Audit Committee Independence and Auditor-Manager Disputes

Abstract

This paper analyzes the role of audit committee independence in resolving disagreements between management and the auditor regarding financial reporting. The common intuition suggests that the audit committee must be independent from management to be able to support the auditor against the manager's manipulation attempts. We build a one-period strategic model to show that this intuition is valid only if overinvestment is a bigger concern to shareholders than underinvestment. Otherwise, any audit committee will agree with management to avoid underinvestment. The audit committee's optimal independence level, which can be fully independent or partially dependent, is affected by investment efficiency, as well as by the strategic interactions of shareholders, the manager, the auditor, and the audit committee.

Keywords: audit committee, manager manipulation, audit quality, dispute, independence, shareholders' value

JEL Classification: M42, M48