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 Do Auditors and Audit Committees Lower Fraud Risk by Constraining Inconsistencies
between Financial and Nonfinancial Measures?

JOSEPH F. BRAZEL, North Carolina State University*

JAIME J. SCHMIDT, University of Texas at Austin

March 2018

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accepted
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* Corresponding Author; Tel: (919) 513-1772
Email: jfbrazel@ncsu.edu
North Carolina State University
Poole College of Management
Department of Accounting
Campus Box 8113
Raleigh, NC 27695

We thank Jennifer Joe (editor), two anonymous reviewers, Keith Jones, Steve Kachelmeier, Bill
Kinney, Christian Leuz, Kathleen Linn, Sarah McVay, Don Pagach, Dick Riley, Greg
Trompeter, Scott Vandervelde, and Mike Wilkins, workshop participants at the University of
Texas at Austin, the University of South Carolina, and the Institute for Fraud Prevention for their
helpful comments and suggestions. We thank Christa Allen, Kareem Aridi, Sahil Batra, Pat
Braun, Addison Collins, Meredith Fincher, Blake Hetrick, Monica Manriquez, Johannes
Moolman, Kylee Phillips, MaryCobb Randall, Sadie Rockefeller, Dalton Rodriquez, Justin
Vaughan, Shell Yang, Samantha Wendt, Nick Williams, and Tayzeer Zaidan for research
assistance. We are grateful for financial support from the Institute for Fraud Prevention (IFP) and
the McCombs Research Excellence grant program. All results, interpretations, and conclusions
expressed are those of the authors alone, and do not necessarily represent the views of the IFP.
 Do Auditors and Audit Committees Lower Fraud Risk by Constraining Inconsistencies
between Financial and Nonfinancial Measures?

SUMMARY: Prior research finds that companies committing fraud exhibit large inconsistencies
between reported revenue growth and growth in revenue-related nonfinancial measures (e.g.,
number of stores, employees, patents). However, prior research also suggests that auditors, on
average, are not adept at identifying and constraining these differences. This study investigates
whether certain auditors and audit committees are able to lower fraud risk by constraining
inconsistencies between financial and related nonfinancial measures (NFMs). For a sample of
companies across a variety of industries, we find that auditors with greater industry expertise and
tenure and audit committee chairs with greater tenure are less likely to be associated with
companies that exhibit large inconsistencies between their reported revenue growth and related
NFMs. Surprisingly, we observe that audit committees with industry expert chairs are more
likely to be associated with large inconsistencies (higher fraud risk) than audit committees
without industry expert chairs. Our results suggest that the audit process can constrain fraud risk,
but that not all forms of audit committee expertise are beneficial.

Keywords: audit; audit committee; fraud risk; nonfinancial measures

JEL classification: M4

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 INTRODUCTION

Professional standard-setters, regulators, and academic researchers have discussed the

potential for nonfinancial measures (NFMs) to be a powerful and independent benchmark for

evaluating the validity of financial statement numbers (PCAOB 2004; Brazel, Jones, and

Zimbelman 2009; Messier, Glover, and Prawitt 2012). Revenue-related NFMs disclosed in

companies' 10-K filings (e.g., number of retail stores, patents, employee headcount) provide

“difficult to manipulate” measures of economic activity (Brazel et al. 2009). Prior research finds

that companies committing fraudulent financial reporting (hereafter, fraud) often exhibit large

inconsistencies between their revenue growth and growth in revenue-related NFMs (Brazel et al.

2009; Dechow, Ge, Larson, and Sloan 2011).1 Thus, large inconsistencies between audited

financial information and related NFMs can be considered a red flag indicative of high fraud risk

(Brazel et al. 2009).2 For parsimonious purposes, and consistent with the terminology used in
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Brazel et al. (2009), we will refer to the difference between revenue and NFM growth as “DIFF”,

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with a “large” DIFF being indicative of high fraud risk (e.g., revenue growth outpacing NFM

growth by more than 20%).

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The auditor is responsible for providing reasonable assurance that financial statements

are free from material misstatements resulting from error or fraud. However, recent research has

called into question the auditor’s ability to detect fraud (e.g., Dyck, Morse, and Zingales 2010).

In addition, evidence exists of an “expectations gap” in which financial statement users expect

more from an audit than what the audit profession believes it can provide vis-à-vis fraud

1
See http://pcaobus.org/Rules/Rulemaking/Docket034/Release_2013-005_ARM.pdf, which refers to such
inconsistencies as a potential indicator of intentional misreporting (p. 7 and Appendices 6 and 7).
2
In this study we are not assuming that all companies that exhibit a large inconsistency between their audited
financial statements and related NFMs are committing financial statement fraud. For example, a company’s revenue
growth could exceed its growth in contemporaneous NFMs because there is a time lag between investments in
NFMs and the realization of financial effects. However, prior research suggests that the risk of fraudulent financial
reporting is higher when a public company’s 10-K filing exhibits a large inconsistency (Brazel et al. 2009; Dechow
et al. 2011).

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detection (e.g., Mock, Bedard, Coram, Davis, Espahbodi, and Warne 2013). Thus, there is a need

to better understand the auditor’s ability to mitigate fraud risk.

The 2013 COSO Framework highlights the importance of fraud risk assessment for those

charged with corporate governance (see Principle 8).3 The audit committee (AC) chair, as the

“CEO of the audit committee” (Ernst and Young 2011), plays an important corporate governance

role by overseeing the accounting, financial reporting, and auditing processes of companies (U.S.

House of Representatives 2002). Thus, AC chairs should play a role in mitigating fraud risk.

However, Beasley, Carcello, Hermanson, and Neal (2009) indicate that AC members try to

distance themselves from their responsibilities to assess fraud risk, suggesting that AC chairs

may not reduce fraud risk.

Because not all auditors or AC chairs are equally adept at identifying and reducing fraud

risk via the use of NFMs (Brazel et al. 2009; Beasley et al. 2009; Brazel, Jones, and Prawitt
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2014), the objective of our study is to determine whether auditors and AC chairs with certain

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attributes are more likely to constrain fraud risk. Specifically, we examine whether greater effort,

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client-specific tenure, and industry expertise on the part of auditors and AC chairs reduce the

likelihood that a company’s audited financial statements exhibit a “large” DIFF.

We begin by utilizing a web-based tool developed for the Financial Industry Regulatory

Authority to identify quantitative, revenue-related NFMs for two consecutive years during the

2007 – 2009 time period for each company in our sample. The average change in NFMs between

the two years is then computed for each company and compared to the change in the company’s

reported revenue across the same two years. Again, consistent with prior research, we identify

revenue growth exceeding the average change in revenue-related NFMs by more than 20% as a

3
http://www.coso.org/documents/COSO%202013%20ICFR%20Executive_Summary.pdf,
http://deloitte.wsj.com/riskandcompliance/2013/06/12/coso-enhances-its-internal-control-integrated-framework.

2
“large” DIFF indicative of high fraud risk (Brazel et al. 2009). We then use logistic regression

models to investigate whether companies with greater auditor and AC chair effort, tenure, and

industry expertise are less likely to exhibit a “large” DIFF (i.e., high fraud risk).4

We find that certain auditor and AC chair characteristics constrain large inconsistencies

between reported revenue growth and related NFMs. In particular, we observe that as auditor

tenure and industry expertise increase, the audited financial statements are less likely to exhibit a

“large” DIFF. However, our significant industry expertise results are obtained using national and

joint measures (national and city) of auditor industry expertise. We do not observe significant

effects for a city-specific industry expertise measure.

Our analyses also demonstrate that as AC chair tenure increases, the audited financial

statements are less likely to exhibit a “large” DIFF. Surprisingly, we observe that companies

engaging an AC chair with industry experience are more likely to exhibit a “large” DIFF
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compared to companies without an industry expert AC chair. Several factors could account for

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this observed relation. For example, AC chairs with industry expertise are likely to have multiple

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board of director appointments and be too busy to monitor fraud risk at any one company (Lublin

2016). Alternatively, AC chairs with industry expertise could have strong connections with

management or receive equity incentives that would make them more willing to side with

management.

As such, we measure the AC chair’s busyness as the number of board appointments,

connectedness using Muckety.com scores and equity incentives following Campbell, Hansen,

Simon, and Smith (2015). We observe that the relation between AC chair industry expertise and

our measure of fraud risk is stronger in settings where the AC chair is less busy or more

4
Because the proportion of “large” DIFF firms can vary across industries (see Panel C of Table 1), we calculated an
industry-adjusted DIFF measure (see the Research Design section). Our results are robust to the use of this
supplemental measure.

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connected with management. In additional tests, we find that the positive relation is driven by

instances where the AC chair has industry expertise, but the auditor does not. While we cannot

ascertain the precise mechanism behind our findings using archival data, our evidence suggests

that AC chairs sometimes have the incentive and power to influence the financial reporting

process such that fraud risk is not constrained. As such, our results indicate that not all forms of

AC expertise aid in contraining fraud risk as it is measured in our study.

Our study contributes to the understanding of the fraud audit process in several key ways.

