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MAJ
24,7
624
Received 3 June 2008
Revised 24 October 2008
Accepted 24 March 2009
Managerial Auditing Journal
Vol. 24 No. 7, 2009
pp. 624-638
q Emerald Group Publishing Limited
0268-6902
DOI 10.1108/02686900910975350
Audit committee characteristics
in financially distressed and
non-distressed companies
Mohd Mohid Rahmat and Takiah Mohd Iskandar
Faculty of Economics and Business, School of Accounting,
Universiti Kebangsaan Malaysia, Bangi, Malaysia, and
Norman Mohd Saleh
Graduate School of Business, Universiti Kebangsaan Malaysia, Bangi, Malaysia
Abstract
Purpose – The purpose of this paper is to investigate whether there is any difference in the
characteristics of an audit committee between financially distressed and non-distressed companies
listed on the Bursa Malaysia (formerly known as the Kuala Lumpur Stock Exchange). Financial
distress among big companies is a sign of weak corporate governance, of which the audit committee is
one of elements. Four characteristics of the audit committee being examined are size, independence,
activity, and accounting knowledge.
Design/methodology/approach – The sample comprises 73 financially distressed and the
matched pair of 73 financially non-distressed listed companies. The financially distressed
companies have been suspended from the listing under the provision of the practice note 4 (PN4) of
the listing requirements.
Findings – Results show that financial distress of companies has a significant negative association
with financial literacy of the audit committee and the quality of external audit.
Research limitations/implications – The finding is limited to PN4 companies and the selected
match of the non-PN4. Results may not be generalized to other companies that are faced with financial
difficulties but are not classified as financially distressed under the PN4 provision.
Practical implications – The paper does not examine other qualitative factors such as the culture
and dynamics of audit committee meetings which may have effect on the audit committee
performance. An examination on the issue requires a different research design. Hence, further research
is needed to address the issue.
Originality/value – The evidence suggests that financial literacy of audit committee members is a
significant factor which helps the audit committee enhance the financial performance of the company.
It also suggests that a quality external audit, in addition to an effective audit committee, enhances
company financial performance.
Keywords Corporate governance, Audit committees, Financial management, Malaysia
Paper type Research paper
Introduction
The audit committee is one of the key elements in the corporate governance
structure that helps control and monitor management (Ruzaidah and Takiah, 2004).
The authors would like to thank participants of the Seminar International Indonesia-Malaysia-
Brunei Darussalam, Universitas Bengkulu, Indonesia, October 3-4, 2004, for their constructive
comments.
The committee plays an important role in monitoring the company’s operation and Audit committee
internal control system with the aim of protecting the interest of the shareholders. characteristics
The audit committee contributes to the development of the strategic plan of the
company and is expected to provide input and recommendations to the board with in companies
regard to any financial or operational matters. Hence, it is recognised that an effective
audit committee would focus on improving the company performance and
competitiveness, particularly in a changing business environment which is beyond 625
the control of the company (Charan, 1998; Craven and Wallace, 2001). An effective
audit committee is expected to focus on the optimisation of shareholders’ wealth and
prevent the maximization of personal interests by the top management (Wathne and
Heide, 2000).
In Malaysia, the formation of an audit committee has been the main focus of the
government since the early 1990s. However, the formation of audit committee was only
on a voluntary basis. It was only in 1994 that the formation of an audit committee was
made mandatory for all companies listed on Bursa Malaysia. The inclusion of the
formation of an audit committee as one of the Bursa Malaysia listing requirements
is complementary with the government initiatives to strengthen the corporate
governance of all listed companies in Malaysia. The Securities Commission, which
was established in 1993, is responsible for regulating the market and ensuring good
governance practices among listed companies. As part of the listing requirements, the
practice of corporate governance must be disclosed in annual reports of listed companies.
The establishment of the Finance Committee on Corporate Governance in 2000,
which is headed by the Secretary General of the Ministry of Finance of Malaysia,
further strengthens the role of audit committees. The main focus of audit committees is
to strengthen transparency, promote effective enforcement, and identify needs for
training and education for directors and key players of an organization. The Finance
Committee Report on Corporate Governance, which was issued by the committee,
outlines principles and best practices for good governance to be practiced by
Malaysian listed companies. The report also outlines principal recommendations
involving reformation of law, regulation and rules in certain areas. In March 2000, the
Finance Committee developed the Code of the Best Practices of Corporate Governance,
which provides guidelines on the formation of the audit committee, particularly with
respect to size, independence, frequency of meetings and financial literacy of members
