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Observations on audit committee characteristics
Article Type: Guest editorial From: Managerial Auditing Journal, Volume 27, Issue 4
Historically, the role of the audit committee has focused on the integrity of financial reporting and accounting matters. However, since recent corporate collapses and the Global Financial Crisis, audit committees have taken on an increasingly significant role with a mandate from the board of directors that covers a wide range of activities. These include risk management, financial and non-financial compliance requirements, and other audit and assurance activities. Worldwide trends on best practice call on corporations to establish an independent audit committee as part of their corporate governance processes. The primary role of the audit committee, as a subcommittee of the board, is to oversee and review the company’s financial reporting processes, internal accounting controls, the audit process and more recently, its risk management practices (Klein, 2002; Mohamed and Hussain, 2005). Since the regulatory reviews that followed the corporate collapses, audit committees are now commonly accepted as a fundamental component of a corporate governance structure with its expanded activities resulting in some companies referring to their audit committees as “risk and audit committees”.
The incidence of high profile corporate failures, most notably in the period since 2000, involving fraud, poor accounting and failure of internal controls have questioned the adequacy of audit committees in effectively applying a monitoring and compliance role. The role of audit committees has evolved from enhancing the independence of its external auditor to overseeing the audit activities, risk management and performance. From this perspective, it appears reasonable to explore whether audit committees enable the firms to better manage risk, financial report quality and conformance. One purpose of this themed issue is to highlight recent evidence of the role effectiveness of audit committees in an effort to assess the perceived benefits of adopting audit committees on financial reporting quality and corporate performance.
The growing global acceptance of audit committees as a relevant governance structure is linked to claims that audit committees benefit corporate governance in a number of aspects. It is from these potential benefits, rather than the mere presence of an audit committee, that are relied upon by researchers to obtain evidence and assess the effects on corporate governance associated with the existence and operation of audit committees. As a major control over the financial and risk management processes in an organisation, audit committee characteristics have been examined by researchers to assess the effect on financial decision making and risk management on corporate performance. A significant amount of empirical research has subsequently examined the association of audit committees with a variety of variables that includes: independence (Klein, 2002; Vermeer et al., 2006), fees (Rainsbury et al., 2009), internal controls (Davidson et al., 2005) firm size (Piot, 2004), financial expertise (Carcello et al., 2002), commitment (Raghunandan, and Rama, 2007), and other characteristics of the board of directors to improved firm performance and value (see also literature reviews: DeZoort et al., 2002; Turley and Zaman, 2004).
A growing stream of research suggests that audit committee characteristics are critically important to the role effectiveness of audit committees (Abbott et al., 2003). Commentators emphasise the need for audit committees to be comprised of members who are independent, including some of whom to possess financial expertise and for the audit committee to meet frequently (Carcello et al., 2002; Abbott et al., 2004). This themed issue of MAJ is focused on key audit committee attributes or characteristics that examine role effectiveness, independence, financial expertise, relevant industry knowledge and diligence on financial reporting quality that incorporates financial restatements, discretionary accruals and timeliness of reporting. The discussion below highlights existing literature in this area of research followed by an outline of the manuscripts published in this themed issue.
The role of the audit committee in improving the quality of information flowing through to users is a key component of its oversight function making it a focus of increased research activity. The influence of audit committees on a firm’s choice of accounting policies, levels of disclosure, and adherence to professional and regulatory standards all of which have an impact on reporting quality. Research evidence suggests that increased reporting quality also increases firm performance with the instalment of an audit committee (Wild, 1996). Recent research suggests however that the impact of audit committees on reporting quality is not always present (Davidson et al., 2005). To the extent that audit committees have an influence on reporting quality, the composition of audit committees has been a major source of research that attempts to explain this relationship. One stream of research has centred on financial literacy. This research examines the extent of financial expertise (usually defined in terms of accounting or finance qualifications or experience) represented on the audit committee and the ability of at least some members to understand financial statements. Expertise whether it is in terms of qualifications or experience is expected to play a complementary role in enhancing the effectiveness of the audit committee with respect to audit and reporting quality. The evidence in this area of research is unclear however board and audit committee expertise has been shown to enhance firm value (Chan and Li, 2008; Bronson et al., 2009). Research on audit committee diligence, which refers to the frequency in which audit committees meet, has been shown to have a potentially positive impact on firm performance (Raghunandan and Rama, 2007; Sharma et al., 2009). According to Abbott et al. (2004), audit committees that meet at least twice a year will decrease the potentiality of misleading and fraudulent reporting.
Following the research findings above, the effectiveness of an audit committee is presumed to be related to the critical attributes that includes independence, expertise and commitment in their oversight role. This themed issue commences with Lary and Taylor’s governance characteristics and role effectiveness of audit committees. The authors developed a model to examine audit committee characteristics and role effectiveness in terms of monitoring the integrity of financial statement and maintaining external auditor independence. Whereas prior research has examined partial aspects of audit committee effectiveness, this study integrated existing research findings into a comprehensive model of governance characteristics and role effectiveness. A sampling frame of 180 observations listed on the Australian Stock Exchange indicates that independence (a higher proportion of independent members) and competence (financial sophistication and industry relevant experience) are related to financial report integrity and competence is related to a lower non audit fee ratio. Lary and Taylor also found that diligence in terms of meeting frequency is related to external auditor independence. Overall, independence competence, and diligence are critical elements in audit committee role effectiveness.
