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.

• 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. 

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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.  

• 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.

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 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.

• The presence of both strong audit committee oversight and an auditor that has been contentious in past negotiations together significantly constrain managers’ aggressive reporting.
• The presence of weak audit committee oversight and an auditor that has been cooperative in past negotiations jointly provide the opportunity for managers to engage in more aggressive reporting.
• Managers report less aggressively in the presence of a contentious auditor and strong oversight by the audit committee to ensure timely resolution and protect the firm’s financial reporting reputation, and to minimize the risk that the audit committee will intervene against the managers’ favor.
• Managers report more aggressively in consideration of his/her relative bargaining power against a cooperative auditor who appears to have high relationship concerns, along with weak oversight by the audit committee that is passive/persuadable. 

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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: 

• how the activities of audit committees are perceived by attendees.
• how the perceptions of audit committee effectiveness are influenced by both the symbolic and substantive layers of meaning. 
  The symbolic ceremonies and rituals of audit committee meetings include agenda items and best practices.  The substantive processes include one’s line of questioning, both during and outside of meetings, in order to become comfortable with their company’s financial reports and internal controls.   
• how members’ backgrounds (expertise and independence) influence perceptions of audit committee effectiveness.

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. 

• The authors suggest there is a heterogeneity in audit committee participants’ emotions, which varies from confidence to hopefulness to anxiety.  Attendees appeared to be comfortable with reviewing the financial statements and reviewing internal control systems and less comfortable with auditor dismissal.  This heterogeneity influences attendees’ configurations of the meaning of effectiveness, both from an intra- and between-individual perspective.
• The authors find that audit committee members perceive extensive financial and accounting background as significant in making their audit committee effective.  Formal competencies appear to generate feelings of confidence in committee members, managers, and auditors. 
• The ceremonial features of meetings contribute to perceptions of effectiveness among audit committee members, managers and auditors.  The “ideal” ceremonial and symbolic features include: structured and well-organized meetings, consistent and orderly agendas, and best practice suggestions from the audit firm.
• The substantive features of meetings also contribute to perceptions of effectiveness.  Interviewees imply that demonstrations of toughness by the internal auditor and tensions and divergences between the internal auditor and corporate managers are indications of independence and effectiveness.  Committee members perceive their relevant and challenging questions as
  key to demonstrating their effectiveness and establishing their self-confidence.  Attendees expect auditors to keep them informed regarding accounting standards and governancepractices.  Thus, the effectiveness appears to be linked with the extent that the audit committee is able to require management and auditors to account for their positions on potentially sensitive topics. 
• The meaning of audit committee effectiveness develops in large part through the interactions and ongoing reflections of attendees concerning the many small events and relatively unremarkable actions that take place within and around meetings.  Thus, regulator efforts at making corporate governance more transparent through the disclosure of input and process measures, are fundamentally limited due to the nature of activities that surround audit committee meetings. Moreover, the emotional heterogeneity that characterizes members’ effectiveness meanings are not easily translated into formal disclosures and detailed indicators of effectiveness. Because of these, the authors argue that several aspects of corporate governance may be doomed to remain in the shadows.

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.

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