Audit Committee Independence and Auditor-Manager Disputes

Abstract

We build a one-period strategic model to analyze the role of audit committee inde-pendence in resolving disagreements between management and the auditor regardingnancial reporting. Common intuition suggests that the audit committee must beindependent from management to be able to support the auditor against the man-ager's manipulation attempts. In contrast, we show that (1) to avoid underinvestment,shareholders choose a completely independent audit committee that agrees with themanager and (2) to avoid overinvestment, shareholders choose a partially indepen-dent audit committee that agrees with the auditor. The reason is that the ex anteshareholders' value is aected by the magnitude of the expected cash ows and themanagerial manipulation, audit quality, and the committee' settling incentives. Moreaudit committee dependence might increase the manager's manipulation, but it alsoincreases audit quality. In sum, our results demonstrate that a completely independentcommittee, as demanded by regulators, is sometimes not optimal.