Having many directors on the AC is not enough to cause AC efficiency. ACMs must also exer- cise independent judgment in order to monitor audit quality. For this reason, I turn to the second important characteristic of an AC: Independence. AC independence refers to the freedom from any business or other relationship that can materially interfere with the exercise of independent judgment of audit committee members (Hong Kong Society of Accountants, 2002; Sarbanes Ox- ley Act 2002; Cadbury Committee, 1992). An independent committee can make its own judg- ment with audit evidence provided by EAs and challenge the position of managers for their mis- stated financial statements (Liao and Hsu, 2013; Carcello, et al., 2011; Sharma and Sharma, 2011; Dimitropoulos and Asteriou 2010; Duchin, Matsusaka and Ozbas, 2010).
Higgs Report (2002) and The UK Corporate Governance Code (2012) provided some examples that a director in the board or in its committee cannot be deemed independent if a director
● has been an employee of the company or group within the last five years;
● has, or has had within the last three years, a material business relationship with the company either directly, or as a partner, shareholder, director or senior employee of an entity that has such a relationship with the company;
● has received or continues to receive additional remuneration from the company in addition to a director’s fee, participates in the company’s share option or a performance-related pay scheme, or is an existing member of the company’s pension scheme;
● has close family ties with any of the company’s advisers, directors or senior employees; holds cross-directorships or has significant links other directors.
● holds cross-directorships or has significant links with other directors through involvement in other companies or bodies;
● represents a significant shareholder; or
● has served on the board for more than nine years from the date of their first election
Blue Ribbon Committee (1999) stated that a listed company must have an AC with at least three directors who are independent. Correspondingly, Higgs Report and Smith Report (2003) pointed out that an AC must include a minimum of three members, who are all independent non- executive directors. It is noteworthy that the Blue Ribbon Committee defined independence as the exclusion of current and former employees, relatives of management, persons receiving com- pensation from the company (except directors’ fees) or controlling for-profit organizations re- ceiving from or paying the corporation significant sums, and compensation committee interlock- ing directorships.
According to the SOX (2002), an AC is independent if its member does not, other than in his or her capacity as a member of the audit committee, board of directors, or any other board commit- tee:
● Become an affiliated person of the issuer or any subsidiary thereof.
Cadbury Report (1992) concurred that an independent AC, which can be characterised by the number of non-executive directors, serves the role of ascertaining the checks and balances on executive directors and resolves the conflict of interest between executive directors and share- holders. Non-executive directors are the best suited executives for this role because they are less directly affected and they can give their independent judgment.
However, non-executive directors only refer to those directors who are not involved in day-to- day operations of companies (HKICPA 2013a), but may not be independent because they may have some relationships with companies. For example, non-executive directors may have busi- ness relationships with the companies, have worked for the companies or have served as EAs of the companies in the past. Besides not being involved in operations of companies, independent non-executive directors do not enter into any relationship with the companies that could materi- ally interfere with the exercise of independent judgment of ACMs apart from the relationship as ACMs of the companies.
HICPA (2013a) recognised the difference between non-executive directors and independent non- executive directors in the requirements of AC independence. It stated that the majority of ACMs must be independent non-executive directors and that the chairman of the AC needs to be inde-
pendent non-executive directors. However, the definition of majority is not defined in Hong Kong. Therefore, it is possible for a company to determine the level of independence that is the most suitable for it. It implies that although majority of ACMs must be independent non- executive directors, executive directors and non-executive directors can have a presence on the AC.
Prior research supports the view that AC independence is important for the purpose of enhancing audit quality. In a study that investigated whether the relationships between the board character- istics, board committee independence and firm performance are moderated by the concentration of family ownership, Leung, Richardson and Jaggi (2014) suggested that the independent direc- tors are more effective in fulfilling their roles. In particular, independent ACMs may objectively review financial statements, audit processes and internal controls in order to ensure that the ac- counting information remains unbiased. The unbiased accounting information may enhance the firm’s performance. However, family firms may use their power to appoint individuals to serve as ACMs due to their relationships with family members so that family ownership concentration may negatively relate to the appointment of independent members on the AC (Leung, Richardson and Jaggi 2014).
They found a sample of 487 firms (from 2005 to 2006) on the Hong Kong Stock Exchange. These years were chosen because the latest Code on Corporate Governance Practices was first implemented by Hong Kong firms during the financial year ending December 2005. Firm per-
formance was measured as market-adjusted returns. If a firm is family-owned, the indicator will show a value of 1, otherwise it would denote 0. They controlled for the effects of firm size, aver- age percentage growth in total assets, percentage of outside directors’ ownership, types of indus- try, CEO ownership and the number of foreign subsidiaries. According to their observation, there was a positive relationship between the independence of the board and the independence of the AC. There was also a positive relationship between the independence of the AC and firm per- formance with regard to non-family firms. This relationship was moderated by the concentration of family ownership. However, the one caveat is that this study did not control for the effects of other AC characteristics. For instance, AC diligence and sufficiency of resource provided to AC may allow ACMs to perform their role more efficaciously.
