The impact of audit committee expertise on auditor resources: the case of Israel

Abstract

We investigate the association between internal audit resources and both audit committee financial expertise and independence using hand-collected data on firms traded on the Tel Aviv Stock Exchange in 2010–2014. This period follows the full implementation of SOX (and a similar regulation in Israel), a law that increased the burden of responsibility of audit committee members. Since expertise allows for a better appreciation of the risks inherent in the firm’s operations and the appropriate audit scope, we believe that expert committee members are more likely to require additional audit hours. Thus, we expect and document a significant and positive association between internal audit resources and audit committee expertise. This relation contrasts with the findings in Barua et al. (J Acc Public Pol 29(5):503–513, 2010), a study conducted on data gathered in the midst of the implementation of SOX. However, we fail to find any significant association between internal audit resources and audit committee independence. Our paper is the first to use publicly available data on internal audit resources, based on mandatory disclosures that are required in Israel but not in the US. Our analysis is thus not subject to non-response and self-selection biases existing in previous studies using survey data. Moreover, our study uses the number of hours worked by internal audit, a more direct measure of internal audit effort than budget or number of employees.

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Notes

  1. 1.

    In most cases researchers attempt to minimize the non-response bias. An example of such an attempt is sending two mailings of the survey a few months apart and controlling for the difference between early and late respondents. Nevertheless, in all survey-based papers we discuss later, response rates to the surveys are in the range of 15–35 percent.

  2. 2.

    Throughout the years a few committees were appointed in order to examine various aspects of Israeli corporate governance and develop recommendations for improvement. One of the most important of these committees was the Goshen Committee, appointed in 2005. The committee focused on improvement of director independence, the workings of audit committees and accountability, as well as the establishment of a court specializing in Corporate and Securities Law. Its recommendations were adopted in 2007.

  3. 3.

    Recall that we refer to data from 2001 to 2002, the period before the full implementation of SOX, as pre-SOX data.

  4. 4.

    The number of employees of internal audit was chosen by the researchers as their measure of the extent of internal audit due to their assessment that it was less sensitive than internal audit budget used in Carcello et al. (2005) and Barua et al. (2010), and was therefore less likely to have a negative impact on the response rate of the survey.

  5. 5.

    However, some papers question these findings (see, e.g., Carcello and Neal 2003; Badolato et al. 2014). For conflicts of interest involving specific types of directors with financial expertise see Guner et al. (2008), Dittmann et al. (2010) and Kroszner and Strahan (2001). See also Hayes (2014) for a critique of Badolato et al. (2014) research design as well as for a detailed description of the literature on audit committee financial expertise.

  6. 6.

    TASE started publishing historical data regarding index composition in 30.6.2010, so the index with respect to the end of 2009 is from that date.

  7. 7.

    See also the analysis in Khanna and Yafeh (2007) regarding the ownership structure throughout the world. Additional analyses of Israeli corporate governance include Lauterbach and Shahmoon (2010) and Schwartz-Ziv and Weisbach (2013), both analyzing research questions different from ours. Lauterbach and Shahmoon (2010) find a positive association between the quality of a firm's corporate governance and its Tobin's Q, using an index ranking the corporate governance of Israeli firms. Schwartz-Ziv and Weisbach (2013) find that Israeli boards spend most of their time on supervisory activities, but that in many instances they do take on a managerial role.

  8. 8.

    Jaggi et al. (2016) provide an insightful discussion of the influence of ownership structure on financial reporting in Italy, that shares the feature of concentrated ownership and the ensuing agency problems with Israel.

  9. 9.

    It has been pointed out by Hwang and Kim (2009) that social ties, not captured in the formal definition of independence, also have an effect on decisions made by the board of directors.

  10. 10.

    In terms of the number of members and composition of the audit committee, Israeli law sets the minimum number of audit committee members at three and requires that a majority of them be independent. While there is no explicit requirement for the committee to have members with financial expertise, other requirements imposed on the board effectively produce the requirement of at least one financial expert on the committee.

  11. 11.

    Out of the 0.97 held by related parties for the company with maximum value, 0.43 were held by institutional investors.

  12. 12.

    One company in our sample has both the minimum ROA and the maximum ROA (in different years). Without this company the mean remains almost the same and the range is − 0.14–0.66. We ran our regressions without this company and the results were materially unchanged.

  13. 13.

    We ran our regressions without the Weak variable and the results were virtually unchanged.

  14. 14.

    The company with 129 subsidiaries operates in real estate in many countries, and many of its subsidiaries consist of one project. Removing it from the sample, as well as another company with many subsidiaries, did not materially alter the results.

  15. 15.

    Recall that in the sample selection process we exclude banks, insurance companies, cross-listed firms and Gas & Oil partnerships. Thus, the single company in the Financial Services sector in our sample is not a bank or an insurance company and the single company in the Gas & Oil Exploration industry is not a partnership.

  16. 16.

    A case where related parties may prefer smaller number of audit hours is related party transactions which is routinely examined by internal audit.

  17. 17.

    Many firms did not report the number of business segments. In addition, the number of business segments is highly correlated with LN assets (r = 0.573). For these two reasons, we did not include this variable in our main regressions.

  18. 18.

    For a discussion of the concentrated nature of the Israeli economy see Kosenko (2008). For a description of the attempts to improve the corporate governance environment, including setting up special committees to review its shortcomings, see OECD (2011).

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Acknowledgements

We wish to thank Kose John, April Klein, Avri Ravid and Avi Wohl for very helpful feedback and advice. We are indebted to John Wald for invaluable help. Research assistantship by Omri Zuckerstein is appreciated. We would also like to thank Yossi Ginossar and Doron Cohen of Grant Thornton, Israel and Kobi Avramov of Tel Aviv Stock Exchange for useful information. We acknowledge the financial support from the Academic College of Tel-Aviv Yaffo. Finally, we are grateful to an anonymous referee for insightful comments which improved the paper significantly.

