CEO financial background and internal control weaknesses

• Author: Javad Oradi,Zabihollah Rezaee,Kaveh Asiaei
• DOI: http://doi.org/10.1111/corg.12305
• Published date: 01 March 2020
• Date: 01 March 2020

ORIGINAL ARTICLE

CEO financial background and internal control weaknesses

Javad Oradi

1

| Kaveh Asiaei

2

| Zabihollah Rezaee

3

1

Faculty of Economics and Administrative

Sciences, Ferdowsi University of Mashhad,

Mashhad, Iran

2

Department of Accounting, Faculty of

Business & Accountancy, University of Malaya,

Kuala Lumpur, Malaysia

3

Fogelman College of Business and Economics,

University of Memphis, Memphis, Tennessee

Correspondence

Kaveh Asiaei, Department of Accounting,

Faculty of Business & Accountancy, University

of Malaya, Kuala Lumpur, Malaysia.

Email: kaveh@um.edu.my

Abstract

Research question/issue: The existing literature documents that the functional

expertise of Chief Executive Officers (CEOs) in finance reduces poor performance

risk, improves financial reporting quality, and mitigates audit risk. In this study, we

examine the association between CEOs' financial background and internal control

weaknesses (ICWs).

Research findings/insights: Using a sample of Iranian listed companies for the period

2007–2017, we find a significant negative association between CEOs with financial

expertise and ICWs. Furthermore, we show that the negative association between

CEO financial expertise and ICWs is stronger if the CEO is recruited from inside the

firm. Our main results are robust after controlling for the potential selection issue,

random effects at the firm level, and the impact of the new Iranian internal control

regulations. Moreover, our results remain unchanged after controlling for other CEO

characteristics, audit committee characteristics, audit fees, and using an alternative

measure of financial expertise.

Theoretical/academic implications: Our study contributes to the extant literature by

examining the association between CEOs' financial background and ICWs, a theme

that remains largely unexplored in previous research. We also extend the literature

on CEO succession origin.

Practitioner/policy implications: This study has important implications for regulators

regarding the improvement of financial reporting quality and the effectiveness of

internal controls, especially in the emerging markets. Particularly, our findings may be

of benefit to auditors when assessing the risks regarding their clients' material weak-

nesses, as well as to shareholders and boards of directors when hiring a new CEO.

KEYWORDS

corporate governance, CEOs, financial expertise, internal control weakness, Iran

1|INTRODUCTION

Internal control reporting and the disclosure of internal control weak-

nesses (ICWs) have been practiced in the aftermath of the passage of

the Sarbanes-Oxley Act of, 2002 in the United States (SOX, 2002).

However, internal control reporting is not limited to U.S. firms, and

companies worldwide, including those in Iran, now report on their

internal controls. Prior research suggests that material weaknesses in

internal control lead to lower financial reporting quality (e.g.,

Ashbaugh-Skaife, Collins, Kinney, & LaFond, 2008; Doyle, Ge, &

McVay, 2007b), higher cost of capital (Ashbaugh-Skaife, Collins,

Kinney, & LaFond, 2009; Beneish, Billings, & Hodder, 2008), less

investment efficiency (Cheng, Dhaliwal, & Zhang, 2013), less opera-

tional efficiency (Cheng, Goh, & Kim, 2018), and increased stock price

crash risk (Chen, Chan, Dong, & Zhang, 2017). Given the conse-

quences of ICWs, researchers have extensively explored the

Received: 29 March 2019 Revised: 2 October 2019 Accepted: 3 October 2019

DOI: 10.1111/corg.12305

Corp Govern Int Rev. 2020;28:119–140. wileyonlinelibrary.com/journal/corg © 2020 John Wiley & Sons Ltd 119

determinants of ICWs, such as firm-level factors (e.g., firm size, age,

complexity, growth, diversification, and corporate governance) and

external factors (e.g., external auditor, regulations, and national cul-

ture; see Chalmers, Hay, & Khlif, 2018, for a review). In particular, pre-

vious studies have documented the link between ICWs and

management-level factors, such as CEO entrenchment, age, and gen-

der (Lin, Wang, Chiou, & Huang, 2014); CEO duality (Michelon,

Bozzolan, & Beretta, 2015); and CEO tenure (Yazawa, 2015). How-

ever, to the best of our knowledge, the link between CEOs' financial

background and ICWs remains unexplored.

The separation of ownership and management causes agency

problems, which means there is conflict over the business objectives

between owners and managers, and shareholders cannot properly

monitor the management practices (Jensen & Meckling, 1976). In this

respect, Lin et al. (2014) argue that top managers may override inter-

nal controls or use ICWs in their own interests and disregard share-

holders' interests. Empirical evidence supports these concerns but

indicates that the effects of CEOs are not the same and vary

according to their characteristics (e.g., Demerjian, Lev, Lewis, &

McVay, 2013; Jiang, Zhu, & Huang, 2013).

