Posts

Posts

  • 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    The Interplay of Management Incentives and Audit Committee...
    research summary posted November 15, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Interplay of Management Incentives and Audit Committee Communication on Auditor Judgment
    Practical Implications:

    This study indicates that increasing the frequency of informal communication between the audit committee and the audit team can positively impact reporting quality, but auditors need to be sensitized to how management may exhibit undue influence and its potential to undermine audit committee effectiveness. From a practical standpoint, this study indicates that failing to consider specific expectations communicated by the audit committee can have severe consequences.

    Citation:

    Brown, J. O. and V. K. Popova. 2016. The Interplay of Management Incentives and Audit Committee Communication on Auditor Judgment.  Behavioral Research in Accounting 28 (1): 27-40.

    Keywords:
    audit committee communication, management incentives, competing preferences, source credibility and auditor judgment
    Purpose of the Study:

    Over the past two decades, the audit committee has evolved from a passive observer to a critical player in ensuring quality financial reporting. Just recently, the PCAOB approved Auditing Standard No. 16 to enhance communication between the external auditor and the audit committee in order to better facilitate the audit committee’s oversight role and improve financial reporting quality. However, despite this reform, auditors continue to harp on the importance of management’s role in corporate governance and its ability to exhibit significant influence during the audit. Consequently, the purpose of this study is to examine the interplay of management and the audit committee on auditor judgment, and whether auditor’s sensitivity to a characteristic of management, its incentive to influence the auditor, moderates the effectiveness of additional oversight by the audit committee. It is also important to examine whether auditors are effectively integrating expressed expectations voiced by the audit committee, in light of the recent passage of AS No. 16.

    Design/Method/ Approach:

    The authors administered a 2 x 2 between-subjects experiment that required audit seniors to evaluate management’s estimate for obsolete inventory. The auditors either were or were not given additional communication from the audit committee of its expectations. Management’s incentives to influence the auditor were also manipulated by varying the perceived propensity to manage earnings.  

    Findings:
    • The authors find that management’s incentives to influence the auditor not only affect the persuasiveness of management-provided information but also spill over to impact the potential benefit of additional audit committee communication on auditor judgments.
    • The authors find that when management’s incentives were lower, additional audit committee communication had no effect on auditor judgments, and auditors documented more items consistent with management’s aggressive reporting preference.
    • The authors find that when management’s incentives were higher, the additional communication of the audit committee had a significant and positive impact on auditors’ evidence evaluation and judgments, as auditors were less supportive of management’s aggressive estimate and also documented a greater proportion of evidence items consistent with the audit committee’s expressed expectations. 
    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Audit Committee Oversight
  • 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
    When Do Ineffective Audit Committee Members Experience...
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.03 Board/Audit Committee Tenure, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    When Do Ineffective Audit Committee Members Experience Turnover?
    Practical Implications:

     Preserving an image of effective monitoring can be just as important as preserving effective monitoring itself. AC-member ineffectiveness due to financial reporting increases the likelihood of AC turnover for both the AC-members who served during the events precipitating the financial reporting failure as well as the “tainted” AC-members (even if they were not serving as AC-members when the events precipitating the financial reporting failure occurred). This result shows that shareholders may take bold and visible actions to “clean house” when such financial reporting failures are revealed. Regarding individual characteristics, under normal circumstances characteristics of an AC-member’s potential ineffectiveness such as multiple board commitments may actually be seen as desirable by shareholders perhaps signaling the quality of the AC-member. However, when shareholder dissent increases these individual characteristics of an AC-member’s potential ineffectiveness increases the likelihood of turnover for that particular AC-members but does not “taint” the other AC-members. That is, characteristics once viewed as slightly positive for specific AC-members become negatives when shareholder dissent increases.

    Citation:

     Kachelmeier, S. J., S. J. Rasmussen, and J. J. Schmidt. 2016. When Do Ineffective Audit Committee Members Experience Turnover?. Contemporary Accounting Review 33 (1): 228-260.

