Saudi Arabia and Auditing Standards

¶ … audit committee characteristics affect firm performance in Saudi Arabia?

What are audit committees?

Many studies have been carried out to demonstrate the manner in which audit committees reports affect the overall performance of companies in Saudi Arabia and elsewhere in the world. The interest in conducting audit of accounts in different firms peaked in the early 1960's. Two main approaches of doing accounts investigations have emerged in financial literature. The first one is mainly based on sending out questionnaires to a pre-determined number of financial accounts users, asking them to rank a number of specific accounting items based on how important the item is to the decision making process (Buzby, 1974; Firth, 1978; Chandra, 1974; Turkey, 1985). The second approach was based on the link between a disclosure index of voluntary or mandatory or even total disclosure and specific company characteristics (source Alsaeed). The first step in conducting financial audit is the establishment of audit committees. Audit committees are essential components of corporate governance (Green, 1994). When defining an audit committee a lot of weight is usually placed on its functions and composition. For example, the Canadian Institute of Chartered Accountants (CICA, 1992: 20) defines an audit committee as a group or team of directors of a firm whose task is to review or examine the annual financial statements of the organization before presentation to the firm's board of directors. The committee is basically a link between the auditor or auditing firm and the board of directors. The responsibilities of the board of directors may also include participation in the selection of the auditor, definition of the scope of the audit, implementation of internal financial controls, and the generation of financial reports for publications (Al-Lehaidan, 2006).

Development of audit committees in Saudi Arabia

The initial step to the creation of audit committees in Saudi Arabia was implemented in 1991 after it was given a Royal Consent. This step was the creation of the Saudi Organization of Certified Public Accountants (SOCPA). This organization was created to regulate the overall field of financial accounting and auditing (Al-Lehaidan, 2006). In Saudi Arabia, banks are regulated by two government institutions, the Saudi Arabia Monetary Agency (SAMA) and the Ministry of Commerce (Al-Moataz 2003). In the year 1994, SAMA issued new rules and regulations to Saudi banks concerning the formation of audit committees (Saudi Arabian Monetary Agency 1994). The regulations stated that the board of directors in each bank were to elect from among themselves the chairmen of audit committees to serve a minimum term of three years and that their independence from the banks' management was of paramount importance to ensure their effectiveness (1994: 3). The selection of the chairmen was regarded as an important activity because they are the ones who set the agenda, scope, tone and manner of operations for the audit committees. For the above reason the individual who was to lead the audit committee, the chairman, had to meet the following requirements:

1. He should not be a relative or be associated in any way to the bank's senior management.

2. The chairman of the board of directors could not be elected to this position.

3. He should not be associated in any way, financial or otherwise, to other members of the board of directors.

The regulations further specified that the audit committees should be comprised of 3 to 5 board members and that a majority (3 members) were required for a meeting to be properly constituted. Audit committees members may be chosen from the board, ex-members of the board and qualified outsiders. However, the majority of the committee members should be outsiders who are not directors, senior managers, employees or major clients of the bank or affiliates of the bank (Al-Lehaidan, 2006).

The current state audit committees in Saudi Arabia

In the year 2003, the SOCPA came up with a draft of new rules and regulations that were to further regulate the audit committees so as to increase their level of success. The rules included:

That all public firms were required to form audit committees

That the audit committees were required to have a minimum of four members all of whom were supposed to be independent directors.

It was recommended that audit committees meet a minimum of four times per year.

That the chairman of the audit committee should not be a member of the board of directors.

That the audit committee should have among its members at least one individual who has a minimum of an undergraduate degree in financial accounting or finance.

That each audit committee was supposed to have a formal charter.

IAC (International Audit Committee) sent this draft to interested parties including auditors both internal and external and academics with expertise in accounting so that they could provide further input so as to finally draft the best practices and regulations for financial auditing.

However, to this day no changes were made to the initial rules and regulations and it is not certain if the input of all these other non-governmental concerned parties will be adopted by the Saudi Arabia Ministry of Commerce (SMC) or the Saudi Stock Exchange Commission (SSEC).

The structures of the audit committees in Saudi Arabia are in such a way that they are regulated by laws and codes of best practice including recommendations and guidelines. Thus such structures are not regulated directly by the SSEC listing rules regarding the set up and framework of audit committees (Al-Lehaidan, 2006).

Effects of structures and composition (characteristics) of audit committees on performance

Many surveys and studies done in the past have investigated the link between cooperate governance (including audit committees) and performance in terms of developed countries (Sueyoshi, et al., 2010). A recent study conducted between 2008 and 2009 found that there was a statistically significant positive correlation between structures and composition of audit committees and the financial performance of companies' listed in the Amman Stock Exchange in Jordan (Hamdan). The study also concluded that there was no link between audit committee characteristics and the operational performance of the same listed companies.

