J. OF PUBLIC BUDGETING, ACCOUNTING & FINANCIAL MANAGEMENT, 21 (1), 1-16
SPRING 2009
THE DILIGENCE OF AUDIT COMMITTEES IN THE HEALTHCARE SECTOR
Thomas E. Vermeer, K. Raghunandan and Dana A. Forgione*
ABSTRACT. Problems with governance at non-profit (NP) healthcare
organizations have recently led to legislative scrutiny of their audit
committee practices. Using data from a survey of chief financial officers of
NP healthcare organizations and from the GuideStar database, we examine
audit committee interactions with external auditors for a sample of 69 NP
healthcare organizations. We find that 71% of the audit committees in our
sample meet privately with the external auditor and the mean number of
such meetings 1.9. Our results also suggest that audit committee interaction
with the external auditor varies in response to resource dependencies,
existence of debt, audit quality, audit tenure, and organizational size. These
findings suggest that NP healthcare organizations respond to monitoring
demands by adopting suitable audit committee related interactions.
INTRODUCTION
In the aftermath of governance-related failures at some
prominent non-profit (NP) organizations, legislators and regulators
-----------------------* Thomas E. Vermeer, Ph.D., CPA, is the Ernst & Young Distinguished
Professor and an Associate Professor of Accounting, Merrick School of
Business, University of Baltimore. His teaching and research interests are in
auditing and assurance services, accounting information systems,
government and nonprofit accounting, and financial accounting. K.
Raghunandan, Ph.D., is the Ryder Eminent Scholar Chair in Business
Leadership and a Professor of Accounting, School of Accounting, Florida
International University. His teaching and research interests are in the areas
of corporate governance and the market for audit services. Dana A.
Forgione, Ph.D., CPA, CMA, CFE is the Janey S. Briscoe Endowed Chair in the
Business of Health and a Professor of Accounting, College of Business,
University of Texas at San Antonio. His teaching and research interests are
in external audits and governance in healthcare and nonprofit entities,
comparative international healthcare accounting, financing systems and
quality of care.
Copyright © 2009 by PrAcademics Press
2
VERMEER, RAGHUNANDAN & FORGIONE
recently have started to examine audit committee related issues in
the NP sector (Salmon, 2002; Hempel & Borrus, 2004; NCNA, 2004).
Although the audit committee provisions of the Sarbanes-Oxley Act
(SOX) currently apply only for SEC registrants, audit partners and
executives have noted that SOX “raises the bar in general” and
makes it more likely that NPs would want to voluntarily comply with
the new legal provisions related to audit committees (McCarthy,
2003; Tieman, 2003; Independent Sector, 2003). Despite such
recent attention from legislators and regulators, the functioning of NP
audit committees has received little attention from researchers. We
fill this void in the literature, using data from a survey of 69 chief
financial officers and financial data from the GuideStar database,
and examine the audit committee’s interaction with the external
auditor at large NP healthcare organizations. We focus on NP
healthcare organizations since they constitute a major segment of the
NP sector and represent a large part of the US healthcare system. Of
the 5,759 US registered hospitals in 2004, 2,967 (52%) are nongovernment NP hospitals. Expenditures of NP hospitals for 2004 were
$364 billion. This accounted for more than 68% of the total
expenditures of all hospitals (AHA, 2006).
The SEC (1999, 2003) and BRC (1999), among others, note that
to be effective audit committees must have a good working
relationship with the external auditor. Reflecting such views, section
204 of SOX requires the auditor to discuss accounting and financial
reporting issues with the audit committee, while section 301 of SOX
mandates that audit committees shall be responsible for the
“appointment, compensation, and oversight of the work of the
auditor.” In this paper we focus on the audit committee-external
auditor interaction, and examine the number of meetings between
the audit committee and the auditor and whether the audit
committee meets privately with the auditor. We provide descriptive
evidence about the audit committee-auditor interaction at large NP
healthcare organizations and also examine factors associated with
variations in the audit committee-auditor interaction.
BACKGROUND AND HYPOTHESES
In the absence of “owners,” the standard principal-agent
framework that is used to develop and test hypotheses related to
governance (including audit committees) must be modified for NPs
THE DILIGENCE OF AUDIT COMMITTEES IN THE HEALTHCARE SECTOR
3
(Forgione, 1999). Research in management suggests an alternative
framework that is applicable for NPs. Pfeffer and Salancik (1978)
suggest that an organization’s need for resources is a determinant of
its structure and activities, and prior studies have used resourcedependency theory to examine diverse issues related to NP
organizations and their boards (e.g., Hillman & Dalziel, 2003; MillerMillesen, 2003; Peng & Kellogg, 2003, Vermeer, Raghunandan &
Forgione, 2006; 2007). We use the resource-dependency theory to
develop our hypotheses related to audit committees of NP healthcare
organizations.
