independence, knowledge and problem-solving ability of audit ...

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Int. J. Business Governance and Ethics, Vol.

Conflict of opinion on accounting policy judgements: independence, knowledge and problem-solving ability of audit committees in Malaysia Rita Anugerah Faculty of Economics, Universitas Riau, Pekanbaru 28293, Indonesia E-mail: [email protected]

Takiah Mohd Iskandar* School of Accounting, Faculty of Economics and Management, Universiti Kebangsaan Malaysia, 43600 Bangi, Selangor, Malaysia E-mail: [email protected] *Corresponding author

Zuraidah Mohd Sanusi Accounting Research Institute and Faculty of Accountancy, Universiti Teknologi MARA, 40450 Shah Alam, Selangor, Malaysia E-mail: [email protected] Abstract: This study employs a field experiment to investigate the effectiveness of audit committee monitoring role. The study relates three audit committee characteristics, independence, financial knowledge and problem-solving ability with judgements on conflicts of opinion between management and auditors on accounting policy. Participants are members of audit committees of public listed companies in Malaysia. Using a Partial Least Squares (PLS) analysis, results show that independence, financial knowledge and ability to solve problems influence audit committee judgements. Financial knowledge mediates the effect of problem-solving ability on the judgements. There is a need for a proper membership selection policy to improve audit committee effectiveness. Keywords: audit committee; problem-solving ability.

judgement;

independence;

knowledge;

Reference to this paper should be made as follows: Anugerah, R., Iskandar, T.M. and Sanusi, Z.M. (2011) ‘Conflict of opinion on accounting policy judgements: independence, knowledge and problem-solving ability of audit committees in Malaysia’, Int. J. Business Governance and Ethics, Vol.

Copyright © 2011 Inderscience Enterprises Ltd.

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Biographical notes: Rita Anugerah is a Senior Lecturer in Accounting at the Faculty of Economics, Universitas Riau, Indonesia and a Research Fellow at the Research and Development of Accounting and Finance Agency, Universitas Riau. She obtained her Master’s Degree in Finance and Information Accounting Systems from Cleveland State University, Ohio, USA and a Doctorate in Business Administration (Accounting) from the Universiti Kebangsaan Malaysia, Malaysia. The focus of her research is in the areas of corporate governance and auditing. She teaches and supervises undergraduate and master students. Takiah Mohd Iskandar is a Professor in Accounting at the Universiti Kebangsaan Malaysia. She obtained her Master’s Degree in Accounting from the Bowling Green State University, USA and her PhD from the Griffