Examining Corporate Governance Research: Any Consistencies with Calls for Reform?

Mark S. Beasley
Assistant Professor, North Carolina State University

The financial press continues to highlight the importance of the board of directors and audit committee in ensuring effective corporate governance (e.g., Fortune August 2, 1999). In many cases, the effectiveness of the board and audit committee in detecting corporate improprieties, including financial statement fraud, is being called into question. For example, an article in the Wall Street Journal (July 17, 1998, pp. B1, B5) accuses audit committees as being “toothless tigers.” Public concerns about the effectiveness of board and audit committee governance, particularly concerns expressed by representatives of the Securities and Exchange Commission (SEC), led to the 1998 creation of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (the Blue Ribbon Panel). The Blue Ribbon Panel’s February 1999 report contains ten recommendations calling for changes in audit committee governance, which are currently under evaluation by the New York Stock Exchange and the National Association of Securities Dealers (BRC Report 1999). Furthermore, another series of recommendations for audit committee reform is expected this fall from the National Association of Corporate Directors’ Blue Ribbon Commission on Audit Committees. Clearly, the roles of the board and audit committee as corporate governance mechanisms are under scrutiny.

Researchers are actively examining the roles of boards of directors and audit committees in corporate oversight. Earlier research in economics, finance, and management documents much of the debate supporting many of the current calls for stronger board oversight, which has been expanded in accounting research to address the role of board and audit committee governance over financial reporting.

My objectives in this essay are to review many of the contributions of this stream of research, particularly that in accounting, to emphasize how that research provides empirical validation of many of the current recommendations for board and audit committee reform currently under consideration. Ultimately, a goal of this essay is to raise the visibility of these research findings to benefit practitioners and others in the business community who are affected by or responsible for board and audit committee governance. Another goal of this essay is to spawn future research that can provide further insight into the need for additional changes in board and audit committee oversight.

Does Board of Director Monitoring Benefit Stockholders?
Research in finance and economics argues that the board of directors serves as an important corporate governance mechanism when stockholders are unable to monitor management on a day-to-day basis. These studies note that stockholders delegate the day-to-day monitoring of top management to boards, given that stockholders generally cannot cost-effectively devote resources on an individual basis to ensure that management is acting in the stockholders’ best interest. That delegation of responsibility makes the board of directors, both in theory and in practice, the top internal control mechanism within today’s corporation.

Much of the debate documented in earlier research about boards notes that the viability of the board as the top internal control mechanism is directly affected by the extent that outside (i.e., non-management) directors are represented on the board. Outside directors serve as effective monitors of top management, given that their concern about exposure to legal liability and their desire to develop reputations as being top-quality directors provide strong incentives for outsiders to closely scrutinize management on the behalf of stockholders.

Numerous research studies in the economics, finance, and management disciplines confirm the importance of board of director composition in improving the board’s effectiveness during key events affecting the corporation. For example, research shows that stockholders receive higher returns during management buyouts when their boards are dominated by outsiders; management salaries are less likely to be excessive when there are more outside directors on the board; and poorly performing corporations are more likely to see changes in chief executive officer positions when boards are composed of greater percentages of outside directors. These studies, among others, collectively confirm that boards do play an important role in corporate oversight, and that role is affected by the extent of board objectivity and independence from top management.

What’s the Relation Between the Board and Financial Reporting?
Current auditing professional standards adopt the view that the board plays an important role in monitoring the financial reporting process. Guidance on internal control contained in SAS No. 55 (as amended by SAS No. 78) identifies the board as a critical component of an entity’s control environment, responsible for establishing the control consciousness of the organization. Other standards require that auditors communicate certain matters to the board or its audit committee. Recent changes in auditing professional standards related to the auditor’s responsibility to detect material misstatements due to fraud (i.e., SAS No. 82) emphasize the importance of considering the role of the board in an entity’s internal governance when assessing the risk that material misstatements due to fraud may be present.

Research about financial statement fraud confirms the importance of considering an entity’s control environment, which includes the board of directors, when assessing the risk of financial statement fraud. That research finds that boards of firms committing material financial statement fraud are significantly more likely to have smaller percentages of outside non-management directors on the board than no-fraud firms. And, fraud firms are significantly less likely to segregate CEO and Chairman of the Board duties, thereby granting greater power to the one executive who serves in both capacities (Beasley, 1996; DeChow, et al. 1996). More recent descriptive research about companies committing financial statement fraud continues to note that boards of fraud companies are dominated by management or other directors who are closely affiliated with top management (see COSO, 1999). These studies confirm views held by many in practice that assessments of the likelihood of financial statement fraud should include consideration of board composition and independence, among other factors.

