Current Research in Auditing and Corporate Governance Presentation to the CAR Doctoral Consortium

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Current Research in Auditing and Corporate
GovernancePresentation to the CAR Doctoral
Consortium

• Joseph V. Carcello
• Ernst Young Professor
• Director of Research Corporate Governance Center

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Outline for Today

• Current state of auditing / corporate governance
  research
• Structure of a research paper
• Question
• Theory
• Literature
• Data
• Method
• Findings
• Conclusions
• Application of above to one research paper
• A few words about other faculty roles

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Current State of Auditing / Corporate Governance
Research

• Corporate governance mechanisms
• Board of directors
• Audit committee
• Nominating committee
• External audit
• Financial statement audit
• Internal control audit (Section 404)
• Internal audit
• Institutional ownership

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Current State of Auditing / Corporate Governance
Research

• Common dependent variables
• Going concern reporting
• Auditor changes
• Fraudulent financial reporting
• Restatements
• Earnings management
• Analyst forecasts
• Cost of equity/debt capital
• Firm performance
• Tobins Q
• Buy-and-hold returns

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Current State of Auditing / Corporate Governance
Research

• Examples (not even remotely a complete list)
• Relation between board of director independence
  and fraudulent financial reporting (Beasley, TAR,
  1996)
• Relation between audit committee independence and
  GC reporting (Carcello and Neal, TAR, 2000)
• Relation between type of audit committee
  financial expertise and earnings management
  (Carcello, Hollingsworth, Klein and
  Hollingsworth, Working Paper, 2007)

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Current State of Auditing / Corporate Governance
Research

• Non-audit fees paid to external auditors and
  audit quality e.g., restatements (Kinney,
  Palmrose, and Scholz, JAR, 2004).
• Financial, governance, and auditor
  characteristics and material weaknesses in
  internal control (Ashbaugh-Skaife, Collins, and
  Kinney, JAE, 2007 Doyle, Ge, and McVay, JAE,
  2007)
• Audit committee processes and activities in
  overseeing financial reporting (Beasley,
  Carcello, Hermanson, and Neal, CAR Conference,
  2007)

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Current State of Auditing / Corporate Governance
Research

• Future opportunities to advance this literature
• Most of the extant research focuses on inputs and
  outputs the process that a better board / AC
  uses to achieve a better output is treated as a
  black box. What do better boards / ACs do to
  achieve better outcomes?
• Governance characteristics are likely endogenous
  to the firm much of the published research
  treats governance characteristics as exogenous.
• How do firms circumvent required corporate
  governance requirements, what characteristics
  describe these firms, and what are the
  consequences?

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Question

• Tackle research questions that
• Involve tension e.g., there is some uncertainty
  as to the outcome
• Are important to one or more groups (academics,
  practitioners, regulators, etc.)
• Ways of making a contribution
• New question
• New data (source)
• New research method

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Theory

• The predicted relations (hypotheses) between your
  test variable and your dependent variable should
  be based on theory.
• Theory can either be mathematically derived or
  based on verbal, institutionally-based,
  reasoning.
• Much of the theory for auditing/corporate
  governance work comes from the finance literature
  (e.g., agency theory) however, other theories
  from management and the other social sciences
  should be considered (e.g., institutional theory,
  resource dependence theory, etc.)

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Literature

• Be sure that the paper that you are contemplating
  hasnt been done by someone else always a risk
  given the proliferation of research journals.
• Be well read in your research area properly
  cite others findings, identify needed control
  variables, discuss new databases and econometric
  approaches.
• If you are interested in governance research,
  youll have to consider the finance, legal, and
  management literatures, in addition to the
  accounting literature.

