Several corporate governance developments have occurred in the wake of the high-profile scandals of the past decade. Some of these developments are motivated by legislation such as the Sarbanes-Oxley Act of 2002 (SOX). Others are best practices enhancements intended to shore up investor confidence. Academic research has monitored these developments. This article summarizes important academic findings and observations recently published in prominent accounting and finance journals.
IMPROVE INTERNAL CONTROL BY HIRING AN ACCOUNTING-SAVVY CFO
The main goal of SOX was to restore investor confidence in financial reporting. Consistent with this goal, SOX section 404 requires companies and auditors to assess the effectiveness of internal controls. Because adverse 404 opinions have negative implications for company value, understanding how companies can prevent and fix conditions related to weak internal controls over financial reporting is important to understand.
Authors Chan Li, Lili Sun and Michael Ettredge studied the relationship between both CFO turnover and professional qualifications with adverse 404 opinions and the correction of internal control weaknesses. CFOs play a central role in the control environment, and the authors argue that CFOs with more accounting knowledge—either as a CPA or with audit firm experience—should better understand internal controls and therefore be in a position to correct control deficiencies.
The authors used a sample of 2,478 companies that disclosed auditors’ initial SOX 404 opinions in 2005, including 416 companies with adverse opinions. The authors’ main findings were that companies with adverse opinions: (1) had CFOs with weaker accounting qualifications; (2) were more likely to fire their CFOs; (3) were more likely to hire new CFOs with better accounting knowledge; and (4) were more likely to receive better SOX 404 opinions after hiring new CFOs who had more accounting knowledge.
The study “Financial Executive Qualifications, Financial Executive Turnover, and Adverse 404 Opinions” was published in May 2010 in the Journal of Accounting and Economics.
COMPENSATION CONSULTANT BIAS
Large corporations often hire executive compensation consultants to provide objectivity in determining executive salaries. But if these consultants are also paid for consulting services in other areas of the company, is their objectivity diminished? Additionally, are they more objective when they are hired by the board’s compensation committee rather than management?
Results of a research study titled “Executive Pay and ‘Independent’ Compensation Consultants,” published in the April 2010 edition of the Journal of Accounting and Economics, suggest that compensation consultants tend to lose their independence when they provide both compensation- and noncompensation-related services to their corporate clients.
Over the past decade, due to the potential for conflicts of interest, the SEC began requiring disclosures regarding executive compensation consulting arrangements including total fees paid and to whom the consultant reports (that is, management or independent compensation committee members). Authors Kevin J. Murphy and Tatiana Sandino sampled regulatory filings for more than 1,000 U.S. companies in 2006, the first year of the required disclosure. The study also included more than 100 Canadian companies, which have compensation disclosure requirements that are similar to those in the U.S.
The authors’ research examined two main questions. First, did CEOs receive larger salaries if their compensation consultant provided services other than the compensation study? Second, was the CEO paid more when management had significant influence over the decision to reappoint or not reappoint the consultant in the future?
Results revealed that compensation increases for CEOs in the United States and Canada were 18% and 33% greater, respectively, when compensation consultants provided “other services” compared with compensation increases where the consultants did not provide other services. Interestingly, the authors found that CEO pay was 13% lower on average when management was influential in the decision to reappoint the consultant. However, the authors could not rule out that this finding was due to the unavailability of a measure of the company’s propensity to hire a compensation consultant that was not correlated with the CEO’s pay.
SOX does not specifically address the area of compensation consultants. However, effective February 2010, the SEC began requiring disclosure of fees paid for both compensation consulting and other consulting engagements within the same firm. Such disclosure is not required if the firm hires a consultant that works exclusively for the board. Results of the study suggest the need for consultants to be aware of the perceived conflict and take action to “mitigate the concerns internally.” In addition, companies are encouraged to carefully consider the risks associated with retaining their compensation consultant for other services.
INTENSE BOARD MONITORING
Corporate boards are designed to provide two distinct and essential services for management—strategic advising and management oversight. Best practices in corporate governance call for an increase in independent board members in the oversight activities to provide a stronger foundation. Additionally, specific requirements of SOX and the major stock exchanges increase the board’s responsibility for monitoring the actions of management, particularly through the use of independent members. These requirements are intended to improve monitoring quality.
