How Boards Use Auditor-Provided, Non-Public Information in Overseeing Management

To what extent do directors care about financial reporting? Prior research provides some evidence that financial reporting quality is important to boards and that financial misreporting influences their executive retention decisions. For example, the public revelation of past financial reporting errors or intentional misstatements increases the likelihood that the board will dismiss the CEO or CFO. However, restatement announcements, financial-statement fraud, and other publicly revealed attempts to misstate earnings reflect poorly on both management and the board, creating an incentive for directors to deflect responsibility from themselves. Thus, it is not necessarily clear whether directors respond to financial misreporting because they care about accurate reporting or because they wish to protect their own reputations for fiduciary oversight.

In our study here, we set out to investigate whether boards care about financial reporting in the absence of a public signal of misreporting. Without a public signal, directors would have less public pressure, if any, to hold management accountable, and we could then observe whether financial reporting is valued by boards.

Boards’ Use of Auditor-Provided Information

The board’s primary source of information is the executive management team, which can make it difficult for boards to gather unfiltered information about executive performance, including information about management’s misreporting. One information source outside of management is the independent auditor. Auditors are required to communicate certain information to the audit committee of the board of directors in connection with the audit of year-end financial statements. As part of that communication, the auditor informs the audit committee of misstatements that the auditors have detected and required management to correct. Because financial reporting for public companies involves significant complexity and subjective estimates, management may be able to report opportunistically. However, auditors independently evaluate the company’s financial reporting and propose accounting adjustments they view as necessary to properly reflect the underlying economic activities. Because these adjustments correct financial reporting misstatements, they result in higher-quality financial statements. Thus, the adjustments are a non-public signal to the board about the quality of management’s financial reporting, and the signal itself corrects the problem before the public can observe any reporting issues. If boards use audit adjustments in their evaluation of management, it suggests they are proactive in their fiduciary responsibilities over financial reporting.

Boards of Directors in China

Information on audit adjustments is not public information. However, we found that the Chinese audit regulator collects audit adjustments to use in its oversight of external auditors, and we were able to obtain these adjustments for use in an academic study. Despite institutional differences, Chinese boards have many similarities with boards in the U.S. and in other jurisdictions around the world. Chinese boards meet regularly throughout the year, make important decisions about firm operations, and oversee and evaluate the firm’s executives on behalf of shareholders. Chinese boards are also structured similarly to U.S. boards, including involvement of independent directors who chair the audit committee. Chinese directors also have clear incentives to monitor managers, including potential discipline of directors from the dominant stock exchanges. Thus, China’s agency problems are not identical to those in the U.S. or other western jurisdictions, but directors have similar responsibilities and incentives to fulfill their fiduciary mandate of monitoring managers.

Our Research Study

We study board oversight of executives in nearly 3,000 companies over a 10-year period, ending in 2019. We find an increased likelihood of CEO and CFO dismissal when auditors identify relatively large audit adjustments. These results are focused in situations when the original misstatements resulted in more favorable financial reporting results. When financial statements include misstatements that make the company look worse, boards do not appear to act on information about the misstatements. These results suggest that boards are particularly attuned to management’s attempts to make the company look better, which could be more representative of intentional misreporting. When managers report conservatively but auditors later correct the excessive conservatism, the board does not appear to punish executives.

Because boards appear to place some importance on financial reporting quality absent a public signal, we examine factors that influence this result. We find that if the company is performing well, the board is less concerned about financial misreporting. We also find that attributes of the board affect the likelihood of board action following audit adjustments. We document that audit adjustments affect CEO and CFO dismissal when board members own more shares of the company, when a greater percentage of the board is informed of the misreporting directly by the auditors, and when the CEO is not the board chair. These results support the importance of careful consideration of governance decisions.

Implications of Our Research

Our research has several relevant implications. James Doty, former chairman of the Public Company Accounting Oversight Board  (PCAOB), noted that auditors “ask for and see anything they think they need in order to assure themselves that there are no material misstatements… Boards don’t do that, but they and their shareholders sure can benefit from knowing what the auditor has learned” (Doty 2016). We find evidence that auditors provide information that boards can use in their oversight of company management, and we document several factors that contribute to the board’s use of this information. Our research also highlights one benefit of independent audits that is generally not observed. Audit regulators around the world, including the PCAOB in the U.S., have argued that auditors’ public reports include too little information relative to the amount of knowledge acquired by auditors during the audit. This belief has culminated in new requirements that expand the audit report. However, our study shows that auditors also provide important information privately to those who represent shareholders, and those individuals can use the information to act on behalf of the shareholders. Our study also provides important information about corporate governance in China. Chinese equities represent a growing share of available emerging-market investments and are a popular choice for global investors. Our study shows that Chinese boards engage in oversight of their executives and demand financial reporting quality, which is a relevant consideration for potential investors.

REFERENCE

Doty, J. R. 2016. The role of the bar and the audit in shareholder-director relationships. Speech given at 19th annual law and business conference, Vanderbilt Law School, Oct. 7th, 2016. https://pcaobus.org/News/Speech/Pages/Doty-speech-Vanderbilt-10-7-16.aspx

This post comes to us from Phillip T. Lamoreaux, a professor at Arizona State University; Summer Liu, a PhD student at Arizona State University; Nathan J. Newton, a professor at Florida State University; and Min Zhang, a professor at Renmin University of China. It is based on their recent article, “Private Signals of Misreporting and Executive Dismissal,” available here.

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