Overlapping Membership on Audit and Compensation Committees and Financial Reporting Quality

This paper examines whether the audit committee members of a board improve financial reporting quality if they are also on their organisation's compensation committee. Audit committees are responsible for overseeing the financial reporting process of organisations and have been urged to broaden their understanding of business risk and of the incentives provided by their firms’ executive compensation structures. Acknowledging the interrelationships among executive compensation, risk‐taking and financial reporting quality, members of audit and compensation committees have been advocating more information sharing between the two committees. Using archival data from a sample of Australian Stock Exchange listed companies, and discretionary accruals as a proxy for financial reporting quality, this study finds that firms with overlapping committees have better quality financial reporting than those without such an overlap. Our evidence for this is stronger in cases where managers tend to manage earnings upwards in order to meet or beat earnings benchmarks. We also find that the beneficial effect of the existence of overlapping committees is adversely affected by the equity holdings of directors with overlapping memberships.     

An exploratory study of the effects of the European Union 8th Directive on Company Law on audit committees: Evidence from EU companies listed on the US stock exchanges

Member States in the European Union will be required to establish audit committees for all public-interest entities, according to the EU 8th Directive on Company Law. This EU 8th Directive creates a convergence of corporate oversight for both audit processes and financial reporting process and thus provides an opportunity to examine and contrast associations that exist among audit committee, board of directors characteristics with audit committee alignment, and the impact of such alignment on earnings management. Results of a logistic regression analysis suggest that firms with audit committees possessing greater financial expertise, with larger boards and more independent boards are less likely to engage in audit committee alignment while firms with audit committees possessing greater governance expertise are more likely to engage in alignment. In addition, we find that firms associated with audit committee alignment engage in less earnings management.     

The effect of disclosure committees on non-GAAP reporting quality

I examine whether company-implemented disclosure committees help to improve non-GAAP reporting quality. I find that firms with disclosure committees provide higher quality non-GAAP performance metrics and that the exclusions used to calculate their non-GAAP numbers are less persistent for future operating income and operating cash flows. Moreover, I find that firms with disclosure committees are less likely to receive SEC comment letters about non-GAAP disclosure. For firms that receive comment letters about non-GAAP reporting, disclosure committees can help to improve non-GAAP reporting quality. Comparing the influence of audit committees and disclosure committees, I find that audit committee financial experts have stronger monitoring effects than those on disclosure committees. Meanwhile, legal experts on disclosure committees provide similar monitoring compared to audit committees’ financial experts. Finally, the interaction between audit committee financial experts and disclosure committee legal experts produces the strongest effect on non-GAAP reporting quality. In sum, my analyses suggest that disclosure committees can provide important monitoring of non-GAAP reporting.     

Audit committee accounting expertise,expectations management,and nonnegative earnings surprises

We investigate whether accounting expertise on audit committees curtails expectations management to avoid negative earnings surprises. Controlling for the endogenous choice of an accounting expert, we find that firms with an accounting expert serving on the audit committee exhibit: (1) less expectations management to avoid negative earnings surprises; (2) less nonnegative earnings surprises through expectations management; and (3) more nonnegative earnings surprises that are less susceptible to manipulations of both realized earnings and earnings expectations. We find, however, that the inclusion of an accounting expert on the audit committee curtails expectations management only in the interim quarters. While Brown and Pinello (2007) find a greater magnitude of downward revisions in analysts’ forecasts in the fourth quarter, they also document a lower incidence of nonnegative earnings surprises. Together, this suggests that with an accounting expert, audit committees likely view the fourth quarter downward revisions as driven more by guidance than by manipulation, thus focusing on curbing only expectations management in interim quarters.     

Audit committee financial expertise and properties of analyst earnings forecasts

An important role of financial accounting information is to aid financial statement users in forming expectations about the firm's future earnings. Prior research finds that accounting financial expertise of the audit committee is associated with higher financial reporting quality. We extend this literature by examining the association between audit committee financial expertise and analysts' ability to anticipate future earnings. We find a significant association between accounting financial expertise on the audit committee and analyst earnings forecasts that are more accurate and less dispersed. In contrast, we do not find a significant association between non-accounting financial expertise (i.e., supervisory expertise) and forecast accuracy or forecast dispersion. These findings contribute to our understanding of the benefits of accounting expertise in audit committees by demonstrating an association between accounting financial expertise and improvements in analyst earnings forecasts.     