to ensure good practices of corporate governance. All listed companies are required
to comply with the recommendation in terms of audit committee characteristics
(Ainuddin and Abdullah, 2001). In cases of non-compliance, justifications must be
properly disclosed in the annual report.
The delegation of some of the board of directors oversight role to the audit
committee has broadened the function of the audit committee to cover wider areas
including the monitoring of top management and the control system, and approving
corporate strategy (De Zoort et al., 2002; Blue Ribbon Committee – BRC, 1999).
The audit committee is identified as part of the company strategic leadership
contributing to the success of turnaround attempts (Mueller and Barker III, 1997).
Hence, the effectiveness of the audit committee is associated with the prosperity or
financial distress of companies. The lack of competency among audit committee
members may contribute to the company financial distress (Simpson and Gleason,
1999). On the other hand, competent audit committees have the capacity to reduce
MAJ financial distress (McMullen and Raghunandan, 1996). In addition, audit committee
24,7 independence is argued to be negatively associated with the going concern of
financially distressed firms (Carcello and Neal, 2000). The greater the percentage
of affiliated directors in the audit committee, the lower the probability that financially
distressed firms will receive a going concern opinion from the external auditors. It is
suggested that competent audit committees help enhance the company performance
626 and hence reduce the probability of financial distress. It is expected, therefore, that
good characteristics of audit committees are associated with good company financial
performance, which in turn, are negatively associated with the financial distress.
However, research on the effectiveness of an audit committee in relation to financial
distress is lacking. The effectiveness of an audit committee has been usually examined
in terms of the quality of reporting (Abbott and Parker, 2000; Kalbers and Fogarty,
1993; Ruzaidah and Takiah, 2004), fraudulent reporting (Menon and Williams, 1994),
the quality of audit (Ali, 1990), or the selection of external auditors (Kuniake, 1981;
Einchenseher and Shields, 1985; Cottell and Rankin, 1988; Takiah and Wan-Zanani,
2004). Company financial distress has often been examined in relation to the board of
directors (Simpson and Gleason, 1999).
This paper uses listed companies which are unable to maintain the listing condition
of the Bursa Malaysia as the proxy of financial distress. Based on the provision in
paragraph 8.14(2) of practice note 4 (PN4) of the Bursa Malaysia listing requirements,
companies that do not comply with any of the specified conditions are identified as
PN4 (Md. Khairi, 2002)[1]. A deficit of shareholders’ equity is one of the conditions that
violate the listing criteria, causing de-listing of companies from the stock exchange.
The problem of financial distress that has been an increasing phenomenon among
large companies after the 1997/1998 economic crisis in South-East Asia, contributes to
a deficit in the shareholders’ equity (Shamsul, 2001). The enforcement of the PN4
provision in Malaysia in 2001 provides a shield for the financially distressed listed
companies from being immediately de-listed. The listing activities of these companies
are suspended[2]. The provision gives an opportunity and time for the affected
companies to turn around and to be fully listed again. During the provisional period, the
company may undertake a financial restructuring plan to overcome the problems.
The success of the plan would reflect on the ability of the top management, including
the audit committee, in addressing the problems.
This paper provides additional evidence on audit committee performance by
examining audit committee characteristics of financially distressed companies in
comparison to those of the non-distressed companies. For the purpose of this paper,
financially distressed companies consist of those suspended from the Bursa Malaysia
listing under the PN4 provision. The financially non-distressed companies are the
non-PN4. It is expected, therefore, that audit committees with good characteristics
would have significant negative relationships with the financial distress of company.
The performance of PN4 and non-PN4 companies has previously been examined only
in terms of differences in magnitude of compliance to specific listing requirements of
the Bursa Malaysia (Haron et al., 2005). The paper did not address the issue of audit
committee effectiveness. Unlike Haron et al. (2005), this paper goes beyond comparing
the PN4 and non-PN4 compliance to listing requirements, by examining the
relationships between characteristics of the audit committee and the financial distress
of both groups of companies. An examination of the relationships should provide
an insight into an understanding of the effectiveness of an audit committee in carrying Audit committee
out their role, and its responsibility to ensure business prosperity and to avoid financial characteristics
distress. This paper also investigates the extent the audit committees of the PN4 and
non-PN4 category are in compliance with the characteristics stipulated in the Code of in companies
Best Practices. Thus, this paper makes a significant contribution in terms of evaluating
the effectiveness of the audit committee in avoiding financial distress.
The following section discusses related prior studies and hypotheses development. 627
The next section followed by the discussion on research method and results of data
analysis in Section Results. Final section concludes the paper.

