THE CORPORATE GOVERNANCE MOSAIC AND FINANCIAL REPORTING QUALITY

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THE CORPORATE GOVERNANCE MOSAIC AND FINANCIAL REPORTING QUALITY

  1. 1. THE CORPORATE GOVERNANCE MOSAIC AND FINANCIAL REPORTING QUALITY Jeffrey Cohen Associate Professor, Boston College Ganesh Krishnamoorthy Associate Professor, Northeastern University Arnie Wright Professor, Boston College Published in Journal of Accounting Literature (2004, pp. 87-152)
  2. 2. THE CORPORATE GOVERNANCE MOSAIC AND FINANCIAL REPORTING QUALITY INTRODUCTION One of the most important functions that corporate governance can play is in ensuring the quality of the financial reportin g process. Levitt (1999 2) stated in a speech to directors, “the link between a company’s directors and its financial reporting system has never been more crucial.” Further, the Blue Ribbon Commission (1999) called for auditors to discuss with the audit committee the quality and not just the acceptability of the financial reporting alternatives. Corporate governance has received increasing emphasis both in practice and in academic research (e.g., Blue Ribbon Committee Report 1999; Ramsay Report 2001; Sarbanes-Oxley 2002; Bebchuk and Cohen 2004). This emphasis is due in part, to the prevalence of highly publicized and egregious financial reporting frauds such as Enron, WorldCom, Aldelphia, and Parmalat, an unprecedented number of earnings restatements (Loomis 1999; Wu 2002; Palmrose and Scholz 2002; Larcker et al. 2004) and claims of blatant earnings manipulation by corporate management (Krugman 2002). Further, academic research has found an association between weaknesses in governance and poor financial reporting quality, earnings manipulation, financial statement fraud, and weaker internal controls (e.g., Dechow et al. 1996; Beasley 1996; McMullen 1996; Beasley et al. 1999; Beasley et al. 2000; Carcello and Neal 2000; Krishnan 2001; Klein 2002b). Given these developments, there has been an emphasis on the need to improve corporate governance over the financial reporting process (e.g., Levitt 1998, 1999, 2000) , such as enacting reforms to improve the effectiveness of the audit committee (Blue Ribbon Committee 1999; Sarbanes-Oxley Act 2002) and to make the board of directors and management more accountable for ensuring the integrity of the financial reports (SEC 2002, The Business Roundtable 2002) as well as a rapid expansion of research on corporate governance. 1
  3. 3. The purpose of this paper is to review research on corporate governance and its impact on financial reporting quality. This review will serve three purposes: (1) to suggest a corporate governance “mosaic”(i.e., the interactions among the actors and institutions that affect corporate governance) that encompasses a broader view of governance than has been considered in prior accounting research; (2) to provide an overview of the principal findings of prior research; and (3) to identify important gaps in the research that represent promising avenues for future study. Accordingly, the remainder of the paper is divided into the following three sections. The next section provides a general framework for understanding the corporate governance mosaic and its impact on financial reporting quality. This section is followed by a discussion of prior research, dealing respectively with the role of the following actors in the corporate governance mosaic: (1) the board of directors and the audit committee; (2) the external auditor; and (3) the internal auditors. The final section provides a summary of areas for future research. THE CORPORATE GOVERNANCE MOSAIC Figure 1 provides an overview of the corporate governance mosaic and its impact on financial reporting quality. Prior accounting research and the accounting profession have focused primarily on the board of directors and the audit committee. For instance, the Public Oversight Board (POB 1993) defined corporate governance as “those oversight activities undertaken by the board of directors and audit committee to ensure the integrity of the financial reporting process.” However, a narrow view of corporate governance restricting it to only monitoring activities may potentially undervalue the role that corporate governance can play. Further, in a recent meta analysis of corporate governance research, Larcker et al. (2004, 1) conclude that “the typical structural indicators used in academic research and institutional rating services have very limited ability to explain managerial behavior and organizational performance.” Thus, as depicted in Figure 1, a more comprehensive framework should consider all major stakeholders in the governance mosaic, including those inside and outside the firm. For instance, the external auditor plays a significant role in monitoring financial reporting quality and hence can 2
  4. 4. be viewed as an important participant in the governance process. We do not suggest that extant research has not looked at the role of the auditor but rather that the role of the auditor in the governance process is very complex as the auditor interacts with other stakeholders in the governance mosaic such as the audit committee and the management. In turn, the interplay among the stakeholders is affected by outside forces such as by regulators and stock exchanges as well as pressure to meet financial analysts. Further, the corporate governance mosaic suggests we need to look beyond much of the focus of current research in corporate governance that has concentrated on documenting associations and not causal relationships (Larcker et al. 2004) and to complement the current research by also investigating the substance of the interactions in the corporate governance arena. For example, although the emphasis in corporate governance research has been on looking at issues of independence, Cohen et al. (2002) document that unless management allows itself to be monitored the substance of governance activities will be subverted. Figure 1 also indicates interrelationships between the various actors and mechanisms within the corporate governance mosaic. For example, the interactions among the audit committee, the external auditor, the internal auditor, the board, and the management are crucial to effective governance and to achieving high quality financial reporting (Sarbanes-Oxley Act 2002). An interview study with experienced auditors (Cohen et al. 2002) revealed that management has a significant influence over these parties. Some of the auditors in that study argue that if management does not want to be “governed”, they can’t be (Cohen et al. 2002 582). Further, management may place passive, compliant members on the board who may satisfy regulatory requirements but are reluctant to challenge management. For example, QWEST had no outside directors with experience in the company’s core business. They also had a compensation committee that consistently awarded excessive bonuses to management in spite of the firm’s relatively subpar performance (Business Week 2002). Other actors and mechanisms depicted in Figure 1, largely external to the corporation, also influence its effective governance in significant ways and are integral to safeguarding the interest 3
  5. 5. of a company’s stakeholders. Examples of such actors include, but are not limited to, regula tors, legislators, financial analysts, stock exchanges, courts and the legal system, and the stockholders. These external players often shape and influence the interactions among the actors who are more directly involved in the governance of the corporatio n. For instance, the Sarbanes-Oxley Act (2002) has significantly impacted all direct players in the corporate governance mosaic not only in terms of their role and function in the governance process but also in terms of how the players interact with one another. Under Sarbanes-Oxley, the audit committee now has the responsibility to hire and fire the auditor and to approve the non-audit services that the auditing firm can perform (Sarbanes-Oxley Act 2002). Further, management must state that it has the responsibility for maintaining the internal control system and for evaluating its effectiveness (Geiger and Taylor 2003). 1 In summary, Figure 1 depicts the actors in the governance process, highlights their potential interactions, and suggests that the governance process impacts the quality of financial reporting (e.g., transparency, objectivity) and, in the extreme, earnings manipulation and outright fraud. Quality of Financial Reporting Although one should expect that “better” corporate governance leads to improved financial reporting, there is a lack of consensus as to what constitutes “financial reporting quality.” For example, although, the BRC (1999) and Sarbanes-Oxley (2002) require auditors to discuss the quality of the financial reporting methods and not just their acceptability, the notion of financial reporting quality remains a vague concept. As Jonas and Blanchet (2000, 353) state, “in light of these new requirement, auditors, audit committee members, and management are now struggling to define “quality of financial reporting.” Rather than define “quality of financial reporting,” prior literature has focused on factors such as earnings management, financial restatements, and fraud that clearly inhibit the attainment 1 Although we don’t discuss the courts in this paper, we do include the courts in the governance mosaic and recognize that they play a critical role in the governance process. For instance, the courts can define and can 4
  6. 6. of high quality financial reports and have used the presence of these factors as evidence of a breakdown in the financial reporting process. Specifically, prior literature has examined the role of the various players in the governance mosaic (e.g., board, audit committees, external auditor, internal auditors) and the extent to which these players have either individually or collectively influenced the attainment of financial reports that are free from material misstatements and misrepresentations. The principal players identified in prior literature include the board of directors, the audit committee, the external auditor, and the internal auditors. Accordingly, in the rest of this paper, we discuss the role of the following players, the interactions among them, and their collective influence in helping attain high quality financial reporting.: (1) the board of directors and the audit committee (2) the external auditor; and (3) the internal auditors.2 A summary of prior research is contained in Table 1. BOARD OF DIRECTORS AND AUDIT COMMITTEE Various attributes of the board and audit committee may influence their effectiveness as corporate governance mechanisms.3 For example, the BRC’s (1999) recommendations looked at strengthening both the independence and expertise of audit committees. In this section, we examine the research of various characteristics of the board and audit committee including issues of (1) composition, (2) independence, (3) knowledge and expertise, (4) effectiveness, (5) power, (6) duties and responsibilities and (7) the association between board characteristics and earnings manipulation and fraud. Composition expand the duties of directors and officers to the corporation such as the duty of care and loyalty. 2 Management potentially has a significant impact on the effectiveness of the governance process and is listed in the corporate governance mosaic. However, since there has been almost no research that explicitly and directly examines the role of management in the governance process, we discuss management primarily in relation to opportunities for future research. 3 DeZoort et al. (2003) provides a framework for the evaluation of audit committee effectiveness and synthesizes the existing literature into four components: audit committee composition, authority, resources, and diligence. However, their study does not directly address board characteristics, nor does their framework provide a basis to synthesize and interpret prior literature in terms of their impact on the financial reporting process. 5
