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  • Jennifer M Mueller-Phillips
    Auditor Communications with the Audit Committee and the...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.02 Board/Financial Experts, 13.05 Board/Audit Committee Oversight 
    Title:
    Auditor Communications with the Audit Committee and the Board of Directors: Policy Recommendations and Opportunities for Future Research.
    Practical Implications:

    The review identifies insights for practice and opportunities for research on communication issues between the auditor, the audit committee, and the board. The authors strongly believe that the academic and the practice communities must have a continual dialogue so that standards reflect research, and research is directed to issues with the greatest potential to positively affect public policy. These implications should interest the PCAOB, the SEC, other standard-setters, and regulators that focus on issues related to corporate governance and financial reporting quality.

    Citation:

    Cohen, J., L. M. Gaynor, G. Krishnamoorthy, and A. M. Wright. 2007. Auditor Communications with the Audit Committee and the Board of Directors: Policy Recommendations and Opportunities for Future Research. Accounting Horizons 21 (2): 165-187.

    Keywords:
    board of directors, communication between audit committees and external auditors, corporate governance, financial reporting quality, internal control reports
    Purpose of the Study:

    In 2004 the Public Company Accounting Oversight Board (PCAOB) began considering a standard to improve guidance on the communication process between external auditors and audit committees. The Sarbanes-Oxley Act of 2002 expands and emphasizes the role of audit committees in ensuring the quality of reported financial results. This increased responsibility requires improved and expanded dialogue between audit committees and external auditors.

    In this paper, the authors review the extant academic literature to address relevant issues pertaining to communications between external auditors and audit committees on matters relevant to the integrity of the financial reporting process as well as to the PCAOB-developed discussion questions (DQs). Specifically, they examine literature regarding communications pertaining to overall financial reporting quality, internal controls, the external auditor’s job performance, the form of communications (oral or written), and communications pertaining to the Management’s Discussion and Analysis (MD&A) section of the annual report. For each major area, they discuss the implications of the academic research for standard-setters and identify future research opportunities for the academic community.  

    Design/Method/ Approach:

    The literature review primarily features research published in academic accounting and auditing journals. In an effort to capture the latest research availableas well as research on emerging topics, such as many of those precipitated by the passage of SOXthe authors also include working papers submitted to major archiving services. The authors searched electronic databases such as Ingenta, ABI/Inform, and American Accounting Association (AAA) Electronic Publications using keywords or combinations of keywords related to the various topics and subtopics discussed in this paper. They also searched Social Science Research Network (SSRN) and scholar.google.com to identify relevant working papers.

    Findings:
    • Financial Reporting Quality:
      • Frequent communications with a well-informed, financially sophisticated audit committee and communications among the audit committee, the auditor, and the full board improve financial reporting quality.
    • Internal Controls:
      • The nature and the extent of communications between the auditor and the audit committee should be sensitive to whether a control weakness or deficiency relates to entity level controls or account-level controls, given the differentially serious implications of these two types of weaknesses.
      • Firm-specific factors (e.g., financial distress, company size) should influence communications and may require the auditor to report directly with the board on matters related to internal control.
      • The audit committee and the external auditor should discuss the quality of the internal audit function and the extent to which the external auditor is able to rely on the work performed by internal audit.
      • The audit committee should discuss with external auditors their policy to protect whistle-blowers.
    • External Auditor Performance:
      • It it is important for the auditor to communicate to the audit committee all relationships with the client, the fees and nature of all services provided, and the extent to which any nonaudit services are beneficial to the audit.
      • The auditor should report all issues and proposed adjustments to the audit committee and the process used for resolving contentious issues.
      • The auditor should also report to the board its evaluation of the quality, effectiveness, and authority of the audit committee in discharging its responsibilities.
    • Other Issues:
      • A review of the literature suggests that the MD&A should be more emphasized in the discussions between the audit committee and the auditors.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Oversight, Board/Financial Experts
  • Jennifer M Mueller-Phillips
    Auditor Resignation and Firm Ownership Structure
    research summary posted October 29, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 13.0 Governance, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience 
    Title:
    Auditor Resignation and Firm Ownership Structure
    Practical Implications:

    The audit profession operates in a highly legal environment, and because of this, audit firms must find ways to manage their risk exposure. One way to reduce the risk of litigation against the firm is to manage the client portfolio and resigning from high risk clients. According to the study, family owned firms are less of a litigation risk to the auditor than non-family owned firms, especially when the CEO of the family-owned firm is not a family member. However, if an auditor does resign from auditing a family-owned firm managed by a non-family CEO, the investing public reacts less negatively to this than if the firm were not family owned.


