The Impact of Audit Committees on Firms financial performance Essay Example

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    Finance & Accounting
  • Document type:
    Research Paper
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    Undergraduate
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Audit Committee and Firm performance 7

Research topic: The Impact of Audit Committees on Firms financial performance

Target Journal: International Journal of Economics and Finance

Abstract

The association between firm’s financial performance and auditing processes in Organizations is well documented in many studies. However, few studies have investigated this association usng auditing fees as proxy for data quality. A total of 52 companies were analyzed for three years on key areas of interest pertinent to this study (auditing fees and firms financial performance) using spss regression models. The variable of auditing fees was used as proxy for data on auditing quality while the firms ROE was used as an indicator of firm’s financial performance. The results of this study indicate that a negative correlation exists between audit fees and the resulting firm financial performance; in addition, change in audit fees over the three years was also found to be negatively correlated against the firm’s financial performance. This observation was contrary to our expectation of auditing quality positively influencing the firm’s financial performance. However, there are studies that have made similar observations.

Keywords

Audit committee, Firms performance, Audit quality, Corporate governance,

Audit committee and firm performance

1. Introduction

The association between firm’s financial performance and auditing processes in Organizations is well documented in many studies. There is enough evidence to suggest that firm’s financial performance is indeed influenced by the quality, nature, investment and consistency of auditing processes that an Organization undertakes. In this study, the Auditing Committee is defined as an independent committee enacted within a firm that has mandate and oversight on evaluation of financial matters in a financial institution as per generally accepted requirements of international accounting standards (Cahan and Sun, 2015). The auditing process of an organization can fall under any of the following two categories; internal and external. The external auditing process refers to auditing done on a firm by an independent third party not associated with the firm in anyway, while the internal auditing process refers to that done by the same firms department delegated to carry out the auditing process (Cahan and Sun, 2015). The auditing process is recognized as one of the most important and critical processes undertaken by a firm for purposes of evaluating its performance. The purpose of this study will investigate the relationship that audit committees have on a firm’s financial performance.

Justification

This research study intends to contribute knowledge on the topic of importance of audit committees in an Organization which is increasingly becoming an area of interest among many academicians, researchers and accountants. Indeed, the need for decision makers and Organizations management to understand the impact that auditing committees and related activities has on a firm has become an important area of focus for various reasons. First, there is growing need of strategic management in Organizations where decisions such as on investment and expenses needs to be evidence-based.

Thus, the need for firms to understand the correlation between audit committees and financial performance is due to the need by Organizations to leverage on the impact that audit process has on the bottom line of the firm in order to ultimately optimize on financial performance (Aldamen et al, 2012). Another reason is to justify the use of resources that firms utilize in the running of auditing committees, as well as justification of decisions on any increased allocation of resources in future. However, a more critical function of information regarding the role of audit committees on firms is for determination of Organizations ethics and credibility of financial statements reported by a firm (Aldamen et al, 2012). This is an essential duty of audit committees that is central to all other related functions. Thus, the need of research studies that investigate how audit committees impact on firm’s profitability, and how this can be leveraged to provide maximal return is increasingly becoming necessary and this study will contribute towards this demand.

Study hypothesis

Hypothesis 1

H0 – There is no association between auditing quality and firm’s financial performance

H1 – There is an association between auditing quality and firm’s financial performance

Hypothesis 2

H0 – There is no correlation between annual changes in auditing fees and firms financial performance

H1 – There is a correlation between annual change in auditing fees and annual firms’ financial performance.

Study objectives

  1. To determine if there is a correlation between auditing quality and firms financial performance using auditing fees as proxy for auditing quality/auditing committee.

  2. To investigate whether change in annual auditing fees translates to change in firm’s financial performance when tracked over three years.

2. Literature Review

The major function that an audit committee has in an organization is to serve as an oversight authority in respect to reporting of financial performance and auditing process in a firm. A more accurate definition of audit committee is described as a “mechanism designed to ensure that a company produces relevant, adequate and credible information that investors as well as independent observers can use to assess company performance” (NYSE, 2002). The audit committees are thus perceived as independent observers charged with a critical role of ensuring that firms do not manipulate its stakeholders through skewed reporting of financial matters. Thus, because of the important role that audit committee plays in the financial reporting of firms, various studies have been done on this area.

