The Impact of Audit Committees on Firms Financial Performance - Research Paper Example

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 Auditor Frequency Percent Cumulative Percent Deloitte 14 26.9 26.9 EY 15 28.8 55.8 Grant Thornton 1 1.9 57.7 KPMG 8 15.4 73.1 PwC 14 26.9 100.0 Total 52 100.0 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 Min Max Mean Std. Deviation Skewness Kurtosis Statistic Statistic Statistic Statistic Statistic Std. Error Statistic Std. Error SGD 47.27 404.70 1.1324E2 78.82808 2.616 .330 7.098 .650 AFEELN 2.97 92.77 27.1513 22.56515 1.277 .330 1.221 .650 ROE -32.18 79.30 18.4820 15.62330 .987 .330 5.890 .650 ROT Valid N (listwise) 0.00 0.00 0.00 0.00 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 SGD AFEELN ROE SGD Pearson Correlation 1 -.032 .044 Sig. (2-tailed) .824 .000** N 52 52 52 AFEELN Pearson Correlation -.032 1 -.168 Sig. (2-tailed) .824 .003** N 52 52 52 ROE Pearson Correlation .044 -.168 1 Sig. (2-tailed) .000** .003** N 52 52 52 ** are significant at p Read More