The effect of audit committee characteristics on audit fees

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1.0 Introduction

Internal governance structure been argued around the world to enhance the effectiveness of the boards in the company and avoid the earning management activities. Due to corporate collapse and earning management issues, many groups especially regulators made recommendation and enforcement of corporate governance to evade these problem arise. For example, Enron case been spread over the world caused by weak internal corporate governance in almost all aspect (Baxter, 2010). The duties and function of directors had been argued as well as external auditor. In Malaysia, board committee in corporate governance consist of nomination committee, remuneration committee, audit committee and risk management committee. But, risk management committee is newly established and not all listed companies are forming this committee. However, required by Listing Requirement of Bursa Malaysia, the companies should report the Audit Committee Report in the specific section on the annual report.

Prior research focused on four common audit committee characteristics - independence, accounting expertise, size and activity (Peters, 2003; Baxter, 2010; Yatim, 2006; Goodwin-Stewart and Kent, 2006). Most of them investigate the effectiveness of the audit committee on the audit quality and audit fees in developed countries like USA (Peters, 2003), Australia (Goodwin-Stewart and Kent, 2006; and Baxter, 2010), New Zealand (Hay et al., 2008; and Rainbury et al., 2009) and UK (Goddard and Masters, 2000).

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According to Hay et al. (2008), they found that internal control and corporate governance are related to audit fees. In addition, good internal governance structure which consist of audit committee and used of internal audit are associated with higher audit fees (Goodwin-Stewart, 2006; Yatim et al., 2006). Even though, the formation of audit committee and accounting expertise that they have are same as external auditor, but, the fees that they should pay to the external auditor still high. The demand for good audit quality and reporting by selecting Big 'auditor' caused the audit fees paid more higher. Thus, after the market merger (Main Board and Second Board), the demand of higher audit quality is increased and the formation of audit committee should be in line with the shareholders' interest that can lower the agency cost.

1.2 Problem Statement

Although many research of audit fees been done in Malaysia, but little research been conducted in relation of audit committee characteristics with audit fees. Furthermore, the topic of gender diversity and ethnicity which related to audit committee characteristics is limited in research.

This study extent the research done by Peters (2003) and Goodwin-Stewart and Kent (2006) in three factors. First, Malaysia is unique country and known as developing country in enhancing the economic growth. The practice of internal corporate governance in Malaysia is different from developed countries like US and UK. Furthermore, the capital markets of Malaysian listed companies are not too strong and the internal corporate governance of the companies is still evolving (Yatim, et al., 2006). Second, women are now been trusted to hold the top management position such as directors. They appointment of women directors in Malaysian listed companies give new view and inspection of gender in audit committee characteristics. Third, Malaysian citizen have three major type of ethnicity; Malay, Chinese and Indian. These three different types of community have different perception and view in decision making as well as controlling the companies. Thus, the present of different type of ethnicity in audit committee might likely give different audit pricing. But, until today, the association of audit committee characteristics and audit fees still is empirical issues and debated.

1.3 Research Questions

There are two research questions under this study:

Do the audit committee characteristics which consist of independence, accounting and financial expertise, size and activity influence the audit fees in Malaysian listed companies?

Do the gender and ethnic of audit committee influence the audit fees in Malaysian listed companies?

1.4 Research Objectives

From the previous research questions, there are two research objectives of this study :

To examine the association of audit committee characteristics that consist of board independent, accounting and financial expertise, size and activity on audit fees in Malaysian listed companies.

To investigate the association of audit committees' gender and ethnicity on audit fees in Malaysian listed companies.

1.5 Significant of the Study

This study will contribute to the certain group of people which can be classified as follows:

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The audit committee member. The member would enhance and improving their knowledge in accounting and financial matters due to keep rapid changing the financial matters or economic volatiles.

The management of the companies. They would report the financial position honestly and not do the misstatement. This is due to a committee that keep their eyes into the reporting the financial position. Thus, the misstatement or risk reporting can be reduced.