    For more information on this study, please contact Samer K. Khalil.
     

    Citation:

    Khalil, S., J. Cohen, and G. Trompeter. Auditor resignation and firm ownership structure. Accounting Horizons 24 (4): 703-727.

    Keywords:
    family firms; auditor resignations; corporate governance; market reactions
    Purpose of the Study:

    In order to manage risk exposure, audit firms can choose to resign from high risk clients. Auditor resignations can bring very negative outcomes to the discharged client because of the audit search and startup costs incurred and the investors’ interpretation in the information signaled by the auditor resignation. This study investigates whether the likelihood of auditor resignations and the subsequent stock market reaction in family firms differs significantly from that in non-family firms. Additionally, this study examines whether the identity of the CEO that manages the family firms has an effect on the aforementioned associations. The identity of the CEO refers to whether the CEO is a founder, a descendant, or a non-family CEO.

    Design/Method/ Approach:

    The evidence for this study was gathered using auditor resignations reported on the Audit Analytics database in the U.S over five calendar years, 2004-2008. Sample firms were matched with control firms that did not switch their auditors using four different attributes: firm size, firm industry, auditor type, and auditor tenure to serve as one benchmark.  A random sample of control firms that did not switch their auditors and had publicly available data on their corporate governance was used as a second benchmark.

    Findings:
    • The primary findings of this study were that: 1) auditors of family firms are less likely to resign than those of non-family firms and that 2) auditor resignations are less likely to occur in family firms managed by a founder or non-family CEO. These imply that auditors appear to attribute lower litigation risk to family firms because the family’s concern to preserve their reputation and contribute family wealth to future generations reduces the risk of misappropriation of assets and/or earnings management.
    • Another primary finding was that abnormal return following auditor resignations in family firms are significantly less negative than those in non-family firms. Furthermore, the findings suggest that the investing public places a lower weight on the bad news associated with auditor resignation in family firms managed by a non-family CEO as opposed to non-family firms. The public’s reaction to a resignation did not vary based on whether a family firm was managed by a founder or descendant CEO.
    • Secondary finding indicate that the following variables also have an impact on auditor resignation:
      • Firm audit reports modified for going concern reasons
      • Firms that report weaknesses in internal control over financial reporting
      • Firms that report a loss in the year preceding auditor resignation
      • The presence of an auditor-client mismatch
      • Firms with large variance in abnormal returns
      • Firms with higher likelihoods of bankruptcy and acquisition
      • Corporate governance mechanisms such as number of audit committee meetings, percentage of financial experts serving on the audit committee, and one or more institutional block holders.
         
    Category:
    Client Acceptance and Continuance, Corporate Matters, Governance
    Sub-category:
    CEO Tenure & Experience, Resignation Decisions
  • 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
    Board Monitoring and Endogenous Information Asymmetry.
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience, 14.10 CEO Compensation 
    Title:
    Board Monitoring and Endogenous Information Asymmetry.
    Practical Implications:

    The author claims that motivating the CEO to reveal information may or may not be beneficial. The disconnection between compensation and outcomes results from active monitoring. Compensation contracts rely on board evaluation, not on the final outcomes, to provide incentives. The proactive board activity can result in poor firm performance. This proactive activity requires extra care to reign in an expert: the CEO.

    Citation:

    Tian, J. J. 2014. Board Monitoring and Endogenous Information Asymmetry. Contemporary Accounting Research 31 (1): 136-151.

    Keywords:
    boarding monitoring, information acquisition, information asymmetry, project decision, executive compensation, CEO compensation
    Purpose of the Study:

    Boards of directors are frequently questioned pertaining to their monitoring role in executive decision making and compensation. The sequence of financial fraud in the early 2000s called public attention that boards have not done enough to align executive incentives with shareholders’ interests. Since shareholders do not normally observe executives’ actions and may not even know what actions executives should have taken to maximize shareholder value, increasing board effort to reduce such information asymmetry is commonly viewed as desirable.

