On the role of internationalization of firm‐level corporate governance: The case of audit committees

• Published date: 01 September 2023
• Author: Aaron Afzali,Minna Martikainen,Lars Oxelheim,Trond Randøy
• Date: 01 September 2023
• DOI: http://doi.org/10.1111/corg.12503

ORIGINAL ARTICLE

On the role of internationalization of firm-level corporate

governance: The case of audit committees

Aaron Afzali

1

|Minna Martikainen

2

|Lars Oxelheim

3,4,5

|Trond Randøy

5,6

1

Hanken School of Economics, Helsinki,

Finland

2

University of Vaasa, Vaasa, Finland

3

Research Institute of Industrial Economics

(IFN), Stockholm, Sweden

4

Lund University School of Economics and

Management, (LUSEM), Lund, Sweden

5

School of Business and Law, University of

Agder (UiA), Kristiansand, Norway

6

Center for Corporate Governance,

Department of Accounting, Copenhagen

Business School (CBS), Copenhagen, Denmark

Correspondence

Lars Oxelheim, Research Institute of Industrial

Economics (IFN), Stockholm, Sweden.

Email: lars.oxelheim@ifn.se

Funding information

Funding for the project received from Peter

Wallenberg Research Foundation.

Abstract

Research Question/Issue: Motivated by the agency theory and the findings of

linguistic studies, we analyze the association between the internationalization of a

firm's audit committee and its corporate governance.

Research Findings/Insights: Based on data from 2159 publicly traded European firms

from 15 countries for the period 2000–2018, we find that firms with foreign directors

on their audit committees are associated with lower financial reporting quality. The

association is mitigated by stronger country-level investor protection and a higher simi-

larity among intra-committee languages. We further find that foreign directors on the

audit committee are related to stock pricesbeing less informativeabout future earnings.

Theoretical/Academic Implication: In this study, we argue that language differences

create communication difficulties that weaken social integration between foreign

directors and the other parties involved in overseeing financial reporting, thus ham-

pering their ability to monitor effectively.

Practitioner/Policy Implications: The results indicate that foreign directors on a cor-

porate board increase its independence. However, appointing foreign directors to the

firm's audit committee may compromise the board's monitoring function.

KEYWORDS

audit committee, board committees, board composition, board of director mechanisms,

corporate governance, director independence, european economy(s), governance environments,

individual director issues, legal control mechanisms, legal origins

1|INTRODUCTION

Studies about the effects of board internationalization on the moni-

toring and advising role of corporate boards have presented mixed

findings. Some of these studies show that foreign directors (FDs) bring

specific knowledge, experience, and network ties that boost the advi-

sory capability of corporate boards, in turn resulting in higher value

and improved performance for firms (Estélyi & Nisar, 2016; Miletkov

et al., 2017; Oxelheim & Randøy, 2003). The appointment of FDs also

paves the way for firm internationalization (Maznevski, 1994;

Oxelheim et al., 2013) and better cross-border acquisitions when the

target is from the home region of FDs (Masulis et al., 2012). Other

studies, however, claim that the presence of FDs on corporate boards

causes cultural and language frictions in the boardroom that lead to

weaker cooperation and thus to a lower value and performance of the

firm (Frijns et al., 2016; Masulis et al., 2012). FDs are also reported to

be associated with lower meeting attendance (Hahn & Lasfer, 2016;

Masulis et al., 2012), higher CEO compensation (Masulis et al., 2012;

Oxelheim & Randøy, 2005), and increased earnings management

(Hooghiemstra et al., 2019).

Received: 14 November 2021Revised: 19 October 2022Accepted: 20 October 2022

DOI: 10.1111/corg.12503

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial License, which permits use, distribution and reproduction in any

medium, provided the original work is properly cited and is not used for commercial purposes.

© 2022 The Authors. Corporate Governance: An International Review published by John Wiley & Sons Ltd.

Corp Govern Int Rev. 2023;31:737–758. wileyonlinelibrary.com/journal/corg 737

The above mixed findings indicate that FDs on corporate boards

may have both positive and negative effects. Therefore, we examine

board internationalization by performing an analysis on the less

explored audit committee, which is an internal corporate governance

mechanism that plays a critical role in curbing earnings management.

Specifically, we address the following research question: What does

the presence of FDs on the audit committee mean for financial report-

ing quality (FRQ)?

Managers are commonly involved in earnings manipulation for

reasons such as meeting the earnings expectations of the financial

market, avoiding violations of debt covenants, or boosting the

compensation of top management (Dhaliwal et al., 2004;Doyle

et al., 2013;Phillipsetal.,2003; Roychowdhury, 2006). The auditcom-

mittee is expectedto minimize such self-serving behavioron the part of

the management by properly overseeing financial reporting practices

and ensuring the integrity of the internal as well as external audit

(The European Parliament and the Council of the European

Union, 2014). Due to its small size and specialized andtechnical focus,

any changes in the composition of the audit committee could poten-

tially result in changed dynamics and efficiencies (Kolev et al., 2019).

