If the audit committee speaks, does the board listen? Interdependencies between the audit committee and the rest of the board Mathijs Van Peteghem KU Leuven, Department of Accountancy, Finance and Insurance Naamsestraat 69, 3000 Leuven, Belgium Mathijs.Vanpeteghem@kuleuven.be Liesbeth Bruynseels KU Leuven, Department of Accountancy, Finance and Insurance Naamsestraat 69, 3000 Leuven, Belgium Liesbeth.Bruynseels@kuleuven.be Ann Gaeremynck KU Leuven, Department of Accountancy, Finance and Insurance Naamsestraat 69, 3000 Leuven, Belgium Ann.Gaeremynck@kuleuven.be We thank Robert Knechel, Steven Vanhaverbeke, Sally Widener and seminar participants at KU Leuven for their helpful suggestions. Deloitte Belgium is acknowledged for their financial support.
If the audit committee speaks, does the board listen? Interdependencies between the audit committee and the rest of the board Abstract: Following a series of accounting scandals, regulators have strengthened the compositional requirements of the audit committee. The SOX requirements have made the audit committee into a strong subgroup within the board, as the audit committee significantly differs from the rest of the board in terms of its composition. We investigate whether the benefit of a distinct audit committee depends on the acceptance of the audit committee s message by the rest of the board. Using a large dataset of listed U.S. firms between 2008 and 2012, we find audit committee effectiveness to benefit from this distinct and strong subgroup identity, measured as the extent to which the composition of the audit committee differs from the rest of the board. However, we also find consistent evidence that the benefit is diminished when the rest of the board forms a cohesive group, as this instigates frictions between both board subgroups, i.e. the audit committee and the rest of the board. As both subgroups strive, the rest of the board may counteract audit committee decisions, lowering audit committee effectiveness. Understanding how the audit committee s effectiveness is dependent on its position versus the rest of the board should be of interest to regulators and companies alike. Keywords: audit committee, board of directors, corporate governance, distance, subgroup formation, subgroup identity Data availability: all data are publicly available from the sources identified in the text. JEL-classification: G30, G38, M41, M42, M48
I. INTRODUCTION Following a series of major accounting scandals in the early 21st century, regulators have increased corporate governance requirements aiming to improve monitoring and financial transparency (e.g. Audit Directive 2006; NYSE Listing Requirements 2003; Sarbanes-Oxley Act 2002 [SOX]). One of the main subjects of corporate governance reforms was the audit committee, given its important role in safeguarding financial statement quality. Since SOX, audit committees are required to be fully independent and to be comprised of financially literate directors of which at least one qualifies as a financial expert requirements which are supported by empirical research (e.g. Abbott et al. 2004; Carcello and Neal 2000; Klein 2002a; Krishnan 2005; Xie et al. 2003). Although these SOX requirements were successful in ensuring that all companies have an independent and knowledgeable audit committee on the board, the SEC and the PCAOB are still exploring other avenues to improve audit committee effectiveness, mainly by focusing on increased transparency in audit committee reports towards the investor community (Compliance Week, 2014). Rather than focusing on increased transparency, we explore how the effectiveness of the audit committee may depend on the characteristics of the non-audit committee board members. In other words we focus on the interaction between the rest of the board and the audit committee. We draw on social categorization theory to argue that the interaction between the audit committee and the rest of the board can influence audit committee s effectiveness. In social interactions, individuals tend to classify themselves and others as belonging to a specific social category (Tajfel and Turner, 1985), which may be based on similarity in observable (i.e. gender, ethnicity, age) or functional attributes (expertise, tenure, independence) (Byrne 1971; Hogg and Terry 2000). The clustering of director independence and financial expertise in the audit committee coupled with the increased responsibility and authority assigned by SOX is likely to create a strong group identity of the audit committee. This is not necessarily a bad thing. According to social 1
categorization theory, identification with a group enhances members support for and commitment to the group, which in turn amplifies group cohesion and cooperation (Ashforth and Mael 1989; Evans and Dion 1991). Audit committee effectiveness may thus improve due to this strong group identity. Furthermore, the fact that board financial expertise is clustered within the audit committee is likely to reinforce the audit committee s authority and autonomy versus the rest of the board, as high expertise has been shown to increase a subgroup s persuasiveness and impact in making complex decisions (DeBono and Klein 1993; Fiske and Taylor 2008). Hence, we argue that audit committees that have director profiles that are very distinct from the rest of the board (i.e. distance) are more effective than audit committees where this difference is less pronounced. However, distance between the audit committee and the rest of the board in terms of director characteristics may also give rise to frictions between both board subgroups, as knowledge imbalances or differences in incentives can produce negative emotions and conflicts (Sell et al. 2004). For example, corporate insiders may disagree with the audit committee on issues such as timely loss recognition. To what extent these negative dynamics influence audit committee effectiveness is expected to be dependent on the cohesion and subgroup identity of the rest of the board. When the rest of the board is a disparate non-cohesive board subgroup, it may suffer from cooperation and coordination issues, and is likely to be less effective in opposing audit committee recommendations, compared to a situation where rest of the board forms a strong, cohesive subgroup. 1 In the latter case, intergroup frictions between the audit committee and the rest of the board are also likely to be more intense as members of both groups remain psychologically located within their subgroups and are not open to the ideas of the other subgroup (Bezrukova et al. 2009; Halevy, 2008; Li and Hambrick 2005; Nesdale and Mak 2003; Thatcher and Patel 2011). In line with this reasoning, we expect the positive effects of compositional differences between the audit 1 Group research has demonstrated a low cohesion to instigate high intragroup conflict, high rates of withdrawal, and poor performance (Evans and Dion 1991; Harrison and Klein 2007). 2