    The present study challenges this common view that increasing board effort in monitoring is always desirable. This view neglects a key fact in corporate decision making: the information asymmetry between the CEO and shareholders is a result of the CEOs expertise. This study highlights the fact that CEOs are hired for their superior ability to make strategic decisions, particularly for their unique skills to acquire, process and interpret information relevant to these decisions.

    Design/Method/ Approach:

    The authors uses analytical modeling to conclude on the questions of interest.

    Findings:

    If board monitoring eliminates all information asymmetry, the board can easily ensure that decisions are made in the best interest of shareholders. It resolves all uncertainty in the remaining decision problems. However, preserving uncertainty is crucial ex ante in order to motivate a risk-averse CEO to acquire information, as effort need not be expended if there is no concern for uncertainty. Thus, board monitoring creates a time consistency problem for the CEO to acquire information.

    The board should actively engage in monitoring activities only when the board is able to evaluate the information provided by the CEO with high accuracy. That is, when board monitoring is able to produce enough information about the CEO’s effort directly, preserving uncertainty to incentivize the CEO to acquire information is a second-order concern. However, if a project requires special skills for implementation and board evaluation may not be accurate enough, it is better for the board to remain passive and not interfere with the CEO’s decisions.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Board/Audit Committee Oversight, CEO Compensation, CEO Tenure & Experience
  • Jennifer M Mueller-Phillips
    Bringing Darkness to Light: The Influence of Auditor Quality...
    research summary posted June 2, 2014 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    Bringing Darkness to Light: The Influence of Auditor Quality and Audit Committee Expertise on the Timeliness of Financial Statement Restatement Disclosures
    Practical Implications:

    This objective of this study is to determine whether auditor quality and audit committee financial expertise are associated with improved restatement disclosure timeliness as reflected in reduced dark periods. Recent actions by regulatory agencies suggest that the timeliness of financial reporting remains a top priority of investors and regulators. This study finds evidence that both the auditors and audit committees can provide significant value to clients and improve timely disclosure of restatement details. 

    Citation:

    Schmidt, J., and M. S. Wilkins. 2013. Bringing Darkness to Light: The Influence of Auditor Quality and Audit Committee Expertise on the Timeliness of Financial Statement Restatement Disclosures. Auditing 32 (1).

    Keywords:
    accounting expertise; audit committees; audit quality; financial expertise; financial reporting timeliness; financial statement restatements
    Purpose of the Study:

    Several recent regulatory actions suggest that the timely reporting of financial data is a top priority of investors and regulators. This study investigates whether auditor quality and audit committee expertise are associated with improved financial reporting timeliness as measured by the duration of a financial statement’s “dark period.” The restatement dark period represents the length of time between a company’s discovery that it will need to restate financial data and the subsequent disclosure of the restatement’s effect on earnings. This dark period restatement setting helps to address the fundamental question of whether better governance helps companies resolve financial reporting problems. 

    Design/Method/ Approach:

    The authors selected a sample of 154 firms announcing dark restatements disclosed between 2004 and 2009. This sample was used to test the following hypotheses:

    • H1: Restatement dark periods are shorter for clients of Big 4 auditors. 
    • H2a: Restatement dark periods are shorter when the audit committee contains a larger proportion of financial experts. 
    • H2b: Restatement dark periods are shorter when the audit committee contains a larger proportion of accounting financial experts.
    • H3: Restatement dark periods are shorter when the audit committee chair has accounting financial expertise. 

    A multivariate model was then used to investigate the determinants of the length of restatement dark periods of the selected sample. 

     

    Findings:
    • Dark periods are shorter in the presence of Big 4 auditors.
    • Restatement dark periods are shorter among clients that have audit committees with more financial accounting experts. 
    • The relationship between the audit committee financial expertise and restatement dark periods is primarily attributable to the presence of an audit committee chair who is an accounting financial expert. 
    • With these factors present, restatement disclosures are provided up to 38 percent faster
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes, Governance
    Sub-category:
    Board/Audit Committee Composition, Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
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  • 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
    CEO Power, Internal Control Quality, and Audit Committee...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    CEO Power, Internal Control Quality, and Audit Committee Effectiveness in Substance versus in Form
    Practical Implications:

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

    Citation:

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

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

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

    Design/Method/ Approach:

