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Audit Committees Oversight Responsibilities Post Sarbanes-Oxley Act

American Journal of Business

In this study we examine the oversight responsibilities of audit committees in the


post Sarbanes-Oxley Act of 2002 (SOX) era. The results show that audit committee
oversight responsibilities assigned and disclosed in proxy statements expanded
post-SOX compared to pre-SOX. We design a survey instrument to measure the
difference between the perceived oversight responsibilities of audit committee
members and the oversight responsibilities actually assigned in the proxy. Our
results indicate that although audit committees made a substantial commitment to
increase their assigned responsibilities over the period of 2001 to 2004, they still
need to do more to meet the many additional challenges facing them in a post-SOX
environment. Overall, our results suggest that the intent of SOX-for audit
committees to be more involved and active in the oversight role of an organization-
is becoming institutionalized. These results should be interesting to policy makers,
a variety of interest groups, and accounting researchers.

Keywords: Sarbanes-Oxley Act, audit committee, corporate governance

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).

1 Since that time, audit committees- characteristics of their membership, their


responsibilities, and their effectiveness-are of great interest to the accounting
community, both academic researchers and practitioners. Recent accounting
scandals raise questions about the oversight responsibilities of the audit
committee. Regulators have responded with governance reforms that attempt to
enhance the oversight responsibilities of audit committees. Although recent
corporate scandals and the Sarbanes-Oxley Act of 2002 (SOX) caused the business
community, corporate directors, investors, and others to focus their attention on
corporate audit committees, the response of audit committees in reaction to the
governance mandates introduced by SOX and stock exchanges is an issue of
concern.

Prior academic and practitioner research that examined audit committee


responsibilities and how effectively these committees handle their responsibilities
pre-SOX suggests the need for further reforms regarding audit committees
(Carcello, Hermanson and Neal 2002; DeZoort 1997; Keinath and Walo 2004;
Rezaee, Olibe and Minmier 2003). Despite the existence of a fair number of studies
that examine audit committee oversight responsibilities before SOX, little direct
evidence exists about such responsibilities post-SOX. Pandit, Subrahmanyam and
Conway (2005) is the only study that examines the effect of SOX on audit
committee disclosures. Using a sample of NYSE firms shortly after the passage of
SOX and focusing only on the audit committee report, Pandit, Subrahmanyam and
Conway (2005) find that many audit committees continue to provide only minimum
required information in their report. The lack of significant impact of SOX on audit
committee disclosures could be attributable to research-design-related factors
(e.g., examine only one stock exchange, not allowing enough time for SOX to
impact audit committees oversight responsibilities, and considering only audit
committee reports) or could reflect the fact that SOX does not significantly impact
audit committee effectiveness.

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.

This study uses a hybrid methodology to investigate the research questions. We


compare the disclosed oversight responsibilities in proxy statements to examine
the trend in audit committee responsibilities pre- to post-SOX. In addition, we use a
survey instrument to capture the perceived oversight responsibilities of audit
committee members and to measure the effectiveness of the disclosed
responsibilities. Based on archival data of proxy statements and survey data from
audit committee members in 373 firms listed on NYSE, AMEX, and NASDAQ for the
period 2001-2004, our results indicate that audit committees made a substantial
commitment to increasing their assigned responsibilities examined in this study.
The results also indicate that audit committee oversight responsibilities are
expanding. Although the results suggest that the intent of SOX for audit
committees to be more involved and active in the oversight role of an organization
is becoming institutionalized (i.e., generally recognized as a vital part of a
structured, well-established system of corporate oversight), audit committee
members still do not recognize all the responsibilities assigned to them in their
proxies. Without such recognition, it is doubtful that members of audit committees
can effectively execute their responsibilities and provide sufficient assurance to
restore confidence in capital markets. In addition, audit committee members in the
current study believe that all examined responsibilities are appropriate duties for
their committees and that internal control evaluation is their most important
oversight responsibility.

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

Sarbanes-Oxley Act of 2002 and Audit Committees In response to many accounting


scandals and irregularities in the period 2000-2002, the U.S. Congress passed the
Sarbanes-Oxley Act of 2002. The Act changes corporate governance, including the
authorities and responsibilities of audit committee members. Section 204 requires
the accounting firm to report to the audit committee the following:

(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,

(3) the consequences or effects of using such alternative disclosures and/or


treatment, and

(4) the treatment preferred by the firm. .

