The audit committee chair is considered the cornerstone of the audit committee. Charged with directing the committee’s activities, the chair sets the agenda and presides over its meetings. The chair must ensure that committee members focus on key issues and fulfill their roles as part of the group. The chair also acts as the liaison between the committee members and management, internal auditors, and external auditors, obtaining and conveying information useful in the audit committee’s decision-making process. Knowledge about the organization—its operations, customs, risks, and controls—should help the audit committee chair perform these duties and monitor the financial reporting process more effectively.
As the volume and complexity of issues faced by the audit committee continue to grow, many practitioners and corporate governance experts have underscored the dangers of appointing directors with limited knowledge about the organization to the audit committee chair role. They suggest that monitoring quality can suffer during an audit committee chair succession, when the audit committee chair is new to the job. However, to the best of our knowledge, there exists no empirical evidence on whether the audit committee chair’s firm-specific knowledge impacts their monitoring over the financial reporting process.
In our recent paper, Audit Committee Chair Succession and Financial Reporting Quality: Does Firm-Specific Knowledge Matter?, we examine whether the audit committee chair’s firm-specific knowledge is associated with the quality of financial reporting oversight. Motivated by insights from the literature on organizational learning and from best practices suggested by accounting firms and corporate governance experts, we contend that prior service on the audit committee allows an audit committee chair the opportunity to accumulate firm-specific knowledge that could be useful in the succession period. For a large sample of U.S. publicly traded companies, we identify whether newly appointed audit committee chairs have prior service on the company’s audit committee and label those who do “internal successors.” These internal successors should possess greater firm-specific knowledge than “external successors” who have not served on the company’s audit committee prior to their appointment to the role of audit committee chair.
Our sample extends from 2005 through 2017 and includes over 3,000 unique audit committee chairs. We find that roughly two thirds of these newly appointed audit committee chairs have previously served on the company’s audit committee. In our primary tests, we examine whether a difference in the monitoring quality of internal and external successors exists during the audit committee chair succession period. We use the presence of a material misstatement, as revealed by a subsequent financial statement restatement, as evidence of low monitoring quality because the incidence of a misstatement suggests a breakdown in some facet of the audit committee chair’s oversight responsibilities.
In our paper, we argue that firm-specific knowledge should help internal successors to overcome the steep learning curve faced by audit committee chairs. For example, through their prior service on the audit committee, internal successors will have been exposed to materials and discussions that should allow them to understand the strengths and weaknesses in the company’s financial reporting processes. They should also be familiar with which individuals in the organization are likely to possess relevant and reliable information that might be necessary in the audit committee’s deliberations. Because of this knowledge, internal successors should be able to more strategically allocate the committee’s limited time to addressing the issues that are most likely to cause financial reporting failures.
We also acknowledge that there could be no difference in the monitoring effectiveness of internal and external successors during the audit committee chair succession period. Although the firm-specific knowledge gained by internal successors should be beneficial, external successors often have rich prior professional experience. For example, many have served as audit partners at professional accounting firms or as chief financial officers at other companies. These experiences could allow a new audit committee chair to quickly gain the requisite knowledge, reducing the extent of differences in monitoring outcomes between internal and external successors. Additionally, a difference in monitoring may not exist because external successors are less tied to the status quo and can bring fresh perspectives or may be more willing to challenge the perspectives of management and other directors. The novel outlook of external successors could offset their lack of firm-specific knowledge, resulting in no monitoring differences between internal and external successors. Finally, a robust audit committee chair onboarding process could allow external successors to quickly obtain the firm-specific knowledge needed to perform the chair role.
Results from our tests reveal that companies with internal successors are less likely to misstate their financial statements during the audit committee chair succession period. This finding suggests that firm-specific knowledge, obtained through prior service on the audit committee, is beneficial for newly appointed audit committee chairs. We also find that the benefit derived from firm-specific knowledge is focused in the first two years of the audit committee chair’s service in their role.
External successors could also possess skills that may make it easier for them to adjust to the audit committee chair role. For example, they could have worked at another company in the same industry or could have served as an audit committee chair at a different company. We test whether these characteristics mitigate the monitoring difference between internal and external successors and find that internal successors continue to exhibit stronger monitoring during the succession period. This highlights the importance of prior company-specific audit committee service for new audit committee chairs.
Overall, our findings indicate that firm-specific knowledge influences the quality of audit committee chair monitoring over the financial reporting process. These findings are important because they suggest that one way to promote higher quality monitoring during the audit committee chair succession period is to focus on succession planning. Our results suggest that as part of the onboarding and succession planning process, companies should expand opportunities for directors to build firm-specific knowledge, perhaps through service on the company’s audit committee.
Linda A. Myers is the Haslam Chair of Business & Distinguished Professor of Accounting at the University of Tennessee’s Haslam College of Business
Stefan Slavov is a doctoral student at the University of Tennessee’s Haslam College of Business
Roy Schmardebeck is an Assistant Professor in the Accounting & Information Management Department at the University of Tennessee’s Haslam College of Business