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This chapter provides on the previous study prepared regarding the activity of audit committee, size of audit committee, independence and financial literate among the audit committee. This section as well describes on the company performance and agency theory that are related with the audit committee
2.1 Activity of audit committee
According to the regulators such as MCCG , Cadbury report and Blue Ribbon, stated in their guidelines of corporate governance, the audit committee should comply with their fiduciary duties such as meet at least twice a year and review the audit report and communicate the result from the external auditor to the internal and board of director of companies. Empirical evidence on the impact of frequent meetings at management level benefits to profit. Vafeas (2005) found a negative correlation between the number of audit committee meetings and the management of profit, which is a proxy as the company performance. Bryan et al. (2004) states that audit committees that regularly meet improves the transparency of reported profits and develops the quality of the profit for the company. However, other researchers did not find any significant correlation between the frequency of audit committee meetings and fraudulent return, or management (Yang and Krishnan 2005). A research done in Australia by Davidson et al. (2005) and He et al. (2007), found no evidence of a significant correlation between the number of meetings of audit committees and earning management. According to Z. Jun Lin et.al (2008), most audit committee in Chinese listed companies held no or very few meetings with a short duration of meeting during a year. The audit committee in the Chinese listed companies also seldom concerned on the decisions to appoint the external auditors or determine audit fees, and keep small contact with internal and external auditors. The conclusion from their research, they found that ineffective audit committee in China caused by insufficient commitment from audit committee members, and the lack of clear and stringent legal requirements on audit committee responsibilities or obligations. Another researcher found that audit committee activity also can be an instrument to reduce the earning management. Besides, the number of meeting of audit committee is associated with the lower level of earning management ( Biao Xie et al., 2003). R.C. Anderson et al., (2004) argued the frequency of audit committee meetings is associated with lower debt costs; indicating that the active monitoring by independent directors of the financial accounting process is quite essential to creditors.
2.2 Size of audit committee
The board of directors selects the members and chair of the audit committee; all of them need to be capable to work as a team. The audit committee should consist at least three members, depend on the size and business of the company. Plus, all the members of audit committee must be independent non executive director. To ensure that audit committee is effective in controlling and monitoring the company, they must have enough members to carry out all the duties ( Vinten and Lee, 1993). In addition, their size must depend on the company environment; if the size if too small or too large, it also could make the audit committee turns out to be unproductive (Dalton et.al 1998). If audit committee grows to be too small, they cannot acquire more diversify of skills and experience to be conferred and will affect the decision. However, if the audit committee is too large, it might be a free ride to some committee members as they will play cheat by leaving all the tasks assigned to other members. Nurwati and Nordin (2010) suggested that a large size of audit committee provides more and further accuracy of forecast earning. They also found that both audit committee and board size significant negatively correlated with Tobin's Q (firm value). It has been proved that a large audit committee size may possibly not be good to the company as well. A potential reason to support the statement is that small board size can provide more valuable decision efficiently and information will pass through more effectively. Audit committee can be classified as an expensive monitoring mechanism that companies with greater potential agency costs are more willing to incur these costs. In this context, companies with larger audit committees are willing to devote greater resources to oversee and supervise the financial accounting process. A company with an audit committee composed of only some members will, on average, less time to perform duties such as overseeing the company to hire auditors to question management, and meeting with the personnel system of internal control. If a large audit committee, better protect and control of the financial standards of the subcommittee will be established; and we then expect a greater accounting transparency and lower cost of debt financing (Pincus, 1989). Empirical evidence on the effects of size on the audit committee financial reports is mixed. Lin et al. (2006) found that companies with audit committees consisting of at least four members tend to restate profits. Felo et al. (2003) reported that a larger audit committee increases financial reporting quality as measured by analysts' scores. Mangena and Pike (2005) also found no effect on the size of the audit committee of the interim financial disclosures. Australian literature does not show any evidence of the relationship between the size of the audit committee and the management of return (He et al 2007, Davidson et al .., 2005). Li.J and C.Chan.K (2008), found in their study that the size of audit committee is insignificant in relation to the firm value. They also believe when the size are combined with other characteristics of audit committee the size of audit committee is no longer important.
2.3 Independence of audit committee
Klein (2002) found that company with a greater part of audit committee members is independent, has significantly smaller abnormal accruals, but it's not applicable if audit committees completely independent. Bédard et al. (2004) found a completely negative relationship on independent audit committees and abnormal accruals. Audit committees consist independent directors are expected to be more active; involved in audit committee activity and less likely to be involved in actions that interrupt on the quality of financial reporting (Elizabeth Rainsbury, 2004). Larger audit committee independence can contribute to improving monitoring of the financial reporting process; supported by a research done by Persons (2005), view that independent audit committees give the positive impact on the financial reporting process, showing that the possibility of financial statement fraud is lesser when the audit committee comprises solely of independent directors. DeFond and Francis (2006) found the implicit benefit of improved audit committee independence which is based on the belief that independent directors are better monitors of management than are inside directors. Abbott and Parker, (2000) stated that an audit committee becomes an agent to the independence of internal and external auditor because they are most likely person who interfere in matters related to them. Independent audit committees also act a role of ensuring the reliability of financial reporting and reducing the possibility of management fraud. Research done by Beasley et al.,(2000) stated that financial statement frauds are more expected to incur in firms with less audit committee independence. A general belief is that independent audit committee directors would ensure better financial reporting (SEC, 1999). A study by Kam C. Chan and Joanne Li, (2008) found that independence of audit committee (i.e., to have at least 50 per cent of expert independent directors serve on audit committee) positively impacts on firm value. While Sunday.O.K (2008) state that the independence of audit committee are not significant with the company performance.
