September 21, 2020

When CEOs and Audit Committee Members Are BFFs, Financial Statements Are Ps of S

Welcome to the latest edition of Accumulated Deprecation, Greg Kyte's monthly column. Go here to read more of Greg's posts.

Dutch people are assholes. In the United States, under SarBox, a 100 percent independent audit committee's good enough, but a group of Dutch researchers1 don’t even want CEOs and audit committee members to be friends.2

Here’s what they studied:

The three kinds of relationships the professors focused on were employment ties, educational ties and friendships from voluntary or leisure activities. While neither employment or educational ties were found to have a significant effect on company financial reporting, the researchers recorded the strongest correlation in the third group.

This correlation led them to the following conclusion:

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 opinions3 or to report internal control weaknesses when friendship ties are present.

SOX says that every audit committee member must be independent. That means

Audit committee members are barred from accepting any consulting, advisory or other compensatory fee from the issuer or any subsidiary thereof.

And

A member of the audit committee … may not be … a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the [issuer]."

But nothing in SOxley puts restrictions on Jamie Dimon’s bestie.

SOA-02 also mandates that every audit committee must have at least one financial expert. So it's pretty clear that at least one audit committee member has no "friendship ties." Financial experts are like yoga mats. Everybody's got one, but nobody really wants to spend time with it.

So what should be done?

One of the study’s researchers said, “Given the problems our study has revealed, the SEC in the U.S. and regulators in Europe should consider mandating the publication of social ties between top management and board members.”

Tough rule to follow for those who’ve slept their way to the top. Also, a hard rule to clarify.

Charles Elson of the Weinberg Center for Corporate Governance said it would be difficult for regulators to define social ties. “Is it one lunch a week, is it two lunches?”

There are, however, lunch, lunch-adjacent, and non-lunch circumstances that clearly indicate that a friendship tie does exist, like when a CEO and an audit committee member exchange friendship bracelets at summer camp.

Regardless of future regulation on friendship, financial reporting risk is reduced when friendship ties do not exist between audit committees and CEOs. Therefore, best practices dictate that CEOs should take the following steps to circumvent the formation of undesirable social relationships:

  • Make a concerted effort to sleep with audit committee members’ spouses
  • Deliver periodic board meeting nut taps
  • Assert that audit committee members’ pay is professional welfare

When you think about it, approximately half of all independence issues would evaporate with just a few more nut taps.

1 Technically, it was one Dutch researcher and one Belgian researcher, but since you can’t identify either country on a map, I’ll just call them both Dutch.
2 Care Bears is not broadcast in the Netherlands.
3 They generally have a very low opinion of Going Concern.

 

 

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