In a study with similar variables, Sun, Wei and Xu investigated audit committee independence and expertise of property liability insurers on financial reporting quality. This study decomposed the notion of financial expertise based on four categories that includes accounting, finance, supervisory and insurance industry knowledge. The authors found that three of the variables relating to expertise (accounting, finance, insurance knowledge) were related to reporting quality but not supervisory financial expertise. The novelty of this study stems from its sample which examines audit committee characteristics in the insurance industry.
Whilst the studies above examine audit committee characteristics for an association with a measure of financial reporting quality, Salleh and Stewart examine the external auditors’ perceptions of audit committee characteristics (expertise and industry relevant experience) on its mediating role in resolving auditor-client disagreements. In an experimental research design, 61 Malaysian auditors perceived audit committees to play a greater mediating role when financial expertise is high. The results of this study suggest that the notion of expertise appears to play a significant role in the effectiveness of audit committees as mediator.
Ika and Ghazali examine the association between audit committee characteristics and timeliness of reporting on the Indonesian Stock Exchange, a country in which governance practice is voluntary and arguably comparatively weak. A study of 211 non-financial Indonesian listed companies found that timeliness is associated with audit committee effectiveness. This finding suggests that audit committee effectiveness is a critical factor for ensuring timely submission of audited financial statements. Research on audit committee diligence is Western-centric that reflects the preponderance of research originating in developed countries. Research from a variety of national contexts is beneficial to the extent that audit committee effectiveness may vary between nation states depending on specific circumstances and governing contexts. In an attempt to redress this Western bias, Feng, Gao, Li, and Lv examine audit committee frequency meetings in Chinese listed companies in which the corporate governance setting is non-mandatory and characterised by a high concentration of government control and ownership. The findings indicate that frequency was lower in state owned firms and negatively associated with the proportion of shares owned by a majority shareholder and the proportion of independent board directors. These findings support the notion that independence and ownership dilution improves corporate governance.
This themed issue deals with a range of audit committee characteristics. It encompasses those characteristics which directly relate to earnings quality such as the financial expertise of audit committee members. It also addresses audit committee practices such as meeting frequency, mediation, and timeliness of reporting. Furthermore, the diversity of host countries in which these were undertaken highlights a growing interest of such research in emerging economies with evidence now emerging in countries such as China, Indonesia and Malaysia as well as developed countries that includes Australia and the USA. Overall, the research evidence published in this theme issue indicates that audit committees with financial expertise, relevant industry knowledge and enhanced meeting frequency are better able to manage financial reporting quality matters.
Steven Dellaportas, Philomena Leung, Barry J. CooperGuest Editors
Abbott, L.J., Parker, S. and Peters, G.F. (2004), “Audit committee characteristics and restatements”, Auditing, Vol. 23, pp. 69–87
Abbott, L.J., Parker, S., Peters, G.F. and Raghunandan, K. (2003), “The association between audit committee characteristics and audit fees”, Auditing: A Journal of Practice & Theory, Vol. 22, pp. 17–32
Bronson, S.N., Carcello, J.V., Hollingsworth, C.W. and Neal, T.L. (2009), “Are fully independent audit committees really necessary?”, Journal of Accounting & Public Policy, Vol. 28, pp. 265–80
Carcello, J.V., Hermanson, D.R., Neal, T.L. and Riley, R.A. Jr (2002), “Board characteristics and audit fees”, Contemporary Accounting Research, Vol. 19, pp. 365–84
Chan, K.C. and Li, J. (2008), “Audit committee and firm value: evidence on outside top executives as expert-independent directors”, Corporate Governance, Vol. 16 No. 1, pp. 16–29
Davidson, R., Goodwin, J. and Kent, P. (2005), “Internal governance structures and earnings management”, Accounting and Finance, Vol. 45 No. 2, pp. 241–67 (in press)
DeZoort, F.T., Heramnson, D.R., Archambeault, D.S. and Reed, S.A. (2002), “Audit committee effectiveness: a synthesis of the empirical audit committee literature”, Journal of Accounting Literature, Vol. 21, pp. 38–75
Klein, A. (2002), “Audit committee, board of director characteristics, and earnings management”, Journal of Accounting and Economics, Vol. 33, pp. 375–400
Mohamed, E. and Hussain, M. (2005), “The roles of audit committees in enhancing a transparent corporate reporting”, Humanomics, Vol. 21 No. 1, pp. 30–47
Piot, C. (2004), “The existence and independence of audit committees in France”, Accounting & Business Research, Vol. 34 No. 3, pp. 223–46
Raghunandan, K. and Rama, D.V. (2007), “Determinants of audit committee diligence”, Accounting Horizons, Vol. 21 No. 3, pp. 265–79
Rainsbury, E.A., Bradbury, M.B. and Cahan, S.S. (2009), “The impact of audit committee quality on financial quality and audit fees”, Journal of Contemporary Accounting and Economics, Vol. 5 No. 1, pp. 20–33
Sharma, V., Naicker, V. and Lee, B. (2009), “Determinants of audit committee frequency: evidence from a voluntary governance system”, Accounting Horizons, Vol. 23 No. 3, pp. 245–64
Turley, S. and Zaman, M. (2004), “The corporate governance effects of audit committees”, Journal of Management and Governance, Vol. 8, pp. 305–32
Vermeer, T.E., Raghunandan, K. and Forgione, D.A. (2006), “The composition of nonprofit audit committees”, Accounting Horizons, Vol. 20, pp. 75–90
Wild, J. (1996), “The audit committee and earnings quality”, Journal of Accounting, Auditing & Finance, Vol. 11 No. 2, pp. 247–76