volume 8, issue 2, continued 1 2012[1]

Corporate Board: Role, Duties & Composition / Volume 8, Issue 2, Continued 1, 2012

89

CORPORATE BOARD:

ROLE, DUTIES & COMPOSITION

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90

EDITORIAL

Dear readers! This issue of the journal is devoted to several issues of corporate board practices. Zied Bouaziz and Mohamed Triki to test the validity of their hypothesis, which states the existence of a certain deterministic between the board's characteristics and financial performance measured by three different ratios, namely ROA, ROE and Tobin's Q, have developed three linear regression models. Authors’ empirical validation was conducted on a sample of 26 companies listed on the Tunisian stock exchange Tunis (Tunis Stock Exchange) over a period that spans four years (2007-2010). The estimated models shows satisfactory results pointing out the importance of the impact of board characteristics on financial performance of Tunisian companies. Jayalakshmy Ramachandran and Ramaiyer Subramaniam study financial reporting by companies that usually is strengthened with auditors’ report. An auditor’s report is a statement which communicates his views on the financial statements prepared by the company. When the auditors are satisfied with all the evidences they have verified, they state that the financial statements give a ‘true and fair view’. ‘True and fair view’ is in existence since a very long time as compared to various other terms. Since its introduction, ‘true and fair view’ had faced a number of criticisms. Past researchers had tried to explore this concept. None of them managed to give any additional information than was traditionally available in the books. This study concludes by stating that it is time to reconsider the concept of ‘true and fair view’. Zuaini Ishak and Abood Mohammad Al-Ebel examine the intellectual capital (IC) disclosures of 137 Gulf Co-operation Council (GCC) listed banks using a content analysis approach. Instead of examining the effect of board characteristics in isolation from each other, this study extends previous research on the determinants of IC disclosure by considering board effectiveness score in relation to IC disclosure. Moreover, this study extends previous studies in board-IC disclosure relationship by investigating the hypothesised impact of information asymmetry in moderating this relationship. Authors’ findings show that IC disclosure is positively associated with the effectiveness of board of directors. In addition, this study provides evidence that the level of information asymmetry in GCC bank moderates the relationship between board effectiveness and IC disclosure. Findings of this study therefore provide strong support of the hegemony theory. These findings are important for policy makers as they confirm that the effectiveness of board of directors in protecting the investors depends on the level of information asymmetry. Bethuel Sibongiseni Ngcamu aims to determine employees’ expectations for the proposed PMS and their perceptions of the system’s impact on effectiveness within the university concerned. The study adopted a quantitative research design and a survey method was used, whereby, a structured questionnaire was administered by the researcher to a selected population size of 150 of which 108 completed questionnaires, generating a response rate of 72%. The study reflects a disproportionately high percentage of 34% of the respondents who disagreed and 21.3% who were undecided as to whether PMS is needed at the university concerned where the majority of these respondents being academics and those with matriculation. Ummi Junaidda Binti Hashim and Rashidah Binti Abdul Rahman investigate the link between corporate governance mechanisms and audit report lag for companies listed on Bursa Malaysia from 2007 to 2009. The 288 companies listed on Bursa Malaysia have been randomly selected. The corporate governance mechanisms examined include the board of directors and audit committee.


91

CORPORATE BOARD: ROLE, DUTIES AND COMPOSITION Volume 8, Issue 2, Continued 1, 2012, CONTENT

Editorial 90

THE IMPACT OF THE BOARD OF DIRECTORS ON THE FINANCIAL PERFORMANCE OF TUNISIAN COMPANIES 92 Zied Bouaziz, Mohamed Triki A QUALITATIVE STUDY ON THE AUDITORS’ ‘TRUE AND FAIR VIEW’ REPORTING 108 Jayalakshmy Ramachandran, Ramaiyer Subramaniam BOARD OF DIRECTORS, INFORMATION ASYMMETRY, AND INTELLECTUAL CAPITAL DISCLOSURE AMONG BANKS IN GULF CO-OPERATION COUNCIL 125 Zuaini Ishak, Abood Mohammad Al-Ebel PERCEPTIONS OF ORGANISATIONAL READINESS FOR THE PERFORMANCE MANAGEMENT SYSTEM: A CASE STUDY OF A UNIVERSITY OF TECHNOLOGY 138 Bethuel Sibongiseni Ngcamu INTERNAL CORPORATE GOVERNANCE MECHANISMS AND AUDIT REPORT LAG: A STUDY OF MALAYSIAN LISTED COMPANIES 147 Ummi Junaidda Binti Hashim, Rashidah Binti Abdul Rahman


92

THE IMPACT OF THE BOARD OF DIRECTORS ON THE FINANCIAL PERFORMANCE OF TUNISIAN COMPANIES

Zied Bouaziz*, Mohamed Triki**

Abstract

The Board of Directors plays a key role as a internal mechanism of corporate governance. Indeed, its effectiveness is dependent on the presence of several factors, the most important are related to characteristics that relate primarily to the independence of its members, board size, the cumulative functions of decision and control, the degree of independence of the audit committee and the gender diversity of the board. To test the validity of our hypothesis, which states the existence of a certain deterministic between the board's characteristics and financial performance measured by three different ratios, namely ROA, ROE and Tobin's Q, we have developed three linear regression models. Our empirical validation was conducted on a sample of 26 companies listed on the Tunisian stock exchange Tunis (Tunis Stock Exchange) over a period that spans four years (2007-2010). The estimated models show satisfactory results showing the importance of the impact of board characteristics on financial performance of Tunisian companies. Keywords: Board Of Directors, Financial Performance, Board Size, The Accumulation Of Functions, Diversity Of The Board * Faculty of Economics and Management of Sfax, Accounting Department, Tunisia E-mail: [email protected] ** Faculty of Economics and Management of Sfax, Accounting Department, Tunisia E-mail: [email protected]

Introduction

In recent years, various authors have predicted that the protection of minority shareholders' interests in a

context of asymmetric information is a prerequisite for the proper functioning of the financial market

(Labelle & al 2000).

Indeed, there are different control mechanisms that are capable of protecting the public interest against

abuse and managerial discretion in firms that are characterized by either a concentrate capital or diluted

capital.

In the same furrow, Fama & Jensen (1983) and Charreaux (1993) provide that the board of directors plays

an important role to limit conflicts of interest between different stakeholders.

The board of directors, as internal mechanism of governance, has a major function on the limitation of

managerial discretion and thereafter to manage the agency relationship between shareholders and

managers and stakeholders of company.

An analysis of the main studies on the subject of the board allowed us to identify several indices

associated with the effectiveness of control by this mechanism. This is mainly the presence of

independent directors on the board, the existence of various board committees, the multiple roles of CEO

and chairman and size of the Board in accordance with the study of Zeghal et al (2006).

In order to clarify and deepen the board's role in the governance system, the sections of this study will be

devoted to the study of the main features of the board and their impact on financial performance of

Tunisian companies. Indeed, the first section deals with the main previous studies that relate to the impact

of board characteristics on financial performance. The presentation of the sample and definition of




93

variables is the subject of the second section. Finally the analysis results will be displayed in the third

section.

1. Previous studies and research hypotheses

Many mechanisms exist to protect the interests of shareholders, it is commonly accepted that the Board of

Directors plays a major role in promoting the interests of investors (Labelle & al 2000). Indeed, the Board

of Directors plays an important role in the proxy resources, determining strategic choices and especially

in the resolution of conflicts of interest between managers and stakeholders.

Also a scan of the main studies on the topic of the board allowed us to identify the characteristics of the

board has an impact on financial performance.

1.1 Independence of board members and financial performance

This is the most important feature of the board to reflect the quality of governance of a company. This

notion has always held the interest of several researches. Indeed, previous studies have focused on the

distinction between outside directors and inside directors

Literature has emphasized the effectiveness of board independence as a mechanism reducing the

manager's discretion and opportunism. They corroborate the hypothesis that the independent members

tend to mitigate agency conflicts between leaders and managers (Alexander &al 2000).

To this extent, much research has shown that a high proportion of independent directors on the board

improve the quality of financial disclosure and subsequent financial performance of companies (Chen& al

2000).

The Empirical research on the relationship between board composition and financial performance of the

firm are far from unanimous. Several previous studies have shown that the presence of outside directors

has a positive effect on performance like the studies of Byrd & al (1992) and Lee & al (1992) that assume

the presence of outside directors protect shareholders' interests when there is an agency conflict.

Black & al (2006) and Lefort & Urzua (2008) corroborate this idea further and predict that increasing the

number of independent directors on the board promotes a positive financial performance of the firm.

In the same furrow, Kor & al (2008) approve that outside directors' have good skills and they can

positively influence the financial performance of the company.

Other authors such as Hermalin & al (1991), Bhagat & Black (2000) and Klein (2002) result in an

insignificant relationship between the fraction of outside directors' on the board and the financial

performance.

Finally, Coles & al (2005) argue that inside directors can also improve the value of the company because

they have access to relevant information and have specific knowledge of the company.

Similarly, Sarkar & Sarkar (2009) and Kaymak & al (2008) support this conclusion and provide that

inside directors leads to higher returns on assets (ROA) and not the outside independent directors.

In the context of our study and in accordance with the provision of the Code of Commercial Companies

of Tunisia, a shareholder is not required for membership of the board of a public company in addition to

the code itself has foreseen the possibility of appointing an employee as a director.We anticipate a

positive effect of the independence of directors on financial performance. Hence our first hypothesis:

1.2 Size of the board of directors and financial performance

The literature is largely interested in the study of the influence of size of the board of directors on the

financial performance of the company.


94

H1: The presence of a significant percentage of independent directors on the board of directors positively

influences the financial performance of Tunisian companies.

A scan of the economic and financial literature we concluded that the link between the size of the board

of directors and financial performance leads to contradictory conclusions. Therefore, unanimity has not

been proven about this relationship.

Indeed, several researchers suggest that the number of directors may influence the functioning of the

board and therefore the financial performance of the company. Some authors seem to favor a large

council. Indeed, in an uncertain environment, the larger the board, the greater knowledge of the various

administrators can improve performance and to exercise effective control (Kiel & al 2003, Coles & al

2005 and Linck, & al 2006).

Similarly Godard & Schatt (2004), provide more the number of directors is important more the company

achieves high performance.

In this line, Pearce & Zahra (1989) and Provan (1980) provide for the existence of a positive relationship

between board size and firm's financial performance.

In the same groove and in their Meta analysis Dalton & al (1999), confirm this positive relationship and

find it is more intense for businesses to large sizes.

In the same direction, Pearce & Zahra (1989) and Adams & Mehran (2003) find that firms with a large

board of directors ensure a better performance.

However, another strand of literature shows that, the large boards of directors are less effective and have a

negative impact on company performance. Indeed, when the board is large, this may present a barrier to

the management control of the company because of poor coordination, flexibility and communication.

Wu (2000), Bhagat &Black (2002), Odegaard & al (2004), Mak & al (2005) and Andres & al (2005) state

that small boards create more value than large boards.

This divergence of results shows that there are no consensuses on the impact of the size of the board on

its monitoring capacity. Some argue for a larger size. Other research shows that the reduced number of

directors strengthens the control of the board and subsequently improves the financial performance of

companies.

In the context of our study the Code of Commercial Companies of Tunisia provides that public companies

are managed by a board composed of three to twelve members at most. Hence our second hypothesis:

H2: The size of the board negatively affects the financial performance of Tunisian companies.

1.3 The dual functions of management and control and financial performance

Another feature is supposed to influence the effectiveness of control exercised by the directors on the

board of directors, it is the cumulative functions of decision and control.

According to Brickley & al (1997), the duality is the allocation of the same person as CEO and Chairman

of the Board for the same period.

As well Rachdi & al (2009) study the relationship between duality and performance has produced a

combination of theories of agency and stewardship.

The first defends the idea that advocates the separation of functions while the second emphasizes the

superiority of the dual functions of decision and control to heighten business performance.

The agency theory states that combine the functions of CEO and Chairman of the Board is considered an

obstacle to the effectiveness of the control exercised by the Board and therefore recommends the

separation of two functions. Indeed, the proponents of agency theory, including Jensen & Meckling

(1976) and Jensen (1993) noted that the separation of management and control decisions reduces agency

costs and improves the performance.


95

Similarly Carapeto & al (2005) recommend the separation between the management function and that of

the general chairman. They show that the function of chairman is to chair the meetings and monitor the

hiring process, referral, assessment and executive compensation. It is therefore clear that the Chief can

not be efficient since it will favor its own interests. Therefore, for the board to be effective it is necessary

to separate the two positions.

In the same furrow, Sarkar & al (2009) consider duality as an obstacle to the board's role since it allows

weakening the control making by the directors and therefore a control system able to encourage the

opportunism of the manager.

Contrary to the agency theory which suggests that duality diminished the independence of the Board, the

proponents of the theory of stewardship like Cannella &al (1993) and Sridharan & al (1997) provide that

plurality of functions increases the financial performance of the firm that the CEO has all the information

for disclosure to members of the board.

The Defenders of duality require the presence of a single responsible with a mission to chart the strategies

and policies of the company because the separation of functions creates a divergence within the council

and promotes conflicts of interest.

In this vein, Tuggle & al (2008) reach this conclusion and argue that the sharing of power between the

CEO and Chairman of the Board is a factor that may determine the ability of the manager in carrying out

its functions.

Weir & al (2002) argued that a combined role can project a clear sense of direction and can have a

positive effect on financial performance. Indeed, these studies have referred to the theory of organization

who said that the company can achieve better financial performance when the leader has complete

authority and that its role is played clearly and without opposition.

In France, Godard& Schatt (2004) found that firms that opted to combine the positions are more

profitable in the long term, confirming the essential role played by the leadership to create value. Hence

our third hypothesis:

H3: The combination of leadership and chairmanship of the board negatively affect the financial

performance of Tunisian companies.

1.4 The size of the audit committee and financial performance

Pincus & al (1989) show that firms with larger audit committees are expected to devote more resources to

monitor the process of accounting and financial reporting.

In the same furrow, Anderson & al (2004) found that large audit committees have a better protection and

better control the process of accounting and finance committees with respect to small by introducing

greater transparency with respect shareholders and creditors which has a positive effect on corporate

financial performance. Hence our fourth hypothesis:

H4: The presence of a significant number of directors on the audit committee positively affects the

financial performance of Tunisian companies

1.5 The independence of audit committee members and financial performance

The audit committee's role is to oversee the audit process and also to resolve any disagreement that may

arise between auditors and management. Indeed, Abbott and al (2000) suggest that firms whose audit

committees consist of independent members were less sanctioned by the SEC.

The composition of the audit committee to the subject of several recommendations which state that the

audit committee should consist of a majority of outside independent directors to ensure their

independence ( Beasley &Salterio 2001).


96

In the same furrow, Klein (1998) shows that the effectiveness of the board depends on its own structure

and the structure of its committees. Indeed, he argues that the allocation of independent outside directors

to the audit committee is likely to improve business performance. Hence our fifth hypothesis:

H5: The presence of a significant percentage of independent members of the audit committee positively

affects the financial performance of Tunisian companies.

1.6 The Board diversity and financial performance

The presence of women in the board was the subject of several theoretical and empirical reflections

especially in developed countries such as the study of Singh (2008) which deals with British companies

as well as that of Adams and Ferreira (2007, 2009) in the American context and also the study of Rose

(2007) for the case of Danish companies.

The question now is whether the presence of women in the board has an impact on the latter. The answer

to this question is mixed between the defendants and opponents of gender diversity on boards. According

to proponents of this diversity, they present some arguments that women bring new ideas, have an ability

to communicate very important to men as they deal with strategic issues at council meetings has a

positive effect on the business (Carter &al 2003, Adams & Ferreira 2003 and Ehrhadto & al 2002).

In the same furrow, Omri& al (2011), provide that the joint councils improve the company image through

the disclosure of their openness, tolerance and fairness. This result was corroborated by the study of Kang

& al (2009) which provide that the announcement of the addition of a woman on the board to an effect on

improving yields recorded.

Contrary to previous results, Shrader & al (1997) analyze 200 American companies with market

capitalization of the highest between 1992 and 1993. They find no significant positive relationship

between the percentage of women on the board and financial performance.

Similarly, Kochan & al (2003) find no positive relationship between diversity men / women in positions

of power and financial performance of the company. Indeed, the study of Zahra &al (1988) on the

presence of minorities on the board of directors (women and racial minorities) and financial performance,

has led to a non significant association between two variables. Hence our sixth hypothesis:

H6: The presence of women on the board of directors negatively affects the financial performance of

Tunisian companies.

1.7 The frequency of meetings and financial performance

The frequency of board meetings may be viewed as a key element in board effectiveness. Indeed, there

are explanations both for and against a positive relationship between the frequency of meetings and

corporate financial performance. A scan of the economic and financial literature we concluded that the

link between the frequency of meetings of the board of directors and financial performance leads to

contradictory conclusions.

Indeed, some authors like Godard& al (2004) predicted that the increase in the number of board meetings

in a positive impact on the financial performance of French companies.

In the same furrow, Davidson and al (1998) found a positive relationship between corporate financial

performance and number of meetings of the Board. However, more research like the study of Vafeas

(1999) which states that increasing the number of board meetings is not synonymous with the existence of

a strong financial performance. Hence our seventh hypothesis:

H7: the frequency of meetings of the board positively affects the financial performance of Tunisian

companies.


97

2. Presentation of the sample and definition and measurement of variables

Prior to the analysis of study results, we present at the next paragraph the methodological choices made in

order to test the hypotheses of the research. First, we present the characteristics of our sample.

Subsequently, we define the measures of variables used in this study.

2.1 Presentation of the sample

The sample for this study consists of 26 companies listed on the Tunisian stock exchange (TSE) over a

period of four years (2007-2010).

Financial data are collected of the financial statements from official bulletins available in the Financial

Market Council (CMF) on its website www.cmf.org.tn and scholarship. The Market data are collected

through the Exchange and on the site www.bvmt.com.tn and also with a few brokers.

The Data on the board of directors are collected from the prospectuses of companies available in the CMF

and guide from stocks provided by the TSE.

Are excluded from the sample, the banks, the insurance companies and the financial institutions due to

their specific accounting rules and a few companies newly listed on TSE. Indeed, we have not considered

all the companies listed in our study period (2007-2010). The choice of listed companies is based on the

fact that more information is available on these companies.

2.2 Definition and measurement of variables

At this point, we tried to list the different variables that can be divided into dependent variables

(performance measurement), independent variables that relate principally on the properties of the board of

directors and control variables.

Table 1. Definition and measurement of variables

Variables authors Measurement of variables

dep

end

ent

va

riab

les

Return On Assets

(ROA)

Barro (1990) and Angbazo

&Narayanan (1997)

Net income / total assets

Return On Equity

(ROE)

Holderness &Sheehan (1988) and

Ang&Lauterbach (2002).

Net income / equity

Q de Tobin Beiner & al (2006) and Bhagat & al

(2008)

((Book value of assets + market value

of equity)- book value of equity) / book

value of assets

ind

epen

den

t v

ari

ab

les

independence of board

members (IND_CA)

Pearce & Zahra (1989), Bhagat

&Black (1999) and Godard & Schatt

(2004)

the number of independent directors

divided by the total number of directors

on the Board

Board size (TAI_CA)

Adams & Mehran (2003), Klein,

(2002), Vafeas (2003) and Godard &

Schatt (2004)

the number of directors on the Board

overlapping functions

(CUM_FON)

Kang &al(2009), Brickley & al (1997)

and Godard & Schatt (2004).

Takes the value 1 when the positions of

CEO and chairman of the board are

occupied by one person. 0 otherwise.

Size of the audit

committee (TAI_AUD)

Klein (2002) and Godard and Schatt

(2004)

the number of directors who serve

Independence of audit

committee (IND_AUD)

Anderson and al (2003), Godard and

Schatt (2004) and Brown & Caylor

(2004)

the proportion of independent directors

who sit on the audit committee

Frequency of meetings

(FREQ_REU)

Vafeas & al (1998), Godard & Schatt

(2004) and Andrés & al (2005)

the number of board meetings per year

Gender diversity of the

Board (DIV_CA)

Singh (2008) and Kang & al (2009) The percentage of women in consulting

Co

ntr

ol

va

riab

les size of the firm

(TAI_FIRM)

Pearce &Zahra (1989) and Godard

(2002)

the natural logarithm of book value of

total assets

level of debt

(DEBT_FIRM)

Mc Daniel (1989) and Turner &

Sennetti (2001)

Debt / total assets


98

3. Analyzes the results

To capture the effect of board characteristics on financial performance of Tunisian companies measured

by ROA, ROE and Tobin's Q, we test the regression models (1), (2) and (3) incorporating the control

variables (firm size and debt ratio) to control their effect on the dependent variables.

ROAi,t = β0 +β1 IND_CA i,t + β2 TAI_CA i,t+

β3 CUM_FONi,t + β4 TAI_AUDi,t + β5 IND_AUDi,t+ β6 FREQ_REUi,t +β7 DIV_CAi,t +

β8 TAI_FIRMi,t + β9 DEBT_FIRMi,t + εi,t

(1)

ROE i,t = β0+ β1 IND_CA i,t + β2 TAI_CA i,t+

β3 CUM_FONi,t + β4 TAI_AUDi,t + β5 IND_AUDi,t+ β6 FREQ_REUi,t + β7 DIV_CAi,t +

β8 TAI_FIRMi,t + β9 DEBT_FIRMi,t + εi,t

(2)

Q Tobini,t+1 = β0+β1 IND_CA i,t + β2 TAI_CA i,t

+ β3 CUM_FONi,t + β4 TAI_AUDi,t + β5 IND_AUDi,t+ β6 FREQ_REUi,t +β7 DIV_CAi,t + β8

TAI_FIRMi,t + β9 DEBT_FIRMi,t + εi,t

(3)

3.1 Descriptive Analysis

The results presented in Part A of Table 1 (Appendix) indicate that Tunisian firms listed on the TSE other

than financial institutions have a low return on assets and sometimes even a negative return (-0.164). This

yield is between (16%) and (19%) with an average that does not exceed 5% (4.98%).

Moreover, these descriptive statistics show that the average Tobin's Q is (1.80) and this ratio to a

maximum value of 4.27. However, some firms have a Tobin's Q is less than unity (0.97) this means

theoretically they have trouble raising money to invest and increase the dividends they pay to

shareholders.

The results presented in Table 1 indicate that the independence of members of the board is more or less

respected by Tunisian firms listed on the TSE. Indeed, it is an average of 49% (0.489) with minimum

(0%) mainly for family businesses whose board members have a family connection between them and

indeed this is the characteristic of the majority of Tunisian companies and a maximum not exceeding 82%

(81.8%).

We find that firms that are the subject of our study are mainly companies that make use of cumulation of

the president of the board and director general (60.6%) and justified the fact that the majority of

companies selected are family. This result is confirmed by the study of Godard and Schatt (2004) who

found that family businesses are opting for French listed the plurality of functions which make them more

profitable in the long term, confirming the essential role played by the leadership create value.

The companies in our study have audit committees with an average size of 3 directors and the size of this

committee varies between 2 and 4 administrators but with the percentage of independence that does not

exceed 75%. Similarly the average of independent audit committee members does not exceed 20%

(19.47%) with minimum (0) and this is justified because of the existence of family firms in our sample.

3.2 Verification of the applicability of the linear regression and multivariate analyzes

Because all dependent variables are continuous, we use the model of multiple linear regressions to

estimate our three equations.

3.2.1 Checking the conditions of application of the linear regression

The application of linear regression is subject to certain conditions. Indeed, this method requires that no

problems of autocorrelation and heteroscedasticity of errors and the lack of multicollinearity among

independent variables.


99

3.2.1.1 Verification of the absence of autocorrelation problems

To affirm that the OLS estimators converge asymptotically to the true values we need to verify the

absence of self correlation of errors.

The results show that the Durbin-Watson statistics are all close to two. This allows us to affirm the

absence of self - correlation of errors. Hence the OLS estimators converge asymptotically to the true

values of the parameters with minimum variance.