What’s the Role of the Audit Committee?
While consideration of the board’s independence is important, often the board of directors delegates responsibility for oversight of the financial reporting process to an audit committee. Accounting regulators and standards setters often emphasize the importance of the audit committee in the oversight of financial reporting. For example, the National Commission on Fraudulent Financial Reporting (the “Treadway Commission”) and the AICPA’s Public Oversight Board have confirmed the importance of audit committees in the financial reporting process by issuing calls for newer efforts to strengthen the audit committee’s role (NCFFR 1987, AICPA POB 1993).

Several empirical studies in accounting have focused on the voluntary formation of audit committees to identify factors affecting an entity’s decision to create an audit committee directly responsible for overseeing the financial reporting process (see Pincus et al., 1989 for example). Collectively these studies suggest that larger companies, who are audited by the Big 8 (now Big 5) and who have bigger boards with greater representation of outside directors, are among the companies more likely to voluntarily form an audit committee.

Some of these studies were able to examine voluntary formations of audit committees because the major U.S. exchanges—the New York Stock Exchange, the American Stock Exchange, and the National Association of Securities Automated Quotation System (NASDAQ)—have not always had requirements for audit committees. While the NYSE requirements have been in effect since 1978, the audit committee requirements for registrants of the NASDAQ National Market were not instituted until 1987, and the requirements for registrants of the NASDAQ Small Cap Market were not instituted until 1998. The evolution of these listing requirements reflects the views of exchange officials that audit committees must serve an important role in the financial reporting process.

Recent accounting research provides some evidence confirming this view. Several studies document that the presence of an audit committee is associated with fewer incidences of financial reporting problems. For example, McMullen (1996) finds that entities with more reliable financial reporting (e.g., those absent material errors, irregularities, and illegal acts) are significantly more likely to have audit committees, and DeChow et al. (1996) show that firms subject to SEC enforcement actions are less likely to have standing audit committees. More recent descriptive research shows that 25 percent of the companies subject to SEC enforcement actions do not have audit committees in place (COSO 1999). These findings collectively suggest that audit committees can have a substantive impact on the quality of the financial reporting process.

Does Audit Committee Independence Matter?
All three major U.S. exchanges address the importance of audit committee composition in their listing requirements. The NYSE requires (and the AMEX recommends) that listed companies have audit committees made up entirely of outside directors. NASDAQ only requires that a majority of the audit committee consist of outside directors for companies trading on the National and Small Cap Markets. Additionally, the Federal Deposit Insurance Corporation implemented new audit committee composition requirements in 1993 mandating the inclusion of independent directors. While these requirements emphasize the importance of having outside directors on the audit committee, they generally leave discretion to the board of directors for selecting who can serve as outside directors on the audit committee.

Such discretion may not always lead to independent audit committees given that merely classifying management and non-management members of the audit committee into insider and outsider director categories, respectively, may not be sufficient. Rather, outside directors should be classified further into one of two categories: independent directors and “grey” directors. An independent director is an outside director who has no other affiliation with top management other than the affiliation from being a director. In contrast, grey directors are outside directors who have some non-board affiliation with the company where they serve as director. Common examples of grey director affiliations include directors who are relatives of top management, former employees of the company, and key customers and suppliers of the company, to name a few.

Research shows that 74 percent of the NYSE firms examined have at least one grey director on the audit committee (Vicknair et al. (1993). Recent descriptive research finds that companies committing financial statement fraud often have audit committees with insiders and grey directors comprising about one-third of the membership on the audit committee (COSO 1999).

These findings highlight the importance of delving further into the relationships that might exist between the company and non-management directors serving on the audit committee as outside directors. Merely excluding managers from service on the audit committee may be insufficient to ensure quality financial reporting.

Current research in accounting is examining the relation between audit committee composition and auditor reporting. Carcello and Neal (1999) find that the likelihood a company in financial distress will receive a going concern modified auditor’s report is lower when the percentage of inside or grey directors on the audit committee is higher. These findings suggest that the independence of the audit committee may affect the objectivity and independence of the external auditor.