First, while prior research suggests that auditors are not adept at reducing fraud risk by

constraining large DIFFs (Brazel et al. 2009; Brazel et al. 2014), we provide empirical evidence

that certain auditors -- those exhibiting longer tenure and greater industry expertise -- are able to

reduce inconsistencies in audited financial statements. Second, our results related to tenure

indicate that mandatory audit firm rotation may not be the best means of mitigating fraud risk.5
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Third, we observe very little evidence of a relation between audit fees (effort) and our measure

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of fraud risk. We therefore illustrate that auditors were not compensated for increased fraud risk

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during our sample period that coincided with the global financial crisis. Finally, while prior

research reports that AC financial and industry expertise are associated with higher quality

financial statements (e.g., Abbott, Parker, and Peters 2004; Cohen, Hoitash, Krishnamoorthy,

and Wright 2014), our study raises the possibility that AC chairs with industry expertise could be

using their influence to enable fraud risk to exist.

The remainder of the paper is organized as follows. The next section presents the

background and development of hypotheses. This is followed by a description of the research

design and the results of the study. The last section concludes the paper.

5
The European Union adopted mandatory auditor rotation (http://europa.eu/rapid/press-release_STATEMENT-14-
104_en.htm) and the PCAOB’s new auditor reporting standard requires the disclosure of auditor tenure
(https://pcaobus.org/Rulemaking/Docket034/2017-001-auditors-report-final-rule.pdf).

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 BACKGROUND AND DEVELOPMENT OF HYPOTHESES

The Link between NFMs and Fraud Risk

Prior research indicates that nonfinancial measures (NFMs) are associated with financial

performance. For example, Behn and Riley (1999) find that NFMs in the airline industry (e.g.,

on-time performance and passenger load) predict quarterly revenue, expense, and net income

numbers. In addition to predicting future financial performance, audit guidance suggests that

NFMs can verify current financial results (PCAOB 2017a). The Public Company Accounting

Oversight Board (PCAOB) has specifically discussed the potential for NFMs to provide a

powerful, independent benchmark for evaluating the validity of financial statement data and has

endorsed the use of NFMs to improve fraud detection (PCAOB 2004).

Brazel et al. (2009) examine the relation between financial performance and NFMs and

find that, for companies that have committed fraud, growth in revenue substantially exceeds
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average growth in related NFMs. In particular, fraud companies in Brazel et al. (2009) exhibited

growth in revenue that exceeded average NFM growth by 20% (what we term a “large” DIFF).6
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Similarly, Dechow et al. (2011) illustrate that fraud companies exhibit asset growth that

substantially exceeds their growth in number of employees. By contrast, for non-fraud

companies, financial and NFM growth is more consistent (e.g., Ittner and Larcker 1998; Brazel

et al. 2009).

Consistent with this empirical research, auditors themselves acknowledge that a “large”

DIFF is indicative of high fraud risk. Brazel et al. (2014) document that audit partners and

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Both Brazel et al. (2009) and our study concentrate on revenues as the financial measure of interest due to the
concentration of frauds related to the revenue account (e.g., Beasley, Carcello, and Hermanson 1999; Beasley,
Carcello, Hermanson, and Neal 2010). To test the assumption based on prior research that a “large” DIFF is
indicative of higher fraud risk, in an untabulated analysis, we examine whether companies in our sample with a
“large” DIFF are more likely to experience litigation or regulatory scrutiny than companies without a “large” DIFF.
We find that “large” DIFF companies are more likely to be subject to class action lawsuits related to their reporting
during our sample period and are more likely to have a subsequent SEC inquiry/investigation.

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managers perceive large inconsistencies between revenue growth and related NFMs to be more

indicative of higher fraud risk than several commonly considered fraud red flags such as high

accruals or CFO turnover in the current year. Thus, a “large” DIFF is an important, empirically-

validated, and intuitive measure of high fraud risk.

Can Auditors and Audit Commitees Constrain DIFF?

Recent research has called into question the auditor’s ability to detect fraud (e.g., Dyck et

al. 2010). While auditors believe that inconsistencies between growth in financial data and

related NFMs are indicative of higher fraud risk, auditors are not always adept at detecting and

constraining large inconsistencies via analytical procedures. For example, Hirst and Koonce

(1996) document that auditors in the past did not use NFMs during analytical procedures.

Trompeter and Wright (2010) extend Hirst and Koonce (1996) and find that auditors report

moderate use of NFM data, but still prefer to use prior year account balances when developing
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expectations for current year account balances. Brazel et al. (2014) report that only a minority of

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senior-level auditors choose to use NFMs when evaluating revenue via analytical procedures and

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that it is uncommon for senior-level auditors to identify and investigate “large” DIFFs.

Concurrently, the PCAOB has questioned how auditors have performed analytical procedures

and the reliability of the resulting evidence (PCAOB 2014). In sum, auditor use of NFMs has

increased over time, but perhaps not enough to effectively constrain “large” DIFFs indicative of

high fraud risk.

With respect to the AC chair’s use of NFMs to verify financial statement information and

lower fraud risk, no academic research to our knowledge has been conducted in this area. In

relation to fraud risk in general, Beasley et al. (2009) indicate that AC members try to distance

themselves from their responsibilities to assess fraud risk. However, several practitioner articles

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highlight the value of using NFMs to evaluate a company’s financial performance.7 As the focal

point for the committee’s relations with the board, the CFO, and the internal and external

auditors (Beasley et al. 2009), the AC chair is also likely to be most knowledgeable about the

company and best suited to use NFMs to aid in the mitigation of fraud risk.

Auditors, Audit Committee Chairs, and Fraudulent Financial Reporting

This section summarizes prior literature that examines the links between auditor and AC

chair effort, company-specific tenure, and industry expertise and various phases of the fraud

audit process.8 Our review of the literature is primarily informed by two fraud research synthesis

studies performed at the request of the PCAOB (Hogan, Rezaee, Riley, and Velury 2008;

Trompeter, Carpenter, Desai, Jones, and Riley 2013).

Auditor/Audit Committee Chair Effort and Fraud

A higher fraud risk assessment at the beginning of the audit should lead to greater audit
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effort because auditors will increase their substantive testing to mitigate fraud risk. Prior research

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finds that auditors increase the extent of budgeted audit hours in response to their initial fraud

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risk assessments (e.g., Glover, Prawitt, Schultz, and Zimbelman 2003). Similarly, an AC that

meets often is more likely to reduce fraud risk by discussing company risks with the auditor, how

the auditor intends to mitigate such risk factors through additional substantive testing, and the

eventual results of those tests. Consistent with this notion, Farber (2005) finds that companies

that have committed fraud tend to have fewer AC meetings (i.e., lower AC effort). Thus, we

7
For example, see http://knowledge.wharton.upenn.edu/article/non-financial-performance-measures-what-works-
and-what-doesnt/.
8
We chose these three attributes based on our review of experimental, survey, and archival studies that suggest that
these attributes are likely to constrain the level of fraud risk present in audited financial statements. In addition,
these attributes can be measured for both the auditor and the AC chair (versus, for example, the level of non-audit
service fees or whether the auditor is a Big Four auditor). Variation in other attributes of auditors and AC chairs
could be associated with financial statements exhibiting low fraud risk. For example, (Kinney, Palmrose, and Scholz
2004) find a negative association between tax-related non-audit services and restatements. As such, in additional
analyses we also examine other attributes, such as the level of nonaudit services and the gender of the AC chair, to
determine if they are associated with our measure of fraud risk (see the Results section).

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expect that auditor and AC effort will be negatively associated with the level of fraud risk

present in audited financial statements.

Auditor/Audit Committee Chair Tenure and Fraud

The appropriate length of the auditor-client relationship has been a long-standing debate

among standard-setters, regulators, and practitioners. Consistent with the view that lengthy

auditor-client relationships impair audit quality, Chu, Church, and Zhang (2013) document that

longer auditor tenure is associated with more aggressive financial reporting. Davis, Soo, and

Trompeter (2009) document a positive relation between auditor tenure and their clients meeting

or beating analysts’ earnings forecasts. Still, other research suggests that no relation exists

between tenure and audit/financial reporting quality (e.g., Knechel and Vanstraelen 2007).

The initial PCAOB release on auditor rotation acknowledges that the majority of

academic studies conclude that engagements with shorter auditor tenure are riskier (PCAOB
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2011). For example, Myers, Myers, and Omer (2003) provide pre-SOX evidence that longer

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auditor tenure is associated with higher earnings quality. Carcello and Nagy (2004) find that

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undetected frauds are more likely to occur in the first three years of the auditor-client relation.

Similarly, AC chairs with a longer tenure should have a greater understanding of the

historical background of the company’s business and the required knowledge to detect when a

company’s financial reports diverge from the true economic state of the company. Beasley

(1996) finds that as outside director tenure increases, the likelihood of fraudulent financial

statements being disseminated to external users decreases.9 In addition, while not examining

fraudulent financial reporting, Mustafa and Meier (2006) report that longer AC member tenure is

associated with fewer incidences of misappropriated assets. In sum, prior literature suggests that

9
At the time Beasley (1996) was conducted, many of the companies in the study’s sample did not maintain an audit
committee.

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longer auditor and AC chair tenure could provide the knowledge required to constrain fraud risk

in audited financial statements.

Auditor/Audit Committee Chair Industry Expertise and Fraud

Prior research indicates that greater auditor industry expertise should improve the

likelihood that intentional misstatements in the financial statements are detected. In an

experimental setting, Hammersley (2006) reports that industry specialist auditors are more likely

than non-specialists to appropriately assess the risk of misstatement and tailor audit procedures

to detect a seeded misstatement. Using archival methods, Chin and Chi (2009) illustrate that

auditor industry specialization reduces the likelihood of subsequent financial statement

restatements. Similarly, we expect that industry expertise will enable the auditor to effectively

customize audit testing to the industry setting and identify and investigate fraud red flags.

