Dec 13th 2013
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By Jason Bramwell, Staff Writer
Despite federal regulations instituted in the wake of corporate financial scandals like Enron and Worldcom that required audit committees to consist solely of independent directors, a substantial number of corporations have audit committees whose members have social ties to the CEO, according to new research that will be featured in the January/February 2014 issue of The Accounting Review, a journal of the American Accounting Association.
The study – The Audit Committee: Management Watchdog or Personal Friend of the CEO? – found that in a sample of nearly 2,000 US companies, 40 percent have audit committee members who have long-standing friendships with the business' top executive.
In particular, the study found that friendships involving voluntary, nonprofessional activities negatively impact corporate financial integrity, which fosters earnings manipulation, low levels of audit effort, concealment of financial distress, and cover-ups of internal-control weaknesses.
One of the authors of the study believes the US Securities and Exchange Commission (SEC) and regulators in Europe should consider mandating the publication of social ties between top executives and audit committee members.
"This should certainly be a priority for a group as essential to financial integrity as the audit committee, which typically consists of only three or four members," said Liesbeth Bruynseels, a professor from the University of Leuven in Belgium. Bruynseels coauthored the study with Eddy Cardinaels, a professor from Tilburg University in the Netherlands.
"As matters stand today, social data of the kind we used in the study is available only at a cost of thousands of dollars, well beyond the means of the average individual investor," Bruynseels added.
The two researchers obtained data on social ties from BoardEx, an international business intelligence service that offers in-depth profiles of 600,000 world business leaders, including relations among these executives.
Bruynseels and Cardinaels focused their research on the following three types of social ties between CEOs and audit committee members:
- Employment ties, whether involving service as directors of another company or prior employment at the same firm other than the one currently headed by the CEO.
- Educational ties, based on a CEO and audit committee member graduating from the same institution.
- Friendships stemming from voluntary or leisure activities, such as membership in the same charity or club.
According to the study, neither employment ties nor educational ties on their own resulted in a significant effect on company financial reporting. However, the strongest effect on financial reporting was derived from friendships nurtured by such elite organizations as the Chicago Club and Washington Roundtable, such sports and culture groups as the Augusta National Golf Club and Carnegie Hall Corporation, or such charities as Cleveland Tomorrow and the Annie E. Casey Foundation.
Specifically, the researchers found that such social ties are associated with the following:
- High levels of noncash items (discretionary accruals) in company financial statements – a sign of earnings manipulation.
- Low fees for external auditors – suggestive of low levels of audit effort.
- Lack of going concern opinions – a finding suggesting a reluctance of the audit committee to counter management pressures for clean opinions.
- Reduced likelihood that the external auditor will report material weaknesses in company mechanisms of internal control, and an enhanced likelihood that such weaknesses will be reported only belatedly.
Bruynseels and Cardinaels noted that CEOs who wish to control the quality of financial reporting may be more apt to draw audit committee members from their friendship network than from their advisory network.
"Friendship ties can lead to audit committee members who are less critical of the CEO's financial reporting policies and who are less likely to rock the boat during conflicts between management and the [company's external] auditor," the researchers wrote.
Bruynseels stated friendships between CEOs and members of audit committees make a significant difference to investors, and cited a new working paper by professors Arnie Wright and Ganesh Krishnamoorthy of Northeastern University, Jeffrey Cohen of Boston College, and Lisa Milici Gaynor of the University of South Florida.
Their paper outlines an experiment of 263 informed, nonprofessional investors who demonstrated the most preference for companies in which CEOs had no social or professional ties to audit committee members and the least preference for firms where social ties existed. In the experiment, the audit committee chair and another member of the committee were classmates with the CEO in graduate school and had stayed in social contact with each other on a regular basis during the fifteen years since graduation.
"Investors already sense the importance of such ties to the quality of companies' financial reporting," Bruynseels said. "It's time for regulators to catch up with investors by requiring this information to be more readily available than it is today."