PRINCIPLES OF GOOD CORPORATE GOVERNANCE AND
PRINCIPLES OF GOOD CORPORATE GOVERNANCE AND
AUDIT FEES
Table of Content
TOC o “1-3” h z u HYPERLINK l “_Toc319675887” CHAPTER 14
HYPERLINK l “_Toc319675888” 1.0 Background of the Study4
HYPERLINK l “_Toc319675889” 1.1 Statement of the Problem5
HYPERLINK l “_Toc319675890” 1.2 Objectives of the Study5
HYPERLINK l “_Toc319675891” 1.2.1 General Objective6
HYPERLINK l “_Toc319675892” 1.2.2 Specific Objective6
HYPERLINK l “_Toc319675893” 1.3 Hypotheses6
HYPERLINK l “_Toc319675894” 1.4 Significance of the study7
HYPERLINK l “_Toc319675895” 1.5 Scope of the Study7
HYPERLINK l “_Toc319675896” CHAPTER 28
HYPERLINK l “_Toc319675897” LITERATURE REVIEW8
HYPERLINK l “_Toc319675898” 2.1 Empirical Review8
HYPERLINK l “_Toc319675899” 2.1.1 Corporate Governance9
HYPERLINK l “_Toc319675900” 2.1.2 Benefits of Corporate Governance9
HYPERLINK l “_Toc319675901” 2.1.3 Corporate Audit12
HYPERLINK l “_Toc319675902” 2.1.4 Issues in Corporate Governance14
HYPERLINK l “_Toc319675903” 2.2 Theoretical Review16
HYPERLINK l “_Toc319675904” 2.2.1 Overview of Audit Quality16
HYPERLINK l “_Toc319675905” 2.2.2 Audit Committee and Corporate Governance17
HYPERLINK l “_Toc319675906” 2.2.3 Board Structure and Audit Quality17
HYPERLINK l “_Toc319675907” 2.2.4 Ownership Structure and Audit Quality18
HYPERLINK l “_Toc319675908” 2.2.5 CEO Duality and Audit Quality and leverage 19
HYPERLINK l “_Toc319675909” 2.3 Corporate Governance in Kenya25
HYPERLINK l “_Toc319675910” 2.4 Gap25
HYPERLINK l “_Toc319675911” 2.5 Conceptual Framework26
HYPERLINK l “_Toc319675912” CHAPTER 327
HYPERLINK l “_Toc319675913” METHODOLOGY27
HYPERLINK l “_Toc319675914” 3.1 Research Design27
HYPERLINK l “_Toc319675915” 3.2 Population28
HYPERLINK l “_Toc319675916” 3.3 Sample and Sampling Design29
HYPERLINK l “_Toc319675917” 3.4 Data Collection30
HYPERLINK l “_Toc319675918” 3.5 Data Analysis32
CHAPTER FOUR ……………………………………………………………………………….33
Findings and Results ……………………………………………………………………………33
CHAPTER FIVE ………………………………………………………………………………..47
Discussions and Conclusion …………………………………………………………………….47
Recommendations ……………………………………………………………………………….53
HYPERLINK l “_Toc319675919” BIBLIOGRAPHY54
HYPERLINK l “_Toc319675920” APPENDIX59
HYPERLINK l “_Toc319675921” 1 Questionnaire59
HYPERLINK l “_Toc319675922” 2 Study Timetable68
HYPERLINK l “_Toc319675923” 3 Budget69
CHAPTER ONE
INTRODUCTION AND BACKGROUND OF THE STUDY
1.1 Background of the StudyAuditing in public corporations is aimed at protecting shareholders who are members of the public by virtue of being taxpayers. Legally, public corporations are required to make available to any interested party the most recent audit results and financial fillings upon request. In this context, auditing is designed to act in a regulatory capacity, keeping public corporations fiscally responsible and honest about their financial practices and economic situation (Economist, 2004).