With respect to the AC chair, Spira (2002) reports that many AC chairs view the AC as
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powerless to prevent and detect fraud. One AC chair interviewee in Beasley et al. (2009) stated

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that asking an AC to detect fraud “is asking a hell of a lot of the audit committee. It is totally

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beyond the competency of any audit committee member to be able to sniff out fraud…” (p. 97).

However, industry expertise should enable the AC chair to have the competency to better

understand the metrics that drive financial performance and thus identify inconsistencies

between a company’s reported financial performance and its underlying economic events. AC

chairs with industry expertise are likely to have more meaningful conversations with the auditor

about how fraud risk, in a given industry setting, can be lowered through effective risk

assessment and substantive testing. Consistent with this reasoning, Cohen et al. (2014) report that

ACs with industry expertise are associated with companies that exhibit higher financial reporting

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quality (measured by less restatements and lower discretionary accruals). In turn, AC chairs with

industry expertise could also constrain fraud risk.

On the contrary, AC chairs with industry expertise could be more aligned with

management and less inclined to constrain fraud risk.10 Because AC chairs with industry

expertise likely provide more value to the company, they could be awarded greater equity-based

compensation and have less incentive to mitigate fraud risk. Recent research illustrates that when

AC equity-based compensation is higher, financial reporting quality declines (Campbell et al.

2015). In addition, AC chairs with industry expertise are also likely to be busy with multiple

board of director appointments which could inhibit their ability to reduce fraud risk. Brown, Dai,

and Zur (2016) report a decline in the monitoring of financial reporting quality as director

busyness increases. Thus, AC chairs with industry expertise could be less able or inclined to

constrain fraud risk.

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However, given that Cohen et al. (2014) find that ACs with industry expertise are

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associated with companies that exhibit higher financial reporting quality and Abbott et al. (2004)

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observe that financial expertise on the AC is negatively associated with the occurrence of fraud,

we expect that an AC chair with industry expertise will provide a similar benefit. Thus, while not

10
For example, see http://pcaobus.org/News/Speech/Pages/10252013_BYU.aspx for remarks by a former PCAOB
board member questioning whether all audit committee members are performing at the level intended by the
Sarbanes-Oxley Act of 2002. In addition, see http://jimhamiltonblog.blogspot.com/2011/11/sag-views-auditor-
independence-as-core.html which describes instances in which the PCAOB Standing Advisory Group members
believe that ACs could side with management when disagreements with the auditor are encountered. Also, consider
this quote we obtained from a former Big Four audit manager about ACs aligning with management: “There is wide
variance here in my opinion. Some audit committees were very much tied to the CEO/CFO. They would golf
together, go on vacations together, knew each other's families, etc. And the tone of the meeting was very much that
the audit committee and management were on the same side for every issue. Some audit committees were just the
opposite where the committee members had a business approach and only viewed management as professional
colleagues. Perhaps the best situation I have seen was situations where the AC members did have social interactions
with management but took their jobs seriously. They would discuss social things with management before the
meeting but once it began, the AC members were all business and openly criticized management. There were a lot of
great honest conversations in these meetings.” Last, Soltes (2016) quotes Dennis Kozlowski, former CEO of Tyco,
with the following: “when the CEO is in the room, directors-even independent directors-tend to want to try and
please him. The board would give me anything I wanted.”

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assured, it is reasonable to posit that greater AC chair industry expertise should mitigate fraud

risk.

Hypotheses

Prior research on auditor and AC chair effort, tenure, and industry expertise (described

above) suggests that variation in these attributes will be associated with a reduction in fraud risk

via the constraint of “large” DIFFs in audited financial statements. We therefore propose the

following hypotheses:

H1A: Companies with greater auditor effort will be less likely to exhibit a “large” DIFF
(i.e., high fraud risk).

H1B: Companies with greater auditor company-specific tenure will be less likely to
exhibit a “large” DIFF.

H1C: Companies with greater auditor industry expertise will be less likely to exhibit a
“large” DIFF.

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H2A: Companies with greater AC chair effort will be less likely to exhibit a “large” DIFF.

H2B: Companies with greater AC chair company-specific tenure will be less likely to

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exhibit a “large” DIFF.

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H2C: Companies with greater AC chair industry expertise will be less likely to exhibit a
“large” DIFF.

RESEARCH DESIGN

Sample Selection and Data

This section describes the sample and empirical models used to test our hypotheses. We

use a web-based tool developed for the Financial Industry Regulatory Authority (FINRA) to

identify quantitative NFMs contained in company 10-Ks. Development of the tool began in 2007

and was completed in 2008, enabling us to obtain data for a 2007 – 2009 sample time period.

Similar to Brazel et al. (2009) and Dechow et al. (2011), the focus of our collection efforts was

on revenue-related NFMs (e.g., number of stores, customers, products). We also include the

11
number of employees obtained from Compustat, which is typically correlated with revenue and

is a common NFM disclosed by most companies (Brazel et al. 2009). The web-based tool

contained a total of 5,400 companies' 10-Ks. From this list we selected 1,164 companies for

hand-collection of NFMs.11 The 1,164 companies were chosen by ordering companies within

each of the Fama-French (1997) 30 industry categories by market value in an effort to obtain a

sample comprised of approximately 90% of the cumulative market capitalization for each

industry. We then use the website to hand-collect the same set of NFMs for two years for each of

these companies. These efforts resulted in reducing the initial sample to 743 companies. The

primary reason companies were dropped from our initial sample was the inability to collect the

same set of NFMs over the two year period.

We then use the Audit Analytics and Compustat databases to obtain audit fees (our

auditor effort measure), auditor tenure, and industry expertise data. Information about the
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number of AC meetings (our measure of AC chair effort), AC chair tenure, and AC chair

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industry expertise was obtained from the Risk Metrics and Board Ex databases. We exclude 32

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(20) companies missing auditor (AC chair) information, which reduces our sample to 691

observations.12 Panel A of Table 1 summarizes our sample selection criteria.

Panel B of Table 1 identifies 11 categories of NFMs collected as well as brief

descriptions. To be included in the sample, companies must have at least three of the same NFMs

in both the current year and the prior year. We then use the average year-over-year percentage

11
The FINRA database was populated with firms that had market capitalizations of greater than approximately $15
million dollars at fiscal year-end 2008.
12
Our sample is further reduced by various amounts (17 – 207 observations) in our tests that examine alternative
explanations for some of our main AC chair findings. The reduced sample sizes are explicitly noted in Tables 5 and
6.

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change in NFMs by company to represent the overall direction and magnitude of NFMs.13 We

collected a total of 4,138 NFMs across the 691 companies (an average of 6 NFMs per company).

The largest categories are “Employees”, “Facilities”, and “Products & Inventory”, which

represent 16.7%, 16.3%, and 12.6% of the NFMs collected, respectively. Each category is well-

represented within the sample, and cross-sectionally each category captures a significant number

of companies. In other words, one particular NFM category does not dominate our study. In sum,

our sample covers a large cross-section of NFMs that drive financial performance and enables us

to create a robust measure of DIFF to be incorporated into our tests.

To begin our analysis, for each company we calculate the average year-over-year

percentage change in NFMs (%AVGCHGNFM).14 Consistent with Brazel et al. (2009), we define

DIFF as the difference between the percent change in revenues reported on the financial

statements and the average percent change in NFMs over the same time period as follows:
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DIFFi,t = % CHGREVi,t - % AVGCHGNFMi,t

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Prior studies examining inconsistencies between financial and nonfinancial measures vis-

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à-vis fraud have either been limited to small sample sizes due to labor intensive hand-collection

of NFMs (Brazel et al. 2009) or using only one type of NFM (e.g., employee headcount; Dechow

et al. 2011). Examining numerous company-specific NFM disclosures across a variety of

industries, we demonstrate that financial growth is typically consistent with NFM growth. In

Figure 1, we show the distribution of DIFF for our sample of companies. Figure 1 illustrates that

financial growth is typically consistent with NFM growth as DIFF for our sample is normally

distributed and centered at approximately zero. For the entire sample, DIFF has a mean of 0%

13
In untabulated analyses we add the number of NFMs collected for the company to our list of control variables. We
find that it is not significantly associated with LARGEDIFF (IND_LARGEDIFF), and our results are robust to its
inclusion.
14
We provide company-specific examples of the calculations of %AVGCHGNFM, DIFF, and LARGEDIFF in the
Appendix.

13
and a median value of about 1%. Approximately 11% of our sample consists of companies

exhibiting a “large” DIFF (74/691 companies), where growth in revenues outpaces the average

growth in NFMs by greater than 20%.

Panel C of Table 1 presents our sample by industry and indicates that two industries have

a concentrated amount of “large” DIFFs: (1) Energy and (2) Healthcare, Medical Equipment,

and Drugs. As a result, we create an industry-adjusted “large” DIFF measure

(IND_LARGEDIFF) where a firm is classified as having a “large” DIFF within its industry if its

difference between revenue growth and revenue-related NFMs is within the top decile of its

industry. IND_LARGEDIFF will be used as a supplement to our main dependent variable of

interest (LARGEDIFF described below). In sensitivity tests, we also re-perform our analyses

without these two industries to determine if our results are driven by them.