There are many research studies that have investigated the association between the audit committees and firms financial performance similar to the objectives of this study. Some of the earlier studies in this subject such as by Wild, (1996) found that presence of functional audit committees on an Organization is essential in portraying to the shareholders a perception of a well-managed firm that can be relied to observe high standards in its financial reporting thereby boosting investor confidence. Another similar study by McMullen, (1996), also found that “companies with an audit committee are less likely to experience errors, irregularities and other indicators of unreliable financial reporting”. The observations made by both these studies, therefore indicate that one of the impact that audit committees have on firms is that they help boost shareholder confidence, which influences the firm’s reputation and ultimately its profitability. This observation is consistent with our research study objectives.

A study by Baxter and Cotter (2009) for instance is among the studies that have established that a positive correlation exists between firm financial performance and auditing committee. In their study Baxter and Cotter (2009) investigated the importance of audit committee independence in regard to auditing quality and found a positive association between the two variables. In the same study the financial expertise of auditing committees was found to be a function of the resulting auditing quality; a premise that would support the use of auditing fees as proxy of auditing quality since expertise is pegged on the variable of fees. The use of audit fees as proxy of determining audit quality is widely utilized in various studies.

A more recent study by Yassin and Nelson (2012) has found an association between the performance of a firm and the level of audit quality within the firm. In this study, researchers analyzed the relationship that exist between the two variables by using audit fees data of ten years as proxy of audit quality for companies based in Malaysia similar to the approach taken in our study. The findings of this study indicate that there is insignificant association between the audit quality and firms financial performance. This is also consistent with research by Sayyar et al, (2015) which found no significant association between audit fees and firms performance.

Another study that has utilized auditing fees as proxy for data quality is by Hoitash et al. (2007) which has documented evidence of association between audit fees and audit quality. This study provides basis as one of the study’s findings that provide justification use of auditing fees as proxy for assessing audit quality in firms. In this study the authors established that higher fees paid towards auditing increases the level of auditing quality and vice versa, and concluded that “there is a significant positive relationship between audit fees and audit quality” Hoitash et al. (2007).

This premise is also supported by findings of study elsewhere that investigated the impact that auditing companies have on financial firm. A study by Ferguson and Stokes (2002) for instance has established that reputable auditor firms tend to earn more on fees than their competitors since their reputation contributes to the perception of reputation in the firm that they are commissioned to audit which translates to added shares value. On the other hand, smaller auditing firms are seen to charge less compared to reputable firms, and this observation is interpreted through data analysis to be associated with low auditing quality, perhaps because of the reduced auditing hours.

Another reason why auditing fees is thought to be correlated with auditing quality is due to the fact that it is thought to be an indicator of the amount of time in hours that auditors take to carry out auditing process in a given year. Finally, the regularity of auditing process in a year is also well known to be a function of audit quality. Both of these factors are known to influence the audit quality, since increased audit times in a financial year will translate to improved financial performance. This association is well documented in a study by Elitzur and Falk (1996), and Lesage et al. (2012); in both studies the authors carried out several regression analysis on data variables of auditing fees and auditing quality and observed that high auditing fees is correlated to quality of audits; in addition, the data indicated that prospective increase of audit fees translated to further increase of audit quality.

Besides, regularity of auditing process was found to act as deterrent of discouraging fraud, and even when fraud occurs it is easily caught quite early before substantive financial loses has occurred. Ultimately, the regularity of how often a firm conducts its auditing process in a financial year impacts directly on it financial performance.

3. Data and methodology

The data for this study was obtained from Bloomberg financial database of the top 100 best performing companies globally. The study sample included companies listed on Fortune 100 companies and their financial statements audited by credible audit firms. Out of the 100 companies listed only 52 companies have complete data on variables of interest that this study sought to investigate, namely; auditing fees and the annual profits. Data on the two variables were chosen in order to investigate the objectives of this study which is impact of auditing committees on firm’s financial performance. Data on auditing fees was chosen in this case as proxy for auditing quality which is the independent variable in this case.

The choice of using auditing fees was chosen since it was more convenient to obtain and readily available as a measure of level of auditing quality since the two variables are directly interrelated. The other reason of choosing to use data on auditing fees as proxy for data quality is because it is quantitative data as opposed to data quality which is qualitative; this allow uniform handling of data during spss analysis. Finally, based on our research study objectives tracking data on auditing fees over the three years allows for easy measurement of change in this variable as opposed to tracking change in data quality per se, which is relatively complicated because of coding and due to the qualitative nature of this variable.

The other data variable that this study analyzed is Return on Equity (ROE) which is also proxy data for financial firm performance, which is essentially firms’ profitability. Because this study analyze dozens of firms that crosscut various sectors and industries, the variable on ROE was found to offer more uniform comparison of the financial performance of each firm as opposed to measuring firms profitability per se on Companies that are different in many regards. In addition, use of ROI variable offers more accurate results compared to profitability as a measure of a firm’s financial performance strictly from a financial perspective.

