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  • 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
    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
    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
    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
    The Role of Firm Status in Appointments of Accounting...
    research summary posted June 7, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    The Role of Firm Status in Appointments of Accounting Financial Experts to Audit Committees
    Practical Implications:

    The primary contribution of this study is finding that status-related concerns can prevent firms from appointing AFEs to their boards. This result has clear implications for regulators, as firms without AFEs are more likely to encounter accounting reporting problems. Specifically, recent regulation changes by the SEC to introduce a more broad definition of “financial expert” may damage the improvement of financial reporting that was intended by SOX. This research is consistent with previous findings that directors’ concerns for firm status and their own welfare can negatively affect accounting reporting quality. 

    Citation:

    Erkens, D. H., and S. E. Bonner. 2013. The Role of Firm Status in Appointments of Accounting Financial Experts to Audit Committees. The Accounting Review 88 (1): 107–136.

    Keywords:
    accounting financial experts; audit committees; director status; firm status
    Purpose of the Study:

    Since 1999 regulators have exerted pressure on firms to appoint accounting financial experts (AFE) to their audit committees in an attempt to improve the monitoring of financial reporting. Despite prior research showing more positive financial reporting outcomes, firms have been reluctant to appoint these experts. This study examines the effect of firm status on some firms’ reluctance to appoint AFEs to their audit committees. The authors propose that higher status firms may be more reluctant to appoint AFEs, which could potentially result in more financial reporting problems. 

    Design/Method/ Approach:

    The sample selected consists of 875 firms and 3,590 firm-year observations that are included in the S&P 1500 index from 1999 to 2008. Firms included in the sample have board member biographical information and board composition data available in the RiskMetrics or BoardEx databases and cannot have previously appointed an AFE to the audit committee. This data, combined with an aggregate measure of firm and director status is used to test the following hypotheses:

    1. The average status of appointed AFEs is less than the average status of sitting directors.
    2. Director status is positively related to firm status
    3. The difference in status of appointed AFEs and sitting directors is larger for higher status firms than it is for lower status firms.
    4. The probability that a firm will appoint an AFE to its audit committee in a given year is negatively related to the status of the firm.
    Findings:
    • Higher status firms were reluctant to appoint AFEs to their audit committees because typical AFEs are of lower director status than typical directors. 
    • The gap between the status of AFEs and sitting directors was larger for higher status firms. 
    • Directors’ personal incentives related to appointing higher status directors outweigh the concerns about damaging firm status.
    • Firms that have directors who serve on other boards with AFEs, have corporations nearby with AFEs, or have an auditor with a significant fraction of clients that have AFEs are more likely to appoint AFEs to their audit committees.
    • Firms with complex accounting or past accounting problems are also more likely to appoint AFEs. 
    Category:
    Corporate Matters, Governance, Independence & Ethics
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts, Impact of SEC Rules Changes/SarBox
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