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.

4.Audit Committee Responsibilities and Effectiveness Prior research investigates


the impact of the inclusion of outside members and financial expertise on audit
committees. Independent boards increase financial reporting quality by playing a
crucial role in monitoring senior management (Lee, Mande and Ortman 2004). Prior
research suggests that as the proportion of independent board members increases,
earnings overstatement is less frequent (Dechow, Sloan and Sweeney 1996;
McMullen and Raghunandan 1996); earnings management is lower (Klein 2002;
Bedard, Chtourou and Courteau 2004); the external audit fee is greater (Carcello,
Hermanson and Neal 2002); occurrence of financial restatement is less (Abbott,
Parker and Peters 2004); and the likelihood of financial fraud in a firm decreases
(Beasley et al. 2000). Carcello and Neal (2000) find that the greater the percentage
of affiliated directors on the audit committee, the lower the probability the auditor
will issue a going-concern report. Carcello and Neal s (2003) findings suggest that
audit committees with greater independence are more effective in shielding
auditors from dismissal after the issuance of new going-concern reports. Lee,
Mande and Ortman (2004) find that when audit committees and boards of directors
are independent, auditors are less likely to resign.

Another line of research examines the association between audit committee


composition and internal control. Raghunandan, Read and Rama (2001) find that
independent audit committees with at least one member having an accounting or
finance background are more likely to have longer meetings with the chief internal
auditor, more likely to provide private access to the chief internal auditor, and
more likely to review internal audit proposals and results of internal auditing.
Krishnan (2005) observes that audit committees who are independent and have
financial expertise are significantly less likely to be associated with internal control
problems.

Several accounting studies examine audit committee responsibilities disclosed in


audit committee charters and reports contained in proxy statements. Keinath and
Walo (2004) examine the audit committee's assigned responsibilities before the
passage of Sarbanes-Oxley using a sample of proxy statements for ninety-eight
domestic companies listed on NASDAQ as of August 2002. Their analysis indicates
that only 63 percent of the audit committees monitor the choice of accounting
policies and principles; 54 percent review the quality of accounting principles with
their auditors; 63 percent have the authority and funding to use outside experts;
10 percent are solely responsible for hiring and firing the auditor; only one percent
indicated that they both discuss and resolve disagreements between management
and the external auditors; and none acknowledged procedures to handle
complaints. In general, their analysis indicates that audit committees are not
fulfilling the oversight responsibilities that would lead to an effective and proactive
oversight role. Their findings also suggest that audit committees must make
significant improvements in their disclosures to shareholders, and they also must
disclose the extent to which they have fulfilled these responsibilities.
Rezaee, Olibe and Minmier (2003) examine the content of audit committee reports
for ninety-four of the Fortune 100 companies in the United States to determine the
information content of these reports and the extent to which these reports conform
to the requirements of the SEC, NASDAQ, and NYSE. Their results indicate that the
majority of audit committee reporting satisfies the mandatory requirements of the
SEC, NASDAQ, and NYSE. Although Rezaee, Olibe and Minmier's (2003) sample is
before the passage of SOX, they indicate that more disclosures will be necessary to
comply with SOX requirements.

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:

Are audit committee oversight responsibilities disclosed in proxy statements


expandedpost-SOX compared topre-SOX?

The audit committee participants in DeZoort's (1997) study responded to survey


questions about their proxy statements assigned duties and their perceptions of
key tasks. The survey instrument includes a list of seventeen audit committee
responsibilities identified by Wolnizer (1995) such as financial reporting oversight,
appointing the external auditor, and other governance duties (DeZoort 1997).
DeZoort finds a significant gap between the assigned duties of the audit
committee members and their perceptions of their assigned responsibilities.
DeZoort (1997) suggests the need to evaluate the quality of the audit committee
disclosures and their effectiveness.

Scandals and governance mandates introduced by SOX increased pressure on


audit committees to enhance their performance, to improve financial reporting
transparency, and to provide higher levels of audit scrutiny. Whether audit
committees have adequately responded is a matter of empirical investigation.
Therefore, we formulate the following research question:

Are audit committees effective in fulfilling their oversight responsibilities?

