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.
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
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.
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.
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.
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.
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.
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).
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.
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
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.
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:
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.
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.
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
Abdolmohammadi, M. 2013. Correlates of Co-Sourcing/Outsourcing of Internal Audit Activities. Auditing: A Journal of Practice and Theory 32(3): 69-85.
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.
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.
This study sheds light on what underlies decision making in the imperative audit committee responsibility of auditor appointment: nuanced interactions and power asymmetry among management, the audit committee, and auditors. The auditors viewed the CFO as the client and tailored the proposal accordingly. The audit committee will not be effective unless both auditors and audit committee members fundamentally change their mindsets about their respective roles in relation to client management. As large public companies employ multiple Big 4 firm, the viability of severing existing relationships to bring in a truly independent auditor mindset through audit firm rotation is questionable.
Fiolleau, K., Hoang, K., Jamal, K., & Sunder, S. 2013. How Do Regulatory Reforms to Enhance Auditor Independence Work in Practice? Contemporary Accounting Research 30 (3): 864-890.
This article presents a study on regulatory reforms that aim to enhance auditor independence work. In order to achieve the right balance between the auditors serving commercial versus professional interests, regulators implemented a set of alternative remedies that include mandatory audit partner rotation and enhanced audit committee responsibilities, expertise and independence. As of September 2013, regulators based in Europe and the U.S. are considering to extend rotation requirement to encompass audit firm rotation rather than partner rotation. In this paper, the authors conduct a field study to investigate how regulatory reforms designed to promote auditor independence (specifically audit committee reforms and proposed audit firm rotation requirements) may actually work in the context of auditor change. This study of auditor change also yields insights into the potential consequences of increasing the frequency of auditor–client courtships through mandatory audit firm rotation, which has recently been proposed by regulators as a way of reinforcing auditor independence. The underlying premise is that audit quality would be enhanced by weakening the economic and relationship bonds between auditors and their clients. The authors investigate how the audit committee interprets and executes its legislative mandate in appointing an independent external auditor.
The authors collected data six months after the company’s RFP process and new auditor appointment. The authors obtained a copy of the company’s RFP document from the CFO, and copies of the bid documents directly from all Big 4 audit firms who bid for this audit. They interviewed the company’s CFO and the chair of the audit committee. The authors interviewed each of the four proposed engagement audit partners for 60-90 minutes.
The results of this study are important to consider when examining the effects of the audit committee on managers’ judgments. This study identifies the changes to the reporting environment stemming from the implementation of SOX, particularly with respect to communications between auditors and the audit committee and the authority and responsibility of the audit committee. This study adds insight to prior archival research that suggests that audit committees considered to be effective are associated with greater financial reporting quality. Further, these findings suggest that managers act as if auditors and audit committees that jointly resist management pressures to engage in aggressive reporting play important roles in ensuring high financial reporting quality.
Brown-Liburd, H., A. Wright and V. Zamora. 2016. Managers’ Strategic Reporting Judgments in Audit Negotiations. Auditing, A Journal of Practice and Theory 35 (2): 47-64.
Prior research has largely characterized audit issue negotiations as a dyadic relationship between auditors and managers. However, the Sarbanes Oxley Act (SOX) substantially enhanced the audit committee’s oversight responsibilities for the financial reporting and auditing process. Thus, negotiations post-SOX may be viewed as a triadic relationship involving managers, auditors, and the audit committee. Differing judgments between auditors during negotiations and managers during financial reporting exist because they have different perspectives and incentives. Whereas managers’ incentives relate to maximizing financial reporting outcomes while maintaining the firm’s reporting reputation, auditors’ incentives relate to fostering a functioning working relationship with the client while appropriately attesting to the financial statements. These differences in perspectives and incentives yield contrasting expectations of negotiation judgments for auditors and managers. This study seeks to examine the joint effects of past auditor-client negotiations and audit committee strength on management’s strategic reporting judgments.
The authors recruited participants from an executive training session attended by CFOs/controllers and held at a large public university in the southeastern U.S. During a controlled experiment, participants completed the hard copy experimental case. Participants engaged in planning for an upcoming audit negotiation involving a subjective estimate for an inventory write down due to obsolescence. The authors asked participants to identify their initial offer and their perception of the negotiated ultimate final outcome. Audit committee strength was manipulated as either weak or strong. The nature of past auditor-client negotiations over “grey” misstatements was manipulated as either contentious or cooperative.
The results are consistent with a strong combined effect of the roles of both the auditor and the audit committee in managers’ pre-negotiation judgments.
This study provides empirical evidence that suggests that auditor ratification vote tallies are informative to the market. First, higher auditor ratification disapproval is associated with a more negative stock market reaction to the announcement of the vote tallies, consistent with the argument that this reflects negative investor perception of the auditor. Second, the authors provide evidence that the market reacts positively to an auditor change when there is high shareholder disapproval, and that audit and auditor characteristics moderate or exacerbate the market reaction in a way that suggests the market finds the ratification vote informative, but does not fully price it.
Tanyi, P. N. and K. C. Roland. 2017. Market Reaction to Auditor Ratification Vote Tally. Accounting Horizons 31 (1): 141 – 157.
