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The Audit Committee Characteristics and Earnings Quality: Evidence from Jordan
1. Introduction
Corporate governance has created significant changes in business environments in general,
and in particular, the accounting and auditing professions. Interest in the role of audit
committees has increased in the last few years because it is the tool of corporate governance,
whose aim is to increase the questioning of the board of management and to increase the role
of audit and its independence, after several financial failures of many local and international
companies (Hamdan & Mushtaha, 2011). During the last years, there was, as well, an
increasing organisational interest in the role of the audit committee in preparing financial
reports (Martnez & Fuentes, 2007). The Wild (1994) study found that the credibility and
fairness of financial reports issued by companies depends on the existence of an audit
committee emerging from management councils of such companies, while Martnez and
Fuentes (2007) found that an audit committee would be more active in the process of
monitoring financial statements and limiting the differences between the management and the
external auditor. This reduces the probability of the company receiving qualified opinions
from the external auditor resulting from accounting errors or non-commitment to accounting
standards.
Many countries and local and international vocational bodies now spend more effort to issue
instructions and standards, which when adopted help restore credibility in the financial data
declared. This also helps in activating the role of audit committees, which consolidates
functioning and independence of the external auditor as an impartial party providing his
opinion on the declared financial data fairly and objectively. One of these efforts is the
recommendation of the Securities and Exchange Commission (SEC) and Exchange
Commission, New York Stock Exchange (NYSE), and the National Association of Securities
Dealers (NASDA), to form a Blue Ribbon Committee (BRC, 1999) to be a natural reaction to
the distortions in financial statements. These committees aimed to develop recommendations
which help improve financial reports through consolidating their role. It also put down a
series of qualities which should prevail in order to have an active audit committee. Such
qualities include size of committee, experience, financial knowledge of members, degree of
their independence, and frequent meetings.
In July 2002, the USA’s Sarbanes-Oxley law was described by analysts to be the most
significant and comprehensive American legislation since the forming of the SEC because of
its impact on general companies and independent accountants. Some of the large reforms that
the legislation included were the right of declaration, submission of financial reports by
foreign general companies’ corporate governance and monitoring of accounting auditors.
According to article 301 of the legislation, a special part was made stressing the duties and
formation of an audit committee, in order to secure the safety and credibility of the report of
the external auditor who might be subjected to managerial pressure. As for Jordan, much
legislation supporting corporate governance was issued in order to regulate the work of audit
committees in Jordanian companies.
Our study attempts to discuss such legislation related to audit committees to ensure their
application by Jordanian companies. Afterwards, this study tries to test the role played by
audit committees in improving earnings quality. Qaraqish (2009) sees that earnings quality
means the absence of such earnings, from estimations and substitutes by which the company
tries to get a targeted net return.
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The contribution of the current study to existing literature is
1) to provide additional evidence about the relationships between audit committee characteristics and earnings quality from developing countries. It uses the new models
to measure the earnings quality in Jordanian corporations, which was not used in
previous studies in this environment.
2) to look for relationships between the audit committee characteristics and earnings quality in Jordan, which regularly takes steps towards the regulatory and legislative
structure to support economic development. This distinguishes this study from other
studies conducted in the United States and Australia.
2. Literature Review
Audit Committees
The concept of audit committees differs according to the goals, functions, and responsibilitie assigned to them. Al-Thuneibat (2006) defined it as the committee that is composed of
nonexecutive directors in the establishment. The major goal behind forming the audit
committee is to increase auditing quality and questioning of board of directors. Arens et al.
(2009) defines it as a group of persons selected from members of the board of directors who
are responsible for retaining independence of the auditor.
Many studies were concerned with checking qualities of audit committees as one of the tools
of corporate governance, with many influences like controlling earnings management, or
improving financial reports, and earnings quality. Hamdan and Mushtaha (2011) showed a
positive impact for the size of the audit committee members on the report of external auditor.
They also showed a negative impact for stock ownership of members of audit committees on
the report of the external auditor.
Stewart and Munro (2007) focused on the results of frequent meetings on the audit
committee. They determined that the presence of an audit committee, the number of its
meetings and the auditor’s attendance for such meetings reduces audit risks, and that the
external auditor believes that the presence of an audit committee is an important factor in
reducing substantial risks of auditing.
