The informational role of CEOs at audit committee meetings

Transcription

1 The informational role of CEOs at audit committee meetings Joseph Johnston City University of Hong Kong John Nowland* Illinois State University Abstract: Regulators are advising firms to exclude CEOs from their audit committees, based on concerns that CEOs will exert undue influence over audit committee outcomes. However, CEOs also have unique knowledge about the firm and may be a valuable informational asset to audit committees. In this study, we use disclosures of CEO attendance-by-invitation at audit committee meetings to separate CEO involvement on audit committees into two aspects power and informational. We find that the informational aspect is associated with strong governance and is negatively related to earnings opacity, consistent with CEOs providing useful accounting-related information to audit committees. Hence, this study identifies significant benefits from allowing CEOs to act as informal advisors at audit committee meetings. Keywords: accounting quality, attendance-by-invitation, audit committee, CEO, informational role. * Corresponding author. Department of Accounting, Illinois State University, Normal, IL. jenowla@ilstu.edu. Thanks to Chris Lee for his help with data collection. 1

2 1. Introduction There is widespread belief that audit committees which are independent from firm management are more effective in overseeing the quality of a firm s financial reporting. For example, the Sarbanes-Oxley Act in the United States and Australia s Corporate Governance Principles and Recommendations require that audit committees are comprised solely of independent or nonexecutive directors. 1 These policies are based on the view that CEO involvement in audit committee matters is dominated by agency concerns CEOs exerting their influence over audit committee outcomes to further their own self-interest. Consistent with these expectations, academic research finds that firm accounting quality is higher when audit committees are comprised of independent directors, directors without social ties to the CEO and when the CEO is not involved in the selection of audit committee members (Klein, 2002b; Carcello et al., 2011; Bruynseels and Cardinaels, 2014). However, there are indications from several countries that firms are circumventing these requirements by informally inviting their CEOs to audit committee meetings. For example, annual reports of Fairfax Media Ltd from 2001 to 2014 state that their CEO attends audit and risk committee meetings as an invitee of the committee. Centrex Metals Ltd state in their 2007 annual report that board policy is that the audit and risk management committee will comprise of all non-executive board members and the managing director will attend by invitation. In addition, the United Kingdom s Corporate Governance Code states that no one other than the committee chairman and members is entitled to be present at a meeting of the nomination, audit or remuneration committee, but others may attend at the invitation of the committee (FRC, 2012, Section B.1, pg 11). 1 Similar guidance also exists in Belgium, Canada, Finland, France, Italy, Luxembourg, New Zealand, Pakistan, Russia, Singapore, South Africa, Switzerland and the United Kingdom. See corporate governance codes available at: 2

3 We propose that audit committees invite CEOs to informally attend their meetings because they receive the benefits of enhanced information exchange about accounting-related issues with the CEO, without the agency costs of formal CEO membership on the committee. Since the financial reporting process can be complex, audit committee members can potentially benefit from CEOs providing additional information about the firm s current and future operating environment and further explanations of particular accounting estimates. Thus, firms that have a mechanism for CEOs to informally attend audit committee meetings and provide this information to its members are likely to have higher quality financial reporting. In essence, this phenomenon of CEO attendance-by-invitation at audit committee meetings allows us to separate CEO involvement on audit committees into two aspects power and informational. Power refers to the agency costs of CEO influence over audit committee outcomes, as documented by prior studies. Informational refers to the potential benefits from enhanced information exchange between CEOs and audit committee members. Prior studies have only been able to test for differences between firms with CEOs on audit committees relative to firms without CEOs on audit committees, which provides a mixed measure of the two aspects (see Figure 1). We use disclosures of CEO attendance-by-invitation at audit committee meetings to identify the two separate aspects of CEO involvement on audit committees. The Power aspect of CEO involvement on audit committees is measured as the difference between CEOs holding formal membership of audit committees and CEOs invited to informally attend audit committee meetings. CEOs holding formal membership of audit committees have the ability to formally influence audit committee matters (Power) and the ability to provide information to the audit committee (Informational). CEOs invited to informally attend audit committee meetings have the ability to provide information at audit 3

