University of
Manchester
University of Wales, Aberystwyth
An earlier version of this paper was presented at the EIASM International Workshop on Accounting Regulation, September 2001,University of Siena, Italy and at the 1st European Auditing Research Network Symposium, October 2001, Wuppertal, Germany. The authors are grateful to the participants for their comments.
Stuart Turley, School of
Accounting & Finance, University of Manchester, Manchester M13 9PL, UK,
email <S.Turley@man.ac.uk>, tel +44 161 275 4015, fax +44 161 275 4023.
*
Author profile:
Stuart Turley is KPMG Professor of Accounting & Finance and
Head of the School of Accounting & Finance, University of Manchester, UK.
His research interests include audit methodology, audit committees,
expectations gap, audit market and accounting regulation.
Mahbub Zaman is a Lecturer in Accounting & Finance at the
School of Management & Business, University of Wales, Aberystwyth, UK. His
research interest is in corporate governance particularly the effects of audit
committees, auditor communication and audit regulation.
Corresponding authorence to:
Prof Stuart Turley, School of Accounting &
Finance, University of Manchester, Manchester M13 9PL, UK, email
<S.Turley@man.ac.uk>, tel +44 161 275 4015, fax +44 161 275 4023 or Mahbub
Zaman, School of Management & Business, University of Wales, Aberystwyth,
SY23 3DD, UK, email <M.Zaman@aber.ac.uk>, tel +44 1970 622509, fax +44
1971 622740409.
T&Z_IJAFINALT&Z_ACEFFECTS_JUNE2K1.PDFACREVIEWCPAJAN2002.DOC.DOC
ABSTRACT
This paper evaluates the
international research evidence relating to effects of audit committees -
perceived effects which may have led to their adoption and documented effects
on the external and internal audit
(both external and internal) function, financial reporting and
corporate performance. The paper concludes that the finds
the promotion of audit committees that has led it its global explosion has been
based on claims and perceptions about their value of ACs for alleviating
weaknesses in corporate governance have not yet been fully supported by rather
than on demonstrated evidence of changes resulting from
their adoption in practice. Further enquiry to establish
actual rather than perceived effects, unintended as well as anticipated
consequences, and the organisational and institutional context in which
particular effects are encountered, would provide a more systematic and robust
basis for discerning the value of audit committees. Moreover, future research
on audit committees needs to adopt a broader perspective, drawing upon
alternative theoretical perspectives and utiliseing qualitative
research methods, and make a departure from extant preoccupation with the use
of agency theory and quantitative methods.
Key words:
Corporate governance; effects of audit committees;
financial reporting quality; corporate performance; agency theory; audit
committee research.
SUMMARY
This paper seeks to
contribute to our understanding of the value and potential of audit committees (ACs) as a governance
mechanism by bringing together arguments associated with their promotion with
evidence of their impact in practice. Theis paper
evaluates the international research evidence on
the effects associated with the introduction of ACs in private sector corporate
enterprises - perceived effects which may have lead to
their adoption and documented effects on the external and internal
audit, audit (both external and internal) function, financial
reporting and corporate performance. We conclude that No a priori position on the
efficacy of ACs for alleviating weaknesses in corporate governance is adopted,
but the international evidence on their effects is evaluated recognising that:
(i) ACs have been widely promoted as an effective corporate governance
mechanism and (ii) concerns have been expressed about the efficacy of ACs. The
paper seeks to contribute to our understanding of the value and potential of
ACs as a governance mechanism by bringing together arguments associated with
their promotion with evidence of their impact in practice.
Numerous
studies have conceptualised the adoption of ACs as a mechanism for reducing
agency costs. The empirical evidence on the formation of, and reliance on, ACs however provides very limited
support for an agency theory explanation for the existence and operations of
ACs in practice. There is some
evidence to suggest that ACs have some effect on the various aspects of external audit and internal
control, in particular the selection, remuneration and independence of auditors. The findings, however, provide limited insights on the nature of the AC’s involvement in and influence on aspects of the audit process. There are some encouraging findings regarding the
reduced likelihood of financial reporting problems when ACs are more active and more independent but
much still needs to be discovered about the process of AC influence on
financial reporting quality. Likewise, although the effects of ACs on corporate performance has not received much attention thus far, related studies on other aspects of governance suggest this may be a potential area for future research.
The
overall conclusion from the assessment of the international evidence on the
corporate governance effects of ACs is the promotion of ACs
that has led to it its global explosion has been based onthat claims
and perceptions about their their value for alleviating weaknesses in
corporate governance are not fully supported by rather
than on demonstrated evidence of changes resulting from ACtheir
adoption. The most fundamental question
concerning what difference ACs make in practice continues to be an important area for research
development. Despite
the preoccupation of many researchers with the topic, extant literature fails
to give due consideration toIn particular there is a need to consider the has not, until
recently, received much attention in the academic literature. There is,
however, a noticeable, emerging trend in recent studies examining the effects
of ACs on various aspects of corporate governance. They predominantly adopt an
agency theory perspective and give very little, if any, consideration to the organisational
and institutional context in which ACs operate. Furthermore, such
studies often tend to be based on large samples, utilising publicly available
and or questionnaire data and rarely reflect the reality of AC operation and
effects.
ACs, however,
do not operate in a vacuum and their operation and
effects cannot be adequately examined without regard to the organisational
context and nature of in which they function and the issue of power
relationships which iswithin intrinsic to that context. . There is a need to
develop theories of effective AC
operation rather than simply adopting agency theories of AC existence. Further
research to establish actual, rather than perceived, effects, and unintended as well as anticipated
consequences, and the organisational
and institutional context in which particular effects are encountered, would
provide a more systematic and robust basis for discerning the value of ACs and
contribute to public policy debates about their role in corporate governance. Such
research would however need to mark a departure from the current preoccupation
with the use of agency theory and should seek to develop theories and
explanations of AC operations and effects.
INTRODUCTION
During the last
two decades audit committees (ACs) have become a common mechanism of corporate
governance in several countries. Originally non-mandatory structures used by a
minority of corporations, more recently numerous official professional and
regulatory committees have recommended their more universal adoption by
corporate enterprises. Early recommendations for ACs made in the US (NCFFR,
1987) and Canada (CICA, 1988) have been followed by proposals for extending
their use in many countries (AARF, 1997; BCA, 1991; Cadbury, 1992; CEPS, 1995;
EC, 1996; see also Porter and Gendal, 1998 and Morse and Keegan, 1999).
Accompanying their widespread adoption, expanded roles for ACs have been
advocated and/or stipulated (see for example AICPA, 1999; APB, 2000; Blue Ribbon
Committee, 1999; KPMG 1999a; ISB, 2000; POB, 2000; SEC, 2000) and various
rules have been adopted concerning their operation (for an analysis of recent
AC regulations see KPMG, 2000).