Method To investigate our first research question of whether audit committees'


assigned duties have been expanded as a result of the passage of SOX, we
compare audit committees' assigned responsibilities disclosed in proxy statements
before and after the passage of SOX. Specifically, we examine financial reporting,
auditing, corporate governance and other responsibilities for the audit committees
(DeZoort 1997). We search proxies where responsibilities assigned for audit
committee members could potentially be reported (e.g., charters, reports, and
description of the board committees).

6 We compare the duties assigned to audit committee members disclosed in proxy


statements to audit committee members' perceptions of their assigned
responsibilities to test our second research question of whether audit committees
are efiective in executing their assigned responsibilities. Although the proxies may
identify certain tasks as the responsibility of the audit committee, the members of
the committee might actually believe that their tasks difier from those identified in
the proxies. Audit committees are effective when their perceptions of what they
are doing meet or exceed what the proxy says they should be doing.

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

Sample and Response Rate


We administered the survey in 2004 by mailing 1,052 questionnaires to audit
committee members in 681 firms identified from LEXIS/NEXIS along with a
stamped, return addressed envelope. The respondents were directed to make their
answers relevant to the company mentioned on the enclosed envelope if they
serve on more than one audit committee. We made a follow-up telephone call to
those participants who did not respond to the initial mailing.

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.

The audit committee effectiveness section of our instrument contains questions


concerning nineteen audit committee responsibilities. The first seventeen audit
committee responsibilities are the same as those originally identified by Wolnizer
(1995) and later used by DeZoort (1997). Upon further examination of the proxy
statements of our sample firms, we note that several additional items were
repeatedly mentioned in these statements as being important to audit committees;
therefore, we add two additional audit committee responsibilities regarding
reviewing the nature and magnitude of fees paid to independent professional
advisers/counsels and reviewing the use of other auditors or counsels for second
opinions.

The respondents are asked to identify three questions related to the


aforementioned nineteen assigned audit committee responsibilities, first, is the
duty formally assigned to your committee? This question relates audit committee
members' perceptions of their assigned responsibilities and those disclosures in
the proxy statement. second, is the duty performed, but not assigned, to your
committee? This question addresses the possibility that audit committees may
perform some functions that are not formally assigned to them. Third, is the duty
appropriate for audit committees? This question provides an opportunity for audit
committee members to express their opinion about the list of proposed oversight
responsibilities.
To explore additional issues of interest facing audit committees, we ask them to list
the most significant issue(s) currently facing their audit committees, to rank the
five most important responsibilities for their committees, and any other comments
they would like to add.

Results

The demographic information for the sample is presented in Table 2. The


demographic profile of our respondents is a mean age of 53.4 with 10.9 years of
work experience in their current industry. Most of the audit committee members
are men (81.2 percent) and well educated (66.6 percent have an advanced
degree). Approximately 64 percent hold at least an undergraduate degree in a
business discipline (48.3 percent are accounting and finance majors, and the
remaining 15.8 percent hold management and marketing degrees). Their
experience is equally divided among the three industry classifications (33.7
percent retail, 31.2 percent service, and 35.1 percent manufacturing), and only
20.3 percent consider themselves financial experts.

Audit Committee Expertise and Composition Table 3 provides results on audit


committee perceptions of the importance of expertise (accounting, auditing, and
industry), possession of the expertise, and the formation of the audit committee.
The audit committee members who participated in our study generally believe that
it is equally important for all audit committee members to have a sufficient level of
expertise related to technical accounting issues, technical auditing issues, and
industry (mean responses of 4J2).11 To a moderate extent, the audit committee
members believe that they possess a sufficient level of expertise related to
technical accounting standards (mean response of 3.9), technical auditing
standards (mean response of 3.9), and to a lesser extent, legal issues (mean
response of 3.8). Despite the high importance of the three types of expertise, it
does not appear that these same committee members possess high levels of such
expertise. There is a significant difference between the importance of the three
types of expertise and the self-reported perceptions of expertise levels of the
committee members in these three areas (p < .05 for the three types of the
expertise). In addition, the participants believe that their audit committee is
properly funded to effectively carry out their duties (mean response of 3.8), and
that their committee is composed of independent members (mean response of
4.1).

