This chapter will review the studies of corporate or financial statement fraud. Then, the study will undergo the revision of audit committees attributes in order to identify the effectiveness of audit committee in relation to the organization that involve in fraud. The scandal in accounting arise because of the unethical behavior such as intentionally in misallocation of assets and financial misrepresentation meanwhile fraud of corporate executive involve accusation of unethical behavior in a company (Choo and Tan, 2009). In order to instill the confidence of investors in the capital market, effectiveness of corporate governance is required in monitoring the process of corporate financial reporting (Chang and Sun, 2010). The concern on the audit committee effectiveness in curbing the manipulation of earnings in order to produce quality financial reporting has raised interest of many parties due to the accounting scandal reported (Lin, Li and Yang, 2006).
2.2 Corporate Fraud
High profile corporate scandals has seriously shocked the corporate world and also shaken the confident of shareholders and stakeholders towards the integrity and responsibilities of corporate governance. The quality of financial reporting also is questionable when the fraud is occurring in the organization. Accounting exploitation is one of the fraud element that the financial reporting and information of the firm has been manipulate by the management or executives in order to present the false financial statement of a firm that will destroy the capital market and image of the firm (Skousen and Twedt, 2009). Corporate wrongdoing or crime is defined as crime that occurs in the organization for the benefit to the organization and management that involve in the wrongdoing. The purpose of the crime is to increase the profit of the organization as well as the incentives of the executives or managers (Zey, 1999). The study by Persons (2000) stated that there are four differences between the organization that involved in fraud and the organization that do not commit fraud are higher leverage in fraud firm, capital turnover is low and less efficient in using their assets to generates sales, the current assets comprise most inventories and debtors (account receivables) and lastly the firm is smaller than the firm that not involve in fraud.
There are several component of fraud that will lead to the firm involve in this scandals which are the purposes or drivers of fraud, intention of the firm, planning of the firm to serve the purposes of fraud or to overcome the problem arise, action that has been taken, and the aim of fraud (Bayou and Reinstein, 2001). The main abuse of financial presentation that lead to the fraud in financial statement include omission of financial information disclose, lag in disclosure of information and also overstated profits. Beasley (1996) indicate that the firm that has ineffective and weak corporate governance will enhance the firm to obligate financial reporting fraud. Moreover, the financial statement fraud is significantly low where boards that have large proportions of independent members (Beasley, 1996). On the other hand, a study by Chen, Firth, Gao and Rui (2006) reveal that there is no significant relation between the fraud firm and the proportion of outside boards, size of the board and the Chief Executives Officer (CEO) that hold two position that as a CEO and also director (duality).
2.3 Audit Committee
Financial reporting will be more quality if the audit committee emphasize more their role oversight the process (Mohamad-Nor, et al., 2010). Some of the duties of directors towards the company has been delegate to the audit committee thus it gives greater responsibility to the audit committee that broaden their function to oversee the top management activities, internal control systems as well as the corporate strategy (De Zoort et al., 2002). Nowadays, the business is become more competitive in the market because of the changing environment of the business that are unpredictable, hence the focus of an effective audit committee is to ensure the better company performance and the competitive edge need than other firm in order to them to compete (Craven and Wallace, 2001). Company may turn into financial distress situation when they have lack of competent audit committee (Simpson and Gleason, 1999). The existence of effective audit committee in a firm will benefits the firm by having monitoring on the financial reporting and also avoid corporate fraud (Rupley, Almer & Philbrick, 2011). The audit committee is effective when they oversight on the management of a firm especially top management duties in order to maximize shareholders wealth rather than their own personal interest (Wathne and Heide, 2000).The effectiveness of audit committee in an organization will prevent the organization involve in fraud (Law, 2011) but the more audit committee that expert in accounting will not reduce the asset misappropriation by public company (Mustaffa and Youssef, 2010). The presence of independent audit committee in an organization will reduce the earnings misappropriation in the organization (Klein, 2001). The agency theory is applicable where the audit committee and board structure are able to enhance the firm to produce quality of earnings thus the intention to commit fraud is low (Vafeas, 2005).
The audit committees roles is to ensure that the quality and integrity of financial reporting and thus will help management to prevent fraud (Harrast and Mason-Olsen, 2007). Afify (2009) stated that the presence of audit committee and has a good communication between management and external auditors will enhance the financial reporting quality and timeliness.
