CHAPTER TWO

LITERATURE REVIEW AND THEORETICAL FRAMEWORK

2.0 Introduction
The literature review is concerned in over viewing the firm performance report and previous
researches conducted to determine the factors causing on audit committee characteristic. The
studies in this area are significant because audit committee characteristics will influence on how
firm financial performance.

2.1 Literature Review

This part will briefly explain literature review on firm financial performance and audit committee
characteristics. It is crucial for any work since it demonstrates the picture of state of knowledge in
the area being researched. In this part of the work we will cover the main theories applicable to
the topic. Afterwards we will cover the most important audit committee characteristics – its
expertise, size, meetings frequency and independence and we will connect the theory with the
relevant previous literature summarized.

2.2 Firm Financial Performance

There are several ratios how to measure the firm performance. Schiuma (2003) mentioned
accounting-based performance using three indicators which are return on assets (ROA), the return
on total equity (ROE) and return on investment (ROI). These are widely used to assess the
performance of firms. Even though more sophisticated methods such as IRR, CFROI and DCF
modelling have come along, ROE has proven as a good technique.

It focuses on return to the shareholders of the company but on the other hand it can obscure
a lot of potential problems. Companies can use financial strategies in order to artificially maintain
healthy ROE. On the other hand, ROA avoids the potential distortions created by misleading
financial strategies. Another ratio used to represent firm financial performance is so called Tobin’s
Q ratio. It is calculated as a market value of the company divided by the replacement value of the
firm’s assets. In our work, we have examined the relationship between various audit committee
characteristic attributes and firm performance represented by ROE5, and Tobin’s Q6.

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2.3.1 Audit Committee Characteristics
The role of the audit committee is important to stakeholders as better quality disclosed
financial reporting might improve market performance. Over time, audit committee characteristic
has evolved and has progressively been re-defined from a voluntary monitoring mechanism
employed in high agency cost situations to improve the quality of information flows to
shareholders. It is now a key component of the oversight function and the focus of increased public
and regulatory interest. The current responsibilities of the audit committee are overseeing the
accounting, audit and financial reporting processes of the company (Sarbanes-Oxley Act 2002,
Section 2). The implied expectation is that a suitably qualified and committed independent audit
committee acts as a reliable guardian of public interest (Abbott et al., 2002). The increasing
significance of audit committees can be observed also in Asia and the Malaysia specifically.

An audit committee is a corporate governance mechanism that started to appear

significantly. Most audit committees consist of members of the board of directors. The major goal
behind forming the audit committee is to increase auditing quality and questioning of the
company's executive management. The concept of audit committees differs according to the
functions and responsibilities assigned to them. It can be concluded that an audit committee is a
corporate governance tool that uses non-executive directors as a means of control and oversight.

Numerous studies of the characteristics and roles of audit committee members were
conducted worldwide. In Malaysia found a positive relation between audit committee frequency
of meetings, and firm performance. Few empirical studies were conducted in Malaysia regarding
audit committees. This study is by far the most detailed study to cover this topic in Malaysia. The
study has the potential to be useful and contribute extensive knowledge about the performance of
audit committee. It will be useful to Malaysian companies, legislators, and policy makers. It uses
prior studies as secondary data to show the impact audit committees and firm performance by
Malaysian companies. It is necessary to consider changes of ROA and EPS to determine whether
these ratios influencing the committee auditing decision of audit auditing either positively or
negatively. The audit committee is regarded as the most important board subcommittee due to its
specific role of protecting the interests of shareholders in relation to financial oversight and control
(Mallin, 2007).

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 The primary role of the audit committee characteristic is to oversee the firm’s financial
reporting process, the review of financial reports, internal accounting controls, the audit process
and, more recently, its risk management practices (Klein, 2002). The above stated is true also about
audit committees of Malaysian companies which duties have grown after adoption of several
Corporate Governance Codes. The role of audit committees was particularly strengthened after
recent corporate scandals.

There are a limited number of previous studies regarding the relationship between different
audit committee attributes, such as its size, frequency of the meetings, financial expertise and
qualification of its members and the firm financial performance. The number of studies is limited
especially in Asia, therefore the work studies the sample consisting of Malaysia non-financial
companies listed on the Kuala Lumpur Stock Exchange. Moreover, the importance of audit
committees in Asia has expanded recently after the Asian Commission has proposed a reform of
the statutory audit. According to Federation of Asian Accountants, this audit reform brings
sweeping changes to the role of the audit committee.

Audit committee characteristics enhances the integrity of financial statements and reduces
the audit risk thereby enhancing the quality of reported figures (Contessotto and Moroney, 2013).
Although companies comply with the regulatory requirements in order to avoid sanctions, not all
of such committees are effective in enhancing the companies’ performance (Beasley, 1996). In
other words, the effectiveness of the audit committee depends on the characteristics of the
committee not just the existence of the committee. Therefore, the purpose of the study is to
examine which attributes of audit committee, if any, lead to better firm financial performance.

