The Association Between Board Risk Oversight and the Risk of Material Misstatement

Abstract

Corporate governance failures in the early 2000s and the financial crisis that emerged in 2008 have contributed to heightened expectations for the board of directors to strengthen its oversight of the firm’s risk management processes. Thought leaders (COSO 2013, 2017, ISO 2018; NYSE 2004; SEC 2010) stress the importance of board risk oversight processes; however, we know little about what boards actually do to fulfill their risk oversight responsibilities. Most of the existing research has focused on the association between certain board of director input characteristics (e.g. member composition, independence, expertise, tenure, etc.) and a variety of financial reporting related outcomes. Studies have called for additional examination of what boards actually do to fulfill their oversight roles (e.g. Cohen, Krishnamoorthy and Wright 2017; Beasley, Carcello, Hermanson, and Neal 2009). Our study responds to this need by utilizing proxy disclosures about the board’s role in risk oversight, instituted by the SEC in 2010, to examine whether boards more engaged in risk oversight processes are associated with a lower risk of material misstatement (RMM) in the financial statements, while controlling for board input characteristics documented by prior studies. We find that boards more engaged in risk oversight are positively associated with two avenues for mitigating RMM: effective internal control over financial reporting and higher auditor quality. In addition, we find that boards with more extensive risk oversight processes are associated with fewer actual instances of materially misstated financial statements.

Keywords: Board Risk Oversight, Internal Control, Corporate Governance, Risk Management, Risk of Material Misstatement

JEL Classification: G30, M40