Professional Documents
Culture Documents
Introduction
Based on the McKesson and Robbins, Inc. fraud in the 1930s, the SEC
recommended in 1940 that publicly-held companies create audit committees to
improve the integrity of corporate financial information; however, it was not until
the 1960s and 1970s that audit committee oversight received widespread
attention in the United States (DeZoort 1997).
2 The objectives of this paper are twofold. Erst, we investigate the trends in audit
committee activities in the periods preceding and following the passage of SOX. In
particular, we test whether audit committee assigned and disclosed oversight
responsibilities have been expanded following the passage of SOX. second, we
examine whether audit committees are effective in executing their assigned
oversight responsibilities in the post-SOX era. Specifically, we compare the
perceived oversight responsibilities of audit committee members and the oversight
responsibilities actually assigned in the proxy.
The remainder of this paper proceeds as follows. In the next section, we identify
key provisions of the Sarbanes-Oxley Act that pertain to audit committees and
then review background information and literature on audit committee
responsibilities and performance. The subsequent section describes the
methodology used for this study and is followed by the results section. We
conclude our study with a summary of our results, limitations of the study, and
suggestions for future research.
Background
(1) all critical accounting policies and practices that will be used,
(2) all alternative treatments of financial information that is within GAAP that
have been discussed with management,
Thus, the audit committee must discuss and help resolve auditor-management
disagreements as required by Section 310 of the Act; however, it should be noted
that this requirement is not a new audit committee responsibility. SAS 61 (1989)
requires audit committees to help in resolving auditor-management
disagreements.
Section 301 requires the SEC to adopt regulations that prohibit stock exchanges
from listing any company that does not have an audit committee meeting the
requirements of SOX.3 Also, Section 301 contains several requirements specifically
for audit committees. Erst, audit committee members must be independent, which
means they may not receive any consulting, advisory, or other compensatory fee
from the issuer (other than for service on the board), and may not be an affiliated
person of the issuer or any subsidiary of the issuer. Second, the audit committee is
responsible for the appointment, compensation, and oversight of the external
auditor.
Third, the committee is to establish procedures for the receipt, retention, and
treatment of complaints (e.g., whistle-blower protection). Fourth, the committee
has the authority to engage outside counsel or expert.
Section 401 requires the audit committee to include at least one member who is
considered a financial expert. Additionally, section 407 requires each company to
disclose whether it has a financial expert on the audit committee. If an audit
committee does not have a financial expert, the company must disclose this fact
along with an adequate explanation. The financial expert of the audit committee
must possess adequate knowledge of GAAP, financial reporting complexity,
internal control, and audit committee functions. The financial expert must also be
capable of assessing different accounting issues related to accruals, reserves,
valuations, and estimates. Further, the financial expert must possess high
standards of personal and professional integrity.
Carcello, Hermanson and Neal (2002) use a random sample of 150 proxy
statements from the NYSE, AMEX, and NASDAQ to compare the assigned duties of
the audit committee (charter) with the actual duties that the committee performs
(reports). The authors find a gap between the information in charters and reports,
suggesting the need for further reforms regarding audit committee disclosures
(e.g., number of meetings and oversight of internal audit). Pandit, Subrahmanyam
and Conway (2005) examine the effect of SOX on the audit committee disclosure in
the 2002 audit committee reports (before SOX) and 2003 (after SOX) proxy
statements for a sample of 100 companies listed on the NYSE. While the overall
results indicate that some audit committees treat their report as more than just a
regulatory requirement and provide more voluntary disclosure, many others
continue to provide only the minimum required information in their report. These
results may be explained by limitations in the study methodology. The study
restricted its focus to the actual audit committee report text rather than including
information disclosed in charters, as well as other venues within the proxy
statement (e.g. description of the board committees and audit fees).
5 Moreover, the authors examined the audit committee reports for a sample of
NYSE-listed companies. Examining a sample from the three major exchanges
allows better understanding of the SEC and stock exchange reactions to SOX.
finally and most importantly, the authors scrutinize proxy statements shortly after
the passage of SOX (only one year). Allowing a longer window after the enactment
of SOX is needed to permit more time for SOX and SEC rule changes to impact
audit committee performance. Pandit, Subrahmanyam and Conway (2005)
concludes that with the significant burdens that SOX imposed on audit committees,
it is imperative that audit committees be cautious in fulfilling their responsibilities
and reporting to the shareholders. The future should see an increase in the amount
of the voluntary disclosure made in the audit committee reports (Pandit,
Subrahmanyam and Conway 2005). Based on the discussion above we ask the
following research question:
Participants
We randomly selected 681 firms with December 31, 2004 year-end that filed proxy
statements during January and February of 2005. To control for stock exchange
bias, we examine proxy statements of an equal number of firms (227) listed on the
three major stock exchanges in the U.S.: NYSE, AMEX, and NASDAQ.7 To be
included in the sample, the firm must have proxy statements filed with the SEC for
year-end 2001 (pre-SOX) through 2004 (post-SOX). We use year 2004 to represent
post-SOX to allow enough time for SOX to impact audit committees. We search
proxy statements on LEXIS/NEXIS to collect company and audit committee member
information for the sample.