  7. 7. The only study to directly examine the composition of AC members in terms of board experience and independence was conducted by Vafeas (2001). He found that members appointed to the AC have significantly less board tenure with the firm, serve on fewer other committees, and are less likely to serve on the important compensation committee. Surprisingly, they hold the same level of equity interest in the firm and are as likely to be a grey4 director as other members of the board. The overall results led Vafeas to conclude that AC appointees are less seasoned board members, who are not chosen because of their greater experience or independence but consistent with a “next in line” strategy. He notes that future research is needed to examine whether the characteristics studied are linked to improved AC performance or financial reporting quality and that the composition of the AC in terms of other characteristics such as financial literacy need consideration. To answer the question of what audit committees are actually doing, Carcello et al. (2002) examined recent disclosures of audit committee charters and reports included in proxy statements. The major finding of this study is that there is a gap between what audit committees say they are doing and what is mandated by their charter. Although this gap may be due to several reasons including liability concerns, it raises the general issue of transparency with respect to activities of the audit committee despite the changes made in disclosure requirements based on BRC recommendations. The study also found that while there is generally a high level of compliance across firms with respect to exchange mandated disclosures, voluntary disclosures of AC activities were more prevalent in larger companies, depository institutions, NYSE firms, and firms with independent audit committees. An important limitation of the study is that it did not explore the specific reasons for the gap between what is stated in the AC reports and the mandate in the AC 4 Independent directors are defined as non-employees with no tie to the firm or its management except in their role as a director. Grey directors are defined as non-employees who may have past or present relationship with the firm or its management such as relatives of management or consultants and suppliers. 6
  8. 8. charter. Future studies should address this issue by using other research methods such as interviews or internal documentation that will complement the archival data. Collectively, these two studies suggest that audit committees prior to Sarbanes-Oxley may have underutilized its potential as the committees had less experienced members on it and there are questions about whether committees fully fulfilled its mandate. Of course, since the data in these studies were collected prior to Sarbanes-Oxley, it is imperative to determine if these shortcomings still hold true in a world where there is more scrutiny placed on AC activities. Independence The recent reforms in Sarbanes-Oxley (2002) enacted to strengthen the audit committee (AC) has implicitly assumed that independence will improve the effectiveness of the audit committee. An early study that investigated this issue was conducted by Vicknair, Hickman and Carnes (1993) who examine the level of “grey” directors who are members of the audit committees of a sample of NYSE firms. They find that about a third of the members of the audit committees sampled were grey directors and, thus, of questionable independence. Since this data was gathered about 15 years ago, it is unlikely that the findings are reflective of the current situation given the movement to improve the independence of audit committees (e.g., Blue Ribbon Committee 1999). Wolnizer (1995) uses an a priori argument approach to evaluate whether independent ACs can significantly improve financial reporting quality. He argues that this is unlikely, because current accounting practices allow wide discretion by management in the choice of accounting methods and estimates. With limited exceptions (e.g., count of cash or inventory) accounting values are not subject to validation through impartial evidence (e.g., market based data). Thus, auditors and the AC can only evaluate or review management’s potentially biased choices. The most significant contribution of this work is to highlight the link between the nature (limitations) of the accounting system and those who seek to monitor the system. Another study relating to the importance of AC independence was conducted by DeZoort and Salterio (2001). They examined the judgments of audit committee (AC) members who were 7
  9. 9. asked to determine their level of support for the auditor vis-à-vis management in a case situation involving a dispute over proper revenue recognition. The primary issue addressed was how AC independence and knowledge affect audit committee members’ propensity to support the auditor’s position. The findings indicate that independent, more knowledgeable AC members were more likely to support the auditor in a dispute with management. A question arises as to what causes the demand for AC independence. To explore this issue, Klein (2002a) examined whether AC independence was affected by a number of board factors and by substitute monitoring mechanisms. Her results indicate a positive association between AC independence and board size and AC independence and the proportion of outside board members. Klein also found negative associations between AC independence and a firm’s growth opportunities, AC independence and the existence of a large blockholder on the audit committee and finally AC independence and firm size. There was no effect for creditors, CEO on compensation committee, and outside directors' shareholdings. The study suggests that prior to the regulations enacted recently after the BRC, the ability of an AC to be independent was affected by the larger outside board and a firm's financial health. This study highlights the importance of the board in its power over assignments and authority afforded to the AC. Collectively, these studie s, especially Klein (2002a), suggest that the independence of audit committees may be affected by the independence of the board in general. Although there is nothing in Sarbanes-Oxley (2002) that mandates the selection of powerful AC members who are independent in fact as well as in form, there is at least the potential that stronger boards in general will seek out AC members who are willing to confront management to a greater degree than previously was documented prior to the enactment of the BRC (1999) reforms. Knowledge and Expertise With the requirement in Sarbanes-Oxley (2002) that all AC members have financial literacy and that at least one member be a financial expert, an understanding of the link that knowledge and expertise has on audit committee effectiveness is quite important. DeZoort (1997) 8
  10. 10. investigated the views of AC members regarding the formal responsibilities of the AC, other duties performed, and the importance of potential duties from those compiled by Wolnizer (1995). The duties from Wolnizer fall into the general categories of financial reporting (including controls); auditing; and other corporate governance (e.g., facilitate communications between the board and the external auditors).The results suggest that AC members were not fully aware of their formal responsibilities when comparing their responses to those reported in the company’s proxy statement. Noteworthy, the majority felt that all AC members should have sufficient knowledge in accounting, auditing, and legal issues and that they perceived they did not have enough knowledge in many of these areas. DeZoort calls for further research examining the divergence of publicly disclosed responsibilities of the AC and those identified by participants. He also emphasizes the need for further work regarding the types and composition of expertise needed by AC members. DeZoort (1998) evaluated whether AC members with experience in auditing and internal controls would make different internal control evaluations than members without this experience. DeZoort found that as hypothesized, the AC members with experience were more likely than AC members without such experience, to make control evaluations more in line with external auditors. The AC members with greater experience also were more consistent and demonstrated a higher degree of consensus. These results suggest that ACs that have members with appropriate domain related experience may at least have a better understanding of the auditor’s side in disputes with management and potentially may even lend support to the auditor in their dispute. Beasley and Salterio (2001) posit that the board has a significant influence on the quality of the AC in terms of independence and knowledge, since it is the board who selects AC members. They argue that strong, independent boards, as evidenced by the proportion of outside members, an independent chair who is not the CEO of the company, and larger size, will be more likely to appoint a higher quality AC. Their findings supported expectations, although a weaker association was found for AC knowledge. This study is noteworthy in that it is the first one to explicitly consider the AC as part of the corporate governance rubric, highlighting that there are many other 9
  11. 11. interrelated mechanisms such as the board, the external auditor, and holders of large blocks of stock. Beasley and Salterio note that future research is needed to examine the causal links (beyond the association found in their study) between AC quality and other governance mechanisms and to examine whether and how AC characteristics impact monitoring effectiveness. The issue of how the expertise and financial literacy of AC members potentially affect the quality of the financial reporting process was examined by McDaniel et al. (2002). The BRC had recommended that ACs be comprised of individuals possessing financial literacy with at least one member being a financial expert. In their study, McDaniel et al. compared how financial experts may differ from financial literates in the evaluation of the quality of financial reporting items and whether the salience and the recurring nature of the items would affect the groups' evaluations. They found that in contrast to literates, the experts' assessment of quality was related to elements of the SFAC framework (relevance and reliability) and they identified reporting concerns that were recurring in nature and would receive little business press. In contrast, literates raised concerns about high salience items that were nonrecurring in nature and those that received attention from the press. Thus, the paper suggests that each group may bring different perspectives to AC meetings and thereby improve financial reporting quality. Finally, DeZoort and Salterio (2001), examine the effect of AC member accounting and auditing knowledge on the propensity to support the auditor’s position in a dispute with management over an ambiguous accounting issue. They find that greater auditing knowledge is positively related to support for the auditor, while, unexpectedly, no relationship is found for accounting knowledge. The latter finding may have been due to the non-technical, generic nature of the accounting issue at hand. Collectively, these studies suggest that getting more knowledgeable audit committee members may lead to greater cooperation between auditors and the audit committee members of their clients. However, consistent with the findings of DeZoort and Salterio (2001) this knowledge potentially may be more important if it relates to knowledge of the complex nature of the 10
