The Relationship between Risk Management Committee Characteristics and Modified Audit Opinion in Malaysia

Suhaimi Ishak

Abstract

The purpose of the study is to examine the relationship between risk management committee (RMC) characteristics and modified audit opinion in Malaysia among the non-banking and financial companies listed in Bursa Malaysia. Data is collected from the annual reports of a sample of 300 companies for a period of 2004 until 2009. Both descriptive and multivariate analyses are employed to address the research objectives. The results indicate that separate RMC is negatively related with acceptance of modified audit opinion. Besides, the larger the size of RMC and the higher number of overlapping status for RMC’s members, it probably will higher the acceptance of modified audit opinion. Further, modified audit opinion that has been received at prior financial year is likely to receive the same opinion at current financial year. However, the status of auditor whether big or small firm is not related to modified audit opinion. The findings provide empirical evidence on the development and importance of RMC and its characteristics for the quality of companies’ financial reporting.

Keywords: risk management committee; risk; modified audit opinion; Malaysia

 

ntroduction

The global economic downturn has exposed the poor risk management practices of many companies and organization (Baker, 2011). At the Corporate Governance Week 2010 and 2011 which jointly hosted by Security Commission (SC) of Malaysia and Bursa Malaysia (BM), the both chairmen of these regulatory bodies stressed about the risk management process and board’s awareness on that process as a key element in the corporate governance practices in a company. The remark was pointed to the board as a key person in establishing and implementing well of risk management process in the company. The remark also is a signal to the board of director (BOD) to give more attention to the company’s risk management profile and the formation of committee at the board level that concentrate on the risk management profile is one of the good initiatives. Again, the deputy executive of SC at the ASEAN Audit Regulators Group Forum 2013 in Kuala Lumpur has stressed about the auditors to consider seriously when assessing the risks surrounding clients’ financial statements. Meanwhile, the objective of the study is to examine the relationship between the risk management committee’s characteristics (separate RMC, RMC size and RMC overlapping) and modified audit opinion issued by the auditors in Malaysia. We seek to ascertain whether RMC enhance the quality of financial reporting particularly on risk profile of the organization. We apply the modified auditor opinion as measure to the quality of financial reporting. In Malaysia, under the best practices in corporate governance of Malaysian Code on Corporate Governance (MCCG) (2007) and (2012) (Revised) clearly stated the board has principle responsibility for “identifying principal risks and ensuring the implementation of appropriate systems to manage these risks”. BOD has the responsibility in setting the strategies and creating the environment for effective risk management system in a company and the existence of RMC is a good step for the effective of the system (Yatim, 2010). The formation of RMC with focusing on the broad areas of risks including internal and external risks will help company in managing those risks without depending only on the audit committee. Some expertise on the company business’s external environmental are needed in RMC rather than depending on audit committee members which have expertise in internal control and accounting transactions. For example, RMC members with expertise on business opportunity and investment will evaluate the company’s viability in future and reducing the risks of going-concern. This situation will reduce the acceptance of modified audit report by the company. The job profile of RMC with focusing on broad areas of risks can reduce the exposure of risks by the company including the external risks such as going-concern risks and competition risks. Consequently, the probability of receiving the modified audit report particularly on risks issue is less due to the effective managing the risks exposure to the company. Theoretically, this situation creates a linkage between RMC and modified audit report and further on the quality of financial reporting.

To be an effective committee, RMC as a board committee should has the strong attributes whether in term of its composition (board size and director’s type), board process (frequency of meetings) and board characteristics (knowledge, skill, experiences, academic qualification, relevant training and multiple directorships). The strong composition of RMC, its process and characteristics is parallel with the argument in resource dependency theory. The theory as proposed by Preffer and Salancik (1978) argued that board (RMC) as a crucial resource to the organization and also acted as a bridge between organization and external link.

