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D Assist. 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 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. Keywords: internal control weakness; audit committee financial expertise; auditor independence.
Introduction 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. Independent audit committees and audit committees with more financial expertise are significantly less likely to be associated with the incidence of internal control problems.
Material weaknesses in internal control are more likely for firms that are smaller, less profitable, more complex, growing rapidly, or undergoing restructuring. Firms with more complex operations, recent changes in organization structure, auditor resignation in the previous year, more accounting risk exposure, and less investment in internal control systems are more likely to disclose internal control deficiencies.
In addition, we document that auditor independence is an important determinant of internal control weaknesses. Background and hypotheses 2. Management must disclose significant internal control deficiencies, when they certify annual financial statements. Specifically, the signing officers, being responsible for internal controls, have evaluated the internal controls and reported in their findings: 1 a list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal control activities; 2 any significant changes in internal controls or related factors that could have a negative impact on the internal controls.
Most of the internal control weakness disclosures are related to financial systems and procedures. This group typically involves financial closing processes, account reconciliation, or inventory processes. Personnel issues rank as the second largest category of weakness disclosures. This category is related to the poor segregation of duties, inadequate staffing, or other related training or supervision problems.
In addition, issues related to international operations and mergers and acquisitions are sources of weakness disclosure, although they represent a relatively small percentage of all disclosures. Based on their severity, these internal control problems are classified into three types: material weakness, significant deficiency, and control deficiency.
The audit committee not only plays an important monitoring role to assure the quality of financial reporting and corporate accountability, but also serves as an important governance mechanism, because the potential litigation risk and reputation impairment faced by audit committee members ensure that these audit committee members discharge their responsibilities effectively. We thus expect that firms with high-quality audit committees are less likely to have internal control weaknesses than firms with low-quality audit committees.
On measuring audit committee quality, we focus on the financial expertise in these committees. It is recommended that each audit committee have at least one financial expert highlights the importance of the financial literacy and expertise of audit committee members. Such financial expertise of audit committee members has been shown to be important for dealing with the complexities of financial reporting and for reducing the occurrence of financial restatements.
In addition, audit committee members with financial reporting and auditing knowledge are more likely to understand auditor judgments and support the auditor in auditor-management disputes than members without such knowledge. Moreover, financially knowledgeable members are more likely to address and detect material misstatements. Audit committee members with financial expertise can also perform their oversight roles in the financial reporting process more effectively, such as detecting material misstatements.
Indeed, there is a significantly negative association between an audit committee having at least one member with financial expertise and the incidence of financial restatement. Audit committees with financial expertise are less likely to be associated with the incidence of internal control problems. Hypothesis 1. Firms with greater audit committee financial expertise are less likely to have internal control weaknesses. Audit committees with accounting financial expertise improve corporate governance.
Therefore, we further separate audit committee financial expertise into accounting financial expertise and nonaccounting financial expertise and test the relation between these two variables and internal control weaknesses. An audit committee member is a financial expert if he or she can be classified into the following two categories: a an accounting financial expert who has experience as a public accountant, auditor, principal or chief financial officer, controller, or principal or chief accounting officer; or b a non-accounting financial expert who has experience as the chief executive officer, president, or chairman of the board in a for-profit corporation, or who has experience as the managing director, partner or principal in venture financing, investment banking, or money management.
With this definition, we measure audit committee financial expertise as the percentage of audit committee members who are financial experts. We further separate audit committee financial expertise into accounting financial expertise, measured as the percentage of audit committee members who are accounting financial experts, and non-accounting financial expertise, the percentage of audit committee members who are non-accounting financial experts.
Non-audit services are associated with increased discretionary accruals and the achievement of certain earnings benchmarks. Given these mixed empirical findings, we measure auditor independence as the ratio of the audit fee to the total fee, and propose the non-directional null hypothesis, as follows.
Hypothesis 2. Auditor independence is not associated with the disclosure of internal control weaknesses. Control variables 2. Audit committee In addition to audit committee financial expertise, other attributes of an audit committee have been found to be important factors in effective monitoring.
Specifically, we control for audit committee independence, there is a positive relation between audit committee independence and the quality of internal control. An audit committee member is independent, if he or she is not affiliated with the firm and does not accept any consulting fees.
We thus expect that a large audit committee is more likely than a small one to improve the quality of internal controls, because increased resources and enhanced status will make the audit committee more effective in fulfilling its monitoring role. We also control for the natural logarithm of audit committee meetings, measured as the number of audit committee meetings held each year, because research shows that effective audit committees meet regularly.