  12. 12. accounting problem on hand for a specific industry. Thus, an issue for future research might be to extend this line of research by examining how the support for auditors from AC members may vary as a function of the AC knowledge of complex industry specific accounting issues and of auditing. Effectiveness Although all factors discussed in the previous subsections can potentially influence AC effectiveness, studies that have directly examined this issue are discussed in this section. Spangler and Braiotta (1990) focus on the impact of the AC chair possessing transactional and transformational leadership attributes. In essence, the transactional leadership attribute pertains to the ability of the AC chair to help provide opportunities and rewards and thus motivate management to act in the best interest in the shareholder while the transformational leadership attribute refers to the ability of the AC chair to provide a vision for management to follow. They found a positive association between AC effectiveness and transformational leadership and some transactional leadership characteristics (contingent rewards and active management by exception). Spangler and Braiotta suggest that further research should examine company specific situational variables that may impact the importance of AC chair leadership characteristics in committee effectiveness. Kalbers and Fogarty (1993) investigate the relationship between various dimensions of power and the effectiveness of ACs in discharging three oversight roles (financial reporting, oversight of external auditors, and oversight of internal controls). Their results indicate that organization types of power are mediated by personal power factors. Specifically, effective ACs require a strong organizational charter or mandate, institutional support (information support from management and auditors and a supportive environment by top management), and diligence. Organization power, however, is not useful unless members exercise strong will and determination. Knowledge (expert power) was important only for the financial reporting oversight function, implying ACs can rely on the support of other parties such as the external and internal auditors to effectively discharge their other functions. Future research could further explore how the complex 11
  13. 13. nature of power dimensions such as the personal relationship between management and the audit committee members could potentially impact AC effectiveness. To explore the impact of symbolic activities (e.g. frequency and quality of the audit committee meetings, the act of asking questions at the audit committee meeting) on the perceived effectiveness of ACs and to determine what impacts the social construction of the effectiveness of the AC, Gendron and Bédard (2004) interviewed governance actors both internal to firm and the external auditors from two corporations. Social construction is the manner in which AC members achieve legitimacy in the eyes of other attendees at audit committee meetings. They found that the social construction was affected by the ability of the AC to ask questions, have private meetings with the external auditors and through the ceremonial and substantive components of the meetings. They conclude that AC meetings are more than mere symbolism and that the performance of members plays a significant role in the social construction of their effectiveness. Their research demonstrates the value of qualitative research methodology to uncover the underpinnings of the workings of audit committees. AC’s may be formed primarily for cosmetic reasons to make it appear to outside stakeholders that the company desires monitoring of financial reporting and controls. Menon and Williams (1994) examine this issue by looking at the relationship between reliance on the AC and factors suggested in the literature that potentially drive the need for an effective AC: management stock ownership; leverage; company size; type of auditor (Big 8 vs. Non-Big 8); board composition; and board size. AC reliance is measured by activity (number of meetings) and independence (presence of a member of management). The sample included OTC companies not required to form an AC. The results indicated that AC activity and independence was positively associated, as expected, with the proportion of outside directors on the board and that AC activity was also greater for larger companies. In an extension of their earlier study (Kalbers and Fogarty 1993), Fogarty and Kalbers (1998) investigate whether AC effectiveness is more closely aligned with agency or institutional 12
  14. 14. theory. Agency theory would predict that factors that create a need for closer monitoring of management (e.g., higher leverage) produce the need for effective ACs. In contrast, institutional theory posits that many organizational structures such as the AC are merely symbolic to conform to social expectations. To test this issue, they reanalyze the data obtained in their earlier study along with considering an additional measure of AC effectiveness (number of AC meetings).5 Although they find support for the importance of some agency variables (e.g., company size), the results generally do not show a strong link between AC effectiveness and agency theory factors. There is also a weak correlation between effectiveness and some measures of organizational bases of power for the AC (sanctionary power relating to the scope of the AC charter). Fogarty and Kalbers call for additional consideration of the joint effects of agency and institutional factors in research explaining AC effectiveness. Collier and Gregory (1999) replicate and extend the study by Menon and Williams (1994) by looking at AC activity for large companies and by examining another measure of AC effectiveness—duration of meetings. The results failed to support the findings of Menon and Williams regarding the impact of agency variables on the number of AC meetings, most likely because of limited variance in this measure (usually two meetings per year). However, the type of auditor (Big 6) was found to be associated with increased duration of AC meetings while leverage had a marginally significant relation with the duration of AC meetings. Importantly, a dominant CEO and AC insiders were found to lead to a significantly lower duration of meetings. These latter results suggest the importance of having an independent chair of the board and independent AC members to foster an active AC. Future research may work on developing a more testable construct of audit effectiveness. Haka and Chalos (1990) investigated the perception of an agency conflict among chief operating officers, internal auditors, external auditors, and audit committee chairs. Examining 5 It should also be noted that Kalbers and Fogarty define AC independence more strictly than many prior studies, excluding members of management and “grey” directors. 13
  15. 15. factors that constitute complete financial statement disclosure and factors that should influence accounting procedure choice, they found that audit committee members wanted greater disclosure than other groups. Further, audit committee chairs and external auditors disagreed on the influence of a number of factors (e.g., cost of audit, government intervention) that are important in the financial reporting process. External auditors and management tended to agree on both what should constitute complete financial statement disclosure and what should influence accounting procedure choice. Krishnamoorthy et al. (2002a) surveyed both audit partners and managers to understand their conceptualization of financial reporting quality and to evaluate factors that influence the effectiveness of audit committees. They found that the expertise and willingness of AC members to confront management are strong influences on the effectiveness of audit committees. They also found that management is perceived to play a significant role in influencing the extent and the quality of communication between the external auditors and the audit committee and that the AC should play a greater role than they currently do in ensuring the quality of the financial reporting process. Also, consistent with the BRC, clarity and consistency of financial disclosures and degree of aggressiveness in accounting principles and estimates were cited as the most important determinants of financial reporting quality. Krishnamoorthy et al. (2002a) did not examine whether there is consensus between auditors and audit committees about what constitutes quality financial reporting. However, they suggest that if audit committee members are in agreement with auditors, then audit committee members will be more likely to support the auditors in disagreements with management. Collectively, these studies suggest that it is important to examine what actually transpires in audit committee meetings and interactions to determine if its reported activities are effective. For example, both Fogarty and Kalbers (1998) and Gendron and Bedard (2004) demonstrate the need to look at the substance of the AC activities to help determine if the AC is effective. The mere 14
  16. 16. recording of activities may be symbolic or a means of complying with regulation. This suggests that future research may explore whether a principles-based approach may be better than a rules- based approach in achieving the desired goals of audit committees to effectively serve as an oversight to management in the financial reporting process. Power The only studies to explicitly consider the importance of AC power were conducted by Kalbers and Fogarty (1993) and Fogarty and Kalbers (1998). In the former study, they examine the relationship between various dimensions of power and AC effectiveness. Power could take the form of support from the organization in terms of the AC receiving appropriate and timely information from management or power for an AC could be manifested in the expertise of its members. The findings indicate that effective ACs require a broad mandate, good institutional support, and a willingness to undertake its responsibilities. Organization power was only valuable when the AC exercised diligence. Interestingly, expert power (knowledge) was important only for the financial reporting oversight function, suggesting the AC could draw on other sources of expertise in addressing other functions such as overseeing the functioning of controls. Also, as reviewed earlier, the primary focus of Fogarty and Kalbers (1998) was to examine agency and institutional theory factors impacting AC effectiveness. They report a weak correlation between AC effectiveness and some measures of organizational bases of power for the AC (sanctionary power relating to the scope of the AC charter). The research by Kalbers and Fogarty (1993) and Fogarty and Kalbers (1998) suggest that it is difficult to measure the construct of power of the audit committee. It appears that research is needed that uses an in depth interview approach similar to the methodology used by Gendron and Bedard (2004) to isolate the characteristics of an audit committee that determine what creates the power for an AC to be effective in its monitoring role over management. This in depth interview approach can also isolate when an AC’s lacks real power and exists as a mere symbolic mechanism in place to comply with regulation. 15