Recent research, however, reveals that the cost may outweigh the benefit when board members intensify their monitoring activities. It appears that the increased emphasis on monitoring effectiveness diminishes the effectiveness of strategic advising by board members, resulting in a negative effect on the company’s value.
More than 2,000 companies were examined in this study. Research analysis focused on the level of monitoring required by independent board members to serve on audit, compensation and nominating committees. The authors defined a board as “monitoring intensive” if board members served on at least two of these three principal monitoring committees.
Positive outcomes with a monitoring-intensive board included lower executive compensation, reduced earnings management and a more realistic approach to performance-based CEO termination. The results suggest that when board members increase their management monitoring responsibilities, their knowledge of the company is enhanced and, simultaneously, their ability to direct management in areas such as compensation, employment and earnings quality is significantly increased.
However, companies whose independent directors served on several monitoring committees exhibited reduced quality in their strategic advising capacity and a management style exhibiting greater tendencies to micromanage. One negative implication of these side effects was measured by a reduction in corporate innovation, as measured by a decline in R&D investments. Additionally, intense board monitoring was found to reduce the success of corporate acquisitions, as measured by a variety of corporate performance measures after a merger, as well as an increase in the time for merger completions. For example, these companies typically took longer to complete the acquisition, and stock price changes at the time of the acquisition announcement were about 0.5% lower for these companies.
The authors’ research aligns with the results of prior studies, revealing a variety of undesirable outcomes when directors closely monitor management. Essentially, intense monitoring creates the unintended side effect of a decline in strategic advising, weakened communications and a perception by the CEO that board support has declined. Moreover, research concludes that independent board members overly involved in monitoring activities exhibit an inability to effectively advise top management.
Practitioner implications call for an awareness of the challenges associated with the dual role of board members: that of management adviser vs. management oversight. The study authors encouraged firms to be proactive in determining the optimal balance of board responsibilities to diminish the negative effects associated with a monitoring-intensive board.
The article titled “The Costs of Intense Board Monitoring,” by Olubunmi Faleye, Rani Hoitash and Udi Hoitash appeared in the February 2011 Journal of Financial Economics.
CORPORATE FRAUD WHISTLEBLOWING
Recent research published by Alexander Dyck, Adair Morse and Luigi Zingales involved the question of who brings corporate frauds to light and why. Evidence about the individuals involved in the revelation of frauds and their motivations provides valuable information regarding whether corporate governance mechanisms are effective and cost-efficient for detecting and curbing fraud.
The authors examined a sample of 216 securities class-action lawsuits alleging corporate fraud filed between 1996 and 2004. Securities regulators were found to be the primary revealing party in 7% of the cases, and auditors uncovered 10% of the cases. However, auditors were more frequently the primary revealing party after promulgation of Statement of Auditing Standards no. 99.
Debt holders and their delegates (investment banks, commercial banks and bond exchanges) were not the detecting party in any of the cases examined in the research. Equity holders and their delegates (analysts and auditors) were the revealing party in 24% of the cases examined. When other market participants, such as short sellers, were included, the percentage of cases detected by the equity holders increased to 38%.
So who were the “whistleblowers” in the rest of the cases? Employees of the company uncovered 17% of cases, nonfinancial- market regulators (industry regulators) found 13%, and popular press journalists uncovered 13%. The authors provide additional evidence that frauds uncovered by the media tend to be the larger frauds. Conversely, insiders are much more likely to reveal frauds in smaller companies.
Interestingly, the authors find little evidence of monetary incentives for auditors to bring frauds to light. Further, the study found an approximately 50% probability that the whistleblowing auditor would lose the account of the company involved in the irregularity. However, the authors found no evidence that uncovering a fraud brings the auditor more work from other companies and organizations.
Employees were more likely to bring a fraud to light when the case involved the federal False Claims Act, where a portion of damages are paid to those filing a claim. Also, potential personal liability for involvement in the fraud was deemed present in 35% of frauds brought to light by employees. Unfortunately, 82% of named employee whistleblowers alleged they were either fired, forced to quit or demoted after blowing the whistle.
The authors recommended that internal company policies and procedures be continually reviewed and updated to ensure that employees feel they can bring potential irregularities to light without fearing for their career or personal safety. The article, published in the December 2010 issue of The Journal of Finance, is titled “Who Blows the Whistle on Corporate Fraud?”