Procedural audit covers various aspects of a corporation including compliance with environmental laws, laws to protect workers’ safety, and all other types of laws relating to management of corporations. Procedural audit may also involve an evaluation and assessment of practices and procedures at a corporation, usually with the objective of improving operational performance. Usefulness of audit reports largely depends on two aspects namely quality of audit and integrity of auditors. Audit quality can be ascertained looking for presence of critical information like accurate financial statements and indicators of organization’s performance. These two are dependent on the extent of auditors’ willingness to issue qualified and independent report (Chen et al., 2005).
Though a number of studies have been undertaken on the topics of corporate governance and corporate audit, not much has been said about implications of corporate governance on audit quality. This study attempts to examine possible explanations as to why public corporations in Kenya which though promptly publish their audit reports as required by law, continue to perform dismally compared to private corporations. One of the assumptions guiding this study includes possible explanations that quality of audit reports from these public corporations could be significantly compromised.
1.2 Statement of the ProblemPoor corporate governance is perhaps the dominance factor blamed for poor performance of public corporations. There is much that can be done to improve the integrity and ethical standards of financial reporting through greater accountability, restoration of resources devoted to audit function, and better corporate governance practices (Saudagaran, 2003). This reserch extends and contributes to existing research using data from public corporations in Kenya to investigate the likely impact of corporate governance on audit quality. The reserch is motivated by the interests surrounding the appropriateness of public sector reforms instituted by the government of Kenya in response to public corporate failures, global best practice and their implied efficacy in the face of significant implementation and audit quality.
1.3 Objectives of the Study1.3.1 General ObjectiveThe general objective of this study is to assess the effectiveness of corporate governance practices on the quality of audit reports.
Specific Objective of the study
To assess the relationship between the strength of audit committee and the quality of audit report.
To assess the relationship between internal audit functions and quality of audit report.
To assess the relationship between corporate code of conduct and quality of audit report.
1.4 HypothesesThe research proposal intends to test the following hypotheses:
There is a significant relationship between the strength of audit committee and the quality of audit report.
There is a significant relationship between the existence of an internal audit function and quality of audit report.
There is a significant relationship between the strength of corporate code of conduct and quality of audit report.
1.5 Significance of the studyThis study provides useful insights into improving audit quality of public corporations in Kenya. It further contributes to audit literature given that it provides additional empirical evidence on the impact of governance practices on audit quality. The study also reflected the quality of audit services between different audit firms in Kenya. This study is useful to taxpayers in Kenya as it provides evidence on the relationship between corporate governance and audit quality and the reforms instituted by the government in formulating the Code of Corporate Governance for public corporations.
1.6 Scope of the StudyThis study is premised on the appraisal of audit quality in Kenya. Therefore, data on public corporations in Kenya has been sought to provide answers to the problems and questions that have been raised for the study. The study covers selected public corporations listed under the Public Corporations Act, Laws of Kenya that are physically located in Nairobi.
CHAPTER TWO
LITERATURE REVIEW2.1 Corporate Governance, benefit and audit
Corporate governance is the way in way everyday activities of a corporation are being run, or technique by which corporations are directed and managed. The governance of corporations is entrusted to the board of Directors as well as concerned committees, all as per shareholders’ interests. Governance activities include balancing individual and societal goals and economic and social goals. In corporate governance, there exist elaborate interaction of stakeholders including shareholders, board of Directors, and management. All the stakeholders work collectively in shaping corporations’ performance. For success to be realized in any corporation there is need to foster healthy working relationships between shareholders and management. Shareholders must ensure actual performance is as per the standards of performance (Management Study Guide, 2012).
Put into broader perspective, corporate governance focuses the manner shareholders guarantee themselves of getting fair return on their investment. This requires distinguishing between shareholders and management. Management should be solely responsible for decision making and authority of the corporation. To ensure shareholder interests are protected, corporate governance ensures transparency which in turn ensures strong and balanced economic development. Demand for good corporate governance is driven by emergence of market-oriented economies and globalization. Corporate governance ensures corporations emphasize trustworthiness, morality, and ethics (Management Study Guide, 2012).
A number of benefits can be realized from corporate governance. These include lowering of capital costs, positive impact on corporation’s share prices, ensuring corporate success and economic growth, and helping in brand formation and development. Other benefits of corporate governance include providing proper inducement to shareholders and management to achieve objectives that are in interests of the owners and the organization, and minimizing wastages, corruption, risks and mismanagement (Management Study Guide, 2012).