In order to examine the relationship between the audit committee characteristics and firm
performance we used a sample of 228 firms industrial and services. We collected data about audit
committee attributes, namely (i) audit committee size, (ii) audit committee meetings frequency,
(iii) audit committee independence and (iv) audit committee financial expertise. We used a data
from last 5 years from 2011 – 2015. We excluded financial companies because they have their
own governance model. The ROE and Tobin’s Q were used as indicators of firm performance and

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afterwards we ran two regressions in fixed effect specifications using a consistent estimator for
our covariance matrix. Then we performed several robustness tests in order to check for the
strength of our models substituting some of the independent variables.

The main conclusion that can be drawn from our work is that firm financial performance
matters. We found a significant positive relationship between the audit committee size, frequency
of its meetings and its financial experience and firm financial performance. On the contrary, we
have discovered a negative significant association between audit committee independence and firm
performance. Besides this section, the dissertation is structured as follows: in the following part,
the literature review is presented. Firstly, the main theories are being described. In the same section
there is also the description of the main attributes of audit committees with the previous studies
about them. Next part develops the hypotheses. The last part of the work is the conclusion where
the results and main findings are summarized and limitations are depicted. Moreover, there are
also some recommendations for future research.

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2.2 Theoretical Framework

2.2.1 Introduction

A theoretical framework is developed in order to answer the following research questions: How to
achieve the main objective by examining the association between audit committee and firm
performance? Does the credibility and fairness of financial reports issue by companies depends on
the existence of an audit committee? What is the relationships between the audit committee
characteristics and firm performance? The theoretical framework for this study provides relevant
theory, justification of variables and hypothesis development.

2.2.2 Agency Theory

Agency theory is when one party (principal) engages another (agent) to act on behalf of
them. This theory explains about the relationship between principals and auditors. Consistent with
agency theory (Beasley et al. 2009) argued that members of the Audit committee are committed
to meaningful and substantive meetings which sill in turn lead to better monitoring and improve
financial reporting process on firm activities. Previous literature contended that frequency of Audit
committee meeting reduces the degree of financial restatement.(Habbash and Alagla 2015) argued
that more frequent meetings reduce discretional accruals (DA) and enhances financial reporting
quality (FRQ).

Mujeeb Saif Mohsen AL-ABSY1, Ku Nor Izah Ku ISMAIL2, Sitraselvi CHANDREN3,

Shehabaddin Abdullah A. AL-DUBAI4 mentions that the article Involvement of Board Chairman
in audit committee and earnings management supports the agency theory and policy-makers’
efforts to prevent board chairman from sitting on audit committees. It is the first study that uses
the agency theory to describe the association between the board chairman’s involvement in the
both audit committee and earning management. This study alerts policy-makers, stakeholders and
researchers to the influence of a board chairman serving on the audit committee in curbing earning
management. Furthermore, it provides empirical evidence that the majority of Malaysian
companies whose board chairman are involved in the audit committee appoint the chairman as an
ordinary member of the audit committee. This indicates that executive directors may affect such
actions.

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 Agency Theory assumes that the interest of the principal and agent varies and that the
principal can control or reduce this by giving incentives to the agent and incurring expenses from
activities designed to monitor and limit the self-interest activities of the agent (Jensen and
Meckling, 1976; Fama and Jensen, 1983; Hill and Jones, 1992). According to Bonazzi and Islam
(2006), the principal will ensure that the agent acts in the interest of the principal by giving him
the incentives and by monitoring his activities.

Among the measures established to reduce the self-serving nature of the agent is an
independent audit committee. Therefore, in order to reduce information asymmetry, there is the
need for governance mechanisms such as board subcommittees composed of directors with the
appropriate attributes such as independence, expertise and experience to prevent or reduce the
selfish interest of the agent (Wiseman et al., 2012).

Reinushini Chandrasegaram et al, Impact of audit committee characteristics on earnings

management in Malaysian Public Listed Companies mentions that the audit committees are
designed to mitigate these problems and acts as monitoring mechanism on the preparers of
financial statement and shareholders.

2.2.3 Schematic Diagram

This explains the relationship between the independent variables and dependent variable. This
study suggests that audit committee expertise, audit committee size, number of meetings and audit
committee independence will affect firm performance. Each of the variables and the development
of hypotheses will be discussed in the following session.

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 INDEPENDENT VARIABLES

 Audit Committee
Expertise DEPENDENT VARIABLE
 Audit Committee Size  Firm performance
 Number of Meetings
 Audit Committee
Independence

Figure 3.1: Research Framework

2.3 Hypotheses Development

This study has developed four hypotheses to investigate four independent variables that will give
impact on dependent variable. Latest evidence proposed that there are more determinants of
characteristics of audit committee that have yet to be discovered. For this reason, the following
hypotheses were developed to test the variables.

2.3.1 Audit Committee Expertise

Financial expertise which is consists of both experience and education. The Malaysian
Corporate Governance Code states in regards with the expertise that “the board should satisfy itself
that at least one member of the audit committee has recent and relevant financial experience.”10
Recent research confirms that accounting expertise within boards that are characterized by strong
governance contributes to greater monitoring by the audit committee and leads to enhanced
conservatism (Krishnan and Visvanathan, 2008). It is widely recognized that within each audit
committee, the chair fulfils a key leadership role and therefore should be the most qualified person
on the audit committee. Spira (1999) claims where the audit committee chair has sufficient auditing
background; it is very likely that the chair and the CFO will form a good working relationship.

