The Impact of Audit Committee Characteristics on the Enhancement of the Quality of Financial Reporting: an empirical study in the Spanish context

• Date: 01 November 2007
• Published date: 01 November 2007
• Author: Cristina De Fuentes,Maria Consuelo Pucheta‐Martínez
• DOI: http://doi.org/10.1111/j.1467-8683.2007.00653.x

The Impact of Audit Committee

Characteristics on the Enhancement of

the Quality of Financial Reporting:

an empirical study in the Spanish

context

Maria Consuelo Pucheta-Martínez* and

Cristina de Fuentes

The purpose of this paper is to analyse the relationship between the likelihood that a company

will receive a qualif‌ied audit report (as a measure of the quality of f‌inancial information) and

the existence and characteristics of the audit committee (AC). For listed companies that

voluntarily created an AC in the period following the publication in 1998 of the Spanish Code

of Corporate Governance, known as the Olivencia Code, we f‌ind that ACs size, the percentage

of independent members in ACs, company size, losses reported in either or both of the

previous two years, receiving the same qualif‌ied audit opinion as in the previous year and

ownership concentration affect the likelihood of receiving error or non-compliance qualif‌ica-

tions. However, the existence of an AC and its composition are not factors associated with the

receipt of audit reports containing uncertainties or scope limitations, while losses reported in

either or both of the previous two years and receiving the same qualif‌ied opinion as in the

previous year are.

Keywords: Audit committee, audit quality, qualif‌ied audit reports, corporate governance,

audit committee effectiveness

1. Introduction

As a result of notorious f‌inancial scandals

such as WorldCom and Enron in the US

and, on the European scene, the f‌inancialcrises

at Parmalat in Italy, Ahold in the Netherlands,

and Gescartera and BBVA in Spain, among

others, the reliability of f‌inancial reporting

and the audit profession have fallen under a

shadow of suspicion, and the role of the audit

committee in the f‌inancial reporting process

has received increased regulatory attention in

recent years.

These events have not left Spain untouched

by international regulatory trends and recom-

mendations aimed at reestablishing users’

trust in f‌inancial information. The regulatory

response in the country is based on the

Financial System Reform Act, 2002 (Law 44/22

November 2002), which seeks to achieve

greater transparency and improve the credibil-

ity of f‌inancial information by regulating

auditors’ independence and providing for the

mandatory creation of ACs in listed compa-

nies. Hitherto, the AC had been voluntarily

implemented by some corporations following

the recommendations of the Olivencia Code

of Good Governance (hereinafter CGG) pub-

lished in 1998.

The aim of this study is to contribute to the

growing literature on the effectiveness of ACs

in terms of the enhancement of f‌inancial

*Address for correspondence:

Universidad Jaume I de

Castellón, Facultad de Ciencias

Jurídicas y Económicas,

Campus del Riu Sec, s/n, 12071

Castellón, Spain. E-mail:

pucheta@cof‌in.uji.es

1394 CORPORATE GOVERNANCE

Volume 15 Number 6 November 2007

© 2007 TheAuthors

Journal compilation © 2007 BlackwellPublishing Ltd, 9600 Garsington Road,

Oxford, OX4 2DQ, UK and 350 Main St,Malden, MA, 02148, USA

information quality. This issue has so far only

been addressed in two studies by Carcello

and Neal (2000, 2003). In particular, we have

analysed the relationship between the volun-

tary formation of an AC and its composition

(number of members, percentage of independ-

ent members, representatives of large share-

holders and meetings hold each year) and the

likelihood that the auditor will issue a quali-

f‌ied audit report. We seek to ascertain whether

ACs enhance the quality of f‌inancial informa-

tion, reducing the incidence of qualif‌ications

referring to errors or non-compliance and

increasing the probability of disclosing uncer-

tainties and scope limitations,which are out of

their control. We posit that an AC that is inde-

pendent, has a high proportion of members

representing large shareholders and holds

several meetings each year will be more likely

to enhance the quality of f‌inancial information.

