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Corporate Governance and the Audit Process*

JEFFREY COHEN, Boston College

GANESH KRISHNAMOORTHY, A^ortAeasfern University

ARNOLD M. WRIGHT, Boston College

Abstract There has been growing recognition in recent years of the importance of corporate governance in ensuring sound financial reporting and deterring fraud. The audit serves as a monitoring device and is thus part of the corporate governance mosaic. The objective of this paper is to examine the impact of various corporate governance factors, such as the board of directors and the audit committee, on the audit process. Importantly, there is little professional guid- ance on how auditors should consider such factors when formulating an appropriate audit strategy, and there has been only one prior study on this issue (Cohen and Hanno 2000).

Because there are no current specific auditing standards that relate to the effect of cor- porate governance on the audit process, we conducted a semi-structured interview with 36 auditors on current audit practices in considering corporate governance in the audit process. Reflecting on client experiences, auditors indicate a range of views with regard to the ele- ments included in the rubric of “corporate governance”. Most significantly, auditors view management as the primary driver of corporate governance. The inclusion of top manage- ment in the “corporate governance mosaic” is inconsistent with agency theory’s prescription of the board and other mechanisms serving as a means to independently oversee management’s actions to protect stakeholders.

Auditors consider corporate governance factors to be especially important in the client acceptance phase and in an international context. Further, despite the attention placed on the audit committee in the academic literature, in the business community, and by regulators in different countries (e.g., Canada, United States, Australia), several respondents indicated that their experiences with their clients suggest that audit committees are typically ineffec- tive and lack sufficient power to be a strong governance mechanism. Implications for research and practice are presented.

Keywords Audit committee; Audit process; Board of directors; Corporate governance

Condense La gouvemance d’entreprise retient beaucoup l’attention depuis quelques annees, chez les

praticiens autant que les chercheurs. Arthur Levitt, auparavant president du conseil de la

* Accepted by Dan Simunic. An earlier version of this paper was presented at workshops at the Univer- sity of Waterloo, University of New South Wales, University of Connecticut, Northeastern University, Lehigh University, Monash University, and Edith Cowan University. We would especially like to acknowledge the comments of Joe Carcello, Wai Fong Chua, James Largay, Gary Monroe, Steve Salterio, Ken Trotman, two anonymous reviewers, and the editor, Dan Simunic.

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Securities and Exchange Commission des Etats-Unis, prononjait ces mots dans une allocution aux administrateurs : « le lien entre les administrateurs d’une soci6t6 et son systfeme d’infor- mation financiere n’a jamais revetu une importance aussi cruciale ». Selon lui, « les comit6s de verification jouent un role primordial en remettant en question les methodes susceptibles de porter prejudice a la qualite de l’information financiere ». De plus, en s’acquittant de la fonction d’attestation, les verificateurs occupent une place de premier plan dans le systfeme de controle de l’entreprise et, par consequent, peuvent aussi etre consideres comme etant un element essentiel de la mosaique de la gouvemance d’entreprise. C’est pourquoi les verifi- cateurs doivent, en principe, travailler avec d’autres intervenants a I’interieur de la mosaique de la gouvernance d’entreprise pour s’assurer que les parties interessees refoivent de rinformation financiere d’excellente qualite pour veiller sur les interets actuels et futurs des actionnaires et des investisseurs. Ainsi, le verificateur doit travailler avec le comite de verifi- cation a revaluation et a la promotion de la qualite de Tinformation financiere.

Malgr6 l’interet croissant que suscite la gouvernance d’entreprise depuis quelques annees, il est etonnant de constater que tres peu de recherches ont porte sur le point de vue des verificateurs sur la mosaique de la gouvemance d’entreprise et sur la fa9on dont les mecanismes de gouvemance, comme le conseil d’administration et le comit6 de verification, influent sur le processus de verification. Les auteurs abordent ces questions en interrogeant, dans le cadre d’entrevues semi-structurees, 36 verificateurs en exercice provenant de tout le groupe des Cinq Grands cabinets d’expertise comptable ainsi que d’un cabinet national, soit 11 premiers verificateurs, 12 chefs de groupe et 13 associes possedant respectivement en moyenne 3,6 (2,8), 9,3 (7,8) et 20,8 (14,1) ans d’experience de verification (d’experience sectorielle). Les auteurs s’interessent aux verificateurs de divers echelons hierarchiques, car leur evaluation de la gouvemance d’entreprise et leur opinion sur la question, ainsi que la confiance qu’ils accordent aux facteurs de gouvemance et I’usage qu’ils en font, peuvent varier selon le rang qu’ils occupent. Les premiers verificateurs, par exemple, qui n’ont pas beaucoup d’interactions avec les membres de la haute direction, du comite de verification et du conseil, risquent d’envisager la gouvemance d’entreprise dans une strlcte perspective de controle et ne la prendre en consideration que dans le processus de planification de la verifi- cation (par exemple, pour I’obtention d’information au sujet des facteurs de gouvemance, •’appreciation des risques et la planification des programmes). Pour leur part, les associds et les chefs de groupe, en plus d’envisager les facteurs de gouvemance d’entreprise dans le processus de planification de la verification, peuvent egalement I’integrer au processus d’acceptation des clients et a la resolution des differends avec la direction au sujet de ques- tions comptables.

Les ecrits en gestion et en finance nous livrent d’autres points de vue sur la gouvemance d’entreprise. L’opinion generalement partagee dans le domaine de la comptabilite et de la finance s’inspire beaucoup de la theorie de la delegation. Selon cette theorie, les cadres agissent dans leur propre interet, au detriment de celui des actionnaires s’il le faut. Divers mecanismes contractuels, notamment la gouvernance d’entreprise, ont pour but la sur- veillance du comportement des cadres. L’un des pivots de la delegation est I’exigence voulant que les personnes qui s’acquittent de la fonction de surveillance (les administrateurs) soient independants de ceux qui font l’objet de cette surveillance (les membres de la direction). Ainsi, les principaux attributs des administrateurs, dans la perspective de la delegation, sont l’independance a l’egard de la direction et les competences en matiere de surveillance et de

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controle. Plus encore, etant donne que la mission primordiale du conseil d’administration consiste a s’assurer que le comportement de la direction respecte les interets des actionnaires, les administrateurs, dans la perspective de la delegation, doivent centrer principalement leur interet sur la surveillance et le controle, revaluation de la performance de I’entreprise, la gestion du risque global et la gestion du recrutement et de la remuneration. Dans cette optique de la delegation. Ton peut considerer que les v6rificateurs font partie de la mosaifque de la gouvemance d’entreprise puisqu’ils assurent la qualite du processus d’information financiere.