The characteristics of Audit Committees that affect company performance include:

1. Size of Audit Committee and the performance of the firm

One of the most important characteristics of an audit committee is its size. It is determined by the number of members that constitute the audit committee of a firm (Bauer et al., 2009; Hsu & Petchsakulwong, 2010; Nuryanah & Islam, 2011; Obiyo & Lenee, 2011).

In the late 20th century, in response to the mega corporate scandals at WorldCom and Enron, the American legislature drafted the Sarbanes-Oxley Act which has become a document of reference with regards to internal controls and corporate disclosure, especially with regards to the responsibilities and tasks of an audit committee. Several recommendations were made by the Blue Ribbon Committee (BRC) for the purposes of improving effectiveness of financial audit committees (BRC, 1999). The BRC had three main recommendations that they thought needed to be strengthened in every audit committee including effectiveness, accountability and most importantly independence. Another commission, i.e. The Cadbury Commission recommended the formation of audit committees in firms and it also recommended a minimum of three members to the committees all of whom should be solely non-executive directors (NEDs). Similarly, the Omani government's code of corporate conduct also mandated that audit committees should be comprised of a minimum of three members all of whom had to be NEDs and independent. The code also recommended that the committee chairman should not be in any way affiliated with the firm and that there should be at least a member who was an expert in financial accounting. Furthermore, audit committees should be the link between internal and external auditors and that these committees should play a key role in selection of auditors and in reviewing the scope of the audit, the results and the drafting of financial reports for publishing (Chanawonge, Poonpol, & Poonpool, 2011). Within that same context, the establishment of audit committees is essential for monitoring and regulating the role of management activities resulting in better financial performance of companies (Mohd et al. ., 2011; Xu et al., 2005). The audit committee also can assist the board of directors in monitoring and implementing better corporate governance that will benefit the company and its stakeholders (Saibaba & Ansari, 2011; Al-Matari, Al-Swidi & Binti Fadzil, 2014a).

Lipton and Lorsch's (1992) study recommended that board members should be about seven to eight. This study was also seemingly backed by another one that was conducted by Jensen (1993). Firstenberg and Malkiel (1994) suggested that a board with fewer than eight members would improve concentration, participation and would lead to more interactive and helpful discussions. Similarly, Shaver (2005) also argued that boards composed of many members (more than eight) were often plagued by responsibility diffusion, leading to social loafing and encouraging committee fractionalization and also it minimizes the commitment to the group.

In the context of resource dependence theory, a larger audit committee would lead to better corporate governance owing to the expertise, knowledge and different skill set that will be contributed additively to the boardroom debate. Additionally large committees could also offer a cultural diversity that could help firms obtain critical resources and be more cognizant of the environmental risks (Goodstein, Goodstein, Gautam & Boeker, 1994; Ghazali, 2010; Pearce & Zahra, 1992; Pfeffer, 1987).

Another similar study by Hutchinson and Zain (2009) investigated the link between the internal audit and the performance of the firm (return on assets) regarding growth opportunities and the independence of audit committees in Malaysia. The companies were selected by two methods; a questionnaire and secondary data from annual reports. The sample included 60 firms that were listed in the Malaysia Bursa in 2003. The study employed multiple regression analyses to investigate the correlation between internal audit and company performance. The study recommended the investigation of other new accounting items of internal audit with company performance. As a result of this recommendation, the current study takes into account the qualifications of a chief audit executive and the size of internal audit with company performance (Al-Matari et al., 2014b).

2. Qualification of the audit committee and its chief auditor (Financial literacy)

The chief of internal audit should have the proper certifications and be registered with recognised institutions such as the Certified Government Auditing Professional (CGAP), Certified Internal Auditor (CIA), Certified Financial Services Auditor (CFSA), Certification in Risk Management Assurance (CRMA) and Certification in Control Self-Assessment (CCSA). These organisations helped provide feedback. A certified head of internal audit has the capability to make good decisions within the shortest time possible without unnecessarily wasting time to consult with other teams. This study emphasises on better qualifications for heads of internal audit teams or committees in order to boost performance (Eighme & Cashell, 2002).

Companies that have recorded good financial performances may be in slightly better positions to use the services of external directors. The high status and importance that any external director holds emanates from different sources including his or her title and the job position (D'Aveni, 1990). Furthermore, the more qualified the director is, the better his ability to monitor the executive and offer useful contributions to the decision making process (Hillman & Dalziel, 2003). Qualified directors may also have the ability to influence external resource allocations and also to signal to investors the higher value of the firm. From this rational point-of-view this study considers better qualifications for heads of internal audit committees as an important variable (Al-Matari et al., 2014b).

