The Audit Committee as a Key Corporate Governance Mechanism

INTRODUCTION There has been considerable interest in recent years in the role of the audit committee as a key corporate governance mechanism. Corporate governance committees and regulators around the world have addressed the need for effective audit committees, with many requiring that listed companies must have a committee (European Union (EU) 8th Company Law Directive, 2006; Smith Report, 2003; United States (US) Congress, 2002). Recognising that the existence of a committee does not guarantee that the committee will be effective, attention has moved to the composition and ctivities of audit committees. Recommendations have focused on the independence and expertise of committee members and the frequency of committee meetings (Smith Report, 2003; Australian Stock Exchange Corporate Governance Council (ASX), 2003; National Association of Corporate Directors (NACD), 1999). However, research suggests that there is considerable divergence in the recommended structure and role of audit committees across different jurisdictions (Collier & Zaman, 2005). Following the well-publicised corporate collapses (such as Enron and WorldCom in the US and HIH Insurance and Harris Scarfe Ltd n Australia), the efficacy of audit committees has been challenged (Turley & Zaman, 2004). Legislators have responded by expanding the responsibilities of audit committees and placing greater emphasis on the role that they play in enhancing audit independence (US Congress, 2002; Commonwealth of Australia, 2004). However, research evidence that demonstrates the value of audit committees is sparse, particularly outside North America (Spira, 2003). As Spira (2003, p. 180) notes, audit committees ‘are assumed, with very little proof, to be an effective governance mechanism’. The objective of this study is to examine the mpact of the existence of an audit committee, the frequency of audit committee meetings, and the auditor’s attendance at those meetings, on various aspects of the external audit. Our focus is on the viewpoint of external auditors. We use an experimental design involving a company with a newly formed audit committee and we manipulate the frequency of meetings and the auditor’s attendance at meetings. We measure the expected impact of these factors on perceptions of audit risk, audit efficiency, audit testing, auditor–client conflict resolution, audit quality and audit fees.

The study was undertaken in Australia between November 2003 and February 2004 and hence reflects the perceptions of auditors after the enactment of the Sarbanes-Oxley Act in the US (US Congress, 2002) and during the period when the Australian governmentwas implementing stronger governance legislation in the form of CLERP 9 (Commonwealth of Australia, 2004). Our study is significant for a number of reasons. First, Turley & Zaman (2004) note that the impact of audit committees on the external audit process is an important issue about which there is limited research evidence.

Prior research suggests that auditors perceive audit committees to be lacking in effectiveness and power, playing a passive role rather than engaging in an active two-way 52 J. Stewart and L. Munro Int. J. Audit. 11: 51–69 (2007) © 2007 The Author(s) Journal compilation © Blackwell Publishing Ltd. 2007 exchange with auditors (Cohen et al. , 2002; Turley & Zaman, 2004). However, these findings may not hold in the current era of greater emphasis on audit committees, and further research is therefore needed. Second, we extend prior research that has tested associations between audit committees and udit fees using traditional audit fee models (Goodwin-Stewart & Kent, 2006; Abbott et al. , 2003; Sharma, 2003; Carcello et al. , 2002; Coulton et al. , 2001; Goddard & Masters, 2000; Collier & Gregory, 1996). While the results of these prior studies have been mixed, they have generally assumed that a positive association between audit fees and audit committee characteristics suggests an increase in the demand for a higher quality audit by committee members. The contribution of our study stems from its focus on the supply of audit services and the perceptions of auditors involved with audit ommittees. As with any experimental design, the ability to manipulate variables is constrained by the number of participants in the study. This problem was enhanced because we required our participants to be partners or managers with audit committee experience and the availability of auditors at this level is restricted. We chose to hold constant audit committee independence and expertise and to manipulate the frequency of audit committee meetings and auditor attendance at meetings. There are three reasons for this choice. First, recent Australian evidence indicates a positive association etween audit fees and both the existence of an audit committee and the frequency of audit committee meetings (Goodwin-Stewart & Kent, 2006). Hence, further exploration of this finding from a supply-side perspective is warranted. Second, audit committee meetings have consistently been found to be associated with higher financial reporting quality (Turley & Zaman, 2004). Financial reporting quality should be an outcome of a high quality audit and hence the impact of audit committee activity on the audit process is worthy of further investigation. Third, according to DeZoort et al. (2002), diligence s the primary process factor needed to achieve audit committee effectiveness, building on a foundation of inputs associated with composition, authority and resources. As we are concerned with the impact of the audit committee on aspects of the audit process, we chose to focus on audit committee process, manipulating meeting frequency as a proxy for diligence. We find that auditors expect the formation of the audit committee to reduce audit risk, with a greater reduction in risk when the committee meets more frequently and the auditor attends those meetings. The impact of the audit committee on audit fficiency is expected to be minimal but there are some differences based on meeting frequency. There is also no perceived impact on audit testing and on budgeted audit hours for the more junior members of the audit team. The hours for the manager and partner are expected to increase, and this is related to the frequency of meetings and the auditor’s attendance at meetings. The audit committee is expected to provide assistance to the auditor in resolving conflicts with management, but there are no significant differences based on meeting frequency or auditor attendance at meetings. Participants expect the existence of an udit committee to lead to some improvement in audit quality but, again, this is not affected by frequency of meetings or auditor attendance. Auditors anticipate an increase in audit fees associated with both meeting frequency and audit partner attendance at the meetings. While the generalisability of our findings to other situations is uncertain, our results provide preliminary evidence of the effect of audit committees, audit committee meeting frequency and the auditor’s attendance at meetings on a number of aspects of the external audit. The study has implications for regulators, boards, audit ommittee members and external auditors as they seek to balance the various corporate governance mechanisms to achieve greater accountability. The remainder of the paper is organised as follows. The next section discusses the background to the study, the results of prior research and the development of our research questions. This is followed in the third section by a description of our research method. The fourth section reports and discusses the findings of the study while in the final section some conclusions are drawn, the implications of the study are discussed and opportunities for further research are noted.