in a more effective manner.

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

    Citation:

    Bierstaker, J., J. Cohen, D. Hermanson, and T. DeZoort. 2012. Audit Committee Compensation, Fairness, and the Resolution of Accounting Disagreements. Auditing: A Journal of Practice & Theory 31 (2): 131-150.

    Keywords:
    Audit committee, incentive compensation, fairness, disagreement.
    Purpose of the Study:

    An emerging body of research examines the relation of incentive-based audit committee compensation with accounting outcomes. We extend this literature by examining the effects of audit committee compensation and perceived fairness to shareholders on actual public company audit committee members’ judgments in accounting disagreements.

    Design/Method/ Approach:

    Fifty-six highly experienced public company audit committee members participated in an experiment involving an accounting disagreement between management and the external auditor, with three types of audit committee compensation (i.e., cash only, cash and short-term stock options, or cash and long-term stock options) manipulated between subjects. We also measured the participants’ perceptions of the fairness to shareholders if the auditor’s adjustment is not recorded. 

    Findings:

    We find that audit committee members are more likely to support the auditor in an accounting disagreement when audit committee compensation includes long-term stock options and when members perceive that failure to record the auditor’s adjustment is less fair to shareholders. Most significantly, we find that the relation between long-term incentive compensation and support for the auditor is fully mediated by a sense of fairness to shareholders. 

    Category:
    Governance
    Sub-category:
    Board/Audit Committee Compensation
  • Jennifer M Mueller-Phillips
    Audit Committee Director-Auditor Interlocking and...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Audit Committee Director-Auditor Interlocking and Perceptions of Earnings Quality
    Practical Implications:

    This study is important to provide an insight into the personal relationships and familiarity between audit committee directors and external auditors in terms of auditor independence. Furthermore, our examination of AC director-auditor interlocking provides a more complete basis for understanding the effectiveness of corporate governance in guarding earnings quality. The results not only support the view that AC director-auditor interlocking positively affects investors’ perception of earnings quality, but also support the regulatory requirement that audit committees include at least one financial expert.

    For more information on this study, please contact Jeng-Fang Chen.

    Citation:

    Chen, J.-F., Y.-Y. Chou, R.-R. Duh, and Y.-C. Lin. 2014. Audit committee director-auditor interlocking and perceptions of earnings quality. Auditing: A Journal of Practice and Theory 33 (4): 41-70

    Keywords:
    Audit committee director-auditor interlocking, investor perceptions, earnings response coefficients, financial expert
    Purpose of the Study:

    In response to Enron and subsequent financial reporting scandals, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (SOX, hereafter), which put particular emphasis on the role of audit committees in ensuring financial reporting quality. Although existing regulations stipulate the composition and qualifications of audit committee directors, audit committee director interlocking that arises when an audit committee director serves on more than one audit committee is allowed. Therefore, we analyze how investors perceive reported earnings when companies with interlocking audit committee directors are audited by the same audit firm (hereafter, AC director-auditor interlocking), using earnings response coefficients (ERCs) as a proxy for investor perceptions of earnings quality. The tendency of AC director-auditor interlocking could have positive or negative implications for the audit committee’s effectiveness in guarding earnings quality.

    • A positive influence may result insofar as closer personal relationships enhance the audit committee’s understanding and trust of auditors, thereby making interlocking audit committee directors more likely to support the auditor in accounting and auditing disputes.
    • An opposing argument is that economic incentives may compromise auditor independence. Also, interlocking audit committee directors may be less critical of auditor performance due to personal relationships with the interlocking auditor.

    Besides the relationship between AC director-auditor interlocking and ERCs, this study investigates whether the potential positive impact of AC director-auditor interlocking in improving earnings quality would be outweigh the potential negative influence in the post-SOX period, when shareholders and regulators have higher expectations and heighten liability concerns for both interlocking audit committee directors and auditors. In particular, this study examines if earnings quality is higher when interlocking audit committee directors are financial experts who are better placed to recommend streamlining of audit committee procedures on the financial reporting process.

    Design/Method/ Approach:

    We collect director information through the RiskMetrics database, which covers S&P 1500 companies, from fiscal years 1998 to 2010, while the impact of financial experts is examined by a sample from fiscal years 2003 to 2010. This study uses ERCs from returns-earnings regressions and designs three measures for the degree of a firm’s AC director-auditor interlocking to examine its impact on earnings quality. 