Our study is not the first to use audit fees as proxy means of obtaining data for audit quality. A study by Yassin and Nelson (2012) which sought to understand the impact that audit quality has on firm performance, similar to the objectives of our study found evidence of positive association between the two factors when using audit fees as proxy by observing that “a higher audit fees indicates that auditors provide more efficient audit services to the companies compared to lower audit fees”. Thus, use of audit fees as proxy for audit quality is well documented. The auditing fees data was picked from the financial statements of the firms while ROE data was calculated for each firm chosen in the list.

4. Data Analysis and Discussion

A total of 52 companies were analyzed on key areas of interest pertinent to this study using spss regression models. Both the auditing fees data, and ROE for the 52 firms were tracked and documented for three years starting from 2012, 2013 and 2014 financial years.

Table 1: List of Auditor

Frequency

Cumulative Percent

Deloitte

Grant Thornton

Regression Model

First, Regression model is developed that aimed at determining if there is a correlation between auditing quality and firms financial performance using auditing fees as proxy for data quality and to investigate whether change in annual auditing fees translates to change in firm’s financial performance when tracked over three years.

The performance of the firm was represented by the following regression equation.

FP = β0 + β1AFEELN + β2SGD + β3ROT + ε

Where: FP= ROE: Net income / Shareholder’s Equity.

AFEELN = Audit fees natural log.

ROT = dummy variable. 1; Audit rotation and 0; no rotation

SGD = Difference of present and previous year sales.

Table 2: Descriptive Statistics

Std. Deviation

Skewness

Kurtosis

Statistic

Statistic

Statistic

Statistic

Statistic

Std. Error

Statistic

Std. Error

1.1324E2

78.82808

22.56515

15.62330

Valid N (listwise)

The table above shows minimum, maximum, mean, standard deviation, skewness and kurtosis of audit fee and performance of the firm with control employed in analysis for the sampled 2012 through 2014 years. The descriptive statistics shows the min audit fee is 2.97 and max of 92.77, while difference in sales among year with minimum of 47.27 and maximum of 404.70 and the ROE represented a low value of -32.18 and a max of 79.30. Lastly zero value of ROT showed that the firms did not change their auditor for the three years.

Correlation Matrix

Table 3: Correlations

Pearson Correlation

Sig. (2-tailed)

Pearson Correlation

Sig. (2-tailed)

Pearson Correlation

Sig. (2-tailed)

** are significant at p<0.05

As shown in the Table 3 SDG has r-value of .044 indicating a significant moderate positive relationship between SDG and ROE at P<0.05. This implies that change in revenue over the years is positively associated with change in ROE of the firm.

With regard to fee charged for audit the analysis returned AFEELN r-value of -.168 indicating a significant negative relationship between fee charged and Return on Equity with at p<.05. This suggest that we reject both the null hypothesis 1 and 2, and accept the alternative hypothesis of;

H1 — There is an association between auditing quality and firm’s financial performance.

However this association is negatively correlated, thus we rephrase this statement to;

H1 — There is a significant negative association between auditing quality and firm’s financial performance.

Also we accept alternative hypothesis 2

H1 – There is a negative weak association correlation between annual change in auditing fees and annual firms’ financial performance. This is because the p-values .003 is below .05 thus leading to rejection of the null hypothesis that there is no correlation between annual changes in auditing fees and firms financial performance, at 5% level of significance.

One possible reason for this observation of negative correlation is explained by the fact that investors tend to increase the regularity of auditing as well as quality (fees) for fear of losing on their investment, which negatively impacts on the firm’s financial performance; this observation is consistent with findings in other studies. A recent similar study by Nidhi and Sharma (2016) analyzed the impact that audit committee have on firms performance on 235 companies and concluded that “audit committee meetings had insignificant influence on firm performance (ROA), and had a negative significant influence on ROE”. This observation is also documented by Sayyar et al, (2015). Another reason could be due to the fact that investors tighten auditing process in the wake of financial underperformance which is reflected through increased auditing fees over the years as reflected in this observation.

Regression analysis

Regression analysis was utilized to investigate the predictive relationship between the independent variables and dependent variable. Multivariate regression analysis was used to determine the significance of the relationship between the dependent variable and all independent variable pooled together. Table 4: gives the model summary of the multiple linear regressions.

