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  • 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
  • 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
    Chief Audit Executives Assessment of Internal Auditors’ P...
    research summary posted February 17, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Chief Audit Executives Assessment of Internal Auditors’ Performance Attributes by Professional Rank and Cultural Cluster
    Practical Implications:

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

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

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

    Citation:

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

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

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

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

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

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

    Findings:

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

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Internal auditor role and involvement in controls and reporting
  • Jennifer M Mueller-Phillips
    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
  • Jennifer M Mueller-Phillips
    How Do Regulatory Reforms to Enhance Auditor Independence...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.07 Audit Firm Rotation, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    How Do Regulatory Reforms to Enhance Auditor Independence Work in Practice?
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    audit committees, reforms, auditor independence, audit firm rotation, independence
    Purpose of the Study:

    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 auditorclient 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.

    Design/Method/ Approach:

    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.

    Findings:
    • Management controlled access to documents and people, and played a powerful role in making the auditor appointment decision.
    • Management engaged the audit firm that offered the least senior level expertise and the lowest fee.
    • The audit committee adopted management’s priorities in encouraging prospective auditors to demonstrate responsiveness to management.
    • Prospective auditors were reticent to probe the client for information that would have helped them identify risks before accepting the engagement.
    • The auditors were focused on winning the client and were willing to cut fees, move partners to the client’s head office city, and curtail quality control.
    • If management, with private information and interests, continues to have substantial influence over hiring the auditor, then regulatory reforms for audit firm rotation and/or audit committee empowerment are likely to be ineffective.
    • Auditor change puts pressure on audit fees, and requires auditors to demonstrate commitment and responsiveness to the management of both prospective clients and current ones used as referees.
    • Instead of strengthening independence and providing a fresh auditor perspective, the authors find that the auditor change process is dominated by management and is characterized by gestures from prospective auditors to win client favor during the courtship, potentially rendering proposed audit firm rotation ineffective.
    Category:
    Corporate Matters, Independence & Ethics
    Sub-category:
    Audit Committee Effectiveness, Audit Firm Rotation, Audit Firm Rotation, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Managers’ Strategic Reporting Judgments in Audit N...
    research summary posted August 31, 2016 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.04 Interactions with Client Management, 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Managers’ Strategic Reporting Judgments in Audit Negotiations
    Practical Implications:

     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.

    Citation:

     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.

    Keywords:
    Audit negotiation, past counterpart relationship, audit committee oversight
    Purpose of the Study:

     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.

    Design/Method/ Approach:

     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.

    Findings:

    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. 
    Category:
    Corporate Matters, Engagement Management, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Audit Committee Oversight, Interactions with Client Management
  • Jennifer M Mueller-Phillips
    Market Reaction to Auditor Ratification Vote Tally
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Market Reaction to Auditor Ratification Vote Tally
    Practical Implications:

    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. 

    Citation:

    Tanyi, P. N. and K. C. Roland. 2017. Market Reaction to Auditor Ratification Vote Tally. Accounting Horizons 31 (1): 141 – 157. 

    Keywords:
    auditor ratification, market reaction, and corporate governance
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    The authors use a sample of firm-year observations with auditor ratification votes over the period of 2010 to 2015. 

    Findings:
    • The authors find higher shareholder disapproval of the auditor is associated with a negative market reaction to the voting outcome announcement; furthermore, they find evidence that this reaction is exacerbated by known auditor or audit-related characteristics and corporate governance measures that are suggestive of high auditor quality, indicating that the market is surprised by the shareholder disapproval.
    • The authors find that the market reacts less negatively to high shareholder disapproval for clients with high non-audit fee ratios, longer auditor tenure, and accounting restatements, indicating that the market is already aware of audit independence or audit quality issues.
    • The authors find that the market responds more positively to a subsequent auditor dismissal when the proportion of shareholder votes against or abstaining from the auditor’s appointment is higher. 
    Category:
    Corporate Matters
    Sub-category:
    Audit Committee Effectiveness
  • The Auditing Section
    On the Constitution of Audit Committee Effectiveness
    research summary posted May 3, 2012 by The Auditing Section, tagged 13.0 Governance, 13.06 Board/Audit Committee Processes, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    On the Constitution of Audit Committee Effectiveness
    Practical Implications:

    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.

    Citation:

    Gendron,Y., and J. Bédard. 2006. On the constitution of audit committee effectiveness. Accounting, Organizations and Society 31(3):
    211-239.

    Keywords:
    Audit committee effectiveness, social constructivist
    Purpose of the Study:

    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.
    Design/Method/ Approach:

    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. 

    Findings:
    • 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.
    Category:
    Governance, Corporate Matters
    Sub-category:
    Board/Audit Committee Processes, Audit Committee Effectiveness
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  • Jennifer M Mueller-Phillips
    Regulation and the interdependent roles of managers,...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 14.0 Corporate Matters, 14.01 Earnings Management, 14.11 Audit Committee Effectiveness 
    Title:
    Regulation and the interdependent roles of managers, auditors, and directors in earnings management and accounting choice.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    Earnings management, earnings quality, accounting choice, financial reporting, auditing, corporate governance, experimental design, surveys, regulation
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    The paper focuses on studies published in Accounting, Organizations, and Society, Contemporary Accounting ResearchJournal 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.

    Findings:
    • Financial reporting regulation:
      • Effects of rules- versus principles-based standards on reporting choices:
        • Overall, evidence indicates the ability of a principles-based standard to constrain aggressive reporting is likely limited.
        • Joint goals of reducing the complexity of standards while also constraining aggressive reporting will only be met where a less-stringent set of rules is replaced with a more-stringent general principle.
      • Effects of information quantity or information location on reporting choices:
        • Overall, research suggests when more detailed information about estimates or economic events must be reported, managers will engage in a lower level of misreporting and auditors will scrutinize the numbers to a greater extent.
        • Effect is dampened when information appears in a footnote disclosure rather than on the face of the financial statements.
      • Effects of reporting frequency and accruals timing on investment choices:
        • Overall, research demonstrates how reporting differences such as reporting frequency, expense deferral, and impairment reversibility can alter project choices, investment location, and investment magnitude.
        • These decisions have direct immediate and/or future real economic consequences and represent a tradeoff between short-term reporting issues and long-term firm value.
    • Auditing regulation:
      • Overall, research suggests the effects of regulations are complicated.
      • Both increased auditor independence and increased auditor accountability can fail to produce desired outcomes and even lead to unanticipated consequences.
      • Open question as to which types of regulation might successfully shift auditors’ incentives away from pleasing client management and towards pleasing other non-client stakeholders.
    • Corporate governance regulation:
      • Overall, research suggests audit committee involvement has improved in recent years and more knowledgeable and independent directors have been more likely to support correction of discovered errors and constrain earnings management.
      • In some cases, however, directors are not as effective at helping auditors to reign in within-GAAP earnings management.
    Category:
    Corporate Matters, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Earnings Management
  • Jennifer M Mueller-Phillips
    Rotational internal audit programs and financial reporting...
    research summary posted October 21, 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:
    Rotational internal audit programs and financial reporting quality: Do compensating controls help?
    Practical Implications:

    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.  

    Citation:

    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.

    Keywords:
    internal auditing, financial reporting quality, audit committee oversight, controls
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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.

    Findings:

    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.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Internal auditor role and involvement in controls and reporting

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