As for the ability of the audit committee to control earnings management, the study of Saleh
et al. (2007) evaluated the role of some qualities of the audit committee with regard to
independence of committee members, its size, its frequency of meetings, and the experience
and knowledge members of the committee have to monitor management behaviour.
Sweiti (2006) endeavoured to develop a model to consolidate the role of audit committees in
Jordanian joint-stock companies for the purpose of strengthening the function and
independence of external auditing. Some of the most important findings of the study were
that recently formed audit committees in the Jordanian corporations did not have the
necessary requirements needed to effectively play their role and did not have any significant
impact on the effectiveness and independence of the external audit.
The study of Felo et al. (2003) is on the relationship between audit committee characteristics
“regarding financial experience, independence, and committee size”, and financial
information quality. Their study also shows a positive relationship between the financial
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experience of audit committee members and the quality of published financial information;
and a positive relationship between the sizes of audit committees and quality of financial
information.
Al-Farah (2001) aimed to measure how active the audit committees were in the Jordanian
corporations, from the viewpoint of directors of internal and external auditors. It also
attempted to know the most important factors that help consolidate efficiency of such
committees from the point of view of members of these audit committees. The study dealt
with all the companies that have audit committees by the end of December 2000. They also
found that the factors that consolidate the role of audit committees are the financial or
accounting background of one member of the audit committee; the independence of members
of the audit committee; the existence of written evidence.
Earnings Quality
Investors’ concerns with earnings quality increased during the last decade after many
international companies announced non-authentic and temporary earnings as part of their
quarterly reports. Thus, investors became more cautious in considering net earnings. Qaraqish
(2009) and Ohlson and Feltham (1995) define earnings quality as the investor’s ability to
predict future abnormal earnings depending on recent data. But Qaraqish (2009) sees that the
real earnings quality is the one honestly and justly announced by the companies as their
actual earnings. In other words, the announced earnings of companies have a substantial
financial existence which is void of exaggeration or probability figures. Many of the
definitions of earnings quality revolve around the two previous ones.
Earnings quality is the ability of the present earnings to provide a real picture about the
company and its ability to survive in the future. The significance of earnings quality stems
from the earnings on which many parties depend when they take their decision. Bagava
(2006) believes that earnings quality is considered an important factor in the financial
statement and is used as a guidance to decision making. Depending on earnings of low-
quality leads to an inappropriate management of fortune (Schipper & Vincent 2003).
Understanding earnings quality plays an important role in the process of financial analysis;
earnings of high-quality help financial analysts in analyzing three basic sides of information.
These are the present functional performance of the company, future functional performance,
and value of the company (Dechow & Schrand, 2004). In addition, earnings quality might be
used as an indicator of dividends.
Previous Studies
Baxter and Cotter (2009) studied the formation and characteristics of audit committees and
their impact on improving earnings quality in a sample of Australian companies before
obligatory requirements were introduced to audit committees in 2003. Their results show that
there was a significant relation between the financial experience of members of audit
committee and earnings quality improvement.
Various studies provided many other factors influencing earnings quality. Teitel and
Machuga (2010) found that supporting rules of corporate governance contributed to the
improvement of earnings quality. Altamuro and Beatty (2006) also found that internal control
quality played a role in improving earnings quality. In comparing public firms with private
ones, Givoly et al. (2010) found that the former was more conservative in their financial
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reports than the latter, and that their management practice through using normal accruals was
less.
With regards to the relationship between auditing quality and improving earnings quality,
Hamdan and Abu Ijeila (2010) found that auditing quality of audit offices in Jordan did not
contribute to limit earning management practices in Jordan industrial companies subject to
auditing. Such offices never played a role in increasing earning qualities in Jordanian
industrial companies. But Teitel and Machuga’s (2010) study on the impact of the application
of Code of Best Governance Practices in the presence of external auditors from highly
qualified audit offices found that it helps improve earnings quality.
Balsam et al. (2003) studied the impact of one of the auditing quality professional auditor’s
specialisation on discretionary accruals and found that the companies which used
professional specialised auditors had less discretionary accruals compared to the companies
which used less professionally specialised auditors.