The formation of separate RMC is still voluntary in most countries in the world including Malaysia and the function of risk management sometimes is combined with Audit Committee (AC) or directly under the Board of Director (BOD) of the company (Subramaniam, McManus & Zhang, 2009). This study tries to relate whether the existence of separate RMC probably will reduce the issuance of modified audit opinion by auditor. Board size is prominently used in corporate governance studies (Dalton, Daily, Johnson & Ellstrand, 1999) and viewed as an important element of company’s governance quality (Musteen, Datta & Kemmerer, 2010). For the risk issues, the smaller board is expected to gain better oversight function due to the less difference of ideas and approaches. Ong and Wan (2008) argued that larger board may have conflicting in executing and maintaining the board effort norms as the oversight function. They may have conflicting among them for the monitoring and decision made. However, for the company’s business and industry risk oversight function, the vast knowledge and experiences of board’ members are needed (Dalton et al., 1999) and the knowledgeable and experienced directors would be gained through outside as the independent non-executive directors who are not involved with the company’s management function and duty. Some companies have limited members of BOD. The same directors might hold several positions as members of some sub-committee of BOD. The member of RMC might be a member of remuneration or audit committee and the overlapping of directorship by directors is view as the insight to the corporate governance mechanism (Zajac & Westphal, 1996).

The structure of this paper is as follows. The next section provides a brief review of past research and hypotheses development. Followed by research methodology section, analysis of result and discussion. The conclusion and recommendation is presented in last section.

Previous Research and Hypotheses Development

The study on the association between risk management committee’s characteristics and modified audit opinion remains scant and limited. However, some previous study have examined the relationship between board’s characteristics or audit committee composition and audit opinion (see Carcello & Neal, 2000; Farinha & Viana, 2009; Masyitoh & Adhariani, 2010; Wenyao & Qin, 2007; Pucheta-Martinez & Fuentes, 2007). The role of RMC in risk management is relatively unexplored and the literature on that field is limited and scant. Tufano (1996) added the lack of research in risk management committee was due to the lack of meaningful data on risk management practices. Again, Subramniam and Carey (2011) reported that the establishment of formalized system of risk management in organization is more recent development. The establishment of RMC is seen to be a complement to the oversight function of board of director and might be able to reduce the burden of task by audit committee. Zaman (2001) suggested it is impossible to expect the audit committee to implement more than high level review given their lack of expertise and time. It was also supported by Fields and Keys (2003) that RMCs have gained popularity as an important oversight committee. The argument is parallel with agency theory that RMC as a board committee should acted on behalf of the shareholders at all. Furthermore, Subramaniam et al. (2009) added that the existence of separate RMC with focusing on the risk profile was also able to increase the quality of internal monitoring in relation to risk management. Thus, the probability of the company to receive modified audit opinion is less and the first hypothesis is generated as follow:

H1:      The existence of separate or distinct RMC is negatively associated with the probability that the company will receive modified audit report.

A smaller board size is seem to be better for oversight responsibility to monitor financial reporting and related internal control (Farinha & Viana, 2009). However, in their study, the result showed the insignificant relationship between board size and the company to receive modified audit report. It means a board size seems to have no influence on modified opinion. The result is consistent with the earlier study by Wenyao and Qin (2007) which found insignificant relationship between board size and audit opinion and the characteristic of board size was irrelevant to the determinant of audit opinion issued. However, Xie, Davidson and Dadalt (2003) reported the negative relationship between board size and earning management activities. In term of accounting fraud, Beasley (1996) found a positive relationship between the number of board members and the occurrence of accounting fraud. In resource dependency perspective, Boyd (1990) argued that sometimes the small board size is due to the scarcity of resource or competitive uncertainty. The earlier study by Pucheta-Martinez and Fuentes (2007) found a positive relationship between the audit committee size and the company to receive qualified audit opinion. Therefore, the study suggests that RMC size can influence on the probability that modified audit report will be issued by the auditor. A smaller RMC size is better for directors’ monitoring functions and less probability that the auditor will issue modified audit report. This situation leads to the second hypothesis:

H2:      RMC size is positively associated with the probability that the company will receive modified audit report.

