Audit Committee Characteristics and Firm Performance in Saudi Arabia

What Are Audit Committees?

Many studies have been carried out to demonstrate the manner in which audit committee reports affect the overall performance of companies in Saudi Arabia and elsewhere in the world. Interest in conducting audits of accounts in different firms peaked in the early 1960s. Two main approaches to accounts investigation have emerged in financial literature. The first is mainly based on sending questionnaires to a predetermined number of financial accounts users, asking them to rank specific accounting items according to their importance to the decision-making process (Buzby, 1974; Firth, 1978; Chandra, 1974; Turkey, 1985). The second approach is based on the link between a disclosure index — whether voluntary, mandatory, or total — and specific company characteristics (Alsaeed, 2005).

The first step in conducting a financial audit is the establishment of an audit committee. Audit committees are essential components of corporate governance (Green, 1994). When defining an audit committee, a great deal of weight is usually placed on its functions and composition. For example, the Canadian Institute of Chartered Accountants (CICA, 1992, p. 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 they are presented to the firm's board of directors. The committee is essentially a link between the auditor or auditing firm and the board of directors. The responsibilities of the committee 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 publication (Al-Lehaidan, 2006).

Development of Audit Committees in Saudi Arabia

The initial step toward the creation of audit committees in Saudi Arabia was taken in 1991 following Royal Consent, with the establishment 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 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 was to elect from among themselves a chairman of the audit committee to serve a minimum term of three years, and that their independence from the banks' management was of paramount importance to ensure effectiveness (1994, p. 3). The selection of the chairman was regarded as a critical activity because chairmen set the agenda, scope, tone, and manner of operations for the audit committee. For this reason, the individual appointed to lead the audit committee had to meet the following requirements:

1. He should not be a relative of, or associated in any way with, 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 — with other members of the board of directors.

The regulations further specified that audit committees should comprise three to five board members, and that a quorum of three members was required for a meeting to be properly constituted. Audit committee members may be chosen from the current board, former board members, 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 its affiliates (Al-Lehaidan, 2006).

The Current State of Audit Committees in Saudi Arabia

In 2003, the SOCPA drafted new rules and regulations intended to further improve the effectiveness of audit committees. These rules included the following provisions:

All public firms were required to form audit committees. Audit committees were required to have a minimum of four members, all of whom were to be independent directors. It was recommended that audit committees meet a minimum of four times per year. The chairman of the audit committee should not be a member of the board of directors. The audit committee should include at least one member holding a minimum of an undergraduate degree in financial accounting or finance. Each audit committee was required to maintain a formal charter.

The International Audit Committee (IAC) sent this draft to interested parties — including internal and external auditors and academics with expertise in accounting — so that they could provide input toward drafting best practices and regulations for financial auditing.

However, to this day no changes have been made to the initial rules and regulations, and it remains uncertain whether the input from these non-governmental parties will be adopted by the Saudi Arabia Ministry of Commerce (SMC) or the Saudi Stock Exchange Commission (SSEC). The structures of audit committees in Saudi Arabia are governed by laws and codes of best practice, including recommendations and guidelines; they are not regulated directly by SSEC listing rules regarding the setup and framework of audit committees (Al-Lehaidan, 2006).

Effects of Audit Committee Characteristics on Firm Performance

Many surveys and studies have investigated the link between corporate governance — including audit committees — and performance in developed countries (Sueyoshi et al., 2010). A recent study conducted between 2008 and 2009 found a statistically significant positive correlation between the structure and composition of audit committees and the financial performance of companies listed on the Amman Stock Exchange in Jordan (Hamdan, Sarea, & Reyad, 2013). That study also concluded that there was no link between audit committee characteristics and the operational performance of those same listed companies.

1. Size of the Audit Committee and Firm Performance

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

In the late twentieth century, in response to major corporate scandals at WorldCom and Enron, the American legislature drafted the Sarbanes-Oxley Act, which has become a reference document with regard to internal controls and corporate disclosure, especially concerning the responsibilities and tasks of an audit committee. Several recommendations were made by the Blue Ribbon Committee (BRC) to improve the effectiveness of financial audit committees (BRC, 1999). The BRC had three main recommendations it believed needed to be strengthened in every audit committee: effectiveness, accountability, and — most importantly — independence.

