Internal Controls and Audit Committee Oversight

Abstract

Ever since Sarbanes-Oxley, a growing body of research has focused on the roles played by the audit committee. However, few theoretical studies exist to guide this research. In this study, we focus on the audit committee’s role in overseeing internal controls and the impact of whether or not the audit committee relies on management in designing the controls. We provide theoretical guidance by characterizing how the associations between internal control strength and overstatement, market overvaluation, expected non-detection risk, and audit risk vary across these two settings, in equilibrium. As one example that highlights the importance of theoretical guidance, consider the literature’s presumption that internal control strength is positively associated with non-detection risk. Depending on the degree of direct audit committee oversight and the change in payoff parameters, we find that this association may be positive or negative as internal control strength changes.

Keywords: Strategic auditing, audit committee, internal control

JEL Classification: M42