CORPORATE GOVERNANCE POST-SARBANES-OXLEY
Several SOX provisions are intended to reinforce and strengthen the responsibilities of important members of the governance mechanisms of companies such as the directors, audit committee members, CEOs and CFOs. Appointment of the independent auditor is a key corporate governance mechanism. Jeffrey Cohen, Ganesh Krishnamoorthy and Arnie Wright, who previously studied similar issues pre-SOX, interviewed auditors to get their views on interactions with key governance personnel post-SOX. Based on responses to their questions, the authors concluded that, while great improvements have occurred since the passage of SOX, too often the audit committee remains more form than substance in the independent auditor appointment process, especially when the CEO chairs the board.
Virtually all respondents (97%) indicated that the use of corporate governance in the planning phase has increased post-SOX. Thus, governance mechanisms are now used in auditors’ planning, field-testing and summary review, suggesting that these mechanisms are viewed as more reliable.
The authors’ pre-SOX study found that auditors usually viewed audit committees as generally lacking meaningful substance. The earlier study found that auditors met with the audit committee only two or three times per year. Post-SOX auditors reported meeting with the audit committee, on average, more than six times per year. Also, post-SOX respondents reported more questions and discussions of accounting, auditing and other mandated issues. Thus, it appears that post-SOX audit committees are taking the monitoring function more seriously than they did in the past.
Respondents were also upbeat about changes in the involvement of the audit committee in controls oversight as required under SOX section 404. In the pre-SOX study, most audit committees were deemed passive and ineffective. However, in the current study, 86% of respondents indicated that the audit committee was now a serious group fulfilling an important role in monitoring the functioning of internal controls. Further, audit committee independence and expertise seemed to have increased post-SOX. Ninety-three percent of the auditors indicated that the audit committee had sufficient expertise, and 96% believed that the audit committee had enough power to confront management regarding the financial reporting process. Further, the internal audit function reported to the audit committee more frequently after the passage of SOX. Finally, more than two-thirds of respondents believed that the management certification requirement had a positive effect on the integrity of financial statements.
The article titled “Corporate Governance in the Post-Sarbanes-Oxley Era: Auditors’ Experiences” was published in the fall 2010 issue of Contemporary Accounting Research.
ROLE OF INTERNAL AUDIT IN THE DISCLOSURE OF MATERIAL WEAKNESSES
Authors Shu Lin, Mina Pizzini, Mark Vargus and Indranil Bardhan, in their article “The Role of the Internal Audit Function in the Disclosure of Material Weaknesses” (The Accounting Review, January 2011) examined how internal audit impacts the quality of companies’ financial reporting systems.
The authors found that the nature and scope of internal audit activities were strongly related to the detection of control weaknesses, more so than the attributes of internal auditor competence and objectivity. Regarding the nature and scope of audit activities, the authors found that material weakness disclosures are less likely when internal auditors use quality assurance techniques during fieldwork and when they include financial reporting processes in the scope of their audit activities. Further, when internal audit diligently followed up on management’s work to correct previously identified control weaknesses, correction was more likely to occur. The research found it important that these activities occurred before year-end, allowing the company to correct problems before having to report them.
Regarding the work at year-end, the research revealed that when internal audit was required to provide a grade or opinion on the financial reporting controls, a material weakness was more likely to be detected and reported. Also, firms whose internal auditors cooperated significantly with the independent auditors were found to be more likely to detect and report a material weakness.
Cynthia E. Bolt-Lee (email@example.com) is an associate professor of accounting and taxation at The Citadel School of Business Administration; David B. Farber (firstname.lastname@example.org) is an associate professor of accounting at the Desautels Faculty of Management at McGill University; and Stephen R. Moehrle (email@example.com) is a professor of accounting at the University of Missouri–St. Louis.
To comment on this article or to suggest an idea for another article, contact Kim Nilsen, executive editor, at firstname.lastname@example.org or 919-402-4048.
Editor’s note: This article is part of a series that samples accounting research and distills key findings for busy practitioners and preparers. These summaries explain the implications of a wide range of research and give CPAs the opportunity to apply the results in day-to-day activities. Readers interested in more detail should review the full text of each article to explore the hypothesis, research process, statistical analysis, supporting theories and conclusions.
“Eight Habits of Highly Effective Audit Committees,” Sept. 2007, page 46
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