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    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 
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    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