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Audit Committee Effectiveness: A Critical Literature

Review

Md. MohiuddinYusuf Karbhari

AbstractThis paper develops a theoretical model on audit committee effectivenessafter reviewing related previous studies. Corporate governance is believedas means of improving economic efficiency in a country. Corporategovernance rules have economically significant impact on firm value. Due

to separation of companys management and ownership, there exists lackof trust between two groups and as a result agency problem emerges.Previous literature generally argue that inclusion of independent,knowledgeable and expert members and delegation of adequate authoritymake an audit committee effective which plays significant role in the areasof financial reporting, internal auditing, risk management, dealing withexternal auditor, and compliance issues. Academic literature suggests thataudit committee effectiveness has significant positive impact inminimizing agency conflicts, protecting stakeholders interests and thus inmaximizing firms overall value.

Keywords: Corporate Governance, Audit Committee, Effectiveness.

Cardiff University, UK

Cardiff University, UK

AIUB Journal of Business and EconomicsVolume 9, Number 1

ISSN 1683-8742anuary 2010 pp. 97-125

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AIUB Journal of Business and Economics, Volume 9, Number 1, Jan 201098

1. Introduction

In the days of ongoing global financial distress and recession, the issue ofgovernance mechanism is being highly discussed. Particularly, corporategovernance (CG) practices of big companies and roles of different special

committees are being closely reviewed. Audit Committee (AC) hasbecome more common mechanism for ensuring good CG in firms (Chenet. al, 2008). Campbell (1990) and Vicknair et. al. (1993) reported that lackof effective AC practice is a factor behind rigorous financial problems ofcompanies. Many studies have addressed the importance of AC inensuring credibility of financial reporting and auditing process [forexample, McDaniel et al., 2002; Blue Ribbon Committee (BRC), 1999;Turpin and DeZoort, 1998; Public Oversight Board (POB), 1993]. Theboard of a firm delegates the responsibilities relating to financial reportingprocess to the AC (Beasley, 1996). An AC, acting as an independentgoverning body, improves CG practices in the firm (DeZoort and

Salterio, 2001). Effective functioning of the AC is essential to mitigate therisk of corporate failures and to enhance public confidence (Dezoort,1998; Lee and Stone, 1997). Many researchers noted that the AC isassigned internal control oversight responsibilities (Millichamp, 2002; Tan& Kao, 1999; DeZoort, 1998 and Wolnizer, 1995). Caplan (1999)mentioned ACs roles in detecting errors, irregularities and fraudulentpractices in the firm. The effectiveness of AC depends on its collectivecapability to meet its oversight objectives (DeZoort, 1998). With thesupport from board along with the co-operation of employees andmanagement team of the firm, AC can perform their assigned duties duly(Haron et al., 2005).

This paper mainly evaluates previous studies conducted on variousaspects of AC including its composition and roles. Two famous theoriesof finance namely, theory and stakeholders theory underpin the practiceof AC and these are discussed in section 2. Prior studies relating to ACattributes and AC roles have been reviewed in section 3 and 4respectively. Section 5 discusses the concept of AC effectiveness whileimpact of an effective AC in the firm is noted in section 6. The maincontribution of this paper is a conceptual model for AC effectivenesswhich has been discussed in section 7. The paper ends with fewconcluding remarks.

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Mohiuddin & Karbhari: Audit Committee Effectiveness: A Critical Literature Review 99

2. Theoretical Underpinning

AC is appointed by the board in order to protect stakeholders bestinterest by its fair and neutral views and judgement regarding differentissues of the firm. This particular body oversees and evaluates decisions

taken by managers. In fact, AC plays role not only as a bridge betweenboard and management but also as a safeguard of the stakeholders. Theissue of AC effectiveness and its impact on firms value is covered in someof the finance theories for example, agency theory, stakeholders theory,shareholders theory, market myopia theory, signalling theory etc.However, it is more closely related with the following two famousfinance theories and an effective AC contributes more in these twotheories.