One director might be a member of twice or more boards’ committees. A member in the audit committee might be a member of RMC. The overlapping of directorship by directors is view as the insight to the corporate governance mechanism (Zajac & Westphal, 1996). Bettenhausen and Murnighan (1985) argued that the experience and knowledge from the other board membership can be brought to the other board committees and the focal and change can be performed. While Alderfer (1986) mentioned that the multiple board membership experience leads to the affecting board decision it is consistent with resource dependency perspective that board as resource in organization should has a pool of experiences. Most importantly and in agency view, several board membership experiences increased the board oversight control on behalf of shareholders (Mizruchi, 1992). The overlapping of members among boards’ committees gives advantages to the BOD entirely because all the committees are the board committee and not related to management function (Carcello & Neal, 2000). The result of each of committees is needed each other. The poor performance of a company is caused by the less directorship member of directors (Gilson, 1990) and the argument was supported by Kaplan and Reishus (1990) that the less directorship member by directors contribute to the emergence of financial distress company. Thus, the next hypothesis is as follow:

H3:      RMC overlap is negatively associated with the probability that the company will receive modified audit report.

 

 

Research Methodology

We use the logistic regression analysis to examine the relationship between modified audit opinion and the variables proposed for the characteristics of RMC. The model used to test the hypotheses is as follows:

MA= β0 + β1 SEPRMC + β2 RMCSIZE + β3 RMCOVER + β4 PRAUREP + β5 BIG4 + ε

where :-

 

 

Variable Definition and Measurement

According to Aren et al. (2009) there are five types of audit reports, namely standard unqualified or clean audit report, unqualified with explanatory paragraph or modified wording, qualified, adverse and disclaimer audit report. For the purpose of this study, the unqualified with explanatory paragraph (modified wording), qualified (except for), adverse and disclaimer audit report are classified as modified audit opinion. If a company received modified audit report, the data is valued as ‘1’ in the worksheet and if a company received the audit report other than modified audit report, the value of ‘0’ is coded accordingly.

Researcher considers the existence of separate RMC if the committee has a single committee with title of ‘risk management committee’ without any combination with any other committees including audit committee. Any combination of task and responsibility of risk management with other committees’ task are considered no existence of separate RMC (Combined RMC). For the purpose of this study, if the company has a separate RMC, it is coded as ‘1’ and if a company has not a separate RMC, the value of ‘0’ is coded. This criterion has been used by previous studies such as Subramaniam et al. (2009) and Yatim (2009).

RMC size is the total number of RMC’s members sitting on the committee until the end of financial year. A member will be considered as a RMC’s member if the appointment as member is at least six months and above. If the appointment as RMC’s member is below six months or the resignation is above six months from the financial year end, he or she can not be considered as RMC’s member. (see Farinha & Viana, 2009; Pucheta-Martinez & Fuentes 2007).

RMC overlaps refer to the dual or more functions of RMC’s members on the different board committees. A Member of RMC might be a member of audit committee or other board committees at the same time. For a company, a member of RMC or any other board committees has become a member of other board committees such as remuneration committee and audit committee at the same time but not all the members having such situation. For the measurement purpose, researcher compares the composition of RMC with all the other board committees’ composition to identify the members of RMC with dual or more functions at the same time. Then, the total numbers of RMC’s members with dual or more function are divided by the total number of RMC’s members. The figure is used for this study. This measurement has been applied by Carcello and Neal (2000).

Prior audit report refers to the audit report that a company has received for prior financial year. The researcher has read the independent auditor report that is located at the end of the annual report booklet. The researcher has carefully read the report starting from the first sentence until the last sentence of the report in order to identify the type of the audit report. For the measurement purpose, the researcher coded a dummy of ‘1’ if the company received modified audit opinion for prior financial year audit and a dummy of ‘0’ if the company received clean audit report for prior financial year audit. This measurement has been used by previous study (Pucheta-Martinez & Fuentes, 2007; Carcello & Neal, 2000).

Big 4 refer to the four largest international audit firms in the world. They are PricewaterhouseCooper, Deloitte Touche Tohmatsu, Ernst & Young and KPMG. The researcher looks at the bottom of auditor report sheet to identify the audit firm audited the company. The name of auditor and audit firm stated at that side. If the audit firm is one of the Big 4, the data is coded as ‘1’ and if the other audit firms or not a Big 4 audited the company, the data is as ‘0’. More studies have used this criterion for their researches (Yatim, 2010, Kabir, Sharma, Islam, & Salat, 2011; Farinha & Viana, 2009; Pucheta-Martinez & Fuentes, 2007).