4 committee meetings (Informational) but have no formal power to influence audit committee matters. Thus, the difference between the two is a clean measure of the Power aspect. The Informational aspect is measured as the difference between CEOs invited to informally attend audit committee meetings and CEOs not involved in audit committee meetings at all. CEOs invited to informally attend audit committee meetings have the ability to provide information at audit committee meetings (Informational) but have no formal power to influence audit committee matters. When CEOs are not involved in audit committee meetings at all, they do not have the ability to provide information and do not have any influence over audit committee matters. Therefore, the difference between the two is a clean measure of the Informational aspect. In our analysis, we examine firm factors related to the two aspects of CEO involvement on audit committees and how these two aspects are related to the accounting quality of firms. We hypothesize that strong CEO influence and weak governance are associated with the Power aspect of CEO involvement on audit committees, while firm complexity, firm uncertainty and strong governance are associated with the Informational aspect of CEO involvement on audit committees. Based on prior studies, we expect the Power aspect of CEO involvement on audit committees to be positively related to earnings opacity. However, we expect the Informational aspect of CEO involvement on audit committees to be negatively associated with earnings opacity, consistent with CEOs providing useful accounting-related information to audit committees. Using a sample of Australian firms, which disclose CEO attendance, CEO attendanceby-invitation and CEO non-attendance at audit committee meetings, during the period , we find that the Power aspect of CEO involvement on audit committees is associated with weak governance and is positively related to earnings opacity. The Informational aspect of CEO involvement on audit committees is associated with strong governance and firm 4

5 complexity, and is negatively related to earnings opacity. Furthermore, we find that the effect of the Informational aspect is stronger for firms operating in more uncertain conditions, where information exchange between CEOs and audit committees is likely to be more beneficial. This paper contributes to the corporate governance literature as we are the first to separate and cleanly measure the two aspects of CEO involvement on audit committees power and informational. In doing so, this study shows that firms and their shareholders can benefit from allowing CEOs to act as informal advisors at audit committee meetings. This improves the information exchange between CEOs and audit committees and is associated with reduced earnings opacity. We also extend the literature on audit committee composition, by showing that informal members of committees can also have an influence on committee outcomes. 2. Literature Review and Hypothesis Development 2.1 Power aspect of CEO involvement on audit committees The CEO power literature originates with agency theory provided by Jensen and Meckling (1976), who suggest that CEOs may exercise their own self-interest, to the detriment of shareholders. Subsequent studies have examined the issue of CEO power from two dimensions. The first area has investigated the adverse outcomes from CEOs wielding their power. For example, Shivdasani and Yermack (1999) show that CEO involvement in the selection of new board members results in the appointment of fewer independent directors and more gray directors with potential conflicts of interest. The second area has investigated the effectiveness of corporate governance mechanisms, such as the board of directors, in offsetting the power of the CEO (Fama and Jensen, 1983). In the context of audit committees, this second area of the literature has been the far more popular, with the focus on establishing audit committees that are independent from the influence of CEOs. 5

6 Audit committees play a specific role in monitoring management. An audit committee that is independent from management is expected to be more effective in overseeing the financial reporting process, particularly in combatting inappropriate earnings management distorting the true financial performance of companies (Levitt, 1998). Following this logic, in 1999 both the NYSE and Nasdaq required companies to maintain audit committees of at least three directors, all of whom have no relationship to the company (Klein, 2002a). Klein (2002b) examines the effects of these new audit committee standards and finds a negative relationship between audit committee independence and abnormal accruals. She states that these results indicate that boards structured to be more independent of the CEO are more effective in monitoring the corporate financial accounting process. Subsequent studies confirm that audit committee independence is associated with reduced earnings management (Bedard et al., 2004; Vafeas, 2005) and the appointment of higher quality audit firms (Abbott and Parker, 2000; Chen et al., 2005). In other countries, such as Australia, similar results are found. Davidson et al. (2005) find that audit committees with a majority of non-executive directors are associated with a lower likelihood of earnings management. Kent et al. (2010) find that a more independent audit committee is associated with higher discretionary and innate accruals quality. More recent work has also examined indirect influences of the CEO on the audit committee. Carcello et al. (2011) investigate CEO involvement in the director selection process and find that the monitoring benefits of audit committee independence are found only when the CEO is not formally involved in selecting board members. Bruynseels and Cardinaels (2014) examine social ties between CEOs and audit committee members and find that these social ties have a negative effect on measurable audit committee outcomes. Thus, there is substantial evidence in the academic literature that audit committees which are independent from firm management are more effective in overseeing the quality of a firm s financial reporting. 6