2.1 Agency TheoryJenson and Meckling (1976) defined agency relationship as a contract

under which one person (the principal) engages another person (the agent) toperform some services on his/her (the principals) behalf. Agencyrelationship can also be defined as a contractual process whereby ownersdelegate some of their authorities and responsibilities to a team consistingof expert member(s) and expect them to exercise their expertise in bestinterest of firms operational success. Muth and Donaldson (1998)described agency relationship as delegation of power by owner tomanagement. The central idea of this theory is that there exists a conflictof interest between owner and management. Eisenhardt (1989) discussedtwo main causes of agency problems namely, conflict of interests, anddifferent attitude towards risk between owner and management. Berle and

Means (1932) argued that when shareholders are not able to monitormanagement properly, the company assets might be used for the welfareof management instead for maximizing shareholders wealth. Chrismanet. al. (2004) noted that this conflict arises from information asymmetrybetween owners and mangers and there exists a gap between them.

Jenson and Meckling (1976) further mentioned that the extent of agencyconflicts varies across the firms depending on level of discretionary powerapplied by management.

Sometimes shareholders may prioritise their own welfare at thecost of other stakeholders and tend to influence management decision formaximizing short run profit. But management prefers to maximize wealth

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of the firm by earning sustainable profit. Thus, conflict of interestsbetween owners and management emerges and grows. For accountabilitypurpose, management decisions and activities need to be monitored. Closemonitoring is possible when owners themselves can actively participate in

this monitoring process. However, because of high cost involvement andin some cases due to lack of expertise and knowledge, they can not beactively involved in this process. Nevertheless, the board has to setmonitoring mechanism because of their oversight responsibilitiescommitted to shareholders (Johnson et al., 1996). DeZoort el. al. (2002)argued that in order to deal with the problem arsing from agencyrelationship, the board has to assume the oversight role of monitoringCEO and other managers, approving firms strategies and evaluatingcontrol system. The board usually hires an expert and knowledgeablebody to oversee management activities on its behalf. AC is such asubcommittee under CG framework to which the board delegates some of

its oversight responsibilities. Chen et. al. (2008) studied non US companiestrading shares in US market and argued effective AC can resolve agencyproblems of foreign companies no matter which CG model is beingfollowed in the companys home country. Dey (2008) found the level andintense of agency problem is less in those firms where ACs are moreeffective in terms of composition and functioning.

Large investors usually dominate the board and exercise undueinfluence on management decisions. Some legal clauses may protect thesmall investors against expropriation by large investors. Congenial legalsystem decreases the magnitude of agency problem. Schleifer and Vishny(1997) argued that the legal protection of investors is essential element of

an effective CG mechanism. Watts and Zimmerman (1986) explainedpositive agency theory by linking managerial incentives for voluntaryfinancial disclosure. It is obvious that good financial reporting practicesensure more managerial disclosure. Thus, financial reporting system hasrole in resolving agency problem. Since managers usually do not have tointeract frequently with shareholders, a distance in terms of trust mightexists due to this communication gap. AC can act as a bridge in such gaps.Chen et. al. (2008) clearly mentioned that AC can help to maintaincontract between management and shareholders.

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2.2 Stakeholder TheoryFreeman (1984) defines a stakeholder as any individual or group who canaffect or is affected by achievement of the organizations objectives. Thus,stakeholders include shareholders, employees, suppliers, customers,

creditors, communities in the vicinity of the companys operations andgeneral public. Most extreme proponents of this theory suggest thatenvironment and future generation are also included in stakeholders.Stakeholder theory represents that the company is a separateorganizational entity and it is connected to different parties in achievingwide range of purposes (Donaldson and Preston, 1995). The theoryhighlights interests of different groups and argues on the possibility offavouring one groups interest over that of other (Jones and Wicks, 1999).Donaldson and Preston (1995) pointed out that managers are responsibleto deploy their wise decisions and best efforts in obtaining benefits for allstakeholders. The board of directors (BoDs) can not ignore its

responsibilities in safeguarding stakeholders interests (Wang and Dudley,1992). Hillman et. al. (2001) found inclusion of stakeholders in the boardmerely improves their relation and performance. They emphasised onboard effectiveness in this regard. An effective AC ensures better CGpractice in a firm that ultimately leads to overall welfare of stakeholders.Deys (2008) conclusion is notable in this respect. He mentioned thatorganizations performance and stakeholders value are positively affectedby various governance mechanisms including AC. Stakeholders interesthas been emphasized in the definition of effective AC given by DeZoortet. al. (2002). They argued that the ultimate goal of the AC is to protectstakeholders interests and welfare.

3. AC AttributesThere is a vast growing literature on AC attributes that mainly thatgenerally argues that a more independent, more expert, more diligent andwith larger size AC tend to carry out its responsibilities more successfully.