Thus, we argue that theappointment of even a single FD increasesthe

cultural and language diversities of the committee in such a way that

the FD potentiallyaffects the culture of corporatereporting in the firm.

We address our research question by analyzing data from 2159

firms representing 15 European countries

1

over the period 2000 to

2018. This sample provides us with 14,328 firm-year observations, of

which 3845 (approximately 27%) have at least one FD on their audit

committee. In our analysis, to measure the FRQ, we use the discre-

tionary accrual measures developed by McNichols (2002) and Kothari

et al. (2005), as well as the future earnings response coefficient

(FERC) (Collins et al., 1994; Lundholm & Myers, 2002). We measure

FDs on an audit committee by their ratio to the total number of direc-

tors sitting on the committee. Our results show that firms with FDs

on their audit committee are associated with lower-quality accruals

and that this relation is contingent on whether the FDs speak the

same language as or a similar language to that spoken in the host

country. When there is no language barrier at all, the FDs contribute

to an improved FRQ. Our results also show that the negative relation

between FDs on the audit committee and FRQ is mitigated by stron-

ger country-level investor protection and the accounting and finance

expertise of the FDs. We further find that firms with FDs on their

audit committee are associated with less informative stock prices due

to lower-quality earnings (in relation to future earnings). We also

show that FDs on the audit committee are associated with higher fees

and longer delays for audits. The latter results are presumably driven

by the FD-induced lower-quality reporting, which increases audit risk

and requires the auditor to exert greater effort in exchange for higher

fees to minimize that risk.

Assessing the relation between FDs on the audit committee and

FRQ presents several methodological challenges. The results fromour

baseline model may be subject to an omitted variable bias. To address

this, we control for firm fixed effects to exploit within-firm intertem-

poral variationsin terms of management quality, corporateculture, and

other unobservable across-firm variations. We also use propensity

score matching(PSM), in which we compare firms whose audit commit-

tee are composed of both FDs and localsto a set of identical firms

whose audit committees are entirely made up of local directors. We

match these firms based on a number of variables, such as firm-level

governance andperformance measures. The results fromthe firm fixed

effects, from PSM, and fromother robustness tests confirm our earlier

findings thatfirms with FDs on their audit committeehave lower FRQ.

Our paper expands the research frontier in several ways. First, we

contribute to the audit committee literature by showing thatthe inter-

nationalization of the audit committee is associated with lower FRQ

and stock prices that are less informative about firm-specific future

earnings. We also add to the literature that addresses FRQ and audit

committee characteristics (Abbott et al., 2004;Carcello&Neal,2000;

Lennox & Park, 2007). Second, by focusing on the communication pro-

cess of an audit committee, our study adds to the literature on board

internationalization by highlighting the positive effectof language simi-

larity in overcoming internal and external communication challenges

(Oxelheim et al., 2013). Third, by showing that investor protection

mechanisms helpmitigate the negative effect of FDs onreporting qual-

ity, we contributeto the literature on the effectivenessof country-level

governance practices (DeFond et al.,2007; Leuz et al., 2003). Finally,

we show that firms with FDs on their audit committee are associated

with higher fees and larger delays for audits,contributing to the litera-

ture on the fees and report delays of audits (Cao et al., 2020;

Caramanis&Lennox, 2008;Chen et al., 2019; Zhang, 2018).

Our study has importantimplications for corporationsand auditors.

If firms use FDs,then they face a trade-off between thepotential bene-

fits of increased director independence and the potential costs related

to FD-induced lower FRQ. A potential solution to the above dilemma

could be to recruit FDs who do not bring language differences to the

committee (e.g., a French-speaking Swiss director in a French firm),

thereby increasingdirector independence while at the sametime main-

taining higherFRQ. As for auditors, FD-inducedearnings misstatements

could increase the auditrisk, requiring the auditor to exert costly addi-

tional efforttoeffectivelyreduce that risk to an acceptable level.

The rest of the paper is organized as follows: In the next section,

we discuss the theoryand formulate hypotheses. Thereafter, we pre-

sent our research design and sample. Then follows a section in which

we presentour results. The concludingsection summarizes our findings.

2|RELATED LITERATURE AND

HYPOTHESIS DEVELOPMENT

2.1 |Audit committee characteristics and FRQ

The literature on the monitoring and advising functions of corporate

boards and their committees has attracted long-standing scholarly

interest (Carson, 2002; Conyon, 1994; Hillier et al., 2011;

Pascual-Fuster & Crespí-Cladera, 2018; Peterson et al., 2007;

Pucheta-Martínez & García-Meca, 2014; Setia-Atmaja, 2009). The

monitoring duties of corporate directors include overseeing the

738 AFZALI ET AL.