Impact of Corporate Governance Mechanisms on Saudi Listed Companies

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Impact of Corporate Governance on Financial Performance 1

The Impact of Corporate Governance Mechanisms on Financial Performance for Saudi Listed Companies

Research Motivation

Since the onset of financial scandals such as those witnessed at WorldCom, Xerox and Enron, the integrity of corporate financial statements has been met with scepticism, which has further worsened investors’ confidence (Abbott, Parker & Peters 2002). As a result, the issue of corporate governance has received substantial attention from governments, regulators and investors. Governments adopt measures aimed at strengthening corporate governance in order to boost investors’ confidence, and ultimately attract investors. As investors search for opportunities to increase their investment portfolio and maximize their profits, they usually scrutinize the corporate governance issues that are likely to lessen or increase risks in the economies they want to invent in. Good corporate governance can assist domestic companies to access foreign capital while at the same time providing a perfect environment for foreign companies with opportunities for portfolio diversification (Abbott, Parker & Peters 2004; Aglietta & Rebérioux 2005; Berger 2005). Given the significance of corporate governance, the proposed study will explore how corporate governance factors, particularly internal audit and audit committee characteristics, affect the financial performance of publicly listed companies in Saudi Arabia. This research is timely and important given the current expansion of corporations, mergers and acquisitions in Saudi Arabia. An increase in corporations, mergers and acquisitions are indicators of investor activity, which poses the need to explore the link between corporate governance and financial performance in order to provide crucial insights for potential investors in Saudi Arabia.

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Research Background

There are several definitions of corporate governance in literature. For Aguilera and Jackson (2003) corporate governance articulates the responsibilities and rights of stakeholders in a given firm. In this regard, corporate governance has the main objective of promoting efficient and transparent markets and to clearly outline the responsibilities of enforcement, regulatory and supervisory authorities. Mcconomy, Bujaki & Merridee (2000) defined corporate governance as a set of structure and processes that are utilized in guiding the firm’s business. Corporate governance has also been viewed as a system of controlling, operating, and structuring a firm in order to achieve its long-term strategic goals of satisfying shareholders, suppliers, customers, employees and creditors, and ensuring compliance with regulatory and legal requirements. Corporate governance operates at two levels of their firm: internal and external. Internal corporate governance places emphasis on the interests of shareholders and focuses its efforts on the board of directors in order to monitor the firm’s top management. External corporate governance controls and monitors the behaviours of managers using external force and regulations involving outside parties such as debtors, accountants and suppliers among others (Baker & Anderson 2010; Bedard, Chtourou & Courteau 2004; Bowen 2004; Singh & Davidson 2003).

The relationship between firm performance and corporate governance has been vastly explored, albeit mostly in Western economies. For instance, with regard to board size, there have been contradicting findings as regards the relationship between board size and corporate performance, with some researchers such as Singh and Davidson (2003) reporting a negative relationship whereas others such as Kiel and Nicholson (2003) reporting a positive relationship. Other aspects of board structure such as board independence have been found to be positively related to corporate performance whereas CEO duality has been negatively linked to corporate performance.

Research Problem

The proposed research focuses on evaluating how corporate governance affects financial companies, especially for listed companies in Saudi Arabia. The proposed research will only focus on two mechanisms of corporate governance, which include internal audit and audit committee and how they affect the financial performance of listed companies in Saudi Arabia. The financial performance variables that will be investigated in the proposed study include Return on Equity (the rate of return on the shareholders’ equity (ownership interest) of common stock owners, Return on Assets (the efficiency of a company’s assets with regard to revenue generation), and Tobin’s Q (the ration of the market value to the replacement value of an asset, mostly physical). The audit committee characteristics that will be taken into consideration in this study will be based characteristics outlined by Abbott, Parker and Peters (2002) and Huang & Thiruvadi (2010), which included the independence of the audit committee, size of the audit committee, number of meetings per year (frequency of audit committee meetings per year), and the number of members with financial expertise in the audit committee. The quality of internal audit draw upon the model developed by Mallin (2011) and Jill (2007), which included an independent audit reporting (independence of the internal audit team), internal audit size, internal audit competence, internal audit objectivity. In the proposed study, each of the variables for financial performance will be modelled using the variables for audit committee characteristics and the quality of the internal audit function.