3.1 Audit Committee IndependenceExistence of independent AC is a sign of the firms commitment for fairCG practice (Sommer, 1991). The AC should be independent of theorganizations management to perform the oversight role and protect

shareholders interests. It may be argued that if the members of an AC are

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independent from management and owners of the organization, then theyshould be able to deter management from manipulating financial results.Beasley (1996) noted that the incidence of financial fraud is negativelyassociated with the independence of the BoDs. Bedard et al. (2004) argue

that more objective oversight of financial reporting process can be ensuredif the AC includes more independent members. Further, Garcia-Meca andSanchez-Ballesta (2009) argued that independent AC can potentiallyimprove the quality and credibility of financial reporting. Cohen andHanno (2000) highlighted the importance of committees independencefor evaluating management actions in respect of risk assessment. Studiesby Klein (2002b) and Dechow et al. (1996) clearly mentioned thatinclusion of more independent members in AC minimizes the likelihoodof financial fraudulent activities. Gendron et al. (2004) mentioned thatmembers willing to be active and effective in the AC should have probingattitude in mind which helps in assessing various management decisions.

ACs independence is needed for carrying out its monitoringresponsibilities delegated by the board in order to add value to firm. Chanand Li (2008) noted that inclusion of expert independent directors inboard and AC enhances firms value significantly. Many stock marketshave already imposed the inclusion of independent members in the ACsin their listing requirements. ACs independence is also reflected inadherence to accounting principles, for example Carcello and Neal (2003)found a positive relation between ratio of independent directors in theAC and the optimism of companys going concern disclosure in financialreporting. Roles of AC ultimately lead to positive impact in terms firmsearning, value creation and goodwill. Pucheta-Martinez and Fuentes

(2007) revealed inclusion of independent members in AC has positiveimpact in improving the reporting quality both externally and internally.The Olivencia Report (1998) stated that the AC should be composed of amajority of independent members. The creation of an AC aims todelegate of responsibilities to hire external auditors and to facilitate andsupervise their work and the AC should be composed of a majority ofindependent members (Olivencia Report, 1998 cited in Osma andNoguer, 2007).

3.2 Committee Members Knowledge and ExperienceMany studies argue that AC members knowledge/expertise or experience

is directly associated with effective functioning of AC (Bedard et al., 2004;

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McDaniels et al., 2002; Beasley and Salterio, 2001 and DeZoort andSalterio, 2001). Since the ACs main task is to oversee corporate financialreporting and auditing processes, its members should possess sufficientexpertise to understand the issues to be investigated or discussed by ACs

(Lin et al, 2008). Positive relationship between members financialknowledge and ACs effectiveness particularly their potentials to ensure agood quality financial reporting process and compliance of related ruleshas been found in many studies, [for example, Defond et al. (2005); Felo etal, (2003); DeZoort and Salterio (2001) and Treadway Commission(1987)]. POB (1993) mentioned that lack of adequate knowledge andrelevant experience causes inability and failure of AC members tounderstand their roles and responsibilities in the firm. Absence of thesequalities also affects the technical aspects of some of the committees roles,particularly in case of internal control evaluation (Haron et al., 2005;Gendrol et al., 2004; Tan and Kao, 1999; DeZoort, 1998 and

Abdolmohammadi and Levy, 1992). Knapp (1987) pointed out frequentdisputes between external auditors and management about accountingestimations. AC resolves these disputes and in doing so, committeemembers have to have adequate knowledge and expertise. To decide onsome of the complex accounting related issues, only data and their literalinterpretations are not enough rather they require technical knowledgeand wider experience. Tan and Kao (1999) pointed out that the essence ofindividuals competence in performing assigned responsibilities. Peoplehaving relevant experience and knowledge can demonstrate betterperformance and prove their competence. McMullen and Raghunandan(1996) identified members expertise in accounting reporting, internal

control, and auditing as important inputs in case of AC effectiveness.Krishnan and Lee (2009) documented a strong negative associationbetween litigation risk and AC members with accounting financialexpertise.

