Boards use private information from auditors about misreporting to hold CFOs accountable.
getty
Boards use private information from auditors about misreporting to hold CFOs accountable, according to a study forthcoming at Review of Accounting Studies.
Prior research studies have clearly demonstrated that boards of directors dismiss executives in connection with public signals of low financial reporting quality, such as instances of fraud and restatements of financial statements. What is unknown is whether boards proactively demand quality financial reporting in the absence of such public signals.
Financial statement auditors frequently discover errors and sometimes fraud in financial reports and often require companies to correct these misstatements before the financial statements are made public. Although investors never know about these adjustments, auditors report them to the audit committee of the board of directors, providing the board access to this private signal of financial reporting quality.
In a study titled “Auditor-provided Nonpublic Signals of Misreporting and CFO Dismissal” researchers investigated whether boards of directors use this information when deciding whether to retain the CFO. The study is authored by Phillip T. Lamoreaux from Arizona State University, Summer Zhujun Liu of Texas A&M University, Nathan J. Newton from Florida State University, and Min Zhang of Renmin University of China.
“We first surveyed 29 audit committee chairs in China to understand how boards interact with auditors and their use of auditor-provided information in evaluating executives. Then, we examined proprietary data from China’s Ministry of Finance to determine whether CFO dismissals in China were correlated with the magnitude of audit adjustments during the period 2010 to 2019,” says Liu.
The study finds that boards are more likely to dismiss CFOs when auditors uncover and require greater adjustments to correct overstated earnings. This result is particularly evident when a company has strong board oversight and when the CEO does not chair the board of directors.
Liu notes, “We were not sure whether boards would use information from auditors in overseeing management. Because the adjustments auditors require are never revealed publicly, boards face no external pressure to act on them—unlike when a restatement of prior financial statements is publicly announced. Our results indicate that boards are proactive in fulfilling their fiduciary responsibilities over financial reporting, even without outside pressure.”
The study also reports that boards use other forms of discipline when auditors discover misreporting. Specifically, boards reduce CFO compensation when auditors discover a higher level of misstatements that overstate earnings. Additional analyses focusing on the dismissed CFOs suggest that most do not subsequently find an executive position at another company.
Liu concludes, “Some boards consider the auditor as part of the company’s system of internal controls. However, our results suggest that boards expect company management to prepare accurate financial reports prior to auditor review. Company management involved in financial reporting, particularly the CFO, should ensure their processes and controls produce accurate financial information. There have also been calls in recent years for auditors to provide more information publicly. Our study indicates that auditors provide value beyond their opinion on the financial statements because they generate information that helps those tasked with governance to know more about what is going on at the company.”