Earnings quality and audit attributes in high concentrated ownership market

• DOI: https://doi.org/10.1108/CG-08-2015-0110
• Date: 04 April 2016
• Published date: 04 April 2016
• Pages: 377-399
• Author: Ahmed Hussein Al-Rassas,Hasnah Kamardin
• Subject Matter: Strategy,Corporate governance

Earnings quality and audit attributes in

high concentrated ownership market

Ahmed Hussein Al-Rassas and Hasnah Kamardin

Ahmed Hussein

Al-Rassas is based at the

School of Accountancy,

College of Business,

Universiti Utara Malaysia,

Sintok, Malaysia.

Hasnah Kamardin is

Lecturer at the School of

Accountancy, College of

Business, Universiti Utara

Malaysia, Sintok,

Malaysia.

Abstract

Purpose –The purpose of this study is to examine the effect of the audit committee (AC)

independence, financial expertise, internal audit function, audit quality and ownership concentration on

earnings quality (EQ) and, consequently, ascertain whether the AC’s independence and financial

expertise has a moderating effect on the relationship between internal audit function and EQ.

Design/methodology/approach –The study sample is 508 firms listed on the Main Market of Bursa

Malaysia (formerly known as Kuala Lumpur Stock Exchange) for the years 2009 to 2012. EQ was

measured using two modified Jones models of discretionary accruals.

Findings –The findings reveal that the independence of AC and investment in internal audit function,

as well as the Big4 audit firm, are related to greater EQ. Ownership concentration is found to be

associated with lower EQ. The study provides evidence that AC’s independence moderates the

relationship between internal audit function (investment in and sourcing arrangements of internal audit

function) and EQ. It also shows that AC’s financial expertise moderates the relationship between

sourcing arrangements of internal audit function and EQ.

Practical implications –This study extends the prior related literature by examining the AC’s

independence and financial expertise as moderating variables on the relationship between internal

audit function and EQ.

Social implications –Policymakers might use the findings regarding EQ in relation to governance

practices, to recognize the important roles played by the AC’s independence and financial expertise on

the effectiveness of internal audit function with EQ.

Originality/value –This study uses the agency theory and resource dependence theory to provide

empirical evidence on the impact of internal audit function and AC on EQ in the ownership concentration

environment.

Keywords Malaysia, Ownership concentration, Earnings quality, Audit committees,

Discretionary accruals, Internal audit function

Paper type Research paper

1. Introduction

The world financial crisis emphasised and drew attention on the importance of

transparency for promoting fair competition, investment and improving confidence on the

public and corporate sectors’ accountability (Nam and Nam, 2004). Therefore, the failures

of publicly known businesses, such as Enron, WorldCom and Parmalat, among others,

have shed light on corporate governance reforms on a global scale (Kim, 2008). Special

attention has been given to key players in the corporate governance, such as the

effectiveness of the audit committee (AC), internal audit and external audit quality. The

ultimate objective of corporate governance is to produce reliable financial reports, upon

which the investment decisions can be taken to produce sufficient returns (Bin-Zulkafli

et al., 2007). According to Klein (2002), effective corporate governance is required to

reduce the opportunistic behaviour of managers to manage earnings and would lead to the

improvement in financial reporting quality.

JEL classification – M41, M48,

G34, G38

Received 14 August 2015

Revised 3 January 2016

Accepted 5 January 2016

DOI 10.1108/CG-08-2015-0110 VOL. 16 NO. 2 2016, pp. 377-399, © Emerald Group Publishing Limited, ISSN 1472-0701 CORPORATE GOVERNANCE PAGE 377

Generally speaking, earnings management (EM) is evidenced by earnings quality (EQ),

where higher EM leads to lower EQ and vice versa. Management gets involved in EM for

several reasons, including to minimize political costs (Warfield et al., 1995), to steer clear

of default in debt covenant (Klein, 2002;Davidson et al., 2005) and to maximize manager’s

wealth (Radzi et al., 2011). There has been increasing investors’ concern over EM following

the major accounting scandals, and for this reason, a great demand for EQ is notable for

the purpose of improving the quality of financial reporting (Bedard and Johnstone, 2004).

Specific aspects like discretionary accruals (DAs) have garnered attention as significant

EQ indicators. In this regard, high EQ and transparency in financial reporting and in

auditing are all significant in obtaining the confidence of stakeholders. Based on the

agency theory view, the internal monitoring mechanisms, such as the AC and internal audit

function (IAF), are considered as important monitoring mechanisms to safeguard the

interests of the shareholders.

During the adoption and reinforcement of corporate governance practices, the East Asian

countries (including Malaysia) have experienced certain problems, as the economies of

these countries have particular characteristics. For example, the level of ownership is

highly concentrated, the government intervenes excessively, legal systems and

enforcement are weak, low quality of information and legal structures and institutions are

not well developed, all of which pose particular and challenging difficulties for the

enhancement of effective governance practices (Hashim, 2009;Nam and Nam, 2004). In

the case of Malaysia, a series of revised corporate governance codes was introduced to

improve the corporate governance practices (MCCG, 2000, revised MCCG 2007, and

MCCG 2012).

The ownership structure in Malaysian listed companies may also have contributed to this

crisis (Nam and Nam, 2004). According to Thillainathan (1999), shareholdings in Malaysian

corporations are often concentrated via cross-holdings and a pyramid structure, where the

controlling shareholders can be individuals or families having over 50 per cent ownership,

which constitutes a scenario that could cause deficiencies in corporate governance.

Claessens et al. (2000) found that Malaysia ranks the third out of the nine East Asian

Countries in terms of concentration of ownership control.

Previous studies in Malaysia have shown the existence of high agency problem (Kallunki

et al., 2007), high EM practices (Abdul Rahman and Ali, 2006,Ardekani et al., 2012) and

high insider trading (Ali et al., 2011) among firms. Specifically, in the same context, Saleh

et al. (2005) noted that poor corporate governance could be the cause of higher EM in

Malaysia. Fan and Wong (2002) found that the accounting earnings informativeness is

lower for East Asian firms including Malaysia, whose controlling shareholders have higher

voting rights and higher divergence between voting rights and cash flow rights. This

ensures the importance of examining the impact of the governance monitoring of the

financial reporting quality in this environment (Kallunki et al., 2007). The MCCG has

emphasized the important role of AC and IAF as monitoring mechanisms to enhance the

quality of financial reporting.

Therefore, it is important to examine the influence of such mechanisms on the level of EQ

in Malaysian listed firms. Thus, this study would provide answers to the questions of

whether AC’s independence (ACIND), financial expertise (ACEXPERT), IAF, external audit

quality (Big4) and ownership concentration (OWCO) affect EQ and, consequently,

ascertain whether the AC has a moderating effect on the relationship between IAF and EQ.

In this study, the main objective is to investigate the effect of ACIND and ACEXPER, IAF and

Big4, as governance monitoring mechanisms that are responsible to evaluate the quality of

financial reporting. The study found that ACIND, investment in IAF and Big4 are related to

higher EQ. However, the study reveals that OWCO is related to lower EQ. In addition, the

study found that high EQ is achieved by having high ACIND and ACEXPERT, as well as by

having a high investment in IAF.

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