The literature on strategic management suggests that CEOs rein-

force their own preferences and tendencies in the organization and

devote more attention to the events that are of more interest to them

(Schein, 2004). In particular, Hambrick (2007) argues that CEOs' past

functional experience shapes the choices they make. Prior research

demonstrates that the functional experience of CEOs enhances their

effectiveness at tackling issues in the related functional areas. For

instance, Barker and Mueller (2002) suggest that CEOs with career

experience in R&D lead to higher expenditure on R&D. Boyd, Chandy,

and Cunha (2010) show that marketing background helps CEOs carry

out marketing policies more successfully than their counterparts.

In recent years, firms have displayed a greater tendency to hire

CEOs with a functional background in finance (“financial expert”; see,

Jiang et al., 2013; Kalelkar & Khan, 2016). Moreover, the importance

of CEOs' financial expertise has been empirically proven. For example,

Bamber, John, and Wang (2010) suggest that CEOs with financial

expertise pursue a conservative strategy in fulfilling their tasks.

Matsunaga, Wang, and Yeung (2013) argue that the corporations run

by CEOs with financial experience tend to provide more conservative

reports. Custodio and Metzger (2014) show that firms hiring CEOs

with financial expertise hold less cash, have better access to capital

markets, and show less sensitivity to changes in cash flows. Moreover,

Hui and Matsunaga (2015) suggest that financial expert CEOs lead to

better disclosure practices.

Prior literature suggests that CEO financial expertise reduces the

risk of poor performance and firm failure (Custodio & Metzger, 2014),

as well as material misstatements (Kalelkar & Khan, 2016). Salehi, Lari,

and Naemi (2018) argue that the impact of CEOs, specifically their

role in financial reporting and internal control, can be enhanced when

they are financial experts. Specifically, Hu (2006) indicates that if the

board of directors had hired CEOs with financial or accounting knowl-

edge, it could have prevented the occurrence of the financial scandals

in the pre-SOX period. Moreover, financial expertise improves CEOs'

ability (Baatwah, Salleh, & Ahmad, 2015; Custodio & Metzger, 2014),

which leads to a lower possibility of receiving a qualified internal con-

trol opinion (Li, Sun, & Ettredge, 2010), because firms with able man-

agers have stronger internal control systems (Hoitash, Hoitash, &

Johnstone, 2012). In addition, regular ICWs may tarnish the reputa-

tion of top managers (Li, 2015). Therefore, reputational concerns

restrain financial expert CEOs from overriding internal controls and

thus engaging in financial reporting misbehaviors (Gounopoulos &

Pham, 2018).

Furthermore, previous studies find that CEOs with financial

expertise are negatively associated with earnings management

(Gounopoulos & Pham, 2018; Jiang et al., 2013), financial reporting

delay (Baatwah et al., 2015), and audit fees (Kalelkar & Khan, 2016),

suggesting that there is a relation between CEO financial expertise,

financial reporting quality, and audit risk. In addition to CEO financial

expertise, effective internal control is another significant factor associ-

ated with financial reporting quality (e.g., Ji, Lu, & Qu, 2017; Lu, Rich-

ardson, & Salterio, 2011) and audit risk (e.g., Ji, Lu, & Qu, 2018;

Munsif, Raghunandan, Dasaratha, & Singhvi, 2011). Because the man-

agement is required to establish and maintain effective internal con-

trols, financial expert CEOs are expected to invest in establishing and

maintaining strong internal control systems, which help them improve

their financial reporting quality and reduce clients' business risks. In

light of the above arguments, our first research question is thus stated

as follows: Is there a negative association between CEO financial

expertise and ICWs?

We further examine the association between CEOs' financial

expertise and ICWs in the context of CEO succession origin (hiring a

CEO from inside the firm as opposed to from outside the firm). Inter-

nal CEOs, compared with external CEOs, have more knowledge of

corporate operations (Kotter, 1982). In addition, CEOs who were

working in the firm before they were appointed as CEO develop bet-

ter relationships with the main subordinate managers, thereby per-

forming better in the face of internal problems (Brockman, Campbell,

Lee, & Salas, 2019). However, during the last decade, hiring outside

CEOs has become increasingly significant (Balsmeier & Buchwald,

2014) and the evidence concerning the effects of CEO succession ori-

gin (inside vs. outside) on the corporate performance is mixed

(Karaevli, 2007; Tao & Zhao, 2019). Therefore, our second research

question asks: Is financial expert CEOs' succession origin associated

with ICWs?

The Iran context is well suited to these research questions for sev-

eral reasons, as specified in detail in Section 2. Such reasons include

the significant increase in internal control reporting in Iran in the past

decade, which is expected to continue, and the differences in the cor-

porate governance structure between Iran and developed countries.

We use a sample of Iranian listed companies for the period

2007–2017. Given prior research (e.g., Ashbaugh-Skaife, Collins, &

Kinney, 2007; Cheng et al., 2013), we use auditors' opinion on the

effectiveness of internal control in disclosing ICWs. In the same vein,

drawing upon previous studies (e.g., Baatwah et al., 2015; Kalelkar &

Khan, 2016), we define financial expert CEOs as those who hold an

accounting qualification, or have work experience as an auditor, CFO,

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