Audit Committee Quality, Auditor Independence, and Internal Control Weaknesses

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Audit Committee Quality, Auditor Independence, and Internal Control Weaknesses

Yan Zhang, Jian Zhou, and Nan Zhou*

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All authors are from SUNY – Binghamton. We thank two anonymous reviewers for detailed and insightful suggestions that have significantly improved the paper. We also thank workshop participants at the 2006 American Accounting Association Auditing Midyear Meeting and the 2006 American Accounting Association Annual Meeting for comments, and Raj Addepalli, Shanshan Chen, Yujing Pan, Gaurav Rastogi, Eric Romanoff, Grace Witte, and Meng Zhao for research assistance. Please address all correspondence to Jian Zhou, School of Management, SUNY – Binghamton, Binghamton, NY 139026000; email: jzhou@binghamton.edu; phone: (607) 777 6067.

Audit Committee Quality, Auditor Independence, and Internal Control Weaknesses Abstract In this paper we investigate the relation between audit committee quality, auditor independence, and the disclosure of internal control weaknesses after the enactment of the Sarbanes-Oxley Act. We begin with a sample of firms with internal control weaknesses and, based on industry, size, and performance, match these firms to a sample of control firms without internal control weaknesses. Our conditional logit analyses indicate that a relation exists between audit committee quality, auditor independence, and internal control weaknesses. Firms are more likely to be identified with an internal control weakness, if their audit committees have less financial expertise or, more specifically, have both less accounting financial expertise and non-accounting financial expertise. They are also more likely to be identified with an internal control weakness, if their auditors are more independent. In addition, firms with recent auditor changes are more likely to have internal control weaknesses.

Audit Committee Quality, Auditor Independence, and Internal Control Weaknesses

1. Introduction The Sarbanes-Oxley Act (hereafter SOX) of 2002 went into effect on July 30, 2002 to address the increasing concern of investors about the integrity of firms’ financial reporting, due to scandals involving once well-respected companies, such as Enron and WorldCom and auditors, such as Arthur Andersen. One important aspect of SOX is that it has two sections specifically focusing on internal control issues related to financial reporting. Under Section 302, management is required to disclose all material weaknesses in internal control, when they certify the periodic, annual, and quarterly statutory financial reports. Under Section 404, a firm is required to assess the effectiveness of its internal control structure and procedures for financial reporting and disclose such information in its annual reports. Furthermore, the firm’s auditor is required to provide an opinion on the assessment made by the management in the same report. Because such mandatory disclosure under SOX provides us with more information on internal controls, we are interested in investigating the determinants of internal control weaknesses in the post-SOX era. We begin with a sample of firms with internal control weaknesses, and, based on industry, size, and performance, match these firms to a sample of control firms without internal control weaknesses. Our conditional logit analyses indicate that a relation exists between audit committee quality, auditor independence, and internal control weaknesses. Firms are more likely to be identified with an internal control weakness, if their audit committees have less financial expertise or, more specifically, have less accounting financial expertise and non-accounting financial expertise. They are also more likely to

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be identified with an internal control weakness, if their auditors are more independent. In addition, firms with recent auditor changes are more likely to have internal control weaknesses. Our paper is related to several recent papers on the determinants of internal control...
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