Audit committee chairs at German companies like to be tipped off by their auditors about looming difficulties with accounting decisions and consider their personal reputations at stake in the financial reporting process, according to a new study. The conclusions come in a paper from a team of academics who interviewed 23 audit committee chairs at large German companies to understand how ‘personal incentives’ play a role in the way they work with auditors.
The study, Audit Committee Chairs’ Objectives and Risk Perceptions: Implications for Audit Quality, concludes that audit committee chairs are so concerned about appearing to be in control that they even worry about ‘positive deviations’ from expected results in case it reflects badly on their ability to maintain control over reliable corporate reporting. ‘In our interviews,’ the team writes, ‘we find that personal reputation concerns are among the risks that ACCs [audit committee chairs] consider.
‘Such risks are perceived as arising from situations that may indicate to outsiders that ACCs are not firmly “in control”, including restatements, enforcement findings and even positive deviations from market expectations.’
Audit committee chairs view their auditors as an ‘early- warning’ system for impending problems
Understanding motivations
The paper offers a rare glimpse of the behind-the-scenes relationship between the audit committee and its external auditor, and lifts the lid on what might be motivating key boardroom personnel when it comes to overseeing audit and accounting decisions.
Regulators and policymakers debate the role of audit committees in monitoring auditors but there is scant research revealing their inner workings. Perhaps the most obvious news is that audit committee chairs view their auditors as an ‘early-warning’ system for impending problems that not only present risk to their companies but to their own reputations.
One audit chair told researchers: ‘I once said, ‘Listen, I’ve got a reputation to lose. And I have no desire whatsoever, after 40 years of success and successful retirement as a member of the board of management, to become the subject of gossip in such a manner.’
‘I need to be able to look at myself in the mirror and say: “Nobody can claim that I fell asleep at the wheel”’
Another chair told the team: ‘Diligence is, of course, particularly important… you can spoil your reputation so quickly in the process, or damage it, so you want to avoid making mistakes somewhere that are then picked up by the media.’
Audit chairs are also capable of viewing reporting problems very personally. ‘I need to be able to look at myself in the mirror and say: “Nobody can claim that I fell asleep at the wheel, or that I was being sloppy, or that all of us together did not do our job well.” It must never come to that.’
This concern with the personal as well as the corporate sees audit committee leaders place enormous importance in an auditor’s skills and disposition. Chairs told researchers that they valued auditors as the ‘only and essential life insurance’, an ‘important companion’ and the ‘only opportunity to look into the company independently of management’.
Transparency providers
Crucially, however, board members see auditors as providing transparency about the ‘extremeness’ of management reporting decisions. This leads to great store being placed on auditors providing informal warnings and without CFOs being present.
For one committee chair, the critical element in their relationship with the auditor is that he ‘did not feel he first has to ask the CFO before he can tell me something’. Another committee leader values approaches from their auditor ‘outside of meetings’. Others want ‘quick availability’ from an auditor, perhaps someone who even says they’ll discuss sticky issues ‘immediately on the phone’.
Audit committee personnel seek ‘bonds of trust’ and ‘chemistry’ with their auditors
These informal meetings can act like a warning to management about their accounting policies, according to one committee chair who conducts their own one-to-ones with an auditor: ‘You see, such a process helps avoid problems because where you have processes like this [management] will think twice before doing or not doing certain things.’
With a desire for such a close relationship, audit committee personnel seek ‘bonds of trust’ and ‘chemistry’ with their auditors. The researchers see the close relationship underpinning an audit committee’s ability to evaluate risk in three ways: smoothing the way for an exchange of information about management accounting decisions; accelerating the transfer of risk information and deterring management from decisions that could be challenged by audit committees.
‘From the audit committee chair’s personal risk perspective, auditors’ proactive and confidential communications skills help ACCs not only in gathering information that is useful for effective monitoring but also for evaluation for their personal risks,’ the researchers write.
Insight for decision-making
But it’s not only about evaluating risk. Information is also used to take action. In particular, audit committees deploy insight from auditors to help them influence management decision-making. They do not expect auditors to make the argument because they are ‘not the preparers’ and are only in place to ‘observe’.
The research term says the finding is ‘somewhat at odds with the widespread assumption that the auditor negotiates accounting adjustments with management, while the audit committee is rather passive’.
Contact between audit committees and auditors is a critical process in the development of audit opinion and, as a result, a core element in effective corporate governance. This latest research shows how nuanced the process can be. As the researchers point out, the ‘transparency’ provided by auditors to audit committees has a ‘deterrence effect’ and bolsters the ability of committee members to ‘challenge management’, the bedrock for ‘effective monitoring’.
Perhaps most importantly, however, the research shows that audit is not just a process: it’s personal.
More information
Read AB’s articles, ‘Governance regimes: the bigger picture’ and ‘Minimum standard for audit committees’