Literature review and hypothesis development

The conflict between managers and shareholders often drives the company’s top
management to make decisions not in the best interest of shareholders, especially when
a very opportunistic person is involved in the process (Jensen and Meckling, 1976).
Without independent and effective control procedures, the top management of a
company is always tempted to deviate from protecting the shareholders’ interests
(Fama and Jensen, 1983). Hence, effective and efficient audit committees are needed
to resolve such conflicts (Klein, 2002) and to maintain good performance (Charan,
1998; Ainuddin and Abdullah, 2001). Prior studies find mixed results on the
relationships between good audit committee characteristics and company performance
(Dalton et al., 1998; Agrawal and Knoeber, 1996; Balinga et al., 1996). This paper
examines relationships between specific characteristics of an audit committee as
identified in prior studies and company financial distress. The characteristics include
size, activeness, composition, and financial literacy of members.

Size of audit committee

In order to make an audit committee effective in controlling and monitoring top
management activities, the committee must have enough members to carry out the
responsibilities (Vinten and Lee, 1993). Results of prior research on the association of
audit committee size and company performance are not conclusive. Dalton et al. (1999)
find that audit committees become ineffective if their size is either too small or too
large. An audit committee with a large number of members tends to lose focus and be
less participative compared to those of a smaller size. On the other hand, an audit
committee with a small number of members lacks diversity of skills and knowledge,
and hence becomes ineffective. An audit committee of the right size would allow
members to use their experience and expertise for the best interest of stakeholders.
However, other research (Pincus et al., 1989; Einchenseher and Shields, 1985;
Menon and Williams, 1994), finds a weak association between the size of the audit
committee and a company’s performance. Although results do not provide strong
support to the monitoring function of an audit committee, the positive relationship
between size of an audit committee and company financial performance is supported
by the argument in resource dependence theory (Pierce and Zahra, 1992). Under
resource dependency theory, the effectiveness of an audit committee increases when
the size of the committee increases, because it has more resources to be devoted to
address issues faced by the company. Thus, the following hypothesis is developed:
H1. There is a significant negative relationship between size of an audit
committee and financial distress.
MAJ Composition of an audit committee
24,7 Composition of an audit committee refers to the ratio of non-executive and executive
directors. Audit committees with a higher composition of non-executive directors are
considered more independent than those with more executive directors. There is
evidence that executive directors would dominate the decision-making process of the
company’s top management, resulting in less objective decisions. For instance, Kaplan
628 et al. (1990), Gilson (1990), Shivdasami (1993), and Yermack (1996) find that executive
directors reveal only a limited amount of information to non-executive directors in
order to prevent stakeholders from getting all the information. The domination of
executive directors results in weak control mechanisms within the management
structure. The presence of non-executive directors as the majority members of the audit
committee would, therefore, enhance the independence of the committee. Studies show
that non-executive directors are able to provide independent opinions to the top
management for consideration because of their potential to act more independently
than executive directors (Vicnair et al., 1993; Weisbach, 1988; Vinten and Lee, 1993).
Non-executive directors are able to play positive roles in corporate governance
(Beasley, 1996). Vicnair et al. (1993) find significant changes in the membership of audit
committees from 1980 to 1987 in terms of an increasing ratio of non-executive director
membership of audit committees. The change reflects the importance of independence
of the PN4 audit committee in order to ensure the effectiveness and objectivity in top
management strategic decision making. Porter and Gendall (1993) observe that an
audit committee should comprise not less than three members with the majority of
non-executive directors. A large composition of non-executive directors in an audit
committee would optimise the reputation of an audit committee as a good monitor
(Porter and Gendall, 1993). Non-executive directors can be seen to be more objective
and more able to offer criticism in relation to policies undertaken by management. As a
result, the non-executive directors would reduce the probability of financial statement
manipulation (McMullen and Raghunandan, 1996). This argument is consistent with
the principles specified in the Code of Best Practice of Corporate Governance
(Malaysian Institute of Corporate Governance – MICG, 2001). The code states that the
audit committee should include not less than three members of which the majority
are independent, i.e. non-executive directors. Based on the above discussion, the
following hypothesis is developed:
H2. There is a significant negative relationship between the composition of
non-executive directors in audit committee and financial distress.

