While federal regulations in the wake of corporate scandals like Enron and Worldcom required audit committees to be solely composed of independent directors, a new study in the American Accounting Association journal The Accounting Review found almost 40 percent of studied companies have committee members with social ties to the CEO.
On average, nearly half of the audit committee members in those 40 percent of companies have these relationships—“friendships involving voluntary, non-professional activities,” according to the study of approximately 2,000 U.S. companies.
These friendships, according to the study, “have a significant negative impact on corporate financial integrity, fostering earnings manipulation, low levels of audit effort, concealment of financial distress, and cover-ups of internal-control weaknesses.”
“Given the problems our study has revealed, the SEC in the U.S. and regulators in Europe should consider mandating the publication of social ties between top management and board members," stated Liesbeth Bruynseels of the University of Leuven, Belgium, who carried out the cross-Atlantic research with Eddy Cardinaels of Tilburg University, the Netherlands. "This should certainly be a priority for a group as essential to financial integrity as the audit committee, which typically consists of only three or four members. As matters stand today, social data of the kind we used in the study is available only at a cost of thousands of dollars, well beyond the means of the average individual investor.”
Bruynseels and Cardinaels conducted the study with data from BoardEx, an international business intelligence service that provides in-depth profiles of 600,000 world business leaders and the relations between them.
The three kinds of relationships the professors focused on were employment ties, educational ties and friendships from voluntary or leisure activities.
While neither employment or educational ties were found to have a significant effect on company financial reporting, the researchers recorded the strongest correlation in the third group, which include friendships developed in elite organizations like the Chicago Club and Washington Roundtable, sports and culture groups such as the Augusta National Golf Club or Carnegie Hall Corporation, or charities like Cleveland Tomorrow and the Annie E. Casey Foundation.
The specific associations of such relationships, according to the study, include: high levels of non-cash items (discretionary accruals) in company financial statements, low fees for external auditors, a dearth of going-concern opinions, and reduced likelihood that the external auditor will report material weaknesses in company mechanisms of internal control and an enhanced likelihood such weaknesses will be reported only belatedly.
"CEOs who wish to control the quality of financial reporting may be more likely to draw committee members from their friendship network than from their advisory network,” according to the study. “Friendship ties can lead to audit committee members who are less critical of the CEO's financial reporting policies and who are less likely to rock the boat during conflicts between management and the [company's external] auditor."
Bruynseels noted that these social ties between CEOs and committee members make a significant difference to investors, according to a new working paper by Arnie Wright and Ganesh Krishnamoorthy of Northeastern University, Jeffrey Cohen of Boston College, and Lisa Milici Gaynor of the University of South Florida.
That paper outlines an experiment of 263 informed, nonprofessional investors who demonstrated the most preference for companies in which CEOs had no social or professional ties to members of the audit committee, and the least preference for firms where these ties existed. In the experiment, those ties were said to be between the audit committee chair and another member, who were classmates with the CEO in grad school and had maintained regular social contact for the 15 years since graduation.
"Investors already sense the importance of such ties to the quality of companies' financial reporting," Bruynseels said in a statement. "It's time for regulators to catch up with investors by requiring this information to be more readily available than it is today."
The study, "The Audit Committee: Management Watchdog or Personal Friend of the CEO?" is in the January/February issue of The Accounting Review, out Jan. 2, 2014.