7 In our context, we examine the involvement of the CEO in audit committee matters, rather than the independence of the audit committee from firm management. The Power aspect of CEO involvement on audit committees represents the agency costs of CEO influence on audit committee outcomes. For example, through formal membership of the audit committee the CEO can exert influence to have financial reports approved that may include a number of opportunistic accounting estimates, which inflate reported income to the personal benefit of the CEO. These types of agency costs are most likely to be present in firms with powerful CEOs and weak governance practices. Using disclosures of CEO attendance, CEO attendance-by-invitation and CEO nonattendance at audit committee meetings, we identify the Power aspect of CEO involvement on audit committees as the difference between formal CEO membership on the audit committee and CEO attendance at audit committee meetings by invitation. We expect strong CEO influence and weak governance practices to be associated with the Power aspect of CEO involvement on audit committees. CEOs that are more entrenched in their firms, e.g. CEO- Chairman duality, longer CEO tenure and higher CEO ownership, are more likely to have the power to obtain a formal position on the audit committee and exert significant influence over audit committee outcomes. Similarly, CEOs are more likely to be able to exert their influence on the audit committee when firm governance practices are weak, e.g. less independent and diligent boards and audit committees. Thus, our first set of hypotheses are: Hypothesis 1a: CEO influence is positively related to the Power aspect of CEO involvement on audit committees. Hypothesis 1b: Corporate governance is negatively related to the Power aspect of CEO involvement on audit committees. 7

8 Consistent with prior studies, we expect the Power aspect of CEO involvement on audit committees to be associated with lower accounting quality. Numerous studies have documented the benefits of more independent audit committees, e.g. higher accounting quality (Bedard et al., 2004; Vafeas, 2005). If CEOs are formal members of the audit committee, the audit committee is less independent, and accounting quality is expected to be lower. Formal membership of the audit committee allows the CEO to exert direct influence over audit committee matters, including the power to set and vote on audit committee agenda items. This gives the CEO opportunity to pursue actions in their own self-interest, such as inflating reported income for their own personal benefit. As we use earnings opacity as our measure of accounting quality and it is an inverse measure of accounting quality, our second hypothesis is: Hypothesis 2: The Power aspect of CEO involvement on audit committees is positively related to earnings opacity. 2.2 Informational aspect of CEO involvement on audit committees Prior literature has shown that accounting, finance and industry expertise on the audit committee are associated with higher earnings quality. For example, Xie et al. (2003) and Bedard et al. (2004) find that firms with business experts, broadly defined, on their audit committees tend to have lower magnitudes of abnormal accruals. Highlighting the importance of accounting expertise, Krishnan and Visvanathan (2008) find that firms with accounting financial experts have more conservative financial reports relative to non-accounting financial experts or non-financial experts. Examining directors industry experience, Cohen et al. (2014) find that firms with directors who have accounting expertise and industry experience have better reporting quality than those with directors who have just accounting expertise. The argument for this relationship between audit committee expertise and earnings quality is that greater accounting, finance and industry expertise improves the effectiveness of 8

9 the audit committee in monitoring the financial reporting process. Cohen et al. (2014) explains this in more detail by stating that financial statements include a number of estimates that reflect the complexities of a company s business environment, including warranty obligations, revenue recognition practices, accounting for construction contracts, valuation of assets and impairment of intangible assets. Audit committee members with more knowledge and experience in these accounting issues are likely to oversee better quality financial reporting outcomes. In this study, we highlight the exchange of information between CEOs and audit committee members, and propose that greater information exchange will have a similar effect to audit committee expertise in improving the financial reporting quality of firms. In particular, firms that allow their CEOs to attend audit committee meetings provide an opportunity for greater information exchange between the CEO and audit committee members. 2 This exchange of information is expected to produce higher quality accounting information in a number of ways. First, greater information exchange is expected to increase the effectiveness of monitoring by the audit committee. Adams and Ferreira (2007) state that directors largely rely on the CEO and the company s management for information and show that greater information exchange between the CEO and the board of directors leads to more intense monitoring (and better quality advice). For example, if the CEO provides an opportunistic accounting estimate, e.g. accelerated revenue recognition, greater information exchange between the CEO and the audit committee increases the chance that this opportunistic estimate will be identified and questioned by the audit committee, particularly in firms with strong governance practices. The 2 It is possible that CEOs not on audit committees are asked to provide information to audit committee members outside of meetings or CEOs meet with audit committee members outside of meetings. This is not disclosed in annual reports, but only works against us finding any significant results. 9