3.2.1.2 Verification of the absence of multi colinearity

The linear regression requires the absence of a problem of multi collinearity between the independent

variables introduced in the same model.

Indeed, Kennedy (1985) provides an r = 0.8 to decide on a serious problem of collinearity between the

independent variables included in a regression model.

We present the coefficients of Pearson correlations between the independent variables in our study (see

Appendix).

This matrix shows the correlation between the different independent variables is moderate. This implies

the absence of the problem of multi collinearity among variables.

3.2.1.3 Verification of absence of heteroscedasticity

To test the existence of a potential problem of heteroscedasticity of errors, we used White's test in 1978.

Indeed, White (1978) regresses the squared residuals of OLS on all independent variables of the model on

the square of each explanatory variable and the variables obtained from the cross-initial theoretical model.

However, when the number of explanatory variables is important, the number of regressions of the

equation of White will be significantly larger than the number of observations, which causes the lack of

robustness of the test.

Thus, White has shown that under the assumption of homoscedasticity, the quantity W = N.R2

asymptotically chi-square has an N-k degrees of freedom.

The results of this test show that there is no problem of heteroscedasticity in all regression models used in

our study (see Appendix Table 3).

3.2.2 Multivariate analyzes and hypothesis testing

Analysis of our results will be divided into three parts. In the first part, we examine the effect of board

characteristics on financial performance of Tunisian companies measured by the ROA by analyzing the

estimation results of the first regression model (equation 1). The second part will analyze the results

regarding the effect of board characteristics on financial performance measured by ROE (Equation 2).

Finally, we discuss in Part III, the results regarding the effect of board characteristics on financial

performance measured by Tobin's Q (equation 3).However prior to the determination of the various

regressions equations it is necessary to ascertain whether or not individual effects in our models and it is

crucial to choose between a fixed effects model or the effects model random by applying the Hausman

specification test.

3.2.2.1 Analysis of the effect of board characteristics on financial performance measured by ROA

Table 2. Type of effect

Tets Values of the Fisher

statistic

Sig Conclusion Type of

effect

model 1

(ROA)

3.5928 0.0000 Reject the null hypothesis of equality of

the constants

specific

effect


100

We find that the probability of acceptance of the null hypothesis of the Fisher test is 0.0000 <threshold of

5%. We reject the null hypothesis H0 and we confirm the existence of an individual effect.

Following the rejection of H0 we turn to the determination of the random effect (BETWIN) for the

judgment of our model.

Table 3. Hausman test

S.D. Rho Cross-section random 0.021787 0.2851

Idiosyncratic random 0.034496 0.7149

At this stage the use of the Hausman specification test (1978) is crucial to identify the nature of the

specification (fixed or random).

Test Summary Chi-Sq. Statistic Chi-Sq. d.f. Prob.

Cross-section random 29.117425 9 0.0006

According to the Hausman test (1978), we find that the probability is (0.0006) less than the critical value

at 5%. This implies that the model is studied in individual fixed effects. From an econometric perspective,

this result means that the individual effects are added to the constant model and not the random term.

Table 4. Results of linear regression on Equation 1

Dependent variable ROA

VARIABLES expected sign Coefficient t-statistic Prob

constant -0.062934 -0.563680 0.5748

IND_CA + 0.112294*** 3.495056 0.0008

TAI_CA - 0.000389 0.120650 0.9043

CUM_FON - -0.017956 -1.091590 0.2788

TAI_AUD + -0.023063 -1.090314 0.2794

IND_AUD + 0.105687*** 3.023016 0.0035

FREQ_REU + 0.123768*** 4.981887 0.0000

DIV_CA - -0.447243*** -2.708355 0.0085

TAI_FIRM - 0.001196 0.126088 0.9000

DEBT_FIRM - -0.098508*** -4.373467 0.0000

R2= 0.846022 R

2 adjusted = 0.770149 F=11.15049 p= 0.000 N= 104

*** Significant at 1% ** significant at 5% * significant at 10%

Inspection of the table reveals a positive and statistically significant at 1% between the financial

performance measured by ROA and the independence of members of the Board IND_CA ( = 0.1122, P

= 0.008). This result supports the hypothesis H1, which states that the presence of a significant percentage

of independent directors on the board of directors positively influences the financial performance of

companies. Indeed, this result corroborates the studies of Black & al (2006) and Lefort & Urzua (2008)

which provide that the increased number of independent directors on the board promotes a positive

performance of the firm. This result also confirms the studies of Lau & al. (2009), Schiehll & al (2009)

and Sarkar & Sarkar (2009) who also agree that independent directors promote better value creation

within the company that managers provide good governance independent from those internal.

Moreover, the results in Table support the hypothesis H5 which states that the presence of a high

percentage of independent members of the audit committee positively affects financial performance.

Indeed, from Table, the coefficient on the variable independence of audit committee members IND_AUD

is positive ( = 0.1056) and statistically significant at 1% (P = 0.0035) which supports the study Klein

(1998) shows that the allocation of the outside (independent) audit committee is likely to improve the

financial performance of the company. Similarly Beasley & Salterio (2001) state that the audit committee

should consist of a majority of independent directors to improve the quality of information and hence the

performance of the company.


101

We also find that the coefficient associated with the frequency of meetings of the board FREQ_REU is

positive and statistically significant at 1% and in accordance with the hypothesis H7 which provides that

the frequency meeting of the board positively affects financial performance. This result is confirmed by

several studies the most important are that of Godard & Schatt (2004) who stressed that a significant

increase in the number of meeting of the Board allows a detailed control of managers and increasing

shareholder wealth that has a positive effect on corporate financial performance.

Furthermore the results indicate that the coefficient on the variable range board DIV_CA is negative and

statistically significant at 1%. We find that the negative sign of the coefficient on the variable DIV_CA is

consistent with expected sign. Indeed this result corroborates the study of Farrell &al (2005) which

provide a negative impact of gender diversity on boards and performance because it reduces the number

of women in these councils, which may bias the scope of their presence.

Finally, we also find that the sign of the estimated coefficient obtained on the control variable (firm size)

is not consistent with the expected sign (= 0.0011, P = 0.9). Indeed the table shows that the size of the

firm in a positive and not significant ( This result is not confirmed in studies of Black & al (2006) and

Arcot & Bruno (2005) which state that small firms are more successful than businesses to large sizes. On

the other hand the results for this regression shows that the debt (debt ratio) to a negative coefficient and

statistically significant at 1 %( = -0.0985, P = 0.000). Indeed, this result is consistent with the work of

Myers (1977) which states that indebtedness leads to high agency costs because of the divergent interests

of shareholders and creditors.

3.2.2.2 Analysis of the effect of board characteristics on financial performance measured by ROE:

We find that the probability of acceptance of the null hypothesis of the Fisher test is 0.0000 less than the

5% level. We reject the null hypothesis H0 and we confirm the existence of an individual effect.




Effects Specification

S.D. Rho

Cross-section random 0.080274 0.3132






According to the Hausman test, we find that the probability is (0.0179) less than the critical value of chi-

Two at the 5%. This implies that the model is studied in individual fixed effects.

The results in Table 6 indicate that except for the signs of coefficients for variables IND_CA TAI_AUD

and signs of the coefficients obtained are consistent with the expected signs.

First note that, contrary to hypothesis H1, the independence of members of the board does not seem to

have a significant effect on financial performance measured by ROE. Indeed, the coefficient on the

variable IND_CA is negative and not significant ( = -0.0425, P = 0.7017). This result is not consistent

with the results of studies of Black & al (2006) and Lefort & Urzua (2008) which showed that the

presence of a significant percentage of independent directors on the board of directors influences positive

financial performance.


statistic


effect

model 2

(ROE)

3.3265 0.0000 Reject the null hypothesis of equality of the

constants

specific

effect


102

Tavle 6. Results of linear regression on Equation 2

Dependent variable ROE


constant 0.78897** 2.050561 0.0441

IND_CA + -0.042590 -0.384654 0.7017

TAI_CA - -0.001008 -0.090703 0.9280

CUM_FON - -0.085096 -1.501170 0.1379

TAI_AUD + -0.304492*** -4.177139 0.0001

IND_AUD + 0.349636*** 2.901997 0.0050

FREQ_REU + 0.280347*** 3.274481 0.0017

DIV_CA - -0.735567 -1.292542 0.2005

TAI_FIRM - -0.009244 -0.282764 0.7782

DEBT_FIRM - -0.055882 -0.719927 0.4740

R2= 0.749528 R2 adjusted = 0.626107 F=6.072948 p= 0.000 N= 104

*** Significant at 1% ** significant at 5% * significant at %

Moreover, the results show that the coefficient on the variable IND_AUD is positive and statistically

significant at 1% ( = 0.3496, P = 0.005). Implying that the independence of audit committee members to

positively impact financial performance. This result supports the hypothesis H5, which states that the

presence of a significant percentage of independent members of the audit committee positively affects

financial performance. This result corroborates the results of several studies including that of Klein

(1998) shows that the allocation of the outside (independent) audit committee is likely to improve the

financial performance of the company.

We also find that the coefficient on the variable frequency FREQ_REU meeting is positive ( = 0.2803)

and statistically significant at 1% (P = 0.0017). This result confirms the hypothesis H7 which provides

that the frequency of meeting of the board positively affects financial performance. This result is justified

by the study of Davidson & al (1998) who found a positive relationship between corporate financial

performance and number of meetings of the Board. Indeed, in their frequency of meeting of the board is

positively related to the quality of control exercised by him on the head of the firm and the information

disclosed to all stakeholders.

However, the results for the variables TAI_AUD indicate a negative coefficient and significant at 1% ( =

-0.3044, P = 0.0001). This result is not consistent with the study by Anderson & al (2004) who found that

large audit committees promote greater transparency for shareholders and creditors has a positive effect

on performance corporate financial.

Similarly, the results indicate that the coefficient associated with the variable size of the board TAI_CA is

negative ( = -0.001) and insignificant (P = 0.9280) according to the prediction of the hypothesis H2 that

includes the board size negatively affects corporate financial performance.

Regarding the control variables, the sign found on the firm size variable is consistent with the expected

sign. Indeed, we found that the coefficient on firm size is negative but not statistically significant (β=-

0.0092, P= 0.778).

Similarly, the table shows that the coefficient on debt (debt ratio) is negative but not statistically

significant ( = -0.0558, P = 0470). Indeed, the negative sign of the coefficient on the variable

DEBT_FIRM is consistent with the expected sign because any debt or the use of debt hinders

performance but in a more or less significant.

However, previous studies such as that of Myers (1977) who found that the coefficient associated with the

variable DEBT_FIRM is negative and statistically significant.

Indeed, the work of Myers (1977) state that the indebtedness leads to high agency costs because of the

divergent interests of shareholders and creditors.


103

3.2.2.3 Analysis of the effect of board characteristics on financial performance measured by Tobin's Q



statistic


effect

Model 3

(Tobin's Q)

1.9393 0.0163 Reject the null hypothesis of equality of

the constants

specific

effect

We find that the probability of acceptance of the null hypothesis of the Fisher test is 0.0163 <less than the

5% level. We reject the null hypothesis H0 and we confirm the existence of an individual effect.



Table 8. Hausman test

Effects Specification S.D. Rho

Cross-section random 0.074723 0.0236






According to the Hausman test, we find that the probability is 0.0005 <less than the 5% level. This

implies that the model is studied in individual fixed effects.

Table 9. Results of linear regression on Equation 3

Dependent variable Tobin's Q


constant -2.375336 -1.528555 0.1309

IND_CA + 2.319313*** 5.186386 0.0000

TAI_CA - -0.041420 -0.923172 0.3591

CUM_FON - 0.488123** 2.132053 0.0366

TAI_AUD + 0.474271 1.610933 0.1118

IND_AUD + -0.622720 -1.279741 0.2049

FREQ_REU + 1.895802*** 5.482612 0.0000

DIV_CA - -0.812927 -0.353689 0.7247

TAI_FIRM -. -0.016666 -0.126227 0.8999

DEBT_FIRM - -1.135921*** -3.623341 0.0006

R2= 0.780103 R2 adjusted = 0.671748 F=7.199509 p= 0.000 N= 104

*** Significant at 1% ** significant at 5% * significant at 10 %

First note that, contrary to hypothesis H3 combine the functions of management and chair of the board

seems to have a positive effect on financial performance measured by Tobin's Q. Indeed, we find that the

coefficient associated with the accumulation of functions CUM_FON is positive and statistically

significant at 5% ( = 0.0488, P = 0.036). This result is consistent with studies of Cannella & al (1993)

and Sridharan & al (1997) which provide that the combination of tasks increases the performance of the

firm that the CEO has all the information for disclose the later members of the board.

Moreover, the results in Table show that the coefficient on the variable independence of members of the

Board IND_CA is positive and statistically significant at 1% according to the prediction of hypothesis H1,

which states that the presence of a significant percentage of independent directors on the board of

directors influences positively the financial performance. This result is not consistent with studies of

Burton (2000) and Bhagat & al (2002) who find that firms with independent boards are not necessarily

perform better than others. Also this result does not corroborate the studies of Core & al (2002) indicates


104

that even a high percentage of independents on the board can have a negative impact on firm

performance.

Similarly the variable frequency of meeting FREQ_REU is associated with financial performance

measured by Tobin's Q and that this association is positive (= 1,895, P = 0.0000) and statistically

significant at 1% Confirming the hypothesis H7, which states that the frequency of meeting positively

affects the financial performance of companies. This result is consistent with the study of Godard &

Schatt (2004) who stressed that a significant increase in the number of meeting of the Board allows a

detailed control of managers and increasing shareholder wealth which has a positive effect on financial

performance of companies.

Regarding the control variables, the sign found on the firm size variable is consistent with the expected

sign. We find that firm size has a negative impact on Tobin's Q. this result joins the study of Beiner & al

(2006) who showed that large size firms are likely to have significant agency problem because of the

difficulty of controlling them and the problem of free cash flow.

Similarly the table shows that the coefficient on debt (debt ratio) is negative and statistically significant at

1% (= -1.1359, P = 0.0006). Indeed, the negative sign of the coefficient on the variable DEBT_FIRM is

consistent with the expected sign.

Indeed this result corroborates the study by Myers (1977) which provides that the debt enjoyed by the

ratio "total debts on total assets" is also significant and negative.

Conclusion

The study of the impact of board characteristics on financial performance of companies was based on an

investigation of 26 Tunisian companies with publicly traded securities of Tunis (Tunis Stock Exchange).

Order to study this impact we used essentially the bivariate analysis by studying the association between

endogenous variables and the explanatory variables and multivariate analysis using multiple linear

regression.

Similarly, the use of descriptive statistics in our study presents a more or less important. Indeed, the

results of descriptive statistics are summarized in a set of mean, median, and frequency. The interest of

these results is to have some information on certain characteristics and practices of Tunisian companies

regarding corporate governance and in particular the main features of the board.

Indeed, the results of all tests show the bivariate and multivariate significant effect of certain

characteristics of the board on financial performance is measured by ROA, ROE and Tobin's Q.

On the one hand regarding the impact of board characteristics on financial performance measured by

ROA, we find that only board independence, the independence of the audit committee, the kind of

diversity Board meeting frequency and have a significant effect on financial performance.

On the other hand, results from these multivariate analyzes have shown that the independence of the audit

committee and the frequency of meeting a significant and positive impact on financial performance

measured by ROE.

Finally, we note the existence of a significant effect on the one hand between the independence of the

board, combining the functions of management and board leadership and the frequency of meetings and

other financial performance measured by Tobin's Q.

We offer some recommendations to Tunisian companies listed on the stock exchange on the development

board, such as limiting the relationship between directors to provide additional insurance against the risk

of collision leaders.

so we propose to limit the percentage of capital held by shareholders to obtain capital companies and not

diffuse type of family businesses.


105

In conclusion, the results of this empirical study showed that the characteristics of the board which relate

to the independence of board members, board size, independence of audit committee members, frequency

of meetings Council have a greater or lesser impact on financial performance measured by the different

ratio of performance used in this study namely ROE, ROE and Tobin's Q.

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A QUALITATIVE STUDY ON THE AUDITORS’ ‘TRUE AND FAIR VIEW’ REPORTING

Jayalakshmy Ramachandran*, Ramaiyer Subramaniam**

Abstract

Financial reporting by companies is strengthened with auditors’ report. An auditor’s report is a statement which communicates his views on the financial statements prepared by the company. When the auditors are satisfied with all the evidences they have verified, they state that the financial statements give a ‘true and fair view’. ‘True and fair view’ is in existence since a very long time as compared to various other terms. Since its introduction, ‘true and fair view’ had faced a number of criticisms. Past researchers had tried to explore this concept. None of them managed to give any additional information than was traditionally available in the books. This study concludes by stating that it is time to reconsider the concept of ‘true and fair view’. Keywords: Auditor, Audit, Opinion, True, Fair, View, Report, Stakeholders, Organization, Override * Asst. Professor, Nottingham University Business School, Jalan brogan, 43,500 Seminyih, Malaysia E-mail : [email protected] ** Lecturer, Faculty of Business and Law, Multimedia University, Bukit Beruang, 75450 Melaka, Malaysia E-mail : [email protected]

1 Introduction

The word ‘audit’ is derived from the Latin word meaning ‘to hear’. It is about upholding the integrity of

financial reporting and business conduct and is about seeking truth (Percy, 1997). ‘True and fair view’ is

used by auditors to convince the user group or the stakeholders that the financial statements are free from

error and are factual. Stakeholder is a party who affects, or can be affected by, the company's actions. The

stakeholder concept was first used in a 1963 internal memorandum at the Stanford Research institute

(Wikepedia). It defined stakeholders as "those groups without whose support the organization would

cease to exist. The examples of stakeholders include owners/investors of companies, Government bodies,

senior management staff, Non managerial staff, creditors, bankers, customers, trade union, and local

community. The most important stakeholders can be seen as those with most to lose from the

organisation's actions, but this does not always reflect their relative power (Worthington, 2004).

The Approved Standards on Auditing (AI), on auditors’ report on financial statements talks about how an

auditor is supposed to express his opinion on financial statements. As per AI 700, the basic reports can be

of two types, a qualified or an unqualified report. An unqualified report is given when an auditor is

satisfied that the financial statements are drawn up without any material misstatements and that they

adhere to the respective accounting and auditing standards. This is when the auditors states that the

financial statements give a ‘true and fair’ view of its income and statement of affairs.

‘True and Fair view’ is in existence since a very long time as compared to various other terms that were

used prior to ‘True and Fair view’. However researchers, lawmakers and the stakeholders have found it

difficult to construe the real meaning of the term and what it intends to communicate to the stakeholders.

This paper is thus an endeavor to determine if ‘true and fair view’ requires an overhaul. The study uses

past literatures to deliberate the idea.

1.1 Research Problem

Researchers have explored and tried to identify the function of ‘true and fair view’ in auditing. While it is

known from various legal regulations and accounting standards, that ‘true and fair view’ is a concept used




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to give an opinion on the financial statements, many still find it a very confusing and a vague term

(Cowan, 1965; Walton 1993). Some believe that it is a legal term (Elliot and Elliot, 1997; Hulle, 1993),

while some believe that the interpretation of ‘true and fair’ could differ with differing interests of the

stakeholders in the company (Gill, 1983). It is clear that the law has not provided clear guidance on

interpretation of ‘true and fair view’ which has led to lack of clarity for the auditors themselves who

solely use the terms (Higson, 1991; Porter 1992; Rutherford, 1985) and at the same time it gives a wrong

interpretation by different stakeholders as to the role of auditors and directors (Parker and Nobes, 1991).

‘True and fair’ is used in number of countries where the language of communication is not English and it

was observed that these countries are fraught with difficulty while trying to literally translate the words

‘true and fair’ into their local language. The authors thus claim that ‘true and fair view’ cannot be used in

a meaningful manner and can only be viewed as adjectives (Burlaud, 1993; Nobes, 1993; Walton, 1993;

Hulle, 1993 Ordelheide, 1993; Stacy 1997; Haider, 2001). This research is, thus, an attempt to address the

concerns which stakeholders could face when auditors provide ‘true and fair’ financial statements

knowing that financial statements are bundled with major drawbacks.

1.2 Objectives of the research

1. To identify whether the Company Law and the Codes of Ethics have an influence on ‘true and fair

view’ opinion given by the auditors.

2. To identify whether stakeholders are able to interpret the concept of ‘true and fair view’.

3. To identify whether stakeholders are satisfied with the concept of ‘‘true and fair’ view communication

by the auditors.

4. To conclude if ‘true and fair view’ can be retained in its original form as countries embrace

International Financial Reporting Standards as a common platform for reporting.

1.3 Scope of the study

The practice of certifying the financial statements as ‘true and fair’ by auditors of public listed companies

and other large organizations was common and rampant. However, after the financial scandals where

large multi-national organizations were exposed globally, several steps were taken to address the issues

involved with the concepts of ‘true’ and ‘fair’ as well as its impact on the expectations of the parties

involved with the organizations. This study focuses on the issues with the current practice of certification

that was developed through legislation and guidelines. The study also extends to the issues faced in the

current financial world as a whole, to the accountants in particular, due to poor accounting and reporting

practices. The choices that are open to an auditor, in the current environment is the main focus of this

study. To be able reconsider the ‘true and fair’ reporting by auditors could be one such alternative.

1.4 Significance of the study

“True and fair view’ today has become a term of art” (Edey, 1971), in the sense that it seems to be

dominant in terms of reporting by auditors on company financial statements (Walton, 1993). A layman

interprets the concept of ‘true and fair’ as accurate financial reporting, while financial reporting should

never be taken as completely accurate due to the number of assumptions that has to be made during

compilation of financial statements (Higson and Blake, 1993). Legal standards also allow departures from

particular standards, if such departure means to give a ‘true and fair’ view. However, the extent of such

departures should be disclosed along with the reason for the departure. Where the companies feel that

compliance with certain standards could give misleading information and at the same time departures are

forbidden, maximum efforts should be taken to reduce the extent of perceived misleading aspects. This

can be achieved by adequate disclosure in the financial statements. It has to be clearly understood that,

while auditors verify the financial statements, they do not intend to guarantee on the accuracy of the said

financial statement. They only intend to give an opinion on the financial statements prepared by the

client. The auditors specifically state in their audit certificate that an audit includes examining on test

check basis, evidence supporting the amounts and disclosures in the financial statements (2003 Annual

report and financial statements of the Malaysian Institute of Accountants). While this might be the correct

approach as far as the auditor is concerned, it has, in fact, given rise to an expectation gap. The

expectation gap has been growing over a period of time due to the ambiguity in the phrase ‘true and fair

view’. It could be perceived that when financial reporting framework develops, the significance of ‘true

and fair’ might change. Other issues pertaining to the lack of auditor independence, lack of regulatory


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guidance and call for the regulators to act on the current explosion of the public on loss of funds, are some

of the incentives to further the scope of study in this area.

2 Literature review

The growing democracy of most countries, globalisation, freedom of practice for the professionals, lack

of control by owners of their own money and the amount of ‘hot’ money floating in the economy are

some of the reasons which had probably prompted the issuance of audit certificates as a convincing tool

to third parties on the performance of companies. However, issuance of such certificates did not deter

companies or their top management from committing fraud or deceit. Suseela Devi et. al. (2004) argued

that the Royal Mail case, in 1931, was the first to have illustrated how it was possible to produce audited

accounts, which met legal requirements and yet omitted mentioning sufficient data so as to completely

mislead investors and shareholders. ‘True and fair view’ was not the first legal standard (Rutherford

1985). In the eighteenth century in United Kingdom, there existed an Act ‘for the relief of the creditors

and proprietors’ which required the senior officers to make a ‘true state or representation of the affairs

and condition’ of the company and ‘to state, make up and balance the accounts’ of the company. In case

of default, they had to give up their right to transfer shares or receive profits with respect to their interests.