The objective of
this paper is to evaluate the available evidence on the effects associated with
the introduction of ACs in private sector corporate enterprises. The paper
examines the research evidence relating to effects of ACs - perceived effects that which
may have lead to their adoption and documentedobservable
effects on the external and internal audit, (both
external and internal) function, financial reporting and corporate
performance. No a priori position on the efficacy of ACs for alleviating
weaknesses in corporate governance is adopted, but the international evidence
on their effects is evaluated recognising that: (i) ACs have been widely
promoted as an effective corporate governance mechanism (see next section two
below) and (ii) concerns have been expressed about the efficacy of
ACs. The paper seeks to contribute to our understanding of the value and
potential of ACs as a governance mechanism by bringing together arguments
associated with their promotion with evidence of their impact in practice.
Concerns about
the effectiveness of ACs in overcoming weaknesses in corporate governance (Lee,
2001) have been expressed by regulators, as is evident, for example, in recent
speeches by the SEC Chief Accountant, Lynn Turner (2001a, 2001b). Researchers
have also questioned whether the potential contribution of ACs to governance
has been overshadowed by intense scrutiny and criticism of the function (Turpin
and DeZoort, 1998, p.37) and suggested that ‘“there is
considerable anecdotal evidence that many, if not most, audit committees fall
short of doing what are generally perceived as their duties’”
(Sommer, 1991, p.9). Concerns have been voiced that many AC members lack
critical attributes such as expertise and experience in oversight (DeZoort,
1997, p.213), that the level of interaction between the AC and auditors is
variable, undermining the AC’s value as an effective vehicle for pursuing shareholders’
interests (Hatherly, 1999, p.62), and that whether ACs are actually discharging
their important responsibilities is not sufficiently understood (Kalbers and
Fogarty, 1993, p.25). Some have argued that the adoption of ACs may be
primarily symbolic (Kalbers and Fogarty, 1998), that although ACs fulfil the
form of regulation in reality they often lack sufficient substance (Cohen et al, 1999) and that there is a need to
evaluate more closely the possibility that the benefits associated with ACs are
more rhetorical than substantive (DeZoort, 1997, p.225). The incidence of
corporate failures involving fraud, poor accounting, inadequate internal
control and apparently ineffective monitoring by ACs accentuate these concerns
(Lee and Stone, 1997, p.100).
Given such
issues concerning the realisation of the intended benefits from having ACs as
part of the governance structure for corporations, this paper evaluates the
available evidence regarding the impact of ACs on a number of specific aspects
of governance in practice. The paper is restricted to evidence on the effects
of ACs in operation and does not set out to review the entire literature on
ACs, which is rapidly expanding and encompasses many issues. Over the years, for example, there
have been several surveys of the historical development of ACs and of the
nature of their constitution and issuesduties[1].
In drawing
together evidence from a variety of studies, it is important to recognise that
there have been major changes in the context in which ACs operate over time.
The degree of codification of best practice and the attention given to the
activities of ACs have increased. Similarly, cultural and structural differences
internationally will be likely to influence the operation of ACs.
Considerable care is therefore needed in interpreting or summarising results
from studies at different points in time and in different environments. Indeed,
one of the conclusions of the paper is that context may be of critical
importance in ensuring AC effectiveness. It is also recognised that there are
significant differences between the private sector and public sector contexts
within which ACs have been established. These differences are particularly
marked with respect to the institutional and governance arrangements the AC is
intended to contribute to and for this reason the current paper focuses on
private sector organisations alone.
The remainder of
the paper is structured as follows. The next section discusses the various
arguments that have been advanced to support the case for ACs. Drawing on the
literature advocating ACs, it identifies the benefits (desired effects)
expected from their adoption and presents these as a structure for evaluating
the evidence on AC effects in practice. In the subsequent four sections of the
paper the evidence on the (i) circumstances of adoption of ACs and their
effects on (ii) the audit function, (iii) financial reporting, and (iv)
corporate performance is evaluated. The paper ends with a summary and
conclusions together with suggestions for future research.
THE EXPECTED BENEFITS OF
AUDIT COMMITTEES
This
section of the paper briefly introduces arguments that have been advanced to
promote the case for adoption of ACs by listed companies, in order to set out a
structure of the main aspects of corporate governance where they may be
expected to have an impact. Subsequent sections then evaluate the evidence of
AC effects on each of these aspects. The arguments on the areas where ACs have
potential benefits or effects are taken mainly from what may be termed the
‘advocative literature’ on ACs, which covers a broad range of largely
professional publications promoting their adoption, and includes reports by
accountancy bodies, professional institutes, and official and governmental
committees.
The concept of
ACs is not new and can be traced back to the 19th century. Tricker
(1978) provides evidence that the Great Western Railway company had an AC in
1872 and reproduces the AC’s report to members. What is notable, however, is
the extent of their promotion and subsequent adoption by listed companies in
several countries during the last quarter century. ACs are now required by law
in Canada and Singapore and are a condition of listing on the stock exchange in
the US and Thailand. In the UK, Australia, New Zealand and South Africa,
companies listed on the stock exchange are required to state whether they have
an AC (and explain why if they do not) in
their annual report. In others such as France, Hong Kong, Japan and the
Netherlands, ACs are recommended as bin the Code of Best
pPractice
(Morse and Keegan, 1999). This recent global recognition of the AC as a
relevant governance structure in a wide variety of environments may be linked
to claims made about AC benefits on a number of aspects of corporate
governance.
Structural incentives
Arguments
associated with the promotion of ACs emphasise their potential contribution to,
for example, the relationships between directors, investors and auditors, the
discharge of accountability and directors’ execution of their
responsibilities. The following quotations illustrate these beliefs in the
value of ACs.
“There is no
doubt that the audit committees can play a major
role in bringing about greater accountability by companies and in restoring
confidence in financial reporting” (Lindsell, 1992).
“[Audit committees can] help directors meet
their statutory and fiduciary responsibilities, especially as regards
accounting records, annual accounts and the audit” (Collier, 1992).
“An audit committee is unique in that it provides a
forum where directors, management and auditors can deal together with issues
relating to the management of risk and with financial reporting obligations” (AARF, 1997).
These extracts, which are echoed in the text of many reports,
suggest ACs
influence the balance of power in accountability and audit relationships.
Whether or not this interpretation is valid, not least in terms of perceived or
implied benefits, may be revealed by the circumstances thatwhich are associated with adoption (and non- adoption) of AC structures. Although voluntary
formation of an AC does not in itself provide evidence of actual effects in
practice, it can indicate something about the motivations associated with ACs
in governance structures and the organisational
circumstances in which accountability benefits are most strongly perceived.
Studies of the factors associated with formation in non-mandatory settings can
thus provide evidence on the justification for AC requirements.
Notwithstanding
the claimed virtues of ACs and the prevalence of normative recommendations for
their adoption[2], there
remains the overriding question of what difference do they make to
organisational accountability in practice. In this context, issues of interest
include the effects of ACs on the audit function, financial reporting and
corporate performance.
Effects on the audit function.
A second aspect of the case for ACs
is their impact on corporate auditing. It has often been as a consequence of
reviews of, inter alia, alleged weakness in audit effectiveness that
recommendations for AC requirements have been made (e.g. Cadbury, 1992), and
actual outcomes in this area are therefore an important subject for evaluation.
The potential for ACs to influence a number of factors concerning external and
internal audit is illustrated by the following extracts.