Selon une autre optique, qui tranche sur celle de la delegation, la gouvemance sert en grande partie a satisfaire les exigences de la reglementation (c’est-a-dire a respecter la « forme »), comme la nomination au conseil d’administrateurs qui ne sont pas membres de la direction (des administrateurs « independants »). Dans la realite, toutefois, la gouvemance d’entreprise est souvent jugee inefficace dans l’accomplissement de ses taches (soit sur le plan de la « substance ») et, par consequent, plutot symbolique en ce qui a trait h la supervision de la direction. En effet, la haute direction nomme souvent au conseil des « petits copains » et des coUegues qui ne contrarieront pas leurs volontes et qui accepteront de jouer un role passif dans le processus de gouvemance. Les fonctions du conseil d’administration se boment ainsi a ratifier les decisions de la direction, a veiller au respect des exigences de la rdglementation et a hausser la remuneration des membres de la haute direction.

Dans les travaux precedents sur la verification, les chercheurs ont defini la gouvemance d’entreprise avant tout en fonction de son role de surveillance, en insistant sur l’independance du conseil d’administration et du comite de verification a regard de la direction. Les resultats de la presente etude indiquent toutefois que les vedficateurs interroges, suivant en cela la recommandation du Committee of Sponsoring Organizations (COSO) selon laquelle « l’exemple doit etre donne par les dirigeants », inscrivent majoritairement la haute direction parmi les composants essentiels de la mosa’ique de la gouvemance et font remarquer que c’est elle qui trace la voie de la gouvemance. Cette reconnaissance explicite du fait que l’efficacite de la gouvemance est indissociable de l’attitude de la haute direction aura d’importantes repercussions sur les recherches h venir. Ainsi, il se peut que le principe de delegation, qui met l’accent sur l’independance du conseil d’administration et du comite de verification k regard de la direction, soit insuffisant pour permettre k lui seul de comprendre parfaitement le role et l’incidence de la gouvemance d’entreprise. En fait, certains pretendront peut-etre que 1’intervention de la haute direction dilue la substance et l’etendue de la sur- veillance exercee sur la direction, mais ce n’est que la poursuite des recherches sur cette question empirique qui permettra de determiner si cet « effet de dilution » est dysfonctionnel. Par exemple, la participation active de la haute direction a la selection des membres du conseil, afin de s’assurer que ce dernier soit en mesure de faciliter k l’organisation l’accfcs aux ressources dont elle a besoin et d’en fixer les orientations strategiques, peut etre extreme- ment precieuse pour I’entreprise. Selon Reingold, dans bien des cas, le travail du conseil « peut consister a faciliter les operations commerciales autant qu’& les evaluer en toute independance ». Ce role eiargi du conseil touche directement les nouvelles methodes de verification qui sont davantage centrees sur les strategies d’entreprise, les processus et les risques du client.

Les constatations des auteurs mettent egalement en relief la relation interactive qui unit la direction, le conseil et le comite de verification. Les recherches realisees jusqu’i maintenant

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dans le domaine de la verification sur la gouvernance d’entreprise ont port6 essentiellement sur le comite de verification et, dans une certaine mesure, sur le conseil d’administration, isol6ment. D’autres travaux s’imposent toutefois si Ton veut analyser les relations entre les divers 61ements constitutifs de la mosaique de la gouvernance d’entreprise, des travaux qui porteraient notamment sur la fa^on dont le verificateur infiuence les differents intervenants et r6ciproquement.

Bon nombre des verificateurs interroges par les auteurs ont observe qu’il arrive souvent que les membres du comite de verification ne possedent pas les competences et le pouvoir necessaires pour s’acquitter de leur tache avec efficacite et que leurs liens de communica- tion avec le comite de verification se boment habituellement a de l’information passive. Les recentes modifications apport6es aux qualifications exigees des membres du comit6 de verification et I’adoption de normes de verification supplementaires (comme le SAS 89) devraient attenuer ces problemes et permettre au comite de verification de mieux jouer son role primordial aupres des v6rificateurs de maniere a ameliorer la qualite de l’information financiere. Ainsi, la Bourse de New York et la NASD exigent maintenant (dans la foulee du rapport du Blue Ribbon Committee) que le comit6 de verification soit compost d’au moins trois administrateurs, ayant tous des connaissances de base en finance, et qu’au moins un membre du comite de verification possede des competences en comptabilit6 ou en gestion financiere. II faudra pousser plus loin les recherches pour determiner si ces modifications, et les interpellations recentes de la presse qui reclame une gouvernance d’entreprise plus efficace en ce qui a trait a Tinformation financiere, suffiront a garantir que les comites de verification se dotent des competences et du pouvoir requis pour s’acquitter de leurs taches. L’6tude des mecanismes visant a ameliorer et a faciliter les communications efficaces entre le v6rifica- teur, le comite de verification et le conseil d’administration s’impose egalement.

