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  • Jennifer M Mueller-Phillips
    Chief Financial Officers as Inside Directors.
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 14.0 Corporate Matters, 14.06 CFO Tenure and Experience 
    Title:
    Chief Financial Officers as Inside Directors.
    Practical Implications:

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

    Citation:

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

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

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

    Design/Method/ Approach:

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

    Findings:
    • Companies with CFOs on the board have more effective internal control over financial reporting, higher accruals quality, and lower likelihood of restatements.
    • The results showed a 4.28 percentage point reduction in material weakness (MW) disclosure likelihood.
    • This suggests that suggest that these CFOs are more likely to share information with other board members about the status of the financial reporting function and secure sufficient resources to invest in the establishment, documentation, and testing of internal controls.
    • The results implied that CFOs are more aligned with shareholder interests.
    • CFOs who serve on their own boards receive 26.9 (36.3) percent higher cash (total) compensation.
    • Further, CFOs serving on their own boards are less likely to face turnover following poor corporate performance. However, the authors also find that board membership does not protect the CFO from turnover when poor performance relates specifically to financial reporting quality.
    • These results suggest that serving on the board generally enables CFOs to gain more resources from the company and avoid penalty in times of difficulty, unless that difficulty is related to their direct responsibility.
    Category:
    Corporate Matters, Governance
    Sub-category:
    Board/Audit Committee Composition, CFO Tenure & Experience
  • Jennifer M Mueller-Phillips
    Client Importance and Earnings Management: The Moderating...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.03 Non-Audit Services, 13.0 Governance, 13.05 Board/Audit Committee Oversight 
    Title:
    Client Importance and Earnings Management: The Moderating Role of Audit Committees
    Practical Implications:

    The results of this study have implications to both New Zealand and the United States. Regulators in New Zealand should assess these results as possible indications that the profession’s self-regulated status may need to be revised in light of the existence of lower financial reporting quality for clients that have weak audit committee oversight and are economically important clients to the auditor. Additionally, these results provide evidence to contribute to the ongoing debate in the United States regarding the merits and the intended and unintended consequences of independent auditor oversight through regulatory bodies such as the PCAOB.

    For more information on this study, please contact Vineeta D. Sharma.
     

    Citation:

    Sharma, V., D.S. Divesh, and U. Ananthanarayanan. 2011. Client importance and earnings management: the moderating role of audit committees. Auditing: A Journal of Practice and Theory 30 (1): 125-156.

    Keywords:
    audit committee; auditor independence; accruals; corporate governance; fees, earnings management; non-audit
    Purpose of the Study:

    As a result of declining investor confidence in the quality of financial information due to financial scandals, many countries have implemented corporate governance reforms that specifically identify the audit committee as the primary mechanism for the oversight of auditor independence and financial statement quality. This study investigates how the association between the economic importance of a client to the auditor and earnings management is moderated by the audit committee. Client importance is a potential threat to auditor independence and thus is a potential threat to audit quality. The authors suggest that the possibility exists that auditors may view the audit wealth provided from a client as more important than maintaining independence which is determinant of the audit quality; therefore, the authors examine if there is a positive correlation between client importance and earnings management. Certain circumstances, such as management ownership, leverage, high growth, and firm size, could potentially promote an environment that is conducive to earnings management independent of the external audit. In consideration of these circumstances, the auditors studied whether the association between client importance and earnings management was effected by these firm environmental factors. The audit committee’s response and efforts to mitigate these factors were also examined, specifically in light of the best practices recommendations. 

    Design/Method/ Approach:

    The authors conducted this study by gathering empirical evidence from firms listed on the New Zealand Stock Exchange in the fiscal years 2004 and 2005. The NZSE was chosen as a proper natural laboratory because there is no ban or limit on non-audit services, no mandate on the roles and composition of the audit committee exists, the audit profession is self-regulated, it is a less litigious environment, and it is geographically and economically small.