  17. 17. Duties & Responsibilities Two studies that focus on the duties and responsibilities of the AC are by Wolnizer (1995) and DeZoort (1997). In a comprehensive review of professional standards and the literature Wolnizer identifies 17 functions for the AC that fall into three areas: financia l reporting (including controls); auditing; and other corporate governance (e.g., facilitate communications between the board and the external auditors). DeZoort provides empirical data to validate this list of functions by asking a sample of AC members whether they perform these functions. He also compares the duties they note as assigned to those indicated in the company’s proxy statement. Respondents indicate that the most important duty for the AC is to evaluate controls. Other important functions were to review financial statements, review the effectiveness of the internal and external audits, review the management letter of the external auditor, and evaluate auditor independence. There was a weak association between duties listed in the proxy statement and those that AC members indicated were assigned to the committee. Collectively, these studies suggest that the public disclosures of AC activities do not seem to map well with those actually exercised. Since the duties and responsibilities of AC members are evolving, future research can investigate the level of convergence between the activities outlined in an audit committee charter and the actual duties that AC members perceive they perform as well as consider factors that may account for greater or lesser convergence. Earnings Manipulation and Fraud The research to date in this area has used an archival approach to assess the link between corporate governance characteristics and instances of earnings manipulation and fraud as documented in Accounting & Auditing Enforcement Releases (AAERs) issued by the SEC. The studies discussed below have generally been consistent in their findings that there appears to be a link between board and/or audit committee characteristics and the incidence of earnings manipulation and fraud. 16
  18. 18. McMullen (1996), using data from when audit committees were voluntary, examined the association between the presence of an audit committee and various indicators of possible lapses in the financial reporting process or the occurrence of illegal acts. Using archival data, she found that the existence of an audit committee was associated with a lower incidence of shareholder litigation of alleged fraud, correction of quarterly earnings, SEC enforcement actions, illegal acts, and auditor turnover due to a reporting dispute with management. A future study could examine the reasons for this finding. For example, does the ability and the willingness of audit committee members to ask tough questions of management result in a lower incidence of these lapses than companies that have audit committees that essentially provide a “rubber stamp” for management? Dechow et al. (1996) compared firms receiving AAERs with a non-AAER sample matched6 on size and industry to determine motives and consequences of earnings manipulation. They also investigated whether characteristics of the corporate governance structure are associated with behavior consistent with earnings manipulation. They found that firms subject to enforcement action have weaker governance structures (e.g. less independent boards and ACs) and are more likely to engage in earnings manipulation. The existence of an audit committee as well as general board characteristics (e. g. composition, power of CEO, stock ownership) were associated with differentiating AAER from non-AAER firms. They found no effect for the existence of a bonus plan but they did find support for motivation to lower the cost of external financing. Thus, this study lends support for investigating the importance of governance structures in improving the quality of the financial reporting process. Beasley (1996) examined the relationship between board of directors’ composition and the likelihood of financial statement fraud. In addition, he examined if the presence of an audit committee reduces the likelihood of fraud. Using a matched sample of fraud and non-fraud firms, 6 Although a discussion of the methodological limitations of using a matched sample in research studies is beyond the scope of this paper, it is important to recognize these limitations when interpreting the results from these studies. Readers interested in a thorough discussion of the limitations of matching in empirical research should refer to Kerlinger and Lee (2000, 489) or a similar treatise on research methods. 17
  19. 19. he reports that boards of no-fraud firms are more likely to have a larger proportion of outside (non- employee) directors than fraud firms. The results were robust to a finer definition of outside directors, separating outside directors into grey and independent directors. Surprisingly, the results indicate that the presence of an audit committee was not associated with a reduced likelihood of financial statement fraud. Finally, supplemental analysis suggests that the likelihood of fraud decreases as (1) the level of stock ownership by outside directors increases; and (2) the number of years of board service for outside directors increases. Further, the likelihood of fraud increases as the number of directorships held by outside directors in other firms increases. Collectively, these results highlight the importance of examining corporate board-level factors when evaluating the impact of corporate governance on financial reporting quality. 7 Using three industries (high technology, health care and financial services), Beasley et al. (2000) compared fraud companies (subject to SEC enforcement) with benchmarks of industry corporate governance practices. They found that the only Board of Director measure that differed was the proportion of outside directors, with fraud companies having a lower proportion of its directors who are outsiders. Examining the AC variables, they found differences in all three industries for the likelihood of independent directors with less fraud occurring when there were more independent AC members. Further, the AC members in the high tech and health care fraud companies met less frequently than was typical for their respective industries. Finally, they found that the internal audit function was less likely to be evident in fraud companies. This study suggests the need to investigate or at a minimum control unique industry effects of specific corporate governance characteristics. Abbott et al. (2000) posit that audit committee independence and increased activity will result in a lower incidence of SEC enforcement actions. Using a matched control sample, they found support for their expectations. Their results were qualitatively the same if they restricted the 7 Beasley’s (1996) results described are for univariate analysis. The results might be viewed with some caution as the results for multivariate analysis are not as strong as those found with the univariate analysis. 18
  20. 20. study to the firms specifically sanctioned for fraud. Since their study is a test of association, a future study could examine the causal link between audit committees characteristics and fraud. Abbott et al. (2001) compared fraud/financial misstatement firms with a control group. They found a negative relationship for both independence and activity of AC. No effect was found for AC financial statement expertise or AC size and, in contrast to Beasley (1996), no effect was found for any of the board characteristics. Their results suggest that some of the BRC's recommendations (e.g., independence) may be effective in mitigating fraud or earnings management while others (e.g., expertise) may either have no effect or may need time to have an influence on the workings of the AC. It must be noted that since the data was from a pre BRC period, the reforms enacted post BRC may be effective in improving the quality of the financial reporting process. When discussing earnings management , it is also important to explore the effect of corporate governance mechanisms on earnings management behavior that does not strictly violate GAAP rules but may nonetheless be potentially violating the spirit of GAAP (Krishnamoorthy et al. 2002a).An archival study in this area was conducted by Klein (2002b) who examined whether there is a link between the independence of the board and/or audit committee and the magnitude of abnormal accruals. She found that firms with a majority-independent board and/or audit committee have a lower level of discretionary accruals. However, there was no additional curtailment of earnings management when the audit committee consisted wholly of independent directors. This result calls into question whether the regulation requiring complete independence of the audit committee is overly stringent as Klein found having a majority of independent directors would suffice.. She also found that when firms switched from a majority-independent to minority independent board/audit committee they experienced a higher amount of abnormal accruals. Klein’s study demonstrates the importance of looking at quality of earnings, and not just the incidence of fraud or earnings manipulation. Since Klein’s paper documents an association and not causality, future research could disentangle whether the management is influencing the selection of 19
  21. 21. compliant boards in order to engage in aggressive earnings management or conversely do more independent boards curtail management from overly aggressive earnings management behavior. Although not directly dealing with earnings manipulation, another relevant study was conducted by Wild (1996) who investigated the association between formation of an audit committee and the quality of accounting earnings. Using an information economics framework, Wild predicts that earnings reports disclosed after the formation of an audit committee will elicit a greater stock price reaction than those disclosed before, after controlling for other relevant factors. Using abnormal stock returns, results were consistent with expectations and showed that the stock market reaction for earnings reports was 20 percent greater for earnings announcements after audit committee formation than before. These results suggest that audit committees provide a useful oversig ht mechanism for the financial reporting process and that this increased oversight results in improved earnings quality. This study also suggests the value of using a longitudinal approach to investigate the effect of corporate governance mechanisms on the quality of financial reporting over time. Collectively, these studies suggest that there is an association between the independence of the audit committee and the incidence of fraud or AAERs as well as activities associated with earnings management behavior. However, there is a need to document why this association exists. Is it that more independent audit committees are more diligent in preventing management from engaging in egregious behavior or is that the through the influence of management of better companies who identify audit committee members that will ask the type of questions that will mitigate the firm committing errors and irregularities? Synthesis of Research on Board of Directors and Audit Committee To synthesize, prior research suggests that audit committees are comprised of relatively junior members of the board, whose effectiveness is largely dependent not only on their knowledge and expertise in financial reporting, but also the extent to which the board supports and empowers 20