“The independent
nature of the audit committee should result in the internal audit department
assuming a greater responsibility in the financial reporting process. This role
should, in turn, promote improvements in the internal control structure,
resulting in heightened integrity in the financial reporting process” (Apostolou, 1990).
“[Audit
committees have the potential to] provide a framework within which the external
auditor can assert his independence in the event of a dispute with management
[and] strengthen the position of the internal audit function, by providing a
greater degree of independence from management. . . [ACs] offer added
assurances to the shareholders that the auditors, who act on their behalf, are
in a position to safeguard their interests” (Cadbury, 1992).
“Audit committees
have an important role to play in enhancing the perceived independence of
internal and external audit from operational management” (Price Waterhouse, 1997).
It is therefore
appropriate to consider what evidence is available regarding the effects of ACs
on the audit function in practice. For example, ACs could be expected to have
an impact on the appointment, removal and remuneration of auditors, the content
and extent of audit work programmes, auditor independence and the resolution of
disputes between auditors and executive management. Also the evidence of the
effects of ACs on the internal audit function and on internal controls and risk
management needs to be evaluated.
Effects on financial reporting.
Many ACs comment
upon and approve choice of accounting policies, and they can be expected to
influence a company’s approach to financial reporting, levels of disclosure,
adherence to standard practice etc. Over many years, the advocative normative
literature has included various claims about the potential
contribution of ACs to improving financial reporting[3].
ACs are expected to monitor the reliability of the company’s accounting
processes and compliance with corporate legality and ethical standards
including the maintenance of preventive fraud controls. There is also a belief
that ACs help ensure the maintenance of proper accounting records and the
reliability of published financial information (ICAEW, 1997). Again, some
extracts indicate the intended benefits of ACs in this area.
“The audit
committee of a company’s board of directors can play a crucial role in
preventing and detecting fraudulent reporting.” (NCFFR, 1987).
“The existence of
an audit committee can strengthen the position of the finance director. He has
a forum in which to explain certain policies or disclosures relating to
external financial statements” (Marrian, 1988).
“[Audit
committees have the potential to] improve the quality of financial reporting,
by reviewing the financial statements on behalf of the board [and to] create a
climate of discipline and control which will reduce the opportunity for fraud.
[Audit committees can also] increase public confidence in the credibility and
objectivity of financial statements” (Cadbury, 1992).
An interesting aspect of research on
the financial reporting effects of ACs is the manner in which proxies for
reporting quality are created, relying on both analysis of actual reported numbers
and more negative signals of poor quality, such as regulatory action against
companies.
Effects on corporate performance.
A fourth and final area of potential impact concerns whether the existence of an AC as a governance mechanism results in better corporate performance or wealth effects for investors. It may seem tenuous to draw a direct link between the AC and company performance, but recommended management and governance structures are intended to lead to improved control and better management practices, and this in turn could be associated with positive improvements in performance on behalf of investors.
“Increasingly, companies will be expected to
demonstrate good governance in order to access the world’s capital markets. The
fact that a company has an audit committee may boost investor confidence in its
governance practice” (Price
Waterhouse, 1997).
The connection
between the particular governance structures and characteristics and corporate
performance has become a notable theme in some recent research and it is
therefore appropriate to examine whether this line of approach offers any
insights and evidence on the value of ACs in companies.
The following
four sections of the paper evaluates the research evidence on each of the
principal areas of AC effects introduced above, i.e. (i) incentives for audit
committee formation; (ii) effects of ACs on the audit function; (iii) effects
of ACs on financial reporting;
and (iv) effects
of ACs on corporate performance.
INCENTIVES FOR AUDIT COMMITTEE
FORMATION
Several studies have conceptualised AC formation as a mechanism for reducing agency costs. The agency framework (Jensen and Meckling, 1976; Fama and Jensen, 1983) can be used to derive hypotheses regarding where one would expect to find ACs as a means of reducing these costs. The link between proxies for agency costs and AC presence has been examined to establish the circumstances and organisations where ACs have been introduced voluntarily. Factors associated with agency costs that have been tested include company size, leverage, inter-corporate stockholding, national stock market listing and the extent of managerial ownership. Examination of the incentives for AC formation using these variables has produced mixed results, as illustrated in Table 1.
[Insert Table 1 about here]
Company size.
Tests of an
association between company size and the formation of ACs have reported
inconsistent findings and do not provide unequivocal support for the suggestion
that reduction of agency cost is the only important factor in voluntary
adoption of ACs. While some studies (Pincus et
al, 1989; Adams, 1997) have found a significant positive relationship
between company size and AC formation, others using similar definitions of size
have not found any significant relationship (Bradbury, 1990; Collier, 1993;
Menon and Williams, 1994). Size has been found to be significant in explaining
firms’ decisions to include a separate AC report in the annual report to
shareholders (as recommended by, for example, NCFFR, 1987; POB, 1993; Price
Waterhouse, 1993) but interestingly other agency variables were not found to be
associated with this voluntary reporting (Turpin and DeZoort, 1998).
Leverage.
Jensen and
Meckling (1976) suggest that, because of the conflicting interests of managers
and debtholders, higher leverage increases debtholders’ need to monitor
managers. Managers have incentives to control the agency cost of debt and can
do so by providing increased monitoring through ACs. Again, as shown in Table
1, the research evidence on the influence of firm leverage
on the formation of ACs is inconclusive. For example, Pincus et al (1989) found only mixed evidence
that AC audit
committee formation is associated with higher leverage and
concluded that there is no strong support
for an association between the agency cost of debt and voluntary AC
formation. In a contrasting result, Collier (1993) asserted that his UK study
is ‘“unique
in highlighting gearing as a significant factor’” (p.429). Although
Adams (1997) provides some support for Collier’s (1993) findings, all other
studies provide contrary evidence, failing to find a significant positive
relationship between leverage and AC formation (Eichenseher and Shields, 1985;
Bradbury, 1990; Menon and Williams, 1994). There is also evidence that leverage
is not a significant factor associated with the level of AC activity (Collier
and Gregory, 1999) or with the likelihood of a firm including a separate AC
report in the annual report (Turpin and DeZoort, 1998).
Other agency factors.
Within an agency
framework a number of other variables have also been tested for their
association with the formation of ACs, but overall with no more conclusive
results. For example, while some studies have found a negative relationship
between the level of management ownership and AC formation (Pincus et al, 1989; Collier, 1993), others have
not found any significant relationship (Bradbury, 1990; Menon and Williams,
1994; Turpin and DeZoort, 1998). Tests have also shown no significant
association between the voluntary formation of ACs and assets in place
(Bradbury, 1990; Collier, 1993; Adams, 1997), the number of shareholders
(Collier, 1993), and the existence of a dominant chief executive officer
(Collier, 1993). However, evidence has been reported of a significant negative
relationship between the presence of a dominant chief executive officer and AC
activity, as indicated by frequency and duration of meetings (Collier and
Gregory, 1999). Although a positive relationship between national stock market
listing and AC formation has been found (Pincus et al, 1989), suggesting that ACs may reflect the greater
information and monitoring demands of the stock market investors, this
influence does not hold when extended to voluntary disclosure of an AC report
(Turpin and DeZoort, 1998). The existence of a large inter-corporate
stockholding increases the probability that a firm will have outside directors,
thereby increasing the probability that a firm maintains an AC (Bradbury,
1990).