Frequency of meetings
Prior research uses frequency of meetings to measure audit committee activeness
(Menon and Williams, 1994; McMullen and Raghunandan, 1996; Collier and Gregory,
1999). Findings suggest that an audit committee that meets more frequently provides a
more effective oversight and monitoring mechanism on financial activities, which
include the preparation and reporting of the company financial information. It is
evident from prior research that audit committees of companies with financial
difficulties do not hold meetings as frequently as those without financial difficulties
(McMullen and Raghunandan, 1996). Hence, the frequency of meetings has a
significant positive relationship with audit committee effectiveness (Collier and
Gregory, 1999; Song and Windram, 2000). This evidence is in line with the guidelines
proposed by the Cadbury Committee (1992) in the UK, the BRC (1999) in the USA, and Audit committee
the Best Practice Code of Corporate Governance in Malaysia (MICG, 2001). These characteristics
guidelines require audit committees to meet not less than three times a year. A properly
planned meeting schedule would ensure the timeliness of audit committee decisions in companies
parallel to the audit cycle and the issuance of financial statements.
The effectiveness of an audit committee in carrying out its monitoring role of
financial reporting process and internal control requires regular meetings (Vafeas, 629
1999). The meetings which need to be held at least three or four times a year must be
clearly structured and well controlled by the chairman (Hughes, 1999; McMullen and
Raghunandan, 1996). A regular and well controlled meeting would assist audit
committees in examining the accounting and related internal control system, and in
keeping top management informed of the committee’s cautious actions (McMullen and
Raghunandan, 1996). A related executive director would provide explanations on
procedures and issues that may have arisen (Hughes, 1999). Based on the above
discussion, the following hypothesis is developed:
H3. There is a significant negative relationship between the frequency of audit
committee meeting and financial distress.