Audit Partners’ Role in Material Misstatement Resolution: Survey and Interview Evidence

Auditors are expected to identify and resolve material misstatements (MMs) in management's financial statements. However, beyond the audit opinion, the audit process is opaque. To address this, we independently survey 462 audit partners and interview 24 audit partners, CFOs, and audit committee members on how partners assess and address MM risk, resolve MMs, and the consequences of MMs. Partners identify MMs in approximately 9% (15%) of public (private) engagements and use qualitative factors to waive apparent MMs. Loan covenant and going-concern issues increase MM risk more than earnings benchmark issues. Partners point to a variety of both auditor and client factors as threats to audit effectiveness. Partners often rely on rapport with management and involve the national office and audit committee in resolving MMs. Partner incentives around restatements are context specific. Our results provide new insights into the auditor's role in financial reporting that are relevant to academics, practitioners, and regulators.     

Management earnings forecasts and the quality of analysts’ forecasts: The moderating effect of audit committees

This study investigates whether effective audit committees influence the association between management earnings forecasts and the properties of analysts’ forecasts. We posit that this influence on the part of an audit committee would likely result from increased responsibility for monitoring voluntary disclosure. Using the four attributes that the Blue Ribbon Committee (1999) and prior research suggest as being indicative of audit committee effectiveness, we find that analysts’ forecasts exhibit higher accuracy and lower dispersion with the issuance of management forecasts for those firms employing audit committees that are composed exclusively of independent directors, include an accounting expert, and act with due diligence. We also find that effective audit committees strengthen the association between management and analyst forecast accuracy. Our evidence, therefore, supports the notion that effective corporate governance influences the reliability of voluntary disclosure, and thereby benefits the users of financial information.     

Problem directors on the audit committee and financial reporting quality

The objective of this paper is to examine empirically the consequences for financial reporting quality of having audit committees that include problem directors, that is, directors with prior involvement in corporate bankruptcies, major accounting restatements, or other accounting scandals. An ordinary least squares regression model is used to examine the association between problem directors on the audit committee and financial reporting quality as proxied by accruals and real earnings management. Results reveal that there is a positive association between the presence of problem directors on the audit committee and real earnings management, and this association is more pronounced in cases where those problem directors have been involved in prior instances of accounting restatements and fraudulent reporting practices.     

The effect of audit committee shareholding,financial expertise and size on interim financial disclosures

In recent years, corporate failures and accounting irregularities have led to concerns about the effectiveness of audit committees in the financial reporting process. In response, corporate governance committees in different countries have made specific recommendations designed to enhance the role of the audit committee in executing its financial reporting oversight duties. We investigate in this study, the effect of some of these recommendations by empirically examining the relationship between selected audit committee characteristics and the level of disclosure in interim reports of a sample of 262 UK listed companies. Specifically, the audit committee characteristics examined are shareholding of audit committee members (as a proxy for audit committee independence), audit committee size and audit committee financial expertise. Employing both a weighted and unweighted index to measure interim disclosure, the results indicate a significant negative association between shareholding of audit committee members and interim disclosure. Our results provide evidence of a significant positive association between interim disclosure and audit committee financial expertise. We find no significant relationship between audit committee size and the extent of disclosure in interim reports. Overall, however, our results suggest that audit committee characteristics have an impact on its monitoring effectiveness of the financial reporting process. These results have important implications for corporate governance policy-makers who have a responsibility to prescribe appropriate corporate governance structures to ensure that shareholders are protected.     

Audit Committee Members: What Goes on Behind Closed Doors?

Using a qualitative research paradigm, this study examines audit committee effectiveness from the perspective of audit committee members of New Zealand listed companies. The findings reveal that audit committee members perform a range of overlapping tasks and justify their existence in their audit committees by fulfilling the ‘expectations’ that are placed on them. Many quantitative research studies have examined the association between different dimensions of audit committee inputs and financial reporting outputs. The empirical evidence, however, is mixed and remains far from conclusive (Bédard and Gendron 2010). One of the primary reasons for the inconsistent findings is the lack of understanding of the actual process by which audit committees perform their responsibilities. Using a qualitative research paradigm, this study examines audit committee activities, processes and effectiveness from the perspective of audit committee members of New Zealand listed companies. The study argues that performing audit committee duties is an intended process, whereby audit committee members justify their actions and the effectiveness of their audit committees. The paper contributes to the limited literature on how audit committees operate and, by doing so, provides possible explanations for the inconsistent findings of the quantitative audit committee research. In particular, the paper invites further discussion on whether audit committee members can be (or should be assumed to be) independent when discharging their role of overseeing auditing and financial reporting‐related matters.     