    Findings:
    • A positive correlation was observed between client importance and the observed proxies for earnings management, which included both performance-adjusted discretionary total and current accruals. This implies that as client importance, as related to the wealth production to the external auditors, increases the possibility of the existence of earnings management in the financial statements also increases.
    • The association became more pronounced for income-increasing accruals that potentially diminish the quality of earnings and are of greater concern to regulators; however, this was moderated by the audit committee.
    • The association between client importance and earnings management is conditional on other firm characteristics such as inside ownership, growth, leverage, and firm size. These factors could create potential agency conflicts but are moderated by the audit committee.
    • Accounting expertise on the audit committee and committees composed completely of outside directors explain the moderating effects of the audit committee.
    • The association with earnings management became more pronounced when the audit committee did not meet the best practices outlined by the NZSEC. These practice suggestions from the NZSEC are merely recommendations, not requirements, as the auditing profession is self- regulated in New Zealand.
       
    Category:
    Governance, Independence & Ethics
    Sub-category:
    Board/Audit Committee Oversight, Impact of Fees on Decisions by Auditors & Management, Non-audit Services
  • The Auditing Section
    Corporate Board Governance and Voluntary Disclosure of...
    research summary posted May 7, 2012 by The Auditing Section, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight 
    Title:
    Corporate Board Governance and Voluntary Disclosure of Executive Compensation Practices
    Practical Implications:

    Consistent with prior corporate governance research, this study concludes that more independent boards of directors are associated with better shareholder representation in disagreements with management.  Moreover, the results highlight the importance of the board governance process for effective decision making. This study documents that having less time to meet as a group and having fewer directors serving on the board can lead to reduced transparency. Frequent board meetings would facilitate greater information sharing among directors and more directors serving on boards would allow better workload distribution and committee assignments.

    Citation:

    Laksmana, I. 2008. Corporate board governance and voluntary disclosure of executive compensation practices.  Contemporary Accounting Research 25 (4): 1147-1182.

    Keywords:
    Board of directors, corporate governance, executive compensation, voluntary disclosure
    Purpose of the Study:

    Recent corporate scandals focused considerable public attention on the role of boards of directors in corporate governance. The purpose of this study is to assess whether higher quality boards voluntarily disclose more information about their compensation practices. The U.S. SEC requires a report justifying the compensation policies, but does not specify the items to be disclosed or the reporting format to be followed. Compensation-related disclosures are particularly important because boards of directors have a responsibility to report the basis of their actions for determining executive compensation in the companies’ proxy statements.

    Unlike other disclosure studies, the present study examines disclosures as the outcomes of board decisions rather than the assumed effect of boards on management decisions. Below are the two primary objectives that the author addresses in this study:

    • Examine whether boards of directors’ time and resource commitments are associated with the extent of compensation practice disclosures.
    • Examine whether more independent boards and compensation committees are more likely to make objective decisions by supporting greater disclosures.
    Design/Method/ Approach:

    This study selects publicly traded firms in nonregulated industries listed on the Standard & Poor’s (S&P) 500 as of December 31, 1992. The author examines the compensation disclosures in proxy statements of those firms filed in 1993 and in 2002. 

    Findings:
    • Boards reported more compensation-related disclosures in 2002 (most recent year) than they did in 1993 (first response to new SEC rules). 
    • More independent boards and compensation committees have more transparent compensation practice disclosures.
    • Meeting frequency and board size are both important factors for increased compensation disclosures.  The board/committee must be of adequate size to distribute workload and meet frequently enough to make decisions. 
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Oversight
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  • 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
    Corporate Managers’ Reliance on Internal Auditor R...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Corporate Managers’ Reliance on Internal Auditor Recommendations
    Practical Implications:

    One of the main implications of the study is that the internal audit function does add value to an organization because their recommendations can significantly impact managers’ operational decisions. The study also finds that in-house internal auditors can improve their influence on management by quantifying their recommendations.

    For more information on this study, please contact F. Greg Burton.
     

    Citation:

    Burton, F. G., S. A. Emett, C. A. Simon, and D. A. Wood. 2012. Corporate Managers’ Reliance on Internal Auditor Recommendations. Auditing: A Journal of Practice and Theory 31(2): 151-166.