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Data

• Much of the early governance research involved
  hand collected data sets.
• New governance-oriented databases
• Board Analyst approximately 2,500 companies, 5
  years of data
• IRRC approximately 2,000 companies, data going
  back to late 1990s
• ISS approximately 7,000 companies (2,000
  international), data going back to early 2000s

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Method

• Be certain to attempt to rule out alternate
  explanations for your results through your
  research design.
• Increasing use of full sample studies rather than
  matched-pair designs.
• Increasing attempts to deal with endogeneity
• Fixed effects models (need repeated observations
  for each firm)
• Instrumental variables regression

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Findings

• Be careful not to claim more than your results
  support.
• Perform sensitivity tests to see if other
  explanations or approaches to variable
  measurement affect your results.
• Readily recognize any remaining limitations of
  your approach.

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Conclusions

• Put your findings in a broader context
• Implications of findings for what we know i.e.,
  academic consequences
• Implications of findings for managers and
  auditors i.e., professional consequences
• Implications of findings for legislators and
  regulators i.e., public policy consequences
• Consider future research that would advance the
  field

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Application to One Research Paper

• CEO Involvement in Selecting Board Members and
  Audit Committee Effectiveness
• Carcello, Neal, Palmrose, and Scholz, 2007

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Question

• Does CEO involvement in selecting board members
  reduce the effectiveness of the audit committee?

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Theory

• CEO involvement in selecting board members
  reduces the objectivity of seemingly independent
  directors (Shivdasani and Yermack, JF, 1999
  Klein, JLE, 1998)
• Objectivity of board members is critical because
  it affects a directors willingness to monitor
  management (Hermalin and Weisbach, AER, 1998)
• Independence is the most important factor in
  determining the effectiveness of a board member
  (Hermalin and Weisbach, FRBNY Economic Policy
  Review, 2003)

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Literature

• There are fewer restatements when the audit
  committee is independent (Abbott, Parker, and
  Peters, AJPT, 2004)
• Board members may be ostensibly independent but
  may have personal or business relationships with
  the CEO or other members of top management (e.g.,
  Shivdasani and Yermack, JF, 1999 Klein, JLE,
  1998 Beasley, Carcello, Hermanson, and Neal, CAR
  Conference, 2007)

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Data

• Hand-collected
• Firms announcing a restatement in 2000 or 2001
  for misstatements of 1999, 2000, or 2001
  financial statements
• Restatement firms from a proprietary database
  developed by Zoe-Vonna Palmrose and Sue Scholz
• Non-restating firms matched on stock exchange,
  industry, and size
• 104 restating firms 104 matched, non-restating
  firms

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Method

• Logistic regression
• Interact CEO Involvement with AC independence
• CEO is coded as being involved if
• CEO sits on nominating committee
• No nominating committee, but proxy indicates that
  the entire BOD is involved in selecting directors
• No nominating committee, but proxy indicates that
  management is involved in selecting directors

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Findings

• Significant negative relation between AC
  independence and restatements (p lt 0.10)
• Significant negative relation between AC
  independence and restatements when the CEO is not
  (or at least, less) involved in selecting
  directors (p lt 0.05), and no relation between AC
  independence and restatements when the CEO is
  involved in selecting directors
• Results are even stronger if we measure CEO
  involvement based solely on the CEO being on the
  nominating committee

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Conclusions

• Benefits of AC independence may not be fully
  realized because companies may appoint directors
  to the AC who are independent in appearance but
  not in fact
• Any regulatory move to loosen the definition of
  independence may be misguided, because it would
  enable the CEO to have more discretion in
  appointing AC members

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Other Thoughts on Faculty Roles

• Teaching
• Importance likely to rise in the future given
  (1) increasing importance of newspaper rankings
  to business schools, and (2) greater use of PQ
  faculty in the future. Challenging given
  increasing research expectations.
• Develop your own style.
• Look for a school where the teaching and research
  expectations are consistent with your abilities
  and preferences.

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Other Thoughts on Faculty Roles

• Service
• Emphasize external service rather than internal
  service, certainly early in your career
• Service to organizations like CAAA, AAA, etc. can
  help you develop relationships offer many
  benefits
• Serving as a referee for high quality journals
  helps you build your national / intl reputation
• Focus on internal service that provides you with
  psychic income rather than service that feeds the
  bureaucratic beast