This was done in order to ensure that the creditors and proprietors had a ‘full satisfaction of the state and

condition, debts and effects of the company’ (Chambers and Wolnizer, 1991). Similar to this Act, they

had various other acts drawn up which required similar disclosures to be made all of which included the

words, ‘true’, ‘exact’, ‘distinct’, ‘just’, ‘correct’, ‘properly drawn up’, ‘full and fair’, ‘full and true’, and

‘true and correct’ to represent their conduct (Rutherford, 1985). The change of ‘true and fair’ from ‘true

and correct’ was advocated by the United Kingdom’s largest professional accountancy body, the Institute

of Chartered Accountants of England and Wales (Amat, Blake and Oliveras, 1996). They also stated that

the word ‘correct’ had always been too strong because it implied that there was one view which was

‘correct’ as against all others which were incorrect.

Between the years 1790 to 1842, various private Acts establishing canal, railway and gas companies were

introduced. Some of these Acts stressed on the quality of accounts that needed to be maintained

(Chambers and Wolnizer, 1991). It was here that the concepts of ‘true and exact’ and ‘full and true’ were

introduced. Prior to the adoption of the phrases ‘true and fair’, various other phrases were used in the

British legislation. ‘Full and fair view’ was used until 1844 (Chambers and Wolnizer, 1991; David Flint,

1982). ‘True and correct view’ was used from 1900 (Rutherford, 1985). Thus, until about the 1920s, the

auditors were primarily concerned with detecting fraud and error, and ensuring that the solvency position

of the companies (or other reporting entities) was properly portrayed in the balance sheet. In accordance

with this, auditors carefully checked the detailed entries in, and arithmetical accuracy of, the company’s

books and made sure that the amounts shown in the balance sheet corresponded to the account balances in

the ledger. This was possible as the transactions were straight-forward on the back of a simple business

environment. However, as the businesses and its complexities grew, it became imperative to maintain

more records than was considered necessary in the past. Subsequently, this led to the reality that it was

not practically possible for the auditor to verify every transaction and check for the correctness, truth or

the accuracy.

The phrase ‘true and fair’ was thus recommended to the Cohen Committee by Companies Act in England

and Wales (Rutherford, 1985), in the year 1944. It was finally adopted in the United Kingdom in the year

1947 (Brenda Porter 1992; Gill 1983) and subsequently many companies, including those in Malaysia,

followed suit. Today ‘true and fair view’ is the fundamental principle for financial reporting not only in

the United Kingdom but also in Europe and in most Asian countries. For the last sixty years the published

financial statements of companies incorporated in United Kingdom have been required by law to show a

‘true and fair view’ of the state of affairs of the company and its results. The ‘true and fair view’ doctrine

thus provides the ‘ultimate foundation for financial reporting and has probably become the single most

important criterion in reporting performance of companies (Flint, 1982; Leach, 1981; Gill, 1983; Cowan,

1965). With the introduction of the Fourth Council Directive of the European Economic Community,

‘true and fair view’ was introduced as an accounting concept within the whole European Union (Ekholm

and Troberg, 1998).

Further developments took place when the ‘override’ principle of ‘true and fair’ view was introduced by

the European Economic Community as a means of ‘accounting harmonisation’. The European

Community started off with initially six countries - France, Germany, Italy, Belgium, Netherlands and


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Luxembourg, as their members (Christopher Nobes, 1993). It was established in 1965 and first headed by

Dr. Elmendroff. The Elmendroff Committee submitted their first draft to the European Economic

commission in 1968, which was subsequently published in 1971. At this stage the accounts were required

to have clarity and were supposed to be ‘not misleading’. When United Kingdom, Ireland and Denmark

joined the Community in 1973, negotiations between the countries led them to submit a second draft in

1974 with the requirement of ‘true and fair’ incorporated within (Alexander, 1993;, Amat, Blake and

Oliveras, 1996). Subsequently there was a third draft submitted in 1978, which gave ‘true and fair view’

an overriding importance.

Article 2 of EEC states that where a particular provision is incompatible with ‘true and fair view’,

“that provision must be departed from in order to give a ‘true and fair’ view within the meaning of

paragraph 3. Any such departures must be disclosed in the notes.”

The major drawback identified was that the extent of maximum departure had not been stated in the Act.

Apart from this it was found difficult to adapt ‘true and fair view’ due to language barriers. Translating

‘true and fair view’ overriding principles to different languages and yet maintaining its legal validity was

one of the other criticisms that cropped up in accounting harmonization. Since its (‘true and fair view’)

acceptance by the other Member States and its inclusion in a Community legal instrument, the

interpretation of this principle could no longer come exclusively from United Kingdom law and principles

(Hulle, 1993). Ordelheide (1993) concurs with this contention and further states that though ‘true and fair’

view is what the British accountants declare it to be, in case of European conflict, it is the European ‘‘true

and fair’’ that will take effect for legal decisions.

However it was argued by Alexander (1993) that it was not possible to have a European ‘true and fair

view’ that was different form the British ‘true and fair’. Another argument given by Burlaud (1993) stated

that the versions of ‘true and fair’ could keep changing depending upon the language one wishes to

choose. Varied interpretations of the concept of ‘true and fair view’, when translated into different

languages, were seen. It was interpreted as ‘real’ in Greece, ‘Faithful’ in France, Netherland and Belgium,

‘true and correct’ in Italy, ‘true and appropriate’ in Portugal and ‘true and fair’ in United Kingdom

(Nobes, 1993). When translated into the Czech accounting system, it actually meant that the financial

statements would provide a true and dependable picture of the matters (Sucher et. al., 1996). This

indicates that the concept of ‘true and fair view’ is now deviating from its original values. The argument

still remains as to whether ‘true and fair view’ is a professional concept or a legal concept. By and large it

was also seen that people equate ‘true and fair view’ to the United States’ term ‘present fairly in

conformity with generally accepted accounting principles’. In the United States the governing criterion is

conformity with Generally Accepted Accounting Principles (GAAP). ‘Present fairly’ is defined by

reference to conformity with GAAP, and there is no authoritative literature in the United States in which

‘present fairly’ is explained or defined (Zeff, 1993). Conformity with GAAP thus implies fair

presentation, claims the author. ‘Present fairly’ in accordance with GAAP, became a part of the standard

United States’ audit report since 1939, (McEnroe and Martens, 1998). The meaning of ‘Present Fairly In

Conformity with Generally Accepted Accounting Principles’, addresses the use of GAAP and fair

presentation. It states that an auditor should not express an unqualified audit opinion if the financial

statements contain a material departure from GAAP unless, due to unusual circumstances, adherence to

GAAP would make them misleading (McEnroe, 2005). Now, with the introduction of the Sarbanes-Oxley

Act of 2002, ‘fair presentation’ meant that the financial statements complied with the regulations

provided by that Act as well (Cunningham, 2003).

The United States accounting and United Kingdom accounting methodologies adopted similar versions of

the ultimate goal of financial reporting (Cunningham, 2003). While in United States financial reports

need to show a fair presentation in accordance with GAAP, in United Kingdom the financial statements

need to present a ‘true and fair view’ of the business conditions and the results, claims the author.

Ironically, in both these cases the law has not defined the term. Thus the achievement of fairness or ‘true

and fair’ view still depends upon professional judgment and application of general rules in specific

situations. Though many have understood the two concepts to be the same, there has been a significant

amount of discussion over usage of ‘present fairly’ as compared to ‘true and fair view’. At the first glance

the two notions might look similar, but conceptually, ‘true and fair view’ goes beyond conformity with

GAAP, since it provides the reporting entity an option to depart from the promulgated accounting

standards in special circumstances (Livne, 2004). The Financial Reporting Council (FRC) of United

Kingdom in its paper published in August 2005 made it clear that the concept of ‘true and fair’ shall


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remain a cornerstone of financial reporting and auditing in United Kingdom despite the adoption of

international financial reporting standards. The Association of British Insurers (ABI) response to FRC

published in November 2005 stated that while FRC considered ‘present fairly’ and ‘true and fair’ to be

similar, the consideration of similarity was not sufficient. The major concern was that the two phrases

were not identical. The reason given by FRC for not changing the concept to ‘fairly present’ was that, the

change could bring about changes in the format and content of the company accounts as well as audit

report. The major criticism faced by ‘true and fair’ as against ‘present fairly’ was that with respect to

present fairly there was one authoritative document, namely Statement of Auditing Standards (SAS) 69 to

use in constructing a rough definition of ‘present fairly in accordance with GAAP’ while with respect to

‘true and fair view’ no such documents existed and there was no common definition as to what ‘true and

fair view’ meant (McEnroe and Martens, 1998).

A great deal was written about the meaning of ‘true and fair’, much of which was intellectually

stimulating for those wishing to research the topic, but few practicing auditors studied this material in any

depth, if at all (Stacy, 1997). In English the ‘true and fair’ view of the.... assets, liabilities, financial

position and profit or loss could be interpreted literally as ‘an exact and trustworthy picture of the assets,

liabilities, financial situation and profit or loss’ (Burlaud, 1993). The word, ‘true’ could mean authentic,

actual, genuine, real and undistorted. All of these could be understood in the manner in which it was

quoted, without ambiguity. This view was also supported by Cowan (1965). He further claimed that

‘truth’ which does not come within the category of fundamental or scientific truth can be judged only in

the light of some clearly defined purpose. However, when we look at the word ‘fair’, it could mean

impartial, average and promising. The Chambers English dictionary has given the meaning of ‘true’ to be

‘faithful’, ‘constant’, ‘trusty’ and ‘genuine’. The word ‘fair’ has variety of meaning (Cowan, 1965), the

relevant one includes ‘clear’, ‘clean’, ‘pure’, ‘reasonable’ and ‘favorable’. All these are very subjective

and there is no conclusive meaning. The word ‘fair’ could have different meanings to different

individuals even within the same context. It all depended upon the expectation of the end users, i.e. who

expects and what they expect. The form of wording ‘true and fair’ has led to separate discussions as to

what is meant by ‘truth and fairness’, which could have been avoided if ‘true and fair’ had been treated as

hendiadys i.e. an expression of a complex idea by two words coupled with ‘and’ (Amat, Blake and

Oliveras, 1996).

In case of companies, the end users are the investors and their expectation is always to have a guarantee

on the financial statements. Thus the inclusion of the word fair in the phrase ‘true and fair’ makes the

audit certificate a subjective opinion, not conveying what it needs to truly convey. It is well understood by

the professional group, that this phrase does not have a clear definition in any statute and hence is subject

to various interpretations. So what constitutes a ‘true and fair view’ mainly depends upon whether the

financial statements are drawn in accordance with the Standard Accounting Practices (SAP) of United

Kingdom. The auditor’s report should clearly set forth the auditor’s opinion as to whether or not they give

a ‘true and fair view’. Financial Statements that were certified ‘true and fair’ indicated that the

performance and changes in the financial position of an enterprise, on which the users of financial

statements rely, were projected without distortion or exaggeration. Thus the ‘true and fair’ figure should

possess the characteristics of ‘reliability’, ‘relevance’, ‘understandability’ and ‘comparability (Lembre et

al. 1998). The general standard of performance required of auditors in the United Kingdom was laid down

by Lord Justice in the case of In re Kingston Cotton Mill Co. (No. 2) (1896) when he said:

“It is the duty of the auditors to bring to bear on the work he has to perform that skill, care and caution

which a reasonably competent, careful and cautious auditor would use. What is reasonable skill, care

and caution must depend on the particular circumstance of each case”

The phrase ‘true and fair’ therefore does not commit anything about the financial position of the

company. It would just mean that there had been no irregularities or material misstatements in the

financial statements. The ‘true and fair’ attestation is generally understood to require compliance with

applicable accounting standards (Kershaw, 2006). Over the years, various parties who have suffered loss

after relying on audited financial statements have taken auditors to court on claims of negligence, that is,

on grounds that the auditors did not perform their duties properly and, as a result, failed to detect errors in

the financial statements. The collapse of Enron in 2001 and the subsequent discovery that its auditor,

Arthur Andersen, had shredded audit documents after notification of a Securities and Exchange

Commission (SEC) investigation of Enron sent shock waves through the financial markets (Tackett et al.

2004).


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3 Discussion

3.1 Meaning and interpretation for the concept of ‘true and fair view’

The phrase ‘true and fair’ originated in United Kingdom and has been in the Companies’ Law since 1947.

However, the UK companies’ Act has not provided a proper definition to the phrase ‘true and fair’. It is

understood that the phrase ‘true and fair’ lacks a proper definition and the interpretation that is drawn

from the phrase is enormous and at times ambiguous. A definition to ‘true and fair’ view was offered by

Lee (1981), who quoted:

“Today, “true and fair view” has become a term of art. It is generally understood to mean a

presentation of accounts, drawn up according to accepted accounting principles, using accurate figures

as far as possible, and reasonable estimates otherwise; and arranging them so as to show, within the

limits of current accounting practice, as objective a picture as possible, free from willful bias, distortion,

manipulation, or concealment of material facts. In other words the spirit as well as the letter of the law

must be observed.”

Higson and Blake, (1993) examined the Oxford dictionary to identify various meanings to the words

‘true’ as well as ‘fair’ and concluded that three distinct meanings appear, each of which may put a

different emphasis on the '‘true and fair” concept:

1. “clear, distinct, plainly to be seen”;

2. “free from bias, fraud or injustice”; and

3. “tolerable; passable; average”.

Lee, (1982) offered the meaning for true and fair view by stating that:

“True means that the accounting information contained in the financial statements has been quantified

and communicated in such a way as to correspond to the economic events, activities and transactions it is

intended to describe, while Fair means that the accounting information has been measured and disclosed

in a manner which is objective and without prejudice to any particular sectional interests in the

company”.

Edey (1971) explained that ‘true and fair view’ had a technical concept and said that it was a term of art.

He wrote:

“To the man in the street…….the words ’true and fair’ are likely to signify that the accountants give a

true statement of facts. He will be likely to associate ‘facts’ with ‘actual profit’ and ‘actual values’. He

does not realise that ‘profit’ and ‘value’ are abstractions. Before they can be conceived at all in any

precise way they must be defined in such a manner that the definition contains in itself, or implies clearly,

a method of calculation that could be followed in practice.”

Prescod, (1996) identified four separate, distinct and not totally complementary meanings for the phrase a

‘true and fair view’ that could be rendered. ‘True and fair’ can be considered

1. as a relaxation of previous accounting rules, acknowledging that various areas of judgement and

estimation arise in the preparation of financial statements,

2. as a strengthening of previous accounting rules, effectively moving towards a ‘substance over form’

approach,

3. as an assertion that the financial statements should be free from bias, and

4. as a basis for the assertion of the authority of the technical pronouncements emerging from the

accounting profession.

McEnroe and Martens (1998) have identified that the phrase ‘true and fair’ means lack of bias in the

financial statements. This view is also supported by several other authors who pointed out that ‘true and

fair view’ means making an effort to provide unbiased information of various components affecting a

company’s intrinsic value (Ekholm & Troberg, 1998). Kirk, (2001) was of the opinion that since ‘true and

fair’ is not defined by law, it allows professional judgement and establishment of meaning through usage.

A study conducted by Laswad (1998), on the perceptions of ‘true and fair view’ concluded that it is only


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possible to interpret the phrase rather than define it. The study identified that the phrase has more of a

‘technical meaning’ rather than a ‘qualitative meaning’. Thus, the interpretation for this phrase would

depend upon the user group. Dunn and Stewart, (2001) explained that since the phrase ‘true and fair’

lacks proper definition, it should be understood in terms of its normal everyday usage according to the

English language. The conclusion made by the authors suggested that the phrase could be perceived

differently by different individuals and can be fully understood only by those who have invested the

necessary time to become immersed in the process of financial reporting. Thus it can be seen that the

concept of ‘true and fair view’ lacks an authoritative meaning. Yet, ‘true and fair view’ has a special

meaning that could extend to both qualitative description and a definition of content, claimed Stacy

(1997). Parker and Nobes, (1993) noted that the word ‘fair’ was more important than ‘true’. While truth

could be construed as factual, fair could mean ‘not misleading’. A number of authors have researched this

aspect and have only managed to conclude that the concept of true and fair mean different things in

different countries (Aisbitt & Nobes, 1998; Higson & Blake 1997; Nobes 1993; Prescod, 1996). Its

existence for a very long time in the legal system of most countries, demands that a definition for this

concept should have emerged by now, yet it can be seen that an acceptable definition has not been

developed by the law till date.

3.2 An Accountant’s version of ‘true and fair view’

Porter (1992), was of the opinion that the phrase ‘true and fair’ could mean different things to different

individuals, like for a lawyer it could mean unambiguous and bias free, while for an accountant it could

have a technical meaning. Thus, to an accountant, if the financial statement has to present a ‘true and fair

view’, the financial statements must be presented in such a way so as to create the ‘correct’ impression of

the reporting entity’s financial affairs. For this to be achieved the rules should be strictly adhered to.

Dunn and Stewart, (2001) were of the opinion that since accountants have different cultural backgrounds,

achieving truth and fairness in financial reporting is a process of communication and negotiation. They

also stated that the meaning attached to truth and fairness is elusive and appears to be situated in the

world in which accountants perceive, act and communicate. In Czech economy it is seen that the concept

of true and fair is used by accountants to obtain specific advantage within the Czech economy and its

advantage is restricted only to a particular group of accountants rather than the whole accountancy

profession (Sucher et. al. 1996). In trying to derive a proper meaning of the concept, from an accountant’s

point of view, the authors could identify that the accounts were supposed to be complete, in a manner

verifiable and correct so that one can derive a fair view of the matters that are the objects of accounting.

The resulting auditors’ report in the form of words and numbers characterized by clarity, logic and

integrity, should convey a description of economic reality as closely as current communications,

economics and accountancy allow (Briloff, 2002).

By and large, from the accountants’ point of view the phrase ‘true and fair’ means compliance with

accepted accounting principles and ‘absence of material errors’ (Rutherford, 1985; Cowan, 1965; Evans,

1990; Walton 1991; Higson, 1992; Parker & Nobes, 1993; Laswad, 1993; Haider, 2001; Karan, 2003).

This view point is not totally shared by Low and Koh, (1993) and Karan, (2003) who were of the opinion

that ‘true and fair’ could mean absence of material errors or free from bias, but it need not necessarily

guarantee compliance with Generally Accepted Accounting Principles(GAAP) or legal requirements. It

was also seen that many auditors thought that an audit report was merely an indication that the auditors

have undertaken their statutory duties (Higson, 1992). Yet, in general the author could identify major

reservations among the auditors in using the phrase ‘true and fair’. In Poland it was seen that the auditors

took a legalistic approach rather than a commercial approach to audit since the adoption of ‘true and fair’

and the corresponding changes in law left the auditors a challenge of de jure adaptability (MacLullich,

2001). Thus it can be seen that some sort of a consensus within the profession or the auditors, with respect

to true and fair, is not established to date.

3.3 Users’ understanding of ‘true and fair view’

The fundamental principle of reporting in company accounts is that the primary responsibility rests on the

directors to make a full disclosure to enable the company and the directors to be judged as to whether

what they have done is acceptable to shareholders and other relevant stakeholders (Flint, 1982). It is often

presumed by the users, including the sophisticated investors, that the financial statements have been

determined by the certifying independent auditor, while in fact the statements are generally those of

management and the auditors only opines if the financial statements are consistent with GAAP (Briloff,


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2002). It is always an unanswered question when one wants to know how the stakeholders perceive the

concept of ‘true and fair’ view. Differing interpretations among the stakeholders makes one feel that the

concept of ‘true and fair view’ is not communicating the actual information that the auditor is trying to

send claimed Higson, 1992.

Any concept that is used to report to the users should have two effects, one that the concept shall not aim

to manipulate users towards a particular conclusion and second that all segments of the community should

be equally well served (Cowan 1965; Higson and Blake, 1993). It has been argued that financial

statements should be complete with respect to qualitative and quantitative information so that the

financially sound shareholders could obtain a detailed understanding of the financial affairs of a business

(Stacy, 1997). However, here again the author, in contrast to the opinion of Cowan (1965) or Higson and

Blake, (1993) is not addressing the shareholders’ group at large. The focus has been restricted to only the

‘financially sound’ shareholders. Interviews with the user group in the Czech economy revealed that ‘true

and fair view’ was not an abstract concept to meet higher objectives (Sucher et. al. 1996). It was used

only to judge if the financial statements satisfied the requirements of the Generally Accepted Accounting

Principles and at the same time for some preparers and users, the concept did not have any particular

individual significance either, noted the authors.

While it is felt that the concept of ‘true and fair’ should satisfy the user needs, it is yet to be clarified as to

whether the auditors’ report does so, due to the remoteness of user needs from the ordinary meanings of

the words used (Rutherford, 1985). In any case by trying to cater to all the user groups, the objective of

financial statements becomes unclear and confusing (Ryan, 1985). Thus, true and fair can be seen as most

important to accountants as an ultimate target in accounts rather than to be used as an accounting

principle (Burlaud, 1993; Soderblom, 2001).

3.4 Legal aspects of ‘true and fair view’

Despite the passing of nearly sixty years since it reached the statute book, however, the term remains

judicially undefined in practice. In Singapore the ‘true and fair view’ requirement is a legal concept.

However, no efforts are made by the legislators or the courts to define the phrase (Lee and Koh, 1997).

Rutherford, 1983 believed that the phrase ’true and fair’ should have a more technical meaning than a

legal interpretation since in case of any complications the law would get back to the accountants to

understand whether ‘true and fair’ was achieved. It is the duty of the auditors to ensure ‘truth and

fairness’ in financial statements, some authors felt that it would be beneficial if ‘true and fair’ was

enshrined in the law properly through clear definition (Kirk, 2001; Lee, 1994; Prescod 1996). It was

researched and identified by Higson and Blake (1993) that true and fair view, was a slippery concept and

was not capable of contemplating a prosecution, neither was any legal action based on the concept by any

country.

3.5 True and Fair View Override

It is understood that the true and fair view override was an origination in the Fourth Directive by the

European Commission (EC) and meant to be followed by countries registered under EC. In accordance

with Article 2(3) of the Fourth Directive ‘the annual accounts shall give a true and fair view of the

company’s assets, liabilities, financial position and profit or loss’. Where, application of a specific

provision of the Directive would not be sufficient to give a true and fair view, additional information must

be given (Article 2 (4)). Where, in exceptional cases, additional information would not be enough in order

to give a true and fair view, the specific provision in the Directive must be departed from (Article 2(5)).

Under such circumstances, the departure must be disclosed in the notes, together with an explanation of

the reasons for it and an assessment of its effect on the company’s assets, liabilities, financial position and

profit or loss. A similar provision is also given in the Seventh directive (Article 16 (3) for the

consolidated accounts. However, under the Seventh Directive the true and fair requirement does not apply

to the scope of the consolidation (Hulle, 1993). Thus the overall impression is that there was no strong

objection to the inclusion of the true and fair view as such in the Fourth Directive since all the key

institutional players formed their policies around the true and fair view principle (Walton, 1997).

Interestingly, the arguments placed by Alan Cook (1997) extend this thought by stating that both ‘true and

fair’ as well as ‘true and fair override’ must always be viewed together, as they compliment and reinforce

each other.


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The major issues raised in application of true and fair view override principles is basically the translation

of English language into various other languages like German and French, as these countries are a part of

EC. It was pointed out by Burlaud, (1998) that in English the true and fair view of the ……..assets,

liabilities, financial position and profit or loss could be interpreted literally as ‘an exact and trustworthy

picture of the assets, liabilities, financial situation an profit or loss’. As for the French version, that states

that the accounts should give ‘a faithful image of the owner’s capital, the financial situation and the

results’. He also pointed out that there is not a single official EC language, and in certain limited cases

one could imagine that the expressions ‘real situation’, ‘exact and trust worthy picture’ and ‘faithful

image’ are not equivalent to each other and that there are therefore several versions of the Fourth

Directive.

