STEVE CAHAN ON RESEARCH

The Enron effect and audit committees

Having an accounting expert on board appears to improve the effectiveness of an audit committee.

HIS MONTH IS the 10th anniversary of the bankruptcy of Enron,

which is noteworthy as companies around the world continue to deal with the effects of regulatory changes made after the Enron collapse. In the US, the changes were swift and meaty. Not surprising since Enron was no small fry. Just six US companies were larger at the time. Signing the Sarbanes-Oxley Act (SOX) in 2002, President George W Bush called it the most far-reaching reform of business practices since the 1930s. SOX set up the PCAOB and laid down stiff rules for nancial reporting and auditing. Reform-minded policymakers in other countries followed suit. These reforms (understandably) had fewer teeth than SOX, but they were still signicant. For example, in New Zealand, the NZX and Securities Commission issued best practice guidelines in 2003 and 2004 to improve corporate governance. Audit committees (ACs) were a focal point of the reforms in NZ, the US and elsewhere. Enrons AC was widely criticised for its lax oversight and was seen as a major culprit in the companys collapse. Shore up the audit committee and public condence would improve, the reformers thought. Among other things, new rules in SOX called for the AC to be composed entirely of independent directors and to have at least one nancial expert. New Zealands guidelines also recommend that every AC have a nancial expert, although nancial expert was dened more narrowly than in the US. While the NZ guidelines are voluntary, companies have to explain if they deviate from the recommendations. For academics, regulatory change is something to smile about. In a lab

experiment, a researcher can randomly assign subjects to different conditions (some mice get drugs, others get a placebo). Not so for accounting researchers, since they cannot force companies to change their accounting or governments to change their policies. A regulatory change is good because it lets researchers compare companies before and after the change or, if the change affects only some rms, companies that are affected or not affected by the change. This month I look at the research on the post-Enron reforms. Ive chosen four studies written by New Zealandbased authors. They provide evidence on the efcacy of the reforms, and show how New Zealand academics contribute to the wider debate. All four studies appear in highly ranked journals (like a league table, better to be at the top than the bottom). Vic Naiker, a colleague of mine at the University of Auckland, has been particularly active in this area. In a 2009 paper, he teamed up with Divesh Sharma, formerly of AUT, to focus on revolving-door appointments to the AC. Thats where a former audit partner joins the AC of a prior client and her audit rm still audits that client. Such appointments make regulators bristle. Close ties with their former audit rm might impair the objectivity and independence of these afliated former audit partners. Indeed, in November 2003, the NYSE and NASDAQ in the US set listing rules that require a three-year cooling-off period before an afliated former audit partner can serve on a board or AC. Not all agree. Some argue that afliated former audit partners have intimate knowledge of a rms reporting practices that make those individuals ideal candidates for board and AC positions. Legal penalties and reputation concerns, they say, are sufcient to ensure that afliated former audit partners maintain their independence.

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Using US data and a sample of former audit partners who were appointed before the NYSE/NASDAQ listing rules were imposed, Naiker and Sharma (2009) examine whether afliated former audit partners on the AC are associated with more internal control deciencies. Contrary to the cooling-off argument, they nd both afliated and unafliated former audit partners reduce the likelihood of an internal control deciency, and they do so by a similar amount. In another paper, Dhaliwal, Naiker and Navissi (2010) focus on the denition of nancial expert. Under section 407 of SOX, ACs need to include at least one nancial expert. In implementing section 407, the SEC denes nancial expert broadly including someone who has accounting expertise, nance expertise, or supervisory expertise (eg, a CEO). Dhaliwal et al consider whether experts in each category are effective in terms of improving earnings quality, measured by the consistency of the rms accruals over time. Stable accruals suggest less earnings manipulation by managers. In their sample of US companies, they nd that accounting expertise matters most. Having a nance expert on the AC can lead to incremental improvements in earnings quality but only if there is also an accounting expert on the AC. On the other hand, supervisory experts on the AC dont seem to have an impact on reporting quality, either directly or indirectly. Thats little comfort for the SEC, but good news for New Zealand. The best practice guidelines here take a leaner view. In general, nancial experts are those with experience as a chartered accountant or chief nancial ofcer. In a third paper, Sharma, Naiker and Lee (2009) use NZ data and examine whether characteristics of AC members including expertise are related to how often the AC meets. Although a noisy proxy for AC effectiveness, one interpretation is that more meetings mean better oversight

and monitoring. Sharma et al nd that ACs with a nancial expert meet more frequently when faced with a high risk of nancial misreporting. Umapathy Ananthanarayanan, a PhD student at Massey University, and two co-authors use New Zealand data to examine whether ACs that t the denition of best practice are less likely to compromise their independence. Their paper, Sharma, Sharma and Ananthanarayanan (2011), assumes the economic bond between auditor and client grows as the client provides a larger chunk of the revenues of a

Of course, all the regulation in the world wont prevent another major accounting scandal

as recommended in New Zealand appears to improve the effectiveness of the AC. Of course, all the regulation in the world wont prevent another major accounting scandal. History buffs out there should read Dale and Tonya Fleshers classic 1986 paper. In that paper, they detail the massive accounting fraud at Kreuger & Toll Inc, which at its peak was the worlds largest producer of matches. In the 1920s, the shares of Kreuger & Toll were the most widely held in the US. Kreuger & Tolls massive fraud was kept hidden by its particularly opaque nancial statements. Flesher and Flesher argue that the eventual bankruptcy of Kreuger & Toll in 1932 was one of the major reasons for the passage of the Securities Act of 1933 in the US. Sound familiar?
REFERENCES

particular city ofce. Think of Enron, which was Andersens largest client in its Houston ofce. However, an effective AC might counteract this bond. That is, ACs that t the NZ Security Commissions best practice guidelines (comprise only non-executive directors, have a majority of independent directors, have an accounting expert, and have an independent chair who is not the chair of the board) may be able to resist pressure from management. Using a sample of New Zealand rms in 2004 and 2005, they nd best practice ACs are associated with fewer income-increasing earnings manipulations when client importance increases. Overall, the research seems to suggest certain aspects of SOX such as the cooling-off period and inclusion of supervisory experts are unnecessary. On the other hand, having an accounting expert on the AC

Dhaliwal, D, V Naiker, and F Navissi. 2010. The association between accruals quality and the characteristics of accounting experts and the mix of expertise on audit committees. Contemporary Accounting Research 27: 787-827. Flesher, D, and T Flesher. 1986. Ivar Kreugars contribution to US nancial reporting. The Accounting Review 61: 421-434. Naiker, V and S Sharma. 2009. Former audit partners on the audit committee and internal control deciencies. The Accounting Review 84: 559-587. Sharma, V, V Naiker, and B Lee. 2009. Determinants of audit committee meeting frequency: Evidence from a voluntary governance system. Accounting Horizons 23: 245-263. Sharma, V, D Sharma, and U Ananthanarayanan. 2011. Client importance and earnings management: The moderating role of audit committees. Auditing: A Journal of Theory and Practice 30: 125-156.
Steven Cahan FCA is a Professor of Financial Accounting at the University of Auckland Business School.

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