05-9101 Page 97-125

Audit Committee Effectiveness: A Critical Literature
Review

Md. Mohiuddin

Yusuf Karbhari

Abstract
This paper develops a theoretical model on audit committee effectiveness
after reviewing related previous studies. Corporate governance is believed
as means of improving economic efficiency in a country. Corporate
governance rules have economically significant impact on firm value. Due
to separation of companys management and ownership, there exists lack
of 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 authority
make an audit committee effective which plays significant role in the areas
of financial reporting, internal auditing, risk management, dealing with
external auditor, and compliance issues. Academic literature suggests that
audit committee effectiveness has significant positive impact in
minimizing agency conflicts, protecting stakeholders interests and thus in
maximizing firms overall value.

Keywords: Corporate Governance, Audit Committee, Effectiveness.

Cardiff University, UK
Cardiff University, UK
AIUB Journal of Business and Economics
Volume 9, Number 1
ISSN 1683-8742
January 2010 pp. 97-125
AIUB Journal of Business and Economics, Volume 9, Number 1, Jan 2010

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1. Introduction
In the days of ongoing global financial distress and recession, the issue of
governance mechanism is being highly discussed. Particularly, corporate
governance (CG) practices of big companies and roles of different special
committees are being closely reviewed. Audit Committee (AC) has
become more common mechanism for ensuring good CG in firms (Chen
et. al, 2008). Campbell (1990) and Vicknair et. al. (1993) reported that lack
of effective AC practice is a factor behind rigorous financial problems of
companies. Many studies have addressed the importance of AC in
ensuring credibility of financial reporting and auditing process [for
example, McDaniel et al., 2002; Blue Ribbon Committee (BRC), 1999;
Turpin and DeZoort, 1998; Public Oversight Board (POB), 1993]. The
board of a firm delegates the responsibilities relating to financial reporting
process to the AC (Beasley, 1996). An AC, acting as an independent
governing body, improves CG practices in the firm (DeZoort and
Salterio, 2001). Effective functioning of the AC is essential to mitigate the
risk of corporate failures and to enhance public confidence (Dezoort,
1998; Lee and Stone, 1997). Many researchers noted that the AC is
assigned internal control oversight responsibilities (Millichamp, 2002; Tan
& Kao, 1999; DeZoort, 1998 and Wolnizer, 1995). Caplan (1999)
mentioned ACs roles in detecting errors, irregularities and fraudulent
practices in the firm. The effectiveness of AC depends on its collective
capability to meet its oversight objectives (DeZoort, 1998). With the
support from board along with the co-operation of employees and
management team of the firm, AC can perform their assigned duties duly
(Haron et al., 2005).
This paper mainly evaluates previous studies conducted on various
aspects of AC including its composition and roles. Two famous theories
of finance namely, theory and stakeholders theory underpin the practice
of AC and these are discussed in section 2. Prior studies relating to AC
attributes and AC roles have been reviewed in section 3 and 4
respectively. Section 5 discusses the concept of AC effectiveness while
impact of an effective AC in the firm is noted in section 6. The main
contribution of this paper is a conceptual model for AC effectiveness
which has been discussed in section 7. The paper ends with few
concluding remarks.

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

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2. Theoretical Underpinning
AC is appointed by the board in order to protect stakeholders best
interest by its fair and neutral views and judgement regarding different
issues of the firm. This particular body oversees and evaluates decisions
taken by managers. In fact, AC plays role not only as a bridge between
board and management but also as a safeguard of the stakeholders. The
issue of AC effectiveness and its impact on firms value is covered in some
of 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 famous
finance theories and an effective AC contributes more in these two
theories.
2.1 Agency Theory
Jenson and Meckling (1976) defined agency relationship as a contract
under which one person (the principal) engages another person (the agent) to
perform some services on his/her (the principals) behalf. Agency
relationship can also be defined as a contractual process whereby owners
delegate some of their authorities and responsibilities to a team consisting
of expert member(s) and expect them to exercise their expertise in best
interest of firms operational success. Muth and Donaldson (1998)
described agency relationship as delegation of power by owner to
management. The central idea of this theory is that there exists a conflict
of interest between owner and management. Eisenhardt (1989) discussed
two main causes of agency problems namely, conflict of interests, and
different attitude towards risk between owner and management. Berle and
Means (1932) argued that when shareholders are not able to monitor
management properly, the company assets might be used for the welfare
of management instead for maximizing shareholders wealth. Chrisman
et. al. (2004) noted that this conflict arises from information asymmetry
between owners and mangers and there exists a gap between them.
Jenson and Meckling (1976) further mentioned that the extent of agency
conflicts varies across the firms depending on level of discretionary power
applied by management.
Sometimes shareholders may prioritise their own welfare at the
cost of other stakeholders and tend to influence management decision for
maximizing short run profit. But management prefers to maximize wealth

