Determinants of Audit Fees and Audit Quality in Light of Corporate Regulatory Changes in Saudi Arabia - Research Proposal Example

Determinants of Audit Fees and Audit Quality in Light of Recent Corporate Governance Changes and other Regulatory Changes in Saudi Arabia: Four-Dimensional Analysis Background In recent times, a number of corporate governance changes and other regulatory changes have been made in Saudi Arabia. For instance, in early 2011, the Saudi Arabian Capital Markets Authority (CMA) called for increased conformity with the Corporate Governance Regulations (CGRs) of November 12, 2006. The CGRs generally apply to the joint-stock corporations that are listed on the Saudi Arabian Stock Exchange (Tadawul) (Issa, Al-Ammar, Alfakhri & Spalding 2011). Initially, the CGRs were optional in terms of their implementation, and companies used the principle of “comply or explain” (Issa et al. 2011, p. 1). However, starting from the year 2010, implementing some of the CGRs started becoming mandatory for listed companies. In particular, under changes that became effective starting from January 2009, the CMA required listed companies to ensure compliance with the CGRs (Alzahrani, 2013). According to Issa et al. (2011), this move was meant to enhance transparency and ensure protection of the rights of companies’ shareholders. The selected compulsory regulations require directors’ annual reports to contain information about (1) compliance with the CGRs; (2) the members who constitute the board of directors as well as the balance between non-executive and executive directors and the other joint directors of joint-stock companies who hold a position in a given company’s board of directors; (3) a brief description in regard to the members who comprise the committees that are firmed by the boards of directors, for instance audit, remuneration and nomination committees; (4) the details of remuneration and compensation paid to the board members, chairperson and the highest paid executives; and (6) any penalty, punishment of limitations that are meted to the corporation by any executive, regulatory or judicial institution, as well as the yearly review of the effectiveness of the company’s internal audit (Issa et al. 2011). Further, the mandatory regulations call upon companies to have boards whose members that are to be independent and non-executive members must be two or more or a third of the total number of board members. Additionally, the audit committee of any listed company must be created comprising not less than three non-executive directors, one of whom should have a financial background (Issa et al. 2011). Other regulatory changes that have been instituted in Saudi Arabia include the New Saudi Arabian Companies Law (2015) and the opening of the Saudi Stock Exchange to foreign investors on 15 June 2015. In regard to the New Saudi Arabian Companies Law (2015), the changes that have been instituted touch on different areas. First are those relating to company formation, ownership and minimum capital for starting a company. Another area is in terms of governance, where combining the roles of the chairperson and any other supervisory position in a company is prohibited. As well, it is required that an audit committee be created to monitor the operations of a company, and that the election of members of a company board should be done through the approach of accumulative voting. Also, under the New Saudi Arabian Companies Law (2015), shareholders in a limited liability corporation cannot any more be held personally accountable the debts of a company if the company’s losses go beyond 50 percent of the firm’s capital. In addition, shares in kind in a joint stock company of a limited liability company must be valued by an authorized valuer (Clifford Chance, 2015). Turning to the recent opening of the Saudi Stock Exchange to foreign investors on 15 June 2015, what this implies is that foreign investors can now trade in shares in companies listed on the Tadawul. While this is likely to increase the number of investors trading on the Saudi Stock exchange, it also presents the challenge of compliance requirements among both companies and investors. All the above mentioned changes – mandatory CGRs, the New Saudi Arabian Companies Law (2015) and the opening of the Tadawul to foreign investors on 15 June 2015, present different opportunities and challenges for companies. These opportunities and challenges pertain to the manner in which companies will have to comply with the new requirements. In particular, companies have to implement changes to the manner in which their activities are audited to ensure compliance based on the scope and nature of their operations. Combined, the different changes are likely to affect the companies’ audit fees and audit quality. This is what drives the proposed research. Research Motivation Although many studies have been carried out in relation to corporate governance in developed countries such as the US, Australia and Japan, there is a dearth of literature about the less developed countries such as Saudi Arabia (Al-Matari, 2012). The proposed research is motivated by the need to find out the factors that determine companies’ audit fees and audit quality in light of recent corporate governance changes and other regulatory changes that have been implemented in Saudi Arabia. The likely scenario is that the changes that have occurred in regard to the management of companies have influenced audit fees and the quality of audit. According to Miettinen (2008), previous studies have utilized audit fees as a measure of audit quality. The concept behind these researches is that audit fees symbolize the level of audit effort, meaning that higher audits charges are anticipated to suggest more auditing work, which in turn is expected to lead to better audit work. This means that as a result of the recent changes in Saudi Arabia, companies with more auditing work are likely to