Multivariate Model
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To test our hypotheses regarding whether auditor/AC chair effort, client-specific tenure,

accepted
and industry expertise are associated with the constraint of fraud risk, we estimate the following

logistic regression model:

manuscript
LARGEDIFF (IND_LARGEDIFF) = β0 + β1 AuditorEffort+ β2 AuditorTenure +
β3 AuditorIndExpert + β4 ACEffort + β5 ACCTenure + β6 ACCIndExpert + β7 Size +
β8 OCF + β9 Lev + β10 Loss +β11 MTB + β12 Restate + β13 Lit + β14 PYDIFF + β15 Big4 +
24
k=9βkINDk + ε

To examine H1A-C and H2A-C, the primary dependent variable is defined as LARGEDIFF and is

equal to 1 if the growth in revenue reported on the financial statements from year t-1 to year t

outpaces the average growth in revenue-related NFMs for the same time period by more than

20% and 0 otherwise. That is, when DIFF is greater than 20%, LARGEDIFF is equal to 1 and 0

otherwise. We use 20% as our threshold, because the prior literature documents that fraud risk is

high when the growth in revenue exceeds the the average growth in related NFMs by 20% or

14
more (see Table 3 of Brazel et al. (2009) for DIFF percentages).15 As explained earlier, our

secondary dependent variable is defined as IND_LARGEDIFF, and it is equal to 1 if the firm is

in the top decile of its industry classification with respect to DIFF. We use the top decile as our

cut-off to be consistent with the frequency of our LARGEDIFF measure which occurs in 10.71%

of our sample (see Panel C of Table 1).

Independent Variables

Our study focuses on whether auditor and AC chair effort, client-specific tenure, and

industry expertise are associated with LARGEDIFF. Our first auditor-related variable of interest

is AuditorEffort, which is equal to the natural logarithm of total audit fees billed in the current

year. We use audit fees as our measure of auditor effort because actual audit effort is not

observable and numerous studies document that audit fees are higher when auditors expend more

effort to address risks (e.g., Pratt and Stice 1994). Our second auditor-related independent
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variable is AuditorTenure, which is equal to the number of consecutive years since 1974 the

accepted
company is reported by Compustat to have retained the auditor as of the end of year t. We use

manuscript
1974 as it is the year that Compustat began identifying auditors. Our final auditor-related

independent variable is AuditorIndExpert, which is an indicator variable set equal to 1 if the

auditor has an annual national market share greater than 30% within the two-digit SIC industry

in year t and 0 otherwise (Knechel, Naiker, and Pacheco 2007; Reichelt and Wang 2010).16

15
We examine signed DIFF (vs. the absolute value) because Brazel et al. (2009) and Dechow et al. (2011) document
that fraud is typically associated with revenue growth that outpaces NFM growth.
16
Our focus on national expertise vs. alternative measures reflects Dyck et al.’s (2010) conclusion that it takes a
“web of monitors” to detect fraud. As such, it is likely that significant consultation between the engagement team
and other offices/cities of the firm, as well as the national office of the firm are needed to constrain fraud risk. These
consultations should be more effective if the firm is a national leader in the industry. In non-tabulated analyses, we
replace our national measure of industry expertise with city-level and joint measures. Results related to joint
expertise are qualitatively similar to those tabulated for our national measure. City-specific results are not significant
in our tests of hypotheses.

15
 With respect to AC chair characteristics, our first variable of interest is ACEffort, which

is equal to the total number of AC meetings that occurred within year t according to the

company’s annual proxy statement (Farber 2005). Next, we use the BoardEx database to capture

the length of the AC chair’s tenure on the board and define ACCTenure, our second variable of

interest, as the total number of years the AC chair has been serving on the board of directors as

of the end of year t.17 Our third AC chair variable of interest is ACCIndExpert, which is an

indicator variable equal to 1 if the AC chair has current or previous work experience within the

same two-digit industry SIC code of the company and 0 otherwise (Cohen et al. 2014).

Control Variables

Consistent with Reichelt and Wang (2010), we control for several factors that have been

documented to be associated with audit and financial reporting quality. First, we control for

company size (Size) by including the natural logarithm of the company’s market value of equity
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in year t. We control for operating performance by including operating cash flows scaled by total

accepted
assets in year t (OCF). We include leverage (Lev), measured as total long-term debt divided by

manuscript
total assets, to control for the availability of resources. Because financial distress often requires a

going-concern assessment by the auditor and discussions with the AC chair (i.e., additional

effort), we include a dummy variable (Loss) that is equal to 1 if net income in the sample year is

negative and 0 otherwise. Previous research suggests that growth companies have less capable

internal control systems, which negatively affect financial reporting quality (Abbott et al. 2004)

and require additional auditor effort. We control for growth by including the market to book ratio

(MTB), calculated as the market value of equity at the end of year t divided by the book value of

equity at year t.

17
We measure board tenure rather than AC tenure because company charters often determine AC tenure length and
because company knowledge can be obtained through any board service, not just AC service.

16
 We also control for whether a company recently issued a restatement or operates in a

frequently litigated industry, because auditors and/or AC chairs could exert additional effort and

expertise to reduce financial reporting and litigation risk. In addition, prior research shows that

auditors shed risky clients (Johnstone and Bedard 2004), and auditors get dismissed after

negative outcomes (Hennes, Leone, and Miller 2013). Thus, restatements and litigation could be

associated with both auditor tenure and LARGEDIFF. Specifically, we include an indicator

variable (Restate) that is equal to 1 if the company issued a restatement in any of the three years

prior to year t and 0 otherwise. We also include an indicator variable (Lit) that is equal to 1 if the

company operates in the biotechnology, computers, electronics, or retailing industries and 0

otherwise (e.g., Reichelt and Wang 2010). We control for DIFF in the prior year (PYDIFF)

because, similar to accruals, DIFF is likely correlated between years. Specifically, PYDIFF is

measured as the growth in revenue from year t-2 to t-1 less the change in the number of
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employees from year t-2 to t-1.18 We control for auditor type with Big4 which equals 1 if the

accepted
auditor is a Big 4 auditor and 0 otherwise. We also include industry dummy variables to control

manuscript
for cross-sectional effects in the data. We use the 10-industry classification scheme of Fama and

French (1997).

Last, we control for three additional AC chair variables (ACCBusyness, ACC_Connect,

ACCOptionHold) that could be correlated with our AC chair variables of interest. ACCBusyness

is a count of the AC chair’s total number of board positions at public companies as of year t. We

include this variable as an AC chair could expend less effort to oversee the financial reporting

process if s/he is serving on multiple boards. ACC_Connect is the AC chairman’s score of 0 –

100 for connectedness and influence as of February 16, 2016 according to muckety.com (a

18
Brazel et al (2009) find that DIFF using only employees as the NFM (versus multiple company-specific NFMs,
such as number of patents and products) serves as an effective measure of fraud risk. Because employees are
available via Compustat (and do not require hand collection), we use employees as our NFM in PYDiff.

17
higher number indicates greater connectedness and influence).19 We include this variable

because we expect that AC chair “connectedness” and “influence” will be correlated with the

likelihood of the chair aligning with management when disagreements with the auditor occur.

Campbell et al. (2015) observe that when AC equity-based compensation is higher, financial

reporting quality declines. Thus, we include ACCOptionHold as measured by Campbell et al.

(2015). We summarize all variable definitions in Table 2.

RESULTS

Descriptive Statistics and Correlations

Table 3 presents descriptive statistics for our full sample (Panel A), as well as categorized

by LARGEDIFF (Panel B) and IND_LARGEDIFF (Panel C). Tests of differences in the mean (t-

tests) and median (Wilcoxon signed rank tests) for continuous variables and tests of differences

in frequency (Chi-square tests) for discrete variables are also presented in Panels B and C. In
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Panel B, we observe that the LARGEDIFF = 1 group’s mean auditor tenure is significantly lower

than the LARGEDIFF = 0 group (10.64 vs. 14.12 years).20 For our first discrete independent
accepted
manuscript
variable, AuditorIndExpert, we find a significantly lower frequency of observations for the

LARGEDIFF = 1 group (6.76%) than in the LARGEDIFF = 0 group (18.64%). However, for the

AC chair’s industry expertise (ACCIndExpert), companies with LARGEDIFF = 1 have a higher

percentage of industry experts (25.68%) than LARGEDIFF = 0 companies (11.99%).

In Panel C, we observe similar differences. Auditor and AC chair tenure are shorter for

companies that exhibit IND_LARGEDIFF = 1 (10.83 versus 14.06 years and 5.87 versus 7.33

years, respectively). Similar to Panel B, AC chair industry expertise is more common for

19
We could not obtain scores for our sample years as muckety.com only provides current information.
20
ACEffort is also found to statistically differ across the two groups, as the LARGEDIFF = 1 companies have an
average of 2.00 AC meetings per year versus 2.08 for LARGEDIFF = 0 firms. However, we do not consider this an
economically significant difference.

18
companies that exhibit a large DIFF compared to industry peers (i.e., ACCIndExpert is present in

approximately 30% of IND_LARGEDIFF = 1 companies versus approximately 12% of

IND_LARGEDIFF = 0 companies).

We report correlation statistics for our variables of interest and AC chair-specific control

variables in Table 4. Our correlation analyses show that all correlations are less than the 0.80

level for which it is suggested that multicollinearity be examined (Gujarati 2003). Even so, as

expected, several of our additional AC chair control variables (e.g., ACC_Connect) are

significantly correlated with each other and with some of our main variables of interest. As a

result, we sequentially add in these additional control variables in individual columns in our

subsequent multivariate analyses (Tables 5 and 6).