Existence does
not constitute effectiveness, and the mere formation of an AC does not mean
that boards of directors actually rely on ACs to enhance their monitoring
ability (Menon and Williams, 1994). Other factors, such as AC composition and
the frequency of AC meetings have been used as potential indicators of AC
impact in practice. AC activity, measured by the frequency of meetings, has
been found to increase with firm size and with increases in the proportion of
outsiders on the board, and AC membership tends to exclude managers as the
proportion of outside directors in the company increases (Menon and Williams,
1994). Adopting a definition of AC activity as the ‘number of meetings and the
average duration of these meetings’, Collier and Gregory (1999) found that AC
activity is negatively related to the presence of a dominant chief executive
officer (CEO)
and positively related to large audit firms. There is some evidence that
companies with strong CEOschief executive
officers have a higher probability of placing insiders and
interested directors on ACs than those with relatively weaker CEOs (Klein,
1998) and also that the ACs of strong CEO companies tend to meet less
frequently than their counterparts (Klein, 1998; Collier and Gregory, 1999).
However, the number and duration of AC meetings are very crude measures of AC
activity which may depend not only on the size and nature of a company’s
business, but also on the scope of the AC’s activities and more fundamentally
on the extent and nature of communication outside AC meetings.
A further
potential indicator of effectiveness that has been used to test the link
between agency cost proxies and the quality of AC monitoring is the inclusion
in the AC of members with relevant experience. Lee and Stone (1997) found that
the composition of ACs is not related to agency costs but is significantly
related to the background of the CEOchief executive
officer and AC chair, and concluded that their evidence was
inconsistent with the agency paradigm that has guided much research on
monitoring and control.
Overall,
the empirical evidence on the formation of, and/or reliance on, ACs provides
very limited support for an agency theory explanation for the existence and
operation of ACs. Given this conclusion, a number of suggestions, including the
adoption of alternative approaches, for AC research are made in the final
section of this paper.
Association with large auditing firms.
In general,
auditing firms have incentives to encourage the formation of ACs. It is argued
that an AC enhances the independence of the auditor from management, which in
turn can be important in protecting the auditor from allegations of inadequate
auditing associated with business failure or fraud (Mautz and Neumann, 1970).
Large audit firms should have more incentive to promote ACs among their clients
than smaller firms, and the rate of voluntary formation for different
categories of auditor could indicate a link with auditor incentives.
There
is some evidence of association between the use of top-tier[4]
audit firms and the formation of ACs. For example, evidence has been reported
for the US showing a positive relationship between a company being audited by a
top-tier audit firm and the existence of an AC (Pincus et al, 1989). Similarly, in circumstances where an incumbent
auditor is replaced by a smaller audit firm, an AC is not likely to be formed
(Eichenseher and Shields, 1985; Bradbury, 1990; Menon and Williams, 1994).
Although this association is consistent with many observations on the
competitive nature of the market for audit services (Pong and Turley, 1997), it
need not imply causality as both the engagement of a top-tier auditor and the
adoption of an AC could simply reflect other company variables. Despite finding
some evidence that companies with auditors outside the top-tier were less
likely to have formed ACs, Collier (1993) confirmed that having a top-tier
auditor was not a significant factor influencing AC formation. However, a
significant positive relationship has been found between top-tier auditors and AC
activity (Collier and Gregory, 1999).
Legal Protection.
ACs can
provide evidence that the board has exercised due care in performing its
prescribed duties which in turn would be expected to reduce the board’s legal
exposure (Buckley, 1979 and Maher, 1981) and there is some early evidence of a
perception amongst auditors and directors, both executive and non-executive,
that an AC provides some legal protection to the directors as evidence of due
diligence in the fulfilment of their responsibilities (Mautz and Neumann,
1970). It has also been suggested that the increase in adoption of ACs in the
US during the late 1970s was a monitoring response to increasing director
liability, primarily stemming from the Foreign Corrupt Practices Act (FCPA) of
1977, and by implication that a perceived effect of ACs is lower liability
costs (Eichenseher and Shields, 1985). However, the legal protection
explanation of the benefits and effects of ACs is likely to be influenced by
the particular legal context in different national environments and so may not
be a universal explanation for the development of ACs internationally.
EFFECTS ON THE AUDIT
FUNCTION
A second theme
relevant to evaluating the governance contribution of ACs is their effects on
the external and internal audit function. There are several research questions
of interest in this area. Does the AC affect the selection, retention and
removal of the auditor or influence the level of audit fees? Has auditor
independence improved as a result of having ACs? What is the likelihood that
the AC will support either the auditors or management in a dispute? How do ACs
impact on the internal control and risk management processes in companies? As
discussed in section two setting out the structure of this paper, many of the claimed
benefits of ACs are linked to these questions. This section discusses evidence
dealing with such issues.
Auditor Selection and Remuneration.
One potential
effect of ACs relating to external auditor appointments is that they will
exhibit a bias in favour of large auditors. A number of rationales can be
offered for this possibility. First, the exposure of AC members to large audit
firms, through their involvement as officers or directors of other companies
that employ these firms, may influence their selection against smaller less
well-known firms. Second, ACs may perceive that large firms provide higher
audit quality. Third, ACs may also perceive that directors’ legal liabilities
may be reduced if larger, more prestigious audit firms are selected.
The link between
ACs and auditor selection has been examined in the US and the limited evidence
that is available does not support the existence of an AC bias leading to
selection of large, better-known auditing firms over smaller, less well-known
firms (Kunitake, 1981, 1983; Eichenseher and Shields, 1985; and Cottell and
Rankin, 1988). While there is evidence of a tendency for companies with an AC
to select a top-tier audit firm at the time of a change in auditor, this
behaviour is also exhibited in companies without an AC and the evidence has not
suggested any statistically significant AC effect on this tendency (Eichenseher
and Shields, 1985; Cottell and Rankin, 1988).
More recent
research has reported that ACs which do not include employees and that meet at
least twice per year are more likely to select auditors specialising in the
company’s industry (Abbott and Parker, 2000). Using evidence from suspicious
auditor switches Archambeault and DeZoort (2001) reported results which do not
indicate a significant negative relationship between the suspicious auditor
switches and (i) the existence of an AC and (ii) the number of AC meetings.
However, there is a negative significant relationship between suspicious
auditor switches and (i) the proportion of independent directors, (ii) the
proportion of AC members with experience in accounting, auditing and finance,
and (iii) the size of the AC.
A related
question to that of auditor selection is the effect of ACs on auditor
remuneration. The auditing literature recognises a link between ACs, the
quality of external audit work and the audit fee, and that ACs ‘provide a link
between management and the auditor in the review of the annual accounts and the
determination of audit fees’ (Sherer and Kent, 1983, p.33). Although research
modelling audit fees has found consistent evidence that audit fees increase
with the size and complexity of an auditee (Pong and Turley, 1997), evidence of
AC effects on fees is rather limited. A difficulty is that different rationales
suggest that ACs could result in increased or decreased fees. If an AC is
effective in increasing audit quality, the impact would be to increase the
audit fee. Conversely, if existence of an AC is associated with increased
internal control strength, a reduced fee would be expected. Collier and Gregory
(1996) examined these propositions and found a significant positive
relationship for the first but no significant relationship for the second. The
authors conclude that ‘there is no conclusive evidence to suggest that [ACs
are] effective in engendering a stronger internal control environment that is
reflected in reduced audit fees’ (p.195).