Corporate audit refers to examination of financial and operational procedures at a corporation. These examinations are either conducted by internal or external corporate audit teams, and they can serve a variety of functions. The sole purpose of auditing is to confirm that corporations are operating within the law, and that their stated ethical standards are upheld by their practices. Corporate audit takes various forms; in the financial sense it involves detailed inspection of accounts and financial practices of a corporation. Auditors will mainly look at possible financial irregularities which may indicate tax evasion, funds embezzlement, as well as other illegal activities. Financial audits may also be concerned with ways of helping a corporation operate more efficiently and effectively by suggesting ways in which a corporation may cut costs and improve performance (Economist, 2004)
2.2 Emerging issues in Corporate GovernanceSuccessful corporations are those that experience financial stability such that interests of shareholders and the corporation itself are effectively addressed and enhanced. Financial stability of a corporation can be achieved by the interaction of three basic necessities namely; sound leadership at the corporation level, strong prudential regulation and supervision, and effective market discipline. Sound leadership begins with good corporate governance consisting of capable and experienced board of Directors and management staff, a coherent strategy and business plan, and clear lines of responsibility and accountability (McDonough, 2002).
Since the board of Directors is mandated to develop overall strategy development within a corporation, it is important that only individuals with necessary skills and competencies are represented in the board. It is necessary that clear guidelines establishing independence of the board are established. The top management should be constituted by individuals capable of setting prudent business strategies and can pursue decisions that would ensure long-term objectives and policies set by the board are realized (McDonough, 2002).
To ensure financial stability, execution of the overall objectives of a corporation must be supported by rigorous internal controls and effective risk management. An effective internal control apparatus is critical to provide reasonable assurance that the information produced by the corporation is timely and reliable and that errors and irregularities are discovered and corrected promptly. Such an apparatus is also needed to promote the firm’s operational efficiency and to ensure compliance with managerial policies, laws, regulations, and sound fiduciary principles. This is where corporate governance associates with audit quality (McDonough, 2002).
Past years have brought widespread questioning of the quality and integrity of the information that corporations make available to the market and the behavior of some corporate executives. Although the developments that gave rise to this questioning are regrettable, there has, in fact, been a positive side. The public uproar that these developments have created and the turmoil they have generated in the financial markets have been immensely powerful as forces for meaningful public sector reform. These painful experiences should help educate a generation of younger managers about the importance of integrity and sound corporate governance based on independent oversight and good audit quality (Konczal, 2009).
2.3 Audit Quality
The various changes in accounting, financial reporting and auditing were all designed to provide protection to investors. This is being achieved by imposing a duty of accountability upon the managers of a company (Crowther and Jatana, 2005). In essence, auditing is used to provide the needed assurance for investors when relying on audited financial statements. More precisely, the role of auditing is to reduce information asymmetry on accounting numbers, and to minimize the residual loss resulting from managers’ opportunism in financial reporting. Effective and perceived qualities (usually designated as apparent quality) are necessary for auditing to produce beneficial effects as a monitoring device. The perceived audit quality by financial statements users is at least as important as the effective audit quality. Conceptually, DeAngelo (1981) defined audit quality as the market-assessed joint probability that the auditor discovers an anomaly in the financial statements, and reveals it. Agency theory recognizes auditing as one of the main monitoring mechanisms to regulate conflicts of interest and cut agency costs. Therefore, assuming a contracting equilibrium in the monitoring policy, a change in the intensity of agency conflicts should similarly involve a change in the acceptable quality of auditing.
The importance of corporate governance in the audit process will likely increase as firms move toward an audit strategy that is more holistic and focuses on business processes and business risks. In this regard, Bell et al. (1997) state that “today’s auditor should place more weight on knowledge about the client’s business and industry, and its interactions with its environment, when forming an opinion about the validity of financial-statement assertions.” Since a key role of corporate governance is often to facilitate interactions with the environment and to help the firm reduce its business and global risks, it appears imperative that auditors focus on the strength and functioning of the board of directors and its support for the audit committee when evaluating the risk that the financial statements are materially misstated.
