The misalignment of incentives between principals and agents (principal-agent conflict) can impede managers from conveying reliable information. Managers may opt to disclose opaque financial information in order to conceal managers’ deviant behaviour and to mislead shareholders that the firm is performing well. This situation may give rise to increased principal-agent information asymmetry. In dealing with information asymmetry, another monitoring mechanism, i.e., an audit committee, assumes an important role. An audit committee, which is part of a firm’s internal control, helps to minimise information asymmetry by improving the credibility of financial disclosures.
An audit committee is a sub-committee of a firm’s board of directors, and thus accountable
to the board (Abdullah and Mohd-Nasir 2004; Chen et al., 2015). A quality audit committee
is essential as it effectively oversees a firm’s financial reporting process and monitors the relationship between the management and the firm’s external auditor (Abdullah and Mohd-Nasir, 2004). In particular, an audit committee facilitates the communication between external auditors and firm’s internal auditors in reviewing a firm’s internal accounting systems and control, audit processes and financial statements. It is typical for the management to discuss and negotiate a firm’s financial results with the external auditors (Nelson et al., 2003). In this situation, the audit committee acts as an arbitrator between the management and the external auditors. A quality audit committee may be willing to disagree with the management on issues (Hadani et al., 2011), including matters related to the application of GAAP. A quality audit committee may demand a wider audit scope from the external auditors, or additional audit procedures (and incur a high audit fee) for areas of uncertainty and high risk. This would improve the detection of accounting misstatement and reporting errors, which then triggers and increases the likelihood of income-decreasing, income-increasing or zero-effect forced restatement.
In Malaysia, publicly listed firms are required to have an audit committee to ensure effective monitoring of the firm’s financial and audit functions so that financial misstatements can be prevented. The Malaysian Code of Governance (MCCG) specifies that at least three directors should make up an audit committee, the majority of whom should be independent and the chairman should be an independent non-executive director. The MCCG further highlights the relevant skills and knowledge an audit committee member should have for them to be able to detect opportunistic management reporting practices.
audit committee in reducing financial restatement is due to two reasons. First, the effectiveness of an audit committee is enhanced when it does not involve any former or current managerial member. Second, the audit committee undertakes more thorough oversight duties and will insist on a greater scope for the external audit to ensure high quality financial reporting. In this case, a quality audit committee can be reflected through its independence, expertise and audit fee.
Prior studies documented several findings with regard to the quality of an audit committee.
Baber et al. (2012) and Abdul Wahab et al. (2014) reveal that a higher level of audit
committee independence lowers the possibility of firms restating their financial statements. Similar studies conducted in the emerging market, such as Malaysia, produced mixed
findings. Abdullah and Mohd-Nasir (2004), Saleh et al. (2005) and Rahman and Ali (2006)
found no association between audit committee characteristics and financial reporting quality. The study by Abdullah et al. (2010), which examined a sample of Malaysian restatement firms from 2002 to 2005, however, found that audit committee independence is positively correlated with the probability of financial restatement. The findings indicate that the audit committee independence is effective in discharging their duties such that they are able to identify misstatements that require the need for earnings restatement. In this case, the first proxy for audit committee quality is audit committee independence, which ensures that an audit committee is effective and of quality. If the audit committee is dominated by insiders, this may cause the audit committee to ignore internal problems and
the potential of not issuing a clean opinion on firm’s financial reporting system (Zhang et
al., 2004). Independence further ensures that the audit committee provides objective and
independent oversight of a firm’s financial reporting process (Abdullah and Mohd-Nasir, 2004), enabling them to detect errors or aggressive accounting practices more effectively, hence triggering income-decreasing, income-increasing or zero-effect forced restatement.
The second proxy is audit committee expertise (Badolato et al., 2014). Having an
accounting or finance background is important for audit committee members to be able to address a firm’s financial reporting or accounting risk. This is possible as a financially expert audit committee may strongly justify the negotiations made by the external auditors to the firm’s management about issues related to accounting estimates and judgements, and accounting principles application (DeZoort and Salterio, 2001; Ng and Tan, 2003). A financially expert audit committee demonstrates a more structured discussion on financial reporting quality, and gives greater focus to concerns that are critical for a company’s
reporting quality (McDaniels et al., 2002). In this case, a financially expert audit committee may lead to the discovery of opportunistic earnings or material accounting errors, thus triggering the need for income-decreasing, income-increasing or zero-effect forced restatement.
In relation to prior research that examined audit committee expertise, the US studies by
Agrawal and Chadha (2005) and Carcello et al. (2011) show that higher financial expertise
sitting on the audit committee is associated with lower financial restatement, while Farber (2005) revealed fewer financial experts in the audit committee among fraud firms compared to the control firms. Hoitash and Bedard (2009) further show that a higher proportion of financial experts on the audit committee is related to a lower likelihood of material weakness disclosure related to financial reporting control problems.
The third proxy is the audit fee. Carcello et al. (2002) reveal that a more rigorous and
thorough audit, which reflects audit quality, is signalled through higher audit fees. In relation to this, an audit committee would demand more extensive external auditing to
gain additional assurance on financial reporting quality. Therefore, a high audit fee thus
gives greater assurance through greater audit effort, where the examination of a client’s accounts and transactions is conducted in great detail. With such a vigilant audit, it is more likely that the auditors will detect errors and misstatements, which trigger the need for income-decreasing, income-increasing or zero-effect forced restatement.
In addition to the above proxies, control variables, such as audit committee size and audit committee meetings, are included in the study. The size of the audit committee ensures that optimal or sufficient resources are available to control and oversee a firm’s financial reporting process: the larger the audit committee, the more likely it is to uncover potential problems in the financial reporting system that increase the likelihood of forced
restatement (Bédard et al., 2004). There is also the possibility that the pooling of experts in
large audit committees increases monitoring effectiveness thus reduces the likelihood of
forced restatement (Sharma et al., 2009). As for audit committee meetings, this allows
more time for the directors to perform their monitoring duties (Karamanou and Vafeas 2005) which reduces the likelihood of forced restatement. In another perspective, the time spent to meet allows audit committee members to discuss and resolve any outstanding accounting issues that require a restatement (Sharma et al., 2009). In this case, the frequency of audit committee meeting allows the detection of fraudulent financial
reporting more effectively, hence increases the likelihood of income-decreasing, income- increasing or zero-effect forced restatement.
Given the above assertions, this study posits that audit committee quality improves the effectiveness of its oversight of a firm’s financial reporting process. As such, a quality audit committee is deemed to improve the detection of earnings misstatement and errors, which may trigger income decreasing, income increasing, or zero-effect forced restatement. It is therefore hypothesised that:
H2: There is a positive relationship between audit committee quality and the occurrence of forced financial restatement.