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of the firm by earning sustainable profit. Thus, conflict of interests
between owners and management emerges and grows. For accountability
purpose, management decisions and activities need to be monitored. Close
monitoring is possible when owners themselves can actively participate in
this monitoring process. However, because of high cost involvement and
in some cases due to lack of expertise and knowledge, they can not be
actively involved in this process. Nevertheless, the board has to set
monitoring mechanism because of their oversight responsibilities
committed to shareholders (Johnson et al., 1996). DeZoort el. al. (2002)
argued that in order to deal with the problem arsing from agency
relationship, the board has to assume the oversight role of monitoring
CEO and other managers, approving firms strategies and evaluating
control system. The board usually hires an expert and knowledgeable
body to oversee management activities on its behalf. AC is such a
subcommittee under CG framework to which the board delegates some of
its oversight responsibilities. Chen et. al. (2008) studied non US companies
trading shares in US market and argued effective AC can resolve agency
problems of foreign companies no matter which CG model is being
followed in the companys home country. Dey (2008) found the level and
intense of agency problem is less in those firms where ACs are more
effective in terms of composition and functioning.
Large investors usually dominate the board and exercise undue
influence on management decisions. Some legal clauses may protect the
small investors against expropriation by large investors. Congenial legal
system 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) explained
positive agency theory by linking managerial incentives for voluntary
financial disclosure. It is obvious that good financial reporting practices
ensure more managerial disclosure. Thus, financial reporting system has
role in resolving agency problem. Since managers usually do not have to
interact frequently with shareholders, a distance in terms of trust might
exists 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 maintain
contract between management and shareholders.

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2.2 Stakeholder Theory
Freeman (1984) defines a stakeholder as any individual or group who can
affect 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 and
general public. Most extreme proponents of this theory suggest that
environment and future generation are also included in stakeholders.
Stakeholder theory represents that the company is a separate
organizational entity and it is connected to different parties in achieving
wide range of purposes (Donaldson and Preston, 1995). The theory
highlights interests of different groups and argues on the possibility of
favouring one groups interest over that of other (Jones and Wicks, 1999).
Donaldson and Preston (1995) pointed out that managers are responsible
to deploy their wise decisions and best efforts in obtaining benefits for all
stakeholders. 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 board
merely improves their relation and performance. They emphasised on
board effectiveness in this regard. An effective AC ensures better CG
practice in a firm that ultimately leads to overall welfare of stakeholders.
Deys (2008) conclusion is notable in this respect. He mentioned that
organizations performance and stakeholders value are positively affected
by various governance mechanisms including AC. Stakeholders interest
has been emphasized in the definition of effective AC given by DeZoort
et. al. (2002). They argued that the ultimate goal of the AC is to protect
stakeholders interests and welfare.