The Cadbury Commission recommended the formation of audit committees in firms and suggested a minimum of three members, all of whom should be non-executive directors (NEDs). Similarly, the Omani government's code of corporate conduct mandated that audit committees comprise a minimum of three members, all of whom had to be NEDs and independent. That code also recommended that the committee chairman should not be affiliated with the firm in any way, and that there should be at least one member who was an expert in financial accounting. Furthermore, audit committees should serve as a link between internal and external auditors and should play a key role in the selection of auditors, reviewing the scope of the audit, evaluating results, and drafting financial reports for publication (Chanawongse, Poonpol, & Poonpool, 2011). Within this context, the establishment of audit committees is essential for monitoring and regulating management activities, resulting in better financial performance of companies (Mohd et al., 2011; Xu et al., 2005). The audit committee can also assist the board of directors in monitoring and implementing better corporate governance practices that 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 membership should number around seven to eight members, a position seemingly supported by Jensen (1993). Firstenberg and Malkiel (1994) suggested that a board with fewer than eight members would improve concentration and participation and lead to more interactive and productive discussions. Similarly, Shaver (2005) argued that boards composed of many members — more than eight — were often plagued by responsibility diffusion, leading to social loafing, committee fractionalization, and diminished commitment to the group.

In the context of resource dependence theory, a larger audit committee may lead to better corporate governance owing to the expertise, knowledge, and diverse skill sets that members contribute to boardroom debate. Large committees can also offer cultural diversity that may help firms obtain critical resources and become more cognizant of environmental risks (Goodstein, Gautam, & Boeker, 1994; Ghazali, 2010; Pearce & Zahra, 1992; Pfeffer, 1987).

A related study by Hutchinson and Zain (2009) investigated the link between internal audit quality and firm performance — measured by return on assets — in relation to growth opportunities and the independence of audit committees in Malaysia. Companies were selected by two methods: a questionnaire and secondary data from annual reports. The sample included 60 firms listed on Bursa Malaysia in 2003. The study employed multiple regression analyses to investigate the correlation between internal audit and company performance and recommended the investigation of additional internal audit variables — including the qualifications of the chief audit executive and the size of the internal audit function — in relation to company performance (Al-Matari et al., 2014b).

2. Qualifications of the Audit Committee and Financial Literacy

The chief of internal audit should hold proper certifications and be registered with recognized 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). A certified head of internal audit has the capability to make sound decisions promptly without unnecessary consultation. This reinforces the emphasis on better qualifications for heads of internal audit teams in order to boost performance (Eighme & Cashell, 2002).

Companies that have recorded good financial performance may be better positioned to engage the services of highly qualified external directors. The high status of any external director stems from multiple sources, including title and job position (D'Aveni, 1990). Furthermore, the more qualified the director, the better his or her ability to monitor executives 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 to signal to investors the higher value of the firm. From this perspective, better qualifications for heads of internal audit committees are treated as an important variable (Al-Matari et al., 2014b).

In one study, researchers examined how financial reporting was approached by executive MBA holders and audit firm managers in order to evaluate differences between financial literates and financial experts. The study found that financial experts focused more on common issues that were often of lesser importance, while financial literates focused on less common but more significant issues. Song and Windram (2000) found that British firms whose audit committees included more financially literate members had a lower probability of experiencing financial reporting problems (Al-Lehaidan, 2006).

Financial literature on the composition of audit committees has historically emphasized expertise and independence while giving relatively little attention to financial literacy. This body of literature shows that the independence and expertise of the chief auditor are important elements of a successful audit committee. The independence and superior skill set of the audit committee chairman were linked positively to committees hiring quality auditors, greater interaction with internal company auditors, protection of external auditors from undue client pressure, and a marked reduction in financial reporting problems (Al-Lehaidan, 2006).

3. Independence of the Auditor and Audit Committee

The financial auditing literature supports the position that audit committees should take steps to protect the independence of auditors in order to reduce reputational and litigation-related losses. For instance, a study by Carcello and Neal (2000) showed that financially distressed companies with independent audit committees were more likely to receive going-concern qualifications. Moreover, their study established that audit firms that issued initial going-concern reports were less likely to be dismissed when the audit committee was composed entirely of independent members. These researchers argued that different audit committee characteristics were very important in influencing how committees performed their functions (Abbott et al., 2003).

Abbott et al. (2003) studied the link between two audit committee characteristics — activity and independence — and the level of non-audit services (NAS) purchases. Their study found that companies with active and independent audit committees had lower relative levels of NAS fees 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 non-executive majority and confirmed by the full board. The independence of the audit committee is typically assessed using the ratio of NEDs on the committee (Abdullah et al., 2008; Kang & Kim, 2011).