If ACMs are independent, they may be perceived to constrain the managers to manipulate the earnings, implying that a firm’s value would increase. In addition, an AC requires adequate re- sources to fulfil their role, otherwise their role is deemed ceremonial at best (Chen et al. 2011). Chen et al. (2011) examined whether the specific structural and operational characteristics of an AC in Hong Kong may encourage an AC to safeguard shareholders’ interest. The sufficiency of resource provided to an AC was measured as an indicator with a value of 1 for the firms which made it evident in their disclosures that adequate resources were provided to ACs in their annual reports, otherwise 0. On the other hand, independence was measured as the proportion of inde- pendent non-executive directors on an AC. The firm value was measured as Tobin’s Q.
They used a sample of 223 companies that were listed on the main board of the HKSE in 2006 and controlled for the effects of other AC variables as well as firm variables. They did not find evidence that AC independence and financial expertise was associated with firm value, but did observe that the disclosure of whether an AC was provided with sufficient resource was a signifi- cant factor to augment firm value. However, the one shortcoming is that sufficient resource could not stand alone as a significant independent variable. If an AC is neither independent nor compe- tent, resource may not be used judiciously to oversee financial reporting and audit process. Therefore, future research may entail studying the moderating effects of resource sufficiency on the association between AC characteristics and firm value. Another caveat is that this study did not examine ACMs’ independence in terms of relationships with CEOs.
While the above studies seemed to examine ACMs’ independence, they may not be independent in substance given that they may have personal relationships with the CEOs (Bruynseels and Cardinaels, 2014). Such personal relationships are not required to be disclosed in annual reports. Notably, CEOs often appoint directors from their informal social networks (Beasley et al., 2009; Finkelstein and Hambrick, 1996). These friendly relationships impel them to be less critical of the CEO’s financial reporting policies and less likely to challenge managers’ assumptions during the conflicts arising between managers and EAs (DeZoort, Hermanson and Houston, 2008; De- Zoort and Salterio, 2001).
of an AC, Bruynseels and Cardinaels (2014) selected the sample firms from 2004 to 2008. They measured CEO-ACM connections in terms of past or present employment, education, or non- professional activities. They made 625 firm-year observations for this four-year period in the US. The oversight quality of ACMs was measured in terms of discretionary accruals, audit fees, go- ing concern opinions, disclosure of internal control weakness as well as internal control deficien- cies.
After controlling for the board and AC effectiveness, profitability, industry type and leverage, they observed that the social ties established through the CEO’s friendship network adversely affected oversight quality. Managers of such companies engaged more in earnings management, and their ACMs purchased less audit efforts. This was evident in lower audit fees. Moreover, they observed that EAs in these companies were less likely to report internal control deficiencies or issue going-concern opinions for companies in distress when friendships were present.
These results imply that AC independence, which was impaired by social ties with CEOs, may affect the oversight quality of ACMs. However, one caveat is that the measures of social ties were unable to capture the true interactions between them. For instance, despite graduating from the same school, they may not be able to establish connections with one another due to lack of interactions. AC independence was not threatened in this case. Further, research may use social ties as a context to investigate how they had interacted and how to impair AC independence.
Archival research above used proxies such as abnormal accruals, market returns and restatement of financial statements in order to measure the levels of audit quality, but they may be unable to capture important elements of audit quality such as ACMs’ and EAs’ judgments, thereby threat- ening the internal validity of the findings. In this regard, the usage of experiments helps enhance internal validity by facilitating the more direct measurement of audit quality. For instance, ACMs’ support for EAs’ position when they have disagreements with managers is not disclosed in the financial statements, which implies that archival research cannot capture their judgments. However, their support for EAs is known to enhance audit quality significantly.
DeZoort and Salterio (2001) investigated the effects of AC independence and expertise about the extent to which ACMs support the position of EAs when they have disagreements with managers. As part of this study, they invited 340 ACMs to participate; 68 Canadian ACMs participated, leading to a response rate of 27 percent. After a hypothetical case was presented to the partici- pants, they were then asked to fill out questionnaires. The hypothetical case pertained to the change in accounting policy of revenue recognition of an electronic goods retailer. The managers wanted to bring about changes in the accounting policy, but EAs asserted that the revenue recog- nition policy propounded by managers was inappropriate in reflecting the stream of revenues. After making the adjustment, net income will decrease by 37 percent and the debt-to-equity ratio will violate the debt covenant. Due to their disagreements about the revenue recognition policy, these participants were required to act as ACMs in the hypothetical company in order to handle the disagreements. They had to decide whether they should choose between EAs and managers
in terms of their stance.