committee and the rest of the board to be moderated by the strength of subgroup identity (i.e., cohesion) of the rest of the board. 2 We use a large dataset of listed U.S. companies between 2008 and 2012 to test whether the cohesion within the rest of the board and its distance to the audit committee matters to explain audit committee effectiveness. Board data has been obtained via Institutional Shareholder Services (ISS) on the Russell 3,000 firms, representing approximately 98% of the investible U.S. equity market. Viewing the board as being comprised of two subgroups, i.e. the audit committee and the rest of the board, distance and cohesion measures have been developed based on subgroup attributes (Bruynseels et al. 2015; Zanutto et al. 2011). Whereas distance between the audit committee and the rest of the board is operationalized as the aggregate difference between both subgroups in terms of member characteristics, cohesion of the rest of the board is defined as the lack of variation in these characteristics for a given subgroup. The member characteristics used to compute these proxies are director independence, insider status, affiliation, financial expertise, tenure, share ownership and director status. These attributes have been identified by previous governance research as key characteristics of the audit committee (Abbott et al. 2003; Bédard et al. 2004, 2013; Klein 2002a, 2002b; Krishnan 2005; Srinivasan 2005; Vafeas 2005). Furthermore, these characteristics are influential in determining audit committee distance to the rest of the board (Hambrick et al. 2008). Whereas director independence and financial expertise are regulated by stock exchanges and SOX, high tenure and the possession of shares clearly pose an obstacle to independence (Klein 2002a; Vafeas 2003). Additionally, directors on the audit committee more often possess multiple board mandates as opposed to the rest of the board, which might be indicative of a difference in status compared to the rest of the board (Erkens and Bonner 2012). The chosen attributes thus represent 2 Descriptive evidence on the interdependency between the audit committee and other board members has been gathered by the 2004 Audit Committee Round Table hosted by KPMG. For example, about half of the audit committee respondents states that pre-meeting information supplied by insiders or other board members is of low or moderate quality. 3
important characteristics in audit committee governance, while clearly showing important compositional differences between the audit committee and the rest of the board. The proxies for distance (i.e. distance between the audit committee and rest of the board) and cohesion are related to output variables commonly used in prior research investigating audit committee oversight quality (e.g. Beasley et al. 2009; Bruynseels and Cardinaels 2014). We focus on measures which are a joint responsibility of the audit committee and the rest of the board. 3 A first set of dependent variables focuses on financial reporting properties, measured by accrual quality (e.g. McInnis and Collins 2011) and restatements (e.g. Abbott et al. 2004). A third measure focuses on the quality of internal controls by investigating the disclosure of an internal control deficiency (e.g. Bruynseels and Cardinaels 2014; Naiker and Sharma 2009). In line with our expectations, we find increased distance between the audit committee and the rest of the board to positively affect audit committee effectiveness, as measured by the occurrence of a restatement or the disclosure of an internal control deficiency. No association is found with accrual estimation errors. The positive effects of audit committee distance thus appear to manifest themselves in extreme situations, where failure is detectable to investors and may have direct consequences for a firm s cost of equity or director reputation (Ashbaugh-Skaife et al. 2009; Fich and Shivdasani 2007; Palmrose et al. 2004; Srinivasan 2005). We also find consistent evidence that these positive effects are diminished when the rest of the board forms a cohesive group and hence is likely to more effectively oppose the recommendations of the audit committee. Jointly considered, our results suggest that corporate governance regulation has been effective in turning the audit committee into a cohesive board committee with a strong subgroup identity. The resulting distance between the audit committee and the rest of the board has proven beneficial for its effectiveness, but may also have amplified potential frictions between the audit committee and the rest of the board. When the rest of the board is a 3 Issues such as the choice of auditor or the amount of audit services purchased are an autonomous responsibility of the audit committee. 4