Multivariate Results

Table 5 estimates the likelihood that a company will exhibit a large difference in reported
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revenues and related NFMs (i.e., LARGEDIFF = 1). Column A represents our main regression

accepted
model, whereas Columns B through D ensure that our results are robust to the inclusion of

manuscript
several alternative AC chair variables (i.e., ACCBusyness, ACC_Connect, and ACCOptionHold).

The area under the ROC curve is between 75-80% for all four columns, indicating that the

logistic regression model has adequate discrimination (Hosmer and Lemeshow 2000). Consistent

with H1B-C, the odds ratios across all columns for AuditorTenure and AuditorIndExpert are

significant and less than one. Our results in Column A suggest that, on average, the likelihood of

a LARGEDIFF decreases as auditors have longer tenure and more industry expertise. We find

that a one-year increase in auditor tenure would lead to an approximate 5% decrease in the

likelihood of LARGEDIFF = 1. Companies with LARGEDIFF = 1 are approximately three times

19
as likely to have auditors that are not industry experts as those with LARGEDIFF = 0.21

However, related to H1A, we do not find support for our measure of auditor effort (i.e., audit

fees) as the coefficient on AuditorEffort is not significant in all of the four columns of Table 5.

With respect to H2A-C, we find mixed results. In Columns A and B, we observe that the

coefficient on AC effort (ACEffort measured by the number of AC meetings) and AC chair

tenure (ACCTenure) to be negatively associated with LARGEDIFF but only marginally

significant. In addition, we do not find either of these variables to be significantly associated

with LARGEDIFF in Column D. Contrary to H2C, we find that when the AC chair has industry

expertise, the likelihood of a company exhibiting LARGEDIFF = 1 increases. Specifically, when

the AC chair has industry expertise, the odds that LARGEDIFF will be present is twice as likely

across all four columns.22 Below we further discuss and investigate this unexpected result related

to ACCIndExp.
preprint
Table 6 estimates the likelihood that a company will exhibit a large difference in reported

accepted
revenues and related NFMs in comparison to the rest of the companies within the same industry

manuscript
(i.e., IND_LARGEDIFF = 1). Similar to Table 5, Column A represents our main regression

model, whereas Columns B through D ensure that our results are robust to the inclusion of

several alternative AC chair variables (i.e., ACCBusyness, ACC_Connect, and ACCOptionHold).

The area under the ROC curve is 73-78% across all four columns, indicating that the logistic

regression model has adequate discrimination. Our results are largely consistent with the results

in Table 5. Consistent with H1B-C, across all columns the coefficients for AuditorTenure and

AuditorIndExpert are negative and significant at at least the 0.10 level. These results suggest

21
Our results in Tables 5 and 6 are robust to re-performing the analyses using a Firth Logistic regression model
instead of a standard Logistic regression model.
22
As noted at Table 5, our tests are one-tailed when coefficient signs are as predicted and two-tailed otherwise.
Since the observed relation for ACCIndExp is opposite our prediction in H2C, the significance level is two-tailed
(i.e., the p-value is not split).

20
that, on average, the likelihood of exhibiting IND_LARGEDIFF decreases as auditors have

longer tenure and more industry expertise. Again, we do not find support for our measure of

auditor effort (i.e., audit fees).

With respect to our Hypotheses 2A-C, in Table 6 we find somewhat similar results to

Table 5. The coefficient for AC chair tenure is, as predicted, negative and significantly

associated with IND_LARGEDIFF. We again find the coefficient on AC chair industry expertise

to be positive and significantly associated with IND_LARGEDIFF. We observe that the counter-

intuitive AC chair industry expertise effect gets stronger in the industry DIFF analysis. Overall,

we find very similar results when we industry-adjust our measure of fraud risk.

Exploring the Counter-Intuitive Audit Committee Chair Industry Expertise Result

As stated above, our results related to ACCIndExpert are opposite to that predicted by

H2C. Companies with an industry expert AC chair are more rather than less likely to exhibit a
preprint
LARGEDIFF (high fraud risk as measured in this study). While industry expert AC chairs could

accepted
have have multiple board of director appointments and be too busy to monitor fraud risk at any

manuscript
one company (Lublin 2016), we do not find support for such an explanation as the coefficient on

ACCBusyness is insignificant in Column B of both Tables 5 and 6. Alternatively, AC chairs with

industry expertise might be better connected with management or could receive equity-based

compensation that motivates them to “look the other way” when faced with financial reporting

discrepancies. However, we again do not find support for such explanations as the coefficients

on ACC_Connect and ACCOptionHold are insignificant in both Tables 5 and 6 (Columns C and

D). Further, the coefficient on ACCIndExpert remains consistently positive and significant when

controlling for these alternative explanations.

21
 However, the above conclusions are based on an examination of the main effects of

ACCBusyness, ACC_Connect, and ACCOptionHold. The relation between ACCIndExpert and

LARGEDIFF may only be present when the AC chair exhibits these characteristics. Such

analyses would help to explain the mechanism behind the counter-intuitive ACCIndExpert and

LARGEDIFF association we observe. Therefore, we perform several exploratory, untabulated

analyses where we split the sample at the median across the ACCBusyness, ACC_Connect, and

ACCOptionHold characteristics and examine the relations between ACCIndExpert and both

LARGEDIFF and IND_LARGEDIFF.

We observe that the positive coefficient on ACCIndExpert only exists in the sub-sample

of AC Chairs with below-the-median busyness (in both LARGEDIFF and IND_LARGEDIFF

analyses). In addition, the coefficient on ACCIndExpert is marginally significant in the sub-

sample of AC chairs connected to management (but only in the LARGEDIFF analysis).23 As

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such, the mechanism driving the counter-intuitive association could be influence as the AC

accepted
Chairs industry expertise result is only present when AC Chairs have more time and are

manuscript
seemingly more connected to management. Anecdotal evidence (see footnote 10) and research

studies (e.g., Cohen, Krishnamoorthy, and Wright 2010) suggest that there is variation in the

extent to which ACs influence the audit process and side with management over the auditor.

Given the above findings, we perform additional analyses to further explore influence as

a potential mechanism for the counter-intuitive result. In particular, we examine: (1) the effect of

combined financial and industry AC chair expertise on LARGEDIFF, and (2) the effect of AC

chair industry expertise on LARGEDIFF when the auditor does not have industry expertise. In

untabulated tests, we find the positive association between AC Chair industry expertise and

23
In general, we obtain similar results to what we find with our subsamples when we include interaction terms for
ACCIndExpert and ACCBusyness, ACC_Connect, or ACCOptionHold in our tests of our hypotheses.

22
LARGEDIFF to only exist when: (1) the AC chair also has financial expertise (reducing the

auditor’s advantage related to their core financial expertise), and (2) the auditor does not have

industry expertise (expanding the AC Chair’s industry advantage over the auditor). Thus, our

additional tests suggest that AC chair industry expertise could empower the AC to negatively

influence the financial reporting process. Our findings complement recent research that

documents that AC status is key to enabling the AC to impact outcomes (Badolato, Donelson,

and Ege 2014) and that board expertise can be detrimental in certain circumstances (Minton,

Taillard, and Williamson 2014). Still, we acknowledge that we are unable to empirically

illustrate the exact mechanism behind our counter-intuitive result. Additional research studies

employing alternative research methods are needed to further ascertain if and why AC chair

industry expertise does not constrain fraud risk.

Additional Untabulated Sensitivity Tests

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While we predicted a negative relation between AuditorEffort (as measured by audit fees)

accepted
and LARGEDIFF (IND_LARGEDIFF), we did not observe significant multivariate relations in

manuscript
Table 5 or 6. Because our sample time period is 2007-2009 and coincides with the global

financial crisis, the components of LARGEDIFF (revenue and NFMs) could have behaved

differently during this time period such that a relation between risk and effort could not be

detected. In addition, the non-significant relation could be attributable to fee pressure that existed

during the crisis (e.g., Ettredge, Fuerherm, and Li 2014). To account for the effects of the global

financial crisis on our results, we perform two additional untabulated sensitivity tests. First, we

remove four firms in our sample that went bankrupt within three years after our sample period

and re-perform our analyses. Our results in Column A of Tables 5 and 6 are robust to this

exclusion. Second, we include the Zmijewski (1984) bankruptcy score as an additional control

23
variable and re-perform our analyses. We find the bankruptcy score is not significantly

associated with LARGEDIFF and IND_LARGEDIFF in a correlation matrix or in multivariate

analyses. Our untabulated results related to H1A-C and H2A-C are largely robust with the

exception of losing some significance due to sample attrition.24

Prior research illustrates that the joint provision of nonaudit and audit services can result

in knowledge spillovers and audit efficiencies (e.g., Davis, Ricchiute, and Trompeter 1993; Joe

and Vandervelde 2007). Thus, nonaudit services could enable auditors to be more directed and

efficient in their substantive testing such that a relation between AuditorEffort and LARGEDIFF

would not be observed. The audit firm could also price some of the effort associated with

increased fraud risk as part of their nonaudit services such that fraud risk is not reflected in audit

fees. As a result, we examine whether (1) nonaudit fees or (2) total audit and nonaudit fees are

associated with LARGEDIFF (IND_LARGEDIFF). In untabulated tests, we do not observe that

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non-audit fees are associated with LARGEDIFF (IND_LARGEDIFF), but we do find that total

accepted
fees are marginally negatively associated with LARGEDIFF. Thus, we find some limited

manuscript
evidence that the total price of services performed is associated with lower fraud risk.