While audit committee members generally agree that expertise in accounting,


auditing, and the company's industry is important, of the 373 participants (31.9
percent) seventy-six members and forty- three chairs consider themselves
financial experts, but approximately one-third of the committee members in our
sample indicate that they possess a very limited level of familiarity with GAAP
(mean response of 2.7) or GAAS (mean response of 2.8), and are only somewhat
aware of the legal issues facing their firm (mean response of 3.1). Comparing the
audit committee chairs and the audit committee members, we find significant
differences (p < .05) between their self-reported perceptions of their xpertise
levels.
Moreover, the results, not reported, show no significant differences in members'
opinions (chair, financial experts, and committee members) of the importance of
areas of expertise or of audit committee composition.

Table 2

Respondents and Sample Demographics (n = 373)

Tables 3

Audit Committee Expertise and Composition

Audit Committee Assigned Responsibilities

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 comparing years 2001 to 2004 regarding audit oversight


responsibilities indicate significant improvement in all responsibilities (p < .01)
except reviewing the external auditor's management letter. Specifically, audit
committees now assume a very prominent role in the auditing area, specifically
with regard to the appointment and fees of external auditors. There is significant
improvement in reviewing plans for effectiveness of internal and external auditors.
Audit committees significantly increase their emphasis on reviewing the
coordination of internal and external auditor work (55 percent to 77 percent),
determining whether auditors are free from undue managerial influence (70
percent to 91 percent), requesting they be informed in cases of auditor
management dispute (47 percent to 81 percent), and reviewing non-audit service
fees paid to the auditor (79 percent to 96 percent).

Regarding corporate governance responsibilities, audit committees significantly


increased emphasis on facilitating communication between external auditors and
the board of directors (p =.028) and monitoring compliance with company's code
of conduct (p =.025). However, we find no significant improvement in the area of
reviewing corporate policies and practices related to ethical issues. Although audit
committees are not improving in the area of assessing and updating the
appropriateness and the sufficiency of its ethical policies, they are improving in the
area of mentoring compliance with such policies.

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.

In general, the results of comparing audit committee assigned responsibility pre-


and post-SOX reveals that these responsibilities expanded following the passage of
SOX. Effectiveness of Audit Committee Oversight Responsibilities

Table 5 provides the results of comparing the assigned and disclosed


responsibilities in proxy statements and the perceived responsibilities of audit
committee members. We find significant differences in four of the six areas of
financial reporting: reviewing all financial statements, evaluating exposure to
fraud, reviewing all significant transactions, and appraising key management
estimates, judgments, and valuations. While in each of these four areas the
responsibility is specifically assigned to the audit committee in the proxy, some of
the members do not perceive it as an assigned responsibility. We also find this to
be the case with three of the auditing responsibilities. Although the task is
assigned to the audit committee members, some members do not acknowledge
the following as a task: reviewing coordination of internal and external auditor
work, requesting to be informed if there is an auditor-management dispute, and
monitoring the resources allocated to the internal audit function. Similarly, a
significant gap exists between the disclosed and perceived responsibilities
regarding two of the three corporate governance responsibilities- facilitating
communication between the external auditors and the board and monitoring
compliance with the company's code of conduct, finally, for one of the two
additional responsibilities that vfe added, we find significant differences between
assigned and perceived responsibilities regarding reviewing the use of other
auditors or counsels for second opinions.

Table 4

Audit Committee Oversight Responsibilities Prior and Post Sarbanes-Oxley Act As


Listed in Proxy Statements (n = 373) *

Table 5

Comparison of Oversight Responsibilities Listed in Proxy Statements and Audit


Committee Members' Perceptions of Responsibilities Assigned (n = 373) DeZoort
(1997) compares the assigned and perceived responsibilities of audit committee
members using the first seventeen responsibilities employed in this study. He finds
that audit committee members only recognize two of the seventeen audit
responsibilities as assigned responsibilities. The comparison of our results to those
of DeZoort (1997) implies that audit committee member perceive that they are
engaging in more activities post-SOX than pre-SOX. Specifically, audit committee
members in our study recognize six more of the original seventeen responsibilities
requirements than audit committee members in the DeZoort (1997) sample,
representing a 300 percent post-SOX improvement.

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

their assigned responsibilities.

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

Normative Assessment of Appropriate Oversight Responsibilities (n=373)

Summary and Conclusions

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.

