Knowledge that Transforms

This paper provides insights into the dynamics underlying the construction of controllability boundaries surrounding the financial audit function, through an analysis of the sensemaking narratives of former members of Arthur Andersen reflecting upon the collapse of their firm. Our focus is how members, in light of their firm’s downfall, assess the abilities of public accounting firms to control financial audit work and auditor behaviour (i.e., organizational controllability), and the abilities of outside, non-accounting bodies to regulate financial auditing (i.e., regulatory controllability). The investigation is predicated on interviews with twenty-five former partners and employees of Arthur Andersen, mostly in Canada and the United Kingdom. Our qualitative analysis indicates that a majority of interviewees adheres to the view that financial auditing can best be controlled via a network of bureaucratic and clan controls established within accounting firm organizations, without any direct involvement from the part of regulators. A number of interviewees, though, consider that a reinforcement of outside regulation is necessary to discipline financial auditors. In spite of these differences, the vast majority of interviewees consider that financial auditing is controllable (via organizational or regulatory control), which is of interest given their spatial and emotional proximity from the controversial collapse of their firm. Also, most participants do not see the professional association as a useful or relevant party in helping the professional accounting community manoeuvring in times of turmoil. Important governance issues, ensuing from our analysis, are discussed.

Relatively few studies have examined the audit committee oversight process--the activities that link audit committee inputs and financial reporting outcomes. To study this process, we conducted extensive interviews with 42 U.S. public company audit committee members. We explore six audit committee process areas, offer insights into the state of audit committee processes in the post-Sarbanes-Oxley Act (SOX) environment, and consider our results in light of agency theory and institutional theory; We find that many audit committee members strive to provide effective monitoring of financial reporting and seek to avoid serving on ceremonial audit committees, but within each of the six process areas we find evidence of both substantive monitoring and ceremonial action, such that neither agency theory nor institutional theory fully explains our results. We also find that many responses vary with personal and company characteristics, with particularly notable differences related to audit committee members' accounting expertise and time of appointment to the audit committee (pre-SOX versus post-SOX). We discuss implications and directions for future research and theory development.

In this discussion, I provide some big picture thoughts on the Collins, Gong and Li (2009) paper (CGL hereafter) entitled: Corporate Governance and Backdating of Executive Stock Options. CGL utilize an estimation algorithm to generate a large sample of potential incidences of grant-level backdating behavior. The conceptual premise of the paper is that the backdating of CEO stock option grants is a direct consequence of “weak ” corporate governance structures. The authors make directional predictions about the relation between firms ’ individual governance structures and the probability that stock option backdating occurs. Each governance structure for a firm is represented by a numerical metric where higher values are interpreted as weaker governance. For example, governance is posited to get weaker as the proportion of inside or gray directors increases. The authors then predict the probability of backdating to be an increasing function of the metric representing each individual governance structure. CGL adds to the stream of papers that empirically examine the backdating issue (e.g., Heron and Lie (2007), Bebchuk, Grinstein and Peyer (2007), and Bizjak et al., (2006)). In some sense, CGL is the culmination of this research line. CGL replicates a number of results spread across the extant literature, and add some twists and turns of their own. The authors do a nice job in the paper of isolating their unique contributions, so I need not repeat any of that here. Overall, this is a very careful piece of empirical research, and I have no intention of nit-picking the empirical analysis. Instead, I offer a critique of the paper that is pertinent to the entire literature on backdating and to empirical corporate governance research in general. In particular, I consider fundamental problems in interpreting statistical associations between corporate behavior and measures of individual corporate governance structures. A large body of corporate governance research, including CGL, regress measures of corporate behavior on metrics of corporate governance attributes. But this design raises a series

We investigate whether risk-related incentives of executive stock option (ESO) compensation plans are associated with income smoothing. Given that risk has both potential benefits and costs, including possible losses and/or large fluctuations that affect reported financial outcomes, flexibilities in financial reporting enable a manager to make apparent risk lower while masking the underlying real risk. As such, income smoothing can be a means by which a manager can reduce the unintended consequences of risk taking without at the same time reducing its intended consequences. Using a sample of approximately 7,000 firm-years, we find that risk-taking incentives and income smoothing are positively related. Our results are robust to alternate specifications of income smoothing and risk-taking, and to various firm-level characteristics, including governance structures, CEO share and option holdings. Additionally, we find that our results are especially pronounced in firms whose risk and risk-taking behavior are high.

We examine the relation between auditor tenure and a firm's ability to use discretionary accruals to meet or beat analysts' earnings forecasts. We find evidence over the period 1988-2006 that firms with both short and long tenure are more likely to report levels of discretionary accruals that allow them to meet or beat earnings forecasts. These results suggest that while regulatory mandates for periodic auditor turnover have negative effects, sustained long-term auditor-client relationships may also be detrimental to audit quality. Further, although we observe a positive relation between tenure and the use of discretionary accruals to meet or beat earnings in the pre-Sarbanes-Oxley (SOX) period, we do not observe such a relation in the post-SOX period. This latter finding is consistent with regulatory reforms and heightened scrutiny of financial reporting in the post-SOX period resulting in less aggressive efforts at managing earnings by client firms and/or increased diligence on the part of auditors. These findings may not generalize to firms that are not covered by analysts, because these firms do not face the same public pressure to manage earnings in order to meet or beat expectations. © CAAA.