In an additional untabulated sensitivity test, we examine whether audit fees are correlated

with PYDIFF (measured as prior year growth in revenue less the prior year change in the number

of employees) as an auditor might negotiate a higher audit fee for the next year’s audit if fraud

risk was elevated in the prior year. However, we observe that PYDIFF and AuditorEffort are not

significantly correlated, and AuditorEffort is not significantly associated with PYDIFF in a

multivariate regression. Overall, we observe very little evidence of a relation between audit

effort/fees and our measure of fraud risk, even when non-audit fees and timing differences

24
In particular, ACCTenure and ACCIndExpert retain their signs but are only marginally significant in the
LARGEDIFF regression. All of our results are robust to the inclusion of the bankruptcy score in the
IND_LARGEDIFF regression.

24
between fees and risk assessment are considered. These results contribute to the audit fee/effort

literature and indicate that auditors were not compensated for increased fraud risk during our

sample period that coincided with the global financial crisis.

While we follow Brazel et al. (2009) when employing 20% as our cut-off for

LARGEDIFF, we examine the sensitivity of our results to alternative cut-offs: top decile and top

quartile. We find our results related to H1A-C and H2A-C are largely robust to these alternative

specifications. In particular, our results are robust when we redefine LARGEDIFF to equal 1

when a company’s DIFF places them in the top decile of the full sample. When we redefine

LARGEDIFF to equal 1 when a company’s DIFF places them in the top quartile of the sample,

we find largely consistent but weaker results. In particular, we find AuditorTenure is consistently

signed but only marginally significant, whereas the coefficients on ACEffort and ACCTenure are

no longer significant. We find our inferences for AuditorIndExpert and ACCIndExpert remain
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the same. Similarly, when we redefine IND_LARGEDIFF to equal 1 when a company is in the

accepted
top quartile of its industry classification with respect to DIFF (rather than top decile as is defined

manuscript
in our main tests), we observe that only AuditorTenure and ACCIndExpert are associated with

IND_LARGEDIFF. In sum, our results indicate that the auditor and AC characteristics we

examine seem to be most effective at constraining more extreme differences in financial and

nonfinancial measures (e.g., top decile).

Given our sample consists of two industries, (1) Energy and (2) Healthcare, Medical

Equipment, and Drugs, with a high proportion of LARGEDIFF (see Panel C of Table 1), we

perform several sensitivity tests to ensure that our results were not driven by those industries.

First, we remove each industry individually and re-perform our analyses. Second, we remove

both industries and re-perform our analyses. Our results for Table 5 improve without these

25
industries. In particular, all five significant variables of interest in Column A of Table 5 retain

their sign and increase in significance. Our inferences in Table 6 remain unchanged when we

remove these industries. The only difference is when we remove only the Energy industry, the

coefficient on ACCTenure is only marginally significant. In sum, our results do not appear to be

driven by industries with a greater proportion of “large” DIFFs.

Last, prior literature suggests that having females or greater gender diversity on boards of

directors improves firm oversight (e.g., Carter, Simkins, and Simpson 2003). We perform one

last additional test by examining whether the gender of our AC chairpersons is associated with

LARGEDIFF (IND_LARGEDIFF). We find that ACs with female chairs are negatively

associated with LARGEDIFF (p = .056) but not associated with IND_LARGEDIFF (p = 0.946).

Our significant gender result is in line with research in economics and finance that women are

generally more risk averse than men (e.g., Borghans, Golsteyn, Heckman, and Meijers 2009).
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CONCLUSION

accepted
Auditors are responsible for providing reasonable assurance that financial statements are

manuscript
free from material misstatements resulting from error and fraud, and ACs are charged with

overseeing the accounting, financial reporting, and auditing processes of publicly-traded

companies (U.S. House of Representatives 2002; PCAOB 2017b). Nonfinancial measures

(NFMs) provide a diagnostic and independent benchmark for evaluating the validity of financial

statement information. Prior research finds that companies committing fraud are likely to exhibit

large inconsistencies between their revenue growth and growth in revenue-related NFMs (Brazel

et al. 2009; Dechow et al. 2011).

Because not all auditors or ACs are equally adept at identifying and reducing fraud risk

via the use of NFMs (Brazel et al. 2009; Beasley et al. 2009; Brazel et al. 2014), we examine if

26
greater effort, client-specific tenure, and industry expertise on the part of auditors and AC chairs

reduce the likelihood that a company’s audited financial statements exhibits a LARGEDIFF

(high fraud risk). Consistent with expectations, we find that as auditor tenure and industry

expertise increase, a company’s audited financial statements are less likely to exhibit a

LARGEDIFF. Similarly, we find that as AC chair tenure increases, a company’s financial

statements are less likely to exhibit a LARGEDIFF.

Contrary to expectations, we observe that companies engaging an industry expert AC

chair are more likely to exhibit a LARGEDIFF indicative of higher fraud risk than companies

without an industry expert AC chair. Our archival setting does not enable us to identify the exact

mechanism for why AC chair industry expertise is positively associated with LARGEDIFF.

However, our additional analyses suggest that AC chairs siding with management may be

conditional on AC chairs with industry expertise having more time available and/or connections
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with management. We also identify that expertise gaps between the AC chair and the auditor

accepted
may be detrimental to the mitigation of fraud risk. Overall, our results indicate that additional

manuscript
research is needed to determine when AC industry expertise is problematic.

The timing of our data collection coincided with substantial shocks to the economy

(2007-2009). We made every effort to collect as much data as possible across all types of NFMs

and various industries to normalize the economic impact as best we could. While our results are

robust to (1) excluding firms from our sample that went bankrupt in the three years following our

time period, and (2) including a bankruptcy score control variable, the economic times within

which our sample spans could have impacted our analyses. Future studies could investigate if the

findings of our study generalize to more stable economic periods.

27
 APPENDIX
Examples of Calculations of %AVGCHGNFM, DIFF, and LARGEDIFF

The formation of our sample requires the collection of revenue-related NFMs disclosed in companies’ 10-
Ks. We collected the appropriate NFMs using a website developed for the Financial Industry Regulatory
Authority. For each company in our sample of 691 companies, we use the average change in NFMs
(%AVGCHGNFM) to proxy for the general direction of changes in company-specific NFMs. The
calculation of DIFF then subtracts %AVGCHGNFM from the percentage change in revenue (%
CHG_REV). LARGEDIFF is then coded 1 if the growth in revenues outpaces the average growth in
NFMs from year t-1 to year t by more than 20% and 0 otherwise. Below, we provide calculations for
%AVGCHGNFM, DIFF, and LARGEDIFF from data for Panera Bread Company, a company in our
sample where LARGEDIFF = 0. We also provide the same data for Company X, a company in our
sample where LARGEDIFF = 1. Given that we propose that a LARGEDIFF = 1 indicates higher fraud
risk, we have disguised the name of this company. However, after 2009, Company X was investigated by
the SEC related to its revenue recognition practices. A class action lawsuit was also filed. Company X has
since restated its financial statements from 2007-2010, and the founder and chairman of Company X has
been fired.

Example 1 – Panera Bread Company, LARGEDIFF = 0 (DIFF < 20%)

Financial Measure 2007 2008 % Change

Revenues (in thousands) $1,066,691 $1,298,853 21.7%
Nonfinancial Measures - NFMs
Number of Delivery Trucks 169 176 4.1%
Number of Bakery/Cafes 63 73 15.9%
Franchised Stores
Company Owned Stores
preprint 666
501
725
527
8.9%
5.2%
Fresh Dough Facilities 23 23 0.0%

accepted
Employees 23,400 23,300 0.0%
%AVGCHGNFM 5.7%
% CHG_REV - %AVGCHGNFM = DIFF
21.7% - 5.7% = 16.0% manuscript
Example 2 – Company X , LARGEDIFF = 1 (DIFF > 20%)

Financial Measure 2008 2009 % Change

Revenues (in thousands) $500,277 $803,045 60.5%
Nonfinancial Measures - NFMs
Number of Products 200 200 0%
Places Distributed 5,000 5,000 0%
US Patents 32 33 3.1%
International Patents 69 73 5.8%
Pounds of Product X Sold (in millions) 32 40 25.0%
Employees 1,520 1,220 -19.7%
%AVGCHGNFM 2.4%
% CHG_REV - %AVGCHGNFM = DIFF
60.5% - 2.4% = 58.1%

28
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31
 120

100

80
Frequency

60

40

20

preprint
FIG. 1— Distribution of DIFF across our sample. For each company in our final sample of 691
accepted
companies, we calculate DIFF as the percentage change in revenues less the average percentage
change in NFMs measured over the same time period. Consistent with Brazel et al. (2009), we define
manuscript
LARGEDIFF = 1 when DIFF is greater than 20% (texture shaded above).