10 result is a less opportunistic (more accurate) estimate, which improves the quality of financial reporting. Second, greater information exchange between CEOs and audit committees is expected to improve the understanding of audit committee members and the decision making of the audit committee. In large and complex firms, in particular, audit committees may request CEOs to provide further information about firm operations and a range of accounting choices. For example, the consolidation of foreign subsidiaries, classification of leases, recognition of offbalance-sheet items, depreciation choices on capital expenditure, recurring versus discontinued operations, capitalization of research and development costs, and so on. Greater information exchange is expected to result in better quality information being available to audit committee members, which improves the decision making of the audit committee and results in better audit committee outcomes. Third, greater information exchange also provides the CEO with an opportunity to adjust the potentially incorrect beliefs of the audit committee. During periods of economic uncertainty, such as downturns in sales, the audit committee may question the accounting estimates provided by the CEO, e.g. inventory valuation and the collectability of accounts receivable. If the estimates are correct, as the CEO has superior information to the audit committee, greater exchange of information provides the CEO with the opportunity to provide additional information to audit committee members to justify the correctness of the estimates. Thus, more accurate estimates are used in the financial reporting process. We identify the Informational aspect of CEO involvement on audit committees as the difference between CEO attendance-by-invitation at audit committee meetings and CEO nonattendance at audit committee meetings. We expect firm complexity, firm uncertainty and strong governance to be associated with the Informational aspect of CEO involvement on audit committees. The greater the complexity of the firm, e.g. firm scope or number of segments and 10

11 subsidiaries, the more likely the audit committee will request additional information from the CEO to improve their decision making. The more uncertain the operating environment of the firm, e.g. high sales variability or low firm profitability, the more likely the audit committee will seek further information exchange with the CEO on accounting-related matters. We also expect the directors of firms with stronger governance practices to be more willing to question and exchange information with the CEO on accounting issues. Therefore, our third set of hypotheses are: Hypothesis 3a: Firm complexity is positively related to the Informational aspect of CEO involvement on audit committees. Hypothesis 3b: Firm uncertainty is positively related to the Informational aspect of CEO involvement on audit committees. Hypothesis 3c: Corporate governance is positively related to the Informational aspect of CEO involvement on audit committees. We also propose that the Informational aspect of CEO involvement on audit committees is associated with higher accounting quality. Allowing the CEO to informally attend audit committee meetings, increases the information exchange between the CEO and audit committee members, without the agency issues of formal CEO membership on the committee. As previously highlighted, greater information exchange between CEOs and audit committees is expected to increase the effectiveness of monitoring by the audit committee and improve the decision making of the audit committee, resulting in higher quality financial reporting outcomes. Thus, our fourth hypothesis is: Hypothesis 4: The Information aspect of CEO involvement on audit committees is negatively related to earnings opacity. 11

12 3. Research Design To test Hypotheses 1 and 3 we use Logit models to relate corporate governance (board of director and audit committee variables), CEO influence, firm complexity and firm uncertainty to the two aspects of CEO involvement on audit committees power and informational. Power i,t = α + Board of Director i,t + Audit Committee i,t + CEO Influence i,t + Firm Complexity i,t + Firm Uncertainty i,t + Year t + ε i,t (1) Informational i,t = α + Board of Director i,t + Audit Committee i,t + CEO Influence i,t + Firm Complexity i,t + Firm Uncertainty i,t + Year t + ε i,t (2) where Power is equal to one for firms with CEOs who are formal members of their audit committees; Informational is equal to minus one for firms whose CEOs are not on their audit committees 3 ; Board of Director variables include: Board Size is the total number of directors on the board, Board Independence is the proportion of independent directors on the board, Female Board Members is the proportion of female directors on the board, Board Meetings is the number of board meetings held during the year; Audit Committee variables include: AC Size is the number of directors on the audit committee, AC Independence is the proportion of independent directors on the audit committee, AC Expertise is the proportion of directors on the audit committee with financial expertise, AC Meetings is the number of audit committee meetings held during the year; CEO Influence variables include: CEO Chair is a dummy variable that equals one if the CEO is also the Chairman of the Board, CEO Tenure is the number of years the CEO has been employed by the company, CEO Ownership is the ratio of the number of shares of the firm held by the CEO relative to the number of shares held by directors; Firm Complexity variables include: Ln(Size) is the natural logarithm of total assets in billions of dollars, Subsidiaries is the number of subsidiaries, Segments in the sum of the 3 This makes CEO attendance-by-invitation at audit committee meetings our base for both the power and informational dummy variables, but keeps CEO attendance-by-invitation as the positive side of the difference with CEOs not on audit committees. 12

