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    The Audit Committee: Management Watchdog or Personal Friend...
    research summary posted November 17, 2014 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.01 Board/Audit Committee Composition, 13.05 Board/Audit Committee Oversight 
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    Title:
    The Audit Committee: Management Watchdog or Personal Friend of the CEO?
    Practical Implications:

    The results of this study shed light on some unanticipated effects of the SOX mandate for “independent” audit committee members. While the growth in board and audit committee size that followed this mandate has led to improvements in audit committee expertise, CEOs might still appoint or maintain directors from their personal network of friends to build an audit committee that is sympathetic to their reporting choices.

    Furthermore, the evidence is informative for shareholders, nomination and governance committees. Such parties might refrain from appointing a director in the audit committee who is too closely connected to the CEO. Additionally, it may be important to require more disclosure about the nature and type of social connections between audit committee members and the CEO.

    For more information on this study, please contact Liesbeth Bruynseels.

    Citation:

    Bruynseels, L. and E. Cardinaels. 2014. The Audit Committee: Management Watchdog or Personal Friend of the CEO? The Accounting Review 89 (1): 113-145.

    Keywords:
    social ties; financial reporting quality; audit committee; monitoring.
    Purpose of the Study:

    To ensure that audit committees provide sufficient oversight over the auditing process and quality of financial reporting, legislators have imposed stricter requirements on the independence of audit committee members. Yet audit committee members who are fully independent according to SOX may still be connected to executives in many ways. They may serve together as directors on the board of another company, they may have worked together in the past as directors or employees, or they may have earned their MBA from the same university. Other connections may be formed outside professional or educational networks, such as those between committee members and executives attending the same business club, playing in the same golf club, working for the same charity, or other non-profit organization. This latter category of non-professional social ties is labeled as CEO-audit committee “friendship” ties.

    The study predicts that connections may enable the CEO to appoint directors who are “friendly” to his or her reporting policies. This may have an impact on the audit committee’s primary task to offer sufficient oversight over the reporting quality and audits of the financial statements.

    This study explores:

    • the extent and type of social ties observed between CEOs and audit-committee members
    • whether such ties reduce the quality of audit committee monitoring.
    Design/Method/ Approach:

    This study uses a large dataset of U.S.-listed companies and focuses on the 2004 to 2008 post-SOX period. A distinction is made between fully independent audit committees and firms whose audit committee members have social ties with the CEO through either employment (e.g., shared current directorships or past employment/directorships), past education (e.g., graduating from the same school), or other non-professional activities (e.g. shared memberships in leisure clubs, charities, country clubs, industry associations etc).  The authors assess the effect of these three types of CEO-audit committee social ties on various output variables that proxy for the oversight quality of the audit committee. 

    Findings:

    The sample of all firm-year observations shows that on average 17 percent of audit committee members share ties with their CEO, mainly through employment. On average in 39 percent of all firm-year observations, the audit committee includes at least one socially connected audit committee member.

    The results show that:

    • Friendship ties between CEOs and the audit committee may reduce the quality of the audit committee’s oversight (proxied by financial reporting quality and levels of audit effort).
    • Consistent with weaker oversight of the audit process, auditors are also less likely to issue going-concern opinions for firms in distress when friendship ties are present.
    • Fewer internal control weaknesses are disclosed in the SOX 404 reports of firms with friendship ties. This presumably occurs because audit committees with such ties to the CEO offer the auditor less support when he or she disagrees with management over the type of internal control report to issue. Further analysis indeed suggests that firms with friendship ties are more likely to subsequently amend initially clean reports because of weak internal controls.
    • Finally, professional and educational ties do not seem to produce negative effects on oversight quality.
    Category:
    Governance
    Sub-category:
    Board/Audit Committee Compensation, Board/Audit Committee Oversight