    Keywords:
    Internal audit; in-house; outsourcing; competence; objectivity
    Purpose of the Study:

    Internal auditors provide both assurance and consulting services to add value and improve the operations of an organization. In order to add value through consulting services, internal auditors must make credible recommendations and effectively communicate those recommendations to management. Therefore, the purpose of the study was to understand the factors that influence managers’ perceptions of and reliance on internal audit consulting recommendations. The factors that the authors studied included:

    • Whether internal auditor recommendations are consistent or not with managers’ initial preferences
    • Whether the internal audit function is performed in-house or outsourced
    • Whether the recommendations are quantified or non-quantified.
       
    Design/Method/ Approach:

    The authors conducted an experiment with business professionals that held either senior or mid-level manager positions in their companies. The participants had an average of 9.12 years of work experience. Participants were given a case study about a plastics company and were given the role of a supervising manager of the company. Managers made an initial operational decision and then were presented with information from internal audit and asked to make their final decision.

    Findings:

    The authors found the following results:

    • Managers change their initial positions more when presented with preference-inconsistent recommendations.
    • There are no differences in managers’ reliance on the non-quantified, preference-inconsistent recommendations of outsourced versus in-house internal auditors.
    • Managers rely more on the quantified recommendations of in-house internal auditors than the non-quantified recommendations of in-house internal auditors. The authors did not find this same effect for outsourced internal auditors.
       
    Category:
    Governance
    Sub-category:
    Internal auditor role and involvement in controls and reporting
  • Jennifer M Mueller-Phillips
    Correlates of Co-Sourcing/Outsourcing of Internal Audit...
    research summary posted February 20, 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:
    Correlates of Co-Sourcing/Outsourcing of Internal Audit Activities
    Practical Implications:

    The primary result that audit committee involvement is significantly and positively associated with “outsourcing” is an important finding that suggests a need for management to pay close attention to the role that audit committee plays in “outsourcing” internal audit activities. The significance of value-added-activities, missing-skill-set, and audit-staff-vacancies on “outsourcing” also require management attention because collectively these three variables indicate trade-offs between acquiring the expertise in-house or “outsourcing” to external service providers.

    For more information on this study, please contact Mohammad Abdolmohammadi

    Citation:

    Abdolmohammadi, M. 2013. Correlates of Co-Sourcing/Outsourcing of Internal Audit Activities. Auditing: A Journal of Practice and Theory 32(3): 69-85.

    Keywords:
    Outsourcing, internal audit activities, audit committee involvement, missing skill set
    Purpose of the Study:

    I use responses from 1,059 chief audit executives (CAEs) of organizations located in Australia, Canada, New Zealand, South Africa, the U.K./Ireland, and the U.S. to investigate several correlates of co-sourcing/outsourcing (referred to as simply “outsourcing”) of internal audit activities. 

    Design/Method/ Approach:

    In 2010 the Institute of Internal Auditors Research Foundation (IIARF) conducted a survey of IIA’s membership world-wide. The long survey had detailed questions about various issues from CAE attributes, organization characteristics, to practice issues such as “outsourcing.” Called the Common Body of Knowledge in Internal Auditing or CBOK (2010), this database has responses from internal auditors of varying experience and professional rank. I only use CAE responses for my study of “outsourcing” because CAEs are presumed to be highly knowledgeable about various issues of internal audit activities, including “outsourcing.” While CBOK (2010) has over 13,500 responses from members of various professional rank (CAEs, audit managers, etc.) in over 100 countries, I limit the data used in my study to only CAEs from Anglo-culture countries. This is to mitigate the possibility of differences due to various languages and cultural dimensions, such as uncertainty avoidance, levels of femininity/masculinity, etc.  