Financial literacy
Knowledge in accounting and finance provides a good basis for audit committee
members to examine and analyse financial information. The educational background
becomes an important characteristic to ensure audit committees perform their roles
effectively. Audit committee members who are financially literate are more
professional in their approach and more adaptable to changes and innovation
(Hambrick and Mason, 1984). Therefore, audit committees with financially literate
members are expected to adopt a high standard of accountability and level of
achievement and to strive for excellent corporate image and performance.
It is evident that audit committees perform poorly when financial literacy is lacking
(Kalbers, 1992). It is also evident that financial literacy is an important factor
contributing towards the effectiveness of audit committees in the UK (Collier, 1993).
Audit committees with good financial literacy are able to reduce the number of
distressed companies (McMullen and Raghunandan, 1996). From the perspective of
internal auditors, audit committees need to include financially literate directors as
members, in order to be effective and efficient (Abdul Hamid et al., 1999). Shamsul and
Abdul Latif (1997) agree that audit committees become more effective when members
are financially literate. These findings provide empirical evidence to support the
Malaysian Code of The Best Practice on Corporate Governance stipulation which
requires the appointment of at least one member with financial literacy on an audit
committee (MICG, 2001).
Hence, an audit committee must have at least one member who is a member of
Malaysian Institute of Accountants (MIA) or must have experience of not less than
three years and passed the professional examination. It can therefore be concluded that
financially literate members of audit committee are those with knowledge in
accounting and finance, and with relevant years of experience in practice. The
existence of a qualified accountant as a member of an audit committee would be able to
provide it with assistance in its controlling and monitoring role. Based on the above
discussion, the following hypothesis is developed:
MAJ H4. There is a significant negative relationship between the financial literacy of
24,7 audit committee members and financial distress.

Research design and methodology

This is a cross-sectional research study examining the relationship between the audit
committee characteristics and the financial performance of companies. The study
630 uses a matched-pair sample of financially distressed and financially non-distressed
companies. The major advantage of the study design is the ability to make valid
comparisons of distressed and non-distressed companies over the same period of time
(Mueller and Barker, 1997).

Sample
The matched-pair sample consists of 146 companies listed in Bursa Malaysia
at 31 December 2001 comprising 73 financially distressed and 73 financially
non-distressed companies. The purpose of the matched-pairs is to ensure an equivalent
comparison exists. Financially distressed companies are firstly identified as those
suspended from the listing on Bursa Malaysia under the PN4 provision of the Listing
Requirements. One common criterion used for the purpose of PN4 is the insolvency
status of the company or inability to generate income (Md. Khairi, 2002). The
matched-pair non-distressed companies are subsequently selected among listed
companies with good performance (i.e. positive return on assets) to differentiate both
sub-samples on the basis of performance. The company performance is properly
identified to ensure a fairly accurate comparison is made between companies with
financial difficulties and those which are financially healthy. The matched-pair
selection is made on the basis of size of company, type of industry and accounting
period, in order to control the influence of such extraneous variables (Mueller and
Barker, 1997). Data on the characteristics of audit committee is collected from the
published financial statements of the companies for the year 2001 being the first year
of the enforcement of the provision of PN4.

Operationalisation of variables
The study uses logistic regression analysis to test the hypotheses. The Code of the Best
Practice of Corporate Governance of MICG is used as the benchmark of good practice.
The following is the model of the study (Table I):

FINDISTRESSi ¼ b0 ACSIZEi þ b1 ACCOMPi þ b2 ACMEETi þ b3 ACLTERACYi þ 1i ;

Operationalisation of variables

Dependent variable
Financial distress
Independent variables
Table I. Audit committee size
Summary of Audit committee composition
operationalisation Meeting frequency
of variables Financial literacy
0 ¼ non-PN4 companies for financially non-distressed
1 ¼ PN4 companies for financially distressed
Total number of audit committee members
The ratio of non-executive audit committee to total members
Frequency of audit committee meeting in the financial year
The number of audit committee with accounting knowledge
where FINDISTRESS, financial distress; ACSIZE, size of audit committee membership; Audit committee
ACCOMP, composition of non-executive directors in audit committee; ACMEET, characteristics
frequency of audit committee meeting; ACLTERACY, financial literacy of audit
committee members. in companies