Nevertheless, the oversight role of the audit committee in corporate America is a


vital responsibility that will require an ever more vigilant and conscientious group
of individuals in the future. Our study suggests that most audit committees have
seriously considered the many mandates contained in the Sarbanes-Oxley Act of
2002 and have incorporated most of the seventeen responsibilities in their
assigned oversight responsibilities. However, they still need to do more to meet
the many additional challenges facing them in a post-SOX environment. Further,
our results suggest that these same individuals take a much more involved stance
with respect to the internal control evaluation of the firm and their role as the
primary point of contact between the firm and the external auditors. Although the
findings of the study show that the governance mandates introduced by SOX were
effective in increasing the audit committee perceptions of their assigned duties
compared to DeZoort (1997), we cannot attribute these results solely to SOX due
to a number of significant audit-committee events that took place prior to SOX and
after the data collected in DeZoort in the mid 1990s (e.g. the National Association
of Corporate Directors NACD of 2000, Blue Ribbon Commission on Audit
Committees of 1999, and SEC rule changes related to audit committee disclosures
of 1999). It is difficult to attribute changes in audit committee assigned
responsibilities from 2001 through 2004 to SOX only because of many other
concurrent major corporate scandals. For instance, the period following the
scandals is likely to be marked by greater investor alertness and increased scrutiny
by auditors and regulators.

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.

We compare the disclosed oversight responsibilities in proxy statements to


examine the trend in audit committee responsibilities pre- to post-SOX.

"The financial expert of the audit committee must possess adequate knowledge of
GAAR financial reporting complexity, internal control, and audit committee
functions."

"...a significant gap exists between audit committee perceptions of the


appropriateness of their oversight responsibilities and their perception of
performing these responsibilities."

Notes

1. A comprehensive history of audit committees is included in DeZoort (1997).

2. For example, the revisions to NYSE governance rules is expected to drive


different assessments of director independence, perhaps changing audit
committee composition and charters as rules around their responsibilities and
processes are clarified (PricewaterhouseCoopers LLP, 2005).

3. Subsequently, the SEC adopted Rule 10A-3 to implement Section 301


requirements concerning audit committees.

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.

8. We called 60 audit committee members to seek their agreement on participation


in our pilot sample. Forty five audit committee members (15 each from the NYSE,
AMEX, and NASDAQ) agreed to participate in our pilot sample. For those individuals
who agreed to participate, we conducted telephone interviews to clarify the issues
under investigation, to draw out new issues, and to explain the terminology used in
our instrument.

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.

12. We recognize the imperfection in our method. Comparison to DeZoort (1997)


does not provide a direct test of the audit committee perceptions post-and pre-
SOX. The direct test requires pre-SOX and
post-SOX survey data from audit committee members serving similar types of
public companies (e.g., 2001 survey data versus 2003 survey data from audit
committee members serving similar companies).
Therefore, we cannot attribute these results solely to SOX.

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).
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Hassan R. HassabElnaby, University of Toledo

Amal Said, University of Toledo

Glenn Wolfe, University of Toledo

Paper received 2007 Best Paper Award, Ohio Region American


Accounting Association. The authors gratefully acknowledge the
helpful support received from Diana Franz, Carolyn Strand Norman,
and Benson Wier. Professor HassabElnaby acknowledges financial
support provided by the College of Business Administration at the
University of Toledo. We would like to thank Paul Subrata and
Dongmei Wang for their research assistance in the data collection
process.

Contact first author for copy of research instrument.

About the Authors

Hassan R. HassabElnaby is Assistant Profesor of Accounting at the


University of Toledo. He received his Ph.D. from Cairo University.
His research interests include financial reporting issues, debt
covenants, corporate governance, and international accounting. He
has published in a variety of academic journals including Journal of
Business Finance and Accounting, Journal of Management Accounting
Research, Critical Perspective in Accounting, Journal of
International Accounting, Auditing and Taxation.., and International
Journal of Ac counting Information Systems.

Amal A. Said is Assistant Professor of Accounting at the University


of Toledo. She earned her Ph.D. in Accounting from Virginia
Commonwealth University. Her research intersts include executive
compensation, earnings management, performance measurement,
corporeate governance, and international accounting. Dr. Said has
published in a variety of academic journals including Journal of
Management Accouting Research, Critical Perspectives in Accounting,
and Journal of Emerging Markets.

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.

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