strong and cohesive subgroup as well, audit committee recommendations are more likely to be overruled. Our paper contributes to existing literature in a number of ways. First of all, this study responds to recent calls for research on boardroom processes and interactions between the audit committee and the board (Carcello et al. 2011; Hambrick et al. 2008). Previous research often considered the audit committee as a stand-alone committee, focusing on audit committee attributes as sole drivers of its effectiveness (e.g. Abbott et al. 2004; Carcello and Neal 2000; Klein 2002a; Krishnan 2005; Xie et al. 2003). Rather than considering the audit committee as an independent body, we focus on the interaction between this committee and the rest of the board. The effectiveness of the audit committee may crucially depend on the directors who are not on the audit committee, as financial reporting is a responsibility of the audit committee and the rest of the board alike and both groups may have very different agenda s (Hambrick et al. 2008). This interdependence between the audit committee and the rest of the board has not yet been taken into account by previous research. In this study, we also look beyond the traditional agency theory framework and use social identity theory to argue how current legislation has influenced audit committee subgroup identity and strength compared to the rest of the board and how this may have impacted its effectiveness (Tajfel and Turner 1985). Next, we contribute to behavioral group literature by validating a distance measure frequently employed by management research in small populations or experimental settings (e.g. Bezrukova et al. 2009; Kaczmarek et al. 2012). Our large-scale empirical setup provides additional external validity for this measure. Additionally, we focus on cohesion at the subgroup level, whereas previous management research has only investigated this at the aggregate group level (e.g. Lau and Murnighan 2005; Zanutto et al. 2011). 5
Our findings should be of interest to regulators and stock exchange commission considering the audit committee as a key governance mechanism in ensuring financial transparency. Regulatory initiatives designed to strengthen audit committee authority and independence have achieved their goal by creating audit committees that function as a strong, cohesive subgroup within the board. Future legislation might take advantage hereof and amplify the positive effect of subgroup distance between the audit committee and the rest of the board, by prohibiting share ownership or imposing tenure limits for audit committee members while not for other board members. These initiatives may ensure that the audit committee stays a distinct group. Furthermore, our findings regarding the rest of the board suggest that increasing non-audit committee director diversity in the rest of the board and tempering cohesiveness within this board subgroup also result to better acceptance of the audit committee recommendations. Turning to companies, we offer some guidelines on how to structure the audit committee and the rest of the board in order to maximize audit committee effectiveness. In this respect, we find convincing evidence that firms should strive for cohesive audit committees and director diversity in the rest of the board. The paper is structured as follows. Section II provides an overview of the related literature and develops our hypotheses. Section III describes the methodology and data, while Section IV discusses the empirical results. Additional analyses are presented in Section V. We conclude this paper with a summary of our main findings and suggestions for further research in Section VI. II. LITERATURE REVIEW The audit committee after SOX The Sarbanes-Oxley Act brought about significant changes for corporate boards and especially the audit committee. Director characteristics such as independence and financial expertise 6
became pivotal in guaranteeing adequate oversight of a firm s financial statements (DeFond et al. 2005). Whereas independent directors are expected to exert objective control (Rosenstein and Wyatt 1990), the presence of financial experts on the audit committee helps to improve the oversight of corporate financial reporting (Erkens and Bonner 2012). However, recent evidence suggests that this is too narrow focus and that it is important to look at audit committee effectiveness in a context that involves its relations with management, the rest of the board and the context of the firm. For example, director independence may be compromised by social ties between independent board members and the CEO. Bruynseels and Cardinaels (2014) shows convincing evidence on the dependency of audit committee oversight quality on social ties outside the audit committee. More specifically, firms whose audit committees have friendship ties to the CEO purchase fewer audit services and engage more in earnings management. Furthermore, the appointment and role of financial experts in the audit committee may be driven by characteristics other than those traditionally acknowledged by previous research, such as more personal factors. Erkens and Bonner (2012) show that audit committee financial experts typically have lower status as opposed to other directors such as retired CEOs, which may influence their appointment on the audit committee as well as their role in board discussions. The results of these studies demonstrate the necessity of relating audit committee functioning to the bigger picture, i.e. investigating how the audit committee interacts with the rest of the board and the broader context of the company. Rather than focusing solely on audit committee characteristics, attention should be given to how these audit committee characteristics influence interactions with the rest of the board (Carcello et al., 2011; Hambrick et al., 2008). We add to this literature by not only looking at individual characteristics of directors in the audit committee, but investigating the group dynamics of the audit committee in relation to the rest of the board. 7