Results
Descriptive statistics 631
Table II shows descriptive statistics of variables of samples. Table II shows that, on
average, an audit committee consists of three members, the majority of which are
non-executive directors. They hold about three meetings in a financial year. In terms of
financial literacy, however, the average number of audit committee members of both
PN4 and non-PN4 companies is less than that required by the Best Practice guideline.
In terms of independence of members and frequency of meetings of the audit
committee, the practice is consistent with the minimum requirement specified in the
Best Practice guideline.
A careful examination of the data reveals that nearly all (except one) sample
companies have three members in the audit committee. Therefore, there is no difference
in terms of size of audit committee between the two sub-samples of PN4 and non-PN4
companies. In addition, only four observations of an audit committee out of 146 show
no independent members. The rest of the sample shows that all members of audit
committees comprise independent (non-executive) directors. Only four companies do
not comply with the requirement of 75 percent independent members of an audit
committee as stipulated in the Code of the Best Practice of Corporate Governance.
A lack of variance in two variables, audit committee size and audit committee
independence (Table II), leads the study to exclude these two variables from the regression
analysis. Parametric test of differences in mean (t-test) and non-parametric test (Mann
Whitney U test) confirm that audit committee size and audit committee independence are
not statistically different between PN4 and non-PN4 companies. Therefore, we conclude,
there is no significant difference in audit committee size and audit committee
independence between PN4 and non-PN4 companies, i.e. H1 and H2 are not supported.

Audit
Audit committee Meeting Financial
Sample committee size composition frequency literacy

Non-distressed (non-PN4) N 73 73 73 73
Mean 3.000 1.000 2.863 0.849
Median 3.000 1.000 3.000 1.000
SD 0.000 0.000 0.481 0.360
Distressed (PN4) N 73 73 73 73
Mean 2.986 0.945 2.836 0.726
Median 3.000 1.000 3.000 1.000
SD 0.117 0.229 0.553 0.449
Total N 146 146 146 146
Mean 2.993 0.973 2.846 0.788
Median 3.000 1.000 3.000 1.000 Table II.
SD 0.083 0.164 0.516 0.410 Comparison of means
Best practice 3 or 4 members 0.750 3 or 4 times At least 1 member and best practice
MAJ Validation test of sample
24,7 T-tests are conducted to validate the matching process and to ensure that the
matched-pair groups are significantly different in financial distress but not significantly
different in terms of control variables, i.e. company size, type of industry and accounting
period. The sub-samples of distressed companies (PN4) and the non-distressed
(non-PN4) are carefully matched on a one-to-one basis, based on industry and accounting
632 period. Therefore, there should be no difference in industry and accounting period
between the two sub-samples. Hence, the t-tests are performed to compare the company
size between the two sub-samples of PN4 and non-PN4. Results of t-tests show that there
is no significant difference (at p , 0.05) in size (i.e. total assets) between the
matched-pair groups. The results indicate that the sampling procedures are successfully
and effectively performed in identifying the distressed and non-distressed companies.

Results of logistic regression analysis

The study uses logistic regression to test the hypotheses. Results of the analysis are
summarised in Table III.
Logistic regressions of audit committee characteristics on the probability of distress
are shown in Table III. Control variables, audit quality and company size, are included
in the regression model as these are important factors that may explain the propensity
of distress (although in the earlier test, the size of companies between the two
sub-samples is found to be not significantly different). There is evidence that audit
quality reduces agency problems (Jensen and Meckling, 1976; Watts and Zimmerman,
1986). Audit quality is also found to be negatively related to earnings management
(NorHaizah et al., 2006).
Results show the value of Cox and Snell R 2 is 0.047 for the basic regression of test
variables, which is moderately low. This low in R 2 is common in studies examining
corporate governance characteristics. To examine the stability of the result, the model
is tested again by including industry dummy variables since the company financial
distress could be due to industry-wide conditions affected by the economy. The result
reveals an improvement in the value of Cox and Snell R 2 to 0.054, while the
significance level of variables under study remains similar.
Results in Table III show that there is an insignificant relationship between the
frequency of audit committee meetings, and company financial distress. The result
does not support H3. This result indicates that audit committees in financially
non-distressed companies, i.e. the non-PN4, are no more active than audit committees