Evidence ‘that
the proportion of non-executive directors has a positive and significant impact
on audit fees [which] is
consistent with increased non-executive representation encouraging more
extensive auditing’ is provided by O’Sullivan (2000)
based on an examination of the 1992 fees of 402 UK companies. Intriguingly,
however, this research did not test whether the presence of an AC affects audit
fees, but a study by the same author (O’Sullivan, 1999) using the 1995 audit
fees for a sample of 146 UK companies found no evidence that board and AC
characteristics influence auditors’ pricing decisions. Given that the 1992
sample is more likely to have contained companies with and without ACs, the
omission of an AC variable is unfortunate.
The potential for
research on AC’s
involvement and influence in audit fee determination is much broader than the
limited examination it has so far received. In this context it is interesting
to note DeZoort (1997) found that AC members ranked external auditor selection
and fee approval as relatively unimportant compared to other oversight duties.
The AC’s perceptions of auditor quality will inevitably influence its approach
to the selection and remuneration of auditors. The perception of auditor
quality is influenced by AC members’ prior exposure to different size audit
firms (Knapp, 1991). Survey results indicate that audit team factors, such as
the level of partner/manager attention given to the audit, are perceived by AC
chairs to have a greater effect on audit quality than factors such as the
relative significance of total fees paid to the audit firm. There is also
evidence that AC members perceive that (i) large audit firms are more likely to
disclose material errors that they discover than are local audit firms and (ii)
a learning curve effect in the early years of an audit appointment results in a
gradual improvement in auditor quality (Schroeder et al, 1986).
Auditor Independence.
Part of the
rationale for the adoption of ACs, both historically and in the recent past,
has been linked to the issue of auditor independence. The Cohen Commission
(1978) on Auditors’ Responsibilities, established by AICPA, stated that the AC
is the best vehicle for establishing and maintaining balance in the
relationship between the independent auditor and management. An important
research question is whether evidence can be provided that ACs do improve
auditor independence and a limited number of studies have addressed this issue.
Some evidence on
ACs and auditor independence is provided by studies that have examined the
impact of AC existence on users’ perception of independence. The presence of
ACs has been found to create a perception of enhanced auditor independence and
more reliable financial reporting among users of financial statements (Gwilliam
and Kilcommins, 1998). Similarly, a small sample study of 20 bankers
considering loan applications identified greater reliance on financial
statements given information on the presence of ACs than given information on
their absence (Tsui et al, 1994). It
is, however, difficult to draw general conclusions from these exploratory and
survey studies. The observed effects could be due to the fact that the
subjects’ attention was drawn specifically to the existence of an AC or
otherwise, and may not represent normal decision processes in practice.
A second source
of evidence on the contribution of ACs to auditor independence is their
behaviour in situations where there is a dispute between the external auditor
and executive management. Confidentiality limits the research potential in this
area, but a limited amount of questionnaire and experimental test results are
available. In an early experimental survey, Knapp (1987) examined factors
affecting AC support for auditors, rather than management, in audit disputes.
The results suggested that AC members, on average, tended to support the
auditors, rather than management, in the conflict scenarios where the dispute
involved objective technical standards and the auditee was in a weak financial
position. More recent similar work identified greater independent director
experience and greater audit knowledge as associated with higher AC support for
an auditor who advocated a ‘substance over form’ approach in a dispute with
client management (DeZoort and Salterio, 2000). Given the evidence of
significant disagreements between executive management, external auditors, and
AC chairs concerning the appropriate level of financial statement disclosure
(Haka and Chalos, 1990), the effects of ACs on auditor independence may be much
more complex than can easily be captured in survey studies.
Some have cast
doubt on the ability of ACs to improve auditor independence, arguing that ‘in
respect of financial reporting matters, we now have audit committees forming
opinions of (accounting) opinions rather than opinions based on dated financial
facts. Given this, the claim that
audit committees enhance the technical quality of financial statements is a
nonsense’ (Wolnizer, 1995, p.63). Spira (1999) shares this cynicism in
questioning the potential of ACs to improve auditor independence and suggests
that ACs may have an unarticulated role in providing an arena for the display
of independence.
Audit process and reporting.
Given the changes
in the methodologies of audit firms (Bell et
al, 1997; KPMG, 1999b; Lemon et al,
2000) and concerns about the external reporting of audit findings (Hatherly et al, 1998; Manson and Zaman, 2000),
the impact of ACs on the external audit process and on auditor communication is
an important issue. Although there is some evidence that auditors gather
information on corporate governance primarily at the preplanning and the planning
stages (Cohen and Hanno, 2000), there is limited research evidence of AC
effects on the audit process. Practising auditors have characterised their
meetings with the AC as normally entailing the auditor reporting on significant
issues, rather than an active two-way, or proactive process on the part of the
AC (Cohen et al, 1999). Interestingly
the auditors believed that ACs are currently currently not
effective and not powerful enough to resolve contentious matters with
management.
Some indication of
the effects of ACs on the outcome of the audit may be gleaned from Beattie et al’s (2000) investigation of
interactions between finance directors and audit engagement partners in the UK.
The authors found that changes to financial statements are not associated with
the existence of an AC. ‘Change occurred in 56% of cases where no audit
committees existed and in 57% of cases where an audit committee did exist,
suggesting that, in practice, audit committees may not have some of the
potential benefits identified in the Cadbury Report’ (p.193). However, ACs were
found to reduce the confrontational intensity of interactions between auditors
and management by increasing the level of discussion and reducing the level of
negotiation. While in interviews, practising auditors state that their
discussions with ACs or boards never affect the type of audit report issued
(Cohen et al, 1999), investigation
for a link between AC independence and audit reporting has found that the
greater the percentage of grey directors on the AC, the lower the probability
that the auditor will issue a going-concern audit qualification (Carcello and
Neal, 2000).
Internal controls and risk management.
While there are
numerous articles in the professional literature discussing the control and
risk management roles of ACs, the academic literature on the impact of ACs in
these areas is rather limited. It is argued that ACs should be responsible for
overseeing management’s assessment of business risk and that ACs can strengthen
management’s ability to identify and assess both internal and external risks
and hence potential opportunities and challenges facing the entity in achieving
its operating, financial, and compliance goals. It is also recognised that the
AC can strengthen the internal audit function (COSO, 1994) and that internal
audit can in turn be an important resource to the AC in fulfilling its
responsibilities. Internal auditors can provide a variety of services to the
AC, such as assurance about the adequacy and effectiveness of the internal
control system and about compliance with corporate policies, procedures and
codes of conduct (Rezaee and Farmer, 1994).
