Do affiliated former audit partners need to 'cool-off' before joining an audit committee? Nonprofessional investors speak.

Author:Flynn, R. Steven
Position:Report
 
FREE EXCERPT
  1. INTRODUCTION

    Passage of the Sarbanes-Oxley Act (SOX) in 2002 ushered in a new era of importance for publicly traded companies' audit committees by emphasizing their role in restoring investor confidence in the audit process. As a means to bolster the actual and perceived efficacy of the committee's operations and decisions, SOX not only requires managerial independence of all committee members but also compels firms to disclose if at least one committee member possesses financial expertise (U.S. House of Representatives, 2002). To satisfy this latter mandate, public companies had initially turned to certified public accountants (CPAs) for committee membership (Naiker and Sharma, 2009). Because of the apparent difficulty in recruiting practicing CPAs (Huron Consulting Group, 2006; Taub, 2006; 2003; Williams, 2005), many have suggested the use of former audit partners (Naiker and Sharma, 2009). However, due to fears that these individuals may behave and act in a less than objective manner, the Securities and Exchange Commission (SEC, 2003), following the lead established by NYSE and NASDAQ, requires former audit partners having prior associations with a firm's current auditor (affiliated former partners) to fulfill a three year "cooling-off" period before joining the firm's audit committee (Naiker and Sharma, 2009; SEC, 2003). Those partners with no prior affiliations (unaffiliated former partners) face no such restrictions.

    Many have strongly criticized this three year "cooling-off" restriction, citing reputational and litigation concerns as effective deterrents against biased behavior (Naiker and Sharma, 2009; Lennox and Park, 2007). In response to this criticism, Naiker and Sharma (2009) investigated in an archival study the effects of affiliated and unaffiliated former partners' audit committee membership on the reported disclosure of internal control deficiencies. They (Naiker and Sharma, 2009) found a negative association between each former audit partner type and internal control deficiencies, both within and outside a three year "cooling-off" period. Naiker and Sharma (2009) concluded that membership of former affiliated audit partners, irrespective of their time of appointment, may result in more effective audit committee monitoring.

    While prior associations may not affect affiliated former partners' actual level of independence, they could jeopardize their appearance of objectivity, a factor critical in ensuring an audit committee's success (SEC, 2000). In light of this consideration, one question remains: how do individual investors perceive the membership of affiliated former audit partners on an audit committee's operation, both within and outside a three year "cooling-off" period? This fundamental research question, examined in an experimental setting, forms the basis of the current empirical study. Its exploration makes two important contributions to practice and to the academic literature. First, from a general perspective, the investigation aids in identifying additional factors important in the formation of individual investors' impressions of audit committee independence. As the SEC (SEC, 2000; Dao et al., 2008) has argued, an external audit will have little value if investors do not consider its participants to be independent. Second, the paper represents the first known empirical research conducted to examine the SEC's controversial affiliated former audit partner restriction. The investigation directly complements Naiker and Sharma's (2009) archival findings and heeds the researchers' call for additional exploration in this area. Its results should interest regulators, academicians, and practitioners desiring to assess the ramifications of the SEC's decision, as well as publicly traded companies seeking to recruit individuals with direct accounting backgrounds for audit committee service.

    The following sections comprise the remaining portions of this paper. The next two sections summarize the background information and develop the research hypothesis. They are followed by an explanation of the research methodology and a statistical analysis of the results. The paper concludes with a discussion of the study's findings and its limitations.

  2. LITERATURE REVIEW

    Since the passage of SOX in 2002, a public company's audit committee has effectively become the auditor's client charged with the hiring and oversight of his/her work (Arens et al., 2010). Along with this elevated status has come a host of additional mandates applicable to the committee's organization and functions including, but not limited to, managerial independence of all committee members and disclosing if at least one committee member has financial expertise (U.S. House of Representatives, 2002). Although SOX established the expertise requirement, it did not provide initial definitional clarity to the mandate, leaving it to the SEC to delineate specific qualifications (Carcello et al., 2006; U.S. House of Representatives, 2002). In an attempt to fulfill this obligation, the SEC initially defined financial experts as those with direct accounting or finance backgrounds (Raghunandan and Rama, 2007; Carcello et al., 2006; SEC, 2002). Public companies, however, soon expressed concerns about this definition, maintaining that they would be unable to recruit such individuals for committee service (Raghunandan and Rama, 2007; Carcello et al., 2006). In response to these concerns, the SEC expanded its definition in its final rule to include individuals who have "experience ... analyzing, or evaluating financial statements ... or experience actively supervising one or more persons engaged in such activities" (Carcello et al., 2006; SEC, 2003)...

To continue reading

FREE SIGN UP