Table 4: Model Summary

Adjusted R Square

Std. Error of the Estimate

15.71118

a. Predictors: (Constant), AFEELN, SGD

The results in Table 4 showed that the value obtained for R, which is the model correlation coefficient was R=.168 which is higher than any zero order value in the table. This indicates that the model improved when more variables were incorporated when trying to analyze the firm performance. The r2 value of 0.028 also indicated that the multiple linear regression model could explain for approximately 2.8% of the variation in the firm performance. To answer the question about which of the independent variables is more important in influencing performance of the firm, the beta value and the results of this are summarized in Table 5.

Table 5: Regression model

Unstandardized Coefficients

Standardized Coefficients

Std. Error

(Constant)

a. Dependent Variable: ROE

From the regression model in Table 5, the regression equation was obtained. Using the unstandardized beta coefficients, the following regression equation was developed.

FP= 21.687 — .117 AFEELN+ 0.004+ Ԑ

From the full regression model, the beta values were obtained which explain the regression equation. The standardized beta coefficients give a measure of influence of each variable to the model. Regarding the performance influence, the study revealed that AFEELN had a negative influence on performance (t = -1.196, p =.001), and SGD a positive through weak (t = -.012, p =.001). Because AFEELN function in the equation represents audit fees, and SGD represent change in revenue over years, then the implication is that increase in audit fees leads to decreased financial performance which is a negative association.

Conclusions

To our knowledge this is among the few studies that have established a negative weak association exists between audit fees and firms financial performance. In our study, to measure data on firm’s financial performance we analyzed the profitability of 52 companies tracked over three years, using ROE instead of profit margin per se. The implications of these findings should steer greater research on this area in order to understand why auditing fees is negatively associated with financial performance by documenting the range of possible factors that is leading to this observation. This study is limited in sample size and greater sample size should be done for future studies.

The uniqueness of this study is that t utilize quantitative data as means of comparison throughout our study in order to compare the association that exists. This is in contrast to many studies that utilizes qualitative data in obtaining data that measures audit committee impact, which is then analyzed against data on firm’s performance which is usually quantitative in nature. Thus, our study contributes to the growing knowledge generated in this area by offering evidence on how investment on auditing process in a firm correlates to its financial performance and by creating demand for increased understanding on this field.

References

Aldamen, H, Duncan, K, Kelly, S, McNamara, R, & Nagel, S. 2012. Audit committee characteristics and firm performance during the global financial crisis. Accounting & Finance, 52:4, 971-1000.

Baxter, P., & Cotter, J. 2009. Audit committees and earnings quality. Accounting & Finance, 49(2), 267-290.

Cahan, S, & Sun, J. 2015. The Effect of Audit Experience on Audit Fees and Audit Quality. Journal Of Accounting, Auditing & Finance, 30:1, 78-100.

Elitzur, R., and Falk, H. 1996. Planned Audit Quality. Journal of Accounting and Public policy. 15(3), 247-269.

Ferguson, A., and Stokes, D. 2002. Brand Name Audit Pricing, Industry Specialization, and Leadership Premiums Post‐Big 8 and Big 6 Mergers. Contemporary Accounting Research. 19:1, 77-110.

Hoitash, R., Markelevich, A., and Barragato, C. A. 2007. Auditor Fees and Audit Quality. Managerial Auditing Journal. 22(8), 761-786.

Lesage, C., Ratzinger-Sakel, N., and Kettunen, J. M. 2012. Is Joint Audit Bad or Good? Efficiency Perspective Evidence from Three European Countries. CAAA Annual Conference

McMullen, D. A. 1996. Audit Committee Performance: An Investigation of the Consequences Associated with Audit Committees, Auditing. A Journal of Practice & Theory, 15, 87–103

Nidhi, B. & Sharma, A. 2016. Audit Committee, Corporate Governance and Firm Performance: Empirical Evidence from India. International Journal of Economics and Finance, 8:3. 103-116.

NYSE. 2002. New York stock exchange corporate accountability and listing standards committee (NYSE), Report (NYSE, New York).

Sayyar, H., Basiruddinb, R , Zaleha, S. Rasidc, A., Elhabibd, M. 2015. The Impact of Audit Quality on Firm Performance: Evidence from Malaysia. International Business School, Malaysia.

Wild, J. J. 1996. The audit committee and earnings quality. Journal of Accounting, Auditing & Finance,11(2), 247-276.

Yassin, F. M., and Nelson, S. P. 2012. Audit Committee and Internal Audit: Implications on Audit Quality. International Journal of Economics, Management and Accounting. 20 (2). 90-101.