8.Table 1
9 Of the 588 individuals who did not return a completed survey instrument, forty-
seven indicated that they were no longer a member of an audit committee and the
remaining 541 non-respondents gave no reason for not returning the
questionnaire. As a result, we have 464 useable instruments, for a response rate of
44 percent. The 464 respondents represent a total of 373 firms (one person from
310 firms, two individuals from 35 firms, and three from 28 firms). To address the
possibility of firm policy response bias, we randomly choose one respondent from
each firm with multiple responses.10 Thus, our final sample consists of 373 audit
committee members from 373 different firms; 129 from NYSE, 124 from AMEX, and
120 from NASDAQ., We report the results of our survey mailings in Table 1. Survey
Instrument Our instrument has four sections: (1) demographic information; (2)
audit committee expertise and composition; (3) audit committee effectiveness;
and (4) audit committee issues. The audit committee expertise and composition
section of the survey consists of eight 5- point Likert-type questions. Three of the
Likert-type questions focus on various types of expertise the audit committee
members deem important (accounting expertise, auditing expertise, and industry
expertise), and those they personally possess (familiarity with GAAP, familiarity
with auditing standards, and familiarity with legal issues). The last two Likert-type
questions concern the proper funding of the committee and the extent of the
committee independence.
Results
Table 2
Tables 3
Table 4 reports the results of audit committee members' responsibilities that are
reported in the proxy statements for years 2001 pre-SOX and 2004 post-SOX.
Comparing preand post-SOX financial reporting responsibilities, we find a
significant upward trend (p < .01) in all financial reporting responsibilities. For
example, only 79 percent of the proxies include the responsibility of reviewing all
financial statements in 2001 and by 2004 that responsibility is included in 99
percent of the proxies. SOX is the result of a series of very costly business frauds
and the subsequent failure of many of those firms; therefore, the results regarding
the impact of SOX on the audit committees' financial reporting responsibilities are
not surprising. Similarly, the proxies indicate that all of the audit committees
increased their commitment to reviewing all existing accounting policies (71
percent compared to 89 percent), reviewing systems of internal control (82 percent
to 96 percent), evaluating exposure to fraud (55 percent to 83 percent), reviewing
all significant transactions (63 percent to 77 percent), and appraising key
management estimates, judgments and valuations (48 percent to 70 percent).
The results of reviewing fees paid to independent advisers and the use of other
auditors for second opinions (the two additional responsibilities), presented in Table
4. These results indicate significant increase in these two responsibilities (p <.01).
Only 4 percent of the proxies include the review of the nature and magnitude of
fees paid to independent professional advisers/ counsels as a responsibility of the
audit committee in 2001 compared to 45 percent in 2004. Finally, 30 percent of the
2001 proxies include the duty of reviewing the use of other auditors or counsels for
second opinions, and by 2004 that increases to 68 percent.
Table 4
Table 5
n addition, audit committee members in our study recognize one of the two
additional responsibilities;12 however, it appears that audit committees still do not
consistently perform all of the functions assigned to them in their proxies. These
are surprising results considering the significant events affecting audit committees
that took place after DeZoort s (1997) study: The National Association of Corporate
Directors 2000, Blue Ribbon Commission on Audit Committees 1999, SEC rule
changes related to audit committee disclosures 1999, and the passage of SOX. Our
results indicate that audit committees still have much room for improvement in the
performance of their oversight responsibilities. Consequently, they must do more
in order to meet the many additional challenges facing them in a post-SOX
environment.
Overall, there are significant differences (47% or 9 out of 19) between the assigned
and perceived responsibilities. In every instance where we find significant
differences between the proxy- assigned responsibilities and the
members'perceived responsibilities, the perceived responsibilities lag the assigned
ones. The results show that audit committee perception of what they are doing is
less than what they should be doing, according to their assigned responsibilities in
proxies. This result provides strong evidence that audit committees are not yet
effective in executing
One explanation for the results above could be that the audit committee members
do not believe that the responsibility assigned to them is an appropriate
responsibility. To explore this possibility, we ask the audit committee members the
following question, "Is this duty appropriate for audit committees?" Table 6 shows
that the majority of the respondents believe that seventeen of the nineteen
responsibilities are appropriate oversight responsibilities for their audit
committees. For example, 99 percent believe that reviewing all financial
statements is an appropriate task for audit committee members. Similarly, 97
percent of the audit committee members consider reviewing all existing
accounting policies to be an appropriate responsibility.