2.3.1 Audit Committee Independent
An independent audit committee consists of outsider that independent from the company and management that enhance the committee to perform their duties. The monitoring process will be improve by having independent audit committee and also the function of the committee to oversee the financial matter in order to ensure the quality of the financial reporting (Siagian and Tresnaningsih, 2011). The audit committee is consider effective when the committee is active and it cannot be measure by the presence of independent non-executive (Mohamad-Nor, Shafie and Wan-Hussin, 2010). The increase in number of independent boards from outside directors, the greater the monitoring on the management (Helland and Sykuta, 2005). The presence of independent outside directors is value added to the monitoring process by the boards (Klein, 2002). The boards that comprise of both independent and non independent directors enhance the financial reporting integrity (Peasnell, Pope and Young, 2001). Chen and Zhou (2007) report that the firm that has large number of independent member with appoint Big Four as their auditor except Anderson after the failure in Enron. The study of the sample of Australian firm stated that the firm that has more non executive directors and audit committee will reduce the earnings manipulation (Stewart, and Kent, 2005). Abbott, Parker and Peters (2004) document evidence on their study that the existence of the independent board of directors in audit committee will reduce the likelihood of manipulation of earnings in the firm. The independent audit committee has negative association with the fraudulent financial reporting hence the high proportion of audit committee will lead to the low financial reporting fraud (Beasley, 1996). Uzun, Szewczyk, and Varma (2004) in their study indicate that the proportion of the independent audit committee on the board has the negative relationship with the corporate fraud thus the decrease of corporate fraud because of the increase in independent audit committee. The financial distress company can be reduced through the competent and effective audit committee in order to ensure the company performance in great condition. The more independence audit committee will inversely affect the going concern status of the firm in financial distress condition (Carcello and Neal, 2000).
The committee member appointed must not have relationship in personal or financial with the company or its top management is considering as an independent committee (Persons, 2009). Audit committee independent is one of the characteristics of audit committee. Felo and Solieri (2009) indicate that lack of independent audit committee will enhance the company management to aggressively manipulate the financial reporting. The audit committees that comprise of all independent committee will reduce the earnings manipulation by the firm (Saleh et. al., 2007). The independent audit committee is more ethical in conducting their responsibilities and has positive relationship with ethic disclosure in financial statement (Persons, 2009). The existence of independent member on audit committee will reduce the likelihood of problem that occurs in internal controls (Krishnan, 2005). The more independent audit committee presence in the company will reduce the manipulation of company assets and also will reduce the likelihood of fraud (Mustafa and Yousef, 2010). In addition to that, large audit committees independent are more effective in constraining earnings manipulation (Liu and Sun, 2010). Independent audit committee that monitor the firm will lead to the negative relationship with the misappropriation of assets (Carcello, Neal, Palmrose and Scholz, 2011). Audit committee effectiveness is where there is an independent audit committee to ensure the quality of financial reporting and will lead to the firm issue their informative and credibility information of management forecast to the users (Liu and Zhuang, 2011). Persons (2005) in his study find that the fraud of a firm will be reduce if the committee consists of independent committee and has little directorship. However, the presence of independent audit committee that free from CEO influences will enhance the reporting quality or vice versa (Woidtkea and Yeh, 2013). The independent audit committee that holds many directorship will lead to the ineffectiveness in their roles and ineffective in monitoring financial fraud due to the task to be taken in many company (Sharma and Iselin, 2012). A study in Hong Kong show that if the firm having little resources, the role of independence audit committee is insignificant especially in the family firm (Chan, Lau and Ng, 2011). The presence of independent audit committee in a firm is significantly lead to the firm misstated their financial position (Abdullah, Mohamad Yusof and Mohamad Nor, 2010). Moreover, the firm that consist all independent audit committee will not prevent fraudulent financial reporting in the company (Owens-Jackson, Robinson and Shelton, 2009). Lin, Li and Yang (2006) find no relationship between audit committee independent and the manipulation of earnings.
On the contrary, the audit committee that comprise of all independent audit committee to found has no relationship with the fraud (Klien, 2001). The study shows no relationship between audit committee independent and the management of firm earnings towards structure of the firm corporate governance (Petra, 2007). It is consistent with the finding by Chang and Sun (2010) on pre the Sarbanes-Oxley Act period that the independent of audit committee has no association with manipulation of information earnings. Abbott, Park and Parker (2000) indicate that the audit committee of a firm that comprise of independent directors and held a meeting at least twice a year are likely to allow the fraudulent reporting occur. There is little evidence stated that the earnings manipulation is reduce when the firm has an effective audit committee (Peasnell et al., 2001). In addition, Peasnell et al. (2005) find that the existence of audit committee in the firm has no different on the manipulation of earnings by it management. Agrawal and Chadha (2005) in their study find no evidence between corporate governance elements and restatements. There are still mixed result on the effectiveness of audit committee and financial statement fraud.