In order to measure AC independence, participants were asked for the number of corporate boards where they served as independent directors. They were also asked whether they served as both senior management and directors on the board of a company. The authors assumed that if ACMs had more experience as independent directors, they may be able to make more independ- ent decisions (Libby and Tan 1995). Additionally, if they serve as both directors and senior man- agement on the board, experience may be biased towards understanding and sympathising with managers’ position, thereby curtailing independence. In order to measure financial reporting and auditing knowledge, they were asked to respond to the items contained in the questionnaires. They observed that serving as both board and senior management encouraged them to support managers’ position. Further, they found that while ACMs with knowledge of audit reporting are more likely to support EAs’ position, knowledge of financial reporting did not significantly relate to their judgments.
These results imply that independent ACMs with sufficient audit reporting knowledge may be more likely to enhance audit quality. The results were in consonance with the suggestions of SOX, Cadbury Report and Hong Kong Stock Exchange that an AC should be sufficiently inde- pendent to challenge managers’ assumption and support EAs’ position. However, one caveat is that the design of this case ignored the interactions taking place between EAs and ACMs. How- ever, their interactions are an important factor in deciding whether ACMs should support EAs’
position.
Audit quality is also influenced by clients’ internal audit function because EAs often rely on the work of internal audit function (Paino, Razali and Jabar, 2015; Suwaidan and Qasim, 2010). Therefore, the issues of audit quality can be investigated in connection with the quality of the internal audit function. In this context, Zaman and Sarens (2013) examined the relationships be- tween AC characteristics and informal interactions between ACs and internal audit functions as well as their concomitant effects on internal audit quality. According to their findings, internal audit assumes importance for financial reporting quality because ACMs rely on the work of the internal audit function to develop their understanding of risk management and efficacy of inter- nal control. ACMs may fulfil their oversight role more effectively with high quality internal audit function. They also suggested that independent ACMs may face greater information asymmetry. This explains why independent ACMs are likely to seek more information whilst performing their monitoring responsibilities.
Additionally, active ACMs may want to obtain more information and be more interested in inter- acting with the internal function. They posited that oversight of internal audit function is often performed in an informal manner and private meetings. Further they suggested that information interactions between ACMs and internal auditors may improve overall exchange of relevant and reliable information. Consequently, interactions between ACMs and internal audit functions can
enhance the quality of the internal audit function.
The data were collected using a questionnaire survey sent to 672 Chief Audit Executives (CAE) in the UK. 187 usable responses were collected, yielding a response rate of 27.8 percent. Infor- mal interactions between them were measured as whether CAEs have informal interactions with AC chair or ACMs besides the regular pre-scheduled meetings. They were asked to indicate the number of independent ACMs, total number of the firms’ ACMs and AC chair’s knowledge and experience relevant to risk management, internal and external audit and corporate governance. They were asked to indicate whether 95 percent of the internal audit plan was completed in order to measure internal audit quality. If so, it assumed that the quality of internal audit function was high. They were then asked whether their internal audit function was subject to formal and exter- nal quality assurance and whether their function complied with the Code of Ethics and Standards issued by Institute of Internal Auditors.
They controlled for the effects of whether these firms are financial companies or listed on the stock exchange. Using regression analysis, they observed that AC independence positively relat- ed to informal interactions, which, in effect, positively related to internal audit function quality. However, this study ignored one important determinant of interactions: the trust between ACMs and CAEs. Without this trust, CAEs may not be willing to interact with ACMs, although ACMs are independent. Therefore, future research should examine the effects of CAEs’ trust in ACMs on their interactions and audit quality.
Table 4 underpins previous studies about AC independence and audit quality in the literature.
Table 4: AC Independence
Studies Measures of Independence Results Leung, Richardson
and Jaggi (2014)
Independence was measured as the proportion of independent non- executive directors on an AC.
There was a positive relationship between the independence of the board and that of board commit- tees, including the AC.
Also, there was a positive rela- tionship between the independ- ence of board committees and firm performance for non-family firms. The relationship was moderated by the concentration of family ownership.
Chen et al. (2011) AC Independence was measured as the proportion of independent non- executive directors on an AC.
The authors did not find evi- dence that AC independence and financial expertise related to firm value, but observed that the dis-
closure of whether an AC was provided with sufficient resource was a significant factor to en- hance firm value.
Bruynseels and Cardinaels (2014)
Independence was measured as a measure of ACMs’ connections with CEO in terms of past or present em- ployment, education or non-
professional activities.
Managers of such companies engaged more in earnings man- agement.
Their ACMs purchased less au- dit efforts - reflected in lower audit fees.
EAs in these companies were less likely to report internal con- trol deficiencies or issue going- concern opinions for firm in dis- tress when friendships were pre- sent.
DeZoort and Salterio (2001)
AC independence was measured as the number of independent corporate boards served and whether senior managers also served as directors on the board.
Serving as both board and man- agement membership encour- aged ACMs to support manag- ers’ positions because AC inde- pendence was reduced.
Zaman and Sarens (2013)
AC independence was measured as the proportion of independent ACMs on an AC using a questionnaire sur- vey.
They observed that AC inde- pendence positively related to