13 number of operating and geographic segments, Debt is total liabilities divided by total assets; Firm Uncertainty variables include: Std(Sales) is the standard deviation of sales over the past 5 years, Loss is a dummy variable equal to one if the firm made a loss, Price-book is the market value of equity divided by the book value of equity, ROA is the firm's return on assets; and Year are fixed year effects. For testing of Hypotheses 2 and 4, we relate the two aspects of CEO involvement on audit committees power and informational to various measures of earnings opacity, while controlling for other documented factors that influence accounting quality. Model 3 is: Opacity i,t = α + Power i,t + Informational i,t + Board of Director i,t + Audit Committee i,t + CEO Influence i,t + Firm Complexity i,t + Firm Uncertainty i,t + Auditor i,t + Year t + ε i,t (3) where Earnings Opacity is measured by: Abs(DA) is accruals estimation error measured using the absolute values of abnormal accruals from the Modified Jones Model (Dechow et al. 1995; Hutton et al., 2009), SUMDA is the sum of abnormal accruals for year t, t+1, and t+2 (Hutton et al., 2009), AQ is accruals estimation error measured using the Dechow-Dichev model; 4 (Dechow and Dichev, 2002; Francis et al., 2005) and Auditor variables include: Big4 is a dummy variable equal to one for firms with Big4 auditors, Ln(Audit fees) is the natural logarithm of audit fees in millions of dollars. According to Hypothesis 1, we expect positive coefficients on the CEO Influence variables and negative coefficients on the Board of Director and Audit Committee variables in Model 1. Hypothesis 3 predicts positive coefficients on the Board of Director, Audit Committee, Firm Complexity and Firm Uncertainty variables in Model 2. Hypothesis 2 predicts a positive coefficient on Power and Hypothesis 4 predicts a negative coefficient on Informational in 4 For AQ, we use the Dechow-Dichev model as implemented by Francis et al. (2005) which uses the standard deviation of the residual from the regression of accruals on current, future and past cash flows, change in revenues, and gross PPE over the previous 5 years to measure accruals estimation error. As an alternative specification, we use the standard deviation of the residual for the future 5 years and our results remain qualitative similar, though there is a substantial reduction in sample size due to attrition. 13

14 Model Sample We use a sample of Australian Stock Exchange (ASX) listed firms, as these are the only firms in the world that disclose the official attendance and unofficial attendance-by-invitation of directors at committee meetings. Information on whether CEOs sit on the audit committee, are invited to audit committee meetings or are not on the audit committee is found in the disclosed attendance data in the Director s Report or Corporate Governance sections of annual reports. Firms are included in our sample if they meet the following conditions: (1) Annual reports available from the Annual Report Database from Connect4 to allow the hand-collection of data on director independence, director expertise, director ownership, board meetings, audit committee size, audit committee meetings, CEO tenure and CEO ownership; (2) Financial data available from Aspect DatAnalysis to calculate the accounting quality and other financial variables, including standard deviation of sales over the past 5 years; (3) Director names, director gender, director position, auditor name and audit fee data from the Boardroom database from Connect4; (4) Non-financial firm and (5) Firms must have an audit committee that meets at least once during the year. Our final sample comprises 1,354 firm-years during the period 2005 to This includes 236 firm-years where the CEO is a formal member of the audit committee, 111 firmyears where the CEO is invited to attend audit committee meetings and 1007 firm-years where the CEO is not on the audit committee. By year, there are 469 observations in 2005, 460 observations in 2006 and 425 observations in This three-year period is chosen as our sample period as there are a sufficient number of observations for firms with CEOs on their audit committees and CEO attendance-by-invitation at audit committee meetings for our analysis. Moving forward in time, fewer firms allow their CEOs to be on their audit committees to be in line with Australia s Corporate Governance Principles and Recommendations. 14

15 Table 1 provides descriptive statistics of the sample. The average firm has total assets of $1.033 billion, 25 subsidiaries, 4 operating and geographic segments, leverage ratio of 0.414, price-to-book ratio of 3.54, 5-year standard deviation of sales of 0.268, return on assets of percent and 38 percent likelihood of making a loss. Average board size is directors with independence of 40.5 percent and 4 percent female directors. Boards meet on average 11 times per year. Audit committees have a mean size of directors, independence of 56.6 percent and meet times per year. Financial experts comprise 22.3 percent of audit committee members. CEO-Chairman duality occurs in 7 percent of firms, with average CEO tenure of years and CEOs own an average of times the shares held by directors. The three measures of earnings opacity have averages of 0.09 for Abs(DA), for SUMDA and for AQ. A total of 65.4 percent of firms hire a Big4 auditor and average audit fees are $374, Results 5.1 CEO involvement on audit committees Table 2 shows the characteristics of firms with CEOs as formal members on their audit committees, CEOs invited to informally attend audit committee meetings, and CEOs not on audit committees. These three settings allow us to separate CEO involvement on audit committees into two the aspects power and informational. We conduct mean tests of differences in characteristics between firms with CEOs on their audit committees and CEOs invited to audit committee meetings (Power), and differences between CEOs invited to audit committee meetings and CEOs not on audit committees (Informational). The accounting quality variables provide some initial results consistent with our expectations. We find that the Power aspect of CEO involvement on audit committees is associated with higher measures of earnings opacity, lower likelihood of employing a Big4 15