The NP healthcare organizations receive restricted resources
from three primary sources: government grants, donor funds, and
debt. These sources often impose restrictions on the use of these
funds, and these restrictions often lead to additional monitoring
demands. The NP healthcare organizations can meet these demands
by having audit committees that meet more frequently and have
better interaction with the external auditor.
The receipt of federal or state government grants brings with it
many additional reporting and internal control requirements, and in
turn leads to increased demand for monitoring. In addition,
organizations receiving government grants may be subject to greater
scrutiny in the form of legislative hearings, and from the media and
the public. Prior research also suggests that the receipt of
government grants is associated with significant changes in the
organizational structure, board composition, and formalization of NP
organizations (e.g., Gronbjerg, 1993; Smith & Lipsky, 1993; Froelich,
1999). Thus, we expect the demand for monitoring is higher at NP
healthcare organizations that receive government grants.
While NPs do not have formal owners, donors provide
endowments (equity capital) and often impose restrictions related to
their funding by stipulating conditions related to the expenditure of
the donated assets. The NP healthcare organizations with a larger
amount of restricted net assets are likely to receive greater scrutiny
from donors because these donors want to ensure that their funds
are used for the intended purpose.
The existence of debt creates the demand for monitoring (Jensen
& Meckling, 1976). In the context of creditors’ demand for monitoring
there is little difference between NP and for-profit (FP) entities since a
4
VERMEER, RAGHUNANDAN & FORGIONE
creditor seeks timely payment of interest and principal, irrespective of
whether the borrower is an FP or NP organization. Since creditors
cannot generally force an NP entity into involuntary bankruptcy, the
creditors may have an increased demand for monitoring and
insurance to compensate for default risk.
The length of the auditor-client relationship is an issue that has
recently received significant attention from legislators. For example,
section 207 of SOX requires the Comptroller General of the US to
conduct a study of the potential effects of requiring mandatory
rotation of external auditors. It is likely that in the initial years of an
audit engagement, both the auditor and the audit committee would
be more likely to have frequent meetings; over time, as each gets
familiar with the other, the meetings may become less frequent.
Most research related to accounting and auditing includes entity
size as a variable. Larger organizations are more complex, and also
more likely to be the focus of attention from the public and the
media; hence, larger organizations may be more likely to adopt
stronger governance and monitoring mechanisms.
Thus, we hypothesize that:
Audit committees at NP healthcare organizations will be likely to
have more frequent meetings with the external auditor and to
provide private access to the external auditor when the
organization:
1. receives government grants,
2. has a greater portion of their net assets in the form of
restricted funds,
3. has long-term debt,
4. has external auditors with shorter tenure, and
5. is larger.
Finally, we also expect auditor type and the presence of internal
auditing to influence the quality of interaction between the audit
committee and the auditor. If the type of auditor / presence of
internal auditing and audit committee quality are substitute
monitoring mechanisms, then NP healthcare organizations that use a
Big 4 auditor or have an internal audit staff would be less likely to
THE DILIGENCE OF AUDIT COMMITTEES IN THE HEALTHCARE SECTOR
5
have the need for a higher level of interaction with the auditor.
However, audit partners from the Big 4 firms and directors of internal
audit departments have noted an increased reluctance to be
associated with clients not following best practices due to concerns
about litigation risk or the adverse publicity surrounding governance
failures (Bryan-Low, 2003; Hindo & Sager, 2003). Hence, Big 4
auditors and internal audit directors may insist on audit committees
following best practices in the area of audit committees meeting
more frequently and having better interaction with the external
auditor. Hence, we do not make a directional prediction for two
variables—auditor type and the presence of internal auditing—but
include them in our analyses.
We use the following model to examine cross-sectional variations
in the audit committee-auditor interaction:
ACX
where:
ACX
ACADMT
ACPV
= β0 + β1SIZE + β2GRANT + β3FUNDBAL + β4BONDS
+ β5TENURE + β6BIG4 + β7INTAUD + ε
= the audit committee variable, is defined as follows
in the two different regressions:
= number of audit committee meetings with external
auditor per year
= 1 if audit committee meets privately with external
auditor, else 0.