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Research Objectives

The main objective of this study is to determine the impact of corporate governance on the financial performance of listed companies in Saudi Arabia. The following are the specific research objectives:

  1. To determine how the independence of the audit committee affects financial performance measured in terms of ROE, ROA, and Tobin’s q;
  2. To determine how the size of the audit committee affects financial performance measured in terms of ROE, ROA, and Tobin’s q;
  3. To determine how the number of audit committee meetings per year relates to firm’s financial performance measured using ROE, ROA and Tobin’s q;
  4. To determine the relationship between the number of financial experts in the audit committee (financial literacy) and financial performance measured in terms of ROA, ROE and Tobin’s q;
  5. To determine how independent audit reporting (independence of the audit team) relates to financial performance measured in terms of ROE, ROA and Tobin’s q;
  6. To determine the relationship between internal audit size and a firm’s financial performance measured using ROE, ROA and Tobin’s q;
  7. To determine how internal audit competence relates to a firm’s financial performance measured in terms of ROE, ROA and Tobin’s q;
  8. To determine how internal audit objectivity affects financial performance in terms of ROE, ROA and Tobin’s q

Research Questions

Main research question: What is the impact of corporate governance on the financial performance of listed companies in Saudi Arabia?

The following are the sub-questions to be addressed in the proposed study:

  1. How does the independence of the audit committee relate to financial performance measured in terms of ROE, ROA, and Tobin’s q;
  2. How does the size of the audit committee relate to financial performance measured in terms of ROE, ROA, and Tobin’s q;
  3. How does the number of audit committee meetings per year relates to firm’s financial performance measured using ROE, ROA and Tobin’s q;
  4. How does the number of financial experts in the audit committee (financial literacy) relate to financial performance measured in terms of ROA, ROE and Tobin’s q;
  5. How does independent audit reporting (independence of the audit team) relate to financial performance measured in terms of ROE, ROA and Tobin’s q;
  6. How does internal audit size relate to financial performance measured using ROE, ROA and Tobin’s q;
  7. How does internal audit competence relates to financial performance measured in terms of ROE, ROA and Tobin’s q;
  8. How does internal audit objectivity relate to financial performance in terms of ROE, ROA and Tobin’s q

Research Hypotheses

  1. Financial performance is positively related to the independence of the audit committee;
  2. Financial performance is negatively related to the size of the audit committee;
  3. Financial performance is positively related to the number of audit committee meetings per year;
  4. Financial literacy in the audit committee (number of financial experts in the audit committee) is positively related to financial performance;
  5. Independence of the internal audit is positively related to financial performance;
  6. Internal audit size is positively related to financial performance
  7. Audit competence is positively related to financial performance
  8. Internal audit objectivity is positively related to financial performance

Research Methodology

Study Population

The statistical population for this study comprises of firms listed in the Saudi Stock Exchange, which has 156 companies that are publicly traded. Coming up with a homogeneous sample will pose the need to make use of firms that have an active internal audit department an audit committee during the end of the Saudi Arabian Calendar year (31 December). In Saudi Arabia, the Capital Markets Authority has a requirement that all publicly traded companies are supposed to have internal audit functions. In addition, only companies with reliable and accessible data will be included in the study sample.

Data Collection

In this research, secondary data will be used. Data will be collected from a number of sources including the Directory of Public Companies in Saudi Arabia, Saudi Arabia Capital Markets Authority and annual reports of the selected companies. Also, the researcher will devise and send a questionnaire to a variety of people, all closely involved with accounting and auditing systems, members of the Securities and Exchange Commission, and members of the professional accounting bodies in the SOCPA, auditors ,and so on. It is expected that financial data will be easily available; however, for data relating to quality of internal audit and characteristics of the audit committee, the researcher will contact the selected companies for relevant information. In addition, notes published by the Saudi Stock Exchange and audited financial statements will also provide crucial information needed for this study. The year of study will be 2013.