The future investors who are interested to invest in certain companies. This would help them to restore the confidence toward the monitoring and controlling the financial aspect by the expert and independent directors.

The future researcher who is interested in this research area. This research will be used as their references and literature as well.

The regulators such as Security Commission, Companies Commission of Malaysia and Bursa Malaysia in enhancing and tightening the Malaysian Code of Corporate Governance to be more effective and valuable.

1.6 Organization of the Study

The organization of this paper is as follows. Next section is reviews of research on theoretical framework that focused on agency theory on audit committee and audit fees. In section three, this study describes the methods and sample used as well as the research design. The forth section is analysis and results of the study. Final section discussed the conclusions and limitation of the study.

CHAPTER TWO: LITERATURE REVIEW

2.0 Introduction

Under this chapter, this study discusses the agency theory which related to audit committee characteristics and audit fees. Then, the literature review of audit committee characteristics (independence, accounting and financial expertise, size, activity, gender and ethnicity of audit committee).

2.1 Agency theory and audit fee/audit committee

Jensen and Meckling (1976) expressed the agency theory as the relationship of

2.2 Literature review of audit committee characteristics

The existing of audit committee in Malaysian listed companies had brought the higher demand of internal monitoring process. The audit committee serve as complement of external auditor in monitoring management and strengthen the internal controls in the companies (Vafeas and Waegelin, 2007). Therefore, the presence of audit committee in the company should lower the audit fees because the firms are well-managed and monitored by financial literate as well as independence boards who would lower the agency cost.

Recently, Malaysian Code of Corporate Governance (MCCG) had been revised in 2007 and reinforced certain criteria to enhance the corporate governance system in Malaysia. Besides that, the effect of market merger of Main Board and Second Board in 2009, increased the likelihood of internal monitoring and strengthen the function and duties of the audit committee. Functions and responsibilities of audit committee include appointment of external auditor, discuss any matters with external auditor regarding auditing and review the financial statements of the company particularly on quarterly and year-end basis (MCCG, 2007).

Board independence:

MCCG (2007) stated that the members of audit committee should be independent and non-executive directors. Independent audit committee member would reduced the agency problem and enhance the transparency in the company. In the presents of independent audit committee members, they have potential to strengthen the corporate boards by controlling the management financial results (Petra, 2005). The misstatements or financial statement fraud can be early detected and lead to lower the audit fees. A number of studies have investigated the association of audit committee independence and audit fees. Abbott et al., (2003) found that audit committee that consist of all independent directors are likely to have higher audit fees. Similarly, study done by Yatim et al., (2006) found that board independence is associated to higher audit fees. This is due to higher demand of quality audit and likely to appointed Big 5 (now Big 3) as external auditor (Abbott et al., 2003 and Yatim et al., 2006).

Board accounting expertise:

Besides that, knowledge and experience that audit committee members have in accounting and financial expertise would lower the risk of external audit and leads to lower the audit fees. When MCCG had been revised in 2007, it stated that the members of audit committee should be financial literate and at least one is a member of recognised accounting body in Malaysia (MCCG, 2007). The audit committee member would understand the issues related to accounting or auditing if there any issues arise (Peters, 2003). Knowledge that they have would protect their reputations in accounting and financial matters when there are issues related to audit.

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Board size:

According to Raheja (2005), the board size and composition should be depending on the type of the company. This is because the new and younger companies require higher proportion of executive directors to increase the performance of the companies. While, the mature and established companies required higher non-executive directors (Raheja, 2005) to control and monitor the executive directors. Besides that, MCCG (2007) best practice stated that the audit committee members should consist of at least three members. Study done by Baxter (2010) found that audit committee in Australian companies had an average of three members and consistent with the best practice recommendations.

The independence of the audit committee increase as the board size increase (Klien, 2002a). While,

Board activity:

Prior research also emphasize that audit committee should meet frequently to enhance the communication channels between the external auditors as well as to be informed any related to accounting and financial matters in the companies. In addition, the frequency of meeting between the audit committee and external auditor without the present of executive member should be increased to encourage the greater exchange of views and opinion (MCCG, 2007).

