The Impact on Auditor Judgments of CEO Influence on Audit Committee Independence and Management Incentives

Abstract

Despite the importance of audit committee independence in ensuring the integrity of the financial reporting process, recent research suggests that even when audit committees meet regulatory independence requirements, certain factors, such as undue influence by the CEO over the selection of the audit committee, may diminish the ability of its members to be substantively independent. This study investigates whether auditors consider CEO influence over audit committee independence when making audit judgments where management’s incentives to manage earnings differ. In an experiment, we find that audit partners and managers waive a larger amount of a proposed audit adjustment when management’s incentives for earnings management are low than when incentives are high. However, when management incentives are high, auditors are less likely to waive as much of an adjustment when the CEO has less influence over the audit committee’s independence than when the CEO’s influence is greater. In all, the results support our expectations that auditors consider CEO influence on audit committee independence in the resolution of contentious accounting issues.

Keywords: audit committee, audit judgments, corporate governance, CEO influence, management incentives

JEL Classification: M41, M49