Without industry control With industry controlb

Variables (n ¼ 146) Score p Score p

Constant 1.152 0.543 2 0.070 0.975

Meeting frequency 0.019 0.478 0.059 0.434
Financial literacy 20.737 0.034 * * 2 0.751 0.048 * *
Audit quality 20.699 0.030 * * 2 0.755 0.024 * *
Company size 20.011 0.989 0.052 0.745
Cox and Snell R 2 0.047 0.054
Table III.
a b
Results of logistic Notes: The variables are defined in Table I; significant at *0.100, * *0.050 and * * *0.010,
regressiona respectively
of financially distressed companies, i.e. the PN4. This result is not consistent with Audit committee
McMullen and Raghunandan (1996), who found that audit committees of companies characteristics
with financial difficulties do not hold meetings as frequently as those without financial
difficulties. In Malaysia, the frequency of meetings does not in itself lead to more in companies
quality discussions by competent members (Ruzaidah and Takiah, 2004).
As shown in Table III, financial literacy of an audit committee has a negative
and significant relationship with the probability of financial distress at p ¼ 0.034. 633
The mean value of financial literacy of an audit committee of PN4 companies is lower
(i.e. 0.726) than that of the non-PN4 companies (i.e. 0.849; Table II). Therefore, H4 is
supported. The result also suggests that financial distress is significantly related to
quality audit services. Table III exhibits a negative relationship between audit quality
and financial distress ( p ¼ 0.030), suggesting that the higher the quality of audit
services, the lower is the probability of financial distress.
Generally, results suggest that the financial distress of companies is significantly
related to the financial literacy of audit committee members. Audit committees
consisting of fewer members with financial literacy may lead the companies to record
lower performance, which consequently may result in financial distress. In the absence
of members with sufficient financial literacy, audit committees may not be able to
perform effectively in monitoring the company operational and financial matters.
Financial literacy is expected to improve the effectiveness of audit committees in
fulfilling their responsibilities. The financially distressed companies may ensure their
audit committees are characterised with the criteria of good governance in terms of
size, independence, activeness, and particularly financial literacy of their members as
prescribed by the Code of Best Practice.