In light of recent calls to mandate shareholder voting on auditor ratification, this paper illustrates that the ratification vote provides new information to investors. The push to mandate shareholder ratification is supported by many and is largely driven by concerns that most audit committees simply “rubber stamp” management’s recommendation of the auditor. Given that shareholder ratification votes are generally overwhelmingly in favor of the auditor, non-binding, and voluntary, the authors ask whether the market finds any new information in the ratification vote. The authors examine whether the proportion of votes against or abstaining from the appointment of the auditor has capital market consequences. They also examine whether the proportion of non-supporting votes affects how the market reacts to auditor dismissal.
The authors use a sample of firm-year observations with auditor ratification votes over the period of 2010 to 2015.
The results of this study are important for regulators when considering corporate governance processes and governance disclosures. This study also provides insight into the importance of small events surrounding audit committee meetings, such as members’ style of questioning and insistence on managers swiftly adopting corrective measures to solve problems highlighted in internal audit reports. The results provide insights into the process with which audit committee attendees define their effectiveness. The results call into question the effectiveness of recent regulatory attempts to strengthen formal disclosures.
Gendron,Y., and J. Bédard. 2006. On the constitution of audit committee effectiveness. Accounting, Organizations and Society 31(3):
211-239.
Corporate stakeholders increasingly rely on the audit committee to constrain managers’ self-interested behavior. Previous practitioner and academic recommendations for audit committee effectiveness have focused on the composition and responsibilities of the audit committee, as well as the expertise and independence of audit committee members. This paper examines the meaning of audit committee effectiveness through the eyes of individuals who attend meetings: corporate managers, auditors and audit committee members. The authors attempted to understand the process by which audit committee effectiveness is internally developed and sustained by audit committee meeting attendees. The authors use sociological techniques to examine:
The authors collected their evidence via interviews with the CEO, CFO, internal auditor, audit partner, and audit committee members associated with 3 Canadian corporations. Interviewees were asked to describe the process of a typical audit committee meeting, the role of the audit committee, and difficult issues faced by the committee. The interviews were conducted primarily in 2000 and 2001 and updated for post-Enron insights in 2004.
This review paper provides an overview of how financial reporting, auditing, and corporate governance regulations influence the earnings management and accounting choice decisions of key stakeholders. The paper provides a summary of key insights (summarized above) of interest to practitioners, researchers, and regulators. Further, the paper highlights the key benefits of experimental and survey work in terms of identifying causal mechanisms and investigating the impact of potential regulatory actions not yet in existence.
Libby, R., K. Rennekamp, and N. Seybert. 2015. Regulation and the interdependent roles of managers, auditors, and directors in earnings management and accounting choice. Accounting, Organizations and Society 47: 25-42.
This paper reviews recent experimental and survey studies of key stakeholders decisions that influence earnings management and accounting choice, and how financial reporting affects these decisions. The authors summarize the contribution of the studies, directions for future research, and key methodological recommendations for researchers doing experimental and survey work. The authors define earnings management and accounting choice broadly to include: 1) choices of accounting methods; 2) implementation decisions related to estimates, classifications, levels of detail, and display format used in mandatory disclosures; 3) the frequency, timing, and content of voluntary disclosures; and 4) investment, financing, and operating choices based on their accounting consequences. The focus of this review is on the determinants (rather than consequences) of accounting choice. In examining the effects of regulation on managers’, auditors’, and directors’ (or audit committee members’) judgments and decisions with respect to earnings management, the study focuses on three types of regulation: 1) financial reporting regulations, 2) auditing regulations, and 3) other corporate governance regulations.
The paper focuses on studies published in Accounting, Organizations, and Society, Contemporary Accounting Research, Journal of Accounting Research, and The Accounting Review from 2008 through 2014. Relevant working papers from SSRN and select older papers that provide motivation for more recent work are also discussed.
Results from this study suggest that rotating internal auditors into operational management programs reduces financial reporting quality. Companies that utilize a rotational internal audit program should be aware of these possible unintended consequences. Companies utilizing these programs should consider implementing several compensating controls (listed in the findings section), as the authors have found that these controls can reduce or even eliminate (if used together) the negative consequences of rotational internal audit programs.
Christ, M.H., A. Masli, N.Y. Sharp, and D.A. Wood. 2015. Rotational internal audit programs and financial reporting quality: Do compensating controls help? Accounting, Organizations and Society 44: 37-59.
The purpose of this study is to examine unintended consequences of rotational internal audit programs. Specifically, the authors inspect how moving internal auditors out of the internal audit function and into operational management can impact financial reporting quality. In addition, the authors examine how compensating controls can mitigate the unintended consequences.
The authors initially utilize semi-structured interviews with audit executives and audit committee chairmen to identify how the rotational internal audit programs impact financial reporting quality. Using the information gathered, the authors test hypotheses utilizing archival data from various firms for the years 2000 to 2005.
Overall, the authors find that the practice of rotating internal auditors into operational management positions is related to lower financial reporting quality. Specifically, it increases Accounting Risk (that evaluates the risk of misreporting by identifying suspicious patterns in accounting data). However, the authors find that several compensating controls can reduce this negative effect. Specifically, the authors find the effect is reduced when companies only rotate staff internal audit positions, have a more effective audit committee, and when management asks the internal audit function to have a greater role in the financial reporting process. Findings also demonstrate that including all three of these compensating controls can eliminate the unintended consequences.