The Association Between Audit Committee Characteristics, the Contracting Process and Fraudulent Financial Reporting

Abstract

In an effort to restore investor confidence in the wake of recent financial reporting scandals, the Sarbanes‐Oxley Act of 2002 mandates that audit committees be fully independent and have at least one financial expert. The SEC adopted rules implementing these Sarbanes‐Oxley provisions. This paper contributes to the literature on the association between audit committee characteristics recommended by SOX and the likelihood of fraud in two ways. First, we focus on audit committee composition and the extent of the underlying nature of the firm (e.g., firm size, growth) and the contracting environment (e.g., managerial ownership, leverage) of the firm on the likelihood of fraud. In particular, we find that the likelihood of fraudulent financial reporting is negatively related to audit committee independence, number of audit committee meetings and managerial ownership and positively related to firm size and firm growth opportunities. Second, we separately examine firms with totally independent audit committees and fraudulent financial reporting. This sample is interesting because these are firms that had good corporate governance and yet still had fraudulent financial reporting. By separately examining firms with totally independent audit committees, we find that the likelihood of fraudulent financial reporting given a totally independent audit committee is inversely related to the level of managerial ownership and the number of audit committee meetings.

The Impact of Managerial Opportunism on Earnings Reliability

“…In this study, audit committee independence is found to be insignificant to the reliability of accounting earnings. This observation is consistent with the overall conclusion of Owens-Jackson et al (2009) which state that even a "fully independent audit committee does not totally eliminate fraudulent financial reporting" (p. 62), though the likelihood of fraud is reduced by committee members independence. In addition, the governance structure of a firm may not be effectively reinforced in the presence of high audit committee independence if opportunistic compensation scheme is deployed (as documented in the regression test on ESOS j,t above).…”

The Influence of Board of Commissioners and Audit Committee Effectiveness, Ownership Structure, Bank Monitoring, and Firm Life Cycle on Accounting Fraud

“…Bronson et al (2009) find that the advantage of the independent audit committee can only be achieved when the whole audit committee is really independent (100% independent). Jackson et al (2009) also conclude that the probability of fraud is negatively associated with the independent audit committee.…”

“…If audit committee has an effective role, company should present higher quality of financial reports. Bronson et al (2009) and Jackson et al (2009) state that the effectiveness of the audit committee will also affect some characteristics which are proven by previous study: independence, activity, size, and competence of the audit committee. The purpose of audit committee is to monitor management performance, including company's operations and financial reporting.…”

“…Rezaee also includes some frauds in some American companies, due to the ineffectiveness of audit committee. The study of Jackson et al (2009) finds that the probability of fraud occurrences in financial reports is related to the audit committee's independence and the number of meetings of the audit committee.…”

The Relationship between Information Asymmetry and the Quality of Audit: An Empirical Study in Istanbul Stock Exchange

“…These factors stand as non-financial variables that can be used for measuring information asymmetry. The existence and the independence of audit committee are quite important for increasing the quality of information and providing exact information (Jackson, Robinson, & Shelton, 2009). Especially the independence of the board of directors is critical in terms of the quality of financial information (Quan, 2007).…”