3. Research Methodology
Sample
The study sample consists of 50 companies listed in ASE94 which met the conditions of
having all necessary data available and having never been merged or delisted through the
period of the study. We focus on the six-year window 2004-2009 because the Code of audit
committee was voluntary in 2002 and portions of the Code became mandatory in the
Securities Market Law in 2004.
The sample of 50 companies will be selected from each of the following industries:
Pharmaceutical and Medical Industries, Chemical Industries, Paper and Cardboard Industries,
Printing and Packaging, Food and Beverages, Tobacco and Cigarettes, Mining and Extraction
Industries, Engineering and Construction, Electrical Industries, Textiles, Leathers and
Clothing, Glass and Ceramic Industries.
The Relation Between Characteristics of Audit Committees and Earnings Quality
We will be using several linear regression models to investigate the relationship between
audit committees and earnings quality. In these regression models the dependent variable
“earnings quality” is measured by using the Richardson et al. (2005) model and the Jones
(1991) model. Each of these regression models contains two measures of audit committees
and a group of control variables, to control the relationship between the dependent and
independent variables.
Independent Variables: Characteristics of Audit Committees
The characteristics of the audit committees will be based on many past studies. The following
variables are selected as independent variables measuring the characteristics of the audit
committee:
1. Audit committee size 2. Audit committee independence: values are 1 if all members are non-executive, and 0
otherwise
3. Number of audit committee meetings per year
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4. Financial experience of audit committee members: this is obtained by dividing the number of qualified members in accounting, finance, banking and management by all
members
5. Percentage of common stocks owned by audit committee
Dependent Variable: Earnings Quality
This study adopted two of the commonest models for measuring earnings quality which are
the Richardson et al. (2005) model, and the Jones (1991) model as modified by Dechow et al.
(1995). We will use these two models to confirm the results.
Control Variables
1. Company size – the company size was used as a controlling one to study the difference between the small and large companies with regard to earnings quality.
2. Degree of financial leverage – the overall ratio of percentage of debts to assets 3. The percentage of the common stocks owned by members of the board of directors 4. The external auditor turnover – according to the study of Shokley (1982), the long
relationship between the company and the external auditor may make the auditor non-
creative and thus adopt less rigid audit techniques and depend on procedures and
solutions of company without verification. The two researchers extended to measure
the level of the auditor's turnover through the number of years of his work in auditing
in companies.
5. Auditor's specialisation in customer’s industry – this variable was listed among the controlling variables because it was believed that the auditor’s specialisation in the
customer’s industry will lead to a better auditing quality. This consequently leads to
increased administration monitoring and preventing manipulation of financial
statements, thus leading to the betterment of earnings quality. Dummy value, 1 if the
Auditor's Specialisation in Customer's Industry; 0 otherwise.
4. Conclusion
Audit committees are one corporate governance mechanism which aims to coordinate the
administration, external auditor, and monitoring of company performance in order to increase
the influence of the corporate governance and secure transparency of financial disclosure.
Therefore, this study aims to explore the status of forming audit committees in the Jordanian
industrial companies after a series of laws and legislation were issued by Jordan in this
respect. It also studies the influence of the qualities of audit committees on earnings quality
referred to in this study as the continuity of earnings in the future or for holding the lowest
ratio of discretionary accruals. The data were collected from 50 Jordanian industrial
companies from 2004-2009.
The findings of the study will show whether the Jordanian industrial companies meet the
demands of forming auditing committees stipulated in Jordanian legislation. The study will
also determine how the size of the audit committee is connected with earnings quality.
The study will also discuss the role of independence of members of the audit committee in
making them more able to improve earnings quality and will investigate the relationship
between this variable and earnings quality.
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Regarding the role of the numbers of meetings of audit committees to make them more active
in monitoring and improving their earnings quality measured through continuity, the study
will investigate the relationship between number of meetings and earnings quality.
This research will be able to provide recommendations to the organisers of works of
Jordanian companies, like the stock market and government authorities, support the
mechanism of corporate governance companies. This will secure more transparency in
disclosures, reduce practices of earnings management, and improve earnings quality, for they
all leave a significant impact on the economic decisions of parties. However, with a small
sample size, caution must be applied, as the findings might not be generalisable.
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