Firms with AC members who have financial expertise are lesslikely to be subject to censure for poor financial reporting (Farber, 2005;Agrawal and Chadha, 2004 and McMullen and Raghunandan, 1996), morelikely to have higher quality earnings (Qin, 2007) and more likely toreduce earnings management for firms with weaker CG mechanisms(Carcello et al., 2006). In addition, ACs with financial experts are morelikely to promote more conservative financial reporting when the overall

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board CG is strong (Krishnan and Visvanathan, 2008). So, there aregrowing number of researches addressing the benefits of inclusionfinancial experts in AC.

3.3 Size of the CommitteeMany researchers (for example, Pincus et al., 1989) report that the size ofAC is an influential factor for its effective functioning. Pucheta-Martinezand Fuentes (2007) documented positive relationship between size of ACand quality of financial reporting which is consistent with the findings ofFelo et al. (2003). Although AC size is affected by the size of BoDs andthe company, a large AC may not necessarily result in more effectivefunctioning as more members in an AC may lead to unnecessary debatesand delay the decisions (Lin et al., 2008; Scarbrough et al., 1998; Kalbersand Fogarty, 1996 and Yermack, 1996;). Therefore, the currentrequirement on AC size laid down by the market regulators in the USAand the UK is a minimum of three members (NACD, 2002; ICAEW,2001), while some empirical studies have found that the normal AC sizein the USA and the UK is about three to five (Davidson et al., 2004; Spira,2002; Raghunandan et al., 2001 and Carcello and Neal, 2000). BRC (2003)recommended minimum three members for an AC. As per the newrequirements, every firm listed under NYSE and NASDAQ must haveAC with minimum three directors.

3.4 Meetings and Diligence of the CommitteeMembers diligence is very important in performing ACs responsibilitieseffectively and with integrity (Sharma et al., 2009). Since diligence isextremely subjective to observe directly, most researchers use AC meeting

frequency as a proxy of diligence (Raghunandan and Rama, 2007).Importance of AC meeting frequency has been recognized by manyresearchers such as Spira, (2002) and Anderson et al. (2004). AC meetingsare not mere rituals devoid of interest to managers and auditors (Gendronand Bdard, 2006 and Gendron et al., 2004) instead meaningful andsubstantive meetings are consistent with an agency perspective (Beasley etal., 2009). While studying the collapse of Andersen, Chen and Zhou(2008) noted number AC meetings as an important mechanism of CG.However, authoritative statements on CG are silent on meeting frequencyand length of meeting and this absence of regulatory guidelines affordsACs considerable discretion in this area (Sharma et al., 2009).

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A few studies reported that ACs in US and UK companies heldmeetings on an average of four to six times per year with the averageduration of three to four hours per meeting (ICAEW, 2001; Collier and

Gregory, 1998 and McMullen, 1996). Menon and Williams (1994) suggesta minimum of two meetings a year. This recommendation as to aminimum meeting frequency to guarantee effective AC control aresupported by empirical evidence of a positive relationship betweenmeeting frequency and the quality of a firms accounting information(Abbot et al., 2004and Xie et al., 2003). It is argued that effective control isunlikely to occur if an AC holds a single yearly meeting, or none at all(Deli and Gillan, 2000; Klein, 1998a; Collier and Gregory, 1998 andMenon and Williams, 1994 cited in Mendez and Garcia, 2007). Abbott etal. (2007) noted that an effective AC should meet at least four timesannually. Further, Sharma et al. (2009) however, noted an average of 3.75

AC meetings annually in New Zealand.

4. Roles and Responsibilities of Audit Committee

Although ACs existed in practice for a long time, the perceptions of ACsroles evolved continuously (Lin et al., 2008). There were varied views onACs roles in the western literature before 2000s, but a relative consensushas emerged in recent years following the promotion of AC function inCG by market regulators and professional bodies. ACs are traditionallyresponsible for oversight of auditing matters relating to the companysfinancial reporting (Brown et al., 2009). Lin et al. (2008) noted AC

oversight roles and responsibilities for improving internal control, rulescompliance, sound corporate financial reporting and auditing processes.While the primary responsibilities of the AC are to assist the board withits duties in overseeing the corporations reporting and audit requirements(Chen et al., 2008), it also (i) monitors the integrity of the companysfinancial statements and reporting system; (ii) ensures that the companycomplies with legal and regulatory requirements; (iii) monitorsindependent auditors qualifications and independence; (iv) monitors theperformance of the companys internal and external auditors; and (v)monitors compliance with corporate legality and ethical standards,including the maintenance of preventive fraud controls (Marsh and

