Who “audits” the audit committee? Shareholder and auditor responses to ineffective audit committees
Jaime Schmidt, Department of Accounting
The Sarbanes-Oxley Act of 2002 (SOX) increased the audit committee’s responsibility to oversee the financial reporting process and ensure that high-quality financial statements are reported to investors. However, the popular press asserts that some audit committees only passively fulfill their SOX oversight responsibilities. In a joint project with Dr. Stephanie Rasmussen at the University of Texas at Arlington, I am investigating whether shareholders and auditors hold audit committees accountable for ineffective past performance.
Shareholders elect the board of directors, and it is in their best interest to appoint a competent and effective governing board. However, shareholders may not have enough voting power to remove ineffective audit committee members or may not be aware of audit committee ineffectiveness. Auditors are required under professional standards to assess audit committee effectiveness. However, auditors are hired and compensated by audit committees and may be more concerned about maintaining amiable relationships with audit committees than drawing attention to AC ineffectiveness. Thus, it is an empirical question if audit committees are held accountable for their performance.
To study this question, we identify a sample of ineffective audit committees during 2006. First, we examine whether shareholder votes against the audit committee members increase at the next annual meeting and whether the members are subsequently removed from the audit committee. Second, we examine whether auditors issue internal control audit opinions that identify the ineffective audit committee. In sum, we are investigating whether the SOX regulatory changes are enforced by parties best positioned to provide audit committee oversight.
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The Real Costs of Employer-Sponsored Retirement. Evidence from the Company Choice of Mutual Funds.
Clemens Sialm, Department of Finance
Employer-sponsored retirement accounts have gained significant importance across the world.
With the ongoing shift from defined benefit to defined contribution (DC) plans, the sheer size of the DC asset pool creates a potential for conflict of interest. Consistent with this, participant complaints of hidden and excessive fees and problems stemming from undisclosed affiliations and arrangements between 401(k) sponsors and the mutual funds selected for the 401(k) plan have attracted media attention. The fiduciary duty of the employer requires that they act in the interest of beneficiaries by being prudent and diligent in diversifying plan options and minimizing plan expenses. A recent series of class action lawsuits against 401(k) sponsors indicates that many companies may have breached their fiduciary duties.
In the proposed project, we investigate the decisions of the plan sponsors. In particular, we examine how and why sponsors choose a given menu of mutual funds for their 401(k) plans.
Our objective is to determine whether mutual fund choices are made with employees’ interests in mind or whether agency problems unnecessarily burden employees with excessive fees.
We hypothesize that, while employers are more likely to choose fund families with a superior performance and significant market share to avoid future legal liability, biases that arise from the firm and industry characteristics of the company or the demographic makeup of the employees may also affect the menu choice. Less innocuous biases may also arise from social ties between company fiduciaries and mutual fund managers. These biases may excessively increase the fees 401(k) participants face and reduce the diversification benefits such plans can offer to the employees (whose age and occupation are likely to affect the characteristics of the other assets in their portfolios). Therefore, we also investigate whether the observed characteristics of the mutual funds chosen by the 401(k) sponsor (such as fees or style) are systematically related to the demographic structure of the firm’s workforce, to social ties with the mutual fund manager, and to other firm/industry characteristics. Finally, we aim to quantify the economic magnitude of these extra costs.
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Knowledge Transfer, IT Governance and IT Investment Performance
Bin Gu, Department of Information, Risk, and Operations Management
IT investments account for over 50 percent of all capital investments in US firms. The effectiveness of IT investments, thus, has a significant impact on firm performance. Research in the past two decades reveals that, while IT investments on average improve firm productivity and performance, there are significant variations across firms and the variations persist over time. Extant research also shows that IT governance explains a significant amount of the variation. In this project, we take a step further to assess whether inter-firm and intra-firm knowledge transfer can be effective to improve low performing firms and business units. We focus on two knowledge transfer mechanisms: 1) Knowledge acquisition through executive movement and transfer. By acquiring executives from outside firms or business units with good IT governance practice, a firm can quickly obtain the managerial capability and improve its IT governance practice. Acquiring executives, however, carries its own risk. In particular, the choice of IT governance requires firm specific knowledge. Outsiders may lack the necessary organizational knowledge and/or organizational resource to implement the right IT governance practice. 2) Knowledge spillover through proximity to high performing business units and firms. We define proximity using multiple measures of organizational distance and assess the influence of spillover effect on adopting good IT governance practice and improving IT investment performance. Overall, this study will contribute to our understanding of knowledge transfer in improving IT governance in multiunit firms.
