The CPA Journal

By Ganesh Krishnamoorthy, Arnie Wright, and Jeffrey Cohen

What makes an audit committee effective? What role does an audit committee play in ensuring financial reporting quality? What factors enhance communication between the auditor and the audit committee? Prodded by sentiments expressed by then–SEC chair Arthur Levitt, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) formed the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (BRC) in 1999. The BRC issued 10 recommendations designed to enhance the effectiveness of audit committees in ensuring high financial reporting quality that were subsequently adopted by the AICPA, NYSE, NASD, and the SEC.

The following study addresses the central question: Are the BRC recommendations enough? Forty-two experienced auditors (managers and partners) from all of the Big Five were asked about the effectiveness of audit committees. Auditor views were also sought on the concept of “financial reporting quality” advanced by the BRC. Finally, auditors were asked about a possible “expectations gap” between the role that audit committees currently perform and what they should be expected to perform.

Audit Committee Factors

The essence of a good audit committee is a committee that is independent of management’s influence and that understands the financial reporting process. For example, 64% of the auditors in our survey expressed support for the BRC’s recommendation that all members of the audit committee be financially literate, and 45% identified independence from client management as an essential factor for audit committee effectiveness. Interestingly, only 19% of the auditors thought that audit committee members should be financial experts, and one-third of the auditors surveyed thought that as long as some of the members have strong financial backgrounds it is desirable to have members possessing broad business experience. One respondent observed that committee members should have skills that complement each other in order to bring different issues and perspectives to the meetings.

To understand the extent to which audit committees are effective, the auditors surveyed thought that one must go beyond just determining whether the committees comply with existing regulations. In fact, 81% of respondents believe that you need to look at the substance (the actual effectiveness of the audit committee) and not just the form of audit committees. Thus, an audit committee might comply with all existing regulations, but if they are not providing active oversight to the quality and integrity of the financial reporting process, they cannot be relied upon.

Another important question is the power that management explicitly or implicitly wields over the audit committee. Management can sometimes influence who serves on the board of directors, which in turn chooses the audit committee. Many of those surveyed believed that management sets the tone on the communication process between itself and the audit committee. Furthermore, respondents thought that management also has a significant influence on the quality of communication between the external auditors and the audit committee. Almost two-thirds (62.5%) of the auditors thought that management has a significant influence in the quality of communication between the external auditors and the audit committee.

Furthermore, few auditors viewed the audit committee as an effective mechanism to resolve financial reporting disputes that external auditors have with management. Over three-quarters (77.9%) of respondents thought that the audit committee cannot be relied upon to mediate financial reporting disagreements between the auditor and management. Some auditors thought that audit committee members lack the necessary financial reporting knowledge and expertise to effectively play a mediating role, but the presence of an active audit committee can be an “unspoken force in negotiation” with management.

Taken together, auditors seem to view the role of management as paramount in allowing the audit committee to fulfill its stated role. Outside parties may not perceive that management is serious about sound financial reporting and strong governance if the audit committee does not have the qualifications, independence, and power to be effective.

The survey indicates that one factor which distinguishes effective audit committees is the willingness to ask hard questions. More than one-third of the auditors surveyed noted the importance of asking questions that would at times challenge management’s suppositions. In addition, the auditors believed that audit committee members need to exhibit a real commitment, for example, by attending more frequent meetings. To be effective, audit committee members must show a steadfast resolve to question management in a free and productive manner.

Respondents expect the near future (the next five years) to bring even greater responsibilities for audit committees. Almost two-thirds of the auditors thought that the role of the audit committee will broaden in the future and this in turn should bring greater accountability to all stakeholders. Perhaps this creates an opportunity for CPAs to educate current and potential audit committee members or even provide a new assurance service to assess the qualifications and workings of audit committees.

Enhancing Financial Reporting Quality

One of the BRC’s recommendations was that auditors and audit committees consider the quality of the financial reporting process and not just compliance with GAAP. This notion of financial reporting quality is relatively ambiguous and is potentially problematic. The survey asked auditors to evaluate the BRC’s suggested characteristics of quality. Approximately half of the respondents said that financial reporting quality consisted of the consistency and clarity of financial disclosures and the degree of aggressiveness management showed in their financial reporting. When auditors were asked about the importance of different components of quality (Exhibit 1), the factor with the highest average response was aggressiveness in reporting, followed by clarity of financial disclosure, and other significant management decisions in preparing financial disclosures.

The survey results suggest that auditors need to alert and possibly educate audit committee members on the importance of scrutinizing management’s position with respect to financial reporting issues. It also reinforces the notion that CPAs have a distinctive competency in handling gray areas and not just blindly following GAAP rules.

The Expectation Gap

One interesting finding was that respondents thought the audit committee should play a greater role than it currently does in ensuring the quality of the financial reporting process. This may also reflect the expectation that an audit committee’s effectiveness in enhancing financial reporting quality will improve as the BRC’s recommendations take effect and result in improved monitoring of management. Respondents believed that the current expectation gap (Exhibit 2) is mainly due to lack of financial sophistication (48%) and lack of power or will to confront management (38%).

Looking Forward

The survey identified some important issues that impact audit committee effectiveness. First, the respondents agreed with the BRC’s view that it is important for audit committees to have independence and financial competency. They also thought it was important to look beyond the form (financial knowledge) of the audit committee and examine its substance (power, charge, will). This implies that auditors need to go beyond mere checklists when evaluating audit committees. The survey also found that auditors believe that management often has an overwhelming influence on the effectiveness of audit committees and the audit committee’s relationship with the external auditors. In certain circumstances, the board of directors as a whole may focus on strategic or compensation issues while placing insufficient importance on the audit committee. Alternatively, the board may be under the sway of management, which highlights the need to educate management on the value of the audit committee.

An effective financial reporting process can diminish the threat of litigation from shareholders and subsequent dismissal of management. The audit committee should be viewed by management and external auditors as a vital component to any effective risk management. Financial reporting quality should be viewed as too important to leave only to management and their external auditors. A strong, knowledgeable, and truly independent audit committee should be the third side of this triangle.

It appears inevitable that the role of the audit committee should continue to grow in the years to come. The authors are optimistic that public accounting firms will provide a valuable service in increasing the effectiveness of audit committees and that external auditors will develop a good, frank working relationship with audit committees and the board of directors. Auditors will then be able to honestly evaluate and communicate the degree to which the audit committee is meeting its responsibilities. This, in turn, will translate into a more effective partnership between audit committees and external auditors in ensuring a high-quality financial reporting process.

Ganesh Krishnamoorthy, PhD, is an assistant professor at Northeastern University; and Arnie Wright, PhD, is a professor and Jeffrey Cohen, PhD, an associate professor, both at Boston College. Interested readers may contact the authors at cohen@bc.edu for a full report of the research results.