The independent variables are defined as follows:
SIZE
GRANT
= natural log of total assets1
= 1 if NP healthcare organization reported
government grants, else 02
FUNDBAL = ratio of temporarily restricted plus permanently
restricted fund balance to total fund balance
BONDS
= 1 if NP healthcare organization reported taxexempt bond liabilities, else 0
TENURE = square root of number of years with current audit
firm
BIG4
= 1 if audited by Big Four accounting firm, else 0
INTAUD
= 1 if there is an internal audit function, else 0;
ε
= error.
6
VERMEER, RAGHUNANDAN & FORGIONE
DATA
We obtained the names, addresses, and related financial data for
the 1,000 largest (in terms of revenue) NPs from GuideStar, the
national database of US charitable organizations as of 2004. We
identified 549 of the 1,000 largest NPs as healthcare organizations.
For these organizations, we mailed a questionnaire (see Appendix)
addressed to their chief financial officer. We received responses from
75 chief financial officers (response rate of 13.7 percent). DeZoort,
Hermanson, and Houston (2003a; 2003b) note the difficulties in
obtaining responses from high-ranking corporate officers, and
suggest that response rates around 15 percent are reasonable. Some
of the respondents had missing data or deleted the control number
used in their return mailing. After deleting these respondents, our
sample has 69 usable responses.
We performed the following two tests to address concerns related
to non-response bias. First, we had two mailings (in July and
September). Hence, we included an early/late respondent variable to
the models, but this variable is not significant in any regression and
has no effect on the results. Second, we also examined if the sample
of 69 respondents used in this study differ in any dimension from the
non-respondents in the largest 549 NP healthcare organizations. We
did not observe any significant difference between these two groups
for any of the variables examined in this study (p ≥ 0.60 in every
instance). These results mitigate concerns about non-response bias.
RESULTS
As seen in Panel A of Table 1, the mean (median) total assets of
the sample are $293 million ($193 million), while the mean (median)
revenues are $266 ($230) million. Slightly less than half (46%) of the
sample observations received government grants, while 65 percent of
the sample reported tax-exempt bond liabilities. The mean (median)
ratio of temporarily restricted plus permanently restricted fund
balance to total fund balance is 0.02 (0.01). Eighty-one percent of the
sample organizations had a Big 4 auditor and 59 percent of the
sample organizations had an internal audit staff.
The mean (median) number of meetings the audit committee had
with the external auditor per year was 1.9 (2.0). Independence
THE DILIGENCE OF AUDIT COMMITTEES IN THE HEALTHCARE SECTOR
7
TABLE 1
Sample Statistics (N = 69)
Panel A: Sample Description for Continuous Variables
25th
75th
Median
Variable
Mean
S.D.
Percentile
Percentile
Total Assets ($M) 293
280
146
193
365
Revenues ($M)
266
168
146
230
309
ACADMT
1.90
0.88
1.00
2.00
2.00
SIZE
8.34
0.33
8.16
8.28
8.56
FUNDBAL
0.02
0.02
0
0.01
0.04
TENURE
2.80
1.44
1.41
2.65
3.87
Panel B: Frequency Counts for Dichotomous Variables
No. of NP Healthcare
No. of NP Healthcare
Organizations
Organizations
Variable
coded “0”
coded “1”
ACPV
49 (71%)
20 (29%)
GRANT
32 (46%)
37 (54%)
BONDS
45 (65%)
24 (35%)
BIG4
56 (81%)
13 (19%)
INTAUD
41 (59%)
28 (41%)
Notes:
1. The data are for the 2003 fiscal year of 69 non-profit (NP) healthcare
organizations that responded to our questionnaire. Financial data are
from the GuideStar database, while information about auditor and audit
committees are from the survey responses.
2. The variables are defined as follows:
ACADMT
= number of audit committee meetings with external
auditor per year
SIZE
= natural log of total assets
FUNDBAL = ratio of temporarily restricted plus permanently
restricted fund balance to total fund balance
TENURE
= square root of number of years with current audit firm
ACPV
= 1 if audit committee meets privately with external
auditor, else 0
GRANT
= 1 if NP healthcare organization reported government
grants, else 0
BONDS
= 1 if NP healthcare organization reported tax-exempt
bond liabilities, else 0
BIG4
= 1 if audited by Big Four accounting firm, else 0
INTAUD
= if there is an internal audit function, else 0
ε
= error.
8
VERMEER, RAGHUNANDAN & FORGIONE
Standards Board (ISB) Standard No. 1 (1999) mandates that external
auditors meet privately with the audit committees of their SEC audit
clients. While there are no equivalent mandates for NP healthcare
organization audit committees, 71 percent of the audit committees in
our sample met privately with the external auditor.