2.3.2 Audit Committee Financial Expertise
Audit committee that has financial expertise also one of the characteristics needed in performing their duties. In order to perform their duties effectively, high degree of accounting knowledge committee is needed to understand the issues in auditing, risk management, audit procedures, and help to resolve the disagreement between external auditor and management (Mohamad-Nor, et al., 2010). As defined by Agrawal and Chadha (2005), a person that has background of accounting and financial literate and has working experience in corporate finance is consider as having financial expertise. In a meanwhile, Chang and Sun (2010) defined financial experts as an individual that has education and experience on accounting and it is required by the committee in order to them to have better understanding on the financial statement, number in it and can communicate effectively with the firm management as well as external auditors. The financial expertise audit committee can improve the reporting and disclosure quality of financial statement (Felo and Solieri, 2009). The financial expertise in the committee can oversight their role in preventing financial fraud (Huang and Thiruvardi, 2010). The financial expertise audit committee is has more professional approach in order to get used to the changes in environment and innovation of the firm (Hambrick and Mason, 1984). Chen and Zhou (2007) report that the firm that has more proportion of financial expertise in audit committee with chooses Big Four as their auditor, however they dismiss Anderson auditors after the failure in Enron. Audit committee that has financial and accounting knowledge will enhance company to have better performance and in a meanwhile can help company to prevent fraud and financial distress situation (Rahmat et. al, 2009). Material misstatement will be easily been detected if the audit committee consists members that have financial knowledge and the misstatement can be corrected (DeZoort and Salterio, 2001). The audit committee that has financial knowledge and competent are able to reduce manipulation of earnings by emphasize on the monitoring system (Choi, Jeon and Park, 2004). Additionally, if the company has high proportion of financial literate in audit committee, the likelihood of fraudulent misstatement is low (Mustafa and Youssef, 2010). Audit committees with financial expertise in the firm are able to reduce the firm that facing financial problem (McMullen and Raghunanthan, 1996). Financial expertise that equipped by the business and other knowledge will enhance the company to perform better as well as the committee that has fewer commitment in other company and also independence will lead to the quality of financial reporting (Dhaliwal, Naiker and Naviss, 2010). Moreover, the occurrence of reporting misstatement is negatively associated with the committee that consists of financial expertise (Abbott et al., 2004). Bedard, Chtourou, and Courteau (2004) stated that the more audit committee with financial or accounting expertise in the committee, the lower the earnings manipulation occurs in the firm. It is easier for the committee to overview the earnings manipulation when they has experienced and technical skills in financial (Xie, Davidson an DaDalt, 2003). The financial expertise on audit committee will enhance the credibility in earnings thus it will improve the information on earnings and also tone down the manipulation of earnings (Chang and Sun, 2010). The audit committee consists at least one financial expertise will tend to reduce the conservative manipulation of earnings (Kang, Kilgore and Wright, 2011). According to Farber (2005), firm that has a few accounting expert in the committee will lead to the firm that involve in fraud. The firm that has financial and legal expertise in the committee will instill the confident of investors and also will provide more effective monitoring on the earnings in the firm (Woidtkea and Yeh, 2013). Market will be positively impact when the firm appointed financial expertise audit committee (Davidson, Xie and Xu, 2004).
On the other hand, there are no relationship between the ethical reporting disclosure and audit committee with accounting expertise (Persons, 2009). Besides that, Lin et al. (2006) also finds that there is insignificant relationship between fraudulent reporting and financial expertise in the committee. The presence of financial expertise in the audit committee of a firm in post SOX period will not reduce the manipulation of earnings activities (Ghosh, Marra and Moon, 2010).