Except for "recommend appointment and fee for external auditor" and "review
plans for effectiveness of
internal and external auditors," a significant gap exists between audit committee
perceptions of the appropriateness of their oversight responsibilities and their
perception of performing these responsibilities. This rules out the possibility that
audit committees are not effective because they do not consider the responsibility
to be appropriate.
Other Audit Committee Issues
Our survey instrument includes a ranking question and an open- ended question to
obtain additional insights regarding audit committee members' beliefs concerning
their most important oversight responsibilities. One of these questions asks each
member to list the most important issues facing his audit committee.13 Committee
members in our sample identify the following five responsibilities as their most
important concerns in the following order:
(1)reviewing systems of internal control;
(2) reviewing all financial statements;
(3) reviewing fees paid to the auditor for non-audit services;
(4) reviewing the external auditor's management letter; and
(5) determining that auditors are free from undue managerial influence.
We also ask the respondents to rank the five most important responsibilities for
their committees. The results of this question strongly support our earlier finding
that audit committee members view the internal control evaluation task as their
most important responsibility.
14 Following this task, the respondents believe that their next most important duty
is to focus on the quality of financial reporting, followed by the work of the internal
and external auditors. Prior research finds a significant association between quality
of financial reporting systems and quality of governance mechanisms, including
audit committee (Farber 2005; Bedard, Chtourou and Courteau 2004; Xie, Davidson
and DaDaIt 2003). The audit committee has a significant role in improving the
quality of financial information. In particular, audit committees recognize that they
are the core decision-making body that is expected to monitor financial reporting
practices. The provision of non-audit fees can strengthen the auditor's economic
relationship with the client, thus increasing the auditor's incentive to submit to
client pressure, which may jeopardize the auditor's independence (Simunic 1984;
Beck, Frecka and Solomon 1998). Frankel, Johnson and Nelson (2002) find that non-
audit fees are positively associated with earnings surprises and the magnitude of
discretionary accruals. Klein (2002) finds a negative relation between audit
committee independence and abnormal accruals.
It is not surprising, considering the findings of prior research, to observe that the
most important five duties before audit committees in our sample are related to
internal control and external auditors. All these duties should lead to better
financial reporting systems. Good internal control is considered to be an important
factor in achieving good quality financial reporting. There is increased pressure to
improve financial reporting transparency and provide higher levels of audit scrutiny
from audit committees and Auditors (Hannon 2005). TheTreadway Commission's
report recommended: "To be effective, audit committees should exercise vigilant
and informed oversight of the financial reporting process, including the company's
internal controls." (NCFFR 1987,12). A primary function of the audit committee
should be the oversight of internal control, although it is not mandated by sec rules
(Krishnan 2005). The sec (2003) has mandated that all material written
communications between management and the external auditor be provided to the
audit committee, including reports on observations and recommendations on
internal controls.
Table 6
The study examines whether audit committee assigned duties have been
expanded after the passage of SOX and whether audit committees are effective in
executing their assigned responsibilities. The results
indicate that assigned audit committee duties expanded after the passage of SOX
with noticeable increases in the percentage of proxies assigning responsibility to
the audit committee in the areas of reviewing all financial statements, reviewing all
existing accounting policies, reviewing systems of internal control, reviewing all
significant transactions, and appraising key management estimates, judgments,
and valuations. Also, the results show a greater emphasis on audit committee
responsibilities opertaining to external auditors. Specifically, a pronounced
increase in the percentage of proxies assigned responsibility to the audit
committee in the areas of reviewing coordination of internal and external auditor
work, determining whether auditors are free from undue managerial influence,
requesting to be informed of auditor-
management disputes, and reviewing fees paid to the auditor for
nonaudit services.
The results indicate that audit committee members perceive they are doing more
post-SOX than pre-SOX. The results show a significant gap between perceived and
assigned responsibilities in four of the six areas of financial reporting, three of the
auditing responsibilities, and two of the three corporate governance
responsibilities. In addition, the results imply significant reduction in the gap
between perceived audit committee responsibilities and assigned audit committee
responsibilities post- SOX as compared to that which existed in the pre-SOX
environment.
Moreover, the results regarding the increase of the audit committee responsibilities
post-SOX reflect a more general voluntary disclosure phenomenon. Pre-SOX firms
chose whether to assign many of the responsibilities to the audit committee and
whether to disclose these assigned responsibilities. So, it is possible that many
firms assigned the responsibility but did not disclose these responsibilities in their
proxies. Post-SOX there is evidence of an increase in the disclosure behavior
relative to pre-SOX (Pandit, Subrahmanyam and Conway 2005; Keinath and Walo
2004). Therefore, the results may be due to an increase in audit committees'
disclosure requirements rather than an increase in the audit committee assigned
responsibilities. As pointed out in Core (2001), the simultaneous choice of
disclosure and corporate governance structure is an interesting question for future
research.