A notable finding by Livne and McNicholas (2003) stated that the reporting practices that result from one

country are a consequence of their standards, legal environment and the manner in which standards are

enforced. Given that UK is at the high end of the range of enforcement of accounting standards, override

behavior in other countries might differ significantly from the behavior documented in the UK. This view

is supported by Zeff (1993) who said that there had been cases in Dutch companies, who had close ties

with the US capital market and have used ‘present fairly’ in place of ‘true and fair view’. It was found in

such cases that ‘give a true and fair view’ as used in the legislation of EC countries is not the equivalent

of ‘present fairly’ as used in the United States. Various authors have different solutions to solve the

problems arising from the interpretation of the phrase ‘true and fair view’ and to narrow down the

differences arising from the adoption of the override principles. But still the basic problem remains

unsolved, which points at the phrase itself. This argument could be supported by the comment made by

Burlaud (1993, 98) who said that “very few companies would take the risk of departing from the

accounting rules and justifying this by the extremely vague notion of the true and fair view”.

It was pointed out by Linve and McNicholas (2003) that Security Exchange Commission (SEC) had

historically objected to the possibility of an override if international accounting standards were to be

allowed for companies listed in the U.S. Amat, Blake and Oliveras (1996) support Burlaud’s view by

stating that Germany does not require, or even permit departure from the detailed requirements of the law

to give a ‘true and fair view’. Walton (1997) looked down upon the override by claiming that the UK

accountants used this concept as a means of escaping from the austere rules of the Fourth Directive.

3.6 ‘True and fair view’ as compared to ‘Present fairly’

Familiar terminology such as a ‘true and fair view’ in the UK, and ‘present fairly’ in the USA, constitute

the means by which users are informed by the auditor about integrity of the management. In both these

cases it can be observed that the concept lacks a proper or acceptable definition (Lee 1994). Neither ‘true

and fair view’ nor ‘present fairly’ helps to reach the objective of financial statements, that is to give

unbiased information about the financial performance of companies (Cowan, 1965). McEnroe and

Martens, (1998) identified that many users considered ‘true and fair’ to be superior to ‘present fairly’ in

accordance with Generally Accepted Accounting Principles (GAAP). These results were consistent with

that of Kirk, (2001) who identified that in New Zealand users preferred to use ‘true and fair’ concept.

Some felt that the two concepts could not be interchanged and they had to be retained as the essential

parts of the UK audit report and US audit report respectively (Kirk, 2001; McEnroe & Marttens, 1998;).

However in order to make financial reporting easier, it is better to come up with one internationally

accepted accounting standard, particularly with the onset of International Financial Reporting standards

with about 110 countries embracing the same.

3.7 Criticisms of ‘true and fair’

The major limitation identified by most authors is that ‘true and fair’ lacks a proper definition and the

interpretation depends upon the people for whom the financial statements are intended to be. This means

that different people could interpret ‘true and fair’ differently. The multiplicity of commonly used Polish

translations and grammatical constructions for ‘true and fair view’ as well as a lack of consensus as to its

classification imply the lack of substantial rationalization in understanding the ‘true and fair’ concept in

Poland (MacLullich, 2001). The research by Higson (1993) affirmed that, in the United Kingdom, the

phrase ‘true and fair’ aroused little enthusiasm amongst those who are concerned with the application of

this phrase.


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Karan, (2003) opined that ‘true and fair view’ has led to discordant interpretations. Dunn and Stewart,

(2001) said that the requirement that financial statements should give a true and fair view creates a great

deal of difficulty for preparers, auditors and users of financial statements. Cultural differences of each

country could influence the practice and application of ‘true and fair view’. Rather than being over-

economical with ‘truth’, it should be unambiguously clarified that both ‘true’ and ‘fair’ adjectives have

been used not in the generally understood sense but in a narrow or restricted or limited sense. Cowan,

(1965) pointed out that insufficient thought has been given to the concept of ‘true and fair view’ while

Ekholm and Troberg, 1998 were of the opinion that true and fair view reporting may many times lead to a

dramatic decline in the market value of an enterprise and consequently, such information may be regarded

as causing significant harm.

3.8 Current significance of ‘true and fair view’ and the override principles

Karan (2003) suggested that one could use “not misleading” in the place of ‘true and fair’ for the reason

that, unlike cultural connotations of the ‘true and fair’ view that have lead to discordant interpretations. In

the author’s words “the concept of ‘not misleading’ has the potential to transcend national idiosyncrasies

and assist in the development of consistent accounting standards in both national and international

application.” The Czech legislation chose to avoid the use of the word ‘true’, which was perceived to

have been misused in the Central Europe over the last sixty years (Sucher et. al., 1996). It was correctly

pointed out by Clarke, (2006) that if a judge were to expect that ‘true and fair’, being ordinary words, be

given ordinary meaning, one will not be able to defend any other usage. It is expected and observed that

all the other professions, which entails greater complexities than financial affairs, have regular, common,

profession wide, tried and proven methods of reporting (Dean and Clarke, 2004). However this acumen is

lacking in accounting, thereby leading to lack of professional expertise.

3.9 Case Study and judgements given on Auditors’ liabilities due to False Certification

History has seen a number of cases where the auditors were charged in the courts for not disseminating

the correct information to the stakeholders. The auditors have taken shield under concept of “true and fair

view” which does not communicate what is meant to be communicated to the stakeholders (Higson and

Blake, 1993). The Royal Mail Case in 1931 was the first to have illustrated how it was possible to

produce audited accounts, which met the legal requirements and yet omitted sufficient data so as to

completely mislead the investors and the shareholders. The trend is still continuing, which could be seen

in Parmalat, the largest Italian food company, which eventually collapsed in 2003 with 14 billion euro

hole in its accounts. Melis (2007), analyzed that in spite of following all the legal requirements including

rotation of auditors, the company was the biggest European bankruptcy case. As against the earlier

corporate collapses like that of Enron and WorldCom, where, Arthur Andersen, the auditors of these

companies were implicated with giving wrong information to the stakeholders, the latest in the series of

financial mismanagement is Satyam computer services, which was incorporated in 1987. This company’s

chairman openly declared having indulged in financial statement fraud and had managed to escalate the

figures beyond recognition. While the name “Satyam” meant “truth”, no truth about the company was

observed. The company claimed to have employed 53,000 employees and later it was discovered that the

company had in fact employed only 40,000 employees, there by creating 13,000 dummy employees, the

salary of who were pocketed by the chairman. PricewaterhouseCoopers, the auditors of the said company,

had failed to discover this fact and had been issuing unqualified reports. When queried, they claimed that

the information provided and verified, had justified an unqualified report. Numerous other leading cases

are analyzed in this research in establishing the principles of law relating to breach of trust like:

The London and General Bank Ltd. The main emphasis in the judgement given by the judge says: “His

(Auditor’s) first duty is to examine the books not merely for the purpose of ascertaining what they do

show but also for the purpose of satisfying himself that they show the true financial position of company.”

The judge, in his judgement, also stressed that the auditor “must be honest that is he must not certify what

he does not believe to be true and he must take reasonable care and skill before he believes that what he

certifies as true.” This was a very good case in projecting the duty of the auditors’ and their

responsibilities.

Republic of Bolivia Exploration Syndicate Ltd. The judge held that “auditors of a limited company are

bound to know or make themselves acquainted with their duties under articles of the company whose


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accounts they are appointed to audit and the Companies Act for the time being in force. When it is shown

that the audited balance sheet did not project the true condition of the company and that damage had

resulted, the onus would be on the auditors to show that it was not the result of any breach of duty on

their part.”

Rex corporation The auditor and the chairman of the company were criminally prosecuted for publishing

annual reports knowing them to be false in a material particular intent to deceive the shareholders. While

the company was making a trading loss, deliberate false representation was made to the shareholders that

the company was making a trading profit.

Scott group : It was held that the auditors were liable since the auditors should have foreseen that the

company’s low profits and rich assets would make the company a good target for takeover. The auditors

report would thus be relied for any such takeover bid.

Jeb Fasteners Limited. It was held that the auditors should have foreseen at the time of audit that some

person might rely on those accounts for the purpose of deciding whether or not to take over the company

and therefore could suffer loss if the accounts were inaccurate. The case of Scott group was upheld.

Twomax Ltd & Goode The financial statements were negligently audited and the auditors’ reports were

relied on for a takeover bid. The auditors were awarded damages of £65,000 plus costs.

United States v. Andersen: The auditors were charged with actively involving themselves in all the

misdeeds of Enron and finally also with the charge of shredding documents related to the firm’s audit of

Enron. This resulted in the company’s restatement of income showing finally a loss of $618 million for

the first quarter of 2001. The auditors were held grossly negligent thereby leading the firm to be barred

from auditing publicly traded US companies. This case is attributed to lack of independence of the

auditors, since they were bribed heavy amounts for consultation services than for statutory audit.

3.10 Factors influencing the acceptance of the concept of ‘true and fair view’

Various factors can be seen influencing the acceptability or the understanding of ‘true and fair view’.

These have been identified from the literatures reviewed. The first and foremost being the restrictions set

by the professional codes of ethics and the legal requirements. Ethical codes help in defining appropriate

behavior for an individual practitioner and also in sending out a message to the wider community about

the type of behavior that can be expected by a member of the professional body concerned (Page & Spira,

2005). In the absence of any guidance, people look to the professional codes of conduct and the legal

rulings to decide on the right or the wrong. Secondly it is acknowledged that auditors’ report is the only

means of communication between the auditors and the shareholders thereby expecting the auditors to

communicate in a clear and unambiguous manner. In order to be able to achieve clear and unambiguous

communication the auditors must ensure that the stakeholders are able interpret the report and reap the

benefit of their reports. The well-being of the society and the economy is dependent on the extant law as

well as its ability to enforce the same. In this research the authors aim to ascertain if the existing law is

sufficient to enforce integrity in the auditors while stating ‘true and fair’.

3.11 Restrictions set by law and ethical conduct

Ethics refer to a system or code of conduct based on moral duties and obligations that indicates how one

should behave (Messier & Boh, 2004) Ethical interrogations will rise every time the decision maker

exercises the freedom of choice given a range of possibilities and those conclusions will have

significances for the wellbeing of the society (Marshall, Smith and Armstrong, 2006). When

contemplating the design and implementation of an ethics program, it is appropriate to first examine the

preconditions that may be necessary in order for the individuals to behave in a morally responsible

manner, insist McDonald and Nijhof, 1999. However, it can be seen that the profession of accounting and

auditing are trying dreadfully to prove to the world their ethical stance (Vinten 2007).

Like any other professions, ethical codes of conduct are not the latest introduction to the accounting

profession. They have been upon since the inception of numbers and accounts. Sihag and Balbir (2004)

noted that during the ancient accounting period, legal rules had to be written with clarity and

completeness, in order to ensure effective enforcement of rules and regulations and allocation of duties to


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various office bearers. While there is, still, misperception on what constitute proper codes of ethics, it is

suggested that the legal system must have precise guidelines, proper documentation and appropriate

disciplinary action that can be instituted against breach of law, enshrined in it (Farrell et. al. 2001).

Professionalism on the other hand, means that the individual possesses certain characteristics, attitude and

aptitude that mark a profession or a professional person (Messier, Jr & Boh, Auditing and Assurance

services in Malaysia, second edition). Professions establish such codes to demonstrate to the users, the

standards of behavior they intend to follow while providing services to their client. Thus in order to

protect the privileges and the coffers of the stakeholders apart from legitimacy, morality of transactions

are indispensable, which means that the auditors have a moral duty not only to check the transaction but

also ensure that the amounts spent are within the regulatory framework (Percy, 2000, Amat et.al.). This

explains the need to have truth in the reporting element which must be unbiased, consistent with rules and

neutral to adopt. The codes of ethics set by the profession consistent with that of the law remain the

guiding forces for the auditors to act ethically, bearing in mind the high level of social obligation they

carry.

Ordelheide (1996) believed that legal norms are formulated in abstract terms and in practice every

particular accounting case can be solved with reference to legal norms only. It is therefore, necessary to

define legal norms, which could bring consistency in interpretations. Consequently, if we could define the

professional codes of conduct in a legal context, it could probably help to bring about reliance or

achievement of the ‘true and fair’ certification. The recent high profile collapses and also the downfall of

Andersen has raised a question as to the adequacy of the rules for the auditors to act ethically (Flugrath et.

al. 2007). This became more questionable when more firms (KPMG and Ernst & Young) were instilled

with civil fraud charges, specially because these firms gave an unqualified audit opinion to nearly half of

the 228 public listed companies that later filed for bankruptcy within the year (Brown, 2005). The

question of ethics cannot be addressed in a vacuum if one has lost his humanity claimed Doost, 2004.

Arthur Andersen with their impeccable reputation for quality audits aggressively pursued the schemes of

wealth generation and accumulation through any means (Toffler & Reingold, 2003). The existing retro

can be seen as a very ambiguous period in human history with lots of openings and opportunities for a

better future, which cannot be achieved by mere revision of accounting and auditing rules of conduct

(Doost, 2004). However it can be seen that number of firmer protocols are being incorporated to monitor

the work performed by auditors, the audit committees and the directors of organization with the

introduction of the Sarbanes-Oxley act (Razaee et. al. 2003).

In spite of all these efforts taken by the regulatory authorities, one could witness the commission of

financial statement fraud, for companies such as WorldCom, Parmalat and Satyam Computers, which

acknowledge good corporate governance as prevailing framework but had failed to implement it,

resulting in loss of wealth by the stakeholders (Mardjono, 2005). This shows that merely having good

ethics, rules and principles, by itself is not sufficient; in fact more focus has to be put on the way in which

it is implemented. UK has taken steps to ensure that the auditor independence is implemented following

the collapse of Enron, noted Fearnley and Beattie (2004). Among the various steps implemented were,

increased transparency and disclosures by audit firms apart from calling for voluntary disclosures

wherever possible in preference to costly and interventionist strategies, claimed the authors. The authors

also posit that further changes to the rules were possible if the existing rules and mechanisms proved

unsatisfactory.

One can assume that as long as the auditors are able to abide by the regulations set by the Law and as

long as the auditors’ code of conduct is within the restrictions set by the standard setters, ‘true and fair

view’ of financial statement could have been achieved. It is difficult to imagine ‘true and fair view’

results that are not obtained and communicated by adherence to a set of rules claimed Low and Koh,

1993. Higson and Blake (1993) quoted the view of Institute of Chartered Accountants of England and

Wales (ICAEW), on the true and fair view, which suggested that the auditor must be, satisfied that

a. All relevant Statements of Standard Accounting Practices have been complied with, except in situations

in which for justifiable reasons they are not strictly applicable because they are impractical or,

exceptionally, having regard to the circumstances, would be inappropriate or give a misleading picture.

b. any significant accounting policies which are not the subject of Statement of Standard Accounting

Practice are appropriate to the circumstances of the business.


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In this regard, a question posed by Porter (1992) is considered very relevant. To what extent must

financial statements comply with the Accounting Practices before they could give a ‘true and fair’ view?

Is full compliance with all Accounting Practices necessary, as accountants have traditionally

maintained? Or is there a “core” of Accounting Practices, which if adhered to, would ensure that the

financial statements portray the ‘correct impression’ of the reporting entity’s financial affairs? Although

one would not expect ethical considerations to be applied across every waking moment of an

organization, the only really guaranteed way to ensure this is by adoption of total quality procedures

suggested Vinten 2007. A higher audit quality increases the chances of informative audit evidence and

helps the auditor make more informed attestations, even though a higher audit quality comes with higher

audit cost (Lu, 2005). The revised statement of auditing standards (SAS 240) issued by the Auditing

Practices Board (UK) on ‘Quality Control for Audit Work’, includes a strong emphasis on independence

of auditors and objectivity as crucial factors in audit quality (Stevenson, 2002).

The financial scandal of the 1980s focused attention on apparent weaknesses within the financial

reporting system, which failed to protect investors and other stakeholders from significant losses (Spira,

2001). These weaknesses continue to lead to major financial scandals in the 21st century (Brown 2005),

which in turn has led to current confidence crisis of investors over the credibility of financial reporting

(Makkawi & Schick, 2003; Sridharan et. al. 2002). Furthermore, the rules of ethics are not considered to

provide sufficient guidelines to practitioners in specific situations, especially when it comes to

independence of auditors (Gorman and Ansong, 1998). A collaborative venture between the American

Institute of Certified Public Accountants, the American Accounting Association, the Financial Executives

Institute, the Institute of Internal Auditors, and the National Association of Accountants recommended

that public listed companies should develop and enforce written costs of corporate conduct, which in turn

can foster a strong ethical climate as well as open channels of communication to help protect against

fraudulent financial reporting (Vinten 1998). The above arguments speak volumes about how ethical

codes do not add value to the current reporting practices by the company, accountants and the auditors.

3.12 Interpretation of the concept ‘true and fair view’

Current audit practices may lay stress on the audit opinion paragraph, but it is not clear whether the users

of the financial statements have sufficient understanding about different forms of opinion expressed by

the auditor and the information content of the audit paragraphs (Soltani, 2000). It is thus a fact that ‘true

and fair view’ lacks a proper and an acceptable definition. This has subjected the concept of ‘true and fair

view’ to various interpretations depending upon the purpose of the audit, the type of audit report and the

users for whom the audit report is being prepared. True and fair could be used to describe non financial

information if the requirement to meet reasonable expectations could be satisfied (Stacy, 1997). This has

created a great deal of ambiguity among the user group and has also brought about an expectation gap

between the user groups and the auditors (Porter, 1993). The user group is by and large, of the opinion

that an audit report which states that the financial statements show a ‘true and fair view’, is in fact

promising the accuracy of financial statements as well as integrity of the managers of funds. The users

assume that the auditors will undertake responsibilities with respect to detection of fraud, improving audit

effectiveness, communicate useful information in a better and effective manner including early warnings

about possible business failure (Guy and Sullivan, 1988).

However, in fact, there is a great deal of difference between what the public and financial statement users

believe accountants and auditors are responsible for and what the accountants and auditors themselves

believe they’re responsible for, which commonly is called as the ‘expectation gap’ (Guy & Sullivan,

1988; Lee, 1994 ). It implies that the auditors are not required to look specifically at the accuracy. They

are only required to ensure that the financial statements do not contain any material errors, which could

change the perception of the users. The users are ignorant of the fact that the word ‘material’ itself is

subjective. With so many vagueness in reporting and communication the concept of ‘true and fair’ view

causes the users to be confused on what the auditor is trying articulate through the audit certificate.

Higson, (1991), in his research deliberated that the phrase ‘a true and fair view’ is not communicating the

message that the auditor wants to send. Thus an alteration to the audit report may reduce the audit

expectation gap. The case of Parmalat was used by Andrea Melis, (2005) in order to understand how the

relationship between the corporate financial reporting and corporate governance influenced, negatively,

the enforcement of the ‘true and fair view’ accounting principle. It was observed that ‘true and fair view’

reporting became just a chance for the auditor’s gateway.


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Nobody is sure of what ‘true and fair’ stands for and how it can be applied without losing its originality.

Ambiguity is said to exist where a message is capable of multiple interpretations, where a single form of

words encompasses multiple substances of meaning (Page & Spira, 2005). When using ‘true and fair as a

single construct, the importance of ‘truth’ in relation to either universal truth or to reliability of

information prevails (MacLullich, 2001). The more ambiguous adjective ‘fair’ is equated with ‘correct’,

‘true’, ‘clear’, or even ‘faithful’ claims the author. This sort of confusion basically exists due to the failure

of the law to define and showcase the correct usage. It was opined by Walton (1993), with respect to the

meaning of the phrase ‘true and fair’, that it is a legal term in origin and yet the Companies Act have

never defined it (nor has the Fourth Directive) and there is very little jurisprudence which bears upon it.

Parker and Nobes, (1991) argued that from the UK point of view it was accepted that ‘true and fair view’

requirement existed mainly for the benefit of the auditors. Whether or not the directors found the use of

‘true and fair’ by auditors in their interest depended upon the circumstances. Thus they concluded that it

was the auditors who used and supported ‘true and fair’ requirement.

Gill, (1983) was of the opinion that the ‘true and fair’ view statement by the auditors depended on who

they directed the report to. In most cases, since the shareholders are known to have appointed the

auditors, the ‘true and fair’ view would mean that it was directed to the shareholders. Diverse interests

within a company make the phrase complicated with different interpretations drawn by different

individuals. This view is also supported by Samuelsson et. al., (2003) who stated that the meaning of ‘true

and fair’ view is based on individual reflections and that it all depends on whom you are asking. A valid

point raised by Gill was that the company legislation consistently speaks of a ‘true and fair’ view and not

the ‘true and fair’ view. This is to be expected because of the multiplicity of choices that are available in

the treatment of various items in the accounts. So, one is forced to conclude that there are as many ‘true

and fair’ views as there are viewers. Higson (1992) viewed that one standard unqualified report being

used for very large public companies as well as very small privately controlled companies could convey

different messages. This calls for a requirement to have different reports depending upon the size of the

client. Comparing what the British Auditors are trying to tell to what the American Auditors are trying to

tell via their audit certificate, it has been identified by Cowan (1965) that, lack of clear cut definition of

objectives in the financial statements bring about a barrier in general acceptance by the investors.

The inference thereby drawn is that if we could draw a clear interpretation for the phrases used in

certifying financial statements, it would help the users to make better judgement and have more reliance

on the audit certificate. The current ‘true and fair’ has very little advantages over the disadvantages when

the users are to interpret it in the way in which it is reported.

3.13 Satisfaction of stakeholders

The wide meaning and a wide range of interpretations drawn by financially sound shareholders and the

other stakeholders, makes the level of satisfaction on ‘true and fair’ reporting questionable. Stakeholders

are individuals within and outside the organisation who have a vested interest in the organisation. The

public, in the form of shareholders and other stakeholders take comfort from the fact that the auditor as a

watchdog is overseeing the integrity of business through the process of reporting on financial information

(Percy, 1997). It is therefore, important that audit is not perceived as an overly expensive overhead, but a

cost willingly spent for value rendered both to the audited organsiation and to stakeholders auditors are

ultimately serving, (Percy, 2000). The main purpose of preparing financial statements and getting them

audited and certified by independent auditors is to provide reliable information to the stakeholders, who

believe that the auditors have a responsibility as watchdogs of the integrity of business (Percy, 1997). On

taking a look at the way in which auditors are hired, reappointed, and paid, it is not wrong to state that

shareholders and other users of accounts have to be concerned with the way in which the stakeholders’

interests will be safeguarded (Firth, 2002). The role of an audit and auditors is to reduce the information

risk associated with financial statements (Makkawi & Schick, 2003). Stacy (1997) argued that the

meaning of ‘true and fair’ view is that it is firmly based on the reasonable expectation of the users and

with changing economic and business activity accounting should also be ready to change with new

financial instruments and new measurement techniques. Having a wide range of people with different

objectives of looking at the same financial statement, it is always seen as a difficult task to satisfy all of

them.

The interests of all users have economic dimensions and should therefore be satisfied by such information

about the entity which is necessary for establishing the entity’s intrinsic value, noted Ekholm and


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Troberg, (1998). However, it is understood that the financial statements are normally prepared to satisfy

the shareholders of the organisation. This means that the audit certificate should be prepared with an aim

of satisfying the shareholders. This is true when the auditors are certifying the annual financial statements

of an organisation. There could also be situations when the auditor is required for special purpose audits

like tax audit, management audit or investigative audit. In such cases again, the users are very specific

and the audit certificate shall be expected to satisfy such specific users. This is to conclude that as long as

the users are satisfied, we could trust the ‘true and fair view’ certification.

The concept of ‘true and fair’ has two aspects: First, that in presenting the accounts there should be no

attempt to manipulate users towards a particular conclusion; and second, that all segments of the user

community should be equally well served. This is emphasised in the American Accounting Association’s

first discussion of accounting conventions and in Paton and Littleton’s 1940 work (Higson & Blake,

1993). This could mean that all the stakeholders should be equally satisfied with the ‘true and fair view’.

In Re London and General Bank (No. 2), for example, the purpose of the statutory audit was described as

securing “to shareholders independent and reliable information respecting the true financial position of

the company at the time of the audit” (Karan, 2003,p.4). Does this mean that as long as the shareholders

are satisfied, one need not be bothered about the rest of the stakeholders?

