Organizational and Economic Explanations of Audit Committee Oversight

Abstract

Corporate governance plays an important role in the production of corporate results. The setting of corporate objectives, and the concomitant measuring and reporting of results, depend in fundamental ways upon the caliber of corporate oversight. Although considerable attention has been focused on the forms that are necessary for such direction, less is known about their effectiveness. The establishment of audit committees in the United States was recommended by the Securities and Exchange Commission (SEC) as early as 1940. However, the place of audit committees in the corporate governance structure has increased dramatically only over the past twenty-five years (Birkett, 1986; Braiotta, 1994). Studies show that the percentage of firms with audit committees has gone from nearly ten percent in 1958 to nearly forty percent in 1972, to over ninety percent in 1982 (as summarized in Harrison, 1987, Figure 1, p. 110). Similar findings were shown in two early studies of audit committees by Mautz and Neumann (1970, 1977). In their first study (1970), they found one-third of their sample to have adopted audit committees. In their second study (1977), eighty-seven percent of responding chief executive officers indicated their corporations had audit committees. Thus, an increasingly rapid adoption of audit committees took place from the late 1950s through the early 1980s. The genesis of audit committees suggests that their inclusion in the structure of corporate governance should be understood as part of the reaction to corporate abuses occurring over the last three decades. Instances of fraudulent financial reporting, defalcations, accounting method choice abuses, and opinion shopping served as evidence that management was not effectively accountable to the full board of directors. The audit committee was an attempt to specifically designate responsibility for accounting-related matters, to provide a reporting structure for insiders that would circumvent managerial retribution, and to supervise relations with the external auditor. In fact, the SEC has forced a number of corporations to adopt audit committees as a remedial measure (see Birkett, 1986). Although many large companies had voluntarily formed audit committees by the mid-1970s, pivotal points occurred when audit committees were mandated for New York Stock Exchange firms in 1978, and for those listed on the National Market System by the National Association of Security Dealers in 1989. This article contrasts two competing theoretical orientations. Agency theory, now considered mainstream thought on control, proposes a primarily economic explanation of the existence and form of control mechanisms. Institutional theory offers a sociological approach that questions the sufficiency of technical rationality for understanding corporate governance. A review of previous empirical studies in the audit committee literature suggests that traditional agency cost measures do not provide an adequate basis to explain the formation of audit committees. Further, the studies on audit committee formation require a presumption that audit committees actually will reduce information asymmetry between principals and agents (i.e., audit committees are effective in carrying out their responsibilities). Other empirical studies link audit committee effectiveness to factors internal to the corporate governance and organization structure, but do not determine the extent to which these internal factors are influenced by external monitoring demands. In the next two sections, agency theory and institutional theory approaches are extended to analyze the contribution of each theory to understanding audit committee activities and effectiveness. Then, the hypotheses, design and results of a study are described. The empirical evidence suggests that neither theory alone is as useful as their synthesis. The last section discusses the results and their implications for the management of corporations. …