NEDs play a crucial role in ensuring that corporate governance practices are adhered to in the auditing process (Swamy, 2011). Abdullah et al. (2008) support this position, finding that companies in which a majority of audit committee members came from within the organization were more likely to commit financial fraud compared to a control group with more NEDs. As a result, audit committees comprised of more non-executive directors are regarded as more independent than those with a minority of NEDs (Mohd et al., 2009; Al-Matari et al., 2014c).

Drawing on agency theory, Berle and Means (1932) and later Fama and Jensen (1983) explained ways in which company outsiders could help boost firm value by providing additional experience and monitoring services. Directors from outside the firm were regarded as protectors of shareholders' interests through their monitoring of financial controls and the expertise they had acquired from prior experience (Mace, 1986). Similarly, using resource dependence theory, the additive contributions of both executive and non-executive members to the committee opened up multiple resource opportunities that served as useful injections to boost the financial performance of companies. NEDs could additionally apply their expertise to make sound decisions in a timely manner (Pearce & Zahra, 1992; Pfeffer, 1987). This study therefore examines this correlation and takes the position that committee independence improves financial performance.

4. Qualifications of the Internal Audit Team

Very few studies have examined the link between firm performance and the qualifications of an internal audit team in either developed or developing countries, and studies from emerging markets are similarly sparse. Among the notable exceptions is Hutchinson and Zain (2009), which investigated the relationship between internal audit quality and firm performance — measured by return on assets — in relation to growth opportunities and audit committee independence in Malaysia. The sample comprised 60 firms listed on Bursa Malaysia in 2003, and multiple regression analyses were employed. The study found a significant correlation between the qualifications of the internal audit team and company performance.

Another study by Prawitt, Smith, and Wood (2009) investigated the link between internal audit qualifications and earnings management. This study was based on 528 company-year observations covering 218 different companies over fiscal years 2000 to 2005, and employed OLS regression analysis. The study concluded that a link existed between internal audit qualification and earnings management. The scarcity of studies examining this relationship was also noted by Al-Matari et al. (2012), prompting further investigation into the correlation between the two (Al-Matari et al., 2014b).

5. Experience of the Internal Audit Team and Firm Performance

Hutchinson and Zain (2009) also investigated the correlation between audit experience, accounting qualifications, and firm performance relative to growth opportunities and audit committee independence in Malaysia. Using a combined questionnaire and secondary data approach, the study examined 60 firms listed on the Malaysian stock exchange in 2003 and employed multiple regression analyses. The study found a significant link between the experience of the internal audit team and company performance.

Prawitt et al. (2009) similarly examined the correlation between internal audit qualifications and earnings management using data from 218 companies over fiscal years 2000 to 2005, employing OLS regression analysis to investigate the relationship between the independent and dependent variables.

Literature on the composition of the audit committee based on expertise has been dominated by archival studies and surveys (e.g., Beasley & Salterio, 2001; DeZoort, 1997; GAO, 1991; Kalbers, 1992a, 1992b; Lee & Stone, 1997). Survey literature showed a number of instances in which committee members were asked to provide their own perceptions about how experienced or qualified they were. For instance, the General Accounting Office (1991) found that approximately 50% of the 40 surveyed audit committee chairs of major American banks regarded their committees as lacking an expert in auditing, accounting, or law. Additionally, a study by DeZoort (1997) revealed that audit committee members believed all committee members should have adequate expertise in oversight areas such as auditing, accounting, and law.

Other studies have investigated auditors' perceptions — both internal and external — of the expertise of audit committee members. Kalbers (1992a, 1992b) sent questionnaires to external and internal auditors and found that both groups believed audit committee members had even lower levels of expertise than what the committee members reported in their own self-assessments. Raghunandan et al. (2001) surveyed chief internal auditors and found that audit committees with at least one member holding an accounting background had a higher probability of conducting longer meetings with the chief internal auditor and of providing access to internal audit proposals and reports.

In contrast, archival literature addresses an extensive range of research questions concerning audit committee proficiency (McMullen & Raghunandan, 1996; Lee & Stone, 1997; Archambeault & DeZoort, 2001; Beasley & Salterio, 2001). According to McMullen and Raghunandan (1996), audit committees of corporations that had financial reporting problems were unlikely to include a member holding a Certified Public Accountant (CPA) designation. In addition, Bedard et al. (2004) established a negative association between aggressive earnings management and the governance and financial knowledge of audit committee members (Al-Lehaidan, 2006).

