Corporate Governance

and Financial Reporting

Quality
Concept of Corporate Governance

 According to the Cadbury Report (1992, para 2.5), CG is a mechanism or

system which directs and control companies.
 The report states that shareholders employ the board of directors and
auditors to assure the appropriateness of governance.
 The responsibility of the board is supervising the management of the
companies and reporting to shareholders on their supervision.
 The role of directors is to control and monitor how managers govern the firm,
while the important role of auditors is checking financial statements
independently for shareholders.
Concept of Corporate Governance

 According to agency theory, due to the separation of ownership and

management, managers might be motivated to make fraud against owners in
order to increase their own wealth (Abdul Rahman and Ali, 2006).
 When there is no effective and strong monitoring system within a company,
managers might behave in a way in which the interests of shareholders
deviate. For example, they are more likely to manage earnings which results
in high agency costs.
 Corporate governance mechanism can address beneficial procedures that may
restrict the managers’ power to deviate the benefit of shareholders.
Consequently, agency costs are decreased.
Concept of Corporate Governance

 The function of different corporate governance characteristics has been taken

into more consideration as monitoring systems. These consist of mechanisms
such as independent board and sub-committees (audit committee,
remuneration committee and nomination committee), internal auditors and
external auditors that prepare more assurance and protection to the
shareholders’ interests.
Financial Reporting Quality - Earnings
Management
 Schipper (1989) defined earnings management as “a purposeful intervention
in the external financial reporting process with the intent of obtaining some
private gain”.
 A broader perspective provided by Healy and Wahlen (1999), where earning
management is the alteration of financial reports by structuring the
transaction to either mislead a number of stakeholders or to control
contractual outcome.
 Unlike fraud, earnings management involves choosing accounting methods and
estimates that are compliant with GAAP (Inaam & Khamoussi, 2016)
Financial Reporting Quality - Earnings
Management
 Earnings management is usually driven by the desire to increase firm’s share
price in order to boost the managerial compensation, which include bonuses,
incentives and stock options (Ruiz-Verdú, 2008).
 Numerous studies use discretionary accruals as a proxy of earnings
management (Abdallah, 2018; Al-Thuneibat, Al-Angari, & Al-Saad, 2016; Piot
& Janin, 2007).
 It is well known that management use accrual-based techniques to manage
firm’s earnings as it provides flexibility over selection of accounting methods,
which has no direct effect on cash flow (Li, Mcdowell, & Moore, 2011).
 Cheng and Warfield (2005) pointed out that discretionary accruals are more
visible in the company where the remuneration of top management is linked
with stock value of company, especially when options are applicable.
Audit Committee
 Audit committee plays an essential role in corporate governance as they can
bring independent and transparency judgement in overseeing the financial
reporting process (Securities Commission Malaysia, 2017).
 Their main responsibilities include oversee and monitor the financial
reporting process, identify and discuss any significant accounting policies, and
review the significant issues in financial reports (Deloitte, 2018).
 A larger size of audit committee is more likely to uncover and resolve
potential problem in the process of financial reporting, as they provide the
necessary strength and diversity views to ensure an effective monitoring in
the organisation (Bédard, Chtourou, & Courteau, 2004).
 Kusnadi et al. (2015) pointed out that the independence of audit committee
may balance the different views between managers and external auditors,
thus produces a higher quality financial report.
Audit Committee

 The specialized experience and accounting knowledge is required for audit

committee members to identify and asking question that challenges
management and external auditors, and therefore improving the financial
reporting quality (Ika & Ghazali, 2012).
 In previous studies, the frequency of meetings have significant impacts on
earnings quality (Davidson et al., 2005; García et al., 2010).
 The number of audit committee meetings indicates the activity level of
committee members. Soliman and Ragab (2013) identified that inactive audit
committees are less likely to oversee and monitor the financial reporting
process effectively.
Internal Audit Function
 MCCG described that internal audit function will helps organisations to
achieve its objectives by assessing and enhancing the effectiveness of
governance, internal control and risk management (Securities Commission
Malaysia, 2017).
 According to previous studies, internal audit function effectiveness can be
assessed through existence, size and sourcing arrangement (Al-Rassas &
Kamardin, 2015b; Alzoubi, 2019; Yasin & Nelson, 2012).
 Some studies found that the establishment of internal audit function will
reduce the level of discretionary accruals and improve earnings quality
(Alzoubi, 2019; Gebrayel et al., 2018).
 The larger size of internal audit function implies more competent personnel
to establish financial reporting controls and reducing the weaknesses (Lin,
Pizzini, Vargus, & Bardhan, 2011).
Internal Audit Function

 The increasing of size in internal audit function indicates greater resources

allocated to recruit and retain competent skilled personnel (Al-Rassas &
Kamardin, 2015a).
 Yasin and Nelson (2012) explained that outsourced internal auditor are more
likely to be independent in carried out their duties and able to fulfil the
monitoring role better than in-house internal audit function.
 However, this view contrary to previous study who claims that in-house
internal audit function has better understanding of business processes and
greater control over audit operations compare to outsourcing (Desai, Gerard,
& Tripathy, 2011).
External Auditor

 External audit is recognised as one of the most essential processes that

contribute to the achievement of accurate and reliable financial information
(Al-Dalabih, 2018).
 According to ISA 200, external auditors have to express an opinion on whether
the financial statements of companies are preparing in accordance to the
financial reporting framework (IFAC, 2019).
 Jensen and Meckling (1976) described external audit as one of the most
effective governance mechanisms that enhance financial reporting quality
and mitigate the conflict between shareholders and management.
External Auditor

 Based on previous studies, external auditor effectiveness can be assessed

through size of audit firm, audit fees, industry specialized auditor and auditor
tenure (Abdallah, 2018; Alhadab, 2018; Chen, Wu, & Zhou, 2006; Manry,
Mock, & Turner, 2008).
 Large audit firms have more to lose such as reputation loss and litigation risk
when an audit failure occurs, and thus they may provide higher audit quality
(Khurana & Raman, 2004).
 Empirical evidences shown that audit firm size is significant associated with
earnings management (Abdallah, 2018; Khalil & Ozkan, 2016). In contrast,
some studies demonstrated that the audit firm size does not have relationship
with discretionary accruals (Davidson et al., 2005; Piot & Janin, 2007).
External Auditor

 Schäuble (2019) claimed that higher audit fees are expected to result in an
increase audit effort by external auditors.
 Prior study argued that industry specialized auditors should be able to carry
out higher quality audit work due to the deeper knowledge and greater
experience in the industry (Solomon, Shields, & Whittington, 1999).
 Ghosh and Moon (2005) reported that that auditor tenure have a negative
effect towards audit quality, as their independence will decrease as the
length of tenure increase.