Academic research and reports in the business press have helped raise the visibility of audit committee members’ independence from top management. In March 1999, the Blue Ribbon Panel recommended that the NYSE and NASD adopt the following definition of independence for purposes of serving on audit committees for listed companies: “Members of the audit committee shall be considered independent if they have no relationship to the corporation that may interfere with the exercise of their independence from management and the corporation” (see Recommendation 1 in the BRC Report 1999).¹ Specific examples of such relationships identified in the BRC Report 1999 would eliminate inside directors and many grey directors from serving on audit committees. In addition to complying with this definition, the Blue Ribbon Panel is also recommending that the NYSE and NASD require listed companies to “have an audit committee comprised solely of independent directors” (see Recommendation 2 in the BRC Report 1999). These changes suggest that U.S. securities markets are moving in a direction consistent with empirical findings documented in corporate governance research. Such research appears to be contributing to these debates.

Are Audit Committees Knowledgeable in Financial Reporting?
Not only does the composition of the audit committee appear to have an impact, but the audit committee’s effectiveness can also be restricted by audit committee member knowledge and experience in financial reporting matters. The BRC Report (1999) notes that “while all members of the audit committee must have the ability to ask probing questions about a corporation’s financial risks and accounting…a director’s ability to ask and intelligently evaluate the answers to such questions…hinges on intelligence, diligence, a probing mind, and a certain basic ‘financial literacy’” (p 25). As a result, the Blue Ribbon Panel recommends that the NYSE and NASD require listed companies to “have an audit committee comprised of a minimum of three directors, each of whom is financially literate” (see Recommendation 3 of the BRC Report 1999). In addition, the BRC panel further recommends “that at least one member of the audit committee have accounting or related financial management expertise” (see Recommendation 3).

Research in accounting is beginning to examine the role of audit committee knowledge and experience in financial reporting matters. These studies support the Blue Ribbon Panel’s call for greater financial literacy among those serving on audit committees. For example, descriptive research finds that most (65 percent) of the audit committee members of fraud companies subject to SEC enforcement actions had no apparent work experience in finance or accounting (COSO 1999). Current empirical research about Canadian companies finds that those companies having higher percentages of outside audit committee members with relevant financial reporting and audit committee knowledge and experience tend to be larger, have higher levels of managerial ownership in the company, and have larger boards composed of greater percentages of outside directors than companies with lower proportions of outside audit committee members with such knowledge and experience. More research, however, is needed to further understand the nature and extent of financial reporting knowledge and experience necessary to contribute to effective audit committee governance.

Conclusion
Discussions in the general business press and evidence documented by research have raised the visibility of issues impacting board and audit committee effectiveness. That visibility has helped fuel the debate ultimately leading to changes in board and audit committee structure in the last decade, including those proposed changes most recently noted in the BRC Report (1999). The issues are far from resolution, and there is much to learn. For example, little is known empirically about audit committee processes, such as the content of information audit committees receive, the substance of discussions between audit committees and management, internal auditors, and external auditors, and dynamics among members serving on the audit committee. These, and other issues, call for research to help contribute to the debate.

References

American Institute of Certified Public Accountants (AICPA) Public Oversight Board (POB). 1993. In the Public Interest: Issues Confronting the Accounting Profession. Stamford, CT: Public Oversight Board.

Beasley, M.S. 1996. An empirical analysis of the relation between board of director composition and financial statement fraud. The Accounting Review 71 (October): 443-465.

Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (BRC Report). 1999. Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees. New York, NY: NYSE and NASD.

Carcello, J.V. and T.L. Neal. 1999. Audit committee characteristics and auditor reporting. Working paper. The University of Tennessee.

Committee of Sponsoring Organizations of the Treadway Commission (COSO). 1999. Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies, by Mark S. Beasley, Joe V. Carcello, and Dana R. Hermanson. New York: COSO.

Dechow, P.M., R.G. Sloan, and A.P. Sweeney. 1996. Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research 13 (Spring): 1-36.

Fortune. 1999. Put bite into audit committees (August 2): 90.

McMullen, D.A. 1996. Audit committee performance: An investigation of the consequences associated with audit committees. Auditing: A Journal of Practice and Theory 15 (Spring): 87-103.

National Commission on Fraudulent Financial Reporting (NCFFR). 1987. Report of the National Commission on Fraudulent Financial Reporting. New York: AICPA.

Pincus, K., M. Rusbarsky, and J. Wong. 1989. Voluntary formation of audit committees among NASDAQ firms. Journal of Accounting and Public Policy. Vol. 8: 239-265.

Vicknair, D., K. Hickman, and K.C. Carnes. 1993 A note on audit committee independence: Evidence from the NYSE on “grey” area directors. Accounting Horizons 7 (March): 53-57.

¹ The report can be viewed on-line at www.nyse.com or www.nasd.com.

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