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

    Findings:
    • The authors find CEO power has a moderating effect on audit committee effectiveness. When CEO power is low, audit committee financial expertise, a measure of audit committee effectiveness, is negatively related to the incidence of internal control weaknesses. However, this relationship is monotonically weakened by increasing CEO power. When CEO power reaches to a high state, audit committee financial expertise is no longer negatively associated with the incidence of internal control weaknesses. This result is not driven by potential indirect involvement by CEO in selecting audit committee members.
    • Consistent with the authors’ expectation, the moderating effect of CEO power is stronger when the CEO extracts more rents from the firm through profitable insider trading.
    • Supporting the main findings, the results also show when CEO power is high, audit committee hold fewer meetings and financial misstatements are more frequent. Both relationships are stronger when internal controls are weaker.
    • The authors also demonstrate the structure and expert dimensions of CEO power are most closely associated with the moderating effect. Specifically, the sources of power of a powerful CEO come from being the chairman of the board at the same time, receiving compensation much higher than other executives, and taking more management positions in the firm before becoming the CEO. 
    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts
  • Jennifer M Mueller-Phillips
    Changes in Corporate Governance Associated with the...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation
    Practical Implications:

    The results of this study support the audit committee regulations under SOX and the board independence regulations of the listing exchanges. These results are important to regulators as they show that improvements in audit committee influence, competence, and incentives are each positively associated with ICMW remediation. In addition, the results reveal that improvements in these audit committee characteristics are most strongly associated with the remediation of ICMWs relating to control activities and monitoring, but not to ICMWs across the other COSO categories. Lastly, the results are important to management as they highlight the importance of hands-on day-to-day leadership by management in addressing situations involving the revelation and remediation of material negative events.

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

    Citation:

    Johnstone, K., C. Li, and K. H. Rupley. 2011. Changes in Corporate Governance Associated with the Revelation of Internal Control Material Weaknesses and Their Subsequent Remediation.  Contemporary Accounting Research 28 (1):  331-383. 

    Keywords:
    internal controls; material weaknesses; corporate governance; materiality; remediation.
    Purpose of the Study:

    Section 404 of the SOX requires public firms and their external auditors to report on the effectiveness of firms’ internal controls over financial reporting (ICOFR) or to reveal the presence of internal control material weaknesses (ICMWs). Other sections in SOX and listing requirements of the NYSE and NASDAQ also contain regulations intended to improve the conduct and oversight of boards of directors, audit committees, and top management. The purpose of this paper is to propose and test a conceptual model of the process that firms use to remediate negative events in general, and ICMWs specifically, with a focus on the role of governance structure changes (including turnover of and improvements in the characteristics of boards of directors, audit committees, and top management). Specifically, the authors examine what actions companies take in changing corporate governance in an attempt to regain equilibrium upon occurrence of a negative event and how do these changes impact the likelihood that a material weakness is remediated.

    Design/Method/ Approach:

    The authors utilize a conceptual model which includes two primary phases, the first of which concerns the association between the disclosure of ICMWs and turnover of boards of directors, audit committees, and top management. The second phase of the model concerns the association between the remediation of ICMWs and both outright turnover of and changes in the particular characteristics of boards of directors, audit committees, and top management. The first phase utilizes an ICMW sample of firms with December fiscal year ends from 2004 through 2007 that report ICMWs in their SOX Section 404 reports and a control sample which received unqualified SOX 404 Reports and examines the association between ICMW disclosure and governance changes. The second model utilizes a similar sample, but only includes firms which disclose ICMWs in 2004-2006 as it is required that firms need a year to remediate.  This second model estimates the association between ICMW and governance structure changes.

    Findings:
    • The authors find that that the disclosure of ICMWs is positively associated with subsequent turnover of members of boards of directors, audit committees, and top management, including both CEOs and CFOs. As such, the authors infer that the incentives to make significant structural changes in governance following the revelation of an ICMW appear to outweigh the disincentives, and firms revealing an ICMW act in a similar manner to firms revealing other material negative events such as fraud or restatements.
    • Furthermore, the authors show that remediation is positively associated with turnover of audit committee members, but not turnover of board members, CEOs, or CFOs.
    • Additionally, the results reveal that ICMW remediation is positively associated with an increase in the proportion of independent directors on the board, an increase in the percentage of independent directors who also serve on other boards, changes involving having an audit committee member chairing the board, improvements in audit committee member financial expertise, an increase in the percentage of shareholdings of audit committee members, changes toward CFOs with greater accounting expertise, greater CFO-specific work experience, and improvements in CEO reputation.
    • Lastly, the results reveal that ICMW remediation is negatively associated with a greater number of ICMWs and the presence of general ICMWs (those having pervasive effects on financial reporting) rather than specific ICMWs.
       