Social identity theory and the audit committee as a board subgroup We draw on social identity theory to explain the process of subgroup formation and the effect it may have on overall group effectiveness. The central premise of social identity theory is that individuals tend to classify themselves and others as belonging to a specific social category (Tajfel and Turner, 1985). This social categorization establishes identification with a group; which in turn positively affects group cohesion, cooperation and group performance (Evans and Dion 1991; Tajfel and Turner 1985). On the one hand, social categorization may happen based on similarity in observable or functional attributes (Byrne et al., 1971). Prior research has indeed shown that similarity is an important basis for coalition formation amongst directors and executives (Westphal and Zajac 1995). On the other hand, identification may also be based on group membership per se (Hogg and Terry 2000). In an organizational context, this group can be the firm itself, autonomous departments or more specific work groups such as the board of directors or the audit committee. Applying social identity theory to a board setting, we argue that the audit committee is a board subgroup with a very distinct and strong group identity. Following the Sarbanes-Oxley Act, audit committees are comprised only of independent and financially literate directors, with at least one financial expert. This has led to a clustering of board independence and financial expertise in the audit committee, which contrasts with the rest of the board where member profiles often do not satisfy these expertise and independence requirements. Next, directors active on the audit committee typically also have relatively low tenure or company shares, compared to the rest of the board. Furthermore, due to the increased demand for financial expert directors over the last ten years, audit committee members typically also hold more board mandates than the rest of the board, which is indicative of differences in status (Erkens and Bonner, 2012). <<<<<Insert table 1 about here>>>>> 8
The compositional differences between the audit committee and the rest of the board are displayed in table 1. Descriptive statistics are shown for all firms in the Russell 3,000 between 2008 and 2012 on which we have non-missing board data. The tables show important differences between the audit committee and the rest of the board all of which are significant at below the one percent level (p < 0.001). For example, a typical board is for 75% comprised of independent directors, with a completely independent audit committee and about half of the rest of the board being independent. About 50% of the audit committee qualifies as a financial expert, whereas no financial experts are found on the rest of the board. Directors on the audit committee on average have significantly lower tenure and possess fewer shares as compared to the rest of the board. The former are also more likely to sit on multiple boards. The differences between the audit committee and the rest of the board thus go beyond financial expertise and independence. Jointly considered, important differences exist between the director characteristics of board members in the audit committee and in the rest of the board, emphasizing the audit committee as a distinct subgroup within the board of directors. The audit committee vis-à-vis the rest of the board We propose that the audit committee flourishes under this strong subgroup identity. The similarity in director profiles within the audit committee establishes high levels of intra-group trust and cooperation (Locke and Horowitz, 1990) which in turn has a positive effect on group decisionmaking and overall effectiveness. Moreover, the differential composition of the audit committee compared to the rest of the board may reinforce its status as an independent expert body which allows the audit committee to weigh heavily on financial reporting decisions. This is in line with prior research which has shown that the presence of expert knowledge increases a subgroup s persuasiveness and impact in making complex decisions (DeBono and Klein 1993; Fiske and Taylor 9
2008). Other subgroups not possessing this knowledge are then more likely to rely on this group s expertise (Zhu 2013). Accordingly, previous governance research has demonstrated that top executives with relevant expertise significantly impact group decisions related to this expertise (McDonald et al. 2008). Therefore, different from previous research we do not focus on the characteristics of the audit committee itself, but how the audit committee differs from the rest of the board. The larger these differences, i.e. the larger the distance in director characteristics between the audit committee and the rest of the board, the higher the effectiveness of the audit committee is expected to be. We thus formulate the following hypothesis: H1: Increased distance in director characteristics between the audit committee and the rest of the board positively impacts audit committee effectiveness. Previous research in board governance has shown that next to differences between subgroups the cohesion of the different subgroups is also relevant for explaining board performance (Bruynseels et al. 2015; Kaczmarek et al. 2012). Hence, the extent to which these positive effects of distance between the audit committee and the rest of the board materialize may depend on the subgroup identity of the rest of the board. Given that directors not active on the audit committee are not always independent, typically do not qualify as financial experts, possess more company shares and are longer tenured, their incentives and point of view may be quite different from the audit committee. These directors may thus not necessarily agree with audit committee decisions and recommendations. Nonetheless, the extent to which these negative dynamics affect audit committee effectiveness is dependent on the subgroup identity of the rest of the board. Based on social identity theory, we argue that a weak identity results in lower intergroup cohesion and cooperation (Evans and Dion 1991; Tajfel and Turner 1985). A disparate, non-coherent subgroup is likely to experience difficulties in coordinating itself and will thus weigh less on the group decision-making processes (Harrison and Klein 2007). Hence, the audit committee can more easily dominate discussions on financial reporting 10