Research done Baxter (2010), found that the average of meetings held is three times held during the year. Through these meetings the audit committee can discuss and review any problems arise from interim and final audits of the financial statements. Furthermore, active audit committee meeting are expected to lower audit fees due to decrease in financial reporting problem (Yatim et al., 2006).

Board gender:

Lately, women who hold the position of directors get increase intention around the world. The ability and performance of women directors been recognised and accepted to contribute in the corporate boards. Women are known as neat and tidy person in all aspect and assume that they can perform these characteristics in the boardroom.

Even gender diversity is more complex and difficult to certain companies or countries, but previous study done in Singapore by Kang et al., (2010) have proven that the investors react positively to the appointment of women directors on the board. In addition, the investors are more likely to have if the women directors would maintain and increase their independence in the corporate boards (Kang et al., 2010).

Board ethnicity:

Study done by Marimuthu (2008) found that ethnic diversity of board of directors in Malaysian companies enhances the firm financial performance. By having ethnic diversity in audit committee, they been expect to offer greater innovative and financial performance of the companies (Marimuthu, 2008).

CHAPTER THREE: RESEARCH METHODOLOGY

3.0 Introduction

Under this chapter, this study discussed on how the hypotheses have been developed from audit committee characteristics and audit fees. Then, how the sample been selected and data been collected to present the research design. Next, this study also described on how the model been developed to analyze the results.

3.1 Hypotheses Development

Independence

It also been argued that, corporate boards can be strengthen by having independent non-executive boards. Similarly, the present of independent directors in audit committee are likely to monitor and control the action of top management in financial matters (Petra, 2005). As Peters (2003) pointed that mostly independent audit committee requires higher demand of audit assurance and expended the scope to avoid any misstatements or erroneous in the financial reporting process or during the audit process.

Thus, this situation may lead to higher audit fees and first hypothesis in this study is:

H1 : There is relationship between audit committee independence and audit fees.

Expertise

Expertise in accounting and financial are demanded when it comes to be a member of audit committee. This expertise would help the committee and auditor in negotiating the issue that may relate to auditing or financial matters. According to Yatim et al., (2006) committee who have accounting expertise more likely to seek quality audit services that lead to higher audit fees.

Audit committee member who posses accounting and financial expertise

The results may lead to next hypothesis in this study:

H2 : There is relationship between audit committee expertise (accounting and financial expertise) and audit fees.

Size

Even though, Raheja (2005) stated that board composition and size may depend on the type and nature of the companies, but the best practice of MCCG (2007) requires that at least three members are in audit committee.

Due to these results, thus lead to third hypothesis of audit committee size and audit fees;

H3 : There is relationship between size of audit committee and audit fees.

Activity

According to Saleh et al., (2007) found that active audit committee provide effective monitoring and controlling mechanism. In addition, Menon and Williams (1994) emphasize that meeting frequency held by audit committee is to signal the committee diligence toward the company's financial performance. Prior research stated that audit committee that meet frequently are more diligent in discharge their duties and likely to be informed the current auditing and accounting issues. Moreover, they are demand of higher scope of audit and can influence the audit coverage (Peters, 2003). Then, this may generate the next hypothesis:

H4 : There is relationship between activity of audit committee and audit fees.

Gender

H5 : There is relationship between gender of audit committee and audit fees.

Ethnic

Ethnic diversity on the boards of directors approved that firm financial performance greater and leads to create creative and innovative decision making of the companies (Marimuthu, 2008). In Malaysia,

This study also assumes that when audit committee have ethnic diversity among their members, the financial performance of the companies also is greater and higher audit fees will be paid. This is because different ethnics (Malay, Chinese and Indian) of audit committee require different groupthink and more discussion and explanation by the external auditors. Thus, this leads to hypothesis:

H6 : There is relationship between ethnicity of audit committee and audit fees.