16 auditor and lower audit fees. The Informational aspect of CEO involvement on audit committees is associated with lower measures of earnings opacity, higher likelihood of hiring a Big4 auditor and higher audit fees. We hypothesize that strong CEO influence and weak governance are associated with the likelihood that the CEO is a formal member of the audit committee rather than attending audit committee meetings by invitation (Power). The mean tests in Table 2 show that the Power aspect is positively related to CEO Chair and is negatively related to the board of director and audit committee variables. These results indicate that CEOs are more likely to be formal members of the audit committee rather than invited to audit committee meetings, when the CEO is also Chairman, when the board is smaller and less independent, and when the audit committee is less independent and has fewer meetings. We expect firm complexity, firm uncertainty, and strong governance to be associated with the likelihood that CEOs are invited to informally attend audit committee meetings rather than CEOs having no involvement with the audit committee (Informational). The mean tests indicate that the Informational aspect is positively related to the measures of firm complexity and the board of director and audit committee characteristics, but is largely unrelated to the measures of firm uncertainty. These results suggest that more complex firms (e.g. bigger firms) and firms with better governance practices (e.g. higher board independence and more audit committee meetings) are more likely to invite their CEOs to informally attend audit committee meetings in an advisory role. Table 3 provides the results of models 1 and 2. Due to high correlations between some of the board of director and audit committee variables, we run separate models for these two groups of variables. The first two specifications examine the Power aspect of CEO involvement on audit committees and confirm that weak governance is associated with Power. We find that Power is negatively related to board size, board independence, female directors, audit 16

17 committee independence, audit committee meetings, firm size and the number of subsidiaries. Power is positively related to audit committee size, audit committee financial expertise and the price-to-book ratio. 6 No significant coefficients are found on the CEO influence variables. The third and fourth specifications examine the Informational aspect of CEO involvement on audit committees and confirm that firm complexity and good governance practices are associated with Informational. We find that Informational is positively related to the presence of female directors, audit committee size and firm size, and is negatively related to audit committee financial expertise and the price-to-book ratio. These results indicate that CEOs are more likely to provide an advisory role to audit committees when firms are more complex (bigger firms), when firms have greater accounting-related monitoring needs (bigger audit committees) and when firms have less financial expertise on their audit committees. 5.2 Earnings opacity and CEO involvement on audit committees In this section, we relate the two aspects of CEO involvement on audit committees to accounting quality, measured by our three earnings opacity variables (Abs(DA), SUMDA and AQ). We expect the Power aspect to be positively related to earnings opacity and the Informational aspect to be negatively related to earnings opacity. Due to a high correlation (0.875) between board independence and audit committee independence, only audit committee independence is included in the regressions of model 3. Table 4 shows that the Informational aspect is negatively related to earnings opacity in all three specifications and the Power aspect is positively related to earnings opacity in two out of three specifications. These results are consistent with Hypotheses 2 and 4 and confirm that the two aspects of CEO involvement on audit committees have different influences on earnings 6 The positive result for audit committee size and negative result for audit committee independence are largely mechanical as they include the existence of the CEO only when the CEO is on the committee full-time. 17

18 opacity. The Power aspect, representing agency costs, is positively related to earnings opacity. The Informational aspect, representing greater information exchange between CEOs and audit committees, is negatively related to earnings opacity. Results for the control variables indicate that earnings opacity is negatively related to board of director characteristics (board size, female directors and board meetings), unrelated to audit committee variables, negatively related to CEO tenure, negatively related to firm size and debt, positively related to firm uncertainty (sales variability, loss and price-to-book ratio), negatively related to return on assets and there are mixed results for Big4 auditors. To provide further evidence of the informational role that CEOs perform at audit committee meetings, we investigate a specific setting where information provision by the CEO is expected to be more beneficial to the audit committee. We focus on high levels of firm uncertainty, as we believe that during uncertain times CEOs are more likely to be required to provide additional information to audit committees to better explain accounting estimates related to the current operating conditions and performance of the firm. Thus, we expect to find a stronger negative relationship between Informational and earnings opacity for firms experiencing greater uncertainty. Table 5 provides the results of model 3 for subsamples of firms with high and low uncertainty (sales variability and loss) using Abs(DA) as the measure of earnings opacity. We find that the negative relationship between the Informational aspect of CEO involvement on audit committees and earnings opacity is generally consistent across all types of firms. However, there are significant differences in the magnitudes of the relationships between the subsamples, which are shown at the bottom of the table. Firms with high sales variability exhibit a stronger negative relationship between Informational and earnings opacity than firms with low sales variability. Similarly, firms making a loss exhibit a stronger negative relationship between Informational and earnings opacity than non-loss making firms. Thus, 18