Evidence based on
experience in an individual company is provided by Allison (1994) who
illustrates a case where the AC has become an integral element in the internal
control system of an enterprise. Analysis of 11 AC reports, for the US fiscal
year 1990, found that all the companies reported that their ACs review and
monitor internal controls. (Rezaee and Farmer, 1994, p.18). An interesting
consideration in this context is the suggestion that internal auditors and
managers believe that where the internal audit function is outsourced it might
be difficult for ACs and boards to come to an overall opinion on the
effectiveness of internal control (Assiri and Sherer, 2000).
A question
related to the review of internal control structure, is the role of ACs in the
hiring and firing of the chief internal auditor. In the US, for example, the
NCFFR (1987) advocated that ACs should review the appointment and dismissal of
the chief internal auditor. The limited empirical evidence on this issue, from
a survey of US chief internal auditors, suggests that ACs are involved in
hiring and firing decisions in 33% and 38% of companies respectively (McHugh
and Raghunandan, 1994). Only in 14% of such cases did the chief internal
auditor have unrestricted access to the AC, and, concerning the question of
independence, the authors found that a strong majority of internal auditors,
particularly those in smaller companies, perceived that vesting the
hiring/firing authority with the AC would enhance internal auditor
independence, improve oversight by the AC, and improve the ability of the
internal auditor to get action on audit findings.
Research evidence on the effects of ACs
on internal controls and risk management is very limited. Survey evidence from
auditors and directors in Singapore where ACs are mandatory reported that,
although the existence of a strong AC is perceived to enhance the effectiveness
of an external audit and to help the company prevent and detect errors in the
financial statements, there was some doubt among respondents about whether a
strong AC would help the company to prevent and detect control weaknesses and
fraud (Goodwin and Seow, 2000).
Although it has been reported that AC
members rank internal control evaluation as the most important AC oversight
responsibility after financial statement review (DeZoort, 1997), a difficulty
with researching this area is identifying generalised signals of internal
control impact. One approach is to compare AC members’ judgements with those of
other groups. In an examination of whether experience affects AC members’
oversight judgements, it was found that AC members with financial experience made
internal control judgements more like auditors than did members without
experience. Thus suggesting that prior work experience can make a difference in
AC member oversight of internal controls and risk management (DeZoort, 1997).
Some evidence is available that the more independent the AC from executive
management the more active its approach to internal audit. This higher degree
of activity on internal audit matters did not however extend to involvement in
decisions to dismiss the chief internal auditor (Scarbrough et al, 1998).
FINANCIAL REPORTING EFFECTS
A further area of significant interest is the effect of ACs on financial reporting quality. Despite the frequent assertions that ACs are effective overseers of the financial reporting process, there is limited substantive evidence that ACs, as opposed to other governance characteristics, enhance the quality of financial reporting.
The principal
question is whether financial reporting is different in the presence of ACs
compared to their absence. Identifying signals of financial reporting quality
may be difficult but can be attempted either through analysis of actual
reported financial numbers, to consider whether, for example, ACs improve
companies’ earnings quality, or through negative signals of problems in
financial reporting, for example instances of apparent or alleged errors, fraud
and irregularities (see Table 2). The growing volume of research in this area
generally falls into two different types: studies which have examined the
effect of AC presence (absence) on various measures of financial reporting
quality (for example, DeFond and Jiambalvo, 1991; Beasley 1996; Dechow et al 1996; McMullen 1996 and Peasnell et al, 1999); and those more concerned
with testing particular AC characteristics, such as meetings, independence and
members’ backgrounds (for example, Abbott, Park and Parker, 2000; Abbott,
Parker and Peters, 2000; Beasley et al,
2000; Parker, 2000; and Windram and Song, 2000).
[Insert Table 2 about here]
Evidence
of a positive link between AC existence and the quality of financial reporting
has been provided by analysis indicating that earnings overstatements, as
indicated by prior period adjustments to correct errors in previous reports,
are less likely among companies that have ACs (DeFond and Jiambalvo, 1991) and
that companies manipulating earnings are less likely to have an AC (Dechow et al, 1996). Evidence has also been
documented that ACs are associated with a reduced incidence of errors and
irregularities in financial statements, as identified by a number of indicators
of financial reporting quality: shareholder litigation alleging fraudulent
financial reporting; correction of reported quarterly earnings; SEC enforcement
actions; illegal acts; and auditor turnover involving a client-auditor
accounting disagreement (McMullen, 1996). In the UK, action against companies
by the Financial Reporting Review Panel (FRRP) for defective financial
statement has been used as an equivalent signal to SEC Enforcement Actions in
the US. While Peasnell et al (1999)
did not find a significant relationship between FRRP action and presence of ACs
for a sample of 47 UK firms subject to FRRP action, Windram and Song (2000)
found a significant negative relationship between FRRP action and (i) the financial
literacy of the AC, (ii) the frequency of AC meetings and (iii) the number of
outside directorships held by AC members.
What is
not resolved by these studies on reporting quality is whether the improvements
in financial reporting are specifically due to the existence of ACs or are a
product of other corporate characteristics. A particularly interesting finding
relating to this is that the presence of ACs does not significantly affect the
likelihood of fraud (Beasley, 1996), although the proportion of outside members
on the board of directors was found to be lower for firms experiencing
financial statement fraud than for no-fraud firms and a significant negative
relationship was also found between the likelihood of fraud and both the
percentage of grey directors on the board and percentage of independent
directors. Although based on a small sample of only 26 companies, the results
suggest board composition, rather than the presence of an ACs, may be
significantly more likely to reduce the likelihood of financial statement
fraud.
In the UK
context, the association between board composition and earnings management
activity in both the pre- and post-Cadbury periods has been examined (Peasnell et al, 2000). Results for the
post-Cadbury period indicate less income-increasing accrual management to avoid
earnings losses or earnings declines when the proportion of non-executive
directors is high. However, no evidence was found of an association between the
degree of accrual management and the proportion of non-executive directors in
the pre-Cadbury period. Consistent with Beasley’s (1996) finding, it appears
the proportion of non-executive directors is significant in explaining reduced
earnings management rather than the increasing use of ACs in the post-Cadbury
period (Peasnell et al, 2000).
Neither of the
above studies examined the effect of AC characteristics, but evidence is now
being reported that AC characteristics are important in explaining, inter alia,
cross-sectional differences in financial reporting quality (Wright, 1996; Klein
2000; Abbott, Park and Parker, 2000; Abbott, Parker and Peters, 2000; Parker,
2000). Analyst ratings of financial reporting quality are higher for companies
with lower percentages of directors, particularly AC members, who are either
relatives of officers or have some business relationships with the firm, i.e.
grey directors; and firms violating SEC reporting standards have a
significantly higher percentage of insiders and ‘grey’
area
directors on their AC (or entire board in the
absence of an AC) (Wright, 1996). AC independence is also positively
related to the informativeness of financial accounting information for equity
valuation and negatively related to the degree of bargaining power that the CEOchief
executive officer commands over the board (Klein, 2000).