pay higher fees for auditing work, and that higher fees are likely to lead to better audit quality. However, the correlation between audit fees and audit quality is an intricate one since audit charges are decided jointly by both supply and demand side drivers (Miettinen, 2008). Therefore, the motivation of the proposed research is to find out the factors that determine audit fees and audit quality taking into consideration recent corporate governance changes and other regulatory changes that have occurred in Saudi Arabia. The research will also seek to determine if there is any relationship between the recent corporate governance and regulatory changes in Saudi Arabia and audit fees and audit quality. Research Problem The problem of the research relates to the need to find out the factors that determine audit fees and audit quality given the recent changes that have occurred in Saudi Arabia’s business regulatory environment. The changes in the regulatory environment imply that companies will have to change their ways of ownership and management structures, reporting, trading on the stick exchange, and compliance other requirements. This ultimately has an effect on the scope of auditing work that companies require, as well as the fees charged and the quality of such work. But given that the relationship connection between audit fees and audit quality is a complex one as noted above, there is need to find out the factors that have a bearing on the two phenomena, keeping in mind the changes that have been implemented recently in Saudi Arabia. Significance of the Research The research findings will help companies and their shareholders in Saudi Arabia to be well informed in regard to audit fees and audit quality on the basis of the changes that have been implemented in the country in recent times. Notably, since the relationship between audit fees and audit quality is a complex one, many companies may presently not be well versed with what the recent changes regulatory changes imply for them. Since the research will seek to find out the wide array of factors that have an impact on audit quality and audit fees, the findings will fill the gap in knowledge along this area. Aims and Objectives of the Research The aim of the proposed research is to find out the factors that determine audit fees and audit quality in Saudi Arabia given the corporate governance and regulatory changes that have been implemented in recent times. This will be achieved by conducting a four-dimensional analysis that will assess the following: firm characteristics, board characteristics, audit committee characteristics, and auditor characteristics. The following are the objectives of the research: 1. To determine how company characteristics affect audit fees and audit quality. 2. To find out the impact of board characteristics on audit fees and audit quality. 3. To determine the relationship between audit committee characteristics and audit fees and audit quality. 4. To find out the effect of auditor characteristics on audit fees and audit quality. Literature Review and Hypotheses Development Literature Review An audit can be defined as “an independent examination of, and an expression of an opinion on, the financial statements of an enterprise” (Pendlebury & Groves, 2004, p. 101). When an audit is conducted, it offers an objective confirmation to shareholders and other stakeholders that a given company’s financial documentation has been prepared appropriately, and in line with the regulatory and legislative stipulations, and that they reflect the information candidly and reasonably and that they comply with the best accounting practice in the manner in which they treat various valuations and measurements (Pendlebury & Groves, 2004). Audit is conducted upon payment of an audit fee, which is defined as fees paid to an auditor for their financial statement audit (Choi, Kim & Zang, 2010). In literature, it has been argued that audit fee is determined by factors such as the size of the auditee, i.e. the company to be audited (in terms of assets and sales); the complexity of the company, as measured by the number of its subsidiaries; the company’s level of risk; and the company’s level of profit among other factors (Whittington, 2007; Gonthier‐Besacier & Schatt, 2007; Beattie, Goodacre, Pratt & Stevenson, 2001; Wang & Dou, 2015). Many previous studies have also relied on audit fees as a measure of audit quality (Miettinen, 2008). This implies that the fees that are charged for an audit process may be used as a determinant of the quality of that audit (as measured by earnings quality, financial statements restatements, and audit opinion). It is this notion that led Eshleman and Guo (2014) to question whether high audit fees are a signal that the auditor used more effort in the audit work or an indicator that the auditor may be losing their autonomy. In their study which involved the relation ship between ‘abnormal audit fees and audit quality’, Eshleman and Guo (2014) found evidence that supports the notion that abnormal audit fees, that is, high audit fees, are indicative of greater effort applied in the audit process. This means that even though the relation ship between audit fees and audit quality is a complex one as noted by Miettinen (2008), the level of audit fees may also determine the audit quality. Audit fees are an important component of the audit process given that there is a positive correlation between corporate governance and audit fees (Wahab, Zain & James, 2011). This means that the higher the corporate governance practices an organization undertakes or complies with, the higher the fees that the same organization is likely to pay for auditing of its operations. This notion can be related to at least two key arguments that concern the association between corporate governance and audit fees. The first one is informed by the substitution theory, which suggests that the more ideal the internal corporate