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 Although it is recognized that the chair of audit committee should have experience,
DeZoort (1998) finds contrary evidence that 76% of audit committee chairs do not have any
auditing experience. Experience alone may not be sufficient to establish financial expertise. Both
experience and education are required to become a financial expert (Giacomino et al., 2009).
However, the research on this topic is very limited in part due to low incentives to disclose
information on backgrounds and careers of directors prior to the post-Enron governance regulatory
boom.

H2: There is positive relationship between AC expertise and firm financial performance.

2.3.2 Audit Committee Size

Previous research found that the effectiveness of audit committees is influenced by factors
such as the committee's size (Dellaportas et al. 2012; Herdjiono and Sari 2017). To be effective in
controlling and monitoring managers' behaviour, the audit committee must have enough members
to carry out its responsibilities (Vicknair et al. 1993), as well as sufficient resources (Kalbers and
Fogarty 1993). For example, Pucheta Martnez and De Fuentes (2007) discovered that the size of
the audit committee affected the likelihood of companies receiving audit reports with errors or
non-compliant qualifications.

However, previous research on the relationship between audit committee size and company
performance has yielded inconclusive results. Audit committees become ineffective if they are
either too small or too large, according to Dalton et al. (1999). An audit committee with a large
number of members is more likely to lose focus and be less participative than one with fewer
members. An audit committee with a small number of members, on the other hand, lacks diversity
of skills and knowledge and thus becomes ineffective. A properly sized audit committee would
enable members to apply their experience and expertise in the best interests of stakeholders.

Eichenseher and Shields (1985) and Menon and Williams (1994) discovered a weak
relationship between the size of the audit committee and company performance. However,
Aldamen et al. (2012) found that smaller audit committees with more experience and financial
expertise were positively and significantly associated with market performance during the
financial crisis.

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 Furthermore, Al-Matari (2013) discovered that audit committee size has a significant
relationship with company performance. The resource dependence theory supports this positive
relationship (Pearce and Zahra 1992; Aldamen et al. 2012). According to this theory, the
effectiveness of an audit committee grows as its size grows because it has more resources with
which to address the company's issues. As a result, the following hypothesis is developed based
on the perspective of dependence theory.

H2: There is positive relationship between company size and firm financial performance.

2.3.3 Number of Meetings

The next feature we examined refers to the frequency by which the audit committee
members meet together. It is expected that more active audit committees that meets often will be
more effective monitoring bodies. An audit committee that rarely meets (considered inactive) may
be less likely to monitor management effectively. The audit committee meetings frequency in the
Malaysian is recommended by the Guide on Audit Committees issued by FRC as not less than
three meetings per year.

It is for the audit committee chairman, in consultation with the company secretary, to
decide the frequency and timing of its meetings. Although the recommendation is to have at least
three meetings per year, most of the chairmen usually call for more frequent meetings. In the
following tables there is an overview of previous studies discovering either positive or negative
relationship between these two variables.

H3: There is positive relationship between number of meetings and firm financial performance.

2.3.4 Audit Committee Independence

The final category of audit committee characteristics that might influence the performance
relates audit committee independence. An important element that will ensure audit committee
effectiveness requires the committee members to be independent or free from the influence and
pressures of top management (Jun Lin et al. 2008). Although previous research on this topic has
yielded inconclusive results, an independent audit committee performs better than a less

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independent committee because the former is more likely to provide better monitoring due to its
ability to resist pressure from managers (Al-Matari 2013; Kallamu and Saat 2015). The audit
committee's independence from managers will allow the committee to take an independent view
of the company's financial reporting process and ensure that the committee is not dominated by
managers, resulting in higher audit quality (Peasnell et al. 2005; Kallamu and Saat 2015).

In addition, audit committees chaired by independent directors is positively linked with

high-quality financial reporting and a lower occurrence of fraudulent reporting (Akhigbe and
Martin 2006; Nekhili et al. 2016). However, where the CEO is involved in the selection of
directors, the independence of the audit committee chair may be ineffective in improving
management oversight (Carcello et al. 2011). The independence of audit committee increases its
strength and reduces the agency problem and the opportunity for expropriation by insiders (Yeh et
al. 2011).

Independence makes the committee more objective in monitoring the transparency of

financial reporting a committee unbiased toward the executive thereby reduces the agency problem
between executives and other shareholders. According to Chan and Li (2008), there is a positive
relationship between audit committee independence and company performance. Similarly,
Kallamu and Saat (2015) and Naimah (2017) discovered a positive relationship between
independent audit committee members and profitability, which is used as a proxy for company
performance. As a result, a positive relationship between audit committee independence and
company performance is expected, and the following hypothesis is proposed.

H4: There is positive relationship between AC independent and firm financial performance.

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