  22. 22. the AC. Further, AC independence, a key factor in the AC’s ability to confront management and work effectively with auditors, is largely dependent on the attitude and independence of the board. Prior studies also indicate that the role of the AC is crucial, especially in resolving auditor- management disagreements on significant financial reporting issues, an aspect critically important in supporting and enhancing auditor independence. Finally, there appears to be an association between characteristics of the board and the audit committee and the incidences of earnings manipulation and fraud. The results imply that for the AC to play an important role in the financial reporting process, the AC must be vested by the greater board with real power and sufficient expertise to serve as an effective monitor over management’s actions. The AC should be viewed as an ally to auditors in being steadfast in the goal of having a high quality financial reporting process and in the prevention of fraud. INSERT TABLE 1 HERE EXTERNAL AUDITOR The external auditor plays a crucial role in helping to promote financial reporting quality. As a result of Sarbanes-Oxley (2002), auditors must be prepared to discuss with the audit committee the quality and not just the mere acceptability of financial statement issues. Through curtailing excessive earnings management techniques such as unexpected discretionary accruals, auditors can serve as an effective monitor on overly aggressive management. Prior research examining the relationship between various actors in the corporate governance mosaic and the external auditor can be summarized into the following themes: (a) auditor selection and client acceptance; (b) audit quality and audit fees; and (c) audit opinion and the audit process. These themes are discussed below. 21
  23. 23. Auditor Selection and Client Acceptance With increased emphasis on the role of corporate boards and especially audit committees in auditor selection and retention decisions, research in this area is of critical importance to both auditors and other corporate stakeholders. Abbot and Parker (2000) argue that independent and active audit committees will demand higher quality audits and are hence more likely to engage an industry-specialist auditor. This reasoning is in line with the earlier cited research on the relationship between governance factors and quality of earnings (e. g. Klein 2002a and 2002b) that suggests that stronger boards may demand a higher quality audit to curtail management’s ability to engage in rampant earnings management behavior. Abbot and Parker defined audit committees as independent if they were comprised entirely of independent directors and as active if they met at least twice a year. The study found support for the hypothesis. However, audit committee independence or activity alone yielded insignificant results. Beasley and Petroni (2001) examined the association between outside directors on the board and the choice of external auditors for property-liability insurance companies. They argued that boards with a higher percentage of outside directors will seek higher quality auditors in order to provide more effective monitoring of corporate management. Using a sample of property- liability insurers, Beasley and Petroni (2001) found that the likelihood that a specialist Big-6 auditor is selected increases with the percentage of outside directors on the board, but the outside board membership percentage has no impact on the choice between a nonspecialist Big-6 and non Big-6 auditor. Thus, board composition is associa ted with choice of auditors based on industry specialization, rather than the blanket brand name (Big 6 vs. non-Big 6) differentiation found in other settings. Together, these two studies suggest that a more independent and active governance structure is associated with the use of higher quality auditors, assuming that industry specialization is an indicator of quality. Shareholders are taking a more active role in decisions relating to the hiring and retention of external auditors (Clapman 2000). Two studies have examined shareholder ratification of 22
  24. 24. auditors selected by management. Raghunandan (2003) investigates whether shareholder ratification of a management-selected auditor is affected by the relative magnitude of nonaudit fees paid to the auditor. Based on the analysis of shareholder voting in a sample of Fortune-1000 companies, Raghunandan hypothesizes that the magnitude of nonaudit fees (relative to audit fees) will negatively impact the percentage of shareholders voting to ratify the appointment of the external auditor. Although the findings were consistent with expectations, the results of the study should be interpreted with caution given that the shareholder ratification rates were very high (about 97%) even in companies where a significantly la rge percentage of the total fees paid to auditors consisted of nonaudit fees. Given the above finding, two questions that arise is what are the characteristics of companies that actually have shareholders debate as well as ratify the choice of auditors and secondly how how the composition of the audit committee influences shareholders’ decision to ratify an auditor appointment when nonaudit fees are high. Raghunandan and Rama (2003) examined this issue and found that shareholders are less likely to vote against auditor ratification even when the nonaudit fee is relatively high if the audit committee consists of solely independent directors. However, audit committee expertise (i.e., the presence of at least one member with accounting or financial expertise) was not associated with shareholder votes on auditor ratification. From an external auditor’s perspective, corporate governance and audit committee factors could significantly influence the client acceptance decision. These factorswill influence the quality of the financial reporting process, because in light of the heightened scrutiny in the post-Enron era, auditing firms may be reluctant to associate themselves with clients where management is likely to engage in egregious financial reporting behavior. Very little professional guidance or prior research exists on how auditors consider governance factors when accepting new clients. Cohen and Hanno (2000) was the first study on this issue. Specifically, they relied upon the monitoring framework of the COSO Report (1992) and POB (1993) to develop an oversight perspective when describing corporate governance factors. Manipulating the strength of the management control philosophy and 23
  25. 25. the strength of the corporate governance structure in an experimental setting, they asked audit partners and managers to make a client acceptance recommendation. They found that both the management control philosophy and the strength of the corporate governance structure significantly affected client acceptance recommendations, control risk assessments and the extent of substantive testing. However, they manipulate corporate governance in an aggregate manner, employ a governance orientation based strictly on the COSO (1992) framework, and do not test the effect of individual elements such as the independence of the audit committee. Their study suggests the need to more fully capture the effect of individual components of corporate governance on various stages of the audit process. Collectively, the studies on auditor selection suggest that stronger governance structures are associated with the selection of higher quality auditors. Further, the studies suggest that although shareholder ratification is influenced by the provision of nonaudit services, stronger audit committees may be viewed by stockholders as effective monitors to ensure that audit quality is not compromised due to the provision of significant nonaudit services. Further, because of the paucity of existing studies, more research needs to be conducted examining how the judgments of auditors are affected by governance factors during the client acceptance process. For example, will auditors view a potential client that has a board with a strong and effective monitoring focus as a client that has a lower r likelihood of revealing overly aggressive reporting behavior by management and thus be a client that is more desirable to actively seek? Finally, with the requirements of the Sarbanes- Oxley Act that the audit committee select the external auditor, research is needed on factors that impact their decision. Audit Quality and Audit Fees Since audit committees can play a key role in auditor selection, audit committee members’ assessment of audit quality is an important issue to consider. Knapp (1991) examined the impact of auditor firm size (Big Eight versus local CPA firm), length of auditor tenure, and general audit strategy (structured versus unstructured) on audit committee members’ assessment of audit quality. 24
  26. 26. Audit quality was operationalized as the likelihood that the auditor will (a) discover a material error; and (b) disclose the error in the audit opinion (DeAngelo 1981). Results suggest that the length of auditor tenure significantly affected perceptions about the discovery of material error while Big Eight firms were perceived as more likely to disclose a discovered error. While the degree of an audit firm’s structure had no effect, audit committee members did perceive a positive relationship between auditor tenure and the discovery of material error for the early years of auditor tenure while the relationship was perceived to be negative for later years. Thus, it appears that audit committee members perceive that financial reporting quality will be positively affected by having a large auditor, as larger firm are more likely to disclose discovered errors. These results also suggest that audit committee members may perceive a “learning” effect in the early years of auditor tenure. However, if the client retains the same auditor for an extended period of time then financial reporting quality may suffer as the audit firm may become too complacent as they adopt “too cozy” of a relationship with the client that could potentially hamper audit quality. It must be noted that this study did not explicitly test the effect of current or future audit fees on audit committee members’ assessments of audit quality. Carcello et al. (2002), using an agency framework, argue that high quality boards would demand more external monitoring and thus be willing to pay for higher quality audits. They found a significant and positive relationship between audit fees and board independence, number of board meetings (a surrogate for diligence) and the number of outside directorships held in other corporations (a surrogate for expertise). However, they report that the characteristics and activities of the audit committee adds no explanatory power above and beyond board characteristics. Their study suggests that if we accept the assumption that higher audit fees is a surrogate for audit quality, then stronger boards will employ better auditors who in turn presumably will be a more effective monitor on management ensuring that appropriate financial statements and disclosures will take place. 25
  27. 27. Abbott et al. (2003a) examine the association between audit committee characteristics and audit fees. A positive association is predicted between audit fees and audit committee independence, expertise, and meeting frequency. This prediction is based on the notion that audit committees that are independent, have expertise, and that meet frequently will demand a higher level of audit assurance requiring an increased level of audit coverage, resulting in higher audit fees. Results indicate that audit committee independence (defined as consisting solely of independent directors) and expertise (defined as committees that include at least one member who has financial expertise as outlined in the BRC recommendations) are significantly and positively associated with audit fees. However, audit committee meeting frequency was not significantly associated with audit fees. Although Abbot et al’s (2003a) results (e.g., that audit committees in general do have a significant effect) are not entirely consistent with those reported in Carcello et al. (2002), they attribute the variation in findings primarily to the difference with respect to the data, and changes in the nature and function of the audit committee as a result of expanded regulatory focus by the SEC and other agencies8 . An important limitation of both studies is that alternative explanations for the positive association between board/audit committee characteristics and audit fees that are unrelated to audit effort (e.g., increased billing rates rather than increased audit hours) cannot be ruled out. Future studies should attempt to address this limitation. Collier and Gregory (1999) investigated the relationship between audit committee activity and firm specific agency factors, including auditor quality. The general expectation was that audit committee activity will increase in firms with higher agency costs. They found that auditor quality (Big 6) and leverage were positively related to AC activity while AC activity was lower in firms where the role of chairman and CEO were combined and where insiders were included in the AC. Their results suggest that ACs are more active where there is more independence on the board and a higher quality auditor is involved. However, it is unclear whether the increased activity of the AC 8 Carcello et al. (2002) study use survey data relating to 1992-1993, while Abbott et al. (2003a) obtain more recent data (Feb through June 2001) from SEC filings. 26