3. AC Attributes
There is a vast growing literature on AC attributes that mainly that
generally argues that a more independent, more expert, more diligent and
with larger size AC tend to carry out its responsibilities more successfully.
3.1 Audit Committee Independence
Existence of independent AC is a sign of the firms commitment for fair
CG practice (Sommer, 1991). The AC should be independent of the
organizations 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 they
should be able to deter management from manipulating financial results.
Beasley (1996) noted that the incidence of financial fraud is negatively
associated with the independence of the BoDs. Bedard et al. (2004) argue
that more objective oversight of financial reporting process can be ensured
if the AC includes more independent members. Further, Garcia-Meca and
Sanchez-Ballesta (2009) argued that independent AC can potentially
improve the quality and credibility of financial reporting. Cohen and
Hanno (2000) highlighted the importance of committees independence
for evaluating management actions in respect of risk assessment. Studies
by Klein (2002b) and Dechow et al. (1996) clearly mentioned that
inclusion of more independent members in AC minimizes the likelihood
of financial fraudulent activities. Gendron et al. (2004) mentioned that
members willing to be active and effective in the AC should have probing
attitude in mind which helps in assessing various management decisions.
ACs independence is needed for carrying out its monitoring
responsibilities delegated by the board in order to add value to firm. Chan
and Li (2008) noted that inclusion of expert independent directors in
board and AC enhances firms value significantly. Many stock markets
have already imposed the inclusion of independent members in the ACs
in their listing requirements. ACs independence is also reflected in
adherence to accounting principles, for example Carcello and Neal (2003)
found a positive relation between ratio of independent directors in the
AC and the optimism of companys going concern disclosure in financial
reporting. Roles of AC ultimately lead to positive impact in terms firms
earning, value creation and goodwill. Pucheta-Martinez and Fuentes
(2007) revealed inclusion of independent members in AC has positive
impact in improving the reporting quality both externally and internally.
The Olivencia Report (1998) stated that the AC should be composed of a
majority of independent members. The creation of an AC aims to
delegate of responsibilities to hire external auditors and to facilitate and
supervise their work and the AC should be composed of a majority of
independent members (Olivencia Report, 1998 cited in Osma and
Noguer, 2007).
3.2 Committee Members Knowledge and Experience
Many 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 and
Salterio, 2001). Since the ACs main task is to oversee corporate financial
reporting and auditing processes, its members should possess sufficient
expertise to understand the issues to be investigated or discussed by ACs
(Lin et al, 2008). Positive relationship between members financial
knowledge and ACs effectiveness particularly their potentials to ensure a
good quality financial reporting process and compliance of related rules
has been found in many studies, [for example, Defond et al. (2005); Felo et
al, (2003); DeZoort and Salterio (2001) and Treadway Commission
(1987)]. POB (1993) mentioned that lack of adequate knowledge and
relevant experience causes inability and failure of AC members to
understand their roles and responsibilities in the firm. Absence of these
qualities 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 frequent
disputes between external auditors and management about accounting
estimations. AC resolves these disputes and in doing so, committee
members have to have adequate knowledge and expertise. To decide on
some of the complex accounting related issues, only data and their literal
interpretations are not enough rather they require technical knowledge
and wider experience. Tan and Kao (1999) pointed out that the essence of
individuals competence in performing assigned responsibilities. People
having relevant experience and knowledge can demonstrate better
performance 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 association
between litigation risk and AC members with accounting financial
expertise.
Firms with AC members who have financial expertise are less
likely to be subject to censure for poor financial reporting (Farber, 2005;
Agrawal and Chadha, 2004 and McMullen and Raghunandan, 1996), more
likely to have higher quality earnings (Qin, 2007) and more likely to
reduce earnings management for firms with weaker CG mechanisms
(Carcello et al., 2006). In addition, ACs with financial experts are more
likely to promote more conservative financial reporting when the overall