Enfin, la pr^sente etude revele aussi que le role du premier v6rificateur en ce qui a trait a la gouvernance est essentiellement de colliger l’information a [‘intention du chef de groupe et de l’associe. II est essentiel d’analyser comment les premiers verificateurs obtiennent cette information, compte tenu du peu de contacts qu’ils ont avec la haute direction et le conseil d’administration (un sujet juge d’une extreme importance). Etant donne que les pre- miers verificateurs sont aussi les premiers responsables de la planification et de l’application concrete des proced6s de verification quotidiens, il leur incombe de bien saisir l’information relative a la gouvernance, ce en quoi ils risquent d’echouer sans une totale comprehension des facteurs qui entrent en ligne de compte. L’utilisation d’une simple liste de controle pour determiner la presence ou l’absence de mecanismes de gouvernance peut, par exemple, faire obstacle a revaluation efficace de la substance des activites de gouvernance. II serait interessant de se demander, dans les recherches a venir, si les premiers verificateurs cement et saisissent les facteurs de gouvernance de maniere adequate dans la conception et la realisation de missions de verification.

1. Introduction

Corporate governance has received wide attention in recent years both in practice (e.g., Brown 1999; Levitt 1998; Cotnmittee on Corporate Governance (hereinafter, the Hampel report) 1998) and in academic research (e.g., Beasley, Carcello, and Hermanson 1999; DeZoort and Salterio 2001). Arthur Levitt (1999, 2), former

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chair of the U.S. Securities and Exchange Commission (SEC), stated in a speech to directors that “the link between a company’s directors and its financial reporting system has never been more crucial”. Levitt (2000a, 1) also argued that “audit committees play an indispensable role in challenging those practices that have the potential to undermine the quality of financial reporting”. In addition, by perform- ing the attest function, auditors are a significant part of a firm’s monitoring system and thus can also be considered an essential component of the corporate govemance mosaic. Hence, in principle, auditors must work with other actors in the corporate govemance mosaic to ensure that stakeholders receive the highest quality financial reports as well as help to protect the interests of current and future shareholders and investors. For instance, the auditor must work with the audit committee to assess and promote financial reporting quality. The objective of this study is to examine auditors’ experiences with various actors in the corporate governance mosaic and how these actors currently and potentially affect the audit process.

There is little professional guidance on how auditors should consider corporate govemance when formulating an appropriate audit strategy. However, the impor- tance of the explicit consideration of govemance factors by auditors is evidenced by research, which documents that weaknesses in governance structure are often associated with lower financial reporting quality, eamings manipulation, and even overt financial statement fraud (e.g., Dechow, Sloan, and Sweeney 1996; Beasley 1996; McMullen 1996; Wright 1996; Beasley et al. 1999; Beasley, Carcello, Her- manson, and Lapides 2000; Carcello and Neal 2000; Felo, Krishnamurthy, and Sol- eri 2001). Further, Krishnan (2001) documents an association between the quality of the corporate govemance structure and the incidence of intemal control problems. Because the strength of corporate govemance may affect the risk associated with a current or potential client, it is expected that such factors will influence auditors’ risk assessments and clients’ acceptance decisions. In addition, given the risk- driven audit approach espoused in auditing standards (SAS No. 47 (AICPA 1983)) as firms move toward an audit strategy that focuses on business processes and busi- ness risks (e.g.. Bell, Marrs, Solomon, and Thomas 1997), corporate govemance could also affect audit program planning and professional staff allocation decisions.

An understanding of the type of corporate govemance in place is likely to help auditors assess various client risks and hence plan a more effective and efficient audit. For example, a corporate governance structure that is primarily under the sway of management is not likely to curb overly aggressive accounting policies, thereby increasing the risk associated with the client (e.g., potential litigation- related costs). In the case of a prospective client, increased risks associated with the governance structure could significantly infiuence the client acceptance deci- sion and, if the client is accepted, the increased risk could, for instance, lead to assigning more experienced professional staff to the engagement (Asare, Cohen, and Trompeter 2002). Despite the importance of corporate governance on client and business risks, there is little professional guidance and only one prior study (Cohen and Hanno 2000) that examines the effect of corporate govemance factors on the audit process.

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2. The importance of corporate governance in the business environment

Strong governance has long been considered crucial for enhancing the long-term value of stakeholders in the business environment. In the new technology-driven information age, strong corporate governance is more than good business practice — it is an indispensable component of market discipline (Levitt 2000b). Recent demands from investors and others for greater accountability from corporate boards and audit committees (e.g., Blue Ribbon Committee 1999; Ramsay 2001) will likely further enhance the quality of managerial stewardship and eventually lead to more efficient capital markets. However, except for the recent stock exchange requirements in the United States (discussed later) and the Cadbury Code in the United Kingdom that requires that audit committees adhere to certain guidelines (e.g., reporting on the quality of internal controls, disclose audit com- mittee membership), there are few universally accepted standards for what consti- tutes “strong” governance in business entities.

Cohen and Hanno (2000, 134), using the Public Oversight Board’s (POB 1993) perspective, defined corporate governance as “those oversight activities undertaken by the board of directors and audit committee to ensure the integrity of the financial reporting process”. This view of governance focuses on the control environment and control activities (Committee of Sponsoring Organizations of the Treadway Commission (COSO) 1992; POB). The Criteria of Control Board Guid- ance on Control (CoCo) of the Canadian Institute of Chartered Accountants (CICA) 1995 takes a broader view of corporate governance than COSO. For exam- ple, CoCo also includes as part of corporate governance an assurance that an orga- nization achieves its objectives as well as an assessment of the risks that can affect the long-term viability of the firm. Further, under CoCo, the board of directors’ functions include monitoring the firm’s vision and strategy as well as overseeing the external environment (e.g., changes in market and competitive conditions).

With a view to strengthening corporate governance and enhancing the integrity of the financial reporting process, Levitt has strongly advocated the strengthening of the audit committee. In a speech entitled “The Numbers Game”, Levitt (1998) said, “qualified, committed, independent and tough-minded audit committees rep- resent the most reliable guardians of the public interest”. Beyond a strong audit committee and a focus on the monitoring function, Dalton and Daily (1999) posit that “positive governance” occurs when members of the board help develop the strategy and long-term direction of the firm. Otherwise, as Jensen (1993) points out, corporate govemance only comes to the forefront in time of crisis. The importance of an active involvement in strategic issues by corporate govemance mechanisms is evident in the corporate govemance survey conducted by the National Association of Corporate Directors (NACD) and Deloitte & Touche LLP (NACD 1997). The report states (NACD, 5) that the “govemance focus has been shifting away from regulations and relationships and toward performance and planning”. In fact, the study found that the four most important govemance issues (in order of impor- tance) are corporate performance, strategic planning, chief executive officer (CEO) board relations, and shareholder relations. Thus, there is an increasing recognition

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in practice that to ensure that firms effectively cope with changes in their environ- ment, boards must adopt a more proactive, strategically focused perspective.

