The second section focuses on the background of corporate governance provisions such as the Blue Ribbon Committee (BRC) and Sarbanes Oxley (SOX) that aim to improve the effectiveness of audit committees. The composition of audit committees is heavily critiqued with an emphasis on independence, financial expertise and frequency of meetings. This paper will examine each of these characteristics in depth in section 3 and their effect on financial restatements. Furthermore, this literature review will show that if audit committees can exhibit these behaviors and attributes the risk of restatements and fraudulent financial reporting will be reduced. Finally in the last section, further research on other audit committee characteristics is suggested to improve the quality of financial reporting and reduce the number of accounting scandals involving financial restatements.
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.
To address these concerns, the “Blue Ribbon Commission on Improving the Effectiveness of Corporate Audit Committees” (BRC) was formed and it issued a set of recommendations aimed at strengthening the independence and effectiveness of the audit committee (BRC, 1999). Additionally, in July 2002, the United States adopted the Sarbanes-Oxley Act (SOX), which requires that the board’s audit committee be comprised entirely of independent directors, having at least one member with financial expertise, and restricts the types of non-audit services that the outside auditor can provide. The first two BRC recommendations address the definition of director independence and requirements for independent audit committees. These recommendations are based upon the BRC’s argument that independent directors are better able to objectively evaluate the operating effectiveness and design efficacy of internal controls and reporting practices (BRC, 1999).
Further the BRC recommendations allude to two other characteristics, financial literacy and frequency of meetings, which can help increase the effectiveness of the audit committee, in addition to maintaining complete independence. The results of several studies have shown that for the majority of audit committee’s governing firms which have had incidents of fraud have had fewer number of ‘independent’ outside board members, fewer audit committee meetings, and fewer financial experts on the audit committee. The next section will discuss the pieces of literature...