Recent academic studies examine the consequences of two aspects of audit committee membership – accounting expertise and committee chair familiarity with the company. The findings of these studies support what one might suspect: Having an experienced accountant or auditor on the committee (as distinguished from a financial expert who merely supervised financial reporting) lowers audit fees and reduces the risk of restatements. And, appointing an audit committee chair with prior experience on the company’s audit committee improves committee monitoring of financial reporting and reduces the risk of financial reporting misstatements, as compared to selecting an external successor.
Impact of Audit Committee Member Accounting Expertise
In Audit Committee Accounting Expertise and the Mitigation of Strategic Auditor Behavior, which appears in the July 2021 issue of The Accounting Review, James C. Hansen (Weber State University), Ling Lei Lisic (Virginia Polytechnic Institute and State University), Timothy A. Seidel (Brigham Young University), and Michael S. Wilkins (University of Kansas) report the results of their study of the impact of audit committee member accounting or auditing expertise on the behavior of auditors.
This research applies the concept of “credence goods” to audit oversight. A credence good (or service) involves a situation in which (1) the seller is an expert who both recommends and provides a level of service to the buyer; (2) the buyer cannot assess how the service is delivered and must rely on the seller’s recommendation; and (3) the buyer cannot evaluate how well the service is performed. Auditing is a credence good because the outcome of an audit is unobservable, and the auditor determines how much effort to exert. The authors assert that this situation creates the risk of ‘‘strategic auditor behavior’’ – that is, that the auditor may expend either more effort (‘‘over-auditing”) or less effort (“under-auditing’’) than is necessary to provide the required level of assurance.
The authors hypothesize that “stronger audit committee oversight, operationalized as the presence of accounting expertise among audit committee members, should mitigate over- and under-auditing when information asymmetries are driven by accounting and auditing complexities.” This is because “audit committees with a better understanding of accounting issues and the proper nature, extent, and timing of audit procedures should be better able to ensure an appropriate alignment between audit effort and audit risk.” To test these propositions, the authors studied the level of audit effort in four situations:
A change in standards which reduces the level of audit effort necessary to audit a particular account (resulting in a risk of over-auditing if the auditor fails to reduce audit effort in response to the change in standards).
The identification and remediation of a material weakness in internal control (resulting in a risk of over-auditing because of auditor concern over increased PCAOB inspection scrutiny notwithstanding remediation of the material weakness).
A new engagement in high competition audit market (resulting in possible competitive pressure to under-audit).
A longer tenure engagement in a low competition market (resulting in a possible incentive to over-audit).
According to the abstract, the study results indicate that, when audit committees have accounting expertise, the risks of under- or over-auditing in these situations is mitigated. Specifically, when such expertise exists on the audit committee, clients “(1) pay lower fees when changes in standards decrease required audit effort; (2) pay a smaller fee premium in the presence of remediated material weaknesses; and (3) have a reduced likelihood of restatement when audit market competition is high.” The authors also note: “Our findings in the under-auditing setting generally are strongest among non-Big 4 engagements, consistent with non-Big 4 auditors being less sensitive to market-wide disciplining mechanisms such as reputation, legal liability, and professional regulation.”
As to the fourth situation (longer tenure/low competition), the researchers found that “although audit fees are higher when tenure is long in less competitive audit markets, audit committee accounting expertise attenuates these fee increases, consistent with the curtailment of over-auditing in these engagements.”
The research also looked at the type of audit committee expertise that impacted auditor behavior. The study found “evidence that the nature of audit committee members’ accounting expertise differentially impacts the committee’s ability to curtail over- and under-auditing.” Specifically, audit committee member expertise in accounting and auditing, as opposed to experience in supervising financial reporting, is a better predicter of the committee’s ability to reduce the likelihood of over- and under-auditing.
Impact of Audit Committee Chair Prior Service on the Committee
Linda A. Myers, Roy Schmardebeck, and Stefan Slavov, all of the University of Tennessee, Knoxville, examined whether a new audit committee chair provides more effective monitoring of the company’s financial reporting when the incoming chair served previously as a member of the company’s audit committee. They find that new audit committee chairs with firm-specific knowledge (as indicated by prior service on the audit committee) are better financial reporting monitors, relative to new chairs without such knowledge. Myer, Schmardebeck, and Slavov conclude: “[I]nternal successor AC chairs are associated with more effective monitoring during the succession period but the relative benefits of this firm-specific knowledge decay over time.”
Specific findings of this study include:
Companies are less likely to misstate their financial statements during the audit committee chair succession period when the chair is an internal successor. (The succession period is the first three years of a new chair’s tenure.) “This supports our hypothesis that the higher firm-specific knowledge of internal successors allows them to be more effective monitors during the succession period. In additional analyses, we also find that higher firm-specific knowledge of internal successors improves AC chair monitoring effectiveness related to core misstatements * * *, the propensity to meet or just beat earnings benchmarks * * *, and internal control quality * * *.”
Internal successors provide more effective monitoring of financial reporting processes, relative to external successors, in the first two years of the succession period. By the third year, the difference between internal and external chairs is not statistically significant. The authors suggest that, during the first two years of service, “external successors are able to accumulate sufficient firm-specific know-ledge such that their monitoring effectiveness is indistinguishable from that of internal successors.”
Internal successors are more effective monitors even when external successors have industry, accounting, or supervisory expertise. Further, prior experience as an audit committee chair at a different company does not compensate for a lack of firm-specific knowledge.
Internal successors with two years or more of prior audit committee service provide more effective monitoring; shorter periods of pre-appointment audit committee service do not yield similar benefits.
The authors conclude with this observation:
“Our results should be of interest to boards of directors, external auditors, and regulators, as well as other parties interested in the AC chair’s role in promoting financial reporting quality. First, boards should consider how their policies on committee chair succession planning impact AC monitoring, and whether a change in these policies could improve future financial reporting outcomes. Second, auditors should consider how AC chair renewal impacts financial reporting quality and whether firm policies and experience related to AC chair renewal necessitate modifications in their risk assessments and audit procedures. Finally, our findings can help to inform debates related to the disclosure of AC activities because they underscore the potential benefits of disclosure about a firm’s AC chair renewal and succession planning strategies.”
Comment: Boards may want to consider the implications of these research findings as they add new members to the audit committee and address audit committee chair succession planning. That individuals with accounting or audit experience can add value to the audit committee, and that there are clear benefits of having an audit committee chair who is already familiar with the company’s financial reporting processes, are not surprising conclusions. Many boards and nomination and governance committees probably already at least implicitly factor these considerations into their decision-making. The challenge is to harmonize those factors with other goals, such as constructing an audit committee that includes members with a mix of complementary skills and with diversity in backgrounds and viewpoints. See the “Enhancing Committee Composition” section of How Audit Committees Can Maximize Their Value, above.