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Solving Economic Miscoordination Though Market Design
Shimon Kogan, Department of Finance
Asset markets play an important role in modern society. Financial markets for stocks, credit- related instruments, and future values of commodities are central components of most developed economies. Similarly, prediction markets are growing in prevalence in the managerial domain as a method for forecasting firm outcomes such as sales and production. As in the examples above, a key feature of many asset markets is that they are linked to economic activity such as investment or production. Therefore, understanding the relationship between asset markets and the economic activities to which they are linked is important for identifying when asset markets can be used to produce more desirable economic outcomes.
Our research explores the relationship between asset markets and underlying economic activity. We model the economic activity using “production” games in which players determine some costly personal input that is then aggregated into collective output. For example, order-statistic coordination games are often used to model economic activity such as investment in macroeconomic models (Bryant 1983; Cooper & John 1988) or production by firms (Brandts & Cooper 2006). We introduce a pre-play asset market in which the future value of assets is determined by the subsequent output in the game. We explore two main questions. First, how do asset markets influence economic outcomes? Second, how accurately do asset markets predict the outcome of the economic activity?
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Understanding and taming wicked business problems
Huseyin Tanriverdi, Department of Information, Risk, and Operations Management
In recent years, societies have had to live with consequences of many high profile examples of poor quality decision making by business leaders. Despite the efforts at improving corporate governance and regulations, poor quality decisions continue unabated. They are likely to become more prevalent as the increasingly interconnected and complex economic landscape continues to increase the “wickedness” of strategic problems faced by business leaders. A wicked problem is ill-defined. It involves many stakeholders with different values and priorities. Its root causes are complex, tangled, and difficult to decipher. The current global financial crisis and the U.S. health care crisis are examples of strategic wicked problems. With every attempt to address it, the wicked problem morphs into a new form. Attempted solutions have consequences that are difficult to undo. Wicked problems present unprecedented challenges and opportunities for firms. On the one hand, they are, by definition, unsolvable. On the other hand, wicked problems can be better understood and tamed. Firms, which understand and tame wicked problems better, could create value and gain advantages over their rivals. This study examines alternative managerial approaches used by leaders to enhance their capacity to understand and tame the wicked problems: e.g., reliance on managerial intuition, evidence-based management, data and analytics-based decisions, design thinking, and so forth. It examines whether and when different decision making approaches substitute or complement each other, how they affect decision quality and leaders’ capacity to understand and tame wicked problems.
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The Evolution of Capital Structure and Operating Performance after Leveraged Buyouts: Evidence from U.S. Corporate Tax Returns
Jonathan B. Cohn, Department of Finance
Lillian F. Mills and Erin Towery, Department of Accounting
The period 2005 through 2007 witnessed an explosion in the number and size of leveraged buyouts (LBOs) in the U.S., with approximately three percent of the U.S. stock market (by market capitalization) being taken private in these transactions in 2006 alone. LBOs are transformative, since they alter an acquired company’s ownership structure and typically leave it with large amounts of debt. Therefore, understanding the consequences of LBOs is important to researchers, policymakers, and investors. However, assessing how companies evolve after they are acquired in LBOs is challenging, since non-public companies are generally not required to make their financial statements public. We circumvent this data availability problem by using U.S. federal corporate tax return data to analyze post-LBO financial evolution. Since both public and private corporations are required to file tax returns, our data covers virtually all companies taken private in LBOs between 1995 and 2007, and is by far the most complete data set used to study the post-buyout effects of LBOs thus far.
While our results are still preliminary, the evidence suggests that LBOs do not, on average, lead to improvements in operating performance. This is inconsistent with one of the leading explanations for the existence of LBOs – that these transactions lead to better firm management through a reduction in the separation between ownership and control, the disciplining effects of debt, and the ability of LBO acquirers to supply operational and strategic expertise. We do, however, find improvements in operating performance in companies that were unprofitable pre-LBO, suggesting that improved efficiency is a likely explanation for LBOs of poorly-performing companies. We also find that the increase in debt and financial leverage that accompanies LBOs tends to be very long-lived: companies on average are just as indebted and leveraged up to five years after an LBO as they are immediately after the LBO. This suggests that a major motivation for LBOs is to transform companies’ capital structures to allow them to capture more of the tax shields that are created by interest payments, and that publicly-traded companies are, for some reason, unwilling or unable to undertake such transformations on their own.