3. The importance of corporate governance in the audit process

The finance and management literatures provide alternative views of corporate governance.’ The view commonly held in the accounting and finance domain relies heavily on agency theory (Fama and Jensen 1983; Baysinger and Hoskisson 1990; Bathala and Rao 1995). Under this view, managers are assumed to act in their own self-interests even if it is detrimental to the shareholders (Jensen and Meckling 1976). Various contractual mechanisms, including corporate gover- nance, are designed to monitor management’s behavior. Central to the agency per- spective is the requirement that those performing the monitoring function (members of the board) be independent of those being monitored (management). Hence, the primary attributes for a board member in the agency perspective are independence from management, and expertise in monitoring and control. Further, because the board’s central mission is to ensure that management’s actions are aligned with stockholders’ interests, the board’s focuses under the agency perspec- tive are expected to be directed primarily toward monitoring and control, evalua- tion of corporate performance, global risk management, and management recruiting and compensation. From an agency perspective, auditors can be consid- ered part of the corporate governance mosaic because they monitor the quality of the financial reporting process (Beasley and Salterio 2001).

In contrast to the agency perspective, another view is that governance largely serves to meet regulatory requirements (“form”) such as placing non-executives (“independent” members) on the board (Galbraith 1967; Wolfson 1984; Kosnick 1987). However, in reality, corporate governance is often seen as ineffective in its duties (“substance”) and thus largely symbolic in terms of providing oversight to management. In effect, senior management selects cronies and colleagues who will not curtail their actions (Patton and Baker 1987) and are willing to be passive par- ticipants in the governance process. Thus, the board’s functions are often limited to ratifying management’s actions, satisfying regulatory requirements, and enhancing senior management compensation (Core, Holthausen, and Larker 1999; Molz 1995).

Despite the importance of corporate governance, there is surprisingly little professional guidance on how and which factors to consider in assessing the strength of corporate governance when developing an audit strategy. However, for auditors, the adoption by their clients of a perspective that goes beyond the audit committee and a monitoring approach may reduce the client’s overall business risk and in turn may potentially affect subsequent audit risk assessments. For example, a strong monitoring function would provide greater assurance that controls are operating effectively, which should reduce the assessed control risk (AICPA 1988; AICPA 1995). Further, in the case where a client’s governance structure has effec- tively implemented a strong monitoring as well as a strong strategic perspective, there is the potential for both a more efficient (e.g., less extent of tests of details) and a more effective (greater assurance of the integrity of the financial statements)

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audit. For example, if the client’s board is proactive in helping formulate strategies that help the company effectively cope with changing market conditions, then the cli- ent’s continued viability is more assured and there will be less of a threat of “going- concern” issues.

The role of corporate govemance takes on a heightened importance in a strate- gic or business systems auditing perspective such as that developed by KPMG (Bell et al. 1997). The strategic systems approach provides the auditor with knowl- edge concerning a client’s strategic advantages and disadvantages by studying the client’s overall business risk resulting from their strategic decisions, the general competitive environment, and the web of relationships the client has with its primary stakeholders (Freeman 1984). This knowledge along with consideration of corporate governance factors could then affect the assessed level of inherent and control risks, thereby affecting the nature, timing, and extent of audit work. For instance, in a new client acceptance situation where a potential client is facing an uncertain and highly competitive environment, auditors may assess whether the company is sufficiently taking advantage of the expertise of its board of directors to develop strategies to ensure long-term survival and growth. This information could in tum influence an auditor’s assessment of potential business risk and affect client accep- tance and continuance recommendations (Cohen and Hanno 2000).

For govemance factors to affect audit plans, the auditor must first recognize and properly assess the strength of corporate govemance and, second, appropri- ately weight and use this evidence to develop an audit plan. If the govemance structure is strong, an auditor could potentially reduce sample sizes (e.g., number of locations visited for the evaluation of inventory) and thus reduce the extent of costly substantive testing. Ultimately program plans affect the evidence obtained and, thus, the quality of audit decisions.

4. Research questions

On the basis of the preceding discussion, issues arise as to the extent to which auditors consider corporate governance in planning an audit engagement and whether the govemance structure that emphasizes different roles of govemance (e.g., monitoring, strategic) affects an auditor’s evaluation of a client’s business risk, inherent risk, and control risk. Given the lack of professional standards and empir- ical evidence on these issues, we now tum to the following research questions (RQs).

RESEARCH QUESTION 1 (RQ 1). What aspect(s) of the corporate structure do auditors think of when they are asked about corporate governance?

RESEARCH QUESTION 2 (RQ 2). How do auditors consider corporate gover- nance in the planning and conduct of an audit?

RESEARCH QUESTION 3 (RQ 3). How does the role and importance of corpo- rate governance vary across different engagements and client settings?

RESEARCH QUESTION 4 (RQ 4). How important and effective is the audit com- mittee vis-a-vis other corporate governance mechanisms (e.g., hoard, management) in an audit engagement?

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RESEARCH QUESTION 5 (RQ 5). What are auditors’ views regarding whether the role of corporate governance in the audit process has changed over time?

RESEARCH QUESTION 6 (RQ 6). How is the role of corporate governance in the audit process expected to change in the future?

