The role of the audit committee in a company’s board of directors has changed significantly since the passage of the Sarbanes-Oxley Act of 2002 (SOX). Traditionally, audit committees have overseen the company’s independent auditor, the internal audit function, and other financial reporting-related functions. More recently, many audit committees have taken on additional oversight responsibilities, such as overseeing enterprise risk management (ERM), environmental, social and governance (ESG) reporting, and cybersecurity.
Since these additional responsibilities are not explicitly required by SOX or the Securities and Exchange Commission (SEC) and are not assigned uniformly in all boards, stakeholders must rely on boards to tell them what audit committees do, typically with information in audit committee charters on a company’s investor relations website and in proxy statement disclosures. However, our interviews with audit committee members (primarily chairs) reveal that it often takes several years for an audit committee to disclose publicly that it has taken on these expanded responsibilities.
In a new study, we examine how companies decide what information to disclose about the audit committee and whether these disclosures mee investors’ needs. We interviewed 30 audit committee chairs or members from U.S. publicly traded companies, five preparers of proxy disclosures (general counsel, corporate secretaries, and a chief financial officer), and 14 members from the investment community (“investors”). These participants represent diverse views across company size, industry, age, and governance. In total, these interviews generated more than 2,900 minutes of data.
Background about Audit Committee Disclosures
In 2013, following enhanced audit committee reporting in the UK, a group of reputable U.S. governance organizations called for U.S. companies to “thoughtfully reassess” their audit committee reporting. Shortly thereafter, the SEC sought public feedback on 74 topics related to audit committee disclosures. After receiving more than 100 comment letters, no further standard setting was initiated.
Following this attention on audit committee disclosures, some companies began voluntarily expanding their audit committee-related disclosures, but most companies left them basically unchanged. Recent publications by the Center for Audit Quality (CAQ) show a trend toward more disclosure; but overall, most companies voluntarily disclose very little information about their audit committee, especially in areas beyond external auditor oversight. Consequently, stakeholders are often largely in the dark about the types of risks audit committees oversee and how they substantively oversee management’s responses to those risks. This can be detrimental to the capital markets because our interviews suggest that investors see these disclosures as an opportunity to assess the quality of corporate governance at the company.
The Importance of Signaling
Proxy statements allow audit committees to “tell their story” and assure investors that they are fulfilling their fiduciary duties. As such, when learning how companies craft their proxy disclosures and what audit committees view as the potential benefits and challenges to more granular disclosure, we expected to hear that audit committees with robust governance use their proxy disclosures to strategically signal their quality to market participants. This expectation was based on prior archival research that found positive associations between the extent of voluntary audit committee disclosures and financial reporting quality, which the studies interpret as evidence of audit committees with high-quality oversight. Instead, we learned that most companies incorporate standard language based on benchmarking against peers and fail to convey information that helps investors distinguish among companies as to audit committee quality..
Why is Investor Feedback Essential to Disclosure Signaling?
In our analyses, we use signaling theory to understand better why companies incorporate standard language instead of unique and more granular disclosures. Signaling theory can be compared to applying for a job, based on seminal research by Michael Spence. Let’s say that a job candidate chooses to get a graduate degree and specific certifications to distinguish herself from other applicants. The job candidate then presents this information on her resume, and employers choose the candidates whose credentials most closely align with the job tasks. This feedback cycle – choosing candidates with desired traits – gives feedback to the job applicants about the types of credentials that the employer desires. Thus, applicants seeking a specific job know which signals (e.g., education, certification) the employers are looking for.
In our setting, audit committee disclosures can convey detailed and granular information about the nature of audit committee responsibilities and how an audit committee fulfills its fiduciary duties. These fiduciary duties include providing additional information about audit committee qualifications, topics that received particular attention during the year, and audit committee actions to evaluate management’s responses to risk. To know whether investors desire these types of qualifications and actions, audit committees need feedback to help them distinguish what gets rewarded (e.g., favorable voting results) and what gets punished (e.g., less favorable voting decisions, contested proxy elections, etc.).
Without such feedback from investors – i.e., without perceiving that there are greater payoffs from signaling the audit committee’s quality—companies are more likely to adopt standard disclosures that meet minimum regulatory requirements and conform to disclosure norms.
Our study reveals that most companies do not include granular, detailed disclosures about the audit committee in their proxy statements. Instead, companies create two types of disclosure: (1) boilerplate designed, which aims to meet minimum SEC requirements, and (2) information that mimics voluntary disclosure by peers, which often follows language recommended by the CAQ and other large accounting firms.
Using signaling theory, we trace this disclosure behavior to the failure of investors to provide feedback. None of the audit committee members interviewed could recall when investors provided direct feedback about their audit committee-related proxy disclosures. Further, none noted dissatisfaction from investors in the form of proxy voting outcomes. Several audit committee members expressed that they would consider enhancing their disclosures; however, because that takes effort, they need investors to tell them directly that it would be useful information.
Interviews with investors confirm that they do not take advantage of opportunities for engagement to provide feedback about audit committee oversight. Yet, they anticipate changes, such as an increased emphasis on the quality of ESG reporting and an expectation that audit committees will be involved in overseeing the controls, processes, and assurance activities related to ESG disclosures. Investors also state that more company disclosure can help them decide which topics to engage on and how to vote. However, they note that current disclosures do not, on average, provide enough information to be useful in making decisions.
Two audit committee participants in our sample provided examples of when feedback can lead to improved disclosures; however, this feedback was obtained because the audit committee member sought it from company investors. A lack of investor feedback may mislead the remaining audit committee members into thinking that their investors are comfortable with their oversight quality and related disclosures.
What Types of Disclosures Do Investors Want?
Interviews with investors reveal that they want disclosures that capture the “personality of the board.” For example, they want disclosures to clearly define and outline all the audit committee oversight responsibilities, including those associated with cybersecurity, ERM, and ESG reporting. Investors also mentioned wanting more information about the audit committee members professional experiences and skills. Finally, investors want more timely information about how the audit committee fulfills its oversight responsibility. Overall, our interviews reveal that investors desire more information to determine whether they can trust the judgments and leadership of the audit committee. Disclosure examples that may inspire these types of changes to audit committee-related disclosures in proxy statements can be found in the appendix of this practitioner-focused publication that we published with the CAQ.
Our research identifies a lack of communication between investors and those involved in the audit committee disclosure process. The latter may mistakenly believe that audit committee disclosures meet stakeholders’ needs because they have not received sufficient and consistent feedback from investors. To improve companies’ disclosure, investors need to provide companies with feedback about the perceived quality of their audit committee disclosures and what they are looking for in audit committee oversight.
This post comes from Lauren Cunningham at the University of Tennessee, Knoxville’s Neel Corporate Governance Center and Sarah Stein, Kim Walker, and Karneisha Wolfe at Virginia Tech’s Pamplin College of Business. It is based on their recent paper “Audit Committee Disclosure Evolution: Evidence from the Field” available here.