    Category:
    Governance, Internal Control
    Sub-category:
    Assessing Remediation of Weaknesses, Board/Audit Committee Composition, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Chief Audit Executives Assessment of Internal Auditors’ P...
    research summary posted February 17, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Chief Audit Executives Assessment of Internal Auditors’ Performance Attributes by Professional Rank and Cultural Cluster
    Practical Implications:

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

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

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

    Citation:

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

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

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

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

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

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

    Findings:

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

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Internal auditor role and involvement in controls and reporting
  • Jennifer M Mueller-Phillips
    Chief Audit Executives’ Evaluations of Whistle-Blowing A...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Chief Audit Executives’ Evaluations of Whistle-Blowing Allegations
    Practical Implications:

    The findings of this study should be of interest to boards of directors, audit committees, and senior management who are accountable to investors and other parties for the timely and unbiased examination of whistle-blowing allegations. Prior research has shown that audit committee members can be biased in their evaluations of whistle-blower allegations and in the allocation of resources to investigate those allegations. However, the results of this study show that CAEs do not exhibit the same bias as audit committee members for allocating resources to investigate whistle-blower allegations. The audit committee often relies on the CAE to investigate whistle-blowing reports, and this study suggests that CAEs may be a better choice for managing the evaluation of whistle-blowing allegations relative to members of the audit committee. CAEs’ decisions are not shrouded in secrecy, and CAEs report to both management and the audit committee, creating multiple levels of accountability. They are less able to ignore allegations that pose personal threats than are directors.

    Citation:

    Guthrie, C. P., C. S. Norman, and J. M. Rose. 2012. Chief Audit Executives’ Evaluations of Whistle-Blowing Allegations. Behavioral Research in Accounting 24(2): 87-99.

    Keywords:
    Chief audit executive; internal controls; whistle-blowing.
    Purpose of the Study:

    Section 301(4) of the Sarbanes-Oxley Act of 2002 (SOX) requires that public companies establish procedures for receiving and reviewing complaints regarding accounting and controls, and SOX requires firms to establish a confidential and anonymous channel for reporting such complaints. Prior research has shown that audit committee members evaluate anonymous whistle-blower allegations as less credible than non-anonymous allegations. Additionally, prior research has shown that when whistle-blowing allegations threaten the reputations of corporate directors, the directors justify decisions to limit the investigation of allegations by ascribing low levels of credibility to the allegation. Therefore, the purpose of this study was to evaluate how Chief Audit Executives (CAE) evaluate whistle-blowing allegations and whether CAEs are subject to the same judgment biases that audit committee members exhibit. The authors studied CAE credibility assessments of:

    • Anonymous vs. non-anonymous whistle-blower allegations.
    • Whistle-blower allegations that threaten the reputations of the CAE.

    The authors also evaluated the amount of resources that CAEs planned to allocate to investigate these whistle-blower allegation reports.
     

    Design/Method/ Approach:

    The authors conducted an experiment that took place sometime before March 2012 with CAEs and deputy CAEs from both public and private companies. The participants had an average of 12.76 years of internal audit experience. About 60 percent of the participants were CPAs and about 50 percent of the participants were CIAs. The participants read a case in which they were informed of a whistle-blower allegation that management of the organization had committed fraud, and the participants then assessed the credibility of the allegation and allocated resources to investigate the claim. 

    Findings:
    • The CAEs ascribed a lower level of credibility to anonymous whistle-blowing reports relative to non-anonymous reports.
    • When the allegations threatened their reputations (meaning that the whistle-blowing reports suggested the wrongdoing was perpetrated by the exploitation of weaknesses in previously evaluated internal controls rather than by the circumvention of internal controls) CAEs further lowered their assessed credibility of the allegations.
    • CAE perceptions of lower credibility for allegations that threatened their reputations did not lead the CAEs to make smaller allocations of resources to investigating these allegations. In fact, the CAEs allocated more resources to allegations for which they would be held more responsible.
       
    Category:
    Accountants' Reporting, Governance, Standard Setting
    Sub-category:
    Impact of SOX, Internal auditor role and involvement in controls and reporting, Investigations

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