2.3.3 Audit Committee Meeting
The effectiveness of audit committees can be assess through the frequency of meeting held and also another main characteristics that need to be emphasize on it. The diligence of audit committee should be determined by the preparation for the meeting, attention and attendance of the meeting, follow-up for the matters arise in the meeting and also the number of meeting held in a firm (Carcello et al., 2002). The most frequent of the meeting held by the audit committee, the committee become more effective (Song and Windram, 2000). Abbott et al, (2004) posit that the meeting by audit committee at least four times meet in a year will enhance low restatement of financial reporting. The discretionary accruals in a company will be reduced when the audit committee conducts meeting frequently (Xie et al., 2003). In addition, Yin et al. (2012) find audit committee in large firm will meet more often than audit committee in small firm. The lack of meeting and a few minutes of meeting will give some difficulties for audit committee to review the follow up matters (Chan et al., 2011). Meeting held by the audit committee at least four times a year is positively related to the accuracy of earnings forecast (Liu and Zhuang, 2011). Farbers (2005) indicate that, the firm that involve in fraud is having weak governance and low audit committee meeting. There is an inverse relationship between fraudulent financial statement and the number of meeting (Owens-Jackson, 2009). In order to provide effective supervision on financial information disclose, the committee need to have more frequent meeting (Rahmat et al., 2009). The effectiveness of audit committee has positive relationship with the frequency of meeting held (Collier and Gregory, 1999). The audit committee meetings is effective when they have well organized meeting and chairman function and also the meeting need to be held three or four times a year. In addition, management will be informed by the committee regarding the matter discuss in the meeting especially on the internal controls and accounting matters (McMullen and Raghunandan, 1996). The more number of meetings will reduce the aggressiveness of the increasing manipulation of earnings (Kang, Kilgore and Wright, 2011). Furthermore, Abbott et al. (2004) indicate in their study that from year 1991 to 1998 stated that the meeting of audit committee that held at least four times a year will reduce the restatement of earnings. Regular meeting need to carry out in order to monitor and oversight the process of financial reporting and internal controls (Vafeas, 1999).
On the contrary, the frequent meeting by audit committee will enhance the earnings manipulation in the firm (Saleh et al., 2007). The current study by Chandresegaram, Rahimmansa, Rahman, Abdullah and Nik Mat (2013) find that the numbers of meeting has no association with the degree of manipulation of earnings. The more number of meetings held by audit committee will increase the manipulation of earnings (Ghosh et al., 2010). Moreover, the more frequent meeting held by the audit committee will not enhance the firm to prevent fraud (Huang and Thiruvardi, 2010). There is no significant relationship between financial distress firm and the frequency of meeting by an audit committee (Rahmat et al., 2009). Raghunandan and Rama (2007) reveals that the size and expertise of audit committee will influence the frequency of meeting where more frequent of audit committee meeting being held if the company that consists of more outside block holder, large size of audit committee and more accounting expertise.
2.3.4 Audit Committee Gender Diversity
Audit committees role in a firm is very important especially in relation to the corporate fraud. The gender diversity is an audit committee also an important characteristics especially the role is play by female on the board. Recent trend show that the presence of female in the committee is increasingly important in corporate world. This is due to the ethical practice by them, they are not easy being influence but they may influence the boards especially on the male committee and also increase the moral values in the governance. The presence of women in the boards will enhance the business run healthily and also consider as a complement to the male directors. Female is more ethical in performing their duties especially those who do not have experience than those in employment (Bilic and Sustic, 2011). Additionally, the firms that have both genders in the committee can perform more effective role than the firm that has single gender (Halpern, 2000). The more female board presence in the corporate governance will reduce the likelihood of corporate failure (Tharenou, 2002). In order to reduce the corporate fraud, the firm needs to increase the existence of female in the committee (Burgess and Tharenou, 2002). The presence of more female on the board will enhance the effectiveness of the company activities and will benefit to the shareholder, stakeholders as well as the companies itself (Grosvold, Brammer and Rayton, 2007). Stewart and Munro (2007) posits in their study that audit committee that consist of female committee show signs of better communication skills and well prepared for conducting a meeting. The presence at least one female audit committee in a firm will give different impact on the roles play by them as compare to male committee (Huang and Thiruvadi, 2010). Srinidhi, Gul and Tsui (2011), indicate that female on the board may develop effectiveness of the board in respect with the decision making and behavior. Further, female directors will have different idea, view and opinion in discussion (Fondas and Sassalos, 2000). Ac compared to male counterpart, female has different social life and experience will lead to different perspective and opinion. The evidence show that, firm will reduce the financial statement fraud when there is a female counterpart hence the better quality of earnings (Srinidhi et al., 2011). In addition, abnormal return of the firm will reduce when the female audit committee is appointed than male committee (Huang, Yan, Fornaro and Elshaht, 2011). Similarly, Krishman and Parsons (2008) stated that the higher the quality of earning, the higher number of female in the boards. Female director practice is more conservative in relation to the strategies and techniques of accounting being adopted (Peni and Vahamma, 2010). The gender diversity show that man in the management process is considered more overconfident than women thus the tendency to commit fraud is higher than women but the evidence is very limited in relation between fraud and gender (Schrand and Zechman, 2011). Moreover, the existence of female board on the audit committee will positively influence the number of meeting held and also enhance the reporting quality of financial statement. In addition to that, the presence of female directors contributes to the effectiveness of corporate governance (Thiruvadi and Huang, 2011). Meanwhile, Thiruvadi (2012) also find that the audit committee is more diligence and enhance the good corporate governance practice when there is an existence of female audit committee at least one female board. Besides that, it also contributes to the great corporate decision making and quality of financial reporting. The existence of female on the audit committee or directors encourage the quality of the earnings reported and has negative association of manipulation of earnings because female committee practice is more ethical, more moral values available and motivated in performing their duties (Gavious et al., 2012). The existence of female in management is likelihood to report any fraudulent financial reporting in the firm (Kaplan, Pany, Samuels and Zhang, 2009) and according to Miethe and Rothschild (1994), female are more responsible to report the wrongdoings or illegal act especially on the matters that relate to financial statement than male. The review of literature finds that firm will performs better when there is at least one female director on the board and also improve the board performance.