19 these results indicate that the informational role of CEOs at audit committee meetings is more beneficial when firms are operating in uncertain conditions. 5.3 Robustness tests A possible concern in our analysis is that other unidentified variables are potentially driving the relationships between CEO involvement on audit committees and earnings opacity. To reduce the possibility of omitted variable bias, we repeat our analysis using a matched sample. We match firms where the CEO is informally invited to attend audit committee meetings with firms where the CEO is a formal member of the audit committee and with firms where the CEO does not attend audit committee meetings. 7 The match is by firm size and industry. A matched sample reduces the identifiable, and by extension the unidentifiable, differences between sample observations. Table 6 presents the results of model 3 using a matched sample of a maximum of 311 observations. We find consistent results. Informational is negative in two out of three specifications and Power is positive in all three specifications. Another potential concern is that audit committees that seek additional information from their CEOs also demand higher quality auditing, which results in lower earnings opacity. To allay this concern, we repeat our analysis by including the logarithm of audit fees in model 3. Due to the availability of audit fee data, this reduces our sample to a maximum of 1209 observations. Table 7 shows that the coefficient on audit fees is significantly negative in all three specifications and the coefficient on Informational continues to be negative in two out of three specifications. Thus, after controlling for the quality of auditing, using both audit fees and Big4, we continue to find that the informational aspect of CEO involvement on audit committees is associated with lower earnings opacity. 7 We try our best to match to both types of firms, but this is not possible for every observation. Observations are still included in the analysis if there is one match, instead of two. 19

20 6. Conclusions Prior studies have provided substantial evidence that audit committees that are more independent from firm management are more effective in overseeing the quality of a firm s financial reporting. In this study, we propose that CEOs can perform a beneficial informational role at audit committee meetings, which is associated with greater information exchange about accounting-related matters with audit committee members, and results in higher quality financial reporting for end users. Using disclosures of CEO attendance, CEO attendance-by-invitation and CEO nonattendance at audit committee meetings, we separate CEO involvement on audit committees into two aspects power and informational. We find that the Power aspect of CEO involvement on audit committees is associated with weak governance and is positively related to earnings opacity. The Informational aspect of CEO involvement on audit committees is associated with firm complexity and strong governance, and is negatively related to earnings opacity, consistent with CEOs sharing beneficial accounting-related information with audit committee members. Thus, this study highlights previously undocumented benefits from allowing CEOs to act as informal advisors at audit committee meetings For policymakers, our results suggest that the current focus on ensuring audit committees are fully independent from firm management may need some adjustment. While we agree that formal CEO membership on the audit committee is not recommended, we highlight that allowing CEOs to informally attend audit committee meetings in an advisory role is associated with higher quality financial reporting. 20

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22 FRC, 2012, The UK Corporate Governance Code, Financial Reporting Council: London. Hutton, A. P., Marcus A.J., Tehranian H., Opaque Financial Reports, R2, and Crash Risk. Journal of Financial Economics 94, Jensen, M. and W. Meckling, 1976, Theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics, 3, Kent, P., J. Routledge and J. Stewart, 2010, Innate and discretionary accruals quality and corporate governance, Accounting and Finance, 50, Klein, A., 2002a, Economic determinants of audit committee independence, The Accounting Review, 77, Klein, A., 2002b, Audit committee, board of director characteristics and earnings management, Journal of Accounting and Economics, 33, Krishnan, G. and G. Visvanathan, 2008, Does the SOX definition of an accounting expert matter? The association between audit committee directors accounting expertise and accounting conservatism, Contemporary Accounting Research, 25, Levitt, A., 1998, The numbers game, Remarks delivered at the NYU Centre of Law and Business, New York, September 28. Shivdasani, A. and D. Yermack, 1999, CEO involvement in the selection of new board members: An empirical analysis, Journal of Finance, 54, Vafeas, N., 2005, Audit committees, boards and the quality of reported earnings, Contemporary Accounting Research, 22, Xie, B., W. Davidson and P. DaDalt, 2003, Earnings management and corporate governance: the role of the board and the audit committee, Journal of Corporate Finance, 9,

23 Figure 1 Research framework CEO on Audit Committee Prior research: Difference = Power + Informational CEO not on Audit Committee This study: CEO on Audit Committee Difference = Power CEO invited to Audit Committee Difference = Informational CEO not on Audit Committee 23