2.3.1 Audit Committee and Corporate Governance
Literature suggests that a valuable audit committee should play an important role in strengthening the financial controls of a business entity (Collier, 1993; English, 1994; Vinten and Lee, 1993). A number of studies have found that companies with an audit committee, particularly when that committee is active and independent, are less likely to experience fraud (Beasley, et al., 2000; Abbott, et al., 2000; McMullen, 1996) and other reporting irregularities (McMullen, 1996; McMullen and Raghunandan, 1996). Findings also suggest that audit committees are effective in reducing the occurrence of earnings management that may result in misleading financial statements (Defond and Jiambalvo, 1991; Dechow, et al., 1996; Peasnell, et al., 2000). Audit committee is also expected to enhance the effectiveness of both internal and external auditors (Simnett, et al., 1993). However, Cohen, et al. (2000) reports that a number of audit practitioners involved in exploratory interviews expressed concern over the effectiveness of audit committees, with some partners suggesting that audit committees are not powerful enough to resolve conflicts with management.
It is generally agreed that, for an audit committee to be effective, a majority, if not all members, should be independent (Cadbury, 1992) and they should have an understanding of accounting, auditing and control issues (Cohen, et al., 2000; Goodwin and Seow, 2000; Hughes, 1999; Lear, 1998). Literature also linked audit quality with the boards of directors, and the audit committees of boards of directors. This shows that audit quality is positively related to boards and audit committees when they are more independent (that is, higher number of outside directors). Carcello and Neal (2000) show that auditors are more likely to issue going concern reports in the presence of more independent boards and are less likely to be fired by the company following the issuance of a going concern audit report.
Auditors work directly and more closely with the audit committee than the board (Cohen et al. 2002). As a sub-committee of the board, the audit committee has, at least in theory, the explicit responsibility to ensure sound auditing and financial reporting. However, recent evidence suggests audit committees have not fulfilled these responsibilities, either because of lack of commitment (e.g., meeting infrequently), knowledge, and/or independence (Beasley et al. 2000, Beasley et al. 1999, DeZoort 1998). Recent findings indicate that audit committees meet with external auditors about twice a year, with limited two-way (i.e., passive) communications (Cohen et al. 2002) and that the audit committee members are often the more junior members of the board (Vafeas 2001). Thus, to date audit committees in most instances do not appear to have served as an effective corporate governance mechanism.
As a result, a number of regulatory and legislative changes have been made to improve the effectiveness of audit committees. Importantly, as noted, the effectiveness and power of the audit committee is likely to be linked to the degree to which the board takes an agency perspective and thereby places importance on maintaining sound controls and ensuring a strong presence of independent external and internal auditors. “If the board is functioning properly, the audit committee can build on and relate to these very same board-wide principles. If the board is dysfunctional, the audit committee likely will not be much better.” (BRC, 1999, p, 6). Further, Beasley and Salterio (2001) found that board of director characteristics influences the composition and experience of the audit committee, thus providing further evidence about the potential role that boards can play in monitoring management’s actions. Hence, the type (foci) of the board should be important to auditors as they assess client business risks and the risk of material misstatement.
Song and Windram (2004) evaluate the recommendations of the Cadbury Committee (1992) in the UK and Blue Ribbon Committee (1999) in the US and examine the effectiveness of UK audit committees in monitoring financial reporting. They find that UK audit committees play a significant role in monitoring the quality of financial reporting. They also find that financial literacy is an important determinant of audit committee effectiveness. Abbott et al. (2004) examine 41 firms that issued fraudulent reports and 88 firms that restated annual results in the period 1991-1999. They find a significant positive association between audit committees that lack a member with financial expertise and the occurrence of financial reporting restatements. Bedard et al. (2004) investigate the effect of audit committee characteristics, namely, expertise, independence and activity, on the extent of earnings management. They use the level of income-increasing and income-decreasing discretionary accruals, applying the modified Jones (1995) cross- sectional model for a sample of 300 US firms in the year 1996. They demonstrate empirically that the presence of at least one member with financial expertise on the audit committee is negatively related to the level of earnings management.
