Academic journal article Auditing: A Journal of Practice & Theory

Getting Inside the Black Box: A Field Study of Practices in "Effective" Audit Committees

Academic journal article Auditing: A Journal of Practice & Theory

Getting Inside the Black Box: A Field Study of Practices in "Effective" Audit Committees

Article excerpt

INTRODUCTION

Most regulators and practitioners view the audit committee (AC) as an important corporate governance mechanism deemed to improve the quality of financial reporting (e.g., Dey 1994; KPMG 1999). However, in contrast to the significance typically conferred to the AC, knowledge is scant about what AC members actually do in meetings (DeZoort et al. 2002; McMullen 1996). Prior studies dealing with the effectiveness of ACs indeed mostly examine the relationship between the AC's inputs (e.g., independence and knowledge of members) and outputs (e.g., publicly reported deficiencies in financial statements). Process issues have been widely neglected. Process issues matter, however, since ACs made up of independent and knowledgeable members are unlikely to be effective if members remain passive in meetings.

For example, although the AC of Enron was made up exclusively of outside directors, included at least one financial expert, and met four times or more a year, the committee did not "probe the [external auditor] independence issue, nor did it initiate the type of communications with Andersen personnel that would have led to its discovering Andersen concerns with Enron accounting practices" (U.S. Senate 2002, 57).

This paper provides insights into practices that AC members carry out in meetings. Specifically, we seek to answer the following questions:

* What matters do AC members emphasize in meetings?

* How do AC members evaluate these matters?

* How do AC members assess responses and comments made by managers and auditors during meetings?

Given the difficulty in assessing the effectiveness of ACs from an ex ante point of view (notably before corporate scandals occur), a better understanding of practices carried out in AC meetings constitutes a valuable knowledge base to assess and perhaps improve the effectiveness of ACs. We conducted the investigation using the field-study method at three large public corporations listed on the Toronto Stock Exchange (TSX). To our knowledge, our study is the first to gather interview data in several public corporations from the key groups of individuals who attend AC meetings, namely, board members, managers, and auditors.

In addition to complying to a large extent with regulatory guidelines of the TSX (Dey 1994) and of the Blue Ribbon Committee (BRC 1999), the three participating ACs are generally viewed as effective by the individuals who attend their meetings. Our paper therefore provides information on practices carried out in normatively compliant and perceptively effective ACs. The practices that we document may provide a benchmark for attendees in other corporations to evaluate their AC. Our findings may also allow regulators to assess the extent to which practices in normatively compliant ACs meet their expectations.

We did not seek to assess the extent to which the practices detailed in the paper are common among other corporations, nor whether these practices are actually effective in preventing financial reporting deficiencies. Our study should rather be conceived as an initial step in the undertaking of research on AC practices. In particular, although skill in questioning is often seen as a prime quality of AC members, we found that a key aspect of the work carried out by audit committee members consists of asking challenging questions and assessing responses provided by managers and auditors. Whether this finding can be generalized to other normatively compliant ACs is an open question.

The paper is organized as follows. The next section locates our research within the literature on the effectiveness of ACs. The third section describes the research method. Field evidence is presented in the fourth section. The last section emphasizes the paper's main findings and suggests areas for future research.

PRIOR RESEARCH ON THE EFFECTIVENESS OF AUDIT COMMITTEES

A growing number of studies have investigated AC effectiveness in the last 15 years. …

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