Discussions and conclusion

Best practice in audit committees is an important determinant of good corporate
governance. An effective audit committee has a significant bearing on the financial
performance and future direction of the company. Being one of the key players in good
corporate governance, an effective audit committee would bring companies to a higher
level of performance. On the contrary, ineffective audit committees may not be able to
help management improve company performance. This research examines
characteristics of audit committees of Bursa Malaysia listed companies in relation to
financial distress (the PN4) and non-financial distress (the non-PN4). In this research,
financial distress is used to measure the effectiveness of audit committee. Good
characteristics of a company audit committee are benchmarked against the Code of
Best Practices of Corporate Governance.
Findings of this paper indicate that financial distress is significantly associated
with financial literacy of audit committee members. Results show that companies with
financially literate audit committees are able to perform better and hence are free
from financial distress, compared with companies whose audit committees are less
knowledgeable about accounting and finance. It is argued that audit committee
members with enough knowledge of accounting and finance are able to monitor and
review more effectively the operational and financial reporting of the company.
However, the availability of individuals with sufficient knowledge and experience in the
field of accounting and finance is scarce. This scarcity poses problems to companies in
getting the right membership for their audit committees. In an exploratory study on
MAJ listed companies in a particular industry in Malaysia, Takiah et al. (2001) find that only
24,7 eight out of 25 construction companies listed on Bursa Malaysia are able to appoint
accountants (i.e. MIA members) as directors of the companies. As a result, the ruling of
the Bursa Malaysia listing requirements on financial literacy is difficult to fully
implement on the appointment of audit committee members. In order to make more
companies comply with the financial literacy requirement for audit committee members,
634 the standard has been lowered to a certain level of sufficient experience of not less than
three years and passed professional examination as approved by the Accountant
Act 1967.
Results show no significant relationships between financial distress and the three
other independent variables, size, composition and the frequency of meetings of an
audit committee. This paper finds that, on average, both financially distressed and
non-distressed companies meet the minimum requirements on audit committee as
prescribed by the Code of Best Practices of Corporate Governance with respect to size,
composition of audit committee, meeting frequency and financial literacy. This
suggests that a company may fulfill the specified rulings merely for compliance
purposes in order to avoid any punitive action by the regulators. However, meeting
the minimum standard does not by itself guarantee the effectiveness of an audit
committee to avoid financial distress. Other qualitative factors such as the level of
commitment of audit committee members, quality of discussions during meetings, and
organizational work environment may have an influence on audit committee
performance. However, these factors are not included as part of this paper, as
addressing these issues may require a different research design.
Thus, the findings of this paper partly support earlier arguments that financial
distress is associated with audit committee characteristics particularly independence,
activeness and knowledge of accounting and finance (Fama and Jensen, 1983; Rechner
and Dalton, 1991; Jensen, 1993; Buang, 1998). Prior studies suggest that audit committee
characteristics are important in determining the effectiveness of an audit committee to
moderate the behaviour of the management team whose preference is to choose an
alternative or decision that maximizes their personal rather than shareholder’s interests
( Jensen and Meckling, 1976; Jensen, 1993). It may be argued that the poor performance
of PN4 companies may be the consequence of an ineffective audit committee. The board
of directors has the responsibility to form an effective audit committee in order to
establish good governance for the company. The audit committee is expected to carry
out tasks independently without being influenced by any party, especially the
managing directors or chief executive officers of the company. In the absence of good
characteristics, an audit committee may lack the ability to help companies overcome
their financial problems and, hence, not undergoing financial distress.
Results of this paper indicate a significant relationship between the quality of
external audit and financial distress. This suggests the importance of an external audit
as an external mechanism in strengthening the corporate governance of the company.
Coordination between the roles of the board of directors, audit committee and external
auditor helps companies enhance the effectiveness of the monitoring mechanism
incorporating elements of accounting, internal control and operational systems.
An effective monitoring mechanism is the key success factor for companies to remain
competitive in business. Hence, it is evident that financially distressed companies need
to obtain good quality external audit services in addition to effective audit committees
in order to turn around their performance. Overall, this paper provides an insight into Audit committee
understanding corporate governance practices of PN4 and non-PN4 companies with characteristics
respect to audit committee and other factors such as external audit quality. This
finding provides support for the significant role of audit committee in strengthening in companies
the company financial performance, and hence, avoiding financial distress. Overall,
competencies in the areas of accounting and finance play an important role in ensuring
the effectiveness of audit committee and external audit. Therefore, there is a need to 635
promote continuous education and training among members of audit committee and
external auditors in order to ensure an enhancement of corporate governance in general
and audit committee in particular.
This paper has several limitations. First, this research focuses only on financially
distressed companies or the PN4 in comparison with the selected match of non-PN4
companies. Hence, the finding may not be generalized to other companies which may
face financial difficulties but are not classified as financially distressed under the PN4
provision. In addition, the small sample size may not provide the strong statistical power
to explain the test results. Beside the selected characteristics, this paper does not
investigate the impact of other qualitative factors such as the culture and dynamics of an
audit committee meeting which may have an influence on audit committee performance.
An investigation into these issues requires a different research design which is beyond
the scope of this paper. Further research is needed to address this issue.

Notes
1. Iris, TV3, CHG, Techno Asia, Aokam, CASH, Chase Perdana, Pan Global, Wembley, Repco,
Sri Hartamas, Promet, and Kelanamas are among large companies in Malaysia first
categorised as PN4.
2. The detail criteria of the PN4 companies are:
.
deficit in the adjusted shareholders’ equity of the listed issuer on a consolidated basis;
.
receivers and/or managers have been appointed over the property of the listed issuer, or
over the property of its major subsidiary or major associated company which property
accounts for at least 70 percent of the total assets employed of the listed issuer on a
consolidated basis;
.
the auditors have expressed adverse or disclaimer opinion in respect of the listed issuer’s
going concern, in its latest audited accounts; or
.
special administrators have been appointed over the listed issuer or the major subsidiary
or major associated company of the listed issuer pursuant to the provisions of the
Pengurusan Danaharta Nasional Berhad Act 1998.

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Corresponding author
Mohd Mohid Rahmat can be contacted at: mohead@ukm.my

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