Academic journal article Accounting Horizons

Audit Committee Composition, "Gray Directors," and Interaction with Internal Auditing

Academic journal article Accounting Horizons

Audit Committee Composition, "Gray Directors," and Interaction with Internal Auditing

Article excerpt

K. Raghunandan and Dasaratha V. Rama are Professors both at Texas A&M International University, and William J. Read is a Professor at Bentley College.

SYNOPSIS: The functioning of corporate audit committees was criticized in recent years by the Treadway Commission, the Public Oversight Board, the Kirk Panel, and the SEC Chairman. In response, the NYSE and NASD sponsored the Blue Ribbon Committee (BRC) on Improving the Effectiveness of Corporate Audit Committees. The BRC Report includes recommendations aimed at strengthening director independence and qualifications, and highlights the role of internal auditors in assisting audit committees in the corporate governance process. Moreover, the first three recommendations of the BRC relate to audit committee composition: absence of inside or directors, and presence of a member with financial expertise.

This study examines the association between audit committee composition and the committee's interaction with internal auditing. Our results, based on responses from chief internal auditors of 114 public companies, indicate that committees comprised solely of independent directors and with at least one member having an accounting or finance background are more likely to (1) have longer meetings with the chief internal auditor; (2) provide private access to the chief internal auditor; and (3) review internal audit proposals and results of internal auditing. These findings provide empirical support for the BRC's recommendations related to audit committee composition.

The functioning of corporate audit committees was criticized in recent years by the Treadway Commission (NCFFR 1987), the Public Oversight Board (1993), the Kirk Panel (1994), and the SEC Chairman (Levitt 1998). In response, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) sponsored the Blue Ribbon Committee (BRC) on Improving the Effectiveness of Corporate Audit Committees. The BRC Report (BRC 1999) includes recommendations for audit committee reform and a discussion of the role of audit committees in ensuring the quality of financial reporting. Similar suggestions are made by another blue ribbon commission sponsored by the National Association of Corporate Directors (NACD 1999). The SEC acted on these recommendations and adopted new rules requiring disclosure about audit committees' composition, charter, and activities in proxy statements (SEC 1999a).

The first two recommendations of the BRC Report relate to the composition of the audit committee and are aimed at strengthening the independence of audit committees. This reflects the belief that independent audit committee members are more likely to "objectively evaluate the propriety of management's accounting, internal control, and financial reporting practices" (SEC 1999b). The NYSE had required its listed companies to have audit committees comprised solely of outside directors, while the NASD had required only that the audit committee have a majority of outside directors. However, outside directors included both those independent of the company (except for board service) as well as those so-called "gray directors" with some nonboard affiliation with top management of the company.

The first recommendation of the BRC Report stated that directors should not be considered independent if (1) the director or a member of his/her immediate family was an employee of the company or its affiliates within the past five years; (2) the director received compensation for work other than board service; or (3) the director serves as a partner or controlling shareholder or executive of a business with which the company has significant business. The second recommendation of the BRC calls for NYSE and NASD to modify their requirements so that listed companies have audit committees comprised solely of independent directors in the sense of the new, more stringent definition. The NYSE and NASD changed their listing requirements as suggested by the BRC (SEC 1999b, 1999c). …

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