  28. 28. will actually result in more effective performance. For example, a future study can investigate if the increased activity results in ACs being more involved in resolving reporting disputes between auditors and management. Recent regulatory efforts (e.g., Sarbanes-Oxley 2002) have highlighted the importance of the relationship between fees for nonaudit services and auditor independence. Using SEC audit and nonaudit fee data, Abbot et al. (2003b) examine the association between audit committee characteristics and the provision of nonaudit services (NAS) by the incumbent auditor. They hypothesize that audit committees that are independent and active are associated with lower ratios of NAS fees to audit fees. Since audit failures in a number of high profile corporate scandals (e.g., Enron) have been attributed in part to the loss of auditor independence due to provision of nonaudit services, the findings of this study provide important insight on this issue. Results indicate that the ratio of NAS fees to audit fees is significantly lower in firms with independent and active audit committees, lending further support to the notion that audit committees could play a positive role in promoting auditor independence, to the extent auditor independence is negatively compromised by the provision of nonaudit services to audit clients. Collectively, these studies suggest that more independent audit committees will demand a higher quality audit and thus be willing to ratify higher audit fees. It also appears that more independent audit committees will be less willing to engage the auditor in activities that may compromise the perceived appearance and perhaps actual level of auditor independence. However, none of the research to date has been successful in documenting causality in the relationships. Audit Opinion and the Audit Process Corporate governance factors could significantly influence auditor decisions relating to the audit process, including the nature of the audit opinion rendered. In addition, the role of the audit committee in helping resolve disagreements between the auditor and the management is an 27
  29. 29. important issue that has been addressed in prior research. Studies dealing with these issues are discussed below. Cohen and Hanno (2000) found that both the management control philosophy and the strength of the corporate governance structure (which as discussed earlier they patterned in a strict fashion after the monitoring focus of the COSO Report 1992) significantly affected auditor control risk assessments and the extent of substantive testing but had no effect on the timing of substantive testing. Their results suggest that auditors consider the overall corporate governance structure during the audit process. From a financial reporting quality perspective, this implies that auditors would view clients with a board that has a strong oversight function as having less risk that management would overstep their bounds in being aggressive in financial statement position issues. Using a semi-structured interview approach, Cohen, Krishnamoorthy, and Wright (2002) examined the impact of various corporate governance factors such as the board of directors and the audit committee on the audit process. Auditors from all levels (seniors, managers, partners), representing all of the then Big-5 firms indicated a range of views regarding the elements included in the concept of what constitutes “corporate governance.” As noted previously, auditors viewed company management as the primary driver of corporate governance, a notion inconsistent with a prescription of the board and other mechanisms serving as a means to independently oversee management’s actions to protect stakeholders. Further, auditors considered corporate governance factors to be especially important in the client acceptance phase and for multinational clients. Despite the attention placed on the audit committee, several auditors indicated that their experiences with their clients suggest that audit committees are typically ineffective and lack sufficient power to be a strong governance mechanism. The lack of reliance on the audit committee potentially means that auditors would conduct more substantive testing than if there was an effective audit committee that auditors could rely upon. However, their data was collected prior to the enactment of the Sarbanes-Oxley Act (2002) and perhaps in the post Sarbanes-Oxley era the 28
  30. 30. audit committee can be relied upon more to serve as an effective monitor over management’s activities. Carcello and Neal (2000) examined the relationship between the independence of the audit committee and the likelihood that the client will receive a going-concern opinion. Using a sample of nonfinancial public companies experiencing financial distress, the study found that the greater the percentage of affiliated directors (inside or gray) in the audit committee, the lower the probability that a going-concern report will be issued. In a follow up study, Carcello and Neal (2003) examined if the composition and characteristics of the audit committee might influence whether auditors were dismissed after the auditing firm issued a going concern report. They expected that a stronger and more independent audit committee would be more likely to adopt an effective monitoring perspective and be less likely to allow management to replace an incumbent auditor in light of an unfavorable opinion. They found that for going concern (GC) firms, there was a greater likelihood of auditor dismissal if the audit committee was less independent and if the audit committee members had greater stock ownership. Additionally, there was a lower likelihood of dismissal if there was greater governance expertise on the audit committee. Contrary to expectations, the financial expertise of the AC members had no significant effect on dismissal. Carcello and Neal suggest that when audit committees are less independent, management may be more likely to pressure auditors to issue clean opinions and if they do issue a GC opinion, then management may be more likely to dismiss the auditors. From a financial reporting quality perspective, this implie s that an effective audit committee can help the auditor be more aggressive to curtail excessive management egregious behavior. However, since the study was archival, Carcello and Neal were unable to identify causality. Further, in the post Sarbanes-Oxley environment, it would be interesting to see if the threat of litigation or the increased scrutiny by regulators over the financial reporting process may lower the relative frequency of audit firms being dismissed for issuing a GC opinion. 29
  31. 31. The audit committee can potentially play a key role in facilitating the resolution of disagreements between management and the external auditor. Knapp (1987) examined the factors that determine audit committee’s support for auditors when there is a dispute with management. The study found that audit committee members are more likely to support the auditor rather than the management when audit committee members are themselves corporate managers; the issue under dispute has objective technical standards that support the auditor’s position; and the client’s financial condition is weak rather than strong. However, Knapp found no effect for whether the auditor is a Big Eight as opposed to a non Big Eight firm. One implication from the corporate governance mosaic, is that attention is needed to be placed on the complex interactions among the players in the mosaic. For example, will heightened scrutiny by regulators or increased pressures from activist shareholders influence audit committees to be more supportive of auditors if there are financial reporting disputes with management? In a study discussed previously, DeZoort and Salterio (2001) examined how AC independence and knowledge affect audit committee members’ propensity to support the auditor’s position. Results indicated that the number of independent directorships and greater audit reporting knowledge were associated with greater support for the auditor, while those serving on the board while also being as a member of management led to more support for management. Surprisin gly, financial reporting knowledge was not found to be a significant factor, perhaps due to the generic nature of the accounting issue at hand. DeZoort and Salterio emphasize that the findings support the need for independent, knowledgeable AC members. Thus, to strengthen the ties between the auditor and the audit committee in ensuring financial reporting quality, care must be taken in choosing audit committee members with the appropriate background perhaps emphasizing at least some members possessing audit ing expertise. Ng and Tan (2003) examined the effects of the availability of authoritative guidance and effectiveness of the client’s audit committee on auditors’ perceptions regarding outcomes when negotiating with a client. A central issue evaluated in the study is whether the effect on auditor- 30
  32. 32. client negotiation of the presence (absence) of authoritative guidance is moderated by audit committee effectiveness (or lack thereof). Results indicate that availability of authoritative guidance has a greater impact on auditors’ perceived negotiation outcome when the client’ audit committee is ineffective than when it is effective. Further, audit committee effectiveness has a greater effect on auditors’ perceptions regarding negotiation outcome in the absence of authoritative guidance than in its presence. In effect, the study suggests that authoritative guidance and effective audit committees can serve as potential substitutes in enhancing auditors’ ability to negotiate with client hence increasing audit effectiveness and financial reporting quality. DeZoort et al. (2003) examine the effects of earnings per share (EPS) proximity to analyst forecast, financial-report timing (quarterly versus year-end), and external auditor argument consistency on audit committee members’ support for a proposed audit adjustment. Using source credibility theory, the study predicts that audit committee members will provide greater support for a proposed audit adjustment when: (1) the financial report relates to the year-end rather than at interim; (2) when unadjusted EPS is above rather than below analysts’ consensus forecast; and (3) when the auditor consistently argues for the adjustment rather than agreeing with the management to avoid adjustment. The study found that audit committee members are more likely to recommend an audit adjustment for annual rather than quarterly financial statements and when the auditor consistently argues in favor of making the audit adjustment. However, no significant effect was found for the EPS proximity variable. The study adds to the growing literature on the conditions under which audit committees will support external auditors in resolving contentious financial reporting issues with the management. Bedard and Johnstone (2004) investigate the impact of earnings manipulation risk and corporate governance risk (e.g., the strength of governance variables) on audit planning and pricing decisions. Using proprietary data from a public accounting firm, the study uses partners’ assessments with respect to engagement risks, together with audit effort and billing rate data relating to those engagements. Results indicate that heightened earnings manipulation risk is 31
  33. 33. associated with increases in planned audit hours and planned billing rates but there is no signific ant association between corporate governance risk and planned audit hours or billing rates. However, an interactive effect between earnings manipulation and corporate governance risk is reported, i.e., corporate governance is associated with increased planned audit hours or billing rates only when earnings manipulation risk is high. From this interactive effect, Bedard and Johnstone conclude that corporate governance risk is most important to auditors when there are indicators of potential earnings management. Collectively, these studies suggest that there is a link between governance factors and the ability of the auditor to resolve disputes with management. It appears that audit committees can potentially serve as an ally to the auditor especially if the audit committee members have sufficient expertise and sophistication. However, as documented by the interview study of Cohen et al. (2002) the potential for audit committees to enhance the quality of the financial reporting process has still not been fully realized. Synthesis of Research on External Auditor To synthesize, prior research suggests that stronger boards and audit committees are associated with a demand for higher quality audits. Further, stronger governance structures are associated with higher audit fees. In addition, evidence from recent research suggests that shareholders are beginning to take a more direct and active role by affecting their voting of ratification of the appointment of auditors where the magnitude of non-audit services is judged to threaten auditor independence. Although there is prior research on the role of governance factors both with respect to auditor selection and compensation, there is a paucity of research that examines the role of a client’s or a prospective client’s governance structure on an auditor’s decision to continue with an existing client or to accept a new client. For example, are auditors more likely to accept clients with stronger audit committees with the hope that a stronger audit committee is more likely to side with the auditor in case of disagreements with the management, or that a strong audit committee is less likely to be price-sensitive with respect to audit fees? 32
  34. 34. INSERT TABLE 2 HERE INTERNAL AUDIT Internal Auditors and The Audit Committee A close relationship between internal auditors (IA) and the audit committee (AC) has the potential to enhance the corporate governance capabilities of both parties. The independence of the IA is strengthened when it reports directly to the AC and is not hampered by concerns of divulging sensitive findings as compared to when IA reports to top management. Further, the breadth and hence, perceived value, of the IA is likely to be enhanced when it is employed as an important agent of the AC. Correspondingly, the effectiveness of the AC is strengthened when it is able to deploy the resources of the IA staff to obtain significant information on issues within the company of concern such as the strength of internal controls and quality of accounting policies.9 Research in this area has used a survey methodology to investigate the affect of AC characteristics on the strength of its relationship with the AC. Scarbrough et al. (1998) survey chief internal auditors (CIA) and find a positive association between AC independence and the frequency of meetings with IAs as well as review of IA work. Raghunandan et al. (2001) report that CIAs indicate companies with ACs that comply with the Blue Ribbon Report recommendations as to independence and financial knowledge had more frequent meetings, more private meetings, and reviewed the work of IAs more than those who did not meet the recommendations. Goodwin and Yeo (2001) find wholly independent ACs had more frequent meetings and more private meetings with IAs. None of the three prior studies noted above report a significant association between AC characteristics and ACs’ power to dismiss the CIA. 9 A large body of literature has examined issues related to external auditor’s evaluation of and reliance on the internal audit function, including external auditor’s use of internal auditors as assistants (see Krishnamoorthy, 2002 for an overview). However, this stream of literature does not consider the role of other players that are traditionally included in the corporate governance mosaic (e.g., board of directors, audit committees). Further, a review and synthesis of literature on internal audit is the subject matter of a separate paper by Gramling et al. (2004). Hence, this section does not include literature that exclusively emphasizes the relationship between the external and the internal auditor. 33
  35. 35. Goodwin (2003) reports the results of a survey where she separately examines the effect of AC independence and financial knowledge on the relationship with IAs. She finds that while AC independence is most significantly associated with “process” factors (e.g., number of meetings, length of meetings, and number of private meetings), AC financial competence is related to the extent of the review of the work performed by IAs. That is, financial knowledge is necessary for the AC to be in a position to evaluate and oversee the work of IAs. She also finds that AC independence is strongly associated with the power to dismiss and appoint the CIA. Collectively, these four studies suggest that internal audit potentially can interact with audit committees to play a role in effectively monitoring management and improving financial reporting quality. Of note, since all of above studies rely on a survey of internal auditors only, future research should examine whether audit committee members have similar perceptions as IAs do and whether auditors would rely more on the work of IA if the internal audit function has a more effective working relationship with the AC. Other Internal Audit Studies Corporate governance can encompass helping management in setting a strategic direction as well as monitoring management activities (Wright et al. 2004). Melville (2003), examines the role of IAs in helping to establish and oversee a Balanced Scorecard system. Such functions would suggest a role for IAs in the strategic management process of a company. To address this issue a survey was sent to practicing IAs. The results indicate IAs are often involved in strategic management initiatives, including a Balanced Scorecard, and also provide assurance on the quality of financial and non-financial measures utilized in such efforts. James (2003) examines lenders’ perceptions of the effectiveness of IAs in preventing and/or reporting fraudulent financial reporting when they report to senior management or directly to the board and when this function is performed in-house or outsourced. The findings indicate lenders believe an in-house internal audit function that reports to the board is significantly more likely to report, but not deter, fraudulent reporting. This result could be because of the greater 34
  36. 36. independence of IAs when reporting to the Board rather than to management. An outsourced IA function that reports to the audit committee is seen as more likely to deter and report fraud than an in-house IA function reporting to management. However, overall, no differences in perceptions are found in fraud deterrence, detection, and reporting between an in-house and outsourced IA function. This finding is attributed to the fact that while an outsourced function is seen as more competent and objective, in-house IAs are viewed as possessing more detailed knowledge of the company. Collectively, these two studies suggest that there is a role for IA to play in fulfilling both the strategic aspect of governance as well as a more traditional monitoring function. Both of these roles could potentially lead to improving financial reporting quality. For example, if internal auditors are effective in monitoring a balanced scorecard and the balanced scorecard is closely tied in with an effective implementation of a far sighted business strategy, then there may be a reduction of the potential for a going concern to arise. Synthesis of Research on Internal Auditors To synthesize, prior studies have documented a positive association between the independence and expertise of the audit committee and the effectiveness of the internal audit function. Recent governance reforms (i.e., The Sarbanes-Oxley Act and the resulting SEC and stock exchange regulations) have emphasized the significance of the internal audit function as an important part of the governance mosaic. For example, companies listed on the NYSE are now required to maintain an internal audit function and the audit committees of such companies are required to meet with the internal auditors without the presence of the management. Increasingly, boards and audit committees view internal and external auditors as partners who must work together for ensuring that the highest quality financial reports are provided to all stakeholders. Hence, an important area for future research is to examine how governance factors, such as the strength of the audit committee, influence the extent to which external auditors partner with internal auditors in the process of providing assurance on financial statements. For example, are 35
  37. 37. external auditors’ assessments of internal audit quality and subsequent reliance on the work of internal auditors influenced by the effectiveness of the client’s corporate governance? Do stronger boards and audit committees promote a higher level of coordination between the external and internal auditors? Future research may examine what are the factors that enhance the internal auditors’ ability to improve financial reporting quality. For example, looking at the governance mosaic, should regulators mandate experience or knowledge requirements for heads of IA departments for publicly traded companies? Further, if this is mandated will these requirements strengthen the power of IA departments and thus enhance their effectiveness in the IA department’s ability to curtail unduly aggressive management behavior INSERT TABLE 3 HERE FUTURE RESEARCH OPPORTUNITIES We now discuss research opportunities that are indicative of the prior review as well as the recent financial scandals and the resulting response from the U.S. Congress as evidenced by the Sarbanes-Oxley Act (2002). These are discussed in the following subsections. We have also, where appropriate, identified gaps in the governance mosaic that is outlined in Figure 1 where there exists future research opportunities. Future Research Relating to Board and Audit Committee Characteristics There are a number of promising directions for future research regarding board and AC characteristics and their impact on governance. Most of the studies primarily focus on the AC and only a few consider the interrelationship between the AC and the board (e.g., Menon and Williams 1994; Kalbers and Fogarty 1993; and Beasley and Salterio 2001). Since the board empowers and selects members of the AC, without strong board support the AC cannot be effective in fulfilling its oversight functions. Thus, consideration of the AC in isolation is questionable. The importance of the type of knowledge base audit committee members should posses is ripe for further consideration in research. Cohen et al. (2002) found that auditors viewed audit committee members as lacking in sophisticated financial and business knowledge. This lack of 36
  38. 38. knowledge could pose problems for auditors since DeZoort (1998) found that audit committee members who did not have appropriate experience did not evaluate control environment activities in a manner consistent with auditors. An interesting research question is whether audit committee expertise has significantly changed in light of the reforms (e.g., the requirement that the audit committee have at least one member who possesses expertise while all other members must have financial literacy) enacted as a result of the BRC (1999) and the Sarbanes-Oxley Act (2002). Additionally, research can focus on whether the increase in audit committee expertise has resulted in an increase in the quality of financial reporting, as intended by the legislators and regulators. Research in this area can provide guidance to legislators and regulators interested in further enhancing the substantive effectiveness of boards and their subcommittees. Further work is also needed in identifying and more precisely measuring the key characteristics of effective AC members. For instance, what forms of knowledge are most important for various types of issues confronting the AC such as a technical accounting matter versus considering auditor independence? Although Sarbanes Oxley has a general requirement for financial expertise and financial literacy, does the life cycle of a company necessitate different types of skill sets from the AC members. Thus, for newer companies in volatile industries such as exists in high tech, a broader business skill set may be necessary than what would be required from AC members who serve in very stable companies in stable industries where a strong financial monitoring skill set may be more appropriate. Further, in our review one notable gap in the literature is the lack of governance related research that focuses on the issue of regulated versus unregulated industries. For example, a fruitful area of future research is to examine if the composition and expertise required of audit committee members in regulated industries (e.g., banking, utilities) is significantly different from that in unregulated industries. Research in this area can provide useful information and guidance to regulators such as the Federal Deposit Insurance Corporation (FDIC) when formulating guidelines that impact its constituent firms. 37
  39. 39. Finally, there has only been one study to examine characteristics of AC appointments vis- à-vis other members of the board and of other board committees (Vafeas 2001), and only a few studies have investigated power dimensions relating to AC performance (Kalbers and Fogarty 1993, Fogarty and Kalbers 1998). Since the data in those studies was collected pre Sarbanes-Oxley, it is essential to see if the findings still hold in a world where corporate governance issues consistently hit the headlines of the business press. These issues are likely to have a profound impact on the effectiveness of an AC and, thus, are promising avenues for future research. Post Sarbanes-Oxley it is imperative for researchers to consider what is the role of the AC and how do we appropriately define and measure AC “effectiveness.” For example, Brown (1999), the Chair of the Ontario Securities Commission argues (p. 8) that “the committee should take responsibility for reinforcing the independence of the auditor and ensuring accounting policies are consistent with not only the letter of GAAP, but also the spirit.” He further recommends that the focus of the audit committee “should be on ensuring the quality of the audit rather than becoming preoccupied with the level of fees quoted, perhaps at the expense of quality.” An important area of future research is to examine if the spate of legislative and regulatory reforms resulting from the Sarbanes-Oxley Act results in unintended consequences that negatively impact the quality of financial reporting. For example, an unintended consequence of the emphasis in the Sarbanes- Oxley Act on financial literacy and expertise for audit committee members may result in audit committees that overly focus on the financial statements without adequate consideration for business and strategic risks faced by the company.. This potentially affects financial reporting quality because of the going concern issues could arise if the firm has not adequately understood its competitive marketplace. Further, this focus on the “form” of the audit committee may detract from the need for the committee to have the requisite power and diligence (“substance”) needed to effectively perform their oversight duties. Research on such issues can be instructive to both legislators and regulators in obtaining valuable feedback that can guide future regulatory efforts. 38
  40. 40. Future Research Relating to Management Management has the primary responsibility for ensuring that the company’s financial reporting system, including the overall control environment, results in a high quality of financial reports provided to the company’s stakeholders. The issue of how management interacts with the other players in the corporate governance mosaic to potentially affect financial reporting quality is ripe for further exploration. To date, there has been almost no research that has directly looked at how management affects the corporate governance mosaic. The prior research on boards and audit committees(e.g. Beasley 1996; Beasley et al. 2000; Abbott et al. 2000) though does suggest that stronger boards and audit committees may potentially deter management from engaging in earnings manipulation and/or committing financial reporting fraud as well as even curtailing earnings management (Klein 2002a 2002b). prior studies suggest the lack of a consistent and a generally accepted definition of “high quality financial reporting” among the players in the governance mosaic. This issue is worthy of future research, especially in the light of the ongoing debate in the accounting profession with respect to a “principles” versus “rules” based approach to generally accepted accounting principles. For example, is a principles based approach more or less likely to build greater consensus across the various stakeholders, especially the management, the auditors, and the audit committee, with respect to what constitutes “high quality financial reporting,” as compared to a “rules” based approach? To date, the literature has focused on identifying an association between corporate governance factors such as characteristics of the board of directors or the audit committee and financial reporting quality. However, this research has not directly examined actual management behavior and the research has largely ignored identifying a causal link between the components of the governance mosaic. Although documentation of such an association is extremely important, an archival approach may not be able to tease out the direct links. For example, although Klein (2002b) found an association between independence of boards and the incidence of earnings management she was not able to state whether this was due to good (bad) management or good 39
  41. 41. (bad) boards. As Klein (399) notes, “A less liberal interpretation is that firms with large accruals inherent in their earnings structure are less inclined to have independent boards or audit committees.” This is an area where applying a judgment and decision making framework or utilizing experimental economics may allow researchers to more finely assess the impact of individual components of the corporate governance mosaic. For example, a future study could manipulate the incentives of management to engage in earnings manipulation and determine under what conditions board member independence will matter (or not) in deterring management’s willingness to engage in this behavior. Thus, research may examine if auditors are sophisticated in evaluating the substantive effectiveness of the board to determine if the board can be relied upon for a risk management strategy and adjust their audit planning decisions accordingly. Further, looking at gaps in the research in the corporate governance mosaic, there can be more research examining the role that the stock exchanges could play in enhancing the effectiveness of the substance of audit committee activities. For example, research can examine if specific rules on the different exchanges regarding the characteristics (e.g., financial expertise) needed for an audit committee member may differentially affect the financial reporting quality for companies listed on a particular exchange. the exchanges about what types of experts should be in place in the audit committees for firms listed on their exchange. Further, archival research is limited in being able to detect the difference between the form and substance of corporate governance mechanisms. For example, management will ensure that ACs comply with the minimum standards of having all independent members, at least one a financial expert, and the rest being financial literates as prescribed by BRC (1999). However, independence can be subverted if audit committee members are all connected with the CEO through being in a similar business and/or social milieu. A future study should investigate if auditors recognize the ability of management to influence the effectiveness of the audit committees so auditors can discern differences in the form and substance of corporate governance mechanisms when assessing the risks associated with the financial reporting process. For example, it is unclear 40
  42. 42. whether auditors can rely on ACs who management has helped shape to merely comply with regulations. Will these ACs be supportive of auditors’ positions in disputes over financial reporting issues? Thus, auditors need to closely examine the substance of the activities of the AC and whether management exerts undue influence on the performance of the AC. If research finds that firms are complying with the letter of the law on governance requirements but the governance mechanisms remain impotent in their ability to challenge management on reporting issues, then perhaps legislators will need to rethink the current “bright line” approach to mandating governance. Although corporate governance has universally viewed inside directors in a negative light (Dalton and Daily 1999), there are times that very close connections between management and the board may enhance the effectiveness of the board’s activities. For example, the presence of some key insiders potentially may help other board members better understand the workings of the company and thus perhaps improve the strategic functions of the board which in turn has the potential to limit the potential down the road for going concern problems. For instance, if the CEO is also on the board, the CEO could provide the board with detailed information on potential new product lines that could significantly affect the performance of the company, and thus perhaps enhance the speed and quality of the type of access and connections that other board members may provide. A future study could examine the trade-off between better strategic decision-making versus the increased probability of agency costs of having management unduly influencing the corporate governance mosaic by placing key insiders on the board. Perhaps regulators may have to adopt a more flexible principles based approach to governance that at times would allow companies to have a more strategic focused BOD. Another area open to research is whether the type of accounting issue will affect the link between corporate governance mechanisms and the ability of management to influence the quality of financial reporting. For example, management may be more aggressive in financial reporting when the accounting standard is less precise (Nelson et al. 2002). Further, Trompeter (1994) found that the ambiguity of an accounting issue was negatively related to auditors' judgments in 41

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