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649THEACCOUNTINGREVIEWVol.80,No.22005pp.649–675AuditCommitteeQualityandInternalControl:AnEmpiricalAnalysisJayanthiKrishnanTempleUniversityABSTRACT:Iexaminetheassociationbetweenauditcommitteequalityandthequalityofcorporateinternalcontrol.Whileinformationonthequalityofinternalcontrolisnotgenerallyavailable,companieschangingauditorsarerequiredtodiscloseanyinternalcontrolproblemsthatwerepointedoutbytheirpredecessorauditors.Theempiricalresultsarebasedonacomparisonofcompaniesdisclosingsuchinternalcontrolprob-lemswithacontrolsampleofcompanieschangingauditorsbutnotdisclosinginternalcontrolproblems.Auditcommitteequalityismeasuredinthreedimensions:itssize,itsindependence,anditsexpertise.Theinternalcontrolproblemsareobservedattwolevelsofincreasingseriousness:reportableconditionsandmaterialweaknesses.Thesampletimeperiodprecedestheeffectivedatesofrecentpolicychangesregardingauditcommittees.Theresultsindicatethatindependentauditcommitteesandauditcommitteeswithfinancialexpertisearesignificantlylesslikelytobeassociatedwiththeincidenceofinternalcontrolproblems.Thisistrueforbothlevelsofinternalcontrolproblems.Theresultsareconsistentwithrecentpolicyemphasisonauditcommitteeindependenceandexpertise.Keywords:auditcommittee;internalcontrol;reportablecondition;materialweakness.DataAvailability:Datausedinthisstudyarefrompublicsources.I.INTRODUCTIONTheSarbanes-OxleyActof2002andtheSecuritiesandExchangeCommission(SEC)rulesintroducedtocarryoutthedirectionsoftheActindicatethatimprovingcor-porateinternalcontrolisanimportantpolicyinitiative(U.S.HouseofRepresenta-tives2002).TheSECnowrequiresCEOsandCFOstocertifyannuallyandquarterlyabouttheeffectivenessoftheircorporateinternalcontrol(SEC2002).Further,theSEChasan-nouncedrulesfortheimplementationofSection404oftheSarbanes-OxleyAct,requiringeveryregistranttoincludeaninternalcontrolreportinitsannualreport,anditsindependentauditortoissuean‘‘attestationreportonmanagement’sassessmentofthecompany’sin-ternalcontroloverfinancialreporting’’(SEC2003a,1).Iappreciatethehelpfulcommentsoftwoanonymousreviewers,DanaHermanson(discussantatthe2001AAAAnnualMeeting),JaganKrishnan,RolandLipka,EricPress,SriRamamoorti,HeibatollahSami,ArnieWright,andseminarparticipantsatthe2001AAAAnnualMeetingand2003Mid-AtlanticRegionalMeeting.FinancialsupportwasprovidedbytheFoxSchoolofBusinessandManagement,TempleUniversity,andTempleUniversity’sSummerResearchFellowship.Editor’snote:ThispaperwasacceptedbyMarkNelson,GuestEditor.SubmittedJune2003AcceptedAugust2004650KrishnanTheAccountingReview,April2005Theemphasisongoodinternalcontrolofcoursearisesbecauseitisconsideredtobeanimportantfactorinachievinggoodqualityfinancialreporting.AmongthenumerouscriticismsleveledatEnronCorporationregardingitsfinancialreportingwasthechargeofafailureinitsinternalcontrol(Verschoor2002).Itisthereforeimportanttoexaminemon-itoringmechanismscorporationscanusetoensuretheeffectivenessoftheirinternalcontrol.Establishingandmaintainingproperinternalcontrolistheresponsibilityofmanagement.Onemonitorofanentity’sinternalcontrolisitsauditcommittee.1AlthoughnotmandatedbySECrules,theaccountingprofessionandpolicymakershavemaintainedthataprimaryfunctionoftheauditcommitteeshouldbetheoversightofinternalcontrol.2Anecdotalevidence(e.g.,disclosuresinproxyfilings)andacademicresearchsuggestauditcommitteesdoviewmonitoringinternalcontrolsasoneoftheirfunctions.Carcelloetal.(2002,294)reportthat91percentofarandomsampleofcorporateauditcommitteecharterslistreviewsofinternalcontrolsasoneofthedutiesoftheauditcommittee.Recently,theSEC(2003b)hasmandatedthatallmaterialwrittencommunicationsbetweenacompany’saccountantandmanagementbeprovidedtotheentity’sauditcommittee,andthisincludes‘‘reportsonobservationsandrecommendationsoninternalcontrols.’’Theimplicationisthatanentity’sinternalcontrolsshouldbeunderthepurviewofitsauditcommittee.Becausetheauditcommitteeisexpectedtomonitortheentity’sinternalcontrol,Ipositapositiveassociationbetweenauditcommitteequalityandinternalcontrolquality.Whatconstitutesagoodauditcommitteehoweverisnotclear.In1999,themajorexchangesintroducednewrequirementsforthesize,independence,andexpertiseofcorporateauditcommitteeswithaviewtoimprovingfinancialreporting.Initsendorsementoftheex-changes’proposalstoreviseauditcommitteerequirements,theSECquotedtheBlueRibbonCommitteeonImprovingtheEffectivenessofCorporateAuditCommittees(BRC)toarguethat,underthenewrequirements,auditcommitteedirectorswouldbe‘‘morelikelytoobjectivelyevaluatetheproprietyofmanagement’saccounting,internalcontrol,andfinan-cialreportingpractices’’(SEC1999)(emphasisadded).However,giventheskepticismabouttheeffectivenessofauditcommitteeindependencefollowingrecentdisclosuresaboutthecompositionofEnron’sauditcommittee(whichwasindependentasdefinedbytheSEC),andconcernsabouttheadequacyoftheauditcommitteeexpertiserequirement(Whitehead2002),itisanopenquestionwhethertheauditcommitteeindependenceandexpertiserequirementscanfavorablyaffectthemonitoringofinternalcontrol.Iexaminetheassociationbetweenauditcommitteecompositionandthequalityofcorporate