Survey studies such as this have a number of limitations, and therefore, the results
should be interpreted within this context. Although we did not find any significant
differences in the early and late responders who participated in our study, there is
always the risk that the individuals who did not respond differed significantly in
their views than those who participated in the survey. Also, we had no control over
the environment in which the members responded to the survey instrument.
Finally, 310 firms in our sample were represented only by one respondent of the
audit committee. It is possible that such a respondent may not be a "prototypical"
member of a given audit committee and that the respondent's perceptions may
not necessarily represent the perceptions of the entire audit committee.
While the results of this study are encouraging, future research is still warranted on
several of the issues examined in the current study. As accounting and auditing
issues become increasingly complex in the future, and based on the obfuscation of
accounting data and financial reports that transpired in many well-publicized
frauds, the technical accounting and auditing expertise of audit committee
members should be a critical topic of interest to policy-makers at all levels. This
suggests several issues for future research, first, there is a need for more indepth
studies that examine the expertise possessed by audit committee members.
Second, should audit committees be required to include at least one senior-level
certified public accountants and/or partners of public accounting firms? If yes,
where are the potential conflicts of interest? Third, should audit committee
members become more aggressive about attaining the required expertise? Perhaps
studies should focus on both the quantity and quality of ongoing education for
audit committee members from internal sources (such as the internal audit staff)
and outside sources (such as specialized training programs).
Another avenue for investigation is whether audit committees are engaging in self-
assessment and, if so, what tools are they using and who is conducting the self-
assessment for the committee. Rossiter (2004) notes that only the NYSE requires
audit committees to conduct an annual self-assessment. He claims that this can be
a valuable undertaking if a committee uses the assessment for continuous self-
improvement. This also offers an opportunity for audit committees to develop best
practices that might be used as standards for "world-class" committees. Based on
the increasing requirements and expectations of audit committees under SOX, this
might also be an important defense for audit committee members in the event of
litigation.
"The financial expert of the audit committee must possess adequate knowledge of
GAAR financial reporting complexity, internal control, and audit committee
functions."
Notes
4. Keinath and Walo (2004) provide a brief summary of each of these provisions of
SOX and identify each provision as either a new or an expanded duty for audit
committees.
5. Pandit, Subrahamanyam and Conway (2005) restricted their investigation to
only nine requirements, while the current study uses a larger list of audit
committee duties and authorities and covers more dimensions than Pandit,
Subrahamanyam and Conway (2005).
6. Ninety-nine percent of the audit committees disclosed that they have charters
that identify the committee's purpose for the entire four year period of our sample
of proxy statements.
7. During January and February of 2005 only 227 firms from NASDAQ filed their
proxy statement (more from the other two stock exchanges). To eliminate any
specific stock exchange impact on the results we included only 227 firms from
each stock exchange.
9. Our analysis did not reveal any significant differences in the early and late
responders.
10. We compared the results from the 464 respondent to the results from 310 firms
on the descriptive component results.The results of the t-test comparison revealed
no significant differences for any of the questions evaluated.
11. The 5-point Likert scale range (for the expertise questions) is 1 = strongly
disagree, 2 = moderately disagree, 3 = neither agree nor disagree, 4 = moderately
agree, and 5 = strongly agree. For the familiarity questions the 5-point Likert scale
range is 1 = don't know, 2 = to small extent, 3 = to some extent, 4 = to moderate
extent, and 5 = to great extent.
13. One-way ANOVA and Tukey's LSD confirms the ranking. We did not observe any
differences (p < 0.05 level) across industry, stock exchanges, or audit committee
members'experiences.
14. We did not find any differences across industry, stock exchanges, or audit
committee members experience (p < 0.05 level).
References
Beck, P., T. Frecka and I. Solomon. 1998. A model of the market for
MAS and audit services: Knowledge spillovers and auditor- auditee
bonding. Journal of Accounting Literature 7:50-64.
Lee, H., V. Mande and R. Ortman. 2004. The effect of audit committee
and board of director independence on auditor resignation. Auditing:
A Journal of Practice & Theory 23(2): 131-146.
Glenn A. Wolfe received his Ph.D. in Finance from Virginia Tech and
is currently Associate Professor of Finance and Accounting
Information Systems at the University of Toledo. His research has
been concentrated in the areas of corporate finance and banking. He
has published numberous articles in a variety of academic and
professional journals including the Journal of Finance, the Journal
of Financial Research, and Financial Review.