The Association Between Audit Committee Characteristics and Financial Restatements

THE ASSOCIATION BETWEEN AUDIT COMMITTEE CHARACTERISTICS AND FINANCIAL RESTATEMENTS

INTRODUCTION

Investigating the impact of audit committee characteristics on restatements is important to policymakers, regulators, academia and investors alike because restatements, some investigated by the SEC as fraud, have shown to occur more frequently over the last decade as a consequence of the highly publicized accounting scandals. Due to the ubiquitous occurrence of management fraud and the inaction or inadequacy of corporate governance, current enterprises are faced with material amounts of financial statement line item risk and financial statement fraud. To curtail or mitigate this risk of restatement and fraudulent financial reporting, organizations should ensure that they have a formal and active corporate governance body, namely the audit committee which must independently maintain member objectivity, communicate on a frequent basis with both management and external auditors; and possess financial expertise to effectively control risk.

The audit committee characteristics examined are taken from prior literature ranging from 1996 to 2009. Many scholars have empirically investigated the relationship between audit committee characteristics and the likelihood of financial restatement and monitoring effectiveness. The specific corporate governance issues that many authors analyzed were audit committee independence, the use and number of independent directors with financial expertise on the audit committee, and frequency of meetings.

BACKGROUND

The Sarbanes-Oxley Act of 2002 was signed into law on July 30, 2002 by President Bush. The new law came after major corporate scandals involving Enron, Arthur Anderson, and WorldCom. Its goals are to protect investors by improving accuracy of and reliability of corporate disclosures and to restore investor confidence. The law is considered the most important change in securities and corporate law since the New Deal.

WHAT EFFECT DOES EACH AUDIT COMMITTEE CHARACTERISTIC HAVE ON THE PROBABILITY OF FINANCIAL RESTATEMENTS?

Audit Committee Independence

The primary responsibility of the audit committee is to serve as an independent and objective body to monitor a company's financial reporting process and internal control system (BRC, 1999). In order to properly serve one's role as an independent audit committee member, one must be free from all personal connections and/or material financial connections to the company or the company's key executives (Persons, 2009, peer reviewed). A typical expectation of audit committee effectiveness is that independent audit committee members or directors would warrant a lower likelihood of financial restatements. This expectation is supported through prior investigation of empirical evidence (Abbott et al., 2000, peer reviewed; Beasley et al., 2000, peer reviewed). Specifically, Abbott et al (2004, peer reviewed) and Persons (2009, peer reviewed) both find a negative correlation between audit committee independence and the likelihood of financial reporting restatement. These studies support the idea that an independent audit committee contributes positively to the quality of financial reporting and effective monitoring of internal controls.

Scholars such as Abbott, Beasley and Persons, support the solution that the presence of non-independent inside directors on the board greatly increases the probability of accounting fraud. Monas (2003, peer reviewed), however, suggests that companies with a majority of independent directors on the audit committee actually do not perform any better than firms which seat individuals with vested interests on the audit committee. This author explains that self-interest or one's personal interpretation of the firm's activities can affect group decision-making bodies such as audit committees. Determining what is personally favorable versus what is actually in the firm's best interest can cause confusion between members and as a result, there is a greater probability of financial restatements.

In addition, mental objectivity and more specifically the appearance of objectivity, is the essence of an audit committee member's independence. In order to justify appointment of a retired partner of the company's audit firm, this person must be seen by a reasonable investor as independent (Guy, 2002, peer reviewed). If this independence is not achieved or maintained by a retired partner, then the audit committee's responsibility of overseeing the quality of the audit is hindered and may result in ineffective financial reporting. Furthermore, in one particular study from 2001, in a sample of over 500 firms, only 74 percent of audit committees were made up entirely of outsiders (Abbott et al., 2004, peer reviewed). This study signified the fact that audit committees comprised of entirely independent directors results in a lower incidence of restatement.

Audit Committee Financial Expertise

According to the requirements of SOX, it is now mandated that the board's audit committee consist of at least one member with financial expertise. The BRC also requires that at least one member of the audit committee have accounting or financial management skills and for the members of the audit committee to be financially literate (Rezaee et al., 2003, peer reviewed). Financial experts also refer to individuals who have prior work experience in the accounting or finance fields. Financial literacy is defined as the ability to read and understand the fundamental financial statements (BRC, 1999). According to one study, for a firm whose audit committee included a financial expert, the probability of restating was about 31 percent lower than that for a control firm without such a director (Agrawal & Chadha, 2005, peer reviewed). DeZoort and Salterio (2001, peer reviewed) suggest that the audit committee's financial expertise increased the probability that detected material misstatements will be communicated to the audit committee and corrected in a timely fashion in order to avoid a possible restatement. Abbott et al. (2004, peer reviewed) also argues with these scholars that financial expertise is negatively associated with the probability of financial restatement.

Audit committees form an integral part of the governance structure of any board, thus in a sense an audit committee is like a 'financial guard dog' of stakeholders at large. In one study, it was reported that only 35% of companies possess audit committee members who are deemed as financially literate. This low percentage should raise