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In this study, I test the return of investment of audit committee (audit committee ROI) of public firms. Particularly, I test how the characteristics of audit committee member are associated with audit committee ROI. There are a number of literature discuss the characteristics of audit committee are associated with the financial reporting quality(Dhaliwal et al. 2010), audit reporting(Carcello and Neal 2000) and market reaction(Chen et al. 2008). But I do not find any research directly tests the efficiency of audit committee.
Audits committees are essential role in firm's financial reporting processes, and already have drawn researchers' attention, especially in this post-SOX age. While there are plenty of literatures both on audit committee characteristics and on compensation for directors, study has not tested how the efficiency of audit committee varies with these characteristics. Prior literature on audit committees has focused on committee characteristics such as composition or size (Deli and Gillan 2000; Klien 2002), and the relation between these characteristics and various outcome. For instance, Klien (2002) investigate the relation between audit committee independence and earning quality, and Carcello and Neal (2000) examine the relation between committee characteristic and auditor reporting behavior. For the meantime, literature on compensation for directors has showed a trend to ignore much of the efficiency of audit committee in director pay, centering instead on compensation for a representative director at a given firm(e.g.,Farrell et al. 2008)).
The definition of ROI is "a performance measurement which is used to evaluate the efficiency of an investment." I want to test the characteristics of audit committee which affects the committee efficiency. The idea of audit committee ROI derives from human capital return of investment (HC-ROI) which is proposed by Bontis and Fitz-enz (2002). HC-ROI calculates the return on investment on a company's employees(HC-ROI=revenue-(training expense-compensation)/ compensation). Audit committee ROI in this study is output, the occurring of ICW, restatement and ERC, divided by input, the compensation (including cash retainer) which company give to committee members. (Audit committee ROI= ICW proxy/audit committee compensation).
There are three reason which we conduct audit committee ROI as the efficiency of audit committee. First, audit committee members are evaluated by their performance, which reflects their capability to prevent occurring of ICW. If the company is issued adverse opinion by auditor, the audit committee member will be dismissal. Srinivasan (2005) demonstrates the financial restatements are empirically related with audit committee director turnover and suggests one of the reason is that oversight audit and internal control is the responsibility of audit committee member. Second, audit committee members are independent and engaged by company which pays these directors compensation and cash retainer. Although audit committee directors have duties to independently monitor the corporation for shareholder, they are one kind of employees. Third, as long as audit committee directors are employees of the companies, they are their human capital.
I examine whether audit committee members quality is associated with audit committee ROI. In addressing this question, we merge the effect of audit committee tenure.
Audit committee is part of the company so they are part of human capital of the company. I conduct the efficiency idea in human capital literature, HC ROI, as my base of research methodology.
III. Related to existing research
In order to test the relationship between characteristics of audit committee member and efficiency of audit committee, this study relates to two parts of liter essential literature review. First part reviews the literature about output, input of audit committee and human capital ROI to derive the idea of audit committee ROI. Second part discusses the characteristics of the committee members.
The Output Input and ROI of Audit Committee
The Effectiveness and Output of Audit Committee
I take financial reporting quality as the output of audit committee and use occurrence of ICW and restatement and ERC to be the proxies. There are many kinds of definition of effectiveness of audit committee. I cite the definition of an audit committee effectiveness from a review paper of DeZoort et al. (2002) which is as following:
An effective audit committee has qualified members with the authority and resources to protect stakeholder interest by ensuring reliable financial reporting, internal control, and risk management through its diligent oversight effort.
A well functional AC should reduce agency problem by minimizing information asymmetry between shareholders and management and protect stakeholders' interest. (Mohiuddin and Karbhari 2010) There are three major outcomes of an effective AC: First, more credible financial information; second, preventing unauthorized earning management, and third, enhancing company's returns and profit. The impact of AC on firm's return is one of the most apparent and measurable output (Mohiuddin and Karbhari 2010). Several research have demonstrated that AC is important on company's earnings and return  and show the foundation of AC is associated with higher-earning return(e.g.,Chen et al. 2008; Wild 1996).
