Audit Committee Independence and Auditor-Manager Disputes
57 Pages Posted: 26 Aug 2020 Last revised: 16 Jan 2023
Date Written: January 14, 2023
Abstract
We build a one-period strategic model to analyze the role of audit committee independence in resolving disagreements between management and the auditor regarding financial reporting. Common intuition suggests that the audit committee must be independent from management to be able to support the auditor against the manager’s manipulation attempts. In contrast, we show that (1) to avoid underinvestment, shareholders choose a completely independent audit committee that agrees with the manager and (2) to avoid overinvestment, shareholders choose a partially independent audit committee that agrees with the auditor. The reason is that the ex ante shareholders’ value is affected by the magnitude of the expected cash flows and the managerial manipulation, audit quality, and the committee’s settling incentives. More audit committee dependence might increase the manager’s manipulation, but it also increases audit quality. In sum, our results demonstrate that a completely independent committee, as demanded by regulators, is sometimes not optimal.
Keywords: audit committee, manager manipulation, audit quality, dispute, independence, shareholders' value
JEL Classification: M42, M48
Suggested Citation: Suggested Citation