issues. On the other hand, when the rest of the board forms a strong subgroup, intergroup frictions are intensified as subgroups strive for recognition and power (Brewer 2001; Hogg and Terry 2000). Additionally, members remain psychologically located within their subgroups and are not open to the ideas of the other subgroup (Nesdale and Mak 2003). Following this line of reasoning, we argue that when large differences between the audit committee and the rest of the board are accompanied by a strong subgroup identity of the rest of the board, the latter will be far less inclined to accept the audit committee s point of view. The frictions between both subgroups are likely to hinder efficient decision-making, diverting the group s attention away from meeting its goals toward handling the negative group dynamics (Bezrukova et al. 2007; Li and Hambrick 2005; Polzer et al. 2006). Furthermore, a strong subgroup identity of the rest of the board is likely to enhance the cohesion and cooperation within this group, allowing it to follow its own agenda and put aside audit committee recommendations. 4 We formulate our second hypothesis: H2: The positive effects of distance between the audit committee and the rest of the board are negatively moderated by a strong subgroup identity of the rest of the board. III. RESEARCH DESIGN Dependent variables To test our hypothesis, we focus on common measures of audit committee effectiveness which are a joint responsibility of the audit committee and the rest of the board. Anecdotal evidence identifies the accuracy of financial reporting and oversight quality as key issues in audit committee 4 Note that differences between subgroups are a necessary condition for subgroup identities to create frictions (Bezrukova et al. 2009). Subgroups in an overall homogeneous group will be far less pronounced, as similarity enhances identification with the overall group and subgroups have less reason to behave antagonistically (Byrne et al. 1971; Westphal and Zajac 1995). 11
meetings (Gendron et al. 2004). Hence, a first set of measures targets financial reporting properties by focusing on accrual quality (e.g. McInnis and Collins 2011) and restatements (e.g. Abbott et al. 2004). A third measure focuses on oversight quality, defined as the occurrence of an internal control deficiency. High-quality audit committees have more influence on the shape and design of the internal control system, and consequently are associated with less internal control deficiencies (Krishnan 2005; Zhang et al. 2007). Other common measures such as the choice of auditor or the level of audit fees are autonomous responsibilities of the audit committee on which the rest of the board has little impact. These measures are therefore not included in this study. Accrual quality Accrual quality is proxied based on the Dechow and Dichev (2002) model, which relates changes in working capital accruals to past, current and future cash flows at the two-digit industrylevel using a time series regression. Prior research has documented accrual estimation errors to outperform discretionary accrual models or the Beneish (1999) M-score (Jones et al. 2008). The following model is estimated: WC t = β 0 + β 1 CFO t 1 + β 2 CFO t + β 3 CFO t+1 + β 4 Revenues t + β 5 PPE t + ε t The change in working capital from year t-1 to t is calculated as the change in accounts receivables plus the change in inventories, minus the changes in accounts payable and taxes payable, plus the change in other assets (Dechow and Dichev 2002). In line with Francis et al. (2005) and Srinidhi and Gul (2007) we augment the model with the firm s property, plant and equipment as well as the change in revenues to reduce measurement error. All variables are scaled by average total assets. The residuals obtained from the regression reflect changes in working capital that are not related to core operating performance. The standard deviation of these residuals constitutes a 12
measure of accrual quality at the firm level, with higher values meaning lower-quality accruals (McInnis and Collins 2011). We calculate the standard deviation over a window of the prior eight years. In addition to basic governance controls, we add five control variables targeting the innate determinants of accrual quality: firm size, length of the operating cycle, volatility of operational cash flows, volatility of sales and whether the firm experiences a loss in the prior year (Francis et al. 2005; Srinidhi and Gul 2007). Details on the control variables can be found in table 2. <<<<<Insert table 2 about here>>>>> Restatement The restatement measure captures severe shortcomings in accounting practices and is based on SEC filings. Consistent with Dao et al. (2011) we focus our analysis on intentional accounting restatements. These are accounting restatements with an adverse effect on the financial statements of the company and are thus presumed to be intentional. A dummy variable takes on the value of one if the firm has been subject to a restatement action concerning accounting irregularities by the SEC, and zero otherwise. The probit model is estimated on the full sample, as well as on a sample of restatement and non-restatement firms matched on year, industry and total assets (Agarwal and Chadha 2005). Aside from governance variables, we include audit and firm complexity control variables as well as general firm controls (Abbott et al. 2004). Details on the control variables can be found in table 2. Internal control deficiencies 13
The audit committee also oversees and shapes a firm s internal control systems, for example through discussion of the internal control system with the internal and external auditor or review of the internal accounting procedures and controls (Krishnan 2005). High-quality audit committees are subsequently associated with better-quality internal controls (Abbott et al. 2010; Krishnan 2005; Zhang et al. 2007). Hence, distant audit committees may have more impact on the shape and design of the internal control system and exercise a stronger control themselves, while a strong rest of the board may actively oppose audit committee influence on these issues. We obtain data on internal control deficiencies from Audit Analytics and define a dummy variable as one when the firm has reported an internal control deficiency, and zero otherwise. In line with the restatement model, a probit model is estimated on the full sample, as well as a matched sample based on year, industry and total assets (Agarwal and Chadha 2005). As with the restatement model, we include firm complexity control variables as well as general firm controls (Naiker and Sharma 2009). Details on the control variables can be found in table 2. Test variables Director attributes The key issue is the operationalization of audit committee distance and the subgroup identity of the rest of the board, two constructs for which we build upon related work by Bruynseels et al. (2015). In line with previous group research, we develop distance and cohesion measures on the basis of a set of director characteristics. Previous research has shown that these aggregate measures have more explanatory power in determining group performance as compared to individual characteristics (Lau and Murnighan 2005). The chosen attributes are director independence, financial expertise, director tenure, the number of board mandates and the number of shares. These attributes have been 14