5. Method

Because current professional standards provide only very general, limited guidance and there is virtually no empirical evidence on how auditors evaluate and ultimately consider corporate governance information in conducting an audit, we employed an exploratory, semi-structured interview approach to address the research ques- tions.2 Interviews were conducted with 36 practicing auditors^ from the U.S. northeast offices of all of the Big 5 firms and one national firm, including 11 seniors, 12 managers, and 13 partners with an average of 3.6 (2.8), 9.3 (7.8), and 20.8 (14.1) years of auditing (industry) experience, respectively.’* We are interested in auditors at varying staff levels because an individual’s views and assessment of corporate governance and his or her reliance and use of corporate governance factors may vary by rank. For example, due to their lack of interaction with senior manage- ment, the audit committee, and the board, seniors may view corporate governance from a narrow, control perspective and may consider corporate governance only in the audit-planning process (e.g., obtaining information about governance factors, assessing risks, and program planning). On the other hand, partners and managers, in addition to considering corporate governance factors in the audit-planning process, may also consider governance in the client-acceptance process and in the resolu- tion of accounting disagreements with management (Gibbins, Salterio, and Webb 2001).

The interview was structured around 13 questions^ identified from four sources: the professional literature (e.g., COSO 1992; POB 1993; the Hampel report 1998); a comprehensive review of relevant research in the management, strategy, finance, and accounting literatures; a review of the audit manuals from four of the Big 5 firms; and discussions with two partners and a senior regarding the potential effects of corporate governance on the audit process. The practitioners also independently evaluated the questions for relevance, completeness, and clarity.

One or two of the researchers conducted the interviews at the offices of the audit firms and each interview took approximately one hour to complete. Subjects were informed that the purpose of the study was to examine the role of corporate governance in the audit process. They were also told that there are no right or wrong answers to the questions, and their responses would be held in strict confi- dence. Following Hirst and Koonce 1996 (460), “when questions took us down an important path, we pursued them before returning to the planned interview materi- als”. Interviews were audiotaped to ensure accuracy and completeness, and were later transcribed by a research assistant. Each interview transcript was coded inde- pendently by two of the researchers, and the initial intercoder agreement was approximately 80 percent. The third member of the research team independently reconciled all items for which there was initial disagreement. The findings.

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reported in the following section, are based on the reconciled responses as well as the comments in subject transcripts.

6. Findings

Aspects of corporate govemance considered by auditors (RQ 1)

Our first research question explores aspect(s) of the corporate govemance mosaic that auditors identify. As discussed earlier, there is no commonly accepted defini- tion of corporate governance in the academic or practice literature. Rather than potentially bias respondents from the onset with our perspective, the first interview question explored how auditors define “corporate govemance”. Respondents’ pre- dominately framed their definition of govemance around senior management (81 percent) and the board of directors (75 percent).

In defining corporate govemance, auditors also identified other mechanisms such as the audit committee (44 percent), but these mechanisms were considered to be of secondary importance.^ In fact, the majority of subjects noted that it is the senior management that sets the tone for govemance. It is important to note that the inclusion of top management in the rubric of the corporate govemance mosaic is inconsistent with the agency theory’s prescription of the board and tbe audit committee serving as a means to independently oversee management’s actions to protect stakeholder interests. One potential interpretation of the inclusion of senior management in the corporate govemance mosaic is that it is consistent with a per- spective that primarily views corporate governance mechanisms to be under the strong infiuence of management.

This focus on senior management could be a function of the emphasis of the COSO report on the “tone at the top”. As one partner mentioned, the CEO helps set the “ethical spine” that permeates all other corporate governance mechanisms. Finally, participants predominately (69 percent) viewed corporate governance from a monitoring (agency) perspective. At first blush, this seems to conflict with the earlier finding that auditors predominately include the client’s management in the governance mosaic, because including management could hinder effective monitoring. However, a closer examination of participant responses reveals the practical inseparability of those “goveming” from the ones “being governed”. For instance, one partner noted that if top management does not want to “be govemed”, other mechanisms such as the board are unlikely to be effective. Some auditors noted that the tendency of management to avoid “being governed” would likely result in management picking an ineffectual board. Indeed, auditors seem to recog- nize that although the primary objective of govemance is the effective monitoring of management to enhance stakeholder value, the role of management in creating an environment to accomplish this objective should not be underestimated. This further reinforces the notion that auditors view the current reality of corporate gover- nance to be consistent with the presumption that corporate govemance mechanisms are under the strong infiuence of management.

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Corporate governance and the planning and conduct of the audit (RQ 2)

The second research question addresses the consideration of corporate govemance in the planning and conduct of the audit. All respondents (seniors, managers, and partners) indicated that they gather and use govemance information in the audit process. With respect to the specific stage of the audit process where govemance information is used, participant percentages were as follows: 100 percent in the audit-planning stage, 54 percent in the field-testing stage, and 20 percent in the review stage. Finally, approximately half of all respondents (and two-thirds of the partners) indicated that corporate govemance plays a key role in decisions to accept a pro- spective client.

As expected, the use of corporate govemance information varied based on the participant’s position within the firm (senior, manager, partner). The senior’s role in general is focused more toward obtaining, rather than assessing, govemance information and in reviewing the minutes of meetings of the board and audit com- mittee. In contrast, partners and managers are involved in assessing and using the information in planning and conducting the engagement. One manager noted, “Seniors would do most of the groundwork . . . . Your seniors will gather a lot of your information. I will review a lot and other managers will review it, and a parmer will review what I have done. So it is a discussion that will go through all levels. The senior is more of a gatherer.”

The client acceptance phase is the first line of defense in controlling a firm’s business risk (Asare et al. 2002; Beaulieu 2001; Johnstone and Bedard 2001). If a potential client has an effective corporate govemance structure, the firm is a more attractive prospect (Cohen and Hanno 2000). Sixty-seven percent of the partners surveyed consider governance in the client-acceptance decision, most likely because an ineffective govemance structure has the potential to heighten litigation and fraud risk (Asare and Knechel 1995). As one partner stated, “I think the under- standing and evaluation of corporate govemance takes place much more at the front end of the audit. Actually, before planning, even more so in client acceptance. Frankly, that is probably the most likely place that an audit firm can truly evaluate its risk relative to a potential client, the risk of being associated with an accounting failure.”

