Sarbanes‐Oxley: are audit committees up to the task?

Purpose – This paper aims to study the audit committee (AC) provisions of the Sarbanes‐Oxley Act with the objective of identifying implementation issues and to recommend firm and board actions to remedy the problems that are identified. Design/methodology/approach – Standard economic theory was used to analyze the incentives and abilities of AC members, relying on results in the financial economics literature regarding outside director behavior. Findings – The framework predicts that the new provisions in conjunction with the new regulatory/liability environment will increase risk‐aversion in directors belonging to ACs. This, in turn, creates an incentive alignment problem between AC members and shareholders leading to sub‐optimal decisions with regard to the audit. In particular, it is noted that demand will increase for high‐quality audits irrespective of cost considerations. The analysis also indicates that director labor markets will not mitigate this sub‐optimality. Research limitations/implications – Because Sarbanes‐Oxley places direct responsibility for the audit in the hands of the AC, interventions by managers who may have incentives more aligned with those of shareholders are not considered. In a real world setting, managers may be playing a constructive role behind the scenes. Practical implications – Specific action items to mitigate the problems are suggested. These steps have the combined effect of: increasing compensation for AC members (to support the additional workload); decreasing their risk exposure (to facilitate incentive alignment); and providing additional resources (to ensure efficiency of oversight). Originality/value – In studying the AC provisions of the Sarbanes‐Oxley Act, this paper has gone someway towards identifying implementation issues and recommending firm and board actions to remedy the identified problems.