Rutherford (1985) stressed that meeting user needs forms a part of presenting a ‘true and fair’ view.

However, it is far from easy to be confident that users of contemporary financial statements do as a matter

of fact feel that their needs are satisfied. Dunn and Stewart, (2001) argued that it cannot be assumed that

truth and fairness has one meaning for all. Therefore achieving truth and fairness in financial reporting is

a process of communication and negotiation. Given that accountants have different meanings for truth and

fairness, the users will have even greater difficulty to deal with the concept. To the layperson truth and

fairness implies correctness and they rely on the accountants as experts to ensure this. However, is it

possible for the auditor to give one ‘true and fair’ view to satisfy all the stakeholders and fulfill their

responsibilities?

It is acknowledged that the current widespread criticism of and litigation against, auditors is a

ramification of auditors failing to meet society’s expectations of them and further that such failure is

serving to undermine confidence in auditors and the work they do, pointed out Porter (1993). It is very

interesting to take note of a couple of comments given in a research undertaken by Higson (1992). One

interviewee claimed that a satisfactory meaning of the concept is yet to be worked out while another

interviewee argued that when professionals themselves were confused with the term, how could one

expect the shareholders to understand and interpret it correctly?

4 Concludingremarks – ‘True and fair view’

The purpose of this study was to infer whether ‘true and fair view’ reporting could be retained in its

current form while hundreds of countries have joined hands in adoption of International Financial

Reporting Standards. This is particularly relevant due to UK’s stand of retaining ‘true and fair view’ as

the corner stone in financial reporting. To aid the study a wide range of literatures, newspaper articles and

text books were used. There were three crucial elements to ‘true and fair view reporting’. The codes of

ethics and law govern the etiquette of the auditors and preparers of accounts. The insinuation from the

literatures is that the codes of ethics nor the law provide sufficient guidelines on the usage of the terms

‘true and fair view’. At the same time it is difficult to enforce legal action against the auditors when they

provide true and fair’ reports despite having knowledge of wrong doings by companies unless evidence

can be hoarded proving the auditors’ lack of integrity. The second element was the ability of the

stakeholders to interpret ‘true and fair view’. There is a wide spread confusion when auditors report using

‘true and fair view’ concluding that, in the long run ‘true and fair view’ will become an oppressed term if

retained in its original form. The last element discussed was extent of satisfaction resulting from reading

true and fair view reports. With varying degrees of independence and competencies, the auditors are

unable to provide the users with observable evidence on their integrity when they report using ‘true and

fair view’. This has led to dissatisfaction among the stakeholders who insist on extending roles of auditors

and also reporting in a manner that does not befuddle the users.

Overall this study has provided mixture of thoughts with respect to ‘true and fair view’ reporting. While it

can be seen that many users favor the concept, it is also evident that there are intense displeasures among

the users. It is therefore the deduction of the researchers that it is time to re-look, or more strongly


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overhaul ‘true and fair’ reporting. The major limitation of this study is that the views of the researchers

have not been tested empirically.

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BOARD OF DIRECTORS, INFORMATION ASYMMETRY, AND INTELLECTUAL CAPITAL DISCLOSURE AMONG

BANKS IN GULF CO-OPERATION COUNCIL

Zuaini Ishak*, Abood Mohammad Al-Ebel**

Abstract

The main thrust of this paper is to examine the intellectual capital (IC) disclosures of 137 Gulf Co-operation Council (GCC) listed banks using a content analysis approach. Instead of examining the effect of board characteristics in isolation from each other, this study extends previous research on the determinants of IC disclosure by considering board effectiveness score in relation to IC disclosure. Moreover, this study extends previous studies in board-IC disclosure relationship by investigating the hypothesised impact of information asymmetry in moderating this relationship. Our findings show that IC disclosure is positively associated with the effectiveness of board of directors. In addition, our study provides evidence that the level of information asymmetry in GCC bank moderates the relationship between board effectiveness and IC disclosure. Findings of this study therefore provide strong support of the hegemony theory. These findings are important for policy makers as they confirm that the effectiveness of board of directors in protecting the investors depends on the level of information asymmetry. Keywords: Board Of Directors, Information Asymmetry, Intellectual Capital (IC) Disclosure, Banks, GCC * School of Accounting, College of Business, Universiti Utara Malaysia, 06001 Sintok, Kedah, Malaysia E-mail: [email protected] ** School of Accounting, College of Business, Universiti Utara Malaysia, 06001 Sintok, Kedah, Malaysia E-mail: [email protected]

Introduction Voluntary disclosure and monitoring activities both are viewed by agency theorists as two effective

mechanisms to reduce agency costs and to ensure improved protection to investors of the company (see

Jensen & Meckling, 1976; Fama & Jensen, 1983). Voluntary disclosure is considered useful to enhance

the protection to such outsiders because it provides a signal to the minority shareholders whether the firm

is committed to treating its shareholders, in a fair and equitable manner (Chobpichien, Haron, & Ibrahim,

2008). Young, Peng, Ahlstrom, Bruton and Jiang (2008) argued that one of the ways to protect the

minority shareholders in countries with weak legal protection towards the minority shareholders is by

having higher disclosure quality and transparency. The present paper focuses on a particular type of

voluntary disclosure, which is intellectual capital (IC) disclosure. The IC disclosure is expected to provide

a more intensive monitoring package for a firm to reduce opportunistic behaviour and information

asymmetry. This is because the intellectual capital is the key driver of the company’s competitive

advantage, and disclosing it allows the shareholders to better anticipate the company risk. The voluntary

disclosure of intellectual capital thus primarily works as one of governance mechanism that reduce an

information asymmetries (Cerbioni & Parbonetti, 2007).

In addition to the voluntary disclosure, other corporate mechanisms have been suggested to protect

shareholders. The board of directors is an internal control mechanism that is intended to make decisions

on behalf of the shareholders and to ensure that management behaviour is consistent with owners’

interests. Fama and Jensen (1983) argued that the board of directors is needed to minimise agency cost, to

fulfil shareholders’ interests, and to enhance the level of disclosure. Cerbioni and Parbonetti (2007)

claimed that the effect of internal corporate governance works complementary to corporate disclosures,

and applying more governance mechanisms will assist the company to maintain its internal control and




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will work as an “intensive monitoring package” for the company in order to reduce opportunistic

behaviours and information asymmetry. Under this environment, managers should not withhold

information for their own benefit; so the level of voluntary disclosure in company’s annual report is

expected to increase. However, previous studies that have examined the relationship between board of

directors and voluntary disclosure of intellectual capital practice (e.g. Cerbioni & Parbonetti, 2007; Singh

& Van der Zahn., 2008; Li, Pike & Haniffa, R 2008) found somewhat mixed results. The reasons for the

mixed results in these studies could be due to the studies that examined the effect of governance

mechanisms in isolation from each other (Ward, Brown & Rodriguez, 2009).

Ward et al. (2009) argued that, in addressing the agency problems, previous studies considered each

mechanism separately thus they ignored the idea that the effectiveness of a mechanism depends on other

mechanisms. Agrawal and Knoeber (1996) argued that the results of the effectiveness of an individual

mechanism might be misleading as the effectiveness of the individual mechanism could disappear if a

number of mechanisms are combined. Based on the idea that the impact of internal governance

mechanisms on disclosures is complementary, the effectiveness of corporate governance may be achieved

via different channels (Cai, Liu, & Qian, 2008) and the effectiveness of a particular mechanism may

depend on the effectiveness of others (Rediker & Seth, 1995; Davis & Useem, 2002). We suggest that the

increase of the characters that enhance the board effectiveness leads to the increase of the level of

voluntary disclosure, and vice versa. Thus, the first aim of this study is to examine the effect of board

characteristics as a bundle of mechanisms in protecting the interest of the shareholders. In more specific

words, this study examines the relationship between score of characteristics (that affects the board

effectiveness) and IC disclosure. However, it should be noted that the intensity of board of directors’

monitoring to reduce the conflict between the majority and minority of shareholders is affected by

information asymmetry (Boone, Casares Field, Karpoff, & Raheja, 2007; Linck, Netter, & Yang, 2008).

This is because, according to hegemony theory, the board of directors’ monitoring is limited internally

through information asymmetry directed by management. Further, Chen and Nowland (2010) stated that

information asymmetry makes the monitoring conducted by the board of directors less effective.

Therefore, transparency in the annual reports could not be achieved by the intensity of board of directors’

monitoring in companies where an information asymmetry is high. Therefore , the second aim of this

study is to examine the moderation effect of information asymmetry on the relationship between

effectiveness of board of directors on IC disclosure in the banking sectors in the GCC countries1.

Banking sector is one of the largest sectors in GCC economies and there are more bank stocks traded in

GCC stock markets than stocks of any other industry. In the GCC, this sector continues to be well-

capitalised across the board with capital adequacy ratios of above minimum standards and comfortable

leverage ratios by international comparisons (Al-Hassan, Oulidi, & Khamis, 2010). The GCC countries

generally have a moderate to high level of financial development. They score the highest on regulation

and supervision, as well as on financial openness compared to the remaining countries in the Middle East

and the North African (MENA) region (Creane, Goyal, Mobarak, & Sab, 2004). Specifically, the banking

sector in GCC is selected for this study based on these three reasons. First, the business nature of the

banking sector is “intellectually” intensive; thus voluntary disclosure of intellectual capital is good proxy

of good corporate governance (Grojer & Johanson, 1999).

Second, by focusing on a single industry, it allows us to control the differential effects of regulation in

making the analysis. This focus also allows us to assess the influence of the board of directors’

effectiveness on the level of IC disclosure of GCC-listed banks more directly. This is because the results

of this study are likely due to the spurious correlation caused by unobserved heterogeneity that is

significantly reduced (Blackwell & Weisbach, 1994). Third, the competition in the banking sector at

GCC is high and the corporate governance in this sector is better than other sectors in putting the board of

committees such as auditing committee and nominating committee in place, and also in appointing a

majority of independent directors. However, dispute the competition is high and the corporate

governance is better than other sectors, the information asymmetry is high and the level of disclosure is

low in the banking sector (Chahine, 2007).

1 The GCC countries comprise the Kingdom of Bahrain, the State of Kuwait, the State of Qatar, the Sultanate of Oman, the State

of United Arab Emirates and the Kingdom of Saudi Arabia, which all have a mature, efficient, stable, and profitable banking system. These countries share some common economic, cultural, and political similarities, which by far outweigh any differences they might have (Al- Muharrami et al., 2006). In 2008, the GCC countries’ economy accounted for around 1.8 per cent of the world’s total GDP of around $61trn (Al-Hassan et al., 2010).


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The present study contributes to the literature in a number of ways. First, it provides systematic evidence

on the relationship between the effectiveness of board of directors and IC disclosure. The results show

that IC disclosure is greater for banks with a high score of effectiveness of board of directors. Second, the

study provides the evidence that the relationship between the score of effectiveness of board of directors

and IC disclosure is moderated by the level of information asymmetry.

The remainder of the paper is structured in the following sequence. The next section is the literature

review on IC disclosure, board of directors’ effectiveness, and information asymmetry. Section 3 presents

research method and the findings are reported in Section 4. The last section of this paper summarises its

key findings, and after discussing some of its limitations, a number of further research topics are

presented.

Intellectual Capital Disclosure

The researchers and analysts have not reached unanimous agreement on the definition of IC disclosure

and its components. However, one of the most widely accepted definitions of intellectual capital, which is

supported by a number of prominent authors (Sveiby, 1997; Brennan & Connell, 2000; Sullivan, 2000), is

formed by three sub constructs: internal capital, external capital, and human capital. Internal capitals

include patents, concepts, models research and development capability, technology, and administrative

systems. On the other hand, external capitals include customer capital comprising relationships with

customers and suppliers, brand names, trademarks, and reputation. Next human capitals refer to

employees’ competence such as skills, education, experience, and capacity to act in a wide variety of

situations.

Disclosing information about IC in the corporate annual report is not costless. Williams (2001) argued

that voluntary disclosure of IC could affect the competitive advantage of company since it provides signal

to competitors of possible value-creating opportunities. According to Vergauwen and Alem (2005), a firm

might be at the competitive disadvantage when it discloses sensitive information to outside investors.

However, from the literature review, it could be said that disclosure of IC has advantages for company,

investors, and markets. For example, IC disclosure can help organisations to formulate their strategies, to

assist in diversification and expansion decisions, and to use the IC as basis for compensations (Marr,

Mouritsen, & Bukh, 2003). Recognising these advantages of IC disclosure, several attempts have been

conducted for reporting of IC. From these attempts, several models have been produced to measure and

report the intellectual capital. Kaplan and Norton’s Balanced Scorecard (Kaplan & Norton, 1992),

Sveiby’s Intangible Assets Monitor (Sveiby, 1997), and Skandia’s Value Scheme (Edvinsson & Malone,

1997) are among the most popular models used to construct reports on intellectual capital.

From the analysis of IC disclosure studies, majority of the studies used Sveiby’s (1997) framework with

some modifications. Sveiby’s (1997) framework contains 24 elements within three categories namely

internal structure, external structure, and employee competence. Using the classification of IC as

proposed by Sveiby (1997) after modifying the names of the categories of IC to internal capital, external

capital, and human capital, Guthrie and Petty (2000) examined the level of IC disclosure in Australia. The

IC reporting framework suggested by Guthrie and Petty (2000) has been followed by several authors in

many countries such as Brennan (2001) in Ireland; Bozzolan, Favotto and Ricceri, (2003) in Italy;

Vandemaele, Vergauwen and Smits, A. J. (2005) in Netherlands, Sweden and UK; Li et al. (2008) in UK;

and Yi and Davey (2010) in China.

Effectiveness Of Board Of Directors

The board of directors is one of the important elements in internal corporate governance mechanisms. The

board is a central institution in the internal governance of a company that provides the key monitoring

function in dealing with agency problems (Chobpichien et al., 2008; Lefort & Urzúa, 2008; Singh & Van

der Zahn, 2008; Aktaruddin, Hossain, Hossain &Yao, 2009). Fama and Jensen (1983) argued that by

exercising its power to monitor and control the management, the board of directors can reduce agency

conflicts as managers may have their own preferences and may not always act on behalf of the

shareholders. Moreover, arguably, the board of directors plays an important role in protecting the interests

of various stakeholders against management’s self-interests. Similarly, Hermalin and Weisbach (2003)

suggested that the board of directors should provide solutions to solve the problems faced by modern

companies.


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Akhtaruddin et al. (2009) and Singh and Van der Zahn (2008) have suggested that the enhancement in

board of directors in terms of board size, board composition, and leadership structure could improve

board effectiveness and its capacity to monitor the management and thus increasing the possibility of

providing more voluntary information to outside investors. Previous studies (Chobpichien et al., 2008;

Goh, 2009) suggested that independence, size, frequency of board meetings, and non-duality of the chief

executive officer (CEO) are the important factors that determine the effectiveness of board that forces

management to disclose more information to outside parties. Cerbioni and Parbonetti (2007) suggested

that a small board chaired by an independent director and composed of a majority of independent

directors playing an active role on the audit, nomination, and compensation are important in improving

the overall quality of corporate voluntary disclosure. These elements, if present, would enhance the

monitoring role of board of directors. However, it has been suggested that the optimal combination of

these mechanisms can be considered better to reduce the agency cost and to protect the interest of all

shareholders because the effectiveness of corporate governance is achieved via different channels (Cai et

al., 2008) and the effectiveness of a particular mechanism depends on the effectiveness of others (Davis

& Useem, 2002). According to Chobpichien et al. (2008) and Ward et al. (2009), it is important to look at

corporate mechanisms as a bundle of mechanisms to protect shareholder interests and not in isolation

from each other; this is because these governance mechanisms act in a complementary or substitutable

fashion (Chobpichien et al., 2008). This is in addition to Hill (1999) who posited that it is desirable to

have a system of overlapping checks and balances, and that none of the mechanisms of accountability is a

panacea to all the problems faced by companies. This study suggests that when characters that enhance

the effectiveness of board of directors increase, the level of IC disclosure also increases. Thus, based on

the arguments above, this study expects a positive relationship between the level of effectiveness of board

of directors and IC disclosure.

Information Asymmetry

According to Jensen and Meckling (1976) and Fama and Jensen (1983), outside directors are perceived as

tools to protect the shareholders’ interest through monitoring managerial opportunism and enhancing the

level of disclosure that reduces agency risk (Bhojraj & Sengupta, 2003). Moreover, McNulty, Roberts and

Stiles (2002) argued that outside directors are always less informed regarding company operations as

compared to their executive colleagues due to their notable operating distance from management. Due to

this reason, the outside directors are incapable of spending enough time with the executive colleagues and

consequently suffer form information asymmetry by providing the outside directors with incomplete

control (Mace, 1971). Hill (1995) further expounded on the issue by stating that non-executive control is

hampered through information asymmetry manipulated by management. This problem could escalate if

the company is manned by large shareholders who have selfish agendas that are contrary to the outside

shareholders’ agendas, which consequently disallow the executive to provide more information to the

outside directors (Fan & Wong, 2002). Thus, information asymmetry is often mentioned to be a prime

indicator in management hegemony theory and is also considered to be a core determinant of double

agency theory. Its presence in the company generally hinders non-executive members from gathering

necessary information on management activities e.g. information needed by the non-executive members

for performance evaluation. So, OCED (2009) suggested to policy makers in GCC to allow outside

directors to easily obtain information that they need in order to make the board governance effective in

protecting all shareholders.

From the discussion above, it can be said that one of the reasons for the mixed results obtained by

previous studies on the relationship between the effectiveness of board of directors and voluntary

disclosure (Gul & Leung, 2004; Ho & Wong, 2001; Patelli & Prencip, 2007; Li, et al., 2008) is

information asymmetry. It is an indicator of entrenchment of management; the lower information, the

lower the entrenchment of management. This would allow non-executives to participate in making

decision and in controlling the management. With a high degree of information asymmetry, entrenchment

of management will increase and managers play a significant role in the decision making while non-

executives would not able to control managers because they do not have sufficient knowledge about the

firm or the power delegated to them by shareholders is actually exercised by the management (Demb &

Neubaeuer, 1992).

Based on hegemony theory, information asymmetry is one of the mechanisms for management control

that influences the effectiveness of board of directors (Yang et al., 2004). This study proposes that, as the

level of information asymmetry increases, the ability of board of directors to enforce the management IC


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disclosure decreases. Therefore, in line with hegemony theory, the greater the level of information

asymmetry, the weaker the positive effect that effectiveness of board of directors has on IC disclosure.

Research Method

Sample

This study used secondary data on all listed banks in GCC Stock Exchange. The listed banks were chosen

for this study because of their greater commitment and exposure to investors in respect of mandatory and

voluntary reporting than unlisted banks. The samples in this study must have the following criteria:

1. The banks published their annual report between 2008 and 2010 in their website.

2. The annual report was accessible and it contained complete information needed.

Based on the criteria above, 137 banks listed in GCC were chosen.

Measurements Of Variables

Dependent variable: IC disclosure

To preserve the comparability of this study with previous ones, categories of IC captured were based on

the index developed in a recent study by Zaman Khan and Ali (2010) (see Appendix A). The reasons for

adopting Zaman Khan and Ali’s framework are: First, they developed their framework based on Sveiby’s

framework, which has later been modified by Guthrie and Petty (2000). Guthrie and Petty’s framework

has been adopted and employed by other studies (e.g. Bozzolan et al., 2003; Vandemaele et al., 2005)

with varying degrees of similarity. Zaman Khan and Ali’s framework is more or less the same with

Brennan (2001), April, Bosmaand Deglon. (2003), Goh and Lim (2004), Abeysekera Guthrie (2005), and

Campbell and Abdul Rahman (2010). Second, Zaman Khan and Ali’s framework was applied on banking

sectors. As a result, only those items consistently identified as relevant and were likely to be disclosed by

banks were included. Zaman Khan and Ali have removed some items from Sveiby’s framework on the

grounds that these would be better reported within the internal management reports of banks and the fact

that IC disclosure is new phenomenon in the banking sector.

To measure IC disclosure, this study employed content analysis, which was also used in previous studies

on IC disclosure (Guthrie, Petty, & Yongvanich, 2004; Li et al., 2008). This is because content analysis

allows repeatability and valid inferences from data according to the context (Krippendorf, 1980). To aid

consistency of scoring, the study instrument was completed by one researcher. However, this raised

questions about reliability of the scores (Gray, Kouhy, & Lavers, 1995). Therefore, to increase reliability

of the scores, this study used the steps2 applied by Milne and Adler (1999) and Guthrie, Cuganesan, &

Ward, (2008).

Independent variables

This study followed the direction of prior studies (e.g. Hanlon, Rajgopal, & Shevlin, 2003; Brown &

Caylor, 2006; Farook & Lanis, 2007; Chobpichien et al., 2008; Singh & Van der Zahn 2008) and used a

composite governance score to measure the effectiveness of board of directors. The score is a composite

measure that sums the value of the five dichotomous characteristics of the board to create a bank-specific

summary measure of the effectiveness of board of directors that takes a score bounding by 0-1, revealing

that a higher score is an indicator of a higher effectiveness of the board of directors. The five binary

characteristics that are included in this measurement are board independence, board’s committees, board

size, board meeting, and CEO duality, ranging from 0-5. Consistent with prior studies, this study viewed

smaller, more independent boards that have higher frequency of meetings and are not chaired by the CEO

2 Following Milne and Adler (1999) and Guthrie et al. (2008), this study used the following steps in order to increase reliability and validity in recording and analysing the data. First, the disclosure categories were adopted from well-grounded, relevant literature i.e., Zaman Khan and Ali (2010) who adapted their framework from well-grounded, relevant literature i.e., Sveiby (1997) and Guthrie and Petty (2000). Second, the sentence was selected as the measurement unit to increase the validity of the content analysis (Milne & Adler, 1999). Third, the coder underwent a sufficient period of training, and pilot study was conducted in order to reach an acceptable level of the reliability of the coding decisions (Guthrie et al., 2008).


130

as effective boards. For each of the components (except for non-duality and number of board

committees), this study calculated the sample median. The value of one for high quality indicators was

assigned (i.e., companies below the sample median for board size and above the sample median for

percentage of independent directors and frequency of meetings). We then summed these values, plus the

score of one for non-duality and also one for board with at least three committees.

Moderator variable: Information asymmetry

Information asymmetry is an indicator of entrenchment of management; lower information is lower

entrenchment of management, which allows non-executives to participate in making decision and

controlling management (Mace, 1971). According to Shleifer and Vishny (1997), the increase in the

concentration of ownership leads to the increase in the entrenchment of management. This is because

owner has strong voting power to appoint someone he or she trusts to be CEO, directors and/or board

chairman (Shleifer & Vishny 1988). Management entrenchment gives members, who act as the

controlling shareholders, the right to extract benefits from the firm at the cost of minority shareholders

(Shleifer &Vishny, 1997; Chrisman, Chua, Sharma, 2005). For example, Attig,Fong,Gadhoum and Lang

(2006) hypothesised that large wedge between controlling rights and cash flow rights can increase the

likelihood of selfish behaviour of those who are in control. The controlling shareholders can do so by

reducing or delaying the information availability so that other shareholders cannot interfere. The

withholding information can also make the monitoring conducted by the board of directors less effective

(Filatotchev, Lien and Piesse 2005; Chen & Nowland, 2010) due to the outside directors are always less

informed regarding company operations.

Glosten & Milgrom (1985) argued that when there are chances of extracting private benefits, the problem

of information asymmetry becomes severe. So, when the percentage of minority shareholder in company

increases, the chances of extracting private benefits will decrease and the problem of information

asymmetry will not be severe (Bruggen, Vergauwen & Dao., 2009). In this case, the entrenchment of

management will therefore decrease, thus the board of directors is able to control the management.

Following Bruggen et al. (2009), this study used the percentage of minority ownership as proxy of

information asymmetry. That means that the increase in the minority ownership in bank leads to the

decrease information asymmetry and thus the board of directors is able to control the management.

