Having accountants on the corporate board’s audit committee seems like a no-brainer, and a recent study suggests it helps companies and their investors.
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Major accounting firms have found their audit quality come into question after a series of accounting scandals in recent years, prompting reforms in the audit market in Europe and the U.K. Having accounting expertise on a corporation’s audit committee helps the board assess the quality of the audits and the financial statements. The findings in the study were strongest for non-Big Four engagements, with non-Big Four auditors found to be less sensitive to market-wide discipline mechanisms in terms of reputation, legal liability, and professional regulation.
“It’s not necessarily that auditors are acting nefariously when they over-audit. It’s just that people respond to incentives, and auditors have an incentive to protect their reputations and avoid inspection findings,” said Mike Wilkins, an accounting professor at the University of Kansas, who conducted the study with James Hansen, Ling Lei Lisic and Timothy Seidel. “All of these organizations have audit committees. If you truly are interested in trying to ensure that the quality of the audit work is what you want it to be, it’s really important you have the right type of individuals on the committee.”
Wilkins’ team performed tests using three different settings: two associated with over-auditing and one associated with under-auditing. The study found evidence that the nature of audit committee members' accounting expertise has different impacts on the committee's ability to curtail over- and under-auditing.
“There’s a tendency for auditors, particularly in large firms who are inspected every year, to over-audit,” Wilkins said in a statement. “This is to make sure they’re doing things as well as they’re able to at all times, when you could have instances where maybe some of the extra work they’re doing is not entirely necessary. One of the jobs of the audit committee is to monitor the auditors. Technically, it’s an active role, but it’s not like the committee is physically there actually watching what the auditor is doing.”
The research uses the concept of “credence goods,” defined as those with qualities that are difficult or impossible to evaluate even after a purchase has occurred. For comparison, Wilkins used the analogy of someone who needs to have a car repaired.
“You take your car in, and the person who is repairing your car is the expert,” he said in a statement. “They also are the party who is selling you the service. You’re not the expert. You can’t observe what they’re doing. Even if you could, you might not have any idea whether the work is good or not. So you have to trust them to explain what you need and to charge you honestly for it.”.
Similarly, an audit committee isn’t watching someone audit everything, but if the committee contains a person with accounting expertise, then collectively this group should comprehend more about what is actually needed.
“Plus, the auditor obviously knows who’s on the committee,” Wilkins said in a statement. “So if the auditor knows that some of the committee members are accounting experts, then he might be less likely to over-audit or not audit enough.”
Despite the obvious benefits, many companies don’t include accounting experts on their audit committees.
“I don’t think it’s likely they actively would avoid it,” Wilkins stated. “It’s just that they might not understand the benefit of having someone on there who has accounting expertise versus other types of financial expertise.”
The study found the results in certain situations apply more for smaller firms than for the Big Four firms. “Auditors work hard to uphold their reputation,” Wilkins stated. “That is a very strong incentive from their perspective. But smaller audit firms are generally less monitored by factors related to litigation and reputation. So it’s even more important in those situations that the audit committee is working toward doing what it needs to be doing.”
Wilkins hopes the study leads to practical benefits for companies. “What our results show here is that — particularly for companies that are not audited by the large audit firms — it really adds a lot of value to have somebody on the audit committee with significant accounting experience,” he said.
