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

• Published date: 03 April 2018
• DOI: https://doi.org/10.1108/CG-02-2017-0043
• Pages: 233-253
• Date: 03 April 2018
• Author: Adel AlQadasi,Shamharir Abidin
• Subject Matter: Strategy,Corporate governance

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

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