Control variables

The study used firm size, profitability, and leverage that were used widely as control variables in the

empirical literature of corporate governance. The measurement used for firm size was natural logarithm

of total asset (Al-Shammari & Al-Sultan, 2010). Profitability was measured as the ratio of net income,

before extraordinary items, to the total assets (Al-Shammari & Al-Sultan, 2010). Following Chahine &

Tame (2009) and Al-Shammari & Al-Sultan (2010), this study measured firm leverage by dividing the

total of liabilities by the total of assets.

Statistical Analysis

Hierarchical regression analysis was used to test the effect of effectiveness of board of directors and

moderating effects3 of information asymmetry on IC disclosure (Cohen & Cohen, 2003). We used control

variables in the first hierarchical step. After using the control variables, we used effectiveness of board of

directors in the second step to examine the relative direct contribution of the effectiveness of board of

3 According to Aiken and West(1991), to detect moderator effects, interaction terms must be created. The interaction term is the product of multiplying the predictor variable with the moderator variable. So, interaction term raises concerns about the multicollinearity problem between interaction terms with their component terms. To avoid this problem, the predictor and moderator variables were standardized (Frazier et al., 2004; Aguinis et al., 2008). Standardizing (i.e., z scoring) also makes it easier to interpret the effects of the predictor and moderator and help to provide a meaningful interpretation (Frazier et al., 2004; Aguinis et al., 2008). After interaction terms have been created, everything should be in place to structure a hierarchical multiple regression equation using SPSS to test for moderator effects. To do this, variables are entered into the regression equation through a series of specified blocks or step. The steps used were in accordance to the suggestion by Baron and Kenny (1986) and Frazier et al. (2004).


131

directors. Moderator variable was then used in the third step. The two-way interaction terms were used in

the final regression model.

Empirical Result Descriptive Analysis

In Table 1, the Panel A presents the descriptive statistics of IC disclosure, in overall and categories. With

regards to overall of IC disclosure, the Panel A in Table 1 shows that the average number of IC disclosure

is 86.72. The maximum value is 175 sentences and the minimum value is 17 sentences. In respect to IC

disclosure categories, the Panel A in Table 1 shows that the banks provided slightly greater number of

information about internal capital at average of 47.83 than both external capital and human capital

disclosures, which scored 31.72 and 14.37, respectively. This result is consistent with prior studies (e.g.

Bozzolan et al., 2003; Brennan, 2001; Ali, Khan, & Fatima, 2008; Striukova, Unerman & Guthrie ,2008).

In Panel B of Table 1, the summary of the descriptive statistics for the independent, moderator, and

control variables is presented.

The panel shows that the average score of the effectiveness of board of directors is 2.53. The maximum

value is 5 and the minimum value is 0. With regards to ownership structure, the percentage of information

asymmetry ranges from 0 to 85% with an average value of 38%. In terms of control variables, the Panel B

in Table 1 shows that the log of total asset varies with a minimum value of 7.36 and a maximum value of

10.89. The samples had an average leverage level of 72% and a ROA of 2%. The negative sign in the

ROA implies that some of the banks experienced a loss during the investigation period.

Table 1. Descriptive statistics for the variables of study

Variable Minimum Maximum Mean Std.

Deviation

Panel A

Overall IC Disclosure

Internal capital

17.00

10.00

175.00

140.00

86.72

47.83

35.21

24.76

External capital 6.00 75.00 31.72 16.81

Human capital 0.00 46.00 14.37 12.51

Panel B

Effectiveness of board of directors

0.00

5.00

2.53

1.06

Information asymmetry 0.00 0.85 0.38 0.20

ROA -0.06 0.10 0.02 0.02

Leverage 0.10 0.91 0.72 0.19

Log of total asset 7.36 10.89 9.81 0.67

Regression Results

As shown in Table 2, when the bank size, leverage and ROA are used as control variables into regression

model in the first step, the coefficient of determination adjusted (R2) was found to be 0.23, indicating that

0.23 of the level of IC disclosure can be explained by the bank size, leverage, and ROA.

Table 2 also shows that by adding independent variable in Step 2, the adjusted R2 increases to 0.26. This

R2 change (0.03) is significant. This implies that the additional of 3 percent of variation in IC disclosure

can be explained by the effectiveness of board of directors. The effectiveness of board of directors was

found to have significant and positive relationship with IC disclosure at 0.05 the level of significance.

These results support the argument that says that there is a positive relationship between the effectiveness

of board of directors and IC disclosure. The moderator variables were introduced in the Step 3. However,

there is no significant F change. This result indicates that there is no major effect from the moderator

variables on dependent variable. In the final step, when the interaction was used, the adjusted R2 increases

from 0.26 to 0.31. This R2 change (0.05) is significant. This indicates that information asymmetry

moderates the relationship between the effectiveness of board of directors and IC disclosure. In more


132

specific words, the results suggest that, as information asymmetry decreases (i.e., the percentage of

minority shareholder increases in the bank), the positive relationship between the effectiveness of board

of directors and IC disclosure increases.

Table 2. Results of hierarchical regression analysis

Step 1 Step2 Step 3 Step 4

LEV 0.41** 0.40** 0.40** 0.36**

BSIZE 0.16* 0.16* 0.16* 0.12**

ROA

EFFBOD

IA

EFFBOD x IA

R2

0.01

0.23

0.02

0.17**

0.26

0.02

0.05

0.05

0.26

0.01

0.09

0.06

0.25**

0.31

Adjusted R2 0.21 0.24 0.24 0.28

R2 change 0.23 0.03 0.00 0.05

F change 12.0 4.80 0.04 8.70

Sig of F change 0.00 0.03 0.94 0.00

*, **, *** = p-value < .10, .05, .01, respectively, one-tailed

where:

ROA = Return on assets, LEV = Leverage, BSIZE = Bank size, EFFBOD = Effectiveness of board of directors, IA =

Information asymmetry.

Figure 1 illustrates the moderating effect of information asymmetry (percentage of minority shareholder)

on the relationship between the effectiveness of board of directors and IC disclosure. It appears from the

figure that lower information asymmetry (higher minority shareholder) is associated with higher IC

disclosure. When the level of the effectiveness of board of directors is low, the level of IC disclosure is

low in banks with high and low information asymmetry. However, when the level of the effectiveness of

board of directors is high, the level of IC disclosure is higher in banks with low information asymmetry

(higher percentage of minority shareholder) than in banks with high information asymmetry (percentage

of minority shareholder).

Figure 1. Moderating effect of information assymetry

Discussion And Conclusions Drawing on the argument that says that corporate governance should be looked as a bundle and not

individually, this study suggests that the increase of the characters that enhance the effectiveness of board


133

of directors leads to the increase in the level of voluntary disclosure, and vice versa. On the other hand,

the increase of the characters that reduce the effectiveness of board of directors leads to the decrease in

the level of voluntary disclosure. In addition, this is based on the hegemony theory and the arguments that

the intensity of board of directors’ monitoring to reduce the conflict between the majority and minority of

shareholders is affected by information asymmetry (Boone et al., 2007; Linck et al., 2008). This is

because, according to hegemony theory, the board of directors’ monitoring is limited internally through

information asymmetry directed by the management; this study suggests that information asymmetry

moderates the relationship between the effectiveness of board of directors and IC disclosure.

There are several important findings revealed in this study. First, this study finds that as the level of the

effectiveness of board of directors increases (particularly the increase in the characters that enhance the

board’s monitoring), the level of IC disclosure in banks’ annual reports also increases. This result

supports the agency theory and the idea that the impact of internal corporate governance mechanisms on

corporate disclosure is complementary.

Second, this study finds that information asymmetry moderates the relationship between the effectiveness

of board of directors and IC disclosure. This means that, as the level information asymmetry increases,

the relationship between the effectiveness of board of directors and IC disclosure decreases. This finding

supports the hegemony theory and the idea that the information asymmetry makes the monitoring

conducted by the board of directors less effective.

This study has a number of limitations that might warrant future research. This study can be considered

exploratory in nature, and further works are needed in specific areas to improve it. First, the dimension of

the sample could be increased by analysing more companies and/or for a longer period of time. Moreover,

the samples used in this paper only involve the GCC-listed banks. Empirical evidence would take

advantage of the test of the hypotheses for different type of firms (i.e., in other sectors) or for the same

type of firms but in different context (i.e., other Arab countries or Asia). Second, this study did not

examine the effect of the variable legal enforcement on IC disclosure due to the low legal protection of

investor rights and legal enforcement in all the GCC. Legal protection of investor rights has been argued

to have an effect on voluntary disclosure policies on intellectual capital. Thus, future researches should

retest these hypotheses in different legal protection setting.

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Appendix A: IC framework adopted for the study

Internal capital External capital Human capital

Patent

Copyright

Corporate culture

Management philosophy

Management and

technological process

Information system

networking system

Financial relations

Customers

Banks’ market share

Business

collaboration

Franchising Licensing

Banks’ reputation for services

Bank name

Training

Employees’ educational

qualification

Work related Knowledge

Work related Competencies

Know how

.Entrepreneurial spirit


138

PERCEPTIONS OF ORGANISATIONAL READINESS FOR THE PERFORMANCE MANAGEMENT SYSTEM: A CASE

STUDY OF A UNIVERSITY OF TECHNOLOGY

Bethuel Sibongiseni Ngcamu*

Abstract

The absence of a single performance management system (PMS) aligned to institutional strategy and business processes often results in failure to deliver anticipated benefits as it is not cascaded down to all departments, teams or individuals. This study aims to determine employees’ expectations for the proposed PMS and their perceptions of the system’s impact on effectiveness within the university concerned. This study adopted a quantitative research design and a survey method was used, whereby, a structured questionnaire was administered by the researcher to a selected population size of 150 of which 108 completed questionnaires, generating a response rate of 72%. The study reflects a disproportionately high percentage of 34% of the respondents who disagreed and 21.3% who were undecided as to whether PMS is needed at the university concerned where the majority of these respondents being academics and those with matriculation. The university concerned should develop a PMS which is aligned to the university strategic plan and to other university policies coupled with structured change management interventions focusing on academics and semi-skilled employees. Keywords: Performance Management System, Rewards Strategies, Effectiveness, Academics * Mangosuthu University of Technology, South Africa

Introduction

At South African universities, performance management (PM) systems are more or less obsolete due to

the fact that employees’s job descriptions are not aligned to departmental and university objectives. The

failure of the system is exacerbated by factors such as approved strategic objectives that are not cascaded

down to the level of employees, unfair and unequal systems on which remuneration and reward is based

(Burney, Henle & Widener, 2009; Chan, 2004), absence of continual feedback (Matunhu & Matunhu,

2008: 11), inadequate internal communication, and unrealistic expectations in terms of rewards (Brennan

& Shah, 2000). However, a number of commentators, especially those within the education sector, regard

this managerialistic approach to performance appraisal as unwarranted, counter productive (Scholtes,

1999) and unworkable and unacceptable in knowledge-based organisations (Simon, 2001: 91). Other

authors describe it as antithetical to a self-governing community of professionals, an infringement of

academic freedom, based on a top-down approach to research and teaching which severely restricts

creativity and self-development, or a covert means of introducing greater governmental control of the

Higher Education and Further Education sectors and increasing the remuneration of those who work in

them (Barry, Chandler & Clark, 2001; Holly & Olivier, 2000; Henson, 1994; and Townley, 1990).

This study intends to answer whether the respondents perceive PMS as having an impact on the

effectiveness within the university concerned as well as to whether expectations will be clarified and

feedback provided on the employees performance. Whilst, the chief objectives of this study were to

determine the perceptions of employees on the impact of PMS on bringing the effectiveness, clarified

expectations and providing feedback to employees on performance. Meanwhile, there is a paucity of

published data on the perceptions of employees in universities on their expectations and impact of PMS in

bringing effectiveness before the system being implemented. This study will add value to the body of

knowledge in the South African universities as human resources managers will understand what factors

they must take into consideration when planning and implementing PMS.


139

Theoretical Approach

Employees’ expectations and feedback on PMS

Failure to link job descriptions to departmental strategic plans and those of the institution lead to

weaknesses and under-performance as a job description clearly describes expectations and desired

performance required of an employee. Furthermore, unclear understanding of roles and responsibilities

between the line manager and the subordinate tends to cause animosity. As Fullan & Scott (2009: 37)

pinpoint another angle on the misalignment problem: the failure of individual position descriptions,

performance plans, accountability, and reward and staff development systems to focus on the capabilities

and priorities for effective delivery, the quality of day-to-day delivery in research and teaching, and the

implementation of key quality improvements.

Hypothesis1: PMS is necessary as it will impact on clarified expectations and performance feedback

given to employees within the university concerned.

Hence, universities’ strategic plans are not cascaded to tactical and operational levels and are further

separated from the strategic management environment, which makes it difficult for the perfomance

indicators and targets to be achieved. Smith & Cronje (1992: 115) define the strategy as the formulation

of an organisation’s vision and mission, and subsequent actions to achieve the vision and mission.

Therefore, performance plans are expected to emanate from the university’s approved strategic plan.

Minnaar (2010: 54) maintains that performance plans are not a list of projects, but that they are directly

related to the institutional mandate and must contain activities required to maintain present levels of

service rendering, as well as those that aim to expand the current scope of services, usually through

project interventions. Employees have expectations based on objectives which they perceive should be set

out in such a way that they are specific, measurable, achievable, relevant and time-bound (SMART), so

that both line manager and employee can determine how the employee is performing.

For an employee to achieve the agreed SMART and deliverable objectives, the competencies should be

identified and recorded in the form of the Personal Development Plans (PDPs). Armstrong (2001: 191)

asserts that both parties in the PM process will also need guidance and training in the use of

competencies, the preparation of performance agreements and plans, the preparation for and conducting

of perfomance reviews, ratings and the completion of review forms. Bernthal, Rogers & Smith (2003)

contend that PM programs also provide a unique mechanism for ongoing feedback and development, a

critical component of engagement. After setting goals together, managers and employees can track

progress and ensure that performance stays in alignment with goals and changing work conditions.

Continuous feedback facilitates performance by helping employees to refocus their behaviour when they

get off track. During performance reviews, managers can provide more specific feedback relative to goals

to help employees identify strengths and areas for development. In this way, new performance goals can

be set to leverage employee strengths and provide opportunities to address developmental or career goals.

Armstrong (2001: 191) believes that some of the skills and procedures, such as providing feedback,

coaching, counselling and rating will be practised by managers so that subordinates are fully aware of the

expected duties and responsibilities.

Impact of PMS on effectiveness

There is little evidence that PMS can accomplish organisational/team/individual objectives, which in turn

can make a positive contribution to organisational effectiveness, as there is little clarity about what

practices make a PMS effective in universities. There are objectives that need to be accomplished by

organisations, which include motivating performance, helping individuals to develop their competencies

(Maybodi, 2010:83), building a performance culture (Cameron & Quinn, 1999), determining who should

be promoted, eliminating individuals who are poor performers and helping implement organisational

strategies. Edward (2003) indicates that virtually every organisation has a PMS that is expected to

accomplish a number of important objectives with respect to human capital management and further

development.

Hypothesis2: PMS is necessary as it will impact on effectiveness within the university concerned.


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Effective feedback based on agreed and understoond objectives and job requirements, specific to agreed

objectives, accurate, relevant, balanced, alternative and timely solutions enable the implementation of the

PMS to go smoothly. Edward (2003: 3) reveals considerable research which shows that PM effectiveness

increases when there is ongoing feedback, behaviour-based measurements are used and trained raters are

employed. However, there is one potential determinant of PMS effectiveness, that has received relatively

little attention: how closely the results of the PMS are tied to significant rewards. Whilst, different

empirical studies have been conducted on job satisfaction and its link to rewards (Probst & Brubaker,

2001), rewards as a tool to promote effectiveness of employees (Hinkin & Schriesheim, 2004) and

enhancing participation and effective commitment (Travaglione & Marshal, 2006).

Some studies have highlighted the important role played by a PMS, claiming that it converts human

performance into dollar values (Bernthal, Rogers & Smith, 2003), increases productivity (Houston, 2000),

and improves organisational culture (Rose, Kumar, Abdullar & Ling, 2008). Armstrong (2001: 5)

maintains that PM embraces all formal and informal measures adopted by an organisation to increase

corporate, team and individual effectiveness, and to continuously develop knowledge, skill and

competence. The main aim of this empirical study was to gauge the perceptions of employees on the

impact of the system on effectiveness, expectations clarifications and feedback on PMS outcome.

Research Approach

The present study is based on the quantitative research design, whereby descriptive statistics, namely

measures of central tendency and measures of dispersion, were used to describe the distribution of scores

on each variable and to determine whether the scores on different variables are related to each other. In

this study, a survey research method was adopted which addressed the dimensions of the PMS in terms of

its impact on effectiveness, expectations and feedback within the university concerned. The primary and

secondary data was utilised to elicit information on the PMS.

In addition, factor analysis was used in this empirical study with the aim of establishing whether four (4)

measures do, in fact, measure the same thing. Hence, principle component analysis was used as the

extraction method, and the rotation method was Varimax with Kaizer Normalisation.

Research method

Research participants and sampling procedure

This quantitative study adopted a stratified random sampling and the university employees were identified

as the total population. Underhill and Bradfield (1998) confirm that stratification is useful when the

population is composite in nature, and can be divided into sub-populations that are distinct in

characteristics of interest.

The employees of the university concerned were divided into three categories, namely, academic,

academic support and administration support. A structured questionnaire was administered by the

researcher to a population size of 150 as per Sekeran’s (1992) recommended population size. Of the

selected scientific sample, 108 completed the questionnaire generating a response rate of 72% which was

used for the final analysis of this study.

There were 50% males and females respectively who responded, wherein, 64.4% were between the ages

of 25-44 years. Of this 21.3% (23) were females who were between 25-34 years. Nearly half of the

respondents (47.2) had postgraduate qualifications. It was observed that by gender, there were no

significant differences (male-24.1%) and (female-23.1%) in the number of respondents having the same

qualification. Nearly 15% (14.8%) of the respondents had a postgraduate degree were between the ages of

25-34 years. Of the sample 25.9% (28) were academics, 22.2% (24) academic support and 51.9% were

administration support. Most 64.8% were at non-management level, 15.7% at junior management, 14.8%

at middle management and 4.6% at senior management. Of all the senior managers, 40% had a tenure for

at least 20 years. Half of this (20%) was for Academic Managers and the other half for Administration

Support Managers. Amongst the description for job type, Administration Support Managers comprised

25% of the respondents. When looking at tenure, this group made up 50% of the respondents.


141

Two major aspects of precision (reliability and validity) were used in this study to ensure that the

researcher used the appropriate instrument to produce consistent results. The sampling approach was

considered relevant because this study is empirical and its aim is to assess the expectations of employees

and examine the employees’ perceptions on the perceived impact of PMS on effectiveness thereof. The

questionnaire was piloted to ten employees with the aim of identifying any errors, as well as testing the

perceived validity and reliability of the questionnaire.

Measuring instruments

A self-developed structured questionnaire using a five-point Likert scale was developed to assess the key

dimensions of PMS (current perceptions on the impact on effectiveness and current expectations for the

PMS. The five-point scale ranging from (1) strongly disagree, (2) disagree, (3) undecided, (4) agree to (5)

strongly agree, was used. The Likert scale was used as it enables certain arithmetical operations to be

performed on the data collected from the respondents and it also measures the magnitude of the

differences among the individuals. The questionnaire the researcher developed for this study consisted of

three sections. Section A contained biographical data about age, gender, education, tenure, job type and

current job level. Section B (10 sub-dimensions) aimed to gauge employee’s perceptions on their

expectation and the perceived impact of the PMS at the university concerned. An example of a sampled

sub-dimension was ‘PMS is needed in my organisation’. An example of the response scale was ‘the

disporportionately high percentage of 34.3% who disagreed, 21.3% who were undecided and 44.4% who

agreed that PMS is needed in this organisation.

Section C contained 8 sub-dimensions aimed to identify employee’s perceptions on the PMS impact on

effectiveness. Overall, 78% of the respondents agreed with the sub-dimensions on average, with 5%

disagreeing. The first four sub-dimensions showed higher levels of agreement than the remaining four.

Even though the percentage disagreeing did not vary much, the levels of uncertainty pertaining to the last

four sub-dimensions was approximately double those of the first four.

Research procedure

This study used a structured questionnaire which was administered by the researcher to a population size

of 150 within the university concerned.

Empirical Findings

Statistical analysis

The data collected from the respondents was analysed using Predictive Analytic Software (PASW)

Statistics version 18.0 for data capturing, presentation, analysis and interpretation. Descriptive and

inferential statistics were used for data analysis and interpretation. Inferential statistics in the form of

Pearson Correlation Matrix was used in this study to indicate the direction, strength and significance of

the bivariate relationship among the sub-dimensions of the PMS. In addition, the psychometric properties

of the questionnaire were statistically assessed using Factor Analysis and Cronbach’s Coefficient Alpha

(www.ats.ucla.ed/stat/SAS/notes2).

Results

Descriptive and inferential statistics were used to analyse the data. The results will be presented in the

form of a table and narratively. Reliability was computed by taking several measurements on the same

subjects, the Cronbach’s Alpha values for individual dimensions were high and a reliability coefficient of

0.70 or higher is considered as “acceptable” (www.ats.ucla.ed/stat/SAS/notes 2). As far as the PMS

dimensions are concerned, current expectations for the PMS (Alpha = 0.834) and current perceptions of

the PMS impact on effectiveness (Alpha = 0.907). The overall reliability score of Alpha = 0.8715

indicates a high degree of acceptable, consistent scoring for the different categories of this study.

Descriptive statistics

The respondents were required to respond to the terms of the leading statements of the key dimensions of

the study using a 1 to 5 Likert scale.


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The study findings indicate that the mean score values indicate that employees have different views on

the sub-dimensions of the PMS, which is in descending level based on mean scores, which are as follows:

Current perceptions on the PMS impact on effectiveness (Mean = 4.0694).

Current expectations for the PMS (Mean = 3.9204).

The mean score values displayed in Table 1 reflect that on a scale from 1 to 5, the respondents were

between 4.0694 and 3.9204. This indicates that a high proportion of employees ranged from agree to

undecided on statements relating to each dimension. These averages reflect the current status quo at the

university concerned as there are transformational and cultural changes taking place, as well as the fear of

the unknown as the PMS is regarded as a threat more especially to academics in terms of their freedom

and autonomy.

Table 1. Descriptive statistics – key dimensions of PMS

Statistic

Current expectations for the

PMS

Current perceptions on the

PMS impact on effectiveness

Mean 3.9204 4.0694

Median 4.0000 4.1250

Standard. Deviation .63552 .69025

Variance .404 .476

Minimum 2.00 1.00

Maximum 5.00 5.00

Inferential statistics

Inferential statistics were computed to make decisions with regard to the hypothesis of the study.

Hypothesis 1: There is a significant difference in the perceptions of employees varying in the impact of

PMS on effectiveness regarding th other dimension (current expectations for the PMS) at the 1% level of

significant. Hence, alternative hypothesis may be rejected.

Hypothesis 2: There is a significant intercorrelations in the perceptions of employees varying in the PMS

expactations, clarifications and feedback regarding the other dimension of the study (current perceptions

on the PMS impact on effectiveness).

The p-value of 0.000 is less than the level of significance of 0.05. This implies that there is a statistically

significant difference between the number of respondents who agreed with the statement and those who

disagreed.

Current expectations of the PMS

A frequency analysis was conducted and the findings of the study revealed that 34.3% of the respondents

disagreed and 21.3% were undecided that PMS is needed within the university concerned. There was a

disproportionately high percentage of 36% amongst the academics, of whom disagreed and 18% of whom

were undecided about the need for the PMS, which strongly contradicts the 34% of the administration

staff who disagreed, 18% who were undecided and 48% who agreed. Almost 60% of senior management

were undecided that the system is needed in this institution and 40% agreed. The study results show that

55% of employees with degrees and 49% with postgraduate qualifications agreed that PMS is needed,

compared to 25% with matriculation who disagreed and 50% who were undecided. Meanwhile, 6.5% of

respondents disagreed and 25.0% were undecided that performance plans will be aligned to the university

objectives. It is also noted that 74.1% of respondents have a definite view regarding the question of

whether PMS will further and support organisational culture change, while 5.6% disagreed and 20.4%

were undecided that PMS will improve interpersonal relations. With regard to non-monetary rewards,

11.1% disagreed and 27.8% were undecided that the system will provide this type of reward. However,

72% of the academics agreed that PMS will provide non-monetary rewards, compared to the 58% of the

administration staff.