32
 TABLE 1

Sample Selection
Panel A:
Number of Companies
Companies with current and prior year NFM data 743

Less:
Companies missing: Audit Analytics/Compustat data for auditor
variables (32)
Companies missing: Risk Metrics/BoardEx data for AC chair
variables (20)

Final sample 691^

^
Our sample size for the multivariate regressions in Tables 5 and 6 will vary based on data availability for our alternative AC
chair variables (ACCBusyness, ACC_Connect, and ACCOptionHold) and the removal of one industry that was perfectly
predicting LARGEDIFF. We perform an alternative industry adjustment in Table 6.

preprint
accepted
manuscript

33
 TABLE 1 (Continued)

Panel B: Collected NFMs by Category

Category Description Number of NFMs in Sample

Employees Number of employees 691

Facilities Number of major facilities owned or leased 676
(centers, warehouses, stores, plants, buildings)

Products & Inventory Number brands or types of products/inventory, 521

units sold or available for sale

Stores Number of stores, locations, branches 458

Geographic Regions Number of geographic areas, countries, states, 430
cities

Facility Size Square footage, miles, acres of facilities owned 379

or leased (centers, warehouses, stores, plants,
buildings)
Sales Channel Number of dealers and distributors from the 325
company, capacity of sales channels, number
of revenue contracts, sales relationships

preprint
Customers Number of customers, orders, visitors, clients, 307
backlogs, metrics per customer

Patents & Trademarks Number patents and/or trademarks owned, 250

accepted
acquired, developed, applied for

manuscript
Suppliers Number of suppliers, manufacturers, 54
distributors to the company

Other Company-specific NFMs unique from those 47

categories above

4,138

34
 TABLE 1 (Continued)

Panel C: Sample by Fama-French Industry

Number of # %
Industry Companies LARGEDIFF LARGEDIFF

Consumer Nondurables 58 3 5.17

Consumer Durables 17 0 0.00
Manufacturing 93 7 7.53
Energy 40 21 52.50
Business Equipment 102 9 8.82
Telephone and Television Transmission 17 1 5.88
Wholesale, Retail, and Some Services 123 4 3.25
Healthcare, Medical Equipment, and Drugs 52 11 21.15
Utilities 34 2 5.88
Other 155 16 10.32
Total 691 74 10.71

preprint
accepted
manuscript

35
 TABLE 2

Variable Definitions

Variables Definition
Dependent Variables
DIFF = the percentage change in revenues less the average percentage change
in NFMs measured over the same time period
LARGEDIFF = 1 if the growth in revenues outpaces the average growth in
nonfinancial revenue measures from year t-1 to year t by more than
20%, and 0 otherwise
IND_LARGEDIFF =1 if the firm is in the top decile of its industry classification with
respect to revenue growth from year t-1 to year t that exceeds NFM
growth over the same time period

Test Variables:
AuditorEffort = natural logarithm of the total audit fees billed in year t
AuditorTenure = Number of consecutive years the company has retained the auditor as
of the end of year t (measured since 1974 according to COMPUSTAT)
AuditorIndExpert = 1 if company is audited by an auditor that has an annual national
market share greater than 30% within the 2-digit SIC industry in year t
ACEffort = total number of AC meetings occurring within year t
ACCTenure = total number of years the AC chairman has been serving on the board
of directors as of the end of year t
= 1 if AC chairman in year t has current or prior experience within the
preprint
ACCIndExpert
same 2-digit SIC industry

Control Variables: Definition

Size
accepted
= natural logarithm of the market value of common equity in year t
= operating cash flows scaled by total assets in year t (winsorized at the
manuscript
OCF
1 and 99 percentiles)
Lev = total long-term debt scaled by total assets (winsorized at the 1 and 99
percentiles)
Loss = 1 if net income in year t < 0 and 0 otherwise
MTB = the market value of equity divided by book value of equity in year t
(winsorized at the 1 and 99 percentiles)
Restate =1 if the company issued a restatement (i.e., filed an 8-K with the title
“Non-Reliance on Previously Issued Financial Statements or a Related
Audit Report or Completed Review”) in any of the three years prior to
year t, and 0 otherwise.
Lit = 1 if the company operates in a high litigation industry (SIC codes of
2833-2836, 3570-3577, 3600-3674, 5200-5961, and 7370-7370) and 0
otherwise)
PYDIFF = the growth in revenues less the change in the number of employees
from year t-2 to year t-1
Big4 = 1 if the company is audited by a Big 4 auditor and 0 otherwise
ACCBusyness = the AC chairman’s total number of board positions at public
companies as of year t
ACC_Connect = the AC chairman’s 0-100 score for connectedness and influence as of

36
 February 15, 2016 according to muckety.com. (higher number = greater
connectedness and influence)
ACCOptionHold = the natural log of 1 plus the number of stock options held by the AC
chairperson as of year t multiplied by the year-end stock price multiplied
by 0.25 (Campbell et al. 2015)

preprint
accepted
manuscript

37
 TABLE 3

Descriptive Statistics
Panel A: Full Sample
Std.
Continuous Variables: Mean Median Dev. 25% 75%

DIFF 0.00 0.01 0.36 -.08 .10

AuditorEffort 14.63 14.61 1.03 13.86 15.32

AuditorTenure 13.75 10 10.28 7 18

ACEffort 2.06 2.08 0.34 1.79 2.30

ACCTenure 7.19 5 5.64 4 10

ACCBusyness 3.03 3 1.97 2 4

ACC_Connect 79.17 83 16.99 69 93

ACCOptionHold 7.09 10.57 5.75 0 12.01

Size 7.59 7.54 1.60 6.61 8.53

OCF 998.55 preprint

248.85 2,537.83
81.30 773.00

Lev 0.23 0.22 0.19 0.06 0.36

MTB 2.09 accepted

1.66 4.69 1.02 2.79

PYDIFF 0.080 manuscript

0.05 0.65 -0.01 0.12
Discrete Variables: Frequency Percent
LARGEDIFF 74 10.71
IND_LARGEDIFF 66 9.55
AuditorIndExpert 120 17.37
ACCIndExpert 93 13.46
Loss 158 22.87
Big4 649 93.92
Restate 79 11.43
Lit 203 29.38
All variables are defined in Table 2. The sample size (n) = 691 for all variables except
that n = 677 for ACCBUSYNESS, n = 484 for ACC_Connect, and n = 647 for
ACCOptionHold.

38
 TABLE 3 (Continued)

Panel B: Sample Categorized by LARGEDIFF

LARGEDIFF = 0 LARGEDIFF = 1
(n = 617)a (n = 74)b
Continuous Std. Std.
Variables: Mean Median Dev. 25% 75% Mean Median Dev. 25% 75%

AuditorEffort 14.64 14.62 1.03 13.87 15.32 14.52 14.41 1.04 13.84 15.27
ACEffort 2.07 2.08 0.33 1.79 2.30 2.00* 2.08 0.37 1.79 2.30
AuditorTenure 14.12 10.00 10.45 7.00 19.00 10.64*** 9.00** 8.06 5.00 15.00
ACCTenure 7.26 5.00 5.65 4.00 9.00 6.59 4.50 5.56 2.00 11.00
ACCBusyness 3.07 3.00 2.00 2.00 4.00 2.72* 2.00 1.71 1.00 3.5
ACC_Connect 79.32 83 17.17 69 93.00 77.63 79 15.14 67 90
ACCOptionHold 7.18 10.57 5.71 0.00 12.01 6.39 10.87 6.12 0.00 12.00
7.57 7.51 1.59 6.57 8.51 7.71 7.59 1.67 6.98 8.69
preprint
Size
OCF 955.06 246.55 2,502.29 80.86730.61 1361.13 279.80 2,809.12 132.96 1103
Lev 0.24 0.22 0.19 0.06 0.36 0.23 0.19 0.20 0.060 0.36
2.05 1.68 4.65 1.03 2.83 2.44 1.58 5.05 0.90 2.58
accepted
MTB
PYDIFF 0.09 0.051 0.67 -0.00 0.11 0.00* 0.02 0.49 -0.13 0.16

Discrete Variables: Frequency manuscript

Percent Frequency Percent
AuditorIndExpert 115 18.64 5 6.76***
ACCIndExpert 74 11.99 19 25.68***
Loss 141 22.85 17 22.97
Big4 578 93.68 71 95.95
Restate 68 11.02 11 14.86
Lit 185 29.98 18 24.32*
*, **, *** Significantly different from LARGEDIFF = 0 group at p-value < 0.10, 0.05, or 0.01, respectively, under a t-test (shown on mean above), Wilcoxon
rank-sum test (shown on median above), or Chi-square test (shown on frequency above). All variables are defined in Table 2. a n = 605 for ACCBUSYNESS,
441 for ACC_Connect, and 579 for ACCOptionHold. b n = 72 for ACCBUSYNESS, 43 for ACC_Connect, and 68 for ACCOptionHold.

