June 17, 2021

Audit Committee Chair Succession & Financial Reporting Risk

When boards name a new audit committee chair, does previous service on a company’s audit committee make a difference? That’s the focus of a recent academic study and it finds that internal successors to the audit committee chair role are better positioned to perform well in the role compared to external successors. A key finding of the study is that the risk of misstating financial reports is less likely when newly appointed audit committee chairs are internal successors. Here’s the abstract from the study:

We investigate whether new audit committee (AC) chairs provide more effective monitoring of the financial reporting process when they have firm-specific knowledge, proxied for by prior service on the firm’s AC. Consistent with practitioner and governance experts’ views on the importance of firm-specific knowledge, we find that firms are less likely to misstate their financial statements when new AC chairs previously served on the AC. This effect is stronger in the first two years of the AC chair’s succession period and when the incoming AC chair has more prior service on the AC. AC chair industry, accounting, and supervisory expertise, as well as prior experience as an AC chair at a different firm, do not compensate for a lack of firm-specific knowledge. These findings contribute to the literature on the AC chair’s role in the financial reporting process, suggesting that AC chair succession planning is important for financial reporting outcomes.

To a certain degree, internal successors seem like a fairly logical choice for the audit committee chair since they have a foundation of company-specific knowledge. Although some advocate for external successors, as they can offer a fresh perspective with some bringing previous experience as an audit committee chair at another company, it’s somewhat surprising that the study found this external experience doesn’t offset the lack of company-specific knowledge.

Based on the study’s findings, succession planning for a potential internal successor to the audit committee chair role appears all the more important. For companies that have mandatory director retirement policies, charting when directors will reach retirement can certainly help identify potential skill and leadership needs as part of the board succession planning process. For more about board succession generally, check out our “Board Succession” Practice Area and our “Board Succession Planning” Checklist.

– Lynn Jokela