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Current perceptions of the PMS’s impact on effectiveness

Under the ambit of the current perceptions of the impact of the PMS on effectiveness, a frequency

analysis was undertaken, showing that 7.4% of respondents disagreed and 25.0% were undecided that

PMS expectations will be clarified and individual performance feedback will be based on mutual

understanding. Whereas, 10.2% disagreed and 24.4% were undecided that there would be an open

dialogue between evaluators and those evaluated. On the other hand, 64% of the administration staff

agreed that there would be an open dialogue between evaluators and those evaluated compared to 46% of

academic support staff who agreed. Furthermore, 7.4% of the respondents disagreed and 21.3% were

undecided that line managers will provide guidance. A total of 16.7% of respondents were undecided that

employees will be measured according to the functions as stated in their job descriptions.

Discussion

Having reviewed the literature in the previous sections of this article, and statistically presented and

analysed the findings of the perception study on the PMS within the university concerned, a discourse is

essential to determine the correlation between the literature and research findings. The descriptive

statistical results show an average mean value of 4, indicating that there is a need for consideration and

improvement for the dimensions of PMS. This in turn reflects negatively to each of the dimensions of the

employee readiness survey on the PMS within the university concerned. Such discrepancies require

strategic and change management interventions to convert employees who are undecided to be the

ambassadors of the PMS throughout its phases. The high proportion of respondents who either disagreed

or were undecided means that there is a need for an improvement plan focusing on communication and

change management. There is a general tendency of agreement with the statements that constitute this

sub-dimension. The average disagreement score is 17% and the disproportionately high percentage

(55.6%) of the respondents who were undecided requires a serious investigation into the respondents’s

uncertainty about the need for the PMS at the university concerned.

Current expectations for the PMS

Even though there is not much conclusive or empirical evidence on resistance to the application of PMS

to institutions of higher learning, such perceptions may emanate from the previous failed initiatives of

PMS projects at the well established and well resourced universities, as well as poor knowledge and

understanding of the PMS’s impact and benefits to organisations. The observations in this study are

reminiscent of studies by Cameron & Quin (1999) and Rose, Kumar & Ling (2008), who examine the

positive relationship between good organisational culture and performance.

The high percentage of academics who disagreed that there is a need for PMS at the university concerned

reflects the dissatisfaction level of this specific group, who often complain about being overloaded and

who may also perceive the PMS as potentially increasing their workload. Gillespie et al. (2001) concur

with this finding, suggesting that contributing factors to the rise in workload include a decline in staff

numbers, an increase in student numbers, the changing nature of students, and unrealistic deadlines. Since

at the university concerned there are no agreed upon workload norms and agreements to determine the

level of the workload, another way of ensuring fair and equitable norms is through the implementation of

the PMS. Furthermore, the disproportionately high percentage of the respondents who possess

matriculation who disagreed and were undecided about the latter sub-dimension is a reflection of semi-

literate employees who lack understanding and knowledge of the PMS in general and its benefits as

highlighted in the literature above. This finding is in agreement with Mweemba & Malan’s (2009: 8)

assertion that the role of education should be emphasized in organisations where employees’ basic

education is at a lower level. Furthermore, the higher percentage of senior management who were both

undecided and who also disagreed that there is a need for PMS at this institution contradicts a study

conducted by Bernthal, Rogers & Smith (2003) which states that effective PMSs are characterised by the

involvement of senior management.

The literature has reflected various types of perfomance rewards which are both monetary and non-

monetary, whilst the findings of this study reveal that 27.8% of the respondents were undecided with

regard to non-monetary rewards. Different authors and successful organisations have learnt that money is

not the only compensation strategy to fulfil the needs of employees (see Harte, 1995: 8; Hinkin &

Schriesheim, 2004 and Scott-Ladd, Travaglione & Marshall, 2006: 406). The fact that 44% of


144

respondents agreed that PMS is needed shows that there was a difference of only 10% between the

number of respondents who disagreed than those who agreed. However, an average of the current

expectations for the PMS, shows that there is a general tendency of agreement with the statements that

constitute this category. On average, 71% of the respondents agreed with the latter dimensions. Hence,

the average disagreement score was 17%.

Current perceptions of the PMS’s impact on effectiveness

The mean scores were calculated on the perceptions of employees on the PMS’s impact on effectiveness,

resulting in a mean score value of 4 for this dimension. This dimension indicates a high mean score value

which shows that the respondents are in favour of the impact of the PMS on effectiveness. Thus, this

study supports the findings of Edward (2003: 3) that performance effectiveness increases when there is

ongoing feedback. Such findings have been confirmed by the present research findings indicating that

67.6% agreed with this sub-dimension even though there is a high percentage of respondents who were

undecided, which leaves significant room for improvement.

This study produced certain findings which were not consistent with previous studies. These include the

highly disproportionate 65.7% of respondents who agreed that there would be an open dialogue between

evaluators and those evaluated. On the other hand, the high percentage of 24% of the respondents who

were undecided requires further consideration and attention to building trust by ensuring the impartiality

and transparency of this system.

Futhermore, 71.3% agreed on the role the line managers will play during the duration of the project,

which confirms the findings of authors such as Armstrong (2001: 191), who discussed the role to be

played by managers in the PMS process. Much room of improvement is indicated for the sub-dimension

that employees will be measured against job descriptions, because, while 78.7% agreed, the fact that

16.7% were undecided and 4.6% disagreed raises serious concerns which are confirmed by Fullan &

Scott (2009: 37).

Due to the fact that there is paucity of published literature on the perceptions of employees in the

universities on the employees expectations and the impact of PMS on effectiveness. This study could

enlighten human resourcces managers to be prepared when planning and implementing the PMS and to

customise it in such a way that it mitigates any aforesaid negative perceptions and uncertainty which

might transpire at any stage of the system.

Recommendations

Various authors have acknowledged that it is impossible to have a single intergrated PMS that can

accomodate all type of organisations. However, it is possible that, even under the diverse circumstances

presented above, certain principles, as recommended below, do indeed prevail:

The university should devise a customised PMS including policy and procedures that accomodates

all job categories.

The line managers at the university concerned should be trained in the use of the entire PMS in order

to provide ongoing feedback to the rated employees with development plans to those who are not

achieving to minimum standards.

The university should improve organisational culture through organisational development

interventions, including change management coupled with trainings to all employees and put more

emphasis on the academics and semi-skilled in order to enable the system to be implemented

smoothly.

The university should implement both financial and non-financial reward systems which would

attract, motivate and retain quality employees.

Employees key performance management areas (KPAs) should emanate from the departmental

strategic plans which are also aligned to the approved university strategic plan.

Conclusion

This study argues that PMS is one of the tools instrumental in improving organisational effectiveness

associated with equal pay for equal value, promote accountability, collegiality and improve the


145

competencies of employees. It seems, though, that poor consultation with key stakeholders, poor and lack

of shared understanding of the system, unequal workload distribution and rewards, unrealistic objectives,

absence of lobbying and advocacy strategies and unaccustomised system to the institution, perpetuate the

failure of the system, especially in South African universities.

This study concludes that in order to implement a developmental and all-inclusive PMS, a flexible PMS

need to be designed in order to accomodate all employees at different job and education levels.

Furthermore, this article recommends that in order for the PMS to improve effectiveness amongst

employees, well crafted departmental strategic plans aligned to the organisational strategy, and that roles

and responsibilities as well as job descriptions need to be clearly defined and in place, thus responding

effectively to the departmental and university objectives.

A noteworthy finding of this study is that the majority of the respondents either disagreed or were

undecided about the need of the PMS, which creates a never-ending search for the factors underpinning

their perceptions. The final point made in this study is the role that should be played by line managers,

which is crucial since the responses indicate a perception of poor employee-employer relationships

emanating from a lack of trust. This article contributes to the discussion of PMS strategies and models

that should be taken into consideration by universities in planning and implementing PMS. In addition,

the main limitation of this study is the fact that it only focussed on the quantitative research design, hence,

future research can be intertwine both quantitative and qualitative for triangulation purposes which could

yield reliable findings. Furthermore, future research is essential on the academics and to semi-literate

employees with the view to establish a customised PMS that could accomodate their levels of reasoning

and nature of work.

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INTERNAL CORPORATE GOVERNANCE MECHANISMS AND AUDIT REPORT LAG: A STUDY OF MALAYSIAN

LISTED COMPANIES

Ummi Junaidda Binti Hashim*, Rashidah Binti Abdul Rahman**

Abstract

This study attempts to investigate the link between corporate governance mechanisms and audit report lag for companies listed on Bursa Malaysia from 2007 to 2009. The 288 companies listed on Bursa Malaysia have been randomly selected. The corporate governance mechanisms examined include the board of directors and audit committee. It shows that there are significant negative relationships between board diligence, audit committee independence and expertise. The higher the number of meetings being held indicates that the board is discharging their role towards the company. The results show that audit committee independence and audit committee expertise could assist in reducing audit report lag among companies in Malaysia. Its provide some evidence supporting the resource based theory, whereby characteristics of the audit committee, such as the resources and capabilities, could improve companies’ performance as well as corporate reporting.However, it could not provide any evidence concerning the link between board independence, board expertise, CEO duality and audit committee diligence on audit report lag. This study provides comprehensive examination of ARL on Malaysian listed companies for three years period. It is consider the initial study to provide a thorough examination of the association between corporate governance characteristics and ARL. Keywords: Audit Report Lag, Corporate Governance, Board Of Director, Audit Committee, Malaysia * Accounting Lecturer, Universiti Sultan Zainal Abidin Terengganu, Malaysia ** Accounting Professor, Universiti Teknologi Mara Shah Alam, Malaysia

Introduction

Timeliness of the reporting is one of the important attributes in the financial market. Financial reporting

will provide users with quality information that could assist them in the decision-making process as

investors of companies, particularly, as users rely on the audited financial reports in their assessment and

evaluation of companies’ performance. Audited financial reports will increase reliability and users will

feel confident concerning the reports verified by the auditors and would be able to make decisions wisely

(FASB, Concepts Statement 2).

Effectiveness and efficiency often represents quality information. Efficiency in the context of quality

information frequently refers to timeliness concerning the reporting delay from the company’s accounting

year end to the date that the audit report is completed (Chambers and Penman, 1984).4

The setback of not achieving timeliness in reporting the financial statements of a company would cause

all the information to lose its relevancy. Such a setback may motivate users to seek information about the

company from other sources, which is likely to expose any unpleasant reports relating to the company.

Consequently, users, particularly investors, would likely postpone their transaction on shares, either

purchase or sales, until the report on earnings is announced (Beaver, 1968). This argument is supported

by Ashton et al., (1987), who identified that a delay in releasing financial statements would increase

4 Other than ‘timeliness’, the term ‘audit report lag’ and ‘audit delay’ also represent efficiency. These terms are used interchangeably in this study.


148

uncertainty concerning investment decisions. Therefore, the success in submitting financial statements on

time would provide greater benefits to the company.

In Malaysia, Bursa Malaysia5 demands timely financial reporting through the provision of Chapter 2 and

Chapter 9 of the Listing Requirements (2009), Bursa Malaysia Securities Berhad. The Bursa Malaysia

Listing Requirements under chapter 9.23 (a) provide that a public listed company must submit its annual

report to Bursa Malaysia within six months of the company’s year end. To prevent companies from late

submission of their audited financial reports, Bursa Malaysia, in consultation with the Securities

Commission, has imposed a penalty on public listed companies for failure to disclose the material facts

such as the annual report within the time frame. In spite of the requirement, the current scenario often

pictures the inability of Malaysian companies in submitting their audited financial reports on time to

Bursa Malaysia (www.bursamalaysia.com).

Many professional and regulatory bodies have taken various actions to identify the factors that hinder

companies in delaying the submission of their financial reports. Among the factors identified are those

that relate to the internal control system of a company (Abdul Rahman and Salim, 2010). Charles River

Associates (2005) stated that increased attention to the internal control system could enhance the

reliability of financial statements. Internal control is important in enhancing the corporate governance of a

company.

The board of directors is recognised as one of the most important mechanisms for corporate governance

in implementing internal control (Beasley, 1996). The board of directors also affects the composition and

structure of the audit committee (AC) (Menon and Williams, 1994), which indirectly influences the

timeliness of financial reporting. This argument is consistent with the notation by the Securities Exchange

Commission (SEC) and Securities Commission (SC), which state that the audit committee is an important

element of corporate governance in ensuring the quality of financial reporting.

Bursa Malaysia highlighted that directors and the audit committee play a significant role in the company

to ensure the fulfilment of the objectives of Bursa Malaysia concerning timely reporting and,

consequently, address corporate governance concern. The Bursa Malaysia Listing Requirements were

revised in August 2009 to strengthen the rules in order to become more effective. The revised

requirements specify that one third of the members on the board must be independent directors, and place

a restriction on the number of directorships – not more than 25 directorships at one time. Out of the 25

directorships, 10 positions should be within public listed companies and 15 positions in non-listed

companies.

In respect of the audit committee, it provides that the members of the audit committee must not be less

than three persons, all members must be non-executive directors, the majority of whom should be

independent directors, and at least one member must be a member of the Malaysian Institute of

Accountants (MIA). If none of the members of the audit committee are members of the MIA, one

member must have at least three years working experience.

The Malaysian Government also recommended the Malaysian Code on Corporate Governance, which

was established in 2000, and was later revised in 2007. The revised code recommends that members on

the board of directors should have skills, knowledge, expertise, experience, professionalism and integrity.

Concerning the audit committee, the code proposes that to strengthen the role of audit committees, all the

members of that committee should be non-executive directors, and be able to read, analyse and interpret

financial statements. This is to ensure that they would be able to effectively discharge their functions.

Therefore, the existence of good corporate governance would be able to facilitate the work of external

auditors in completing the audited financial report and reduce the delay in reporting.

This study aims to answer the following research question: “Could the board of directors and audit

committee play an important role in effectively monitoring the timeliness of the audit report?”Thus, the

current paper examines whether the existence of the board of directors and audit committee could assist in

reducing audit report lag. Such examination is important since the audit literature has identified the role of

the board of directors and audit committee in reviewing the financial statement.

5 Bursa Malaysia was previously known as Kuala Lumpur Stock Exchange.


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Previous studies have proposed that corporate governance is an important determinant to ensure the

success of a company in various aspects such as companies’ performance, financial reporting quality,

corporate failure, audit quality, environmental reporting, and earnings management. Afify (2009) and

Tauringana et al., (2008) examined the impact of corporate governance mechanisms on audit report lag.

Both studies were conducted in a non-Malaysian setting.

Within the Malaysian context, studies have examined the issue of timeliness using firm specific variables

(Ahmad and Kamarudin, 2003; Che-Ahmad and Abidin, 2008). Furthermore, past studies have provided

investigation concerningthe issue of corporate governance in association with companies’ performance

(Mohd Ghazali, 2010), financial reporting quality (Ismail et al., 2008), corporate failure (Hsu and Wu,

2010), audit quality (Wan Abdullah et al., 2008), environmental reporting (Said et al., 2009) and earnings

management (Abdul Rahman and Mohamed Ali, 2006). However, these studies did not examine

corporate governance mechanisms in relation to audit report lag. Thus, the current study extends the

corporate governance literature by examining the issue of the timeliness of annual reports in the

Malaysian market by incorporating corporate governance, and firm specific variables in relation to audit

report lag.

This study contributes to the corporate governance and audit literature by examining the association of

corporate governance: board of directors, audit committee and the audit report lag. The findings of the

study would have policy implications for the Malaysian Code on Corporate Governance (MCCG). It

provides supporting evidence concerning whether the development of corporate governance could

significantly increase the timeliness of annual reports among companies in Malaysia. This study could

assist the Malaysian Institute of Corporate Governance (MICG) to provide best practice in order to

enhance corporate governance mechanisms. The findings could also assist external auditors in evaluating

the effectiveness of the board of directors and audit committee in their audit planning. Such assistance

would assist the external auditors in identifying the best time to be allocated for their audit engagements

in terms of effort, such as whether to reduce or increase effort and the amount of fees to be charged.

The remainder of the paper is organised as follows. The following section highlights the literature review

and hypotheses development relating to audit report lag, board of directors and audit committee. The third

section describes the research design of the current study and follows with the results. Lastly, this paper

provides the conclusion, limitations and future research avenues of the study.

Literature review and Hypotheses Development

Within the corporate governance mechanisms, the board of directors and audit committee play an

important role in the monitoring process as well as concerning the reporting role in companies. Bursa

Malaysia has outlined the appointment requirements for members being appointed on the board of

directors and audit committee. Such requirements would ensure that monitoring targets are achievable

since expert members would be able to clarify matters relating to the company. Consequently, these

members would reduce auditors’ task complexity and improve the timeliness. Therefore, arguably, the

board of directors and audit committee would be able to reduce the audit report lag. This is because the

appointment of the directors and audit committee are in line with the agency theory where agents act on

behalf of principles in ensuring the company is performing well and provides quality annual reporting.

From the perspective of the resource based theory, ability, qualification, and experience of the board of

directors and audit committee are among the other vital resources that the company possesses in

enhancing its performance.

This study has developed seven hypotheses in meeting the objective of this study, which are related to the

characteristics of the board of directors and audit committee.

a) Board independence

An effective board of directors is an important mechanism of internal governance in managing an

organisation (Che Haat et al., 2008). Resolving the agency problem would be more effective when the

boards comprise independent directors. Weir et al., (2002) found that boards of directors consisting

wholly of inside directors would not be adequate to monitor the company, and, in certain cases, such

structure would merely worsen the agency problem. A number of studies have argued that the

effectiveness of the board would increase when more non-executive directors are on the board of directors


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(Ho and Williams, 2003; Weir et al., 2002). For example: Beasley and Petroni (2001) investigated the

association between board composition and the choice of auditors of 681 property-liability insurance

companies. They found that boards of directors with a higher proportion of independent directors would

have a greater tendency to employ specialised brand name auditors (high quality auditor) than board of

directors with a lower percentage of independent directors. This characteristic of board of directors also

ensures greater assurance concerning financial reporting (Carcello et al., 2002). O’Sullivan, (2000) and

Salleh et al., (2006) also found that a proportion of non-executive directors had a positive impact on audit

quality. The authors stated that non-executive directors exert pressure to have a proper and intensive

audit.

It is anticipated that an increase of non-executive directors on the board of directors also improves audit

quality. This occurs when boards with independent directors provide more independent monitoring, and,

as a result, increase financial reporting quality and also the quality of the audit. Board independence with

financial expertise is related to a more transparent disclosure of the company’s performance (Felo, 2009).

They might require more audit effort than the usual amount of effort being expended, which would

eventuate to an increase in audit quality and, consequently, reduce audit report lag. Therefore, this leads

to the first hypothesis developed in this study.

H1: There is a negative relationship between board independence and audit report lag.

b) Board diligence

One method that can be used to assess whether the board members play their roles in representing the

shareholders is by examining the activities of the board. The activities of the board would reflect the

board’s commitment in discharging its role as an agent for the company (Jensen and Meckling, 1976).

The board of directors is expected to have a firm grip on the company’s internal control processes and

heighten their vigilance in identifying, addressing and managing risks that may have a material impact on

the financial statements and operations of the company (Corporate Governance Guide p.10, Bursa

Malaysia).

A diligent board of directors would be more concerned with the financial reporting aspects of the

company. Lipton and Lorsch (1992), and Conger et al., (1998) provide support that boards of directors

that meet frequently are more likely to discharge their duties well. This indicates a good internal control

mechanism. A board of directors in a company that has more frequent meetings would allow the board

members to discuss identified problems, which leads to the superior performance of the company (Evans

and Weir, 1995). Tauringana et al., (2008) found a significant negative relationship between the

frequency of board meeting and the timeliness of the annual report for companies listed on the Nairobi

Stock Exchange (NSE) in Kenya. This indicates that companies that hold frequent meetings publish their

annual reports earlier, increase the company’s performance and is evidence of an effective corporate

governance mechanism.

The most recent guide on corporate governance by Bursa Malaysia highlights that a typical board of

directors would hold a minimum of 6 to 8 board meetings annually. More frequent meetings would

enable the auditors to rely more on the strong internal control of the companies and reduce their

workload. Consequently, this would lead to a decrease in the audit report lag. Therefore, this study

hypothesizes that:

H2: There is a negative relationship between board diligence and audit report lag.

c) Board Expertise

Cross directorships or multiple directorships are also known as “interlocking directors”. This occurs when

a director sits on several boards (Haniffa and Cooke, 2000). Directors that hold cross directorships could

offer their valuable insights based on their experience from being on the board of another company

(Dahya et al., 1996). The number of additional directorships could reflect a director’s prominent

reputation and ability in effective monitoring of the companies (Beasley, 1996). Carcello et al., (2002)

examined the board characteristics and audit fees and found that boards with multiple directorships are

more supportive in looking for high quality auditors. Their results show that the boards are more careful

in discharging their duties. Consistent with the resource based theory, the internal resources that the


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company owns may aid the company to be more prosperous or outperform other companies. The

resources that the company possesses are the skills, experience and knowledge of the board of directors.

This, in turn, would produce higher quality and more reliable financial reporting, and would also lead to a

reduction in the auditors’ workload due to their heavy reliance on the high quality and reliable financial

reporting, and, consequently, reduce audit report lag. Therefore, the third hypothesis is developed.

H3: There is a negative relationship between board expertise and audit report lag.

d) CEO Duality

As discussed in agency and organisational economics theories, the interests of the owners would be

sacrificed to a degree in favour of management when a CEO holds the dual role of chair. This action

would create managerial opportunism and agency loss since power and authority are concentrated in one

person. The position of CEO Duality would not act in the best interests of the shareholders. The person

who engages both roles would be reluctant to reveal unfavourable information to outsiders, specifically,

the shareholders of the company. Forker (1992) affirms that a dominant individuality in both roles causes

threat to the monitoring quality. Donaldson and Davies (1991, p. 50) state that “where the chief executive

officer is chair of the board of directors, the impartiality of the board is compromised”. Auditors may face

greater risk of audit failure when the roles of the chairman and chief executive are combined (Peel and

Clatworthy, 2001). This is because there is a higher possibility for concealment or misstatement of

relevant facts and even fraud to be perpetrated. Therefore, CEO duality could influence the auditors’

assessment of the control risk and audit risk, audit hours and the level of substantive testing increase. The

characteristics of CEO duality are not associated with the companies’ performance (Abdul Rahman and

Mohamed Ali, 2006; Mohd Ghazali, 2010). In contrast, Afify (2009) found that CEO duality significantly

affects audit report lag whereby the duality of roles imposes a threat for them to monitor the company in

an effective manner and, thus, increase the audit report lag. Therefore, this study hypothesizes that a lack

of impartiality of the board would increase the audit report lag.

H4: There is a positive relationship between CEO duality and audit report lag.

e) Audit committee independence

Agency theory highlights that the independent members on the audit committee could help the principals

to monitor the agents’ activities and reduce benefits from withholding information. Audit committees

with more independent directors are considered as being a more reliable group than the board of directors

in monitoring the company. The effective role provided by the audit committee would be appropriate to

represent the rights and privileges for all stakeholders.

Audit committee independence would enhance the effectiveness of the monitoring function, as it serves as

a reinforcing agent to the independence of internal and external auditors in a company. Audit committees

must be comprised entirely of independent directors in order to be more effective, as posited by Menon

and Williams (1994).Klein (2002) shows that independent audit committees reduce the likelihood of

earnings management, thus, improving transparency. Carcello et al., (2000) found that audit committee

independence has a positive significant relationship with audit fees. This provides evidence that the

independence of the audit committee would lead to higher quality financial reports.