Recent studies
have reported that independent and active ACs are associated with a decreased
likelihood of both fraud and non-fraudulent earnings misstatements (Abbott,
Park and Parker, 2000; Abbott, Parker and Peters, 2000), but also
that AC size and AC expertise are not significantly related to reduced earnings
misstatements (Abbott, Parker and Peters, 2000). Similarly, income-increasing
accounting has been found to be constrained by independent ACs and by public
disclosure of ACs responsibility for monitoring financial reports (Parker,
2000). Among companies subject to SEC AAERs, Beasley et al (2000) found that fraud firms have fewer ACs, less
independent ACs, fewer AC meetings and less internal audit support than non-fraud
firms.
While some of the
variables representing AC characteristics have been associated with mixed
findings, it is noticeable that both AC meetings (a measure of AC activity) and
the independence of AC members have consistently been found to be associated
with a lower likelihood of problems in financial reporting quality (see Table 2). This
result indicates that the character and operations of ACs may be fruitful areas
for research into the conditions under which the anticipated benefits of ACs can
be realised.
A final
area of potential AC impact is corporate performance. As noted earlier, it is
important to be clear whether particular benefits or effects are due to the
existence of ACs as such or if they are a result of other features of corporate
governance. A growing body of literature has examined the relationship between
board characteristics and corporate performance. Positive findings on this
issue could imply that ACs, being a subcommittee of the board with a majority
of outside directors, might lead to similar performance effects.
Taking as a
starting point the idea that good corporate governance is equated with good
corporate performance, some researchers have examined whether the inclusion of
outside directors on the board enhances corporate performance and the returns
to shareholders. Examples of the available evidence relevant to this issue
include the finding that the stock market reaction to announcements of poison
pills is positive when the board has a majority of outside directors and
negative when it does not (Brickley et al,
1994), and that characteristics of the board of directors’ and ownership
structure are significant determinants of the likelihood that a firm is a
target of hostile take-over attempts (Shivdasani, 1993). Results of this nature
are consistent with the proposition that outside directors do perform an
important role in corporate governance and serve the interests of shareholders.
A relevant avenue
of research, though not one yet fully exploited, to examine AC impact on
performance is the investigation of the links between board membership
characteristics and shareholder wealth effects. Some studies have distinguished
between inside directors, affiliated outside directors, and independent outside
directors[5].
As an example, in a study of the returns to shareholders of bidding firms in
tender offers, Byrd and Hickman (1992) reported that the average announcement
date abnormal return is significantly less negative for bidding firms on whose
boards at least half the seats are held by independent outside directors.
Examination of the wealth effects accompanying appointments of an outside
director by management indicates that the appointment is accompanied, on
average, by significantly positive excess returns, although most boards are
numerically dominated by outsiders before the appointment. Thus providing
further evidence that outside directors are viewed as likely to act in the
interests of shareholders (Rosentein and Wyatt, 1990).
Future
research on the relationship between ACs and corporate performance should also
recognise the conclusions from other general reviews addressing the
relationship between board composition, board leadership structure and
corporate performance. Dalton et al (1998)
found little consistency in results and concluded that, in general, neither
board composition nor board leadership structure has been consistently linked
to corporate financial performance. This view is supported by Weisbach and
Hermalin’s (2000) conclusion, based on a survey of the economic literature on
boards of directors, that board composition is not related to corporate
performance, although board size is negatively related to corporate
performance.
Some evidence on
the wealth effects specifically related to ACs is provided by Wild (1994 and
1996) in his test of the proposition that the formation of the AC enhances
earnings quality. It was hypothesised that if the AC enhances the quality of
reported earnings, then release of earnings reports after AC formation would be
accompanied by greater revisions in users’ expectations of future company
performance than before the formation of the AC. The findings indicate a
significant increase in stock returns variability, specifically 20% greater
than for earnings reports prior to AC formation, leading to a conclusion that
the “evidence is characteristic of effective audit committees that
substantially enhance the quality of reported earnings” (p.274).
SUMMARY
& CONCLUSIONS
This paper
has evaluated evidence on the incentives for AC formation and the effects of
ACs on external and internal audit, financial reporting and corporate
performance. Concluding observations based on an evaluation of the evidence
presented on each of these aspects are summarised and suggestions for further
research are made in this section.
An initial
general observation is that the predominant emphasis in extant research is on
testing incentives for the use of ACs within an agency framework, where the
underlying proposition is that an effect of the AC will be to reduce agency
costs. Overall, however, the empirical evidence that the use of ACs are
intended to achieve a reduction in agency costs is very limited. It is
unsurprising that certain company characteristics used as agency proxies are
correlated strongly with the adoption of ACs and the existence of such
relationships does not point unambiguously to motives for the use of ACs. An
important research question that is yet to be addressed in the AC literature is
even if ACs do indeed reduce agency costs, why is preference given to ACs over
other means of achieving the same goal?
While research
attempting to identify generalised patterns, for example of AC formation,
undoubtedly has value, there is also a case for focusing attention on where
practice deviates from the norm. Clearly there are variations in the degree of
effectiveness between ACs and the context and nature of AC activities which
appear to be associated with the greatest impact should be investigated more
fully. This focus might suggest rather different types of research than those
that have so far been prominent. To an extent it could be said that much of the
research to date has been developed around theories of the existence of ACs but
that for the future there is a need to give greater attention to possible
theories of operation.
There is
considerable scope for further study of AC effects on all aspects of the audit
process. Future research into the effects of ACs on the audit function would
benefit from the adoption of qualitative methodology, employing the use of case
studies and interviews. In particular, cases may allow identification of
specific independence and audit process effects and recognition of the complex
environment of the AC and the interaction of the AC with other parties such as
executive management and auditors. There are a number of reasons for believing
this area of effect could be of particular significance. First, in the context
of the debate on corporate governance, the interaction between the AC audit
committee and auditors is potentially an important means of
enhancing overall governance. The issues surrounding auditor independence and
the appointment and retention of auditors, including the negotiation of fees
and the provision of non-audit services, need to be examined in more detail.
Second, communication between the AC and auditors clearly has the potential to
influence auditors’ work programmes, both through direct suggestion and through
the onus it places on auditors to be able to justify their intended approach.
Potentially the audit process is made more visible than previously. Third, as
the methodologies employed by the audit firms continue to evolve, and
particularly in recent years as a tension has arisen between the ‘attest’ and
‘consultancy’ attributes of the audit (Jeppesen, 1998), the degree to which the
methodologies meet the expectations of ACs will be of interest. Finally, in
exercising influence over both internal control and external audit there are
different potential strategies available to ACs, – with varying implications for external
audit. How ACs make relevant choices and the circumstances in which, for instancesay,
external audit costs are increased or decreased should be investigated.
The evidence on
the link between AC presence, and more recently characteristics, and financial
reporting quality raises some important questions. Similarly, although the
research on board composition suggests that ACs, as a subcommittee of the board,
may fulfil a useful role, they do not provide direct evidence of AC effect on
corporate performance. Extant research provides very little understanding of
the processes through which governance structures affect financial reporting
quality and corporate performance. While, possibly encouragingly, there is some
evidence of a correlation between financial reporting characteristics and
governance arrangements, however, further research is necessary to establish
issues relating to the processes and impact unique to ACs. It is important to
establish whether the effects on financial reporting and corporate performance
are simply due to the mix of insiders and outsiders on the board or whether
particular governance structures such as ACs really make a difference.