    Keywords:
    Audit Committee, Audit Committee Turnover, Audit Committee Legitimacy Ineffective Governance, Shareholder Dissent, Institutional Theory
    Purpose of the Study:

     The study deepens our understanding of when and why ineffective audit committee members experience turnover and not just that it occurs. The authors broaden the traditional theories used to understand corporate governance to include institutional theory. This theory allows them to predict and observe that the image of effective monitoring can be as important as ensuring effective monitoring itself. Audit committee ineffectiveness is studied from both a broad perspective, financial reporting failures, as well as from a narrower perspective, individual AC-member characteristics. Their analysis focuses not only on the individual ineffective AC-member but also those AC-members “tainted by” (i.e. associated with) the ineffective AC-member. Additionally, the important influence of active shareholders and their dissent on AC-member turnover likelihood due to each type of ineffectiveness is studied.

    Design/Method/ Approach:

     Sample: Hand-collected database of effective, ineffective, and “tainted” AC members from S&P 1500 companies that require annual election of all directors in 2007. Source: Glass, Lewis, & Co proxy service voting recommendations (to infer AC-member effectiveness), Compustat, RiskMetrics, & Audit Analytics Model: Logistic regression with AC-member turnover regressed on ineffectiveness indicators (i.e. financial reporting failure or individual ineffectiveness characteristics) for individual AC-members, indicators if AC-member is “tainted” by another ineffective AC-member, interaction terms for level of shareholder dissent, and governance/company/board-characteristic controls

    Findings:
    • AC-member turnover is associated with financial reporting failures (i.e. main effect)
    • AC-member turnover is not associated with individual AC-member characteristics of ineffectiveness and is, in fact, slightly negative (i.e. main effect)
    • AC-member turnover is associated with shareholder dissent (i.e. main effect)
    • When proxies for shareholder dissent is interacted with financial reporting failure, the main effect loses significance, but the interactive effect is statistically positive.
    • When proxies for shareholder dissent is interacted with individual AC-member characteristics of ineffectiveness, the non-association becomes significantly positive.
    • New AC-members who serve with AC-members present during events that precipitated a financial reporting failure are “tainted” and are associated with increased turnover.
    • AC-members who serve with AC-members who have individual characteristics of ineffectiveness are not “tainted” and are not any more likely to face turnover.
    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Audit Committee Oversight, Board/Audit Committee Tenure
  • Jennifer M Mueller-Phillips
    The Efficacy of Shareholder Voting in Staggered and...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Efficacy of Shareholder Voting in Staggered and Non-Staggered Boards: The Case of Audit Committee Elections
    Practical Implications:

     This study contributes to the accounting landscape in many different ways. First, the results suggest that, through voting and differentiating between AC and non-AC directors, shareholders can influence the AC’s oversight over financial reporting. Second, the study complements previous research on similar topics by showing that dissatisfaction with AC members is also associated with subsequent turnover of accounting financial experts and that low auditor ratification and AC votes are both associated with a reduction in auditor-provided tax services. Finally, the results show that going forward all studies examining the efficacy of shareholder votes should separately consider staggered and non-staggered boards.

    Citation:

     Gal-Or, R., Hoitash, R., and Hoitash U. 2016. The Efficacy of Shareholder Voting in Staggered and Non-Staggered Boards: The Case of Audit Committee Elections. Auditing: A Journal of Practice and Theory 35 (2): 73-95.

    Keywords:
    staggered boards, director elections, audit committee, and proxy advisors
    Purpose of the Study:

    Previous accounting research provides evidence that certain characteristics of audit committees (ACs) are associated with improved effectiveness, finding that features such as size, independence, and member expertise all contribute to the quality and effectiveness of the audit committee. Research on the influence of shareholders on audit committee effectiveness is scarce, so this paper examines whether shareholders voting on audit committee members and the frequency of those elections (staggered versus non-staggered) can influence the effectiveness of the audit committee. Because of the way shareholder votes are cast, the votes in director elections provide an important mechanism to monitor and discipline directors.

                Despite the majority of directors standing for election every year, a significant number of firms have staggered boards, in which only a fraction of members face election every year. Under the staggered board regime, shareholders can typically voice their opinion on any given director only once every three years, making it conceivably possible that directors on staggered boards who do not face election following poor performance will be insulated from the scrutiny of shareholder votes. This could lead to a decrease in accountability, responsiveness, and the overall efficacy of shareholder votes. This paper separates itself from others because prior research has not considered the issue of diminished efficacy of shareholder voting and has not examined whether the effectiveness of shareholder votes is similar across staggered and non-staggered boards. 