identified by previous governance research as key characteristics of the audit committee (Abbott et al. 2003; Bédard et al. 2004, 2013; Klein 2002a, 2002b; Krishnan 2005; Srinivasan 2005; Vafeas 2005). Furthermore, these characteristics may be considered influential in determining the distance between the audit committee and the rest of the board (Hambrick et al. 2008). The Sarbanes-Oxley Act and stock exchange listing standards (e.g. NYSE, AMEX) require audit committees to be fully independent with at least one financial expert. These characteristics are thus clustered in the audit committee. Additionally, descriptive evidence in table 1 shows directors active on the audit committee to have relatively low tenure or shares, as well as multiple board mandates as opposed to the rest of the board. Differences between the audit committee and the rest of the board thus reach beyond only the regulated attributes. The focus on functional characteristics is corroborated by empirical research on work group diversity finding deeper-level (i.e., functional) attributes to have strong and persistent effects on work-group cohesiveness, whereas the influence of surface-level (i.e., demographic) characteristics concentrates in the short run and thus is neutralized over time (Harrison et al. 1998, 2002). Accordingly, Bruynseels et al. (2015) and Kaczmarek et al. (2012) demonstrate functional characteristics being the most important towards explaining group dynamics in a boardroom setting. Functional attributes furthermore pose the greatest risk to board cohesiveness (Forbes and Milliken 1999; Pelled 1996). Note that including demographic (e.g., age, race, gender) characteristics in our measures would introduce noise as group dynamics caused by demographic characteristics may have different effects than those caused by functional characteristics (Bezrukova et al. 2009; Hutzschenreuter and Horstkotte 2013). The chosen characteristics are transformed to equal scales prior to calculating the distance and cohesion measures (Bruynseels et al. 2015). Not doing so would distort the measures as attributes with higher values will weigh more on the measures (Zanutto et al. 2011). Director 15
independence has been disaggregated into three categories. We define three mutually exclusive dummy variables indicating whether a director qualifies as independent, insider, or affiliated ( gray ). Similarly, financial expertise is defined as a dummy variable equal to one if a director qualifies as a financial expert according to the SOX requirements and zero otherwise. Director tenure and the number of shares are measured as continuous variables and are scaled by their range on the board. These variables subsequently range from zero to one. The number of board mandates is defined as a dummy equal to one when a director has multiple mandates, and zero when the director sits only on the company board. Distance between the audit committee and the rest of the board Previous diversity research has operationalized distance between group members or subgroups by calculating the Euclidean distance based on a set of diversity attributes (Bezrukova et al. 2009; Harrison and Klein 2007; Zanutto et al. 2011). Squared distances between subgroup means are calculated for each characteristic separately and then aggregated, after which the square root is taken from the total sum. Applied to the audit committee setting, the Euclidean distance is calculated between the mean attributes of the audit committee and the mean attributes of the rest of the board. The mathematical specification is the following. Distance g = (X 1j. X 2j. ) 2 p j=1 where the distance measure is comprised of the distance between the subgroup averages for each characteristic. X 1j. Is the mean of the j th variable for subgroup 1, whereas X 2j. is the mean of this characteristic for subgroup 2. The square root is taken from the aggregate variable differences between both subgroups. The larger the total Euclidean distance, the more different subgroups are 16
from one another. Given that the maximum difference for each characteristic is one for our set of attributes, the distance can range from zero to 2.828. 5 We refer to the appendix for a computational example. Cohesion of the rest of the board A key determinant of a strong subgroup identity is the cohesion of the group (Evans and Dion 1991; Tajfel and Turner 1985). In line with previous behavioral studies, we define cohesion as the lack of variation of certain attributes within a group (Bezrukova et al. 2007; Harrison and Klein 2007). The more variation is found within a group, the less strong its cohesion will be. Relating this to a subgroup setting, we define subgroup cohesion as one minus the subgroup variance over total group variance. Variances are aggregated over all characteristics. The more variance is found within the subgroup, the higher the numerator and subsequently the lower the cohesion measure will be. Higher values indicate a stronger cohesion, with one being the maximum value. Mathematically, this entails the follow specification. n g (X ijg X.jg ) 2 p i=1 j=1 (N 1) Cohesion g = 1 n (X ij. X.j. ) 2 p i=1 j=1 ( (N 1) ) In this equation, X ijg represents the value of the j th task-related characteristic of the i th member of sub-group g, X.j. is the overall group mean of characteristic j, X.jg is the mean of characteristic j in sub-group g, n g is the number of members of the g th sub-group (g = 1, 2). The closer to one, the more cohesive the group is. Note that the cohesion measure can be negative, as the 5 A maximum distance between the audit committee and the rest of the board necessitates a maximum difference of one on each of the eight attributes. Aggregating the squared differences leads to a total difference of eight. Taking the square root of eight renders a maximum value of 2.828. 17