Auditors also identified several other factors when evaluating the strength of govemance. Of greatest importance were the credibility of management (69 per- cent), the strength and independence of the board (58 percent), and the control environment (56 percent). However, responses to some of these issues varied by rank. For example, although 85 percent of partners discussed the strength and inde- pendence of the board, only 36 percent of seniors did. As one partner stated, “How much infiuence can the board really exert on management, how much of a check is the board, how much does management really have to report to the board or just report to the board” (emphasis added). This suggests that auditors must consider how effectively a board actually carries out its activities (quality) and not just which activities are on its agenda or charter (quantity).

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Role of corporate governance across different contexts (RQ 3)

The third research question addresses whether the role and importance of corpo- rate governance in affecting the audit process varies across different engagements and client settings. Although most auditors felt governance was of greater impor- tance when client risks were high than low because of the greater need in this setting for monitoring and guidance, there was variation in responses here. For instance, one partner observed that governance determines whether the client is considered risky. If, for instance, management is not credible and governance does not provide com- pensating controls, the client is then considered to be of high risk.

All participants echoed the view that management credibility is of utmost importance. Some argued that because top management sets the tone, you cannot have strong corporate governance without credible senior management. One man- ager noted that “at the end of the day, they (management) drive the corporate ethos, the values and the culture”. This sentiment is consistent with COSO’s 1992 emphasis on the “tone at the top”. Governance was also considered to be of greater impor- tance for a first-time engagement than a continuing engagement (91 percent), because of the lack of prior knowledge and experience with the client.

The interviews explored whether the existence and type of code of conduct is important to auditors in planning and conducting the engagement. Although 59 percent of respondents indicated that a code of conduct could potentially be impor- tant, auditors felt that in general, codes of conduct were not effective and, thus, in practice they had little infiuence on the audit. As one manager stated, “most of our clients do have a code of conduct now and this is due to litigation. I look at that as a more cover your rear type of deal.” Most respondents perceived codes of conduct to be significantly less important in affecting the potential for misstatements and fraud than the underlying “corporate culture” established by senior management. This response again reinforces the notion that in the corporate governance mosaic, those being governed (e.g., management) will infiuence the effectiveness of the monitoring process.

Responses varied as to the importance of governance for a domestic versus a transnational client, which is apparently related to the amount of experience the auditor had with multinational clients. Auditors having greater exposure to multi- national clients (100 percent of the partners) indicated that governance is more important for a transnational than a domestic company given the variations in cul- ture, business practices, and regulations faced by such enterprises.

Auditors considered governance to be more important for a public than a private client (91 percent) due to the greater number of stakeholders and higher litigation risk for the audit firm. An initial public offering (IPO) was also seen as a situation where the importance of governance is significant, given the client’s desire to report strong results prior to the pricing of the IPO. Some participants considered the role of governance to evolve as a client moves from a private company to an IPO, to a long-standing public company. One partner noted, “The governance pro- cess is very important in the IPO, and corporate governance is most properly docu-

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mented in the process because all the lawyers are involved and if there is a hole in corporate govemance they are making sure that it is filled.”

Approximately three-quarters (76 percent) of the respondents believed that the importance of corporate govemance varied by industry, with corporate govemance viewed to be of greater significance for industries such as high technology, where greater inherent risks require stronger govemance. This finding is consistent with Beasley et al. 2000, who document the importance of considering industry charac- teristics when examining the association of corporate govemance characteristics with fraudulent financial reporting. One partner noted that in high-growth indus- tries such as technology the “transactions are going to be non-systemic, so if you have a technology company you are going to want to know who are the two or three people that look at the contract reports and someone who the board is directing”.

Beasley et al. (2000) found that an intemal audit function was less likely to exist in fraud companies than in nonfraud companies. Although 90 percent of respondents indicated that intemal audit could potentially affect the strength of corporate govemance, they did not place a corresponding high level of emphasis on its importance. The general view was that few intemal audit departments were evaluated as strong. For example, one manager commented, “It [intemal auditing] may not always be effectively applied. We have companies with deficient intemal auditing departments and functions.” This lack of emphasis could also be a func- tion of the relative infrequent and perhaps ineffective interactions between the intemal audit department and the audit committee (Raghunandan, Read, and Rama 2001). Moreover, internal audit departments are perceived to be focused on a micro level rather than on overall corporate operations or controls, where the exter- nal auditor is most concemed.

The role of the audit committee and the board of directors (RQ 4)

The fourth research question explores the role of the audit committee vis-a-vis other corporate govemance mechanisms (e.g., board of directors) as they affect the audit process. The importance of strengthening the independence and power of the audit committee has recently been reinforced in the United States and elsewhere (e.g.. Blue Ribbon Committee (BRC) 1999; Ramsay 2001). Abbott, Parker, and Peters (2001) found that some of the audit committee characteristics identified by the BRC are associated with the likelihood of financial reporting misstatement (e.g., independence of the members, frequency of meetings). Abbott et al. sug- gest that their study provides support for the BRC’s effort to improve the finan- cial-reporting process. However, when asked to evaluate the importance of the audit committee, auditors in our study considered it to be somewhat important, but of lesser significance than senior management or the board. In fact, one-third of the respondents indicated that the audit committee was less important than other mechanisms. This observation may occur because the audit committee’s focus is limited to monitoring the financial-reporting process rather than the broader concems of business strategies and risk. As discussed earlier, focusing on business strategies and risk is an integral part of the audit strategy in today’s envi- ronment (Bell et al. 1997) as a means of controlling and minimizing audit risk.

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Further, the composition and experience of the audit committee is determined in part by the overall board of directors (Beasley and Salterio 2001), and the audit committee’s effectiveness is related to the composition of the entire board (Menon and Williams 1994; Collier and Gregory 1999).

