The effectiveness of internal corporate governance and audit quality: the role of ownership concentration – Malaysian evidence

AuthorAdel AlQadasi, Shamharir Abidin
DOIhttps://doi.org/10.1108/CG-02-2017-0043
Pages233-253
Publication Date03 Apr 2018
The effectiveness of internal corporate
governance and audit quality: the role of
ownership concentration Malaysian
evidence
Adel AlQadasi and Shamharir Abidin
Abstract
Purpose This study is motivated by the competing views on whether internal gove rnance
mechanisms complement or substitute for external auditing, and how this association is affected by
ownership concentration. The complementary view predicts that good internal governance
mechanisms are related to high-quality audit. On the other hand, corporate governance
mechanisms may be substituted for each other, so more investment in governance mechanisms
leads to less investment in external auditing. Therefore, this study aims to examine the association
between internalgovernance mechanisms and the demand for audit quality.
Design/methodology/approach Data from Malaysian listed companies during the period 2009 to
2012 areused. Ordinary least square (OLS) regressionis applied to analyse the data.
Findings Companies with a higher concentration of ownership are less likely to demand extensive
auditing. In addition, the study provides supporting evidence for the complementary association
between a company’s governance and audit fees. However,the ownership concentration plays a minor
role in the positiveassociation between internal corporategovernance and audit quality.Further tests are
conductedand support the main findings.
Practical implications Significant implications are provided for the audit profession in emerging
economies, where concentrated ownership is common, to help policymakers and regulators in
determining the power of controlling shareholders on audit quality and firm’s governance. The study’s
findingsopen up avenues for further research.
Originality/value This is the first work to address the role of ownership concentrati on in the
association between corporate governance and audit qu ality; it suggests that the ownership
structure must be considered in examining the effectiveness of corpor ate governance. The study
also provides a comprehensive combination of internal governance mechanisms.
Keywords Malaysia, Corporate governance, Audit fees, Audit quality,Ownership concentration
Paper type Research paper
1. Introduction
Audit is the cornerstone of corporate governance (Cadbury, 1992). However, its efficiency
depends on the actuality and development of the corporate governance environment (Holm
and Laursen, 2007).Good corporate governance has enticing properties,demanding a high
level of audit quality by company managers (Lin and Liu, 2009). Fan and Wong (2005)
confirm that companies demand a high level of audit quality to enhance their governance.
Nevertheless, n ational differe nces in ownersh ip structure coul d make companies
governance more flexible and responsive to local features. This variety in corporate
governance and how corporate governance is conceptualised are still hotly debated
Adel AlQadasi is Assistant
Professor at the College of
Science and Humanities in
Al-Dawadmi, Shaqra
University, Al-Dawadmi,
Saudi Arabia and at the
Hodeidah University,
Hodeidah, Yemen.
Shamharir Abidin is
Associate Professor at the
Tunku Puteri Intan Safinaz
School of Accountancy,
Universiti Utara Malaysia,
Sintok, Malaysia.
Received 26 February 2017
Revised 22 August 2017
Accepted 20 September 2017
DOI 10.1108/CG-02-2017-0043 VOL. 18 NO. 2, 2018, pp. 233-253, © Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 233
(Aguilera and Jackson, 2003;Gedajlovic and Shapi ro, 2002;Desender et al.,2013;
O’Sullivan, 2000;Shleifer and Vishny, 1997). Aguilera and Jackson (2003) state that the
degree of ownership concentration (OC) increases the external pressures on management,
while diffused o wnership reassures the shar eholder voice.
Corporate governance is defined as a set of interrelated mechanisms that has strategic or
institutional complementarities to align the conflict of interests between principals and agents;
this is dependent on certain combinations, including ownership structure (Aguilera et al .,2008;
Desender et al., 2013). Ownership structure plays a major role in the effectiveness of
corporate governance mechanisms, where OC could mitigate or exacerbate age ncy
problems that affect governance (Setia-Atmaja, 2009). Shleifer and Vishny (1 986) state that the
controlling shareholders have more incentives and power to monitor the co mpany’s managers,
contributing to the reduction of agency problems. However, Shleifer and Vishny ( 1997) argue
that major shareholders could expropriate the wealth of minority shareholders in concentrated
ownership settings. Different governance mechanisms are applied to monitor agents and
shareholders, such as external auditors, where the external auditor provides a significant
monitoring role in testing the credibility of financial statements provided by management on
behalf of the shareholders (Lin and Liu, 2009;Watts and Zimmerman, 1983).
Malaysia is an interesting case for studying the role of corporate governance in demanding
audit quality because of the dominance of blockholders in listed compani es. Malaysian listed
companies, with their ownership concentrated in families, individuals and the g overnment, are
thus differentiated from their Western counterparts (Hasnan et al.,2013). According to agency
theory, agency conflicts occur between principals and agents because of widely dispersed
ownership and the separation of shareholders and management (Jensen and Meckli ng,
1976). However, agency conflicts also occur between majority and minority shareholders as a
result of concentrating the shareholdings in the hands of a few shareholders on account of
other shareholders (Claessens et al., 2002;Claessens and Fan, 2002;Shleifer and Vishny,
1997). Consequently, Claessens et al. (2000) and Hay et al. (2008) argue that companies with
concentrated ownership are run by the major shareholders, who play a significant role in their
decision-making processes. Shleifer and Vishny (1997) propose that major sharehol ders are
considered a corporate governance mechanism. A company with active shareholders who
hold a large proportion of shares and participate in the company’s strategic direction is a
signal of holding a good control and governance structure (Jensen, 1993). Thus, majority
shareholders may demand a higher audit quality to monitor their investment or to signal non-
expropriation behaviour (Fan and Wong, 2005;Hay et al., 2008). In addition, minority
shareholders might demand an extensive audit service to protect themselves from the
expropriation of major shareholders (Hay et al., 2008). Hence, OC is a significant feature in the
Malaysian setting (Claessens et al.,2000), although it is questionable to explain the demand
for corporate governance by using agency theory in an emerging market like Malaysia, where
conflicts of interest shift from owner–management to owner–owner.
Motivation for this study comes from the unique institutional settings of Malaysia, where
companies are dominated by controlling shareholders in a concentrated ownership
structure. As a result, managers are more likely to be under pressure and stricter
supervision by dominant shareholders. These organisational and environmental
characteristics might determine effective corporate governance (Desender et al.,2013).
Thus, these unique featurespresent a fruitful opportunity to examine the impact ofcorporate
governance on the demand for audit quality.
To the best of our knowledge, this is the first work to examinea comprehensive combination
of governance mechanisms including board of directors and audit committee
characteristics, and internalaudit function (IAF) attributes with the demand for audit quality.
It extends the work of Wahab et al. (2011) and Srinidhi et al. (2014) by including the IAF’s
attributes (costs and sourcing arrangements) to measure the effectiveness of a company’s
governance. The IAF is considered one of the key pillars of the governance structure of
PAGE 234 jCORPORATE GOVERNANCE jVOL. 18 NO. 2, 2018

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