    Findings:
    • An important finding of the study is that audit committee involvement is positively and significantly associated with “outsourcing” of internal audit activities. Interactions of audit committee involvement with organization size and location generally indicate that medium and large international/multinational organizations with audit committee involvement “outsource” more than medium and large local/national organizations with no audit committee involvement.
    • Other important findings indicate an inverse relationship between “outsourcing” and value-added-activities of the internal audit function, and positive relationships between “outsourcing” and missing skill set and audit staff vacancies.
    • Finally, I find no evidence of relationships between CAE age, college degree (graduate/undergraduate), major (accounting versus others), internal audit certification, and regular meetings with the audit committee and “outsourcing.” Also, country of residence (U.S. versus other Anglo-culture countries) is not significant, but for-profit organizations “outsource” significantly more of their internal audit activities than not-for-profit organizations.
    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Internal auditor role and involvement in controls and reporting
  • The Auditing Section
    Discussion of “Internal Audit Sourcing Arrangement and the E...
    research summary posted May 7, 2012 by The Auditing Section, tagged 07.0 Internal Control, 07.01 Scope of Testing, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Discussion of “Internal Audit Sourcing Arrangement and the External Auditor’s Reliance Decision”
    Practical Implications:

    The points noted below suggest some limitations in Glover, Prawitt & Wood (2008) article. However, Messier acknowledges that the article provides insight on some factors that might affect the external auditors’ reliance decisions under AS 5.

    Citation:

    Messier, W. F. 2008. Internal Audit Sourcing Arrangement and the External Auditor’s Reliance Decision. Contemporary Accounting Research 25 (1) 215-218.

    Purpose of the Study:

    This is a discussion of the Glover et al. article (2008). The comments are based on Messier’s comments provided during the 2006 Contemporary Accounting Research Conference.

    Findings:
    • Glover, Prawitt, & Wood (2008) used a first-year audit scenario for their experiment. Messier suggests that auditors are more conservative in first-year audits. This conservative nature may have caused the auditors (participants) to assess the internal audit work as relatively low in terms of reliability. 
    • Messier suggests that the evaluation of “task subjectivity” may be confounded with the auditors’ consideration of the type of work performed, in accordance with SAS No. 65. (The “objective task” was control testing; the “subjective task” was inventory valuation.) This may limit the implications for the findings related to task objectivity/subjectivity, noted above.
    Category:
    Internal Control, Governance
    Sub-category:
    Scope of Testing, Internal auditor role and involvement in controls and reporting
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  • Jennifer M Mueller-Phillips
    Do Former Audit Firm Partners on Audit Committees Procure...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.03 Non-Audit Services, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    Do Former Audit Firm Partners on Audit Committees Procure Greater Nonaudit Services from the Auditor?
    Practical Implications:

    This study presents new evidence that suggests the presence of AFAPs and UFAPs on the audit committee has the potential to reduce threats to auditor independence by pre-approving the purchase of less NAS form the auditor. The findings of this study are consistent with the view that AFAPs serving as independent audit committee members appear not to make economic decisions in favor of their former audit firm, and, thus, may be exercising objective and independent oversight to enhance auditor independence. This evidence is also in line with the goal of SOX to reduce actual or perceived threats to auditor independence. From a regulatory perspective, the findings suggests that concerns about audit firm alumni on client’s audit committees may not be warranted in the post-SOX environment and the three-year cooling period rule may be unnecessary. However, further research in other contexts is needed.

    For more information on this study, please contact Vic Naiker.
     

    Citation:

    Naiker, V., D. S. Sharma, and V. D. Sharma. 2013. Do Former Audit Firm Partners on Audit Committees Procure Greater Nonaudit Services from the Auditor? The Accounting Review 88 (1): 297–326.

    Keywords:
    alumni; audit committee; cooling-off period; former partner; independence; nonaudit; revolving-door
    Purpose of the Study:

    This study focuses on how the presence of a former audit firm partner (FAP) on the audit committee is related to nonaudit services (NAS) procured from the external auditor. The Sarbanes-Oxley Act of 2002 requires the audit committee to pre-approve nonaudit services procured from the auditor to prevent potential independence issues. The presence of a FAP affiliated with the current auditor on the audit committee could undermine the audit committee’s due diligence over the NAS pre-approval process. To alleviate these concerns, the SEC implemented a three-year cooling-off period for appointing audit form alumni as independent directors. This study analyzes the effects of these relationships on auditor independence.