Therefore, we make no prediction on the relation between the number of audit committee meetings and the quality of internal controls. First, we focus on board independence, measured as the percentage of outside directors on the board 2, because research suggests that board independence is negatively related to the likelihood of financial fraud. We also control for the natural logarithm of board size, measured as the number of directors on the board.
While some researchers find that a large board has more expertise than a small one, that it tends to be more effective in monitoring accruals, others suggest that a small board is more effective in mitigating the agency costs associated with a large board. Given the mixed empirical evidence on board size, we expect that the relation between board size and the likelihood of internal control weaknesses is indeterminate. Finally, we control for the natural logarithm of board meetings, as measured by the number of board meetings held each year.
While board meeting frequency is important to improve board effectiveness, it is inversely related to firm value, because of the increased board activities following share price declines. Smaller and less profitable firms are more likely to have internal control problems than larger or more profitable ones. On the one hand, such firms with internal control problems are less likely to hire a Big 4 auditor, because they are constrained by financial resources and cannot afford it.
On the other hand, they might also be avoided by the Big 4 auditors, because they are perceived as being risky and may expose the Big 4 to potential litigation. Given that a firm shunned by a Big 4 auditor may signal that it has potential internal control problems, we introduce the dummy variable BIG4 to control for auditor quality. Auditor changes Firms with recent auditor changes are likely to have internal control problems. On the one hand, auditors may drop risky clients as part of their risk management strategies, since firms with material internal control weaknesses may represent high audit failure risk.
On the other hand, firms may dismiss auditors for lack of performance, when the firms discover material internal control weaknesses. Other variables We also control for firm characteristics that may be associated with internal control problems.
Small and high growth firms are likely to have internal control weaknesses, we control for size, measured as the natural logarithm of total assets TA , and growth, measured as industry-median-adjusted sales growth. It may take some time for a firm that recently engaged in mergers and acquisition to integrate different internal control systems; consequently, such a firm is more likely to have internal control problems.
A firm experiencing restructuring is also likely to have internal control 2 Outside directors are those who are not affiliated with the firm, other than serving on its board.
Conclusion In this paper, we examine the relation between audit committee quality, auditor independence, and the disclosure of internal control weakness.
The results from our conditional logit analyses suggest that a relation exists between audit committee quality, auditor independence, and internal control weaknesses.
Abbott, L. Auditing: A Journal of Practice and Theory 23 1 , DeFond, M. Doyle, J. Krishnamurthy, S. Krishnan, J. Reynolds, K. Related Papers. By Aprodio S. Internal and external influences on IT control governance. By Jee-hae Lim. By Duaa Zammar. Audit Committee Quality, Auditor Independence.
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What is Auditor Independence? The SEC has amended Rule f 4 to include a dual materiality standard for assessing whether entities under common control are affiliates for the purpose of assessing auditor independence. Furthermore Rick Hayes, et. Under this new dual materiality threshold, only if both a the entity under audit is The Need For Auditor Independence. Self-review threat These occur when the auditor has also prepared some of the accounting for the fund.
Skip to search form Skip to main content You are currently offline. Some features of the site may not work correctly. DOI: This study applies Heckman two-stage approach to investigate whether the adoption of an audit committee and its effectiveness could mitigate the incidence of internal control weaknesses hereafter ICWs for firms listed in Taiwan. The empirical results reveal that the incidence of ICW problems could be depressed by adopting the audit committee voluntarily.
Free PDF. Under this new dual materiality threshold, only if both a the entity under audit is independence of auditors is in fact ensured by the imposition of contractual duty, the observance of ethical codes, distancing the auditor from negotiations with the client, and dissociating the fee charged for the audit from the granting of the ISO certificate. Members are obliged to be straightforward and honest in professional and business relationships and not to allow their judgment to The new audit independence rules provide a conceptual approach which takes into account threats to independence, accepted safeguards and the public interest.
Abbott, L. Audit committee characteristics and auditor choice. Auditing: A Journal of Practice and Theory 19 2 : Parker, and G. Audit committee characteristics and restatements.
This study examines the relationship between the effectiveness of an audit committee and the amount of audit fees. Data are obtained from the IDX and company's annual reports. The effectiveness of an audit committee is measured by independent audit committee size, frequency of audit committee meetings, and expertise of the audit committee.
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