6. Foreign Members Serving on the Board and Company Performance

Foreign managers bring valuable information concerning problems in foreign markets, and therefore play a significant role in the quality of strategic decision-making (Al-Matari et al., 2012). Moreover, they are less likely to be connected to the company and its management and are thus perceived as independent (Kang et al., 2007). Foreign managers may also bring much-needed diversity and skill, particularly for firms operating globally. However, foreign managers can be expensive; they may come from different cultural backgrounds, be physically removed from the boards on which they serve, speak a different language, and may demand higher compensation because of the difficulties involved in working for boards outside their home countries.

Although the significance of this variable is clear, there is very limited research evaluating this relationship. Al-Matari et al. (2012) and Kang et al. (2007) have proposed that this gap be addressed by providing clearer insight into the corporate governance–firm performance association (Al-Matari et al., 2014a).

7. Audit Committee Meeting Frequency and Company Performance

Among the characteristics of the audit committee, meeting frequency is one of the most important factors. In prior literature, the liveliness of the audit committee has been gauged by how often it meets (Hsu & Petchsakulwong, 2010; Khanchel, 2007; Kyereboah-Coleman, 2007; Mohd et al., 2009). The efficiency of the audit committee in carrying out its oversight duties — including internal control and financial reporting — requires frequent meetings (Vafeas, 2005). Meetings should be conducted approximately three to four times annually and must be structured and chaired by the committee chairman (Hughes, 1999; McMullen & Raghunandan, 1996).

From the agency theory perspective, Jensen (1993) argued that boards should be relatively passive, and that heightened activity signals a reaction to poor performance. In contrast, Lipton and Lorsch (1992) and Jackling and Johl (2009) found that regular meetings led to better company performance. Regular annual meetings indicate that the board is fulfilling a management oversight duty rather than a purely supervisory one. Hsu and Petchsakulwong (2010) analyzed the relationship between audit committee meeting frequency and the performance effectiveness of public Thai non-life insurance firms over the period 2000–2007, employing performance metrics such as allocative, cost, technical, and revenue efficiency.

8. Executive Committee Meeting Frequency and Company Performance

The executive committee meeting is a third key factor among executive committee characteristics and greatly influences board efficiency. Meeting frequency gives the board more opportunities to observe and review management performance (Hsu & Petchsakulwong, 2010), and the executive committee is assessed by the regularity of its annual meetings.

Lipton and Lorsch (1992) and Jackling and Johl (2009) proposed that greater meeting frequency yields superior outcomes. Conger, Lawler, and Finegold (1998) and Kyereboah-Coleman (2007) similarly proposed that the time spent in board meetings is an essential resource for enhancing the board's effectiveness. Frequent board meetings allow directors to carry out their duties in line with the interests of shareholders (Kyereboah-Coleman, 2007). Accordingly, boards are required to be prepared to increase meeting frequency when circumstances demand greater control and supervision (Khanchel, 2007; Shivdasani & Zenner, 2002).

Resource dependence theory associates company performance and control with the strength of board actions, which are gauged by meeting frequency. This perspective holds that board meetings assist directors in examining and conducting board business on an ongoing basis and in addressing issues that employees encounter. Therefore, an increase in meeting frequency is expected to be associated with improved company performance. From the agency theory perspective, however, Jensen (1993) maintained that boards should be dominant, and that heightened board activity is a manifestation of their reaction to poor performance.

9. Resources Available to the Audit Committee

Audit committee members should be granted access to all significant resources required to carry out their responsibilities efficiently. The audit committee resources literature has largely focused on the roles that both external and internal auditors can play in assisting audit committees, and on audit committee size as an important determinant of audit committee effectiveness (ACE) (DeZoort et al., 2002).

Various studies (Cohen & Hanno, 2000; Knapp, 1987, 1991; Schroeder et al., 1986) identified significant roles that external auditors can play in improving ACE. Knapp (1987) conducted a study to identify features that affect the likelihood of audit committees supporting auditors in disputes with management. The results revealed that companies with audit committees were more likely to support auditors in management disagreements when they engaged a Big 8 auditor compared to a non-Big 8 auditor.

Cohen and Hanno (2000) found that external auditors made unfavorable audit planning decisions in cases where the firm's governance structure included an audit committee lacking technical expertise and frequent access to external and internal auditors in the absence of top management. DeZoort et al. (2000) found that internal audit directors perceived that prearranged communication programs between audit committees and internal auditors could enhance the quality of firm management.

Only a few studies have analyzed the effect of audit committee size on ACE in various situations. Archambeault and DeZoort (2001) examined the effect of audit committee size on suspicious auditor switches and found a negative relationship between the two. By contrast, Felo et al. (2003) found a positive relationship between audit committee size and the quality of financial reporting. These studies together support the use of audit committee size as a proxy for accessible audit committee resources.