2.3.2 Board Structure and Audit Quality
The pinnacle of the governance structure is the board of directors, who are charged directly with representing the shareholders’ interests. Hence, the type of the board is likely to have a significant impact on the quality of financial reporting and the risks of fraudulent financial reporting. Arthur Levitt, former Chair of the U.S. Securities & Exchange Commission (SEC), stated (1999, 2): “The link between a company’s directors and its financial reporting system has never been more crucial.” For instance, if there is a board that places great importance on maintaining a strong monitoring perspective (an “agency” perspective, as will be described more fully in the next section), it is likely that the board will ensure that a sound audit committee is in place.
Further, the type of board could also have a significant effect on corporate strategy and eventually the business risks faced by the corporation. The Business Roundtable Principles of Corporate Governance (2002, 4) states while discussing the board’s role in overseeing the firm’s strategic direction that, “Once the board reviews a strategic plan, the board should regularly monitor implementation of the plan to determine whether it is being implemented effectively and whether changes are needed.” Thus, if the board focuses a great deal on ensuring the company has a sound business strategy and maintains a reasonable level of business risks (a “resource dependence” role, as will be discussed), then it is reasonable to expect that corporate failures and significant losses are potentially less likely to occur.
The linkage between the board and the quality of audit services performed may be formal or informal. In terms of formal linkage, the board of directors typically collaborates with management in selecting the external auditor, often subject to shareholder ratification. Since auditor looks to the board as its client, it is reasonable to expect the board to review the overall planned audit scope and proposed audit fee (Blue Ribbon Committee 1999; Public Oversight Board 1994). The board also may influence audit quality through informal means. The board’s commitment to vigilant oversight may signal to management and the auditor that the expectations placed on the audit firm are very high. If the auditor understands that the client (that is, the board) is particularly of high quality and demanding, the auditor may perform a higher-quality audit so as not to disappoint the client and jeopardize the relationship. Given the board’s oversight of the financial reporting and audit processes, as well as prior literature linking certain board characteristics to adverse financial reporting outcomes (Beasley, 1996; Dechow, et al. 1996), this proposed study explores the link between board’s characteristics and audit quality in Kenya.
Fama and Jensen (1983) have theorized that the board of directors is the best control mechanism to monitor actions of management. The study explored board’s independence based on the agency theory. Studies of O’Sullivan (2000) and Salleh, et al. (2006) found that the proportion of non-executive directors had a significant positive impact on audit quality. They suggested that non-executive directors encouraged more intensive auditing as a complement to their own monitoring role while the reduction in agency costs expected through significant managerial ownership resulted in a reduced need for intensive auditing.
2.3.3 Ownership Structure and Audit Quality
The relationship between outside shareholders and managers is marked by moral hazard and opportunism, which result from information asymmetry. The social role of financial reporting increases with the separation of ownership and control (Wan, et al. 2008). Indeed, accounting numbers are essential indicators to assess managers’ performance. However, the discretionary power of managers over the accounting policy being important in firms with diffused ownership, their propensity to manipulate the outputs of the accounting process is higher. In contrast to the directors’ ownership, an institutional ownership is an investment from a group of outside investors or investment from a certain institution. The percentage of ownership from institution is normally higher than individual investor. It is assumed that institutional investors have more influence than individual investors. With the high portion of ownership, institutional ownership has executive authority, say and power in the auditing process. It is rational that institutional investors demand comprehensive and informative information from the company. Kane and Velury (2002) observed that the greater the level of institutional ownership, the more likely it is that a firm purchases audit services from large audit firm in order to ensure high audit quality.
