The Effects and Potential Benefits of Audit Committee Oversight in a Strategic Setting

Abstract

The purpose of this paper is to provide theoretical guidance for both analytical and empirical researchers, as well as regulatory agencies, by investigating the effects and potential benefits obtained from audit committee oversight in a strategic setting. Ever since Sarbanes-Oxley, a growing body of research has focused on the roles played by the audit committee, but few theoretical studies exist to guide this research. 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 characterize how the nature of control risk changes, as well as how internal control strength is associated with overstatement, the expected probability of detection (audit effort, on average), and audit risk across two settings defined by the degree of audit committee oversight. As one example that highlights the importance of theoretical guidance, consider the literature's presumption that internal control strength is negatively associated with audit effort. 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