The Association Between Audit Committee Characteristics, the Contracting Process and Fraudulent Financial Reporting

In an effort to restore investor confidence in the wake of recent financial reporting scandals, the Sarbanes-Oxley Act of 2002 mandates that audit committees be fully independent and have at least one financial expert. The SEC adopted rules implementing these Sarbanes-Oxley provisions. This paper contributes to the literature on the association between audit committee characteristics recommended by SOX and the likelihood of fraud in two ways. First, we focus on audit committee composition and the extent of the underlying nature of the firm (e.g., firm size, growth) and the contracting environment (e.g., managerial ownership, leverage) of the firm on the likelihood of fraud. In particular, we find that the likelihood of fraudulent financial reporting is negatively related to audit committee independence, number of audit committee meetings and managerial ownership and positively related to firm size and firm growth opportunities. Second, we separately examine firms with totally independent audit committees and fraudulent financial reporting. This sample is interesting because these are firms that had good corporate governance and yet still had fraudulent financial reporting. By separately examining firms with totally independent audit committees, we find that the likelihood of fraudulent financial reporting given a totally independent audit committee is inversely related to the level of managerial ownership and the number of audit committee meetings.