Auditing the Audit Committee

Audit committees are increasingly responsible for overseeing the
financial reporting and auditing process of companies. But audit
committees themselves rarely get audited, according to a by Jaime J.
Schmidt and Stephanie Rasmussen of the University of Texas.

Schmidt and Rasmussen looked at the companies on the S&P 1500 in
2007, using a sample the 639 of them that required annual election of
all directors. They found that while shareholder votes and
institutional investor funds punished audit committee ineffectiveness,
none of the companies in the sample saw their external auditors
disclose audit committee material weaknesses.

Casting a wider net, the researchers looked at the more than 2,000
auditor internal-control opinions issued and available in Audit
Analytics from 2004 to 2010, finding only 42 such disclosures. Of the
six of these which occurred during the sample period, one disclosure
identified a one-member audit committee as a material weakness and two
others cite lack of audit committee financial expertise coupled with
complex accounting.

"We find that auditors rarely disclose ACI (audit committee
ineffectiveness) with an AC (audit committee)-related material
weakness, which suggests that auditors are reluctantly to publicly
identify ACI, perhaps due to fear of not being reappointed by the AC,"
they write. "Accounting and internal control problems must be
extremely severe for an auditor to issue a material weakness" based on
audit committee shortcomings.

Shareholders, on the other hand, withhold 7.8% more votes from
ineffective audit committee members, directing negative votes
especially against all members of committees with at least some
ineffective members. "Board turnover is greater for all audit
committee members at companies with at least one ineffective audit
committee member compared to members of fully effective audit
committees," the paper states.

In addition, institutional investors are "more likely to reduce
ownership positions in companies with increasing ACI," although "the
economic significance of the reduction is small (3.5%)."

Collectively, our results are encouraging because they indicate that
most stakeholders do attempt to hold ineffective audit committee
members and the companies they serve accountable," the paper
concludes.

On the other hand, there is much room for improvement. For one thing:
"Policymakers may want to consider corporate governance reform that
could further empower shareholders to influence board composition
decisions." For another, the Sarbox provision requiring auditors to
disclose audit committee ineffectiveness "does not appear to result in
its intended disclosures."