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Powell, 1989and Baruch, 1980). Chambers (2005) discussed fourresponsibilities of ACs which are (i) advising board on the reliability offinancial information, (ii) advising board in risk management and internalcontrol, (iii) dealing with external auditors, and (iv) overseeing the

internal audit process. The committee regularly meets with outsideauditors and internal financial managers for reviewing internal controlprocess, financial reporting system, and external audit process (Klein,2002a). ACs roles in overseeing and monitoring financial reportingprocess, internal controls, and external auditing are also noted by Sori etal. (2007) and Sharma et al. (2009). Among many areas of ACresponsibilities, main four roles are discussed in following subsections.

4.1 Financial Reporting ProcessThe financial process and ensuring reliable financial information is one ofthe most important functions of the AC (Rezaee and Farmer, 1994).While the AC should not become involved in day-to-day operations, thereis pressure from the oversight role for the AC to get more involved inensuring the integrity of the financial reporting process. Effective ACprocesses for overseeing financial reporting are studied by Truly andZaman (2007); Cohen et al. (2007); Gendron and Bedard (2006); Gendronet al. (2004); Smith (2003); Spira (2002); Porter and Gendall (1998); Leeand Stone (1997); Wolnizer (1995); Rittenberg and Nair (1994); Rezaeeand Farmer (1994); Luecke and Westfall (1990); Braiotta (1986) and Mautzand Neumann (1970).These studies generally noted that ACs are expectedto:

Review all financial statements, whether interim or annual, before

they are approved by the BoDs and publicly disseminated toensure their objectiveness, accuracy, and timeliness;

Review all existing accounting policies, and concentrate on theimpact on the financial statements of any changes in accountingpolicies including the likely impact of any contemplated changes;

Evaluate exposure to fraud;

Appraise key management estimates, judgements, and valuationswhere they are thought to be material to the financial statements;

Evaluate the adequacy of financial statement disclosures;

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Review adequacy of organisation's structure, includingmanagement's implementation of internal controls; and

Review all significant transactions, especially those that are non-routine and those that might be illegal, questionable, or unethical.

4.2 Internal Auditors ResponsibilitiesThe AC can strengthen the entity's internal audit function by ensuringthat management has established and is maintaining an adequate andeffective internal audit structure (Beasley et al. 2009; Turley and Zaman,2007; Rezaee and Farmer, 1994). Also, Oliverio and Newman (1993) afterdiscussion in the Treadway Commission's Report identified theinteraction between the internal audit function and the AC that shouldensure the internal audit function's effectiveness and objectivity. Whiletalking about internal auditors responsibilities, Wolnizer (1995) notedthat ACs are expected to:

Evaluate the independence and competence of internal auditfunction;

Discuss with the chief of internal auditors about internal auditreports, effectiveness of internal controls and problems inperforming the internal audit.

Review the scope of internal audits planned for the year;

Review management's response to internal auditors'recommendations;

Review and approve internal audit budget;

Review the relationship between internal and external auditorsand coordination of their work; and

Appoint and dismiss the head of internal audit.

4.3 External Auditors' ActivitiesThe AC is a valuable instrument for initiating direct contact with theindependent/external auditor, participating in the selection of the externalauditor, and promoting effective communication between theindependent auditor and corporate directors (Beasley et al. 2009; Rezaeeand Farmer, 1994). Beasley et al. (2009) also found AC membersdependency on external auditors in performing their oversight

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responsibilities. In the case of annual audit and external auditors,Wolnizer (1995) mentioned that ACs are expected to:

Review the findings of the external audit;

Determine the completeness and appropriateness of management'sresponse to audit findings;

Evaluate independence of external audit function;

Review the reasonableness of the external audit fees;

Arbitrate in disputes between management and auditors;

Nominate external auditors;

Review the management letter prepared by the independentauditors; and

Discuss with external auditor about problems of the audit, audited

financial statements and scope and timing of the audit.4.4 Risk Management and Others CG IssuesACs play singificant role in managing risk of the business. ACs roles inrisk management have been noted by many researchers for example,Chambers (2005) and BRC (1999) highlighted the ACs role in advisingthe board risk management. Similarly, Saren et al. (2009) also discussedAC roles in this regard.