Data Collection and Sampling Procedure

The population frame for this study is all the public-listed companies excluding banking and financial institutions listed in Bursa Malaysia’s website from the period of financial year ended 2004 until 2009. Based on the data gathering through the Bursa Malaysia’s website, there are approximately more than 130 companies with modified audit report for the same period (2004-2009) and there are more than 200 companies which have a separate or a stand-alone RMCs disclosure for the said period (Bursa Malaysia’s website, 2012; Yatim, 2009; 2010). Banking and financial institutions are omitted from the sample as the nature and regulations of these firms are significantly different from non-financial companies. The public-listed companies are chosen for this study. Public-listed companies have published the annual report that publicly available and can be accessed through the Bursa Malaysia’s website.

A match sampling approach is adopted as a control procedure (see Ballesta & Garcia-Meca, 2005; Wenyao & Qin, 2007; Sekaran, 2003). Firstly, the researcher selects the companies with modified audit report for the period of study (2004-2009). Then, they matched to the control samples which have the clean audit report based on the conditions that paired companies are in the same industry, most similar in companies’ size (total assets) and in the same period of financial year (Ballesta & Garcia-Meca, 2005; Wenyao & Qin, 2007). To keep reliable and independence, once a control company has been matched to the corresponding company in the test sample in particular year, it is not allow to be matched again with another company (test sample) in another year (Ballesta & Garcia-Meca, 2005). Besides, any company with never stated of whether separate or combined RMC or risk management matters, it is dismissed as the subject in the sample’s list. Lastly, in this study, there are 150 samples with modified audit opinion are gathered and are matched with 150 samples with clean audit opinion. Therefore, the total number of samples in this study is 300 samples.

 

 

 

 

Analysis of Result and Discussion

Descriptive Statistics for Samples

Table 1 presents the descriptive statistics result for all the companies, modified audit opinion companies and clean audit opinion companies together with the result of t-test. For variable of Separate RMC (SEPRMC), the result shows an average of 13 per cent from the samples have the separate RMC for all companies but in modified audit opinion companies, the result shows only 6 per cent of the samples have separate RMC while for clean audit opinion companies the result shows an average of 20 per cent of the samples have the separate RMC. As expected earlier, the percentage of companies with separate RMC is larger in clean audit opinion companies due to the characteristic of this separate RMC and its function. For the result of Independent t-test, it shows statistically significant for variable of Separate RMC with level of p < 0.01. It is means that there is a significant difference in average for this variable between two different sets of samples (modified and clean audit opinion companies).

Variable Definition:

For RMC Size (RMCSIZE), the result for three categories of companies (all, modified and clean companies) reveals quite similar with average three members. However, in the modified audit opinion companies, two members are recorded in minimum and maximum with seven members of RMC. It is different in clean audit opinion companies, the result states between three and six RMC members. The difference result indicates that in modified audit opinion companies sometimes have very small members of RMC and maximum can be with quite high. Yet, in t-test, the result reveals statistically insignificant for variable of RMC Size.

The result of descriptive analysis also reports for the variable of RMC Overlapping (RMCOVER). All the groups of samples including all companies have minimum with zero per cent of RMC members have overlapping status or do not hold some other board committee members in the same company. While 100 per cent in maximum for the RMC members with overlapping status for all the categories of samples. In average, the modified audit opinion companies recorded with 77 per cent of RMC members with overlapping status and only 72 per cent recorded in group sample of clean audit opinion companies. This difference is statistically significant at weak level (p < 0.1) as showed in the result of t-test.

For the control variable of Prior Audit Report (PRAUREP), the group of all companies recorded 34 per cent in average for the companies received modified audit report for prior year. The descriptive analysis also shows a larger value for the modified audit opinion companies with average of 67 per cent of the samples have received modified audit report for prior year whereas only 0.7 per cent of samples have experienced the said situation for the group of clean audit opinion companies. The huge difference is already expected by the researcher and the result of t-test also reveals the statistically significant at strong level (p < 0.01) for this difference of mean.

