EXECUTIVE SUMMARY: The objective of this study was to analyze the value that audit committees added to small commercial banks. The authors were able to evaluate specific internal control questions that assessed the benefit of having an audit committee. The findings of this study, for the most part, are aligned with the findings of the 1999 Committee of Sponsoring Organizations study. This study finds that institutions with audit committees report more internal controls in place on most questions than institutions without audit committees. The most important finding of this study is that institutions with audit committee members who had banking or financial experience reported significantly more effective internal controls than institutions without this expertise on their audit committee.
The 1992 report by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) defined internal control as a "process, effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories:
* Effectiveness and efficiency of operations.
* Reliability of financial reporting.
* Compliance with applicable laws and regulations." (1)
In 1999, COSO published Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies. The authors of this study analyzed fraudulent financial reporting alleged by the SEC in Accounting and Auditing Enforcement Releases for 204 companies. Companies committing financial statement fraud were small in size (median assets, $16 million), had senior executives involved in the fraud, and had a board of directors and audit committee that were not functioning properly. Study results showed that approximately 60% of directors were either insiders or "gray" directors (outsiders with special ties to the company or its management). Twenty-five percent of the companies studied had no audit committee. Twelve companies had an audit committee but it never met. Of the companies with an audit committee, only 44% met two or more times per year.
AUDIT COMMITTEE STUDY
We surveyed more than 1,000 commercial banks with assets ranging from $6 million to $350 million. The median asset size of the respondent banks was $50 million. The research instrument, (54 total questions) along with a cover letter addressed to the Chief Executive Officer, was mailed to 1,036 financial institutions. A total of 421 responses were received. Of these 421 responses, 410 were usable, yielding a usable response rate of 39.58%. Coincidentally, 205 of the usable responses were from new banks (banks chartered less than three years) and 205 were from old banks (banks chartered more than 10 years). Eighty of the 410 usable responses were from banks that were publicly traded.
Eighty-three percent of all banks responding to the survey had an audit committee. Of those banks with an audit committee, 63% met three or more times. Sixty-three percent of audit committees consisted of only outside directors (directors not employed by the institution). Approximately 81% of all audit committees had individuals with either banking or related financial management experience.
AUDIT COMMITTEE VALUE
The internal control questionnaire identified five questions that assessed the value of audit committees. These questions either directly or indirectly assessed the objectives of internal controls dealing with the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations. By analyzing the responses on these five questions, the researchers were able to assess the value added by audit committees based on the following criteria:
* Does the institution have an audit committee?
* Did the audit committee meet three or more times during the year? …