variance within the rest of the board may exceed the total board variance. 6 We refer to the appendix for a computational example. Interaction variable Lastly, we include an interaction of distance and the cohesion of the rest of the board to capture the interdependencies between both variables and examine our second hypothesis. The potential negative effects of a strong subgroup are contingent upon how this subgroup relates to the other group (Bezrukova et al. 2009). Both aspects can amplify or exacerbate one another and hence should be examined jointly (Zanutto et al., 2011). The importance of targeting the joint effect has previously been demonstrated in a governance setting (Bruynseels et al. 2015; Kaczmarek et al. 2012). In the empirical analyses, we orthogonalize the interaction to eliminate multicollinearity issues. 7 IV. EMPIRICAL RESULTS Data and descriptive statistics Governance data is obtained from a specialized database provided by Institutional Shareholder Services (ISS) covering the Russell 3,000, which represents about 98% of the investable U.S. equity market. The database contains detailed information on director and board characteristics. The sample period covers 2008 to 2012 and contains 13,098 firm-year observations. We drop observations where the full board sits on the audit committee (n = 214). Financial data for these firms 6 As the within-group variance of the rest of the board is relative to the total variance of the board, audit committee cohesion is indirectly taken into account. The total variance is an aggregate of director characteristics in the full board. 7 This approach is also known as residual centering (Little et al. 2006). Essentially, this entails regressing an interaction variable on its determinants and using the residuals rather than the interaction in subsequent analyses. Excessive correlations are thus filtered out. 18
are acquired from Compustat. We next exclude all firms active in the financial sector or regulated industries (SIC codes 6000-6799 and 4900-4999; n = 1,883). After elimination of missing values, the sample comprises 5,912 observations for the accrual quality model. Data on auditor characteristics, restatements and internal control deficiencies are obtained from Audit Analytics. The restatement model is comprised of 7,526 observations, while the internal control deficiencies model counts 6,939 observations. Details on the sample selection procedure are found in table 3. <<<<<Insert table 3 about here>>>>> Table 4 displays descriptive statistics on the final sample for the variables used in the models. All variables are winsorized at the top and bottom 1% level. The accrual quality variable is quite evenly distributed, though slightly skewed to the right. Next, about 8% of the firms in our sample have been subject to the issuance of a restatement. Lastly, 3.5% of the firms has issued an internal control deficiency. These numbers are in line with previous research (Bruynseels and Cardinaels 2014; Dao et al. 2011; Francis et al. 2005; Srinidhi and Gul 2007). The distance measure has a mean value of 0.783 and is strongly skewed to the right, indicating large differences in director profiles to exist between the audit committee and the rest of the board. The cohesion of the rest of the board is on average -0.065, which confirms the rest of the board as being a disparate group of directors. Negative values of this variable arise when the variance within the rest of the board is larger than the total variance of the board. Jointly considered, these descriptive statistics hint at structural differences between the audit committee and the rest of the board. On average, 75% of the directors is independent, with the average audit committee being comprised of 3.5 directors. About half of the directors active on the audit committee satisfy the SOX requirements for qualifying as a financial expert. Directors having multiple mandates account for 45% of the board. The mean value of 14.346 for the logarithm of the average number of shares on the board indicates the importance of shares as a director compensation tool. Lastly, large differences in tenure are found within the board of 19
directors. The descriptive statistics on the other control variables are in line with previous research (e.g. Bruynseels and Cardinaels 2014; Dao et al. 2011; Francis et al. 2005; Srinidhi and Gul 2007). In total, 86% of firms are audited by a Big 4 audit office. <<<<<Insert table 4 about here>>>>> An undisclosed correlation matrix shows multicollinearity not to be an issue, the highest correlation not exceeding 0.58 and the maximum VIF being 5.85. Accrual quality model The results from the model estimation are shown in table 5. The model is estimated robust to heteroscedasticity using ordinary least squares estimation. The analyses show no significant main effect of audit committee distance on accrual quality (DISTANCE, p = 0.819). However, both the cohesion of the rest of the board as well as the interaction between distance and the rest of the board are significant with a positive sign (COHESIONROB, p = 0.006; INTERACTION, p < 0.001). This is in line with our second hypothesis, posing a strong cohesion of the rest of the board to have particularly negative effects on audit committee effectiveness when a high distance exists between both subgroups, as strong subgroup entities may instigate intergroup frictions and a preference for within-subgroup interactions (e.g. Bezrukova et al. 2009; Nesdale and Mak 2003). A potential explanation for the positive main effect of the cohesion of the rest of the board may be differential incentives between this group and the audit committee. This may result in different accounting choices and lower accrual quality. Focusing on the governance variables, we find high-tenured boards to have more experience in estimating accruals, showing lower accrual estimation errors (MEANTENURE, p = 0.001; Vafeas 2005). Busy boards on the other hand are associated with higher errors, as these directors may devote less time and resources to the estimation of accruals (PCTBUSY, 20