Apart from the above discussed foukey roles, ACs presume someCG responsibilities for the firm. In the case of CG responsibilities, ACsare expected to (Wolnizer, 1995):

Facilitate and enhance communication between the externalauditors and the BoDs;

Review corporate policies and practices in the light of ethicalconsiderations;

Monitor the manner in which the company's affairs are conductedand, where applicable, compliance with the company's code ofcorporate conduct;

Review significant transactions outside entity's normal business;and

Review adequacy of management information systems.

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5. Audit Committee Effectiveness

With high-profile financial fraud cases in early of this decade, academicand industry seek for effective ACs to provide sound monitoring (Chanand Li, 2008). ACs effectiveness is very crucial for sound CG practices in

the organization. Campbell (1990) and Vicknair et al. (1993) reported thatlack of effective AC practice is a factor behind rigorous financial problemsof companies. However, effectiveness is an elusive concept that can beapproached through several models, none of which is appropriate in allcircumstances (Cameron, 1981). Spira (1998) considered "there is nodiscussion of the meaning of effectiveness, resources, or independence withinthe literature and this assertion is unsupported. Lee and Stone (1997) inexplaining their purpose of study noted actual effectiveness is impossible toobserve.

Many authors who have written on ACs' effectiveness have usedthe word effectiveness to mean the carrying out or fulfilling its specificoversight responsibilities or duties (Smith, 2003; Raghunandan et al.,2001;Millstein, 1999; Porter and Gendall, 1998; Rittenberg and Nair, 1994;Vanasco, 1994; Kalbers and Fogarty, 1993; Kalbers, 1992; Sommer, 1991;

Jenkins and Robinson, 1985). Various studies have used discharging theiroversight responsibilities for the definition of ACs' effectiveness, [see forexample, Zain and Subramaniam (2007); Watts (2002); Turley and Zaman(2002); Lee and Stone (1997); Pomeranz (1997); Rezaee (1997); Verschoor(1989);Braiotta (1986)]. DeZoort (1998) defined effectiveness as "acommittee's collective ability to meet its oversight objectives."Baugher (1981)noted "the investigator should determine which type of effectiveness is of thegreatest concern to the constituency or constituencies to which he or she mustreport.", Emphasizing AC roles, DeZoort et al. (2002) further definedeffective AC an effective AC has qualified members with the authority andresources to protect shareholders interests by ensuring reliable financialreporting, internal controls, and risk management through its diligentoversight efforts. Strong and well resourced internal control function is anecessary criteria for effective AC (Zain and Subramaniam, 2007) sinceAC members especially reply on the work of internal auditor in order todevelop their own appreciation of the controls effectiveness (Spira, 1999).In respect of effective functioning of AC, Zain and Subramaniam (2007)emphasized on good relationship between external auditors and ACthrough private meetings and informal communication.

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An AC represents a standing committee of the BoDs, which isresponsible for dealing with audit-related concerns and should assist inresolving disputes between the auditor and management. Pomeranz (1997)argued that the effectiveness of ACs could not be judged by the mere

comparison of companies with ACs to companies that do not have them.Rainsbury et al. (2008) found membership of AC as one of the key factorsto improve AC effectiveness. An effective AC should have a greaterlikelihood of detecting problems than an inactive one (Choi et al., 2004).Finally, the AC-related disclosure and reporting is a necessary element forassessing the effectiveness of AC function (Spira, 1998; ICAEW, 2001; Ngand Tan, 2003; Lee et al., 2004). Relevant disclosures include a writtencharter or terms of reference specifying the AC responsibilities that havebeen endorsed or approved by BoDs, and AC reports demonstrating howan AC has fulfilled the described responsibilities during the year. Theeffectiveness of ACs depends, to a large extent, upon their diligence or

activities, such as the frequency, duration, and content of AC meetings(Teoh and Lim, 1996; Collier and Gregory, 1998; Beasley and Salterio,2001; Ng and Tan, 2003; Abbott et al., 2004. In fact, ACs effectivenessdepends mainly on how successfully they can carry out its roles andresponsibilities no matter how they are composed of. However, previousliterature documents that there are casual relationship between ACattributes and effectiveness.

