A recent study reported in the American Accounting Association’s The Accounting Review suggests that in many cases the relationship between the the top executive and the respective audit committee members may be too comfortable to achieve truly independent oversight.
The study found that approximately 40 percent of the 2000 companies analyzed have committee members who are socially intertwined with the CEO. The particular relationships tracked included employment ties, educational ties and friendships from voluntary or leisure activities, with the latter showing a significant effect on financial reporting. The study points out that these types of relationships may “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.”
By definition, audit committee members are supposed to be independent outside directors. They are charged with overseeing various areas which rely upon independence from management, such as
- overall financial reporting and related disclosures
- activities (and independence) of the external auditors
- performance of the internal auditors
- whistleblower hotlines and other areas of compliance
While it may be difficult to prevent such relationships between CEOs and Audit Committee members, the authors suggest that disclosure is appropriate so that investors are able to make their own assessments of the reliability of financial reporting delivered under such circumstances.