An interesting observation was made by several respondents that members of the audit committee often lack the expertise to perform their job effectively. As one manager stated, “Sometimes members of the audit committee might not be the most appropriate people to be on the audit committee because they lack experience on financial matters. You will get a lot of questions that are very basic and you can tell that they are almost asking questions just because they feel like asking questions.” Several partners also indicated that, in general, audit committees are ineffective and are not powerful enough to resolve contentious matters with management. These observations are consistent with DeZoort and Salterio 2001, who found that audit committee members with insufficient accounting and auditing expertise are less likely to agree with auditors in financial reporting disputes with management than those with such expertise. Further, Felo et al. (2001) found that the expertise of audit committee members is associated with the quality of the financial-reporting process. Collectively, these observations support the recommendations of the Blue Ribbon Committee 1999 that were recently adopted by the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) that all audit committee members must have “financial literacy” and that at least one member must have “financial expertise”.

All of the partners and managers responding indicated that they met regularly (approximately two to three times a year”) with the audit committee. The major items discussed \yere the audit plan (84 percent) and the results of the audit (92 percent). In addition, one-third of the partners indicated that they discussed with the audit committee significant disagreements they had with management. In gen- eral, audit committee meetings were characterized as entailing the auditor reporting on significant audit issues, rather than an active two-way, proactive process on the part of the audit committee. As one partner described a typical meeting, “it is mostly a reporting action. Now there is some interaction, some questions, but it is really a reporting back.”

The passivity of audit committees supports the arguments of Fogarty and Kalbers 1998, who use institutional theory to explain the symbolic nature of audit committees. Further, KPMG (1999) in a survey of audit committee members in the United States found that over half of CEOs attend most audit committee meetings, perhaps also partly explaining why audit committee members are so pas- sive in their interactions with auditors. Some auditors observed that as public com- panies become larger the audit committee might start asserting a more active role. However, respondents also suggested that a major change in the “culture” of the audit committee must accompany any cosmetic change brought on by regulation.

Auditors indicated that they rarely meet with the entire board of directors; instead, they usually work only with the audit committee. On occasion, the board may ask the auditors to attend a board meeting for a specific accounting or audit issue of concern. This result is not surprising given that the audit committee is a

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subcommittee of the entire board charged with the explicit responsibility of over- seeing the financial-reporting process and interacting with the extemal auditors.

Auditors indicated that discussions with the audit committee or board have the greatest impact on audit-risk assessments and in the audit-planning phase (both indicated by approximately three-quarters of respondents). These discussions may suggest areas of concem regarding potential misstatement risks, which would affect program planning in terms of extent as well as the possible allocation of pro- fessional staff. However, this impact is apparently asymmetric, leading to increased, not decreased, audit scope. None of the participants indicated discussions with the audit committee or board ever affected the type of audit report issued.

Trends in the use of corporate governance (RQs 5 and 6)

The last two research questions explore trends in corporate govemance, as they affect the audit process. Three-quarters of respondents indicated that corporate governance is now of greater importance and plays a bigger role for audits in recent years than in the past. As one partner stated, “I think over the extent of my career, we’ve moved from auditing transactions to auditing controls to auditing corporate govemance.” In addition, 84 percent of respondents believed govemance will play a greater role in the future while 77 percent indicated that corporate gover- nance should play a greater role than is currently observed in practice. This finding corroborates that of Krishnamoorthy, Wright, and Cohen 2002, who found an “expectations gap” between what auditors perceive the role of the audit committee should be versus what it currently is in practice.

Respondents expecting a greater focus on corporate govemance in the future cited the heightened awareness of corporate govemance brought forth by the SEC. For example, because of the recommendations of the Blue Ribbon Committee 1999, auditors will be required to enhance the quantity and quality of their commu- nications with audit committees.

Other findings

Finally, the interview questions provided additional findings on the level of profes- sional guidance provided by firms and the importance of govemance with respect to fraud and nonaudit engagements. Auditors indicated that on-the-job experience and firm guidance were the primary ways they learned how and what factors to consider in evaluating and relying on corporate governance in the audit process. Although professional standards and firm guidance are available, often in the form of a “yes/no” checklist, participants indicated that they received minimal exposure during their academic (college) training, and there are almost no “in-house” pro- grams that emphasize the role of corporate govemance. The firm guidance that exists is primarily in the planning stages of the audit process (92 percent of respondents).

SAS No. 82 (AICPA 1997) has increased auditors’ attention to detecting fraud, and weaknesses in corporate govemance have been found to be associated with incidences of fraud (KPMG 1999; Beasley et al. 1999). Approximately three-quarters of respondents and 90 percent of the partners indicated that corporate govemance plays a heightened role when fraud is suspected. The degree of elaboration to this

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question depended in part on the auditor’s perspective of corporate governance. Auditors, who considered management to be an essential component of the corpo- rate governance mosaic, indicated that their firm would not want to be associated with a client where fraud is suspected and, thus, the strength of other governance mechanisms would be irrelevant. For example, a partner commented that in case of fraud, “we either abandon any reliance on corporate governance or we would more likely resign from the engagement”. Respondents who considered governance from a strict agency perspective identified the strength of the board as being more important in a high fraud risk setting. For example, one partner noted that “if I saw red flags I would certainly feel better if I knew I had a strong board”, while another partner noted, “if you have a situation where you suspect fraud or some sort of wrong doing, you want an audit committee to go to”. However, a recent study by Krishnamoorthy et al. 2002 suggests that auditors perceive that as currently consti- tuted, auditors do not view audit committees to be very effective in preventing fraud.

Given the trend toward the provision of nonaudit services (Panel on Audit Effectiveness 2000) the final interview question explored the importance of gover- nance in nonaudit engagements. The qualitative answers suggest that governance is important when providing other-assurance and tax services because manage- ment assertions need to be relied on, while governance may be less important for consulting clients where an advocacy focus is present. However, many auditors (over three-quarters of those responding) indicated that governance was important for all engagements, because client trustworthiness and a strong corporate culture were essential considerations in any business relationship. As a partner noted, “There may be some reputational risk for being associated with the company that ends up on the front page of the Wall Street Journal for whatever reason.”