6. Significance of an Effective Audit Committee

An underlying assumption of exercising sound AC in the firm is that it

has a positive effect on the quality of financial disclosure. Previousempirical researches documented a positive association between AC andthe quality of financial information. A well functioning AC system leadsto the improvement of corporate financial reporting and the decrease ofearnings management or financial frauds, as well as the increase ofunqualified auditor reports (Sharma, 2004; Bedard et al., 2004; Klein,2002b; DeZoort and Salterio, 2001; Carcello and Neal, 2000; Wild, 1996).Garcia-Meca and Sanchez-Ballesta (2009) noted that existence of ACreduces errors and irregularities in financial statements and enhances thecredibility of financial reporting which was consistent with the conclusionof McMullen (1996). It is axiomatic that poor standards of CG, for

instance ineffective or non-existent ACs, facilitate abuses such as

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fraudulent financial reporting (Chambers, 2005). ACs significance inpreventing misstatement in financial reporting has been highlighted inmany studies, for example, Magee and Tseng (1990) and Dye (1991).

Many studies documented that existence of effective AC reduces

financial frauds and disputes in the company and also ensures earninginformation to the stakeholders. Klein (2002b) and Bedard et al. (2004)noted that ACs independence and financial expertise are negativelyassociated with earnings management as measured by discretionaryaccruals. Xie et al. (2003) explained the role of AC in preventing earningmanagement. Independent ACs are effective mechanisms in limitingearning management (Garcia-Meca and Sanchez-Ballesta, 2009). Further,Lin and Liu (2009) added that an independent auditing function can detectand disclose earnings management and other types of misconduct bybusiness managers or controlling shareholders. Defond and Jiambalvo(1991) concluded firms having AC are less likely to overstate earnings.

Similar conclusion was drawn by Dechow et al. (1996).As a liaison between the external auditor and the board, the AC

bridges the information asymmetry between them, facilitates themonitoring process (Klein 1998b; Sori et al., 2007), and enhances theindependence of the auditor from the management (Mautz and Neumann,1977). Thus, a properly functioning AC is critical in enhancing theeffective oversight of the financial reporting process and ensuring high-quality financial reporting (Chen and Zhou, 2007).

On of the most visible and measurable outputs of Ac effectivenessis its impact on firms return. ACs significance on firms earnings and

return has been noted in many studies Chen et al. (2008) found that theestablishment of AC is positively related with higher-earnings returnassociations. Bryan et al. (2004) found positive association between ACexistence and firms earning and informativeness. In respect of firmsearning, Wild (1996) found significant relationship between forming ACand earnings and returns of the firm. This result is presumably due tomarket perception that formation of an AC is likely to improve thequality of financial reporting.

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7. AC Effectiveness Model

The following model summarises the main message of all literaturediscussed in this paper.

AC Attributes AC Roles MinimizingAgencyConflicts

Composition

Characteristics

Structure

Process

Independence

FinancialReporting

InternalAuditing

ExternalAuditing

RiskManagement

ComplianceIssues

AuditCommitteeEffectiveness

ProtectingStakeholdersInterests

ImprovingQuality ofFinancialInformation

ReducingEarningManagement

EnhancingFirmsPerformance

MaximizingFirm Value

The self explanatory model clearly describes that AC effectivenessmainly depends on the ability and scope of performing its oversight rolesand responsibilities delegated by the board. The key functional areaswhere AC contributes are financial reporting, internal auditing, externalauditing, risk management and firms compliance issues. Committeesattributes namely, composition, members characteristics, structure,process, and independence have obvious impacts in carrying out theseroles successfully. An effective AC minimizes agency problem byreducing information asymmetry between owners and management and

also acts as a safeguard of stakeholders interests. The main outcomes of aneffective AC are (i) more credible financial information, (ii) preventingunauthorized earning management in the firm and in effect and (iii)enhancing firms returns and profit. All these outputs ultimately lead tomaximizing firms long term wealth which is the ultimate goal of anybusiness entity.

8. ConclusionAlthough formation of AC is voluntary in some developed economieslike China and Japan (Tafara, 2006), it has undoubtedly become an

accepted and effective mechanism for ensuring good governance in firms.

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AC mitigates agency problem in the firm and also acts as a trustedsafeguard for the large stakeholders. Inclusion of majority independentdirectors in the AC has been regarded as a key factor of AC effectiveness.At the same time AC members background in terms of qualification,

knowledge and experience is equally important. An accountable andindependent AC can effectively carry out its oversight responsibilitiesincluding monitoring management activities. Effective ACs impact onthe quality of firms financial reporting and earnings as a result on wealthis generally recognized

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