2.3.5 Audit Committee Ethnic Diversity
The ownership structure in Malaysian is more concentrated where most of the listed firm is owned by family members. Thus the cultural effects also consider important especially in Malaysian there are many races that act as important players in the industries. Cultural values are important factors especially in order to understand the belief and behaviour of an individual. Corporate financial, operation and strategies is influence by culture (Schuler and Rogovsky, 1998). In Malaysian, there are many different cultures and the development of accounting is influence by this culture (Iskandar and Pourjalali, 2000). The increase in ownership structure and the involvement of Bumiputera in the firm will lead to the individualistic behavior in Malays. Additionally, the races of the directors give no impact to the manipulation of earnings (Rahman and Ali, 2006). The practice of corporate governance is better in the Bumiputera owned firm as compared to Chinese owned firm (Yatim, Kent and Clarkson, 2006). Furthermore, Haniffa and Cooke (2002) in their study show that individualistic behavoiur is more on the Chinese counterpart as compared to Malays. In Malaysian, Malays are considered as having low individualism that they are comfortable to works with others that has same beliefs, behavior and races. Malays also have high uncertainty avoidance as compared to Chinese (Salleh, Stewart and Whisenant, 2006). This study is consistent with the study by Hamzah, Saufi and Wafa (2002) stated that as compare to Malays, Chinese has low in uncertainty avoidance and high individualistic. There is difference in monitoring system where the ethnic dominance of board composition and listed company (Yatim et al., 2006). However, more accounting conservatism in mixed races of audit committee that consists of Chinese and Bumiputera committee (Mohamed Yunos, Ismail and Smith, 2012). In Malaysian, the business owned by Malays is likelihood to employs Malays auditors for their company (Ahmad, Houghton, Yusof, 2006). The firm that controlled by Bumiputera in positively related to the audit fees paid as compared to non Bumiputera firm. This may be due to the low level of conflict exist in non Bumiputera firm (Ahmad and Houghton, 2001). According to Lim (1998), both Malays and Chinese counterparts have high collectivism but in different ways where Malays channel their responsibility toward community while Chinese distribute their help through association. Both Chinese and Malays entrepreneurs in Peninsular Malaysia are share the same culture values such as individualism, power distance and masculinity except the values of uncertainty avoidance is low at Chinese (Juri, 1999). The fraud attitude in relation to business is cause by the cultural tradition (Watson, 2003). Moreover, the culture of an organization can affect the company into financial fraud situation (Gerish, 2003). The culture values will enhance the voluntary disclosure in accounting and improve the financial reporting disclosure by the Bumiputera directors (Haniffa and Cooke, 2002).
2.3.6 Firm Size, Leverage, Performance and Growth (Controls Variables)
Firm size, leverage, performance and growth are included as control variables in the study. Felo and Solieri (2010) posit that large firm is more likely involved in manipulation of earnings because of the resources available. Mohamad Yunos et al., (2012) noted that the firms tend to employs conservatism in earnings when the leverage of the firm is high in order to reduce the problem between management and debt holders. The firm that with high leverage tend to manipulate earnings (LaFond and Roychowdhury, 2008) Bell, Szykowny, and Willingham (1991) indicate that firm with poor financial performance that is firm with loss situation may increase the likelihood to be involved in financial fraud. In addition, the performance of the firm is in unhealthy condition is more risky (Asthana and Balsam, 2010). Further, the firm with high prospect of growth is more likely to manipulate earnings (Matsumoto, 2002)
2.4 Chapter Summary
In summary, the literature review has shown the important of audit committee attribute in relation to the corporate fraud. Effectiveness of audit committee attribute in this study consists of audit committee independent, expertise, meeting, gender diversity and ethnic diversity. Additionally, this study also includes some control variables that are firm size, leverage, performance and growth.