Notwithstanding
the extant research on the incentives for adoption of ACs and their effects on
the audit function, financial reporting and corporate performance, there has
been limited progress in understanding the operations and effects of ACs. This situation major
shortcoming may be attributed to two facts. First, a disappointing
feature of much of what has been researched on ACs is that it has resulted from
studies where the primary subject matter has indeed not been ACs but rather
topics such as independence, auditor tenure and fees, and financial reporting
quality. In such studies, researchers tend merely to add a variable relating to
AC to their model of, for example, audit fees or financial reporting quality.
The fact that AC issues are a secondary concern in the research design inevitably
limits the contribution such studies make to the understanding of AC operations
and effects.
Second,
the fact that extant AC research has primarily adopted a positive methodology
and predominantly relied upon quantitative methods has also significantly
limited the contribution. Studies examining the effects of ACs on various
aspects of corporate governance predominantly adopt an agency theory
perspective and give very little, if any, consideration to the institutional
and organisational context in which ACs operate. ACs do not operate in a vacuum
and their operation and effects cannot be adequately examined without regard to
the organisational context in which they function and power relationships which
are intrinsic to that context. The ways in which ACs affect behaviour within
organisations is an open and potentially interesting area for future researchresearch..
AC effects need to be
examined in the context in which they operate so that due account can be
taken of the relational dynamics in and around the AC, and the interaction of
the AC with other internal structures of the entity. It should also be
recognised that the personality of AC members, particularly that of the AC
chair, and the underlying corporate culture are important factors affecting the
operation and effects of ACs. Within the individual organisation, these factors
may be particularly important in determining AC impact and their link to AC
effects warrants investigation.
Future
research on ACs needs to make a departure from the extant preoccupation and
adopt a broader perspective, draw upon alternative theoretical frameworks and
utilise qualitative research methods. Extant AC studies are often based on
large samples, utilising publicly available and or questionnaire data and rarely
attempt to reflect the reality of AC operation and effects. The effects of ACs
cannot be adequately investigated using solely questionnaire surveys and
analysis of databases. Qualitative research methods incorporating case studies
and interviews provide a significant potential for researching the operations
and effects of ACs in the organisational and institutional context in which
they operate. It has to be acknowledged that there are significant difficulties
in conducting qualitative research, for example, in access to research sites,
ensuring consistency and interpreting qualitative data. NonethelessNonetheless,
such research would be expected to complement rather than replace other
research approaches and methods, particularly in providing insights about the
operational arrangements and interaction between ACs and other aspects of
governance..
In the introduction to
this paper reference was made to a number of concerns about the operation of
ACs in practice that have been expressed by practitioners, regulators, and researchers. The
overall conclusion from the assessment of the international evidence on the
corporate governance effects of ACs is that while some beneficial effects have been
established, on many areas of expected benefits the findings thus far are either inconclusive or
very limited. It remains that much of the case for advocacy of ACs as a
generalised solution to certain business problems needs still
has to be supported with appropriate additional evidence.
Further research to establish actual rather than perceived effects, unintended
as well as anticipated consequences, and the organisational and institutional
context in which particular effects are encountered, would provide a more
systematic and robust basis for discerning the value of ACs and contribute to
public policy debates about their role in corporate governance. Such research
would however need to make a break with the apparent reliance on the
application of agency theory and should seek to develop theories and
explanations of AC operations and effects.
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Table 1: Agency Studies of AC
Adoption/Activity
|
Variable / Study |
Pincus et al (1989) |
Bradbury (1990) |
Collier (1993) |
Menon & Williams
(1994) |
Adams (1997) |
Turpin & DeZoort
(1998) |
Collier &
Gregory (1999) |
|
Company size |
+SR |
NSR |
NSR |
NSR |
+SR |
+SR |
NSR |
|
Leverage |
NSR |
NSR |
+SR |
NSR |
+SR |
NSR |
NSR |
|
Large firm auditors |
+SR |
NSR |
NSR |
NSR |
|
|
+SR |
|
Management ownership |
-SR |
NSR |
-SR |
NSR |
|
NSR |
|
|
Assets in place |
|
NSR |
NSR |
|
NSR |
|
|
|
Inter corporate
holdings |
|
+SR |
|
|
|
|
|
|
Dominant
CEO |
|
|
NSR |
|
|
|
-SR |
|
No of shareholders |
|
|
NSR |
|
|
|
|
|
Stock market listing |
+SR |
|
|
|
|
NSR |
|
[Note: +/-SR =
positive/negative significant relationship; NSR= no significant relationship.]
|
Signal of reporting quality
|
Studies |
AC related variables
|
% NEDs on Board |
|||||
|
Existence |
Size |
Meetings |
Independence |
Expertise |
AC Outside Directorships |
|||
|
Fraud (SEC Action) |
Beasley (1996) |
NSR |
|
|
|
|
|
-SR |
|
Dechow et al
(1996) |
-SR |
|
|
|
|
|
-SR |
|
|
Beasley et al (2000) |
-SR |
|
-SR |
-SR |
|
|
|
|
|
McMullen (1996) |
-SR |
|
|
|
|
|
|
|
|
Abbott, Park and
Parker (2000) |
|
|
-SR |
-SR |
|
|
NSR |
|
|
FRRP Action |
Peasnell et al (1999) |
NSR |
|
|
|
|
|
|
|
Windram and Song
(2000) |
|
|
-SR |
|
-SR |
-SR |
-SR |
|
|
Earnings Management |
Abbott, Parker and
Peters (2000) |
|
NSR |
-SR |
-SR |
NSR |
|
NSR |
|
Parker (2000) |
|
|
-SR |
-SR |
|
|
-SR |
|
|
Peasnell et al (2000) |
NSR |
|
|
|
|
|
-SR |
|
|
DeFond and Jiambalvo
(1991) |
-SR |
|
|
|
|
|
|
|
|
Audit Qualification |
Carcello and Neal
(2000) |
|
|
|
-SR |
|
|
|
[1] Over the years, for example, there have been several surveys of the historical development of ACs and of the nature of their constitution and duties. See for example Birkett (1986), Collier (1996) as well as Mautz and Neumann (1970), Lam (1975), Lam and Arens (1975), Lovedal (1977), Tricker (1978), Marrian (1988), DeZoort (1997), Lee and Stone (1997), and Porter and Gendal (1998).
[2] A wide range of professional firms, accountancy bodies and regulatory committees has variously supported the adoption of ACs. For further details see BCA (1991), CEPS (1995), CICA (1981), Cohen Commission (1978), Colbert (1989), English (1994), Colegrove (1976), Ernst & Whinney (1987), ICAEW (1997), Kollins et al (1991), Lindsell (1992) and Mautz and Neumann (1970).
[3] See for example Williams (1977), Baruch (1980) Marsh and Powell (1989), APB (1994) and ICAEW (1997).
[4] The term top-tier refers to the Big-5 as well as the previous Big-6 and Big-8 audit firms.
[5] See Vicknair et al (1993) for a discussion of these distinctions in AC research.