39
 TABLE 3 (Continued)

Panel C: Sample Categorized by IND_LARGEDIFF

IND_LARGEDIFF = 0 IND_LARGEDIFF = 1
(n = 625)c (n = 66)d
Continuous Std. Std.
Variables: Mean Median Dev. 25% 75% Mean Median Dev. 25% 75%

AuditorEffort 14.64 14.61 1.03 13.86 15.30 14.47* 14.42 1.01 13.90 15.38
ACEffort 2.06 2.08 0.33 1.79 2.30 2.03 2.08 0.38 1.79 2.40
AuditorTenure 14.06 10.00 10.44 7.00 19.00 10.83*** 9.00** 8.10 6.00 14.00
ACCTenure 7.33 6.00 5.74 4.00 10.00 5.87*** 5.00** 4.37 2.00 9.00
ACCBusyness 3.03 3.00 1.99 2.00 4.00 2.98 3.00 1.81 1.50 4.00
ACC_Connect 79.40 83.50 17.10 69.00 94.00 76.65 78.50 15.73 67.00 88.50
ACCOptionHold 7.08 10.56 5.73 0.00 11.98 7.21 11.00 6.00 0.00 12.25
Size 7.60 7.53 1.60 6.60 8.53 7.45 7.54 1.59 6.83 8.08
OCF 1037.22 254.70 2626.76 85.17 preprint
775.30 632.36** 205.40 1407.12 75.63 491.20
Lev 0.24 0.22 0.19 0.07 0.36 0.21 0.20 0.21 0.00 0.34
2.02 1.67 4.60 1.01 2.74 2.75 1.64 5.44 1.09 3.25
accepted
MTB
PYDIFF 0.09 0.05 0.66 -0.00 0.12
-0.06*** 0.02* 0.55 -0.13 0.16

Discrete Variables: Frequency Percent manuscript

Frequency Percent
AuditorIndExpert 113 18.08 7 10.61*
ACCIndExpert 73 11.68 20 30.30***
Loss 147 23.52 11 16.67
Big4 586 93.76 63 95.45
Restate 67 10.72 12 18.18*
Lit 181 28.96 22 33.33
*, **, *** Significantly different from IND_LARGEDIFF = 0 group at p-value < 0.10, 0.05, or 0.01, respectively, under a t-test (shown on mean above),
Wilcoxon rank-sum test (shown on median above), or Chi-square test (shown on frequency above). All variables are defined in Table 2. c n = 613 for ACCBUSYNESS,
444 for ACC_Connect, and 587 for ACCOptionHold. d n = 64 for ACCBUSYNESS, 40 for ACC_Connect, and 60 for ACCOptionHold.

40
 TABLE 4

Pearson Correlation Matrix

A B C D E F G H I J
LARGEDIFF A
IND_LARGEDIFF B 0.668
AuditorEffort C -0.038 -0.048
ACEffort D -0.060 -0.032 0.265
AuditorTenure E -0.105 -0.092 0.291 0.002
ACCTenure F -0.037 -0.076 0.056 -0.133 0.170
AuditorIndExpert G -0.100 -0.058 0.000 -0.004 -0.006 -0.029
ACCIndExpert H 0.124 0.160 -0.052 -0.024 -0.102 -0.033 -0.125
ACCBusyness I -0.054 -0.007 0.219 0.087 0.089 0.020 0.039 -0.008
ACC_Connect J -0.028 -0.045 0.444 0.130 0.146 0.004 -0.004 -0.009 0.417
ACCOptionHold K -0.042 0.007 0.003 0.012 0.038 0.080 -0.009 -0.007 0.043 0.028
preprint
All variables defined in Table 2. Correlation in bold if association is statistically significant at <= 10 percent. For brevity, only
dependent and test variables are included.

accepted
manuscript

41
 TABLE 5

Fraud Risk and Auditor and AC Chair Characteristics

Dependent Variable: LARGEDIFF

Column A Column B Column C Column D

Odds Odds Odds Odds
Variable Exp Ratio Coeff z Stat Ratio Coeff z Stat Ratio Coeff z Stat Ratio Coeff z Stat

Auditor Characteristics:
AuditorEffort - 0.84 -0.17 -0.80 0.86 -0.15 -0.69 0.88 -0.13 -0.48 0.79 -0.23 -1.10
AuditorTenure - 0.95 -0.05 -2.77*** 0.96 -0.04 -2.58*** 0.95 -0.05 -2.16** 0.95 -0.05 -3.10***
AuditorIndExpert - 0.38 -0.97 -1.83** 0.40 -0.92 -1.72** 0.40 -0.91 -1.68** 0.35 -1.06 -1.74**

Audit Committee Chair Characteristics:

ACEffort - 0.52 -0.65 -1.46* 0.56 -0.57 -1.27* 0.63 -0.46 -0.80 0.57 -0.57 -1.21
ACCTenure
ACCIndExpert
-
-
0.96 -0.04
2.20 0.79
-1.43*
2.22**
0.96
2.24 preprint
-0.04
0.81
-1.35*
2.27**
0.91
2.16
-0.10
0.77
-1.85**
1.82*
0.97
2.01
-0.03
0.70
-1.10
1.92*

accepted
Control Variables:
ACCBusyness -- -- -- 0.96 -0.04
-0.43 -- -- -- -- -- --
ACC_Connect
ACCOptionHold
--
--
--
--
--
--
--
--
manuscript
--
--
--
--
0.99 -0.01
-- --
-0.81
--
--
0.98
--
-0.02
--
-0.86
Size 1.10 0.10 0.76 1.12 0.11 0.84 1.23 0.21 1.22 1.17 0.16 1.12
OCF 1.00 0.00 0.57 1.00 0.00 0.45 1.00 0.00 1.42 1.00 0.00 0.53
Lev 0.65 -0.43 -0.53 0.67 -0.41 -0.49 0.89 -0.12 -0.13 0.74 -0.31 -0.36
Loss 0.87 -0.14 -0.38 0.90 -0.10 -0.28 0.68 -0.38 -0.68 0.92 -0.08 -0.22
MTB 1.01 0.01 0.31 1.01 0.01 0.24 0.98 -0.02 -0.45 1.00 0.00 0.12
PYDIFF 0.64 -0.44 -0.85 0.69 -0.37 -0.88 0.11 -2.24 2.95*** 0.74 -0.30 -0.91
Big4 2.64 0.97 1.46* 2.43 0.88 1.33* -- -- -- 3.28 1.19 1.56
Restate 1.97 0.68 1.48 1.94 0.66 1.49 1.07 0.07 0.12 2.14 0.76 1.64*
Lit 1.98 0.68 1.33 1.98 0.68 1.32 0.53 -0.63 -1.42 1.67 0.51 1.03

42
IndustryDum Included Included Excluded^ Included
n 674 660 470 647
Wald χ2 82.79*** 85.42*** 32.61*** 80.00***
Area under the
0.80 0.79 0.75 0.80
ROC curve

*, **, *** indicate significance at 10, 5, and 1 percent respectively. Tests are one-tailed when obtained coefficient signs are as predicted and two-tailed otherwise.
All variables defined in Table 2. ^ Industry indicators were excluded because several of the indicators were perfect predictors of our dependent variable given the
unavoidably restricted sample.

preprint
accepted
manuscript

43
 TABLE 6

Fraud Risk and Auditor and AC Chair Characteristics

Dependent Variable: IND_LARGEDIFF

Column A Column B Column C Column D

Odds Odds Odds Odds
Variable Exp Ratio Coeff z Stat Ratio Coeff z Stat Ratio Coeff z Stat Ratio Coeff z Stat

Auditor Characteristics:
AuditorEffort - 1.01 0.01 0.07 0.96 -0.04 -0.16 1.46 0.38 1.49 1.00 -0.01 -0.03
AuditorTenure - 0.97 -0.03 -2.18** 0.97 -0.03 -2.09** 0.97 -0.03 -1.43* 0.96 -0.04 -2.34***
AuditorIndExpert - 0.52 -0.65 -1.47* 0.56 -0.59 -1.33* 0.54 -0.62 -1.27* 0.50 -0.70 -1.46*

Audit Committee Chair Characteristics:

ACEffort - 0.56 -0.58 -1.19 0.60 -0.51 -1.01 0.83 -0.19 -0.27 0.61 -0.49 -0.91
ACCTenure
ACCIndExpert
-
-
0.95 -0.05
2.98 1.09
-1.62**
3.40***
0.95
3.04 preprint
-0.05
1.11
-1.63**
3.45***
0.89
3.08
-0.12
1.12
-2.20**
2.56***
0.95
2.72
-0.05
1.00
-1.43*
2.73***

accepted
Control Variables:
ACCBusyness -- -- -- 1.04 0.040.63 -- -- -- -- -- --
ACC_Connect
ACCOptionHold
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manuscript
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0.99 -0.01
-- --
-0.92
--
--
1.00
--
0.00
--
0.01
Size 1.02 0.02 0.16 1.07 0.07 0.44 1.20 0.18 1.02 1.04 0.04 0.29
OCF 1.00 -0.00 -0.72 1.00 -0.00 -0.75 1.00 -0.00 -2.46** 1.00 -0.00 -0.61
Lev 0.42 -0.86 -1.05 0.40 -0.91 -1.07 0.77 -0.26 -0.27 0.44 -0.81 -0.96
Loss 0.51 -0.68 -1.70* 0.56 -0.59 -1.48 0.14 -1.97 -2.95*** 0.53 -0.64 -1.51
MTB 1.03 0.03 0.73 1.02 0.02 0.73 1.02 0.02 0.38 1.02 0.02 0.68
PYDIFF 0.26 -1.36 -2.40** 0.31 -1.18 -2.19** 0.10 -2.30 -3.16*** 0.34 -1.09 -2.04**
Big4 2.25 0.81 1.28 2.09 0.74 1.14 -- -- -- 3.20 1.16 1.52
Restate 2.05 0.72 1.89* 2.07 0.73 1.92* 1.43 0.36 0.62 2.17 0.78 2.01**
Lit 1.97 0.68 1.49 1.92 0.65 1.43 1.04 0.04 0.09 1.85 0.61 1.32

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IndustryDum Included Included Excluded^ Included
n 691 677 484 647
Wald χ2 52.86*** 54.90*** 41.70*** 51.93***
Area under the
0.73 0.73 0.78 0.73
ROC curve

*, **, *** indicate significance at 10, 5, and 1 percent respectively. Tests are one-tailed when obtained coefficient signs are as predicted and two-tailed otherwise.
All variables defined in Table 2. ^Industry indicators were excluded because several of the indicators were perfect predictors of our dependent variable given the
unavoidably restricted sample.

preprint
accepted
manuscript

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