    Design/Method/ Approach:

    The authors used cross-sectional time-series data spanning the years 2004 to 2010. The final sample contains over 18,296 director elections taking place in more than 6,786 firm-year observations. The authors also use several measures to test the reaction of ACs to low shareholder approval rates separately for non-staggered and staggered ACs. 

    Findings:
    • The authors find that most AC members serve on non-staggered boards, which typically have higher shareholder votes than staggered boards.
    • The authors find that, consistent with former research, firms with non-staggered boards perform better than those with staggered boards and are more likely to have majority voting rather than plurality voting.
    • The authors find that companies do not necessarily respond to low votes by indiscriminately replacing AC members; instead, they remove and replace financial accounting experts on the AC when shareholders express dissatisfaction with the AC. This appears to only be the case in non-staggered boards; staggered boards do not react to low votes in the same manner.
    • The authors find that low shareholder support is associated with an improvement in the composition and diligence of the AC; however, these associations are prominent only in non-staggered firms.
    • The authors’ findings suggest that dissatisfaction with the AC and the auditor expressed through low votes is associated with a decrease in the tax NAS ratio.
    • The authors’ findings suggest that low shareholder votes in firms with non-staggered boards are associated with changes to the composition and diligence of the AC, changes to the relationship with the auditor and gradual changes to financial reporting quality. 
    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Audit Committee Oversight
  • 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    The effects of disclosure type and audit committee expertise...
    research summary posted October 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, 14.05 Earnings Targets and Management Behavior, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The effects of disclosure type and audit committee expertise on Chief Audit Executives’ tolerance for financial misstatements.
    Practical Implications:

    The results suggest that internal auditors contribute to decreased reliability of disclosed amounts. It appears that the incentives of external auditors and internal auditors are closely aligned on this issue. In general, both of these parties seem to feel less responsibility for disclosed, relative to recognized amounts. The results indicate that financial reporting location has significant effects on internal auditors’ decisions to correct misstatements. Specifically, internal auditors are more willing to waive disclosed misstatements relative to recognized misstatements. Contrary to expectations, the results do not indicate that increased audit committee expertise and associated increases in audit committee members’ perceived powers cause internal auditors to be less willing to waive misstatements.

    Citation:

    Norman, C. S., J. M. Rose, and I. S. Suh. 2011. The effects of disclosure type and audit committee expertise on Chief Audit Executives’ tolerance for financial misstatements. Accounting, Organizations & Society 36 (2): 102-108.

    Keywords:
    audit committee expertise, misstatements, Chief Audit Executives, audit committee, financial executives
    Purpose of the Study:

    External audit partners are more willing to waive misstatement corrections for disclosed than for recognized amounts. This willingness to allow misstatements may increase management’s incentives to manipulate disclosed amounts and increase the levels of error and bias in disclosed information. While external auditors are more willing to waive disclosed amounts, relative to recognized amounts, internal auditors may require management to adjust misstatements regardless of their reporting locations. If internal auditors do not tolerate misstatements that are disclosed, this will increase the reliability (i.e., decrease the random error and bias) of disclosed amounts and decrease the likelihood of management manipulation of disclosed amounts. As a result, the impact to practice of external auditors’ willingness to waive misstated disclosures could be mitigated or even eliminated by internal audit oversight.

    The authors examine Chief Audit Executives’ and deputy Chief Audit Executives’ decisions to require adjustments of misstatements that are either recognized or disclosed. Chief Audit Executives (CAEs) may require equivalent adjustments for recognized and disclosed amounts, and act to counter the actions of management and external auditors. Understanding the decision processes of CAEs will help to inform regulators and standard setters of the underlying factors that drive financial statement reliability.

    Design/Method/ Approach:

    The participants are 73 Chief Audit Executives (CAEs) and deputy CAEs. CAEs and deputy CAEs are the ultimate decision makers in internal audit. None of these participants are from outsourced internal audit departments. The average number of years of internal audit experience is 13.71. The study was completed on paper and provided to participants in sealed envelopes by one of the study’s authors. All participants completed the materials in their professional offices under controlled conditions in the presence of one of the authors. The evidence was gathered prior to 2011.

