Audit Committee s Propensity to Challenge Significant Accounting Estimates: The Joint Effects of Audit Report Content and Investor Type

Transcription

1 Audit Committee s Propensity to Challenge Significant Accounting Estimates: The Joint Effects of Audit Report Content and Investor Type Yoon Ju Kang Lehigh University

2 Outline Research Question Motivation Theory & Hypotheses Experimental Design Results Opportunity for Future Research & Contributions

3 Research Question General: What are the determinants of AC members scrutiny in the financial reporting and audit oversight process? Specific: How does the content of the auditor s report and investor type interact in affecting the AC members propensity to challenge management s significant accounting estimates?

4 Motivation AC s fiduciary duty Oversee the financial reporting and auditing process One way of fulfilling oversight duty Challenge the assumptions underlying management s critical financial judgments and estimates Important as it will affect the content of the financial statements provided to financial statement users. Failing to ask challenging questions may lead to substantial penalties (e.g., WorldCom case)

5 Motivation (cont d) Modification of the Auditor s Report Criticism on the current pass/fail reporting model Demand for more relevant information PCAOB Standing Advisory Group: Auditor Reporting Model Project (July, 2010) Academic research (e.g., Peecher et al., 2011) Not clear how greater disclosure will affect AC members who are an important part of the financial reporting supply chain and who ultimately may well be providers of the disclosed information along with auditors and management.

6 Motivation (cont d) AC members are accountable to the shareholders they represent. Have the duty to act on behalf of investors and other financial statement users. Not clear whether and to what extent the type of investors that comprise the firm s investor base influences AC members oversight process.

7 Theory & Development of Hypotheses While audit committee members owe shareholders a fiduciary duty, they also face complex accountability pressures (e.g., loss of position or being sued for failure to act in good faith). Ex ante, it is not clear whether AC s perceived risk of being held accountable for potential adverse financial statement outcomes or their internal sense of responsibility to protect shareholders is the more influential mechanism underlying their behavior.

8 Theory Two Perspectives of Accountability 1) Self-Serving Perspective Self-interest is the motivation underlying accountability. Asserts people develop different social and cognitive strategies for coping with accountability to obtain acceptance from, or avoid conflict with important interpersonal or institutional audiences (Tetlock et al., 1989) 2) Altruistic Perspective Altruistic reasons is what motivates accountability (i.e., internal sense of responsibility is the core motivation underlying accountability) Factors that trigger a greater sense of responsibility will increase the probability of providing help

9 Effect of Content of Auditor s Report Both accountability perspectives provide the same prediction Self-Serving Perspective Altruistic Perspective Greater disclosure in auditor s report Serve as token of defense against being culpable for negative outcomes Serve as substitute for due diligence Decrease perceived accountability towards firm s investors Decrease AC members perception of investors need for aid Lower propensity to challenge management s estimates

10 Effect of Investor Type Accountability perspectives offer different predictions Self-Serving Perspective Altruistic Perspective Greater investor sophistication Greater awareness of shareholder activism Decrease in perceived investor vulnerability Increase perceived accountability towards firm s investors Decrease AC members perception of investors need for aid Greater propensity to challenge mgt s estimates Lower propensity to challenge mgt s estimates

11 Joint effect of the content of auditor s report & investor type Accountability perspectives offer different predictions Self-Serving Perspective Altruistic Perspective More salient concern: behavior of sophisticated investors More salient concern: vulnerability of unsophisticated investors Effect of greater disclosure will likely be greater when primary shareholders are sophisticated Effect of greater disclosure will likely be greater when primary shareholders are unsophisticated

12 Joint effect of the content of auditor s report & investor type (cont d) Self-Serving Perspective (H1a) Propensity to Question Altruistic Perspective (H1b) Propensity to Question Disclosure_Low Disclosure_High Disclosure_Low Disclosure_High Unsophisticated Sophisticated Back to Results

13 Experimental Design Full factorial 2 x 2 between subject online experiment Content of auditor s report AC members propensity to challenge mgmt s estimates Investor type Presence vs. absence of additional disclosure Number of probing questions Primary shareholders are sophisticated vs. unsophisticated

14 Experimental Participants Seasoned professionals of which 90% hold AC experience Recruitment method: invitations via the alumni association of the college of business and professional networks

15 Experimental Procedure Read background information about the company (includes manipulation of investor type and content of auditor s report) Read summary of auditor s comm. about mgt s estimate regarding obsolete inventory Review I/S and B/S reflecting mgt s original and revised (more favorable) estimate View either standard auditor s report or new auditor s report with additional disclosures Complete Qs about treatment of the significant accounting estimate Develop Qs to ask management and/or auditors Complete follow-up Qs including manipulation checks Complete demographic Qs

