Economic Determinants of Audit Committee Composition and Activity

Abstract

In this study, I examine possible reasons behind observed differences in audit committee composition and activity. Although 97.9% of all audit committees for large U.S. firms have at least one outside, independent director, more than one-half of the sampled firms also have at least one affiliated, interested director and nearly 5% have a member of the firm's upper management. These percentages fly in the face of the Treadway Report which advocates that audit committees be comprised solely of independent directors. In addition, contrary to the Treadway Commission's explicit recommendation, only 38.9% of audit committees meet four or more times per year.

Two possible explanations for these observed variations are put forth and examined. The first is that boards with dominant CEOs are reluctant to have active, independent audit committees whose sole purpose is to act as a monitor on upper management's actions. The second explanation is that audit committees are constructed and act according to the economic needs of the firm. The evidence presented throughout this paper supports both points of views. The governance structures of audit committees appear to be sensitive in meeting the monitoring and litigation risk needs of the parent firm. However, there is also some evidence that boards with strong CEOs have a higher probability of placing insiders and interested directors than boards with relatively weaker CEOs. Audit committees of strong-CEO firms also tend to meet less frequently than their counterparts. These results suggest that there may be room for firms to better structure their audit committees to fulfill their needs.

In this paper, I examine possible reasons behind observed differences in audit committee composition and activity. The governance structures of audit committees appear to be sensitive in meeting the monitoring and litigation risk needs of the parent firm. However, boards with stronger CEOs also have a higher probability of placing insiders and interested directors on their audit committees than boards with relatively weaker CEOs. Audit committees of strong-CEO firms also tend to meet less frequently than their counterparts.