Thus, ACs will more effectively oversee the

preparation of the f‌inancial statements and

prevent disagreements between the auditor

and management, thereby reducing the prob-

ability of qualif‌ications for error and non-

compliance, while the likelihood of disclosing

uncertainties and scope limitations could be

greater. We also posit that AC size affects the

enhancement of f‌inancial information quality,

although we make no prediction on the direc-

tion of this inf‌luence, which is not clear.

The main interest of this contribution to the

empirical literature lies in the particular

context in which ACs were created. Firstly,

research on this topic is patchy in continental

European countries, where corporate gover-

nance systems exhibit a degree of convergence

towards the Anglo-Saxon model. However,

consistency in the structure and role of audit

committees is limited (Collier and Zaman,

2005) because of the lower level of regulation

of AC formation and practices (see Willekens

et al., 2004). Among other matters, this makes it

more diff‌icult to collect data on AC character-

istics, because the fewer companies have an

AC and because they disclose less information

about ACs than is usual in Anglo-Saxon

countries.

Furthermore, the Spanish stock exchange

provides an interesting scenario, since many

listed companies are characterised by high

ownership concentration (Díaz and García

Olalla, 2003) and, consequently, agency prob-

lems arising from the separation of ownership

and control may be smaller (Azofra and

Santamaría, 2000) than in Anglo-Saxon f‌irms,

where the ownership structure is more diver-

sif‌ied. Thus, large dominant shareholders can

exert a strong inf‌luence on management

behaviour in favour of their own interests (La

Porta et al., 1999, 2001; Cuervo Cazurra, 1997)

with the result that attention frequently

focuses on conf‌licts between large and minor-

ity shareholders. In this regard, the archival

literature shows that ownership structure

may have relevant corporate governance

implications (Short, 1994 or Shleifer and

Vishny, 1997).

Indeed, ownership concentration is one of

the features that makes Spanish corporate gov-

ernance different from countries such as the

US, Germany and Japan, as well as the high

proportion of representatives of large share-

holders in ACs, the low level of legal protec-

tion for investors and pyramidal groups and

underdeveloped capital markets that focus

largely on f‌inancial institutions and banks.

According to De Miguel et al. (2003), the last

two characteristics explain why the ownership

structure is so concentrated in Spain in com-

parison to common law countries and even to

some French-origin civil law countries such as

Germany. Consequently, this high ownership

concentration acts as a legal control inf‌luenc-

ing Spanish corporate governance (Grant and

Kierchmaier, 2004).

Finally, one of the reasons for the publication

in 1998 of the Olivencia Commission’s f‌irst

Code of Corporate Governance (hereinafter

CCG), which recommended the formation of

ACs, was the signif‌icant incidence of qualif‌ied

audit reports among listed companies. As the

Commission report indicated, the situation

was anomalous,indeed unique, among the devel-

oped stock markets, and as such it needs to be

rectif‌ied (CEECECAS, 1998, 59). In this light, we

may well examine whether the existence of

ACs and their composition do actually reduce

the likelihood of companies’ receiving quali-

f‌ied audit reports referring to errors or non-

compliance issues and increase the probability

of disclosing qualif‌ications for uncertainties

and scope limitations.

The institutional, legal and corporate gover-

nance peculiarities that make Spain so differ-

ent from the circumstances of theAnglo-Saxon

and US, the countries to which most of the

existing AC literature refers, may affect the

audit committee’s eff‌iciency and its impact on

audit reports. Consequently, this research

may offer new insights into the relationship

between corporate governance, and ACs in

particular, and auditor reporting behaviour in

the Spanish context, which explains the inter-

est of analysing this association.

The structure of this paper is as follows.

The next section provides a brief review of the

accounting literature referring to ACs. In the

third section, we def‌ine the hypotheses,

methodology and sample used in our em-

pirical study. The fourth section presents and

analyses our results, and the f‌ifth and f‌inal

AN EMPIRICAL STUDY IN THE SPANISH CONTEXT 1395

Volume 15 Number 6 November 2007© 2007 TheAuthors

Journal compilation © BlackwellPublishing Ltd. 2007