governance arrangement of a company, and thus the less the agency costs, the smaller amount of risks the audit company and the auditor will come across and hence the lower the audit fees that will be charged (Wu, 2012). That is to say that an audit is regarded as a kind of outside governance for which effectual internal corporate governance may supplant to some extent (Elshafie & Nyadroh, 2014). The second argument relates to the signaling theory, which asserts that managers hint at better corporate governance to external stakeholders by encouraging more meticulous external audits, which without doubt lead to higher audit fees (Wu, 2012). This is to say that firms with solid corporate governance pay more audit fees to audit companies (Wu, 2012). Hypotheses Development Based on the review of literature, the following hypotheses will be used to guide the research: 1. Large companies attract higher audit fees because of the audit quality required. 2. Board characteristics (number of board directors, attendance of board meetings, frequency of board meetings, board independence, board interlocking, number of board committees, board members' compensation) increase quality of audit and hence increase audit fees. 3. Audit committee characteristics (size, frequency audit committee meetings, number of members with financial/accounting expertise and the independence of members) lead to higher audit fees and audit quality. 4. Large and more experienced audit firms attract higher audit fees because of the higher quality of audit they are likely to produce. Research Questions The following research questions will be used in the research: 1. Do large companies in Saudi Arabia attract higher audit fees because of higher audit quality expected? 2. What are the effects of board characteristics on audit fees and audit quality? 3. What impact do audit committee characteristics have on audit fees and audit quality? 4. Do large and more experienced audit firms attract higher audit fees because of the higher quality of audit they are likely to produce? Proposed methodology/design, including research sample and methods of data collection Population and sample The target population of this study will be Saudi Arabian companies listed on the Tadawul. The sample that will be used in the study will consist of 122 companies listed as banks. Methods of data collection The study will employ the use of closed-ended questionnaires that will have different types of questions in different sections based on the purpose of the research. The questionnaire will be pre-tested with assistance from senior business executives as well as audit experts to determine the content, ordering of questions, and terminology used. The questionnaire will be then be revised accordingly to ensure that it fits the purpose of the research. The questionnaires will be or posted or emailed to the target companies together with a cover letter explaining the purpose of the research and assuring the confidentiality of the responses. Potential Limitations The research will be limited by the fact that the sample is limited to banking institutions. This means that other limited liability companies in other industries will be excluded from the research, thus limiting the generalizability of the findings. Schedule for Variable Measurements Dependent Variables: Audit Quality: measured by earnings quality, financial statements restatements, and audit opinion. Audit Fees: measured by size of the auditee; the complexity of the company, as measured by the number of its subsidiaries; the company’s level of risk; and the company’s level of profit Independent Variables (4 Dimensions): 1. Firm Characteristics: A. Size: Total Assets B. Business Complexity: number of subsidiaries or main activities C. Industry D. Tobin’s Q E. Liquidity F. Corporate Governance Regulation Violations and Other Market Authority Penalties G. Ownership: The proportion of foreign ownership H. The company’s level of risk; 2. Board Characteristics A. Board size: number of board directors B. Board Independence: number of independent directors C. Frequency of Board Meetings D. Attendance of Board Meetings E. Number of Board Committees F. Board Members' Compensation: ratio of board directors' compensation to net income G. Board Interlocking: The proportion of directors on the board with directorships in other companies to the total number of directors on the board of the company 3. Audit Committee Characteristics: A. Size: Number of Audit Committee Members B. Frequency Audit Committee Meetings C. Number of Members with Financial/Accounting Expertise D. Independence of members 4. Auditor Characteristics: A. Auditor Size: Big 4 Vs. non-Big 4 B. Market share: Number of Current Clients C. Experience in industry: Number of Current Clients within the same industry D. Technical ability References Al-Matari, Y. A. (2012). Corporate governance and performance of Saudi Arabia listed companies. British Journal of Arts and Social Sciences, 9(1), 1-30. Alzahrani, Y. A. (2013). The corporate governance in Saudi listed companies. International Journal of Humanities and Management Sciences (IJHMS), 1(4), 243-445. Beattie, V., Goodacre, A., Pratt, K., & Stevenson, J. (2001).The determinants of audit fees – evidence from the voluntary sector. Accounting and Business Research, 31(4), 243-274. Choi, J., Kim, J., & Zang, Y. (2010). Do abnormally high audit fees impair audit quality? Research Collection, School of Accountancy, Singapore Management University, Singapore. Retrieved from http://ink.library.smu.edu.sg/?utm_source=ink.library.smu.edu.sg%2Fsoa_research%2F12&utm_medium=PDF&utm_campaign=PDFCoverPages Clifford Chance. (2015). New Saudi Arabian companies law. Retrieved from http://www.cliffordchance.com/briefings/2015/11/new_saudi_arabiancompanieslaw.html Elshafie, E., & Nyadroh, E. (2014). Are discretionary accruals a good measure of audit quality? 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