    Design/Method/ Approach:

    A sample of 2,748 firm-year observations with available corporate governance, director, and CFO biographical data for fiscal years ending in 2004 and 2005 was selected. The sample was tested using regression models to investigate the association between affiliated former audit partners (AFAPs) and unaffiliated audit partners (UFAPs) on the audit committee and nonaudit services purchased from the auditor.

    Findings:
    • Firms with FAPs purchase significantly less NAS compared to firms without and FAP.
    • The capacity of the audit committee to reduce dependency on auditor-provided NAS in the post-SOX era may be enhanced when committee members possess partner-level experience.
    • AFAPs on the audit committee adopt a more conservative NAS pre-approval strategy by reducing NAS purchased from the auditor.
    • Audit committees including AFAPs not meeting the mandatory three-year cooling off periods are equally conservative when pre-approving NAS purchased for the auditor relative to audit committees that include AFAPs satisfying this rule and UFAPs.
       
    Category:
    Governance, Independence & Ethics, Standard Setting
    Sub-category:
    Board/Audit Committee Composition, Impact of SOX, Non-audit Services
  • Jennifer M Mueller-Phillips
    Does Internal Audit Function Quality Deter Management...
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.04 Management Integrity, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Does Internal Audit Function Quality Deter Management Misconduct?
    Practical Implications:

    These findings suggest that regulators, audit committees, and other stakeholders should consider ways to improve IAF quality, specifically IAF competence, and IAFs improve corporate governance by assisting audit committees in monitoring management. This study provides empirical evidence consistent with the proposition that IAF quality and competence deter management misconduct. IAF quality and, particularly, IAF competence are important in deterring observable instances of management misconduct, both accounting- and nonaccounting-related. These findings are important because in the early 2000s, regulators responded to public outcry over observable management misconduct, yet IAF quality was largely left out of the regulatory debate and reforms that followed.

    Citation:

    Ege, M. S. 2015. Does Internal Audit Function Quality Deter Management Misconduct? Accounting Review 90 (2): 495-527.

    Keywords:
    corporate governance, internal audit function, internal audit quality, management misconduct
    Purpose of the Study:

    This study examines the relation between internal audit function (IAF) quality, as defined by standard-setters, and the likelihood of management misconduct, such as financial reporting fraud, bribery, and misleading disclosure practices. Standard-setters posit that IAFs serve as a key resource to audit committees for monitoring senior management and that high-quality IAFs deter management misconduct. However, U.S. regulators do not enforce IAF quality or require disclosures relating to IAF quality. The U.S. Securities and Exchange Commission (SEC) proposed requirements to increase IAF quality by adding the appointment, compensation, retention, and oversight of the internal auditor to audit committee responsibilities, but these proposed requirements were abandoned. Ten years later, after withdrawing its recent proposal to require high-quality IAFs, NASDAQ is considering how to revise the proposed rules. These proposals demonstrate the need for evidence regarding whether IAF quality results in improved monitoring of management.

    This study informs standard-setters, regulators, audit committees, and shareholders about whether IAF quality deters management misconduct incrementally to other monitors.

    Design/Method/ Approach:

    The author obtained the initial sample from the Institute of Internal Auditors’ proprietary Global Auditing and gathered additional information from COMPUSTAT. The final sample covers 1,398 firm-years representing 617 unique firms from 2000 through 2009. The management misconduct sample comes from four data sources: the Federal Securities Regulation Database, the Stanford Securities Class Action Clearinghouse, SEC’s website and the Department of Justice website.

    Findings:

    The author finds a negative relation between IAF quality and management misconduct, even after controlling for other determinants of misconduct, including board of director, audit committee, and external auditor quality. This effect is economically significant, as a firm with IAF quality one standard deviation above the mean is approximately 2.3 percentage points less likely to have management misconduct than a firm with average IAF quality. This is approximately 29.5 percent of the 7.7 percent unconditional probability of management misconduct. Further analysis reveals that IAF competence, but not objectivity, is negatively related to the likelihood of management misconduct, suggesting that IAF competence is important in deterring management misconduct.