Ali Shah et al., (2009) found that companies in Pakistan are having good corporate governance through

having independent audit committees. In contrast, Ismail et al., (2008) found that the independence of the

audit committee would not influence the quality reporting of the companies. They argue that this is due to

the companies only fulfilling the requirements, rather than the impact of the requirements.

The MCCG (2007) and the Bursa Malaysia Listing Requirements (2009) emphasize that the audit

committee might institute stronger internal control and good monitoring of the financial reporting process

in a company. The strong internal control managed by the audit committee would lead to auditors

reducing their work on the company’s accounts because of their reliance on the internal control of the

company. Consequently, this would lead to a decrease in audit delay. Thus, the fifth hypothesis is

developed.

H5: There is a negative relationship between audit committee independence and audit report lag.


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f) Audit Committee Diligence

The audit committee is an integral part of a company that emphasises high level monitoring (Dechow et

al., 1996). Moreover, the monitoring function would be more effective in terms of financial reporting.

Activities conducted by audit committee members, such as meetings, are considered as an important tool

in ensuring they are fulfilling their responsibilities towards the company. Ismail et al., (2008) measure

audit committee diligence based on the actual number of audit committee meetings held in a year. Audit

committees must carry out activities effectively through increased frequency of meetings in order to

maintain their control functions (Bedard et al., 2004). Abbott et al., (2000) in their examination found that

audit committees that meet at least twice annually are subjected to less exposure of sanction by the

authorities. This is because the conducting of regular meetings would indicate that the audit committee

discharges their duties in an appropriate manner as an agent for the company. They also noted that audit

committees that are wholly independent are also active by way of having meetings.

The American Bar Association posits that an audit committee that holds less than two meetings annually

is considered as being uncommitted to its duties. This indicates that the audit committee is unable to

contribute to the internal control in that situation. Auditors who really monitor the internal control

function of the company would reduce their works. However, Ismail et al., (2008) found that the

frequency of audit committee meetings does not influence the quality of reporting of the companies. They

argue that this is because the companies are only fulfilling the requirements, rather than the impact of the

requirements.

Another study, done by Razman and Iskandar (2004), found that Malaysian companies that have good

reporting meet more frequently than poor reporting companies. This is because, during the meeting, they

can monitor the management activities. Consequently, this will lead to a decrease in the time taken for

auditing by the auditors and reduce the reporting lag. Therefore, this study developed the following

hypothesis.

Ha6: There is a negative relationship between audit committee diligence and audit report lag.

g) Audit Committee Expertise

Audit committee expertise is important in order to deal effectively with external auditors. Audit

committees typically act as the mediator between the management and the auditors. Members of audit

committees with experience in financial reporting and auditing, especially those who are CPAs would

understand the auditors’ tasks and responsibilities (De Zoort et al., 2003). They would become more

supportive of the auditors compared to audit committee members who do not have similar experience.

Audit committee members who are experts are more ‘friendly’ with the auditors, and comprehensible,

logical and coherent when they are discussing with the auditors regarding the financial reporting of the

company.

Audit committees with more expertise would be more concerned about the financial reporting quality of

the company. DeZoort (1998) contends that an audit committee with more internal control experience

makes decisions or judgments similar to auditors compared to those audit committee members who are

without experience. This reflects that experience in the accounting, internal control or auditing is

fundamental to enable the audit committee to understand and address problematic issues concerning the

financial reporting system of the company. They would also realise the benefits to the market of

producing financial statements on time.

Audit committees with financial expertise are also identified that they are going to facilitate each other.

This characteristic of audit committees shows as the resources and capabilities that the company has, as

discussed in resource based theory. Capabilities are the expertise that the audit committee possess, which

may assist in improving the performance of the firm.

Listed companies in Malaysia will frequently end up with a good financial report when members of the

audit committee are financially literate (Razman and Iskandar, 2004). This is because audit committees

who have knowledge in accounting and auditing are able to demonstrate their ability in monitoring the

internal control and reporting. Strong internal control would also lead to the auditors reducing their work

because of their reliance on the credibility of the internal control. Therefore, the following hypothesis is

developed:


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Ha7: There is a negative relationship between audit committee expertise and audit report lag.

Research design

The 288 companies listed on Bursa Malaysia have been randomly selected in this study involving

financial years 2007 to 2009.This period is chosen in order to increase the reliability and accuracy of the

results in this study. The listed companies are selected because they are governed by the rules and

regulations imposed by MCCG and the Bursa Malaysia Listing Requirements. However, listed companies

from the Banking and Financial Institution Act 1989 are excluded, because they are heavily regulated and

the governance structure is determined by Bank Negara Malaysia. Table 1 shows the number of

companies selected from various sectors.

Table 1. Total number of companies and sample based on industry

Industry Population Sample of companies Percent

Construction 49 19 7

Consumer 139 53 18

Hotel 5 2 1

Industrial 265 88 30

Infrastructure 7 3 1

Property 88 31 11

Plantation 43 16 6

Technology 29 12 4

Trading & services 181 64 22

TOTAL 806 288 100

There are seven variables that describe the characteristics of boards of directors and audit committees

while another three variables describe the control variables. These variables are defined in Table 2.

Table 2. Variables Measurements

Variable Measurement

Dependent

ARL

(Audit report lag)

Represents the number of days elapsing between the end of the fiscal year of the

company to the completion of the audit for the current year for each individual firm

(the audit report date).

Independent

BDINDs

(board independence)

The proportion of non-executive directors to total number of directors is the number

of non-executive directors on the board divided by the total number of directors on the

board at the year-end.

BDMEET

(Board meeting/diligence)

Number of board meetings for the financial year.

BDEXP

(Board

experience/expertise)

Number of multiple directorships by non-executive directors to the total number of

non-executive directors.

DUAL

(CEO duality)

DUAL = ‘1’ if CEO is the chairman and ’0’ otherwise.

ACIND

(AC independence)

Percentage of non-executive directors to the total of audit committee members.

ACMEET

(AC meeting diligence)

Number of audit committee meetings.

ACEXP

(AC experience/expertise)

No of audit committee members with background experience in financial reporting

(such as MIA, MICPA) to the total of audit committee members.

Control

SIZE (Company size)

Natural log of year end total assets.

AUDIT TYPE

(Type of audit firm)

Dummy variable, ‘1’ if auditor is one of the former Big-4 audit firms, ‘0’ otherwise.

PROF

(Profitability)

PROF = Return on assets, measured by net income divided by total assets.


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Results Descriptive statistics

Table 3 below presents the descriptive statistics of the variables used. Overall, it shows that companies

have improved over the years concerning the number of days taken to complete the audited financial

statement although results from previous studies are at variance with these findings. Che-Ahmad and

Abidin (2008) found it took442 days while Ahmad and Kamarudin (2003) reveal that 273 days was the

maximum number of days to complete the annual report. The current study is similar to Afify (2009) who

found that the maximum and mean score number of days to complete the annual report was 115 days and

67 days, respectively.

Table 3. Descriptive Statistics for Audit Report Lag (N= 288)

Year N Minimum Maximum Mean Median

2007 ARL 288 40.00 184.00 103.14 110.50

2008 ARL 288 40.00 146.00 103.42 111.00

2009 ARL 288 36.00 136.00 102.46 110.00

2007- 2009 ARL 864 36.00 184.00 103.00 111.00

Notes: ARL = number of days between the end of the fiscal year to the date of completion of audit

Table 4. Number of companies and audit report lag for 2007 – 2009

Audit report lag

ARL(within)

No. of

companies

No. of

companies

No. of

companies

Year / percentage 2007 Percen

t

2008 Percen

t

2009 Percen

t

1 month (30 days) 0 0.00 0 0.00 0 0.00

2 months (60days) 22 7.64 20 6.94 25 8.68

3 months (90days) 42 14.58 41 14.24 41 14.24

4 months (120days) 198 68.75 211 73.26 208 72.22

5 months (150days) 25 8.68 16 5.56 14 4.86

6 months (180days) 0 0.00 0 0.00 0 0.00

More than 180days 1 0.35 0 0.00 0 0.00

Total 288 100 288 100 288 100

Table 4 shows the movements on audit report lag from year 2007 until 2009. For the three-year period,

no companies completed or submitted their annual report within a month. Year 2008 shows the least

number of companies submitting their annual report within two months, followed by 22 companies in

2007 and 25 companies in 2009. The results also show 41 to 42 companies have completed and submitted

their annual report within three months.

The results show that most companies completed and submitted their audited reports much earlier than

the deadline stipulated by Bursa Malaysia. Such results indicate that the companies are concerned and

realise that audited reports are useful for users’ decision-making. The results support the notion that

excessive delay in publishing financial statements would increase the uncertainty in relation to investment

decisions (Ashton et al., 1987; Ahmad and Kamarudin, 2003).

Table 5 provides the descriptive statistics for the board of directors and audit committees among the listed

companies. The mean score of the board independence (BODIND) is 0.63 (63 percent). The results show

that most companies have more than half independent directors on their board of directors. The results

show that, at minimum, independent directors represented 25 per cent of the board composition in the

companies, which is less than one third. The average number of board meetings (BODDIL) held was 5. In

table 5, the results also show that, on average, 71 percent of independent directors have interlocking

directorships. The results indicate that the management of the companies hold the belief that independent

directors who hold directorships in other companies could enhance the companies’ performance by


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providing vast experience and skills. In addition, on average, the results also show that slightly less than

half of the companies (41 percent) practice CEO duality where the CEO also holds the position of the

chairman.

Audit committee independence (ACIND) has a mean score of 0.93, which is 93 percent and a minimum

score of least 0.60 (60 percent) of their audit committee members being represented by independent

directors. The results also show that almost all the audit committees in the listed companies discharge

their duties appropriately with five meetings being held. The highest number of meetings held by the

audit committee during the three-year period was 12. The mean score of audit committee expertise

(ACEXP) is 0.4 (40 percent). Such results indicate that listed companies have audit committee members

with experience in financial reporting. Only 24 of the companies (2.78 percent) formed their audit

committee with members not having an accounting qualification.

Table 5. Descriptive statistics for Board of Directors, audit committee and control variables

Variable N Minimum Maximum Mean Median Std. Deviation

Independent

BODIND 864 0.25 1.00 0.63 0.63 0.17

BODDIL 864 1.00 13.00 5.00 5.00 1.51

BODEXP 864 0.00 1.00 0.71 0.75 0.29

CEODUAL 864 0.00 1.00 0.41 0.00 0.49

ACIND 864 0.60 1.00 0.93 1.00 0.18

ACDIL 864 1.00 12.00 4.84 5.00 1.67

ACEXP 864 0.00 1.00 0.40 0.33 0.19

Control

SIZE -TOTASSET

(RM BILLION) 864 9 -3 36.64 0.79 0.24 2.86

TYPEAUD 864 0 1 0.58 0.00 0.49

PROFITABILITY 864 -1.88 11.059 0.03 0.03 0.40

Notes:

BODIND = proportion of independent non-executive director to total number of directors

BODDIL = number of board meetings

BODEXP = average number of outside directorships in other firms held by outside directors

CEODUAL = 1 if CEO is the chairman and “0”otherwise

ACINDP = percentage of non-executive directors to the total of audit committee members

ACDIL = number of audit committee meetings

ACEXP = no of audit committee members with background experience in financial reporting

TOTASSET = total assets that the companies have at the end of the financial year.

TYPEAUD = ‘1’ if audited by Big-4, ‘0’ if otherwise

PROFITABILITY = net income divided by total assets

Correlation matrix analysis

Table 6 provides the results on the normality test. The results show a non-significant value (0.333),

which is more than 0.05, indicating data normality. Based on Kolmogorov-Smirnov and Shapiro Wilk

tests, this study concludes that audit report lag is normally distributed.

Table 6. Normality Test for Audit Report Lag

Kolmogorov-Smirnova Shapiro-Wilk

Statistic df Sig. Statistic df Sig.

NARL 0.034 864 0.021 0.998 864 0.333

a. Lilliefors Significance Correction


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The Pearson product moment correlation was used to determine the strength and direction of the

relationship between the independent variables and dependent variable. Table X presents the results of the

correlation matrix analysis. The results show no correlation problem among the variables since the value

is less than 0.5. The variance inflation factor (VIF) indicates that all variables have a value below two,

which is within the acceptable range of 10(M. Yasin et al., 2009).

Table 7. Correlation Matrix Table

ARL

BOD

DIL

BOD

IND

BOD

EXP

CEO

DUAL

AC

DIL

AC

IND

AC

EXP

Log_

Asset

TYPE

AUD ROA

ARL 1

BOD

DIL 0.036 1

BOD

IND -0.083

* 0.172

** 1

BOD

EXP -0.097

** -0.023 0.065 1

CEO

DUAL 0.093

** -0.111

** -0.279

** -0.144

** 1

AC

DIL 0.096

** 0.234

** 0.051 -0.002 0.069

* 1

AC

IND -0.068

* 0.043 0.215

** -0.002 -0.038 0.030 1

AC

EXP -0.019 0.075

* -0.068

* 0.020 0.112

** 0.022 0.013 1

LOG

_ASSET -0.170

** .0.178

** 0.156

** 0.128

** -0.097

** 0.093

** 0.078

* -0.003 1

TYPE

AUD -0.170

** 0.000 0.005 0.104

** -0.008 -0.088

** 0.010 -0.021 0.195

** 1

ROA -0.076* 0.013 0.016 -0.039 0.031 0.033 0.029 -0.032 -0.021 0.006 1

**Correlation is significant at the 0.01 level (2-tailed).* Correlation is significant at the 0.05 level (2-tailed)

Fixed Panel Regression

The current section presents the results of the fixed panel regression using Eviews. The panel data

analysis is an increasingly popular form of longitudinal data analysis among social and behavioural

science researchers (Hsiao, 2003). A panel is a cross-section or group of people who are surveyed

periodically over a given time period. In this study, the group is the listed companies selected and the

time is the duration of the data collected, which is the three-year period between2007 and2009. Since the

data is bound to be heterogeneous, the panel data technique could take such heterogeneity explicitly into

account by allowing individual specific variables (Gujarati, 2003). Normal regression does not adjust for

the firm’s specific effect, which would lead to variables being omitted and the model being mis-specified

(Fraser et al., 2005). The fixed effect model could overcome such problems by adjusting the effects

through the firm’s specific intercept by capturing the immeasurable firm’s specific characteristics (Fraser

et al., 2005). The panel data provides more informative data, variability and efficiency. Under the panel

data, the model is generated as follows:

ARL = 1BDINDs + 2BDMEET+ 3BDEXP +4DUAL+5ACINDP + 6ACMEET + 7ACEXP

+8SIZE+ 9AUDTYPE +10PROF+ ε it

The fixed panel regression result is shown in Table 8. It shows that board diligence (BODDIL), audit

committee independence (ACINDP) and audit committee expertise are significant at the 1% level. One of

the control variables, company size is also significant at the 1% level. Other variables –board


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independence, board expertise, CEO duality, profitability and type of auditor – do not have a significant

association with audit report lag.

Table 8. Fixed Panel Regression Result

Variable Coefficient Prob.

BODIND -0.025864 0.288

BODDIL -0.005616 0.001*

BODEXP -0.002881 0.205

CEODUAL 0.002235 0.863

ACIND -0.021706 0.001*

ACDIL -0.009835 0.899

ACEXP -0.040084 0.001*

LOG_ASSET -0.129782 0.012

ROA -0.002146 0.264

TYPEAUD 0.002535 0.294

C 5.786734 0.000

N 864

Adjusted R-squared 0.802562

F-statistic 12.811

Prob(F-statistic) 0.000

Notes:

BODIND = proportion of the non-executive directors divided by total number of directors

BODDIL = number of board meetings

BODEXP = average number of outside directorships in other firms held by outside directors

CEODUAL =‘1’ if CEO is the chairman, ‘0’ if otherwise

ACINDP = percentage of non-executive directors to the total of audit committee members

ACDIL = number of audit committee meetings

ACEXP = no of audit committee members with background experience in financial reporting

LOG_ASSET = natural log of total assets (in billions of ringgit Malaysia)

TYPEAUD = ‘1’ if audited by Big-4, ‘0’ if otherwise

ROA = net income divided by total assets

Adjusted R2 = adjusted R2 coefficient determination

F stat = indicate how much variation is explained by the regression equation.

*significant at 1%.

Discussion

There are seven hypotheses developed in this paper and three are accepted. The first hypothesis states that

there is a negative relationship between board independence and audit report lag. However, this study

could not provide any evidence concerning the association between board independence and audit report

lag. Therefore, Hypotheses one(H1) is rejected. This is consistent with Hsu and Wu (2010) who found no

association between board independence and corporate failure among companies listed on the London

Stock Exchange. Similar to Buniamin et al., (2008), they indicated that board independence could not

play an effective monitoring role in influencing financial reporting quality and, thus, is not effective in

resolving the agency problem.

The results of this study however, contradict with Afify (2009) who found that board independence could

reduce audit report lag. Similarly, Che Haat et al., (2008) found that internal governance mechanisms

could lead to significantly higher firm performance and Wan Abdullah et al., (2008) found that board

independence is one of the important factors for a company to perform effectively.

The results show that there is a significant association between the number of board meetings and audit

report lag. This indicates that a higher number of board meetings is more likely to reduce the audit report

lag of the companies. Therefore, the second hypothesis (H2) is accepted. The results of this study are

consistent with Tauringana et al., (2008) who found that there is a relationship between the number of

board meetings held and the timeliness of annual reports for companies listed on the Nairobi Stock

Exchange (NSE) in Kenya. The results indicate that companies that hold meetings more frequently tend

to publish their annual reports earlier; an evidence of an effective corporate governance mechanism. The


158

other study done by Carcello et al., (2002) found a relationship between board meetings and audit fees. A

higher number of meetings of the board of directors would likely address problems and, consequently,

would instigate the approval of releasing the annual report.

This study shows that there is no significant relationship between the number of independent

directorships with audit report lag. Therefore, hypothesis three(H3) is rejected. The results of this study

are consistent with Carcello et al., (2002) who found that there is no relationship between that variable for

a small sample of companies on audit fees. Similarly, Che Haat et al., (2008) also found no relationship

on the directorship of the directors in relation to the performance of the company. Such results are

consistent with Abdul Rahman and Salim (2010) who explain that too many directorships may impair the

level of independence among the directors and, consequently, affect the effectiveness in performing their

roles and responsibilities. This is consistent with resource dependency theory, which recognises the

importance of addressing the updating of sources of power and dependence and cataloguing the new set

of available tactics for managing dependence.

The last characteristic for board of directors is CEO duality. The results show that there is no significant

association between CEO duality and audit report lag. The results indicate that CEO duality did not

influence audit report lag, therefore, hypothesis four (H4) is rejected. The results of this study are in

contrast to the findings of Afify (2009) who found that CEO duality is significantly associated with audit

report lag in which CEO duality increases audit reporting lag.

As for the characteristics of audit committees, this study hypothesized that there is a negative relationship

between audit committee independence, diligence and expertise in relation to audit report lag. Upon the

analysis, it provides evidence to reject hypothesis six (H6) because there is no significant difference

between audit committee diligence and audit lag. However, the results support Ha5 and Ha7. Audit

committee independence and audit committee expertise may reduce audit report lag, however, audit

committee diligence could not influence audit report lag. The results are similar to the study by Klein

(2002) who found that more independent audit committee members would effectively influence financial

reporting quality.

This study supports the view that an audit committee with a simple majority of independent audit

committee members is more likely to fulfil its duties effectively compared to an audit committee with no

independent members. This is consistent with agency theory where independent members in an audit

committee could assist principals to monitor the agents’ activities and reduce benefits from withholding

information. They would provide more effective roles in monitoring the companies.

Increasing the number of financial experts on audit committees will reduce the incident of fraud (Farber,

2005). Those who have financial expertise demonstrate a high level of financial reporting knowledge and,

thus, are expected to lead the committee, and identify and ask knowledgeable questions that challenge

management and the external auditor (He et al., 2009).

Generally, it is believed that more meetings and discussion of the committee would improve the

performance of the company. However, similar to the study done by Uzun et al., (2004), the results in this

study show that the number of audit committee meetings held is not significantly associated with audit

report lag. More frequent meetings of the company does not necessarily provide better achievement of the

company. Thus, the company needs to ensure that audit committee members raise and try to resolve the

issues with management during the meeting, and, as a result, improve the quality of reporting.

Conclusion

This study provides empirical evidence that audit report lag has a significant negative relationship with

the number of board meetings (BODDIL), audit committee independence (ACINDP) and audit committee

expertise (ACEXP).

The characteristic of board meetings indicates that as the number of meetings increase, the time taken to

produce the annual report reduces. The findings of this study support the notion by Dalton and Daily

(1999) in that the monitoring role of the board is important in overseeing the process of accounting,

financial reporting, auditing and also concerning the disclosure of information to the shareholders,

potential investors and other relevant stakeholders for evaluation on company performance. When more


159

meetings are conducted, the board may discharge their duty properly regarding the monitoring function of

the company, consequently, increasing the quality of reporting of the company, particularly timeliness.

Based on this study, board independence is not found to bean influencing factor in reducing audit report

lag. The results indicate that board independence does not necessarily assist timely corporate reporting.

Of vital importance is that the board of directors needs to fulfil their role effectively and efficiently

regardless of whether they are independent directors or non-independent directors. This study could not

provide evidence that companies would have better performance even when they comply with the rules

provided by Bursa Malaysia Listing requirements concerning board composition. The results indicate that

there is a possibility that companies with one third of independent directors on the board are just in form

rather than substance. The authors also noted that the directors of listed companies also view that the

independent directors must be independent in mind whereby they have to understand the company

background, and strengths and weaknesses to ensure they are successful in carrying out their role for the

benefit of the company.

The characteristics of the board on board expertise do not significantly influence the reduction of audit

report lag. This is because of the different skills of the board expertise, which although useful in one

company may not be useful in another company. This study proposes that companies should have stricter

rules and criteria selection for their directors to ensure their monitoring role can be effectively discharged.

Furthermore, the results of this study also provide that CEO duality does not significantly influence audit

report lag. Carter and Lorsch, (2004) recommended that a leader needs to appoint independent directors

for companies that practice CEO duality. This study provides that audit committee independence and

audit committee expertise are important factors that affect the audit report lag of the companies. Thus, it

corresponds with the resource based theory where those characteristics of the audit committee, such as the

resources and capabilities, may improve companies’ performance as well as corporate reporting. These

two characteristics represent the Bursa Malaysia Listing Requirements, which require audit committees to

be composed of not fewer than three members, with the majority of them being independent directors,

and with at least one member of the audit committee possessing financial expertise. Audit committees

with these characteristics could assist the companies to be timely in their annual reporting.

This study did not find a significant association between audit committee meetings and audit report lag.

This suggests that audit committees could prioritise important things that need to be resolved during the

meeting in order to improve the performance of the company as well as in assuring audit report lag.

As an exploratory study of the Malaysian market in relation to corporate governance mechanisms

concerning audit report lag, this paper acknowledges a number of limitations. First, this study employs

only seven variables that are related to corporate governance. This study did not include other factors

such as government policy or political issues, which might also affect audit report lag. Additionally,

McGee (2007) noted that the influence of timeliness might be attributed to culture, or the political and

economic system of the country. Next, the findings of this study would be more accurate if the study

covered the entire population. This would provide greater generalization on the Malaysian listed

companies concerning audit report lag and corporate governance characteristics.

Examining other corporate governance variables such as corporate ownership in assuring audit report lag

of the companies is suggested for future research avenues. In addition, it would be interesting to examine

the link between corporate governance mechanisms to share price in relation to audit report lag. As well

as looking at the timeliness of annual reports, it is also important to examine the other reports such as the

interim and quarterly report since these reports are important in assessing company performance. In

addition, which parties are liable for the delay of the annual report –the preparers or auditors – can also be

explored.

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volume 8, issue 2, continued 1 2012[1]

Documents

journal corporate board

duties composition volume

fair view

financial statements

concept of true

auditors report

boards characteristics

single issues