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Correspondence to Shlomith D. Zuta.

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Appendix

Appendix

In this appendix we provide full definitions of directors with financial expertise and independent directors both in the US and in Israel.

Definitions of a director with financial expertise

US definition (Securities and Exchange Commission [RELEASE NOS. 33-8177; 34-47235; File No. S7-40-02])

The final rules define an audit committee financial expert as a person who has the following attributes:

  • An understanding of generally accepted accounting principles and financial statement;

  • The ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves;

  • Experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant’s financial statements, or experience actively supervising one or more persons engaged in such activities;  An understanding of internal controls and procedures for financial reporting; and  An understanding of audit committee functions.

Under the final rules, a person must have acquired such attributes through any one or more of the following:

  1. (1)

    Education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor or experience in one or more positions that involve the performance of similar functions;

  2. (2)

    Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;

  3. (3)

    Experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or

  4. (4)

    Other relevant experience.

Israeli definition (Israel Securities Authority, Regulation 2005)

A director with accounting and financial expertise is a director is a director possessing education, experience and skills such that his or her high proficiency and understanding of accounting, business and financial reporting issues enable him or her him or her to fully understand the financial statements of a company and stimulate discussions regarding the way in which financial items are presented in the statements. The evaluation of the director’s proficiency will be done by the board of directors, who will consider, among other things, the education, experience and knowledge in the following issues:

  1. (1)

    Accounting and control issues typical to the industry in which the firm operate and to the size of complexity of the firm, relative to other firms;

  2. (2)

    The role and duties of the external auditor;

  3. (3)

    Preparation of financial statements and their approval according to company law and ISA regulation.

Definitions of an independent director

US definition (Securities and Exchange Commission [RELEASE NO. 34-47516; File No. SR-NASD-2002-141])

“Independent director” means a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship, which, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The following persons shall not be considered independent:

(A) a director who is, or during the past three years was, employed by the [corporation] company or by any parent or subsidiary of the company [any of its affiliates for the current year or any of the past three years];

(B) a director who accepts or who has a Family Member who accepts any [compensation] payments from the [corporation] company or any [of its affiliates] parent or subsidiary of the company in excess of $60,000 during the current fiscal year or any of the past three fiscal years [previous fiscal year], other than compensation for board service, payments arising solely from investments in the company’s securities, compensation paid to a Family Member who is an employee of the company or a parent or subsidiary of the company (but not if such person is an executive officer of the company or any parent or subsidiary of the company),benefits under a tax-qualified retirement plan, or non-discretionary compensation (provided, however, that audit committee members are subject to heightened requirements under Rule 4350(d));

(C) a director who is a [member of the immediate] [f]Family Member of an individual who is, or [has been in any of] during the past three years was employed by the [corporation] company or byany [of its affiliates] parent or subsidiary of the company as an executive officer[. Immediate family includes a person’s spouse, parents, children, siblings, mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law, daughter-in-law, and anyone who resides in such person’s home];

(D) a director who is a partner in, or a controlling shareholder or an executive officer of, any [for-profit business] organization to which the [corporation] company made, or from which the [corporation] company received, payments (other than those arising solely from investments in the [corporation’s] company’s securities) that exceed 5% of the recipient’s [corporation’s or business organization’s] consolidated gross revenues for that year, or $200,000, whichever is more, in the current fiscal year or any of the past three fiscal years;

(E) a director of the listed company who is employed as an executive officer of another entity where any of the [company’s] executive[s] officers of the listed company serve on [that entity’s] the compensation committee of such other entity, or if such relationship existed during the past three years; or

(F) a director who is or was a partner or employee of the company’s outside auditor, and worked on the company’s audit, during the past three years.

Israeli definition (Corporation Law 1999)

(a) An independent director is a director with qualifications matching those of an external director according to 240 (b)–(e), as confirmed by the audit committee, and has not been a director in the company for over 9 consecutive years…

(b) An individual cannot be appointed as an external director if he, his relative, his partner, his employer, anyone who he is subordinated to directly, indirectly or through a company under his control, at the time of appointment or during the two years preceding the appointment, has a linkage/affinity to the company, its controlling shareholder or another company, where:

“Affinity”—the existence of employment relationships, any recurrent business or professional ties or control, holding a position as an officer or director, except as a director appointed in a company about to offer its shares to the public for the first time; the minister, in consultation with Israel Securities Authority, might decide that certain matters, under conditions he determines, will not constitute an affinity;

“Another company”—a company that the controlling shareholder, at the time of appointment or during the two years preceding the appointment, has been the company or its controlling shareholder;

(c) An individual cannot be appointed as an external director if his other roles and activities create or might create a conflict of interests with his position as a director, or if they might hamper his ability to serve as a director.

(d) A director in company A cannot be appointed as an external director in another company if at the same time an individual serving as a director at the other company serves as an external director in company A.

(e) An individual cannot be appointed as an external director in a public company if he is an employee of Israel Securities Authority or an employee of a stock exchange in Israel.

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Berkman, O., Zuta, S.D. The impact of audit committee expertise on auditor resources: the case of Israel. Rev Quant Finan Acc 55, 579–603 (2020). https://doi.org/10.1007/s11156-019-00853-0

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Keywords

  • Audit committee
  • Internal audit
  • Audit committee independence
  • Audit committee financial expertise
  • Corporate governance
  • Board of directors

JEL Classification

  • G34
  • G38
  • G42