In one study researchers examined how financial reporting was done by executive MBA holders and audit firm managers so as to evaluate the differences between financial literates and financial experts on the issue. The study found that financial experts focused more on common issues which were often of less importance, while financial literates focused more on less common but more significant issues. Song and Windram (2000) discovered that British firms which had audit committees with members with more financial literacy had smaller chances of having problems with financial reporting (Al-Lehaidan, 2006).

Basically, financial literature on the composition of audit committees emphasised on expertise and independence with very little consideration given to financial literacy. Additionally, this study has shown that the independence and expertise of the chief auditor are very important elements of a successful audit committee. The independence and better skill set of the chairman of the auditing committee was linked positively to committees hiring quality auditors, more interactions with internal company auditors, protections of external auditors from undue client pressure and a marked reduction in financial reporting issues (Al-Lehaidan, 2006).

3. Independence of Auditor and Audit Committee

Literature on financial auditing support the position that audit committees should take steps towards protecting the independence of auditors so as to reduce reputational and litigation-based losses. For instance, a study by Car cello and Neal (2000) showed that financially distressed companies that had independent audit committees had higher chances of getting going-concern qualifications. Moreover, their study also established that audit firms, which gave initial going-concern reports, had a lower likelihood of being fired in cases where the audit committee was entirely comprised of independent members. These researchers were essentially of the idea that different audit committee characteristics were very important in influencing the committee in performing its functions (Abbott et al. 2003).

Abbott et al. (2003) studied the link between two characteristics of the audit committees, i.e. activity and independence, and the level of NAS purchases. This study found that companies with active and independent audit committees had lower relative levels of NAS fees that were paid to serving internal auditors compared to audit fees (Al-Lehaidan, 2006).

Generally audit committees should be composed of a minimum of three directors with two thirds of the members being non-executive directors (NEDs). The chairman is to be elected from among the two thirds and shall be confirmed by the board. The independence of the audit committee is assessed utilizing the ratio of NEDs in the committee (Abdullah et al., 2008; Kang & Kim, 2011).

The NEDs play a very crucial role in guaranteeing that the corporate governance practices are adhered to in the auditing process (Swamy, 2011). The study by Abdullah et al. (2008) supports this position, in that it is of the notion that companies with a majority of the members of its audit committee being from within the organization were more likely to commit financial fraud in comparison to a controlled committee with more NEDs. As a result audit committees comprised of more non-executive directors were regarded to be more independent relative to those that had a minority NEDs (Mohd et al. ., 2009; Al-Matari et al., 2014c).

Utilizing the agency theory, Berle and Means (1932) in the early 20th century and later Fama and Jensen (1983) explained ways in which company outsiders could help boost the value of a company by according it with additional experience and monitoring services. Similarly, directors from without the firm were regarded as the protectors of the shareholders' interests through their monitoring of financial controls and the expertise they had acquired from previous experience (Mace, 1986). In the same way, using the resource dependence theory, the additive contribution of both executive and non-executive members to the committee led to the opening up of more opportunities in terms of multiple resources that were useful injections to help boost the financial performance of companies. The NEDs could also additionally use their expertise to build to make good decisions in a timely manner (Pearce & Zahra, 1992; Pfeffer, 1987). Thus, this particular study examines this correlation and is of the opinion that the independence of the committees improves financial performance.

4. Qualifications of the audit committee

Very few studies have examined the link between firm performance and the qualifications of an internal audit team in both developed and developing countries. There are also not so many studies among the emerging markets category. Of this few studies done on this subject matter, one of the most notable ones is the Hutchinson and Zain (2009). This study investigated the link between the internal audit and the performance of the firm (return on assets) regarding growth opportunities and the independence of audit committees in Malaysia. The companies were selected by two methods; a questionnaire and secondary data from annual reports. The sample included 60 firms that were listed in the Malaysia Bursa in 2003. The study employed multiple regression analyses to investigate the correlation between internal audit and company performance. The study found a significant correlation between the qualifications of internal audit and company performance.

Another study by Prawitt et al. (2009) investigated the link between qualification of internal audit and earning management. This particular study was based on sufficient evidence with regards to data in that it was anchored on 528 company-year observations (218 different companies for 2000 to 2005 fiscal years. This study also employed an OLS regression analysis to investigate the link between independent and dependent variables. The study concluded that there was a link between qualification of internal audit and earning management. The lack of studies that examined the link between firm performance and the qualifications of an internal audit team was also noted by Al-Matari et al. (2012). As such this study seeks to re-examine the correlation between the two (Al-Matari et al., 2014b).