24 Table 1 Descriptive statistics n Mean Std Min Median Max Accounting Quality Abs(DA) SUMDA AQ Board of Director Board Size Board Independence Female Board Members Board Meetings Audit Committee AC Size AC Independence AC Expertise AC Meetings CEO Influence CEO Chair CEO Tenure CEO Ownership Firm Complexity Size ($billions) Subsidiaries Segments Debt Firm Uncertainty Std(Sales) Loss Price-book ROA Auditor Big Audit Fees ($millions) This table presents summary statistics for our sample of ASX-listed firms during the period 2005 to Abs(DA) is accruals estimation error measured using the absolute values of abnormal accruals from the Modified Jones Model. SUMDA is the sum of abnormal accruals. AQ is accruals estimation error measured using the Dechow- Dichev model. Board Size is the total number of directors on the board. Board Independence is the proportion of independent directors on the board. Female Board Members is the proportion of female directors on the board. Board Meetings is the number of board meetings held during the year. AC Size is the number of directors on the audit committee. AC Independence is the proportion of independent directors on the audit committee. AC Expertise is the proportion of directors on the audit committee with financial expertise. AC Meetings is the number of audit committee meetings held during the year. CEO Chair is a dummy variable that equals one if the CEO is also the Chairman of the Board. CEO Tenure is the number of years the CEO has been employed by the company. CEO Ownership is the ratio of the number of shares of the firm held by the CEO relative to the number of shares held by directors. Size is total assets in billions of dollars. Subsidiaries is the number of subsidiaries. Segments in the sum of the number of operating and geographic segments. Debt is total liabilities divided by total assets. Std(Sales) is the standard deviation of sales over the past 5 years. Loss is a dummy variable equal to one if the firm made a loss. Price-book is the market value of equity divided by the book value of equity. ROA is the firm's return on assets. Big4 is a dummy variable equal to one for firms with Big4 auditors. Audit fees are in millions of dollars. 24

25 Table 2 Mean tests of CEO involvement on audit committees CEO CEO CEO not Power on AC invited on AC (1) (2) (1) (2) (3) Informational (2) (3) Accounting Quality Abs(DA) *** *** SUMDA *** *** AQ *** *** Board of Director Board Size *** *** Board Independence *** *** Female Board Members *** *** Board Meetings Audit Committee AC Size ** *** AC Independence *** AC Expertise AC Meetings *** *** CEO Influence CEO Chair *** CEO Tenure CEO Ownership Firm Complexity Ln(Size) *** *** Subsidiaries *** ** Segments *** *** Debt ** *** Firm Uncertainty Std(Sales) *** Loss *** *** Price-book ROA *** ** Auditor Characteristic Big *** *** Ln(Audit Fees) *** *** n This table presents the tests of sample means across subsamples of ASX-listed firms during the period 2005 to CEO on AC (1) is the subsample of firms where the CEO is a formal member of the audit committee. CEO Invited to AC (2) is the subsample where the CEO is informally invited to audit committee meetings. CEO not on AC (3) is the subsample of firms where the CEO is not involved in audit committee meetings. The fourth and fifth columns test the differences between the (1) and (2) subsamples and the (2) and (3) subsamples respectively. *, **, *** indicate significant differences at the 10%, 5%, and 1% levels, respectively. 25

26 Table 3 Logit models of CEO involvement on audit committees Power Informational (1) (2) (3) (4) Board of Director Board Size (-2.98) *** (1.02) Board Independence (-3.15) *** (0.91) Female Board Members (-2.14) ** (2.89) *** Board Meetings (0.97) (-0.97) Audit Committee AC Size (2.26) *** (5.36) *** AC Independence (-4.69) *** (-1.01) AC Expertise (1.72) * (-1.75) * AC Meetings (-1.78) * (-0.69) CEO Influence CEO Chair (0.71) (0.50) (0.27) (0.39) CEO Tenure (0.26) (0.95) (0.06) (0.47) CEO Ownership (-0.86) (-0.64) (0.21) (0.41) Firm Complexity Ln(Size) (-1.78) * (-3.43) *** (2.60) *** (2.25) ** Subsidiaries (-2.31) ** (-2.17) ** (-1.29) (-0.65) Segments (0.52) (-0.21) (1.10) (0.96) Debt (-0.95) (-0.62) (0.87) (0.71) Firm Uncertainty Std(Sales) (0.72) (0.69) (0.14) (-0.21) Loss (1.20) (1.11) (-0.95) (-1.15) Price-book (1.89) * (1.11) (-1.76) * (-1.33) ROA (-1.10) (-0.77) (-0.61) (-0.38) 26