Despite Sarbanes-Oxley requirements, audit committee influence over hiring the outside auditor and setting the audit fees remains more of a hope than a reality, according to a new study.
The study, by Elaine G. Mauldin, an associate professor of accountancy at the University of Missouri, and Matthew J. Beck, an assistant professor at Michigan State University, found that CFOs continue to dominate the process of choosing an audit firm and negotiating the fees paid to the firm.
The study, entitled "Who’s Really in Charge? Audit Committee versus CFO Power and Audit Fees," appears is in the November/December issue of the American Accounting Association’s journal The Accounting Review.
In response to a series of accounting scandals, the Sarbanes-Oxley Act of 2002 mandated among other provisions a greatly expanded role for audit committees of corporate boards, including the tasks of overseeing the work of external auditors and determining their compensation. However, 12 years later, the success of this reform remains in doubt.
The new study, according to its authors, “raises questions about regulation successfully changing historical patterns of influence between management and the audit committee. Our results indicate that CFOs often continue to significantly influence the external audit fee negotiation despite regulatory requirements placing the primary responsibility for audit fees with the audit committee.”
The study suggests that the audit committees’ power has turned out to be less than anticipated, and “current regulations may give investors a false sense of security.”
“In an environment where the CFO interacts extensively with the auditor and often influences or controls fee negotiations, it may be unrealistic and misleading to investors to indicate that audit committees are in charge,’” according to the study.
“When push comes to shove, the power of audit committees can be an iffy proposition,” Mauldin said in a statement. “Our findings suggest that in many companies it is still primarily the CFO who calls the shots when it comes to hiring an auditor and setting the audit fee.”
“If it makes a difference to investors who’s in charge—as it should—they may want to do what we did in this study: refer to company proxy statements or 10K filings to see who has the longer tenure,” Mauldin added. “If the CFO has been with the firm a good while and most of the audit committee is fairly new to the board, in all likelihood the CFO dominates on matters related to auditing. If the CFO is fairly new and the audit committee is a seasoned group, the opposite is probably the case.”
Mauldin and Beck reached that conclusion through an analysis of auditing fees during the Great Recession of 2008-09. Whereas in normal times fee arrangements for auditors tend to be fairly static, the recent recession, in the words of the study, “provided an exogenous shock that simultaneously introduced conflicting pressures on audit-fee negotiations. The contracting economy reduced profitability, introducing widely recognized downward fee pressure. At the same time, the contracting economy also increased audit risk through increased likelihood of [company] failure, increased likelihood of earnings management, and potential reductions in internal controls. Higher audit risk requires greater audit effort, introducing upward fee pressure.”
Those circumstances, the study found, put audit committees and CFOs at odds to a greater extent than usual. As the authors explained, CFOs were greatly motivated “to negotiate [audit] fee reductions during the recession for two reasons. First, cutting audit fees directly improves net income. Second, reduced audit fees could result in less audit effort and allow management more earnings-management opportunities.” For their part, audit committees were motivated to “support the auditor’s and the shareholders’ desire for higher fees to combat higher audit risks.”
With these contrary interests at play, how did events play out? To find out, Mauldin and Beck combined data from several major databases to analyze 1) changes in audit fees charged to companies between 2006-07—the two years preceding the recession—and 2008-09, the recession period, and 2) how these changes related to the patterns of CFO and audit-committee power in several thousand companies. In total, the study’s final sample consisted of 9,214 firm-years of observations.
Relative power was assessed principally by comparing the average board tenure of members of audit committees to CFO company tenure. Since being a CFO is a full-time job and being an audit-committee member is only part-time, the comparison was not made in terms of years but quartiles—that is, where the CFOs and committees in each company ranked with regard to all the CFOs and committees in the sample.
For example, in one company the committee might rank in the first quartile (lowest tenure) while the CFO would rank in the fourth quartile (highest tenure), where in another company the quartile rankings might be the reverse of that.
Mauldin and Beck found that during the two years of recession, 2008-09, audit fees for the sample as a whole were 4 percent lower than they were in 2006-07. But in individual companies audit-fee reductions were smaller when the rank of audit-committee tenure was greater than that of CFO tenure and larger when the rank of CFO tenure was greater. As the study noted, “when audit-committee tenure is two quartiles higher than CFO tenure, recessionary fee reductions disappear, but when CFO tenure is two quartiles higher than audit-committee tenure, recessionary fee reductions double.”
The researchers saw similar results when they measured power in several other ways, and found that CEO tenure did not affect the CFO-audit-committee power balance in determining audit fees. In addition, they investigated whether the pattern prevailed for different levels of company bargaining power with auditors—for example, whether it would be true for a small firm that was a relatively minor client as well as for a big firm that was a major client. The results confirmed that the power of the audit committee relative to that of the CFO similarly affected audit-fee negotiations regardless of the extent of client bargaining power.
Mauldin doubts that Sarbanes-Oxley needs to be strengthened in order for the audit-committee dominance envisioned in the legislation to be realized. “The legislative mandate is pretty clear, and, given the staying power of historical patterns of influence, it’s hard to imagine that further legislation will help,” she said. “Regulators, auditors and organizations concerned with corporate governance are currently pursuing efforts to foster audit-committee assertiveness and to provide resources to encourage it, and hopefully those will have some effect.”
Meanwhile, the professor added, investors would do well to rely on their own investigating. “Other research has found downward audit-fee pressure to be associated with increased likelihood of financial misstatements, so obviously market participants have an interest in knowing to what extent that pressure will be exerted in a given company,” she said. “To that end, investors should avail themselves of readily accessible information in corporate proxy statements or 10K filings as to the relative power of CFOs and audit committees.”