The strength of a company’s corporate governance structures is expected to affect a client’s financial reporting quality and business risks, it is expected that governance will impact auditors’ risk assessments and subsequent program planning decisions (Cohen and Hanno 2000). The relation between an auditor’s business risks and the risk of material misstatement in financial reports is increasingly recognized as a critical aspect in the audit process (Bell and Solomon, 2002, p. 8). Further, auditing standards prescribe that audit efforts are to be tailored to the level of client risks (SAS 47). However, for such factors to affect audit plans, the auditor must first recognize and properly assess the strength of corporate governance and, second, appropriately weight and use this evidence to adapt the nature, extent, timing, and/or staffing of tests. For example, if the overall strength of the corporate governance structure is perceived to be strong, auditors could assess client associated risks as lower. This, in turn, could potentially reduce the planned audit effort. Ultimately, program plans are posited to have a significant impact on the quality of audit decisions, since audit plans affect the evidence obtained.
For the purpose of the current study, institutional ownership can be separated into two main categories which are financial institutional and non-financial institutional ownership. The main difference between both groups is related to core business of investors. The core business of financial institutions is investment but not for non-financial institutions. However, both institutions are expected not to have different influence on audit quality. Mitra, et al. (2007) found that diffused institutional ownership was significantly and positively related to audit fees. The studies linked their finding to either institutional investor demand for the purchase of high quality audit services as safeguard against fraudulent financial reporting or firms’ endeavor to purchase high quality audits to attract institutional investment in common stock. It is expected that the portion of institutional ownership will have impact on audit quality of the company.
Assessing and relying on a corporate board and its audit committee, thus, entails complex audit judgments, particularly in evaluating how the type and strength of board affects overall client risks. Despite the proliferation of auditing research relating to corporate governance, there is little prior work that examines the impact of governance on audit planning judgments. Cohen and Hanno (2000), Cohen et al. (2002), and Bedard and Johnstone (2002) all provide evidence on the extent to which auditors rely on governance factors in assessing risks and planning audit testing. Although Cohen and Hanno (2000) found that management control philosophy and corporate governance activities affect client acceptance and audit planning judgments, they focused exclusively on the monitoring framework presented by COSO (1992) and did not test for different governance perspectives.
Using semi-structured interviews, Cohen et al. (2002) found auditors have a broad range of views regarding the elements included in “corporate governance”, with the predominant belief that management is the primary driver of corporate governance. In essence, management influences the strength of the corporate governance mechanisms by influencing who gets appointed to the board and what type of information is shared with members of the board. For example, Klein (2002a) found that firms experiencing losses have less independent audit committees and that (Klein, 2002b) earnings management is more likely to occur when a CEO is also a member of the board’s compensation committee.
Bedard and Johnstone (2002), using archival data, examine the impact of corporate governance risk and earnings management risk on planned audit effort and billing rates. While their study does not explicitly examine the type of corporate board (i.e., agency versus resource dependence), they find no significant effect of corporate governance risk on planned audit effort. In fact, their study predominately focused on corporate governance risk resulting the monitoring role of the board. Further, given the nascent stage in the development of auditing and firm standards on the impact of corporate governance on audit risk and planning decisions, it is not clear if all of the relevant corporate governance risk factors that audit managers and partners typically consider in audit planning decisions are yet adequately captured in audit work papers.
Cohen et al. (2002) also report that auditors include top management as part of the “corporate governance mosaic”, which is inconsistent with the agency theory’s prescription that mechanisms must act as a means to independently oversee management’s actions to protect stakeholders. Also, as noted, auditors’ experiences indicated that generally audit committees were not very effective in helping to curb financial reporting abuses. There has been no prior research to investigate the impact of board type on auditor judgments, the focus of the current study.
2.3.4 CEO Duality and Audit Quality
A number of studies have attempted to establish and discover the relationship between the CEO duality and audit quality. The CEO duality refers to non-separation of roles between Chief Executive Officer (CEO) and the Chairman of the Board. In normal circumstances, boards with CEO duality are perceived ineffective because a possibility of a conflict of interest. This is often attributed to the nature of family owned business in developing countries. Yemark (1996) posits that large companies that have separate persons for the two positions normally trade at higher price and have higher return on assets and cost efficiency ratios (Pi and Timme, 1993).
2.3.5. Financial and Non-Financial Intuitions and Audit Quality
Recent corporate reporting scandals (Enron, Worldcom, etc.) have put a discussion on reforms to the current financial reporting model on the top of the