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board CG is strong (Krishnan and Visvanathan, 2008). So, there are
growing number of researches addressing the benefits of inclusion
financial experts in AC.
3.3 Size of the Committee
Many researchers (for example, Pincus et al., 1989) report that the size of
AC is an influential factor for its effective functioning. Pucheta-Martinez
and Fuentes (2007) documented positive relationship between size of AC
and quality of financial reporting which is consistent with the findings of
Felo et al. (2003). Although AC size is affected by the size of BoDs and
the company, a large AC may not necessarily result in more effective
functioning as more members in an AC may lead to unnecessary debates
and delay the decisions (Lin et al., 2008; Scarbrough et al., 1998; Kalbers
and Fogarty, 1996 and Yermack, 1996;). Therefore, the current
requirement on AC size laid down by the market regulators in the USA
and the UK is a minimum of three members (NACD, 2002; ICAEW,
2001), while some empirical studies have found that the normal AC size
in 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 new
requirements, every firm listed under NYSE and NASDAQ must have
AC with minimum three directors.
3.4 Meetings and Diligence of the Committee
Members diligence is very important in performing ACs responsibilities
effectively and with integrity (Sharma et al., 2009). Since diligence is
extremely 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 many
researchers such as Spira, (2002) and Anderson et al. (2004). AC meetings
are not mere rituals devoid of interest to managers and auditors (Gendron
and Bdard, 2006 and Gendron et al., 2004) instead meaningful and
substantive meetings are consistent with an agency perspective (Beasley et
al., 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 frequency
and length of meeting and this absence of regulatory guidelines affords
ACs considerable discretion in this area (Sharma et al., 2009).

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A few studies reported that ACs in US and UK companies held
meetings on an average of four to six times per year with the average
duration of three to four hours per meeting (ICAEW, 2001; Collier and
Gregory, 1998 and McMullen, 1996). Menon and Williams (1994) suggest
a minimum of two meetings a year. This recommendation as to a
minimum meeting frequency to guarantee effective AC control are
supported by empirical evidence of a positive relationship between
meeting frequency and the quality of a firms accounting information
(Abbot et al., 2004and Xie et al., 2003). It is argued that effective control is
unlikely to occur if an AC holds a single yearly meeting, or none at all
(Deli and Gillan, 2000; Klein, 1998a; Collier and Gregory, 1998 and
Menon and Williams, 1994 cited in Mendez and Garcia, 2007). Abbott et
al. (2007) noted that an effective AC should meet at least four times
annually. 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 ACs
roles evolved continuously (Lin et al., 2008). There were varied views on
ACs roles in the western literature before 2000s, but a relative consensus
has emerged in recent years following the promotion of AC function in
CG by market regulators and professional bodies. ACs are traditionally
responsible for oversight of auditing matters relating to the companys
financial reporting (Brown et al., 2009). Lin et al. (2008) noted AC
oversight roles and responsibilities for improving internal control, rules
compliance, sound corporate financial reporting and auditing processes.
While the primary responsibilities of the AC are to assist the board with
its duties in overseeing the corporations reporting and audit requirements
(Chen et al., 2008), it also (i) monitors the integrity of the companys
financial statements and reporting system; (ii) ensures that the company
complies with legal and regulatory requirements; (iii) monitors
independent auditors qualifications and independence; (iv) monitors the
performance 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 four
responsibilities of ACs which are (i) advising board on the reliability of
financial information, (ii) advising board in risk management and internal
control, (iii) dealing with external auditors, and (iv) overseeing the
internal audit process. The committee regularly meets with outside
auditors and internal financial managers for reviewing internal control
process, financial reporting system, and external audit process (Klein,
2002a). ACs roles in overseeing and monitoring financial reporting
process, internal controls, and external auditing are also noted by Sori et
al. (2007) and Sharma et al. (2009). Among many areas of AC
responsibilities, main four roles are discussed in following subsections.
4.1 Financial Reporting Process
The financial process and ensuring reliable financial information is one of
the most important functions of the AC (Rezaee and Farmer, 1994).
While the AC should not become involved in day-to-day operations, there
is pressure from the oversight role for the AC to get more involved in
ensuring the integrity of the financial reporting process. Effective AC
processes for overseeing financial reporting are studied by Truly and
Zaman (2007); Cohen et al. (2007); Gendron and Bedard (2006); Gendron
et al. (2004); Smith (2003); Spira (2002); Porter and Gendall (1998); Lee
and Stone (1997); Wolnizer (1995); Rittenberg and Nair (1994); Rezaee
and Farmer (1994); Luecke and Westfall (1990); Braiotta (1986) and Mautz
and Neumann (1970).These studies generally noted that ACs are expected
to:
Review all financial statements, whether interim or annual, before
they are approved by the BoDs and publicly disseminated to
ensure their objectiveness, accuracy, and timeliness;
Review all existing accounting policies, and concentrate on the
impact on the financial statements of any changes in accounting
policies including the likely impact of any contemplated changes;
Evaluate exposure to fraud;
Appraise key management estimates, judgements, and valuations
where 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, including
management'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 Responsibilities
The AC can strengthen the entity's internal audit function by ensuring
that management has established and is maintaining an adequate and
effective internal audit structure (Beasley et al. 2009; Turley and Zaman,
2007; Rezaee and Farmer, 1994). Also, Oliverio and Newman (1993) after
discussion in the Treadway Commission's Report identified the
interaction between the internal audit function and the AC that should
ensure the internal audit function's effectiveness and objectivity. While
talking about internal auditors responsibilities, Wolnizer (1995) noted
that ACs are expected to:
Evaluate the independence and competence of internal audit
function;
Discuss with the chief of internal auditors about internal audit
reports, effectiveness of internal controls and problems in
performing 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 auditors
and coordination of their work; and
Appoint and dismiss the head of internal audit.
4.3 External Auditors' Activities
The AC is a valuable instrument for initiating direct contact with the
independent/external auditor, participating in the selection of the external
auditor, and promoting effective communication between the
independent auditor and corporate directors (Beasley et al. 2009; Rezaee
and Farmer, 1994). Beasley et al. (2009) also found AC members
dependency on external auditors in performing their oversight