Lastly, for Big4 (BIG4), the result of mean for the sample of modified audit opinion companies is at 47 percent whereas for the sample of clean audit opinion companies is at 41 per cent which mean that 41 per cent of the companies in clean audit opinion companies audited by Big 4 audit firms. However, the mean difference for this variable is not statistically

(Pearson Correlation Matrix) for Variables

Table 2 reports the result of correlation among the variables. The correlations are quite low, generally below 0.3 except for a pair of Modified Audit Opinion (MA) and Prior Audit Report (PRAUREP) which are correlated at 70 per cent with significant at level of 0.01. It is means that MA and PRAUREP have strong relationship with assumption of that PRAUREP has major effect on MA. Besides, Separate RMC also has an effect on MA with correlation by 21 per cent and it is significant at 0.01 levels. The other variables that correlated are between Separate RMC and RMC Size, Separate RMC and PRAUREP, RMC Size and RMC Overlap, RMC Size and Big4. The result also reveals that there is no higher correlation with more than 0.85 which means no multicolinearity problem exist in the samples.

 

 

 

Logistic Regression Analysis

Table 3 reports the logistic regression result. The model consists of independent variables (characteristics of RMC) and control variables with Modified Audit Opinion as dependent variable. The result reports the level of correct classification (the percentage of correct predictions) at 83 per cent while Cox & Snell R Square and Nagelkerke R Square report at 49 per cent and 66 per cent respectively. The Chi-square’s test reports at 203.123 and the model is significant at level of 0.00 (p < 0.01). All the independent variables (characteristics of RMC) are statistically significant while for the control variables, only the variable of PRAUREP is significant.  All the variables are significant at expected direction except for variable of RMCOVER which is significant at positive direction.

 

SEPRMC          = 1, if the existence of separate RMC, otherwise 0

For hypothesis of Separate RMC (SEPRMC), it is statistically significant at level of 5 per cent and following the proposed direction with negative sign. For coefficient, SEPRMC reports at more than 200 per cent and it means that if a company has separate RMC, the probability of the company wills not to receive modified audit opinion is at 200 per cent. The examples of companies that have separate RMC are Opcom Holdings Berhad, Bolton Berhad and Genetec Technology Berhad. The result supported the argument by Subramaniam et al. (2009) that the existence of separate RMC with focusing on the risk profile is also able to increase the quality of internal monitoring and quality of financial reporting in relation to risk management. Consequently, the likelihood of the company to receive modified audit report particularly for risk issues is less. Meanwhile, Harrison (1987) reported that RMC is seen to specifically enhance the accountability of the board as it provides an independent oversight of various board activities especially on the risk issues. Due to the contribution of the RMC, Fields and Keys (2003) argued that RMC has gained popularity as an important oversight committee even though most of the countries in the world are still not to reserve as mandatory requirement to form the separate RMC in a company. The result is supported the proposition of first hypothesis (SEPRMC) that the existence of separate RMC will influence the company not to receive modified audit report. This result is also consistent with the requirement under MCCG 2007 and 2012 which clearly stated that the board has principal responsibility on the risk process including the identification of principal risk until the implementation of appropriateness system to manage those risks. Consequently, the formation of separate RMC as a board committee is able to enhance the effectiveness of risk oversight function by BOD as reported in the result of this study which the existence of separate RMC give impact on the company not to receive modified audit opinion.

For second hypothesis (RMCSIZE), the result also shows a statistically significant at level of 10 per cent with positive direction as expected earlier. For coefficient, the result present at 69 per cent with indication that if a company with higher number of RMC size, the probability it will receive modified audit opinion is at 69 per cent. The result is consistent with the earlier study by Beasley (1996) which found a positive relationship between the number of board members and the occurrence of accounting fraud. However, the result is inconsistent with the finding study done by Xie et al. (2003) that there is a negative relationship between board sizes and earning management activities. While Wenyao and Qin (2007) found insignificant relationship between board size and audit opinion. A big size of committee cause some members ignore their responsibility and assume the other members will look for the duty and responsibility. As a conclusion for this hypothesis, the size of RMC has influence on modified audit opinion.