    Findings:

    The results of this study indicate that reporting location has a significant effect on internal auditors’ decisions. Specifically, CAEs and their deputies require lesser amounts of misstatement correction of disclosed amounts relative to recognized amounts. While increased audit committee expertise increases audit committee members’ perceived power over management, the authors do not find that CAEs require greater misstatement corrections when the audit committee has more financial expertise, relative to less expertise. It appears that internal auditors may not have enough concern about disclosed misstatements to warrant a decision to exercise the power they derive from audit committee expertise. The results suggest that internal auditors, like external auditors and managers, act to decrease the perceived and actual reliability of disclosed information. Further, increasing the power of the internal audit function does not mitigate this problem. The authors find reason for serious concerns about the accuracy of disclosed amounts, relative to recognized amounts.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Earnings Targets & Management Behavior, Internal auditor role and involvement in controls and reporting
  • Jennifer M Mueller-Phillips
    The influence of director stock ownership and board...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.04 Board/Audit Committee Compensation, 14.0 Corporate Matters, 14.01 Earnings Management, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The influence of director stock ownership and board discussion transparency on financial reporting quality.
    Practical Implications:

    Understanding why stock ownership can bias directors’ objectivity, and examining how board discussion transparency can yield differential effects for stock-owning and non-stock-owning directors makes it possible to anticipate the effects of increased board transparency on earnings management and directors’ decisions. The notion of increased board discussion transparency is valid in the current environment in which shareholders are pushing for “constituency board seats” because information leaks surrounding board discussions likely will result when constituent directors report back to their shareholder groups. Hence, if controversial boardroom discussions are eventually divulged to the public, the findings suggest that directors’ judgments and decisions will be influenced by knowledge of increased board transparency.

    Citation:

    Rose, J. M., C. R. Mazza, C. S. Norman, and A. M. Rose. 2013. The influence of director stock ownership and board discussion transparency on financial reporting quality. Accounting, Organizations & Society 38 (5): 397-405.

    Keywords:
    stock ownership, board of directors, transparency in organizations, earnings management, corporate governance quality
    Purpose of the Study:

    Stock ownership requirements for directors have become commonplace, and institutional investors can pressure corporate boards to rely wholly or partly on stock based forms of pay for board service. Consistent with the underlying principles of agency theory, the usual justification for stock ownership requirements is for directors to have “skin in the game,” thus aligning their personal interests with those of company shareholders. Recent archival studies strongly favor board stock ownership requirements and indicate that firms with ownership requirements exhibit better performance the year after implementing the requirements. Existing literature often equates director stock ownership with improved financial performance and improved corporate governance. On the other hand, improved firm performance associated with stock ownership could arise from a narrow focus on short-term earnings. Support for this potential alternative explanation is provided by extant archival studies indicating that managers often become myopic when paid with stock options and stock grants. In addition, recent experimental findings suggest that director stock ownership can harm objectivity and lead to biased financial reporting.

    The current study examines whether stock ownership will induce directors to go along with management’s aggressive revenue recognition in light of pressure from the Chief Audit Executive (CAE) to take a more conservative approach. In particular, the authors examine whether the effects of board stock ownership are dependent upon board discussion transparency.

    Design/Method/ Approach:

    The current study involves a 2 X 2 between-participant randomized experiment. The experiment was computerized and administered via the Internet. The authors contacted current and former CEOs and board chairs to request the participation of board members. 72 directors completed all of the response items and correctly answered manipulation check items. Of the 72 directors who are included in the final sample, there were 58 (81%) male and 14 (19%) female directors. This data was collected prior to July 2013.

    Findings:

    The authors find that stock ownership can affect directors’ independence and objectivity as well. They conclude that independence requirements resulting from SOX and adopted by the NYSE and NASDAQ focusing on board member affiliation are threatened by directors’ ownership of stock in the companies for which they serve. The authors suggest that the temptation of stock-owning directors to engage in myopic behavior that could boost the company’s stock price can be mitigated by increasing the transparency of board discussions. In examining the effects of transparency of board discussions on the likelihood of directors agreeing with management’s aggressive reporting attempts, the authors find competing effects, depending on whether directors own or do not own stock. Specifically, directors who own stock were less likely to agree with management’s aggressive reporting when board discussions were more transparent, compared to less transparent. Yet, there were no benefits of increased transparency for directors who did own stock, and directors who did not own stock were more likely to support earnings management attempts than were stock owning directors when transparency was high.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Audit Committee Effectiveness, Board/Audit Committee Oversight, Earnings Management