Clubby Ties Bind Audit Committee Members and Executives

News Brief
December 12, 2013

As noted in blog, this article in Reuters, "Clubby ties between U.S. CEOs and board audit committees: study," reports on a recent study conducted by two accounting professors at Tilburg University in The Netherlands that examines the independence of audit committee members. The study appears in the forthcoming January 2014 issue of the American Accounting Association's Accounting Review.

You might be able to guess the conclusion of the study just from reading its title: "The Audit Committee: Management Watchdog or Personal Friend of the CEO?" The study found that "members often have long-standing social ties to executives, belonging to the same elite clubs or charity boards….' Although such firms appear to have independent audit committees, in reality these committees offer little to no monitoring at all,' the study found."

While SOX, which was adopted in 2002, imposed mandatory independence requirements on audit committee members, it did not specifically address social ties. (Note, however, that the exchange listing standards do require that an independent director not have relationships that would impair the director's ability to exercise independent judgment.) According to the article, the study of approximately 2,000 U.S. companies from 2004 to 2008 found that almost 40% of audit committee members "have social ties to the chief executive, … making them look more like lapdogs than watchdogs. The study reinforces long-held perceptions of a clubby culture on U.S. corporate boards, where members seldom challenge the executives they are meant to police….Where that was the case, earnings manipulation was more frequent and problems such as weak financial controls were covered up, the study found." More specifically, the abstract of the study indicates that the authors found that "these social ties have a negative effect on variables that proxy for oversight quality. In particular, [the authors found] that firms whose audit committees have ‘friendship' ties to the CEO purchase fewer audit services and engage more in earnings management. Auditors are also less likely to issue going-concern opinions or to report internal control weaknesses when friendship ties are present. On the other hand, social ties formed through ‘advice networks' do not seem to hamper the quality of audit committee oversight."

According to the article, the two professors advocate legislation that would require more disclosure about social connections, but commentators questioned how regulators would even be able to define "social ties."

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