3.2 Sample Description and Data Collection

In line with previous studies, this study used cross-sectional approach (Simunic, 1980; Yatim et al., 2006; Peters, 2003). The sample is mainly obtained from the list of top 100 companies by market capitalisation issued by The Star newspaper. The list of companies been published on Monday, 4th January 2010 on Starbiz column. The calculation of market capitalisation is drawn from number of shares of the company multiply by market price. The market price of top 100 companies is based on 31st December 2009. The list of top 100 companies by market capitalisation is attached in appendix. But, due to several problems to reach the annual report, out of 100 companies, only 99 companies are valid in this study.

This sample represents 11.12% of the total companies listed in Main Market of Bursa Malaysia for year 2009. However, based on total market capitalisation, the sample in this study was RM827,152.15 million, which represents xxx% of the total market capitalisation of Bursa Malaysia for year 2009.

This study used content analysis. Data been collected totally from the publicly available annual reports. Annual reports of the sample are drawn from Bursa Malaysia website and companies' website. The mostly used section in the annual report is Audit Committee Report section. This section reports the types of directors, the number of audit committee member, the number of meeting held during the year as well as the names of audit committee members. While the audit fees are report in the section Notes to the accounts. Non-audit fees that the companies paid during the year are excluded in this study. Only audit fees paid to the external auditors.

3.3 Event Study Model

Measurement of variables - Dependent variable

Audit fee represent the dependent variable in this study. This variable is the amount of audit fees paid by the Malaysian companies to the auditors. Data is publicly available and disclose in annual reports.

Measurement of variables - Independent variables

Six audit committee characteristics been used as independent variables; independence, accounting and financial expertise, size, activity, gender and ethnicity. These characteristics have been disclosed in annual report at Audit Committee Report section.

Independence of audit committee

Board independence measured as the proportion of independence directors on the committee (Goodwin-Stewart and Kent, 2006; Yatim et al., 2006). According to Goodwin-Stewart and Kent (2006), the independence directors refer to non-executive directors who have no direct or personal interest toward the company's transactions. Thus, this study excluded directors who have direct interest of company's transactions.

Accounting and financial expertise of audit committee

Board AC accounting expertise - AC member is an accounting association body, the code is '1' and if not, otherwise.

Size of audit committee

If the total AC member is more than 3, the code is '1', and if less than 3 the code is '0'.

Activity of audit committee

The proxies to measure the board activities are frequency of meeting and number of attended training or seminars during the year.

Gender of audit committee

proxies; male and female.

Ethnicity of audit committee

AC member who posses equity holding in the company.

The regression model of this study is as follows:

LAF = b0 + b1ACIND + b2ACEXP + b3ACSIZE + b4ACMEET + b5ACGEN + b6ACRACE + e

Where,

LAF = natural log of audit fees (not included non-audit fees)

ACIND = the proportion of independent non-executive on audit

committees

ACEXP = the proportion of audit committee members with

accounting and financial expertise

ACSIZE = total number of directors on audit committees

ACMEET = total number of audit committee meetings held during the year

ACGEN = dummy variable of 1 if a audit committee member is female, 0

if male director

ACETH = 1: Malay director. 2: Chinese director and 3: Indian director

3.4 Summary of Chapter

CHAPTER FOUR: DATA ANALYSIS AND FINDINGS

4.0 Introduction

4.1 Composition of Sample

4.2 Event Study Results

4.3 Discussion of results

4.4 Summary of Chapter

CHAPTER FIVE: SUMMARY AND CONCLUSION

5.0 Introduction

5.1 Summary of the Main Findings

5.2 Implication of the Study

5.3 Contribution of the Study

5.4 Limitation of the Study

Some limitations and weaknesses of this study also been revealed. First, the sample involves are limited to top 100 companies which based on market capitalisation. Thus, it cannot represent for the whole listed companies in Malaysia.

Second, this study is limiting the variables to six independent variables only. Other variables like business backgrounds of the audit committee members and the years they have served on the audit committee have not been tasted (Rainsbury el al., 2009).