    Findings:
    • This study finds that a greater extent of AC director-auditor interlocking is perceived as associated with higher earnings quality.
    • This study finds that investors’ perceptions of earnings quality are more affected by the extent of AC director-auditor interlocking in the post-SOX era than before it, whatever we use the pre- and post-SOX subsamples or the interaction item of SOX for the test.
    • This study finds that investors perceive AC director-auditor interlocking especially positively when interlocked audit committee directors are financial experts. That is, the results document that the positive impact of AC director-auditor interlocking on the ERCs is more pronounced when interlocking audit committee directors are financial experts.
    Category:
    Corporate Matters, Governance, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts, Impact of SOX
  • The Auditing Section
    Audit Committee Financial Expertise, Litigation Risk, and...
    research summary posted April 23, 2012 by The Auditing Section, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.02 Board/Financial Experts 
    Title:
    Audit Committee Financial Expertise, Litigation Risk, and Corporate Governance
    Practical Implications:

    Based on the positive relation between litigation risk and the likelihood of appointing an accounting financial expert, this study suggests that firms with a demand for accounting financial experts are able to obtain accounting financial experts for their audit committees.  However, this relation is only present in the presence of good governance.  The authors suggest that this follows because either (1) only firms with good corporate governance seek to appoint accounting financial experts or (2) only firms with good corporate governance can attract accounting financial experts.

    Citation:

    Krishnan, J., and J.E. Lee. 2009. Audit Committee Financial Expertise, Litigation Risk, and Corporate Governance. Auditing: A Journal of Practice and Theory 28 (May): 241-261.

    Keywords:
    audit committee; financial expert; litigation risk; corporate governance.
    Purpose of the Study:

    Policy makers believed that financial expertise on audit committees would “enhance the effectiveness of the audit committee in carrying out is financial oversight responsibilities” (SEC 1999). While it was generally acknowledged that financial expertise on the audit committee would be beneficial, the definition of financial expertise (and what qualifies as financial expertise) was not widely debated until SOX Section 407 was proposed.  The SEC’s initial definition of audit committee financial expertise included a very narrow definition of expertise, including essentially accounting and auditing expertise only.  However, after many comment letters opposing the narrow definition, the SEC adopted a broader definition of expertise.  The broader definition allows those with experience in evaluating financial statements or actively supervising those who prepare, audit, analyze, or evaluate financial statements to be designated as financial experts. The initial narrow definition was motivated by the assumption that accounting/auditing financial experts would provide better monitoring than non-accounting financial experts. 

    Previous academic research has found that firms who appoint accounting financial experts (based upon the original narrow definition proposed by the SEC) have higher measures of financial reporting quality and that investors have reacted favorably to the appointments.  However, few firms actually appoint accounting financial experts to the audit committee; not all accounting experts are designated as audit committee financial accounting experts; and many audit committee financial experts do not have prior accounting expertise.  The authors set out to examine the determinants of appointing an accounting expert versus a non-accounting expert.

    Design/Method/ Approach:

    The authors construct a measure of litigation risk (a proxy for the demand for an accounting financial expert) and gather corporate governance quality measures for the Fortune 1000 firms as of 2004.  The authors then classify audit committee members as accounting or non-accounting financial experts by gathering biographical information on the audit ommittee members using proxy statements and 10-Ks.

    Findings:
    • Of the 3,218 audit committee members identified in the study, only 572 (17.8%) have accounting financial expertise as originally defined by the SEC.  The authors indicate this is a relatively low ratio. 
    • Well-governed firms with higher litigation risk have a greater likelihood to appoint an accounting financial expert.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Composition, Board/Financial Experts
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  • Jennifer M Mueller-Phillips
    Audit committee stock options and financial reporting...
    research summary posted July 30, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.04 Board/Audit Committee Compensation 
    Title:
    Audit committee stock options and financial reporting quality after the Sarbanes-Oxley Act of 2002.
    Practical Implications:

    This study contributes to existing literature by re-examining the relationship between audit committee compensation and financial reporting quality. The findings indicate the continuance of a negative relationship between audit committee members’ stock-option compensation and financial reporting quality in the post-SOX era. These results are relevant to regulators, compensation committees, and auditors because they imply that shifting audit committee director compensation away from stock options has the potential to improve financial reporting quality.

    Citation:

    Campbell, J. L., J. Hansen, C. A. Simon, and J. L. Smith. 2015. Audit Committee Stock Options and Financial Reporting Quality after the Sarbanes-Oxley Act of 2002. AUDITING: A Journal of Practice & Theory 34 (2):91-120.

    Keywords:
    audit committee quality, financial reporting oversight, financial reporting quality, independence
    Purpose of the Study:

    The Sarbanes-Oxley Act (SOX) was passed by Congress in 2002 in order to improve the accuracy and reliability of corporate disclosures. The introduction of SOX resulted in a substantial increase in audit committee members’ required level of independence and responsibility. In defining independence, however, regulators did not restrict companies from providing equity incentives for audit committee members. Pre-SOX research has shown stock option incentives to be associated with lower financial reporting quality. This study aims to re-examine the association between audit committee equity-based incentives and financial reporting quality (as proxied by a company’s propensity to meet or beat its consensus analyst forecast) in the post-SOX environment.