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Data Analysis

Data analysis will make use of multiple regressions, with the dependent variables comprising of the measures of financial performance (ROA, ROE and Tobin’s q), independent variables comprising of the characteristics of the audit committee (the independence of the audit committee, size of the audit committee, number of meetings per year (frequency of audit committee meetings per year), and number of members with financial expertise in the audit committee) and quality of internal audit (independent audit reporting (independence of the internal audit team), internal audit size, internal audit competence, internal audit objectivity) (Aguilera & Jackson 2003; Calder 2008; Campbell & Woodley 2004; Carcello et al. 2011; Clarke & Rama 2006). In establishing a link between corporate governance and financial performance, the size of the firm will be controlled in this study (Driver & Thompson 2002). The following are the regression equations that will be used in this study.

Where ACIND – independence of the audit committee = 1 if the audit committee is independent, otherwise 0;

ACSIZE – number of members in the audit committee during the 2013 financial year;

ACMEETINGS – number of audit committee meetings in 2013 financial year;

ACFEXPT – number of financial experts in the audit committee

IAIND – independence of the internal audit team/department = 1 if internal audit department is independent, else 0;

IASIZE – number of employees in the internal audit department;

IACOMP – internal audit competency measured using the experience, academic education, professional certification and professional training of the members of the audit team. The average was computed for all staff in the audit department. A value of 1 was added for audit departments with more than the average, otherwise 0 was awarded (Clarke 2004; Eesley & Lenox 2006; Fernando 2009).

IAOBJ – objectivity of the internal audit, which involves the internal audit manager submitting the audit report to the board of directors or the audit committee, in which case, a score of 1 will be awarded, else a score of 0 will be awarded (Franks & Mayer 2003; Hajiha & Rafiee 2011; Holton & Glyn 2006; Jill 2007).

Research Significance

Findings from this research will provide important insights as regards the association between corporate governance mechanisms, especially internal audit function and characteristics of the audit committee, and financial performance. Specifically, findings from this research will offer insights on how listed companies can improve their financial performance by improving the quality of the internal audit function. In addition, findings from this study will provide crucial information on the ideal composition of the audit committee that can be used to improve financial performance in listed companies.

Research Schedule

Year one:

A review of the literature will be made, and the research questions will be devised, followed by a pilot study. A precise research design will then be established.

Year two:

The empirical element of the work will be carried out, with questionnaires being sent to the chosen recipients early in the year, and the interviews taking place at a later date. Towards the end of the year the empirical data will be thoroughly analysed. .

Year three:

Early in the year, further analysis will be carried out, after which the researcher will begin to write the thesis, completing it before the end of the year.

NOTE:

This proposal may be altered after discussion with the Supervisor.

References :

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Abbott, LJ, Parker, S & Peters, GF 2004, 'Audit committee characteristics and restatements', Auditing: A Journal of Practice & Theory, vol 23, no. 1, pp. 69-87.

Aglietta, M & Rebérioux, A 2005, Corporate Governance Adrift: A Critique of Shareholder Value, Edward Elgar, Cheltenham, UK.

Aguilera, RV & Jackson, G 2003, 'The cross-national diversity of corporate governance: Dimensions and determinants', The Academy of Management Review, pp. 447-465.

Baker, K & Anderson, R 2010, Corporate Governance: A Synthesis of Theory, Research, and Practice, John Wiley and Sons, New York.

Bedard, J, Chtourou, SM & Courteau, L 2004, 'The effect of audit committee expertise, independence, and activity on aggressive earnings management', Auditing: A Journal of Practice & Theory, vol 23, no. 2, pp. 13-35.

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Eesley, C & Lenox, M 2006, 'Firm responses to secondary stakeholder action', Strategic Management Journal, vol 27, no. 8, p. 765–781.

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