Besides, there is also a significant (p < 0.05) positive association between RMC Overlapping (proxy by RMCOVER) and modified audit opinion received by the company. The statistical result shows more than 170 per cent for beta coefficient for this variable meaning that if there are RMC members with overlapping status, more than 170 per cent of the company will receive modified audit opinion. However, the expected sign is negative association between RMC overlapping and modified audit opinion. Some reasons would explain the situation and even though the experience and knowledge from the other board membership can be brought to the other board committees and the improvement can be performed as reported by Bettenhausen and Murnighan (1985) but the burden of tasks should be borne by the RMC members. They might not be able to perform well at a board committee (RMC) even they have successful at the other board committees. They also have to spend a lot of time to the several board committees and the concentration on a RMC that focus on risk profiles is at a minimum of time. The other reason might be due to the knowledge gained through multiple board membership that lead to the board oversight control (Mizruchi, 1992) and they have more aware on the risk issues. The highest awareness on risk issues probably gives highest attention by auditor before the modified audit opinion will be issued. As a conclusion, the result provides support to this hypothesis

For control variable, Prior Audit Report (proxy by PRAUREP) is statistically significant (p < 0.01) and with a positive sign as proposed earlier. For coefficient, it is recorded more than 600 per cent and it indicates if a company got modified audit report at prior year, it is 600 per cent likelihood of the company will receive modified audit report in current year. The result is consistent with some previous researches as performed by Pucheta-Martinez and Feuntes (2007) and Mutchler, Hopwood and McKeown (1997). They found that modified audit opinion that has been received at prior year has higher potential to be received at the same in current year. For companies those received modified audit opinion at prior year, they might not be able to solve the issues at current year. Hence, they have probability to receive the same modified audit opinion at current year. This situation leads to the issuance of same modified audit opinion by the auditor which the old issues are concerned by them. As conclusion from this result, Prior Audit Report has a strong association with modified audit opinion that issued by the auditor.

For Big 4 (BIG4), the result states statistically insignificant and there is no relationship between Big 4 audit firms and modified audit opinion. The finding indicates that Big 4 audit firms have no influence on the issuance of modified audit opinion by the auditor. This situation is consistent with study done by Farinha and Viana (2009) that Big 4 audit firms have no significant relationship with modified opinion issued by the auditor.

Conclusion and Limitations

The result from the statistical analysis has shown some significant findings. Firstly, the result documented that the existence of separate risk management committee (RMC) affects the issuance of modified audit opinion by the auditors. The finding contributes to the knowledge and literature that the existence of separate RMC has implication on modified audit opinion specifically for Malaysian environment. The existence of separate RMC probably will reduce the issuance of modified audit opinion. Consequently, the formation of separate RMC as a board committee is able to enhance the effectiveness of risk oversight function by BOD as reported in the result of this study which the existence of separate RMC give impact on the company not to receive modified audit opinion. The regulators and policy makers have to consider for this situation. The formation of separate RMC should be mandatory in future as to perform the risk oversight function at board level.

Secondly, the size of RMC probably affects the issuance of modified audit opinion. The big size of RMC probably the issuance of modified audit opinion is high. The company and regulators have the choice whether to form the big or small RMC since this board committee has influence on modified audit opinion.

The regulators and policy-makers should also be aware on the overlapping status of board members. They have to look at the number of board committees sited by the board members. Some board members sited for more than two or three board committees in the same company at the same time. They also have to spend a lot of time to the several board committees and the concentration on RMC that focus on risk profiles is at a minimum of time. The result of this study shows the higher status of board overlapping will probably higher in acceptance of modified opinion.

Lastly, the acceptance of modified audit opinion by a company at prior accounting year has effect on the acceptance of same modified opinion at current year.  For companies those received modified audit opinion at prior year, they might not be able to solve the issues at current year. Hence, they have probability to receive the same modified audit opinion at current year.

This study is like as the other studies which has the limitations. This study used the secondary data as the samples which the company’s annual reports are used as the main source. May be in the future, the researcher can use the different method in data collection such as interview with auditors and risk officers. Questionnaires also can be used by the researcher in order to collect the primary data. These type of data collection methods are important to the researcher to know some others implicit information that rose up by the auditors or other respondents. The formation of RMC is till voluntary and not mandatory in most countries in the world. The study for the efficiency of this board committee is limited and scant. Future study should be done on its efficiency in term of other indication like the company market share, profit and investment opportunity. The study should also examine the roles played by this board committee for said indication besides the characteristics of RMC. In term of research framework, this study used modified audit opinion as the dependent variable. May be the other researchers will use qualified audit opinion or going-concern opinion as the dependent variable in the framework. The scope is different for qualified or going-concern audit opinion compared to modified audit opinion. The treatment for each type of auditor report is different and some different results would be produced if different type of auditor report is used as dependent variable in the study.

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