The financial restatements are empirically related with audit committee director turnover(Srinivasan 2005). Srinivasan (2005) discusses that audit committee member may leave the board for several reasons. First, the audit committee is accountable for the monitoring audit and internal control. Second, restatement causes firm value lower and damaging the firm's reputation. Third, in order to control damage to their reputation, director may voluntarily leave the board.
The Input of Audit Committee
Based on managerial productivity theory, Engel et al. (2010) demonstrates that audit committees spend more time and effort than compensation committees to learn and understand company's financial reporting process, so they get higher compensation than compensation committees. I conduct compensation which includes cash retainer as input of audit committee. Companies find these independent directors from labor market to join its audit committee and pay them compensation and cash retainer as reward. Although audit committee directors have great responsibility to independently monitor the corporation internal control and audit for shareholders, they are one kind of employees. As long as they are employee, the company must will pay attention on their performance.
The ROI of Human Capital
HC is identified as intelligence, skills, and knowledge within an organization that come from individuals in an organization (Edvinsson and Malone 1997).There are four factors of human capital; genetic inheritance; education; experience; and attitudes about life and business. (Hudson 1993). The audit committee members' background and experience will cause different combination of human capital. And the longer audit committee members stay in the same company, the more human capital they accumulate in the company which will cause them more efficiency.
The idea of audit committee ROI derives from human capital return of investment (HC-ROI) which is a break-through idea and proposed by Bontis and Fitz-enz (2002). They initially measure the input and output of effective human capital management. HC-ROI calculates the return on investment on a company's employees:
HC-ROI=revenue-(training expense-compensation)/ compensation
Based on the context of literature, I derive the HC ROI to audit committee ROI.
The Characteristics of Audit Committee Director
Dhaliwal et al. (2010) finds accounting experts directors in audit committee can significantly enhance the effectiveness of accounting experts on audit committee. They also demonstrate the supervisory experts cannot increase the audit committee's capability to improve accruals quality.
I conduct the methodology to Engel et al. (2010) to categorize the audit committee members into four groups.
H1:The more accounting expert in the AC, the better AC ROI is.
H2: The longer tenure in the AC, the better AC ROI is.
AC_ROIi= Î± + Î²1AC_EXPERT+Î²2 AC_TENURE +CONTROL
Return of AC compensation=(Number of ICW+RESTATEMENT)*(-1)/Average compensation of AC member. I use total number of ICW and restatement multiply (-1) divide by audit committee compensation to capture the efficiency of audit committee.
Return of AC compensation=ERC/Average compensation of AC member.
Non_Financial_Expert: non-financial director, audit committee members have financial training or experience.
Expert_Finance: Finance Financial Expert, audit committee members have financial training or experience including CFO, vice-presidents of finance.
Expert_Accounting_General: General accounting financial expert, audit committee members have accounting training or experience including CAO, CPA.
Expert_Accounting_Big 5(4): Accounting expert with Big5(4)employment experience() audit committee members have employment experience at a Big5(4) accounting firm.
The average tenure of audit committee members.
I will follow Engel et al. (2010) to use ROA, Rï¼†D, Leverage, M/B ratio as my control variable.
VI. Resource needs
I attempt to use the sample from ExecuComp firms covering the post-SOX period from 2002 to 2011 for the AC compensation. I can use the biographies included in corporate proxy statement to categorize the employment experience and background.
VII. Expected result and contribution
I expected the more accounting expert in the audit commit, the higher audit committee ROI is. The longer tenure in the AC, the better AC ROI is.
Efficiency of audit committee is a very important issue. There are lots of literature discuss that the characteristics of audit committee are associated with the financial reporting quality(Dhaliwal et al. 2010), audit reporting(Carcello and Neal 2000) and market reaction(Chen et al. 2008). Using the efficiency view point can have a more complete idea about the cost and benefit effect of the accounting expert in audit committees.
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