p = 0.013; Fich and Shivdasani 2006). In line with previous research, we find Big 4 auditors to be associated with better reporting quality (BIG4, p = 0.012; Francis and Wang 2008). Of the innate determinants of accrual quality, the length of the operating cycle and the standard deviation of operational cash flows are associated with higher estimation errors (OPCYCLE, p < 0.001; STDOCF, p < 0.001), while larger firms and firms with a higher standard deviation of sales show lower estimation errors (LOGTA, p < 0.001; STDSALES, p = 0.088). The signs and significance of the control variables is in line with previous research (Dechow and Dichev 2002; Francis et al. 2005). <<<<<Insert table 5 about here>>>>> Restatement model Table 6 displays the results of the restatement model estimations. Probit has been used to estimate the propensity of being subject to a restatement. Model one is estimated on the full sample, while model two is estimated on a sample matched on year, industry and total assets (Agarwal and Chadha 2005). The estimation of the probit model shows distance between the audit committee and the rest of the board to decrease the probability of receiving a restatement (DISTANCE, p = 0.006, p = 0.031). A high distance allows the audit committee to weigh strongly on discussions on accounting matters, as its expert status and superior expertise increases it s persuasiveness on financial issues (DeBono and Klein 1993; Lau and Murnighan 1998; Fiske and Taylor 2008). The cohesion of the rest of the board is insignificant, but the interaction is (COHESIONROB, p = 0.343, p = 0.571: INTERACTION, p = 0.074, p = 0.042). A strong cohesion of the rest of the board may thus prove detrimental when distance between the audit committee and the rest of the board is high. Inter frictions are intensified, while the desire for subgroup members to remain distinct from and superior to members of the other subgroup leads to conflicts (Bezrukova et al. 2009; Halevy, 2008; Li and 21
Hambrick 2005; Thatcher and Patel 2011). The effects of subgroup identities conditional on the differences between them is in line with management research (Bezrukova et al. 2009). Both hypotheses are thus confirmed. Of the control variables, board size, the percentage of independent board members and busy directors are found to decrease the likelihood of receiving a restatement (BOARDSIZE, p = 0.098; p = 0.196; PCTINDEP, p = 0.003, p = 0.013; PCTBUSY, p = 0.007, p = 0.235). The monitoring effects of independent directors have been extensively documented by previous research (e.g. Cornett et al. 2009). Busy directors have high reputation concerns, which can explain the negative sign (Fich and Shivdasani 2007). The contrast with the previous model may be due to the open character of a restatement, while accrual estimation errors are harder to perceive by investors (Francis et al. 2005; McInnis and Collins 2011). Somewhat surprisingly, when taking into account group dynamics both audit committee financial expertise as well as Big 4 auditors are associated with a higher incidence of restatements (ACFINEXP, p = 0.010, p = 0.055; BIG4, p = 0.003, p = 0.138). Further analyses show the positive impact of these variables weakens or disappears when dropping the crisis years, indicating financial experts and Big 4 auditors may have grown more conservative during the financial crisis, disallowing accounting practices which were tolerated precrisis. Initial audit engagements furthermore lead to a higher likelihood of being subject to a restatement (INITIAL, p = 0.004, p = 0.108). This may be due to either increased monitoring by the new auditor. Of the general firm controls, a higher leverage, growth prospects and increased complexity are associated with more restatements, while more profitable firms and firms with a higher current ratio have a lower likelihood of being subject to a restatement (LEVERAGE, p = 0.019, p = 0.290; MTB, p = 0.337, p = 0.078; NUMSEG, p = 0.246, p = 0.029; ROA, p = 0.003, p = 0.002; CR, p = 0.055; p = 0.012). <<<<<Insert table 6 about here>>>>> 22
Internal control deficiency model Table 7 shows the estimation results of the internal control deficiency model. Probit has been used to estimate the propensity of being subject to a restatement. As for the restatement sample, model one is estimated on the full sample, while model two is estimated on a sample matched on year, industry and total assets (Agarwal and Chadha 2005). The results show distance between the audit committee and the rest of the board to negatively impact the disclosure of an internal control deficiency, as distant audit committees have more impact on board discussions and can exercise more influence on management and the design of the internal control systems (DISTANCE, p < 0.001, p = 0.025; DeBono and Klein 1993; O Leary and Mortensen 2010). A cohesive rest of the board as well as its interaction with distance both have a significant positive effect on the likelihood of disclosing an internal control deficiency (COHESIONROB, p = 0.089, p = 0.086; INTERACTION, p = 0.102, p = 0.037). A strong subgroup identity instigates conflicts, which are contingent on the differences between both subgroups (Bezrukova et al. 2009). The rest of the board may thus oppose audit committee input on internal control deficiencies, leading to lower quality internal controls and a higher probability of disclosing an internal control deficiency. Our both hypotheses are again confirmed. The main effect of the cohesion of the rest of the board may again be explained by differential incentives between the rest of the board and the audit committee. Of the governance characteristics, we find high more independent, high tenured and busy boards to be associated with a decreased likelihood of disclosing an internal control deficiency (PCTINDEP, p = 0.020, p = 0.024; MEANTENURE, p < 0.001, p < 0.001; PCTBUSY, p = 0.032, p = 0.364). As in the previous models, we attribute these findings to the high monitoring of independent boards, increased experience of high-tenured directors and the status concerns of busy directors (Cornett et al. 2009; Fich and Shivdasani 2007; Vafeas 2005). Larger audit committees increase the likelihood of disclosing an internal control deficiency, while auditors with relatively high non audit fees are associated with a 23