Does Firm-Specific Knowledge Matter for New Audit Committee Chairs and Financial Reporting Quality?

Overcoming the learning curve for a new situation or role at work can be difficult, especially when the situation or role requires specialized knowledge. Newly appointed audit committee chairs face a particularly steep learning curve, given that audit committees of publicly traded corporations are responsible for monitoring management’s financial reporting decisions. Doing the job effectively requires understanding the company’s culture, risks, internal controls, activities, and policies. It also requires coordinating the activities of the audit committee and obtaining information about important company decisions and practices from members of the senior management team, internal auditors, and external auditors. Corporate governance experts have expressed concern that, if new audit committee chairs do not have sufficient knowledge or experience, the quality of monitoring can suffer, especially during the audit committee chair succession period, when the audit committee chair is new to the role.

In a recent study, we investigate whether new audit committee chairs provide higher quality monitoring when they have previously served on the company’s audit committee. Our evidence suggests that they do, having acquired an understanding of the organization needed to more effectively adjust to their new role. We refer to the knowledge gained from this prior audit committee service as firm-specific knowledge.

The idea that firm-specific knowledge is beneficial is supported by previous findings in organizational learning research, but these findings have not been tested in the audit committee setting. This setting is particularly important because strong audit committee chair oversight is necessary to protect stakeholder interests and to generate high quality financial information. We find that, in our sample, approximately two thirds of newly appointed audit committee chairs have previously served on the company’s audit committee – we refer to these individuals as “internal successors.” This means that many audit committee chairs are “external successors” who do not have firm-specific knowledge when they assume this important role.

The nature of the audit committee chair’s responsibilities suggests that internal successors should have a monitoring advantage over external successors. The audit committee chair is responsible for ensuring that the scope of audit committee activities is appropriate, that the highest-risk issues are given adequate attention, and that committee members have access to information necessary to make well-informed judgments and decisions. To do this, the chair determines the structure and content of audit committee meetings and communicates both formally and informally with key parties involved in the financial reporting process. These parties can include the chief financial officer (CFO), the director of internal audit, and the external audit partner. These communications are especially important when difficult financial reporting issues arise. The audit committee chair is also responsible for all decisions made by the audit committee and must also hold committee members accountable. Because many of these duties require information about the company’s activities, resources, and practices, having firm-specific knowledge should help audit committee chairs effectively execute their role.

However, there could be benefits from selecting an external successor who does not have a prior relationship with company management or audit personnel because external successors can bring a fresh perspective to the company’s financial reporting practices and to the audit committee chair’s role. External successors are often former CFOs or audit partners, so they have deep knowledge about financial reporting risks and practices. In addition, many have previously served in the audit committee chair role at other companies. Finally, some companies have developed strong on-boarding programs and practices that can reduce the knowledge gap between internal and external successors.

Our sample of U.S. publicly traded companies represents more than 3,000 unique audit committee chairs from 2005 through 2017. We use this sample to test whether internal successors provide better monitoring than external successors. To measure the quality of monitoring, we identify cases where a company’s financial statements were materially misstated, as evidenced by a restatement. We use these misstatements as our proxy for low-quality financial reporting because the primary role of the audit committee is to ensure that high quality, reliable information is provided to market participants, and material misstatements suggest that the audit committee chair’s oversight of the financial reporting process may have failed in some way. We find that misstatements are less likely when newly appointed audit committee chairs are internal successors. These findings support the recommendations of some corporate governance experts and professional accounting firms that directors serve on the company’s audit committee before assuming the chair role.

One possibility is that the monitoring advantage of internal successors is short lived and that as external successors gain on-the-job experience, they can perform their monitoring function as well as new audit committee chairs with prior audit committee experience can. Our results indicate that this is the case, but the monitoring advantage of new audit committee chairs derived from firm-specific knowledge lasts for two years, on average. Because audit committee chairs have relatively brief tenures, this finding has important implications for the quality of oversight at U.S. publicly traded companies.

We also examine whether audit committee chair characteristics can compensate for a lack of firm-specific knowledge, leveling the playing field between internal and external successors.  Here, we test whether the difference in monitoring performance is eliminated when an external successor has accounting expertise (for example, as a certified public accountant), supervisory expertise (for example, as a CFO at another company), or industry expertise (for example, as an executive at another company in the focal company’s industry). We find that this is not the case. That is, companies with external successors are still more likely than companies with internal successors to misstate their financial statements even when external successors have accounting, supervisory, or industry expertise. Finally, we test whether prior experience as an audit committee chair at another publicly traded company is sufficient to offset differences in monitoring outcomes, and we find that it is not. Our findings underscore the notion that firm-specific knowledge gained through direct experience on a company’s audit committee prior to becoming audit committee chair is important for high quality monitoring.

Our findings suggest that corporate boards and nominating committees should place even more emphasis on succession planning for new audit committee chairs and perhaps for committee chairs more generally. Newly appointed audit committee chairs perform more effectively when they have had the opportunity to develop a deeper understanding of company practices and risks and when they have prior knowledge about how to access relevant information from other parties within and outside of the company. Because we find that firm-specific knowledge is a characteristic of the audit committee chair that can affect the likelihood of financial reporting failures, investors and other stakeholders may benefit from more visibility into company strategies related to audit committee chair succession planning, and perhaps related to board appointments more generally.

This post comes to us from professors Linda A. Myers and Roy Schmardebeck, and PhD candidate Stefan Slavov at the University of Tennessee’s Haslam College of Business. It is based on their recent article, “Audit Committee Chair Succession and Financial Reporting Quality: Does Firm-Specific Knowledge Matter?,” available here.

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