108
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's
response 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 independent
auditors; 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 Issues
ACs play singificant role in managing risk of the business. ACs roles in
risk management have been noted by many researchers for example,
Chambers (2005) and BRC (1999) highlighted the ACs role in advising
the board risk management. Similarly, Saren et al. (2009) also discussed
AC roles in this regard.
Apart from the above discussed foukey roles, ACs presume some
CG responsibilities for the firm. In the case of CG responsibilities, ACs
are expected to (Wolnizer, 1995):
Facilitate and enhance communication between the external
auditors and the BoDs;
Review corporate policies and practices in the light of ethical
considerations;
Monitor the manner in which the company's affairs are conducted
and, where applicable, compliance with the company's code of
corporate 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, academic
and industry seek for effective ACs to provide sound monitoring (Chan
and Li, 2008). ACs effectiveness is very crucial for sound CG practices in
the organization. Campbell (1990) and Vicknair et al. (1993) reported that
lack of effective AC practice is a factor behind rigorous financial problems
of companies. However, effectiveness is an elusive concept that can be
approached through several models, none of which is appropriate in all
circumstances (Cameron, 1981). Spira (1998) considered "there is no
discussion of the meaning of effectiveness, resources, or independence within
the literature and this assertion is unsupported. Lee and Stone (1997) in
explaining their purpose of study noted actual effectiveness is impossible to
observe.
Many authors who have written on ACs' effectiveness have used
the word effectiveness to mean the carrying out or fulfilling its specific
oversight 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 their
oversight responsibilities for the definition of ACs' effectiveness, [see for
example, 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 "a
committee's collective ability to meet its oversight objectives." Baugher (1981)
noted "the investigator should determine which type of effectiveness is of the
greatest concern to the constituency or constituencies to which he or she must
report.", Emphasizing AC roles, DeZoort et al. (2002) further defined
effective AC an effective AC has qualified members with the authority and
resources to protect shareholders interests by ensuring reliable financial
reporting, internal controls, and risk management through its diligent
oversight efforts. Strong and well resourced internal control function is a
necessary criteria for effective AC (Zain and Subramaniam, 2007) since
AC members especially reply on the work of internal auditor in order to
develop 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 AC
through private meetings and informal communication.