Table 2 presents the results from two regressions where the
dependent variables are (a) the number of audit committee meetings
with the external auditor per year and (b) whether the audit
committee meets privately with the auditor. Our results (not tabled)
indicate that none of the variable correlations exceeds 0.40,
indicating that multicollinearity is not a problem in our data, which is
confirmed by an examination of variation inflation factors, all of which
are less than 1.5. The meetings regression is significant (F = 3.48, p
≤ 0.00), with an adjusted R2 of 0.24. The coefficients of SIZE,
FUNDBAL and BIG4 are positive and significant, indicating that there
is a higher frequency of meetings between the audit committee and
the external auditor when (a) the NP healthcare organization is larger,
(b) the ratio of restricted fund balance to total fund balance is bigger,
and (c) the NP healthcare organization uses a Big 4 auditor.
In the regression where the dependent variable is the audit
committee meeting privately with the external auditor, the model is
significant (χ2 = 12.87, p ≤ 0.08) with a pseudo R2 of 0.25. The
coefficient for GRANT, BONDS and BIG4 are positive and significant.
Thus, when the agency costs related to creditors and suppliers of
grant funds are higher and the NP healthcare organization uses a Big
4 auditor, the audit committee is more likely to take a proactive role
in its interactions with the external auditor by meeting privately with
the auditor. The coefficient for TENURE is negative and significant
suggesting that NP healthcare organizations with an external auditor
with longer tenure are less likely to meet privately with the external
auditor.
SUMMARY AND CONCLUSIONS
Legislators and regulators have also started to examine audit
committee related issues in the NP sector, but there is little
systematic empirical evidence about the functioning of audit
committees at NP organizations. In this study, we examine audit
committees at large US NP healthcare organizations based on survey
THE DILIGENCE OF AUDIT COMMITTEES IN THE HEALTHCARE SECTOR
9
TABLE 2
AUDIT COMMITTEE INTERACTIONS WITH EXTERNAL AUDITOR
RESULTS FROM OLS AND LOGISTIC REGRESSIONS
Model: ACX
Variables
Intercept
SIZE
GRANT
FUNDBAL
BONDS
TENURE
BIG4
INTAUD
= β0 + β1SIZE + β2GRANT + β3FUNDBAL + β4BONDS +
β5TENURE + β6BIG4 + β7INTAUD + ε
Dependent Variables
ACADMT
ACPV
Audit Committee Meets
Number of Audit
Privately with
Committee Meetings with
External Auditor
External Auditor
Coefficient
Coefficient
p-Value
p-Value
Estimate
Estimate
-6.02
(0.02)
9.56
(0.21)
0.89
(0.01)
-1.02
(0.25)
-0.15
(0.27)
1.68
(0.05)
2.55
(0.00)
12.80
(0.22)
-0.09
(0.35)
1.19
(0.08)
0.06
(0.22)
-.42
(0.07)
0.57
(0.06)
0.55
(0.07)
0.11
(0.31)
1.02
(0.13)
F = 3.48, p ≤ 0.00
χ2 = 12.87, p ≤ 0.08
R2 = 0.24
Pseudo R2 = 0.25
Notes:
1. The values in the cells are coefficients and the associated p-values are
in parentheses; p-values are one-tailed except for BIG4 and INTAUD
(two-tailed for these two variables).
2. The variables are defined as follows:
ACADMT
= number of audit committee meetings with external
auditor per year
SIZE
= natural log of total assets
FUNDBAL = ratio of temporarily restricted plus permanently
restricted fund balance to total fund balance
TENURE
= square root of number of years with current audit firm
ACPV
= 1 if audit committee meets privately with external
auditor, else 0
GRANT
= 1 if NP healthcare organization reported government
grants, else 0
BONDS
= 1 if NP healthcare organization reported tax-exempt
bond liabilities, else 0
BIG4
= 1 if audited by Big Four accounting firm, else 0
INTAUD
= if there is an internal audit function, else 0
ε
= error.
10
VERMEER, RAGHUNANDAN & FORGIONE
responses from 69 chief financial officers and financial data from the
GuideStar database.
We find that 71% of the audit committees in our sample meet
privately with the external auditor and the mean number of audit
committee meetings with the external auditor is 1.9 per year. Our
multivariate results suggest that NP healthcare organizations that are
larger, have a large restricted fund balance, and use a Big 4 auditor
meet more frequently with their external auditor. We also find that NP
healthcare organizations that receive government grants, have
bonds, and use a Big 4 auditor are more likely to meet privately with
the external auditor. Our findings suggest that NP healthcare
organizations respond to resource dependency and other demands
for monitoring mechanisms by adopting suitable audit committee
related measures.
