Corporate Audit Committees too chummy with execs to be objective, study finds

Friends Meeting House - Elliott Brown

Photo courtesy of Elliott Brown on Flickr

Rob Swystun, Pristine Advisers

A study has found that close to 40% of corporate directors in the US who are responsible for monitoring profit-and-loss ledgers cannot effectively do so because they are BFFs with the chief executive.

And you know BFFs don’t rat on each other.

For those of you who are wondering what I’m rambling on about, let me explain; a lot of corporate directors and CEOs run in the same social circles. Being pals, this obviously clouds the directors’ judgement in regards to doing their job when it comes to sitting on the auditing committee.

The study, done by accounting professors Liesbeth Bruynseels and Eddy Cardinael of Tilburg University in The Netherlands along with business intelligence service BoardEx, looked at about 2,000 U.S. companies and their board audit committees, which are responsible for overseeing outside auditors and making sure financial reports are accurate.

For a committee made up of completely independent directors, this isn’t a problem, but for directors who are chummy with the CEO, this gets a bit sticky.

As outlined by Dena Aubin in a Reuters piece, the two researchers found that audit committees often contained friends of senior managers of the company, meaning it was more likely they’d go along with the company’s reporting practices instead of looking at them objectively, like they were supposed to.

In the companies where audit committee members and senior management were pals, unsurprisingly, earnings manipulation was more frequent and problems like weak financial controls were more likely to be covered up rather than exposed and rectified.

Now, there were regulations put in place over a decade ago after a couple of minor little incidents known as Enron and WorldCom. These regulations stipulate that audit committees could only be made up of independent directors who had never been employed by the company or a firm that did business with the company.

But, there was no BFF clause put into place, meaning that board members who ran in the same social circles, belonged to the same country clubs or sat on the same charity boards as the company’s executive could still sit on the audit committees.

How bad is it, exactly? Here’s a quote from the study:

“Although such firms appear to have independent audit committees, in reality these committees offer little to no monitoring at all.”

So what can be done to fix this problem?

The researchers suggest legislators require more disclosure about the social connections between audit committee members and CEOs.

However, as Charles Elson, director of the Weinberg Center for Corporate Governance in Newark, Delaware, points out, that would be a bit difficult.

“Is it one lunch a week, is it two lunches? Inevitably, social ties will develop when you’re on a board – you have to see that person on a regular basis,” he said.

But things are being done, like the passage of the 2002 Sarbanes-Oxley Act in the United States, which tightened membership requirements, or attempts in Europe and the United Kingdom that have been trying to get audit committees to be more rigorous in choosing outside auditors and monitoring them.

The study appears in the January 2014 issue of the American Accounting Association’s Accounting Review.


One response to “Corporate Audit Committees too chummy with execs to be objective, study finds

  1. Pingback: Investors have long memories when it comes to material misstatements |·

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