2.4 Financial literate of audit committee
According to the guideline at least one of the audit committee members should have a financial knowledge; and to become audit committee members, ones should have experience in the company's primary sector or industry. Treadway Commission (1987) highlighted that audit committees should be "informed, vigilant and effective overseers of the financial-reporting process and the company's internal controls" and fully consulted about significant accounting issues. To become an audit committee that has the financial knowledge, an audit committee member must encompass a good understanding of economic condition and accounting principles. Members also ought to always realize and apprehend how financial reporting choices and what the underneath reasons of a company's decision. Besides, they should also identify either the accounting policies can affect a company's financial reports, and have an understanding of internal controls and procedures. Potential audit committee members who have financially literate or financially expert are limited, and for the firms are finding that such persons, if they are willing to serve, high possibility of they putting a high demand is on the list. Companies should give training and educational seminars for their current and new audit committee members to ensure that they possess these necessary skills and are informed as to directors' duties and liabilities as well as relevant financial accounting issues. Companies should also consider sending their audit committee members to educational programs.
Financial expertise in audit committees continues to be an important determinant of internal control weaknesses. It becomes a suggestion and requires firms to disclose in reports, whether a financial expert serves on a firm's audit committee and if not, they have to disclose why they did not put the financial expert in audit committee. Hence, financial expertise in audit committee has been shown to be important for dealing with the complexities of financial reporting (Kalbers and Fogarty, 1993). DeZoort and Salterio (2001) stated that audit committee members with knowledge in financial reporting and auditing are more likely to understand auditor judgments and support the auditor in auditor-management disputes than members who do not enclose to the knowledge. Moreover, financially knowledgeable members are more likely to deal with and notice material misstatements. Krishnan (2005) provided the evidence that audit committees with financial expertise are less likely to be connected with the occurrence of internal control problems. Audit committee members with financial expertise can also bring out their oversight roles in the financial reporting process more effectively, such as detecting material misstatements (Raghunandan et al., 2001). Price Waterhouse (1993), in a study, concluded that the most particular important related to audit committee effectiveness was that audit committee members must thoroughly understand their responsibilities and acquire the knowledge and experience to meet their responsibilities effectively. Accounting firms (PricewaterhouseCoopers, 1999), and regulators argued that financial expertise is necessary medium to ensure that the audit committee fulfill their primary responsibilities of overseeing the financial reporting process and enhancing financial reporting quality (Sameer T. Mustafa and Nourhene Ben Youssef, 2010).
McMullen and Raghunandan (1996) documented in a survey that the company faces financial problems as there is no CPA sitting on their audit committees. Abbott et al. (2002) found that companies with financial experts from the audit committee is not likely to experience problems of the financial statements are manipulated or commit fraud. Carcello and Neal (2003), however, found that audit committee financial expert does not defend auditors from firing after the issuance of going concern reports.
2.5 Company Performance
There are numerous studies on the relationship between firm performance and corporate governance. Companies with good corporate governance have better operating performance than companies with poor corporate governance (Black, Jang, and Kim, 2002). It was supported by a research done by Jensen and Meckling, (1976); that better corporate governance firms might have more competent operations, resulting in higher return. Another study proved that corporate governance has contributed to the company in improving the operating performance and preventing fraud. It could be concluded that the performance of a firm is directly connected with good corporate governance. Audit committee is a part of corporate governance mechanism. Prior research found there is a mix result association between good audit committee characteristics and firm performance (Agrawal and Knoeber, 1996 and Dalton et al., 1998). However, the view from main user of financial statement initiated to be positively associated with financial expertise member in audit committee group (Davidson et al., 2004). Better corporate governance may also be linked with better financial reporting practices. It causes in reducing agency conflicts that leads the managers to have more incentives to hint the private information to users and have less motivation to manage earnings (Xie et al., 2003)
2.6 Agency Theory
Agency theory considers a moral hazard inherent in principal-agent relationships that lead to agency costs. For instance, agents can adopt the accounting procedures and methods that provide profitable results and accounting can maximize their own wealth under incentive compensation and reward schemes. An audit committee is one way to reduce the problem of incentives as an effective audit committee enhances the quality and credibility of audited annual financial statements, assist sthe board of directors, in charge of maintaining and furthering the interests of shareholders Fama and Jensen (1983) .
Independent audit committee is one of the vital features of the mechanism of the agency cost when it comes to investment and audit committees. It is expected to meet the needs of both internal and external users of financial statements. Previous studies have shown the magnitude of the independence of the audit committee to maintain the integrity and quality of financial reporting process; by means of the audit committee should understand the difference between control functions and functions of committees of management decisions, and be willing to challenge management when needed if the decision can be harmful to the company (BRC, 1999).
The Audit Committee should comprise a financial expert as a member of both have professional qualifications or experience preparing, auditing, analyzing or evaluating financial statements, and have an understanding of audit committee functions. In January 2003, the U.S. Natonal SEC regulations required companies to disclose on their annual reports; both contain at least one member of the audit committee financial expert, or, if not, reasons should be provided. Recent studies also examined the relationship between the financial expertise of audit committees and corporate financial reporting quality (Farber, 2004.
2.7 Chapter Summary
This chapter has briefly discussed the characteristics of the audit committee and the concept of the audit committee as an agent to the shareholders in order to accomplish the Objectives of this study. From the literature, it can be concluded that audit committee members have significantly contributed to helping the company with either direct or indirect to the company. Audit committee is also the basis for board of director of communications for the company and the external auditor and the shareholders. Audit committee board of director also helps to make decisions that will bring benefits to the company as well as the shareholders who always require benefits from what they have invested.