7. Discussion

Auditors are an integral part of the corporate governance mosaic and have the potential to work with other governance actors to improve the quality of the finan- cial reporting process. Despite the increasing focus on corporate governance in recent years, there has been surprisingly little research on how auditors view the corporate governance mosaic and how governance mechanisms such as the board and the audit committee affect the audit process. This study addresses these issues by using an interview approach to obtain evidence of auditors’ client experiences.

Prior auditing research has characterized corporate governance primarily in terms of the monitoring role, emphasizing the independence of the board of direc- tors and the audit committee from company management. However, the auditors in this study, consistent with the emphasis placed by COSO (1992) on the “tone at the top”, predominately include senior management as the dominant component in the governance mosaic, noting that senior management sets the tone of governance. This explicit recognition that effective governance is inextricably intertwined with senior management’s attitude toward governance has important implications for future research. For instance, the agency perspective alone, with its emphasis on independence of the board and audit committee from the management, may be

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insufficient to fully understand the role and impact of corporate governance. Indeed, some may argue that the inclusion of senior management dilutes the nature and extent of the monitoring of management’s actions. Whether such a “dilution effect” is dysfunctional is an empirical question that is worthy of future research. For example, the active involvement of senior management in the selection of board members to strengthen the roles of the board in helping to access resources and to set strategic directions may be extremely valuable to the company. Reingold (2000, 131) states that in many instances the board’s “job might be to help facilitate business deals as much as it is to evaluate those deals independently”. This broader role of the board is of direct relevance to the newer audit approaches that focus on a client’s business strategies, processes, and risks.

The findings also highlight the interactive relationship among management, the board, and the audit committee. Previous auditing research on corporate gover- nance has largely focused on the audit committee and to some degree the board in isolation. However, future research is needed to explore the interrelationships between the various parties of the corporate govemance mosaic, including how the auditor affects and is affected by these parties.

An observation made by a number of respondents in our study was that mem- bers of the audit committee often lack the expertise and power to perform their jobs effectively and that communications with the audit committee were usually of a passive, reporting nature. Recent changes in audit committee qualification requirements and the issuance of additional auditing standards (e.g., SAS No. 89 (AICPA 1997)) are expected to mitigate these problems and enhance the important role of the audit committee in working with auditors to improve financial reporting quality. For instance, the NYSE and NASD (on the basis of the BRC 1999 find- ings) now require that the audit committee be made up of at least three directors, each of whom is financially “literate”, and that at least one member of the audit committee have “expertise” in accounting or financial management. Future research is needed to determine whether the recent changes and calls in the press for improved corporate govemance with respect to financial reporting are sufficient to provide audit committees with the requisite skills and power to accomplish their role. Further, research is needed on mechanisms to etihance and facilitate effective communications between the auditor and the audit committee and board.

Finally, the study also revealed that an audit senior’s role with regard to gover- nance is primarily one of gathering information for manager and partner consider- ation. It is important to examine how seniors obtain this information, given their limited exposure to senior management and the board (mechanisms considered of greatest importance). Because seniors are the primary parties responsible for the actual platining and execution of day-to-day audit procedures, if they do not have a comprehensive understanding of govemance factors, they may be insufficiently impounding information on govemance. For example, the mere use of a checklist to evaluate the presence or absence of corporate govemance mechanisms may poten- tially inhibit an effective evaluation of the substance of corporate govemance activi- ties (Asare and Wright 2002). A future study may examine whether seniors adequately capture and impound govemance factors in designing and executing an audit.

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Limitations in the current study should be considered in interpreting the find- ings and offering opportunities for future research. A potential limitation is that subjects were asked to respond, on the basis of their general experiences. A semi- structured interview approach (e.g., Hirst and Koonce 1996) provides a rich data set, but by its very nature limits the sample size. As a result, we wanted to obtain auditors’ general experiences across a broad array of engagements. Thus, we rec- ognize that these results provide exploratory evidence about the nature and role of corporate governance in the audit process. However, future studies could employ an archival approach (e.g.. Mock and Wright 1993, 1999) and use cross-sectional and longitudinal client data, or employ a case-based approach and focus on auditor experiences with specific clients.

The findings in this study provide initial evidence of the manner in which cor- porate governance factors are considered by auditors in the planning and execution of an engagement and how auditors obtain the knowledge and decision support to incorporate such factors. However, there is much to be learned. Further work is needed to extend and corroborate the findings to determine whether corporate gover- nance factors are sufficiently considered by auditors to promote audit effectiveness and efficiency.

Endnotes

1. A third perspective of govemance identified from the strategy literature, but not discussed in the paper, is the resource dependence perspective. It entails the view that (Pfeffer and Salancik 1978; Boyd 1990) the stockholders and/or management rely on the board as a means to access and manage scarce resources (Aldrich and Pfeffer 1976; Boyd; Pfeffer and Salancik) and help set the strategy of the firm (Williamson 1999). Thus, the primary role of the board shifts from being a “watchdog” (as is the case in the agency framework) to one that fosters a collaborative effort to help management set effective policies and strategies for the firm (California Public Employees’ Retirement system (CalPERS) 1999).

2. Interview data are costly in terms of availability of participants and researcher compilation and coding efforts. As a result, the sample size is inherently restricted. However, such data are rich in providing insights on participants’ experiences and views with a large number and variety of clients because subjects’ responses are based on general observations rather than limited focus on one client or a few specific clients.

3. One additional subject’s interview had to be deleted because the tape containing the interview was defective.

4. The number of participants with industry specialization included high technology (9), investments (7), financial services (6), manufacturing (6), consumer products (6), health care (3), retail (3), and others (12). “Others” included public sector, distribution, mergers and acquisitions, real estate, communications, and entrepreneurial services.

5. The interview instrument may be obtained from the authors upon request. 6. Potential explanations of why audit committees were not included by more

respondents in their view of corporate govemance are explored later in the paper. 7. This is consistent with Beasley et al. 2000, who found that even for nonfraud

companies, audit committees typically met two or three times a year. Note that this

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question referred to the number of meetings the audit committee had with the auditor present and not the total number of times the audit committee actually met during the year.

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CAR Vol. 19 No. 4 (Winter 2002)