    Misconduct firms have low IAF quality and IAF competence during misconduct years as compared to a matched sample of firms. Then, in post-misconduct years, misconduct firms increase IAF quality through IAF competence. This increase in competence is due to hiring more certified internal auditors and increasing training. However, misconduct firms do not appear to have lower IAF objectivity during or after misconduct years compared to a matched sample. These results are consistent with the proposition from standard-setters that IAFs serve as a key resource for audit committees in monitoring management.

    The findings suggest that high-quality IAFs are effective at deterring both types of management misconduct. Disclosures related to IAF quality would assist stakeholders in predicting accounting-related management misconduct.

    Category:
    Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Management Integrity
  • Jennifer M Mueller-Phillips
    External Auditor Evaluations of Outsourced Internal...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    External Auditor Evaluations of Outsourced Internal Auditors.
    Practical Implications:

    These results have implications for both audit research and practice as well as policy makers and firms deciding on whether to outsource the internal audit function. From a research perspective, this study is the first to examine how external auditors view various internal audit outsourcing arrangements. Further, the results indicate a potential cost of internal audit outsourcing that has not been previously considered. That is, if outsourced internal auditors provide other services, the cost of the external audit could increase, which potentially interferes with some of the expected cost savings of AS No. 5.

    Citation:

    Brandon, D. M. 2010. External Auditor Evaluations of Outsourced Internal Auditors. Auditing: A Journal of Practice & Theory 29 (2): 159-173. 

    Keywords:
    auditor independence, external auditing, nonaudit services, outsourced internal auditing
    Purpose of the Study:

    In the last several decades many companies began outsourcing the internal audit function (IAF) to public accounting firms. The prevalence of outsourcing is likely to continue given current exchange requirements to establish and maintain an IAF. Further, lack of an IAF could be considered a significant internal control deficiency or even a material weakness. The primary concern over external auditors providing nonaudit services appears to be the potential negative effects of the fees from those services on the external auditor’s objectivity. This concern was so pervasive that part of the Sarbanes-Oxley Act prohibits external auditors from performing certain nonaudit services for external audit clients. The Panel on Audit Effectiveness acknowledges the role of internal audit in maintaining good corporate governance and encourages the cooperation between internal and external auditors. Public accountants can utilize the client-specific expertise possessed by strong internal audit departments to increase external audit efficiency (resulting in cost savings that could be passed on to the auditee) and also provide a higher level of assurance. These benefits are of particular interest given concerns over the cost of complying with Section 404 of the Sarbanes-Oxley Act (SOX).

    This study investigates some implications of an outsourced internal auditor providing nonaudit services.

    Design/Method/ Approach:

    The 89 participants for the study were experienced practicing auditors. Fifty-six participants were obtained via contact partners at the respective firm. The contact partners were asked to distribute the instruments to auditors who typically evaluate internal auditors. The remaining participants were obtained through an in-house training session. 89 auditors participating, approximately 64 percent were CPAs and had an average of 4.7 years of audit experience. The evidence was gathered prior to September 2007.

    Findings:

    Results indicate that certain external auditor judgments and decisions are negatively affected when an outsourced internal auditor also provides consulting services, while other judgments (long touted by proponents of auditor-provided nonaudit services as benefits) are not. Specifically, inconsistent with proponents of auditor-provided nonaudit services, competence perceptions do not appear to be improved by the provision of consulting services. Consistent with arguments of opponents of auditor-provided nonaudit services, external auditor perceptions of internal auditor objectivity appears to be impacted negatively by the provision of consulting services. Further, consistent with previous research, these results appear to be tempered by the staffing of the team providing the consulting services.

    Other results indicate reduced planned reliance on outsourced internal auditors also providing other services. External auditors appear reluctant to rely on outsourced internal auditors providing additional services, regardless of staffing decisions. Results also indicate differences in audit fee adjustments. Specifically, participants would recommend greater audit fee increases when consulting services are provided, again regardless of the outsourcing arrangement.

    Category:
    Governance, Independence & Ethics
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Non-audit Services

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