    Design/Method/ Approach:

    After removing problematic data, the sample collected for the study consisted of audit committee members’ equity holdings and compensation data for a sample of 2,172 company-year observations from 2006 to 2008. This information was then used in conjunction with a series of probit models in order to examine whether audit committee member’ equity incentives are associated with the likelihood of meeting or beating the analyst forecast. In order to mitigate the effect of outliers, the top and bottom 1% of the selection was winsorized.

    Findings:

    Findings were consistent with stock-option incentives being associated with lower financial reporting quality. Specifically, it was found that:

    • 58.8 percent of the average audit committee members’ pay is in the form of stock options and grants.
    • The likelihood of meeting or beating analyst expectations is positively associated with audit committee members’ stock-option compensation and holdings.
    • There is no association for non-equity compensation and holdings, and meeting or beating analyst expectations.
    • A company whose audit committee holds the mean value of exercisable options (i.e., about $200,000 in exercisable options) is associated with a 10.0 percent increase in the likelihood of meeting or beating its consensus analyst forecast.
    • A high-growth opportunity company whose audit committee holds the mean value of exercisable options is associated with a 17.8 percent increase in the likelihood of meeting or beating its consensus analyst forecast.
    Category:
    Governance, Independence & Ethics
    Sub-category:
    Board/Audit Committee Compensation, Impact of SEC Rules Changes/SarBox
  • Jennifer M Mueller-Phillips
    Auditing Related Party Transactions: A Literature Overview...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 13.0 Governance 
    Title:
    Auditing Related Party Transactions: A Literature Overview and Research Synthesis.
    Practical Implications:

    In this paper, the authors link academic research and other pertinent literature to issues raised in the PCAOB briefing paper on auditing related party transactions. Overall, the authors believe that the findings in academic research and the significance of related party transactions in recent prominent fraud cases are consistent with the PCAOB’s reconsideration of auditing of related party transactions.

    Citation:

    Gordon, E. A., E. Henry, T. J. Louwers, and B. J. Reed. 2007. Auditing Related Party Transactions: A Literature Overview and Research Synthesis. Accounting Horizons 21 (1): 81-102.

    Keywords:
    related party transactions, arm’s length transactions, corporate governance, financial disclosure
    Purpose of the Study:

    Related party transactions are difficult to audit for a number of reasons.  

    • Related parties and transactions warranting examination may be difficult to identify.
    • Auditors must rely on management to provide detailed information on related parties and related party transactions.
    • Despite the increased internal control requirements imposed by the Sarbanes-Oxley Act of 2002, internal controls have difficulty tracking related party transactions. This difficulty arises because of the wide variety of parties and types of transactions and because some transactions may not be given accounting recognition, e.g., receipt of free services from a related party.

    The authors examine research relevant to auditing related party transactions to contribute to the PCAOB project on this topic and to provide other policy makers, auditors, and academics with an overview of relevant literature. Specifically, they report on the challenges associated with the identification, examination, and disclosure of related party transactions. Additionally, they address issues and research evidence related to nondisclosure and reliance on management assertions, risk assessment, materiality, fraud detection, the effect of related party transactions on corporate governance, and international auditing issues.

    Design/Method/ Approach:

    To prepare PCAOB Standing Advisory Group (SAG) members for discussion of these issues, the PCAOB staff prepared a briefing paper posing 13 broad questions for consideration by the SAG. The authors contribute to the PCAOB project by reviewing pertinent literature and providing appropriate insights from academic research relevant to auditing related party transactions. They highlight instances where existing research addresses the questions raised in the briefing paper. 

    Findings:

    The primary conclusions from the literature review are:

    • The definition of related parties varies across regulatory bodies.
    • Related party transaction disclosures are present in the Securities and Exchange Commission (SEC) filings of most publicly held companies.
    • While listed as a fraud risk factor in authoritative literature, related party transactions do not appear to be more common in companies committing fraud than in companies in which no fraud has been detected. Accordingly, but in opposition to authoritative guidance, survey research indicates that the presence of related party transactions alone does not appear to significantly increase external auditors’ client risk assessments.
    • Although related party transactions in isolation may not be a significant indicator of fraud, when fraud does exist, the presence of related party transactions is one of the top reasons cited for audit failures. The willingness of auditors to tolerate greater misstatement in footnotes may help partially explain this apparent contradiction.
    • Related party transactions should be assessed in the context of the company’s overall governance structure, particularly given the importance of managements’ assertions about the existence and nature of these transactions.
    • Related party transactions often impact the corporate governance of the company by creating gray directors, i.e., directors who are neither insiders nor totally independent of the company. Whether gray directors differentially impact a board’s monitoring effectiveness may depend on the specific board committee (audit, compensation) or may depend on the specific type of gray director.
    Category:
    Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment

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