16 Results Participants (n = 81) Avg. AC experience: 7.4 years 52.1% of those with AC experience are designated as financial experts Manipulation checks Investor type: Perceived sophistication: higher in sophisticated condition (1.56 vs , p < 0.01, one-tailed) Perceived vulnerability: lower in sophisticated condition (1.41 vs. 0.86, p = 0.02, one-tailed) Content of auditor s report: Extent to which auditor s report issued for the hypothetical firm alerts users of the significant accounting issue: higher (0.09 vs. -1.5) in the greater disclosure condition (p < 0.01, one-tailed)

17 Results (Test of Hypotheses) No. of Qs Sophistication_High Sophistication_Low Disclosure_Absent Disclosure_Present Prediction graph

18 Results (Test of Hypotheses) No. of Probing Qs Sophistication_High Sophistication_Low Disclosure_Absent Disclosure_Present

19 Results (Test of Hypotheses) Planned contrast coding Source df Mean Square F-Ratio p-value * Overall tests: Audit committee members' level of questioning is greatest when there is less disclosure and the primary shareholders are sophisticated, lower when there is less disclosure and the primary shareholders are unsophisticated, and lowest when there is greater disclosure <0.01 Contrast Weights (3, 1, -2, -2) * Reported p-values are onetailed equivalents. Results are consistent with prediction based on the self-serving perspective of Accountability (H1a). Suggests perceived accountability risk is the mechanism underlying AC members behaviors.

20 Supplemental Analysis (1) Effect of Designation as Financial Experts Designated financial experts: likely to perceive greater accountability (Paskell-Mede and Jackson, 1999; Rupley et al., 2001; Vera-Munoz, 2005) If perceived accountability is in fact what drives AC members behaviors, finding likely to be stronger for those designated as financial experts. Findings show further evidence in support of the self-serving perspective of accountability.

21 Designated Financial Experts (n = 38) Non-financial Experts (n = 43) No of Probing Qs No of Probing Qs Disclosure_Absent Disclosure_Present Disclosure_Absent Disclosure_Present Unsophisticated Sophisticated

22 Planned Contrast Coding Source df Mean Square F-Ratio p-value * Financial Experts Overall tests: Audit committee members' level of questioning is greatest when there is less disclosure and the primary shareholders are sophisticated, lower when there is less disclosure and the primary shareholders are unsophisticated, and lowest when there is greater disclosure. Contrast Weights (3, 1, -2, -2) <0.01 Non-Experts Overall tests: Audit committee members' level of questioning is greatest when there is less disclosure and the primary shareholders are sophisticated, lower when there is less disclosure and the primary shareholders are unsophisticated, and lowest when there is greater disclosure Contrast Weights (3, 1, -2, -2) * Reported p-values are one-tailed equivalents.

23 Supplemental Analysis (2) Mediation Effect of Perceived Comfort on Financial Experts Perceived accountability risk is likely to be negatively associated with AC members comfort regarding the accounting issue at hand Greater accountability risk >> Lower comfort level >> Greater need to obtain justification >> Increase in propensity to question. Mediation analysis results show that greater disclosure in audit report increases AC s overall comfort level, ultimately resulting in decreased questioning behavior.

24 Supplemental Analysis (3) AC Members Self-Insight into Decision Processes Correctly believe they will increase level of questioning with increase in investor sophistication. (mean = 0.12, p = 0.02, one-tailed) Incorrectly believe they will increase level of questioning with greater disclosure in auditor s report (mean = 1.24, p < 0.01, one-tailed)

25 Implication of Findings Contrary to what regulators appear to believe, greater disclosure may lead to unintended consequences of decreased AC effectiveness & investors may not benefit from greater disclosure Sophisticated investors have positive upstream influence on judgment processes of AC members.

26 Potential for Future Research Effect of changes in the auditor s report as part of a portfolio of other policies Effect of greater disclosure in the auditor s report on other members of the financial reporting supply chain (e.g., auditors and financial statement users) Effect of different composition of investor type Ex: presence of one big institutional investors where primary shareholders are unsophisticated Effect of group dynamics among several audit committee members

27 Main Contributions Enhances our understanding on the determinants of AC members propensity to challenge management s estimates Provides evidence that perceived accountability risk is the underlying mechanism. Provide ex ante evidence of possible policy resistance to greater disclosure in the auditor s report in terms of decreased AC effectiveness. Add to the expertise and corporate governance literature by demonstrating that designated financial experts have a greater capacity to challenge management s estimates, but that a potentially troubling boundary condition is when the firm s primary shareholders are unsophisticated investors.

28 Thank You!!!