110
An AC represents a standing committee of the BoDs, which is
responsible for dealing with audit-related concerns and should assist in
resolving 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 factors
to improve AC effectiveness. An effective AC should have a greater
likelihood of detecting problems than an inactive one (Choi et al., 2004).
Finally, the AC-related disclosure and reporting is a necessary element for
assessing the effectiveness of AC function (Spira, 1998; ICAEW, 2001; Ng
and Tan, 2003; Lee et al., 2004). Relevant disclosures include a written
charter or terms of reference specifying the AC responsibilities that have
been endorsed or approved by BoDs, and AC reports demonstrating how
an AC has fulfilled the described responsibilities during the year. The
effectiveness 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 effectiveness
depends mainly on how successfully they can carry out its roles and
responsibilities no matter how they are composed of. However, previous
literature documents that there are casual relationship between AC
attributes 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. Previous
empirical researches documented a positive association between AC and
the quality of financial information. A well functioning AC system leads
to the improvement of corporate financial reporting and the decrease of
earnings management or financial frauds, as well as the increase of
unqualified 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 AC
reduces errors and irregularities in financial statements and enhances the
credibility of financial reporting which was consistent with the conclusion
of McMullen (1996). It is axiomatic that poor standards of CG, for
instance ineffective or non-existent ACs, facilitate abuses such as

111
fraudulent financial reporting (Chambers, 2005). ACs significance in
preventing misstatement in financial reporting has been highlighted in
many 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 earning
information to the stakeholders. Klein (2002b) and Bedard et al. (2004)
noted that ACs independence and financial expertise are negatively
associated with earnings management as measured by discretionary
accruals. Xie et al. (2003) explained the role of AC in preventing earning
management. Independent ACs are effective mechanisms in limiting
earning management (Garcia-Meca and Sanchez-Ballesta, 2009). Further,
Lin and Liu (2009) added that an independent auditing function can detect
and disclose earnings management and other types of misconduct by
business 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 the
monitoring process (Klein 1998b; Sori et al., 2007), and enhances the
independence of the auditor from the management (Mautz and Neumann,
1977). Thus, a properly functioning AC is critical in enhancing the
effective 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 effectiveness
is its impact on firms return. ACs significance on firms earnings and
return has been noted in many studies Chen et al. (2008) found that the
establishment of AC is positively related with higher-earnings return
associations. Bryan et al. (2004) found positive association between AC
existence and firms earning and informativeness. In respect of firms
earning, Wild (1996) found significant relationship between forming AC
and earnings and returns of the firm. This result is presumably due to
market perception that formation of an AC is likely to improve the
quality of financial reporting.


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7. AC Effectiveness Model
The following model summarises the main message of all literature
discussed in this paper.
AC Attributes AC Roles Minimizing
Agency
Conflicts

Composition

Characteristics

Structure

Process

Independence

Financial
Reporting

Internal
Auditing

External
Auditing

Risk
Management

Compliance
Issues

Audit
Committee
Effectiveness

Protecting
Stakeholders
Interests

Improving
Quality of
Financial
Information

Reducing
Earning
Management

Enhancing
Firms
Performance

Maximizing
Firm Value

The self explanatory model clearly describes that AC effectiveness
mainly depends on the ability and scope of performing its oversight roles
and responsibilities delegated by the board. The key functional areas
where AC contributes are financial reporting, internal auditing, external
auditing, risk management and firms compliance issues. Committees
attributes namely, composition, members characteristics, structure,
process, and independence have obvious impacts in carrying out these
roles successfully. An effective AC minimizes agency problem by
reducing information asymmetry between owners and management and
also acts as a safeguard of stakeholders interests. The main outcomes of an
effective AC are (i) more credible financial information, (ii) preventing
unauthorized earning management in the firm and in effect and (iii)
enhancing firms returns and profit. All these outputs ultimately lead to
maximizing firms long term wealth which is the ultimate goal of any
business entity.

8. Conclusion
Although formation of AC is voluntary in some developed economies
like China and Japan (Tafara, 2006), it has undoubtedly become an
accepted and effective mechanism for ensuring good governance in firms.

113
AC mitigates agency problem in the firm and also acts as a trusted
safeguard for the large stakeholders. Inclusion of majority independent
directors 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 and
independent AC can effectively carry out its oversight responsibilities
including monitoring management activities. Effective ACs impact on
the quality of firms financial reporting and earnings as a result on wealth
is generally recognized

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