5. The experience of the Internal Audit and Firm Performance and expertise

Hutchinson and Zain (2009), as mentioned above, conducted a study that investigated the correlation between audit experience and accounting qualification and the performance of the firm based on growth opportunities and the independence of audit committees in Malaysia. The firms were selected by two methods; a questionnaire and secondary data from annual reports. The sample included 60 firms that were listed in the Malaysia stock exchange in 2003. The Hutchinson and Zain (2009) employed multiple regression analyses to investigate the correlation between internal audit and company performance and found a significant link between experience of internal audit and company performance.

Moreover, a study by Prawitt, Smith and Wood (2009) examined the correlation between qualification of internal audit and earning management. This particular study was based on sufficient data (218 different companies for 2000 to 2005 fiscal years). This study also employed an OLS regression analysis to investigate the link between independent and dependent variables.

Literature on the composition of the audit committee based on their expertise was mostly dominated by archival studies and surveys (e.g., Beasley and Salterio 2001; DeZoort 1997; GAO, 1991; Kalbers 1992a, 1992b; Lee and Stone 1997).

The survey literature on this matter showed a number of instances in which the committee members were asked to give their own perceptions about how experienced or qualified they were. For instance, the General Accounting Office (1991), showed how approximately 50% of the 40 surveyed audit committee chairs of major American banks regarded their committees as not having an expert in auditing, accounting and law. Additionally, a study by DeZoort (1997) revealed that audit committee members believed that all the committee members should have adequate expertise in oversight areas such as auditing, accounting and law.

Other studies have investigated the perception of auditors (both internal and external) on the expertise of audit committee members e.g. Kalbers (1992a, 1992b) sent questionnaires to external and internal auditors and found that audit committees that both groups thought that the audit committee members had even lower levels of expertise compared to what the committee members had said in their self-report. Raghunandan et al. (2001), surveyed in their study, chief internal auditors and reported that audit committees with at least a member with an accounting background had a higher probability to have longer meetings with the chief internal auditor and to provide him/her with access to review internal audit proposals and reports.

In contrast, an extensive range of research questions concerning the audit committee proficiency is addressed by the archival literature (McMullen and Raghunandan 1996; Lee and Stone 1997; Archambeault and DeZoort, 2001; Beasley and Salterio 2001).

According to McMullen and Raghunandan (1996), the audit committees of those corporations possessing any financial reporting issues were not likely to have any associates holding a Certified Public Accountant (CPA).

In addition, Bedard et al. (2004) established that there was some negative association between aggressive earnings management and the governance and financial know-how of the members of the audit committee (Al-Lehaidan, 2006).

6. Foreigners Serving on the Board and Company Performance

Foreign managers carry along with them priceless information concerned with the related problems in the foreign markets. They therefore end up playing a great role in the quality of strategic decision making [47]. Moreover, they are not likely to be linked to the companies and their management and are hence perceived to be independent [48]. The foreign managers might also carry along with them the much sorted diversity and skill, mostly for those firms that function globally. The foreign managers are, however, very expensive; they might be originating from a different backgrounds, be physically secluded from the boards of the various firms where they work, speak a different language and might end up insisting for a higher compensation due to the various difficulties they face during their time working for boards not in their home countries.

Even though the significance of this particular variable is quite clear, there is the absence and only very minimal study evaluating this relationship. According to the proposal of (Al-Matari et al., 2012; Kang et al., 2007), the recent study covers this specific disparity through the provision of a clear insight concerning it. Therefore, the recent study examines this problem so as to analyse the corporate governance-firm association (Al-Matari et al., 2014a).

7. Audit Committee Meeting and Performance of the Company

Among the characteristics of the audit committee, the third important factor is the audit committee meeting. In the past literature, the liveliness of the audit committee is gauged by the meeting frequency (Hsu & Petchsakulwong, 2010; Khanchel, 2007; Kyereboah-Coleman, 2007; Mohd et al., 2009). The efficiency of the audit committee in carrying out its managing duty of internal control calls in addition to the financial reporting procedure necessitates frequent meetings (Vafeas, 2005). Moreover, the meetings have to be conducted around three to four times annually and they must be structured and controlled by the chairman himself (Hughes, 1999; McMullen & Raghunandan, 1996).

Jensen (1993) displayed that boards should be dormant and their liveliness should be a clear reflection to poor performance, in reference to the point-of-view of the agency theory. According to Lipton and Lorsch (1992) and Jacckling and Johl (2009), a better performance of the company was brought about as a result of regular meetings. Particularly, regular annual meetings point out that the board is carrying out a management duty as opposed to a supervision duty. It is also perceived that the board's duty is to oversee management as contradicted to managing the company. In the period of 2000-2007, Hsu and Petchsakulwong (2010) analysed the relationship between the audit committee meeting and the performance effectiveness of the public Thailand non-life insurance firms. Information development such as allocative, cost, technical and revenue effectiveness is determined using insurance efficiency performance.