Board Characteristics,Firm Profitability and Earnings Management: Evidence from India

The present paper explores the association between earnings management and specific board characteristics and the firm's profitability in the Indian context. In India, the corporate ownership model is the promoter dominated shareholders model. This is the first study based on a panel data framework that employs a fixed effect model to control for time‐invariant endogeneity. It also contributes to the literature by exploring the role of the firm's profitability in transmitting the impact of audit committee independence on earnings management. The study finds that profitability is an important variable, as it moderates the association between audit committee independence and earnings management. Managers of a profit‐making company would have little need to modify their earnings. This signifies that independent audit committees are more effective monitors of earnings management in profitable firms than in non‐profitable firms. Independent directors with multiple directorships are also found to be ineffective monitors. The findings are of material significance to policymakers in analysing board effectiveness and earnings management and improving policymaking for corporate governance by using profitability and related variables.     

Audit Committee Members’ Reputation Incentives and Their Effectiveness in Monitoring the Financial Reporting Process

We examine whether the reputation incentives of audit committee members are associated with their effectiveness in monitoring the financial reporting process. Prior research assumes that audit committee members allocate their effort proportionately across all memberships on which they serve. However, our findings suggest that audit committee members with multiple audit committee memberships tend to focus their attention on the memberships that provide them with the greatest reputation incentives. Specifically, firms with a larger proportion of audit committee members where the membership is the most prominent are associated with higher financial reporting quality and more effective monitoring of internal control. Additional tests reveal that audit committee members’ reputation incentives are driving our results rather than independent non-audit committee members’ reputation incentives. We conclude that reputation is a strong incentive for audit committee members, such that it influences their monitoring effectiveness over the financial reporting process.     

Earnings conservatism and audit committee financial expertise

Using an Australian sample of 494 firm‐year observations, this study finds that accounting financial expertise is the primary type of expertise that influences earnings conservatism, rather than nonaccounting financial expertise. The association between accounting financial expertise and conservatism holds only when the accounting financial expert(s) on audit committees is (are) independent. Overall, results suggest that audit committee accounting financial expertise is important in recognising the asymmetrical timeliness of losses. Findings provide a better understanding of the dynamics between audit committee financial expertise and earnings conservatism and demonstrate the importance of accounting financial expertise in improving financial reporting quality.     

The effect of audit committee characteristics on intellectual capital disclosure

This paper, using data from 100 UK listed firms, investigates the relationship between audit committee characteristics and intellectual capital (IC) disclosure. We find that overall IC disclosure is positively associated with audit committee characteristics such as the size and frequency of meetings, and negatively associated with audit committee directors' shareholding. We find no significant relationship between IC disclosure and audit committee independence and financial expertise. We also observe that the association between audit committee characteristics and IC disclosure varies with the IC components (i.e. human capital, structural capital and relational capital), suggesting that the underlying factors that drive various components of IC disclosure are different. These results have important implications for policy-makers in that they confirm that the effectiveness of audit committees in the corporate reporting processes is a function of certain characteristics.     

CFOs and CEOs: Who have the most influence on earnings management?

This study examines the association between chief financial officer (CFO) equity incentives and earnings management. Chief executive officer (CEO) equity incentives have been shown to be associated with accruals management and the likelihood of beating analyst forecasts (Bergstresser and Philippon, 2006; Cheng and Warfield, 2005). Because CFOs’ primary responsibility is financial reporting, CFO equity incentives should play a stronger role than those of the CEO in earnings management. We find that the magnitude of accruals and the likelihood of beating analyst forecasts are more sensitive to CFO equity incentives than to those of the CEO. Our evidence supports the Securities and Exchange Commission's (SEC) new disclosure requirement on CFO compensation.     

