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) 1 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 reporting 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. 2 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 3 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 4 of a company’s stakeholders. Examples of such actors include, but are not limited to, regulators, 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 corporation. 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 5 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. 6 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 grey 4 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. 7 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 8 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 studies, 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) 9 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 [...]... 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. .. 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... 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... 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... 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... 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 Auditor Selection and Client Acceptance With increased emphasis on the role of corporate boards and especially audit committees... 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,... 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... 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 . 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. 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. Journal of Accounting Literature (2004, pp. 8 7-1 52) 1 THE CORPORATE GOVERNANCE MOSAIC AND FINANCIAL REPORTING QUALITY INTRODUCTION One of the most important functions that corporate governance