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CEO Power, Internal Control Quality, and Audit Committee Effectiveness in Substance vs. in Form

71 Pages Posted: 9 May 2012 Last revised: 25 Jul 2015

Ling Lei Lisic

Virginia Polytechnic Institute & State University - Pamplin College of Business

Terry L. Neal

University of Tennessee

Ivy Zhang

University of Minnesota - Twin Cities

Yan Zhang

State University of New York at Binghamton - School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: July 2015

Abstract

During the past decade, new regulations have been adopted to improve audit committee effectiveness. Prior research has generally provided evidence in support of these regulations and suggests that a more independent and expert audit committee is more effective. We posit that CEO power reduces or even eliminates the improvements in audit committee effectiveness resulting from independent and financially expert committee members. Thus, CEO power may result in an audit committee that appears effective in form but is not in substance. We construct a composite index for CEO power by combining ten CEO characteristics and employ the incidence of internal control weaknesses as a proxy for audit committee monitoring quality. Since all of the firms in our sample have completely independent audit committees, we use financial expertise to examine the impact of CEO power on audit committee effectiveness. We find that, when CEO power is low, audit committee financial expertise is negatively associated with the incidence of internal control weaknesses. However, as CEO power increases, this association monotonically weakens. When CEO power reaches a sufficiently high level, this association is no longer negative. The moderating effect of CEO power on audit committee effectiveness is more prominent when the CEO extracts more rents from the firm through insider trading. Our results are not driven by the CEO’s involvement in director selection. Our paper suggests that more expert audit committees in form do not automatically translate into more effective monitoring. Rather, the substantive monitoring effectiveness of audit committees is contingent on CEO power.

Keywords: CEO power, audit committee, financial expertise, internal control

JEL Classification: M41, M42

Suggested Citation

Lisic, Ling Lei and Neal, Terry L. and Zhang, Ivy and Zhang, Yan, CEO Power, Internal Control Quality, and Audit Committee Effectiveness in Substance vs. in Form (July 2015). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2054966 or http://dx.doi.org/10.2139/ssrn.2054966

Ling Lei Lisic

Virginia Polytechnic Institute & State University - Pamplin College of Business ( email )

1016 Pamplin Hall
Blacksburg, VA 24061
United States

Terry L. Neal (Contact Author)

University of Tennessee ( email )

639 Stokely Management Center
Knoxville, TN 37996-0560
United States
865-974-2664 (Phone)
865-974-4631 (Fax)

Ivy Zhang

University of Minnesota - Twin Cities ( email )

19th Avenue South
Minneapolis, MN 55455
United States

Yan Zhang

State University of New York at Binghamton - School of Management ( email )

P.O. Box 6015
Binghamton, NY 13902-6015
United States
607-777-6195 (Phone)
607-777-4422 (Fax)

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