LIMITATIONS AND FUTURE DIRECTIONS
This paper is subject to limitations that should be considered in
interpreting the findings. As with any survey-based study, the results
may have been influenced by self-selection. While we did not find any
difference between (a) early and late respondents, or (b) respondents
and non-respondents, self-selection and response bias can never be
entirely ruled out. In addition, in this initial study we concentrated on
large NP healthcare organizations; future research can examine
whether the findings of this study apply to smaller NPs.
NOTES
1. We obtain substantively similar results if we use log of revenues
as the measure of size.
2. We include a dichotomous measure since the amount of grants
could vary significantly over the years. Hence, using a continuous
measure of grants would be less appropriate if the NP healthcare
organization had either received (or, expected to receive)
significant governmental grants in the recent past (near future).
We performed sensitivity tests by using a continuous measure for
the GRANT variable and the results with this alternative measure
were weaker.
THE DILIGENCE OF AUDIT COMMITTEES IN THE HEALTHCARE SECTOR
11
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APPENDIX
Survey Instrument
Dear Chief Financial Officer:
We are three Professors of Accounting conducting a survey regarding
external audits and governance in the non-profit sector. With the recent
accounting scandals in the for-profit sector, we are examining governance
structures in the non-profit sector. Please take a few minutes to answer the
following questionnaire. All responses will be confidential, and no individual
or entity will be publicly identified.
14
VERMEER, RAGHUNANDAN & FORGIONE
1. What is the name of your current external audit firm?
______________________________________
a. How long have you had this audit firm as your external auditor?
_____ years.
2. If you have had your current audit firm for less than three years and you
had a prior external audit firm, what was the name of your prior external
audit firm? __________________________________________
a. How long did you have this audit firm as your external auditor?
_____ years.
3. What were your external audit fees and non-audit fees (non-audit fees
include all other fees except external audit fees) paid to the external
audit firm?
External audit fees Non-audit fees
Fiscal year 2003
Fiscal year 2002
Fiscal year 2001
4. Does your external audit firm issue a separate attestation report on
management’s evaluation of internal control over financial reporting?
YES___ NO___
5. Does your organization have an audit committee? YES___ NO___
If not, is there a similar committee that provides oversight over
accounting and auditing issues?
a. YES (name of committee) ___________________________________
b. NO, but the full board provides such oversight
c. NO
If you answered “NO” (options b or c) to question 5 above, then stop here
and return the questionnaire in the enclosed envelope. Thank you for your
time.
If you have an audit committee or have a similar committee that provides
oversight over accounting and auditing issues, please continue.
In the questions below, the word “audit committee” is used for convenience,
but it also implies any similar committee of the board that provides oversight
over accounting and auditing issues. If fiscal year 2003 has not been
completed, please provide estimated responses.
THE DILIGENCE OF AUDIT COMMITTEES IN THE HEALTHCARE SECTOR
6. Number of audit committee members as of
fiscal year end
7. Number of independent members (* see
definition below)
8. Number of members who are CPAs
9. Number of members (other than CPAs) with
senior level accounting or finance experience
10. Number of audit committee meetings per
year
11. Average length of audit committee meeting
(in minutes)
12. Was there a change in the committee chair
during the year?
13. During the year did any member(s) join/quit
the audit committee:
—New member(s) joined
—Existing member(s) quit
14. Is the audit committee responsible for hiring
the external auditor?
15. Number of meetings the external auditor had
with the audit committee
16. Did the audit committee meet privately with
the external auditor without management
being present?
17. Does your organization have an internal audit
staff?
18. If yes to question 17, number of meetings
the chief internal auditor had with audit
committee
15
Fiscal year
2003
Fiscal year
2002
YES
NO
YES
NO
YES
NO
YES
NO
YES
NO
YES
NO
YES
NO
YES
NO
YES
NO
YES
NO
* Audit committee members are independent if they, their spouses, or
children (a) do not currently work or have not worked for the organization or
its affiliates within the past three years; (b) have not received compensation
in excess of $60,000 from the organization or its affiliates for work other
than board service; or (c) are not partners, shareholders or officers of a
business with which the organization has significant financial transactions
($200,000 or 5% of the revenues of such a business, whichever is higher).
16
VERMEER, RAGHUNANDAN & FORGIONE
19. The audit committee members’ knowledge-level with respect to
accounting and auditing issues is: (please circle one)
(a) EXCELLENT (b) VERY GOOD (c) GOOD (d) BELOW-PAR (e) POOR
If you have any comments related to audits and governance in non-profits,
please add them below.
We thank you for your time and consideration. If you would like to receive a
copy of the results of the survey, please attach your business card.