Impact of family dominance on monitoring of earnings management by audit committees: Evidence from Hong Kong

This study examines whether the establishment of audit committees by Hong Kong firms would constrain earnings management, especially in firms with family-dominated corporate boards, a condition unique to Hong Kong. The study uses the methodology of three-stage (3SLS) regression analyses to control for endogeneity among earnings management, voluntarily established audit committee, and corporate board size. The results of regression analyses based on 523 observations for the period of 1999-2000 when the audit committees were first established by Hong Kong firms show that overall audit committees play a significant role in constraining earnings management even in the business environment of higher ownership concentration. The effectiveness of audit committees is, however, significantly reduced when family members are present on corporate boards, especially when family members dominate the corporate board.     

The implications of ineffective internal control and SOX 404 reporting for financial analysts

The mandatory reporting of firms’ internal control effectiveness continues to be debated by equity market participants, U.S. regulatory agencies and oversight committees. We investigate the implications of material weaknesses in internal control and SOX 404 required reporting of such for financial analysts because analysts are important intermediaries in the U.S. capital market and it is not known whether analysts’ forecasts or coverage decisions are affected by firms’ internal control problems or reporting, respectively. Results of our empirical tests indicate that analysts provide less accurate forecasts and there is greater forecast dispersion for firms with ineffective internal control. We also find that firms that disclose internal control problems have less analyst coverage and that analyst following declines after the material weakness in internal control is disclosed. The results are robust to controlling for potential self-selection bias and management earnings guidance. Our study documents the consequences of ineffective internal control for an important class of financial statement users and suggests the required reporting on the effectiveness of internal control is beneficial to understanding the properties of analysts’ forecasts.     

Investor perceptions of an auditor’s adverse internal control opinion

In response to recent corporate scandals, Congress passed the Sarbanes–Oxley Act of 2002 (SOX) which, among other things, requires that the auditor render an opinion as to the effectiveness of a company’s system of internal controls. The assumption implicit in this requirement is that the new internal control opinion provides investors with value-relevant information. Our evidence suggests that an adverse audit opinion on internal control over financial reporting provides incremental value-relevant information to investors beyond that contained in the financial statement audit opinion alone. Specifically we find that an adverse audit opinion on internal controls over financial reporting relative to an unqualified opinion is significantly associated with investors assessing a higher risk of financial statement misstatement, higher risk of a future financial statement restatement, higher information asymmetry, lower financial statement transparency, higher risk premium, higher cost of capital, lower sustainability of earnings, and lower earnings predictability. Overall, our empirical results support our hypotheses that the auditor’s opinion on the internal controls over financial reporting provides financial statement users with value-relevant information.     

The association between audit committees,compensation incentives,and corporate audit fees

This study uses audit fee data from the 2001–2003 reporting periods to examine the relationship between measures of audit committee effectiveness and compensation incentives with corporate audit fees. Our results suggest that audit committee size, committee member expertise, and committee member independence are positively associated to audit fee levels, consistent with the notion that audit committees serve as a complement to external auditors in monitoring management. In contrast, CEO long-term pay and insider ownership are inversely related to audit fee levels, substituting for external audit effort in motivating management. Notwithstanding results on the full sample of firm-years, we uncover significant differences in the determinants of audit fees between the years examined. An important implication of these results is that explaining the intra-firm variation in audit fees over time is clearly necessary in order to understand the antecedents and consequences of audit fees.

Auditors’ Economic Incentives and the Sensitivity of Managerial Pay to Accounting Performance

The use of managerial incentives to manage earnings in order to enhance accounting performance‐based compensation is greater when auditors have economic incentives to compromise their independence. Hence, compensation committees face more difficulties in determining cash compensation when earnings quality declines. This study investigates whether boards of directors can mitigate the agency problems between managers and shareholders by being aware of the opportunistic earnings management encouraged by auditors’ economic incentives and actively adjusting performance‐based compensation for the reduced earnings quality. To this end, it examines how auditors’ economic incentives affect the sensitivity of managerial pay to accounting performance. The findings show a negative association between the client's economic importance to the auditor and the sensitivity of managerial pay to accounting performance, with this association more pronounced for firms that opportunistically inflate earnings, suggesting that boards mitigate agency problems by actively intervening to modify performance‐based compensation schemes for the reduced earnings quality. Additional analyses show that board effectiveness in determining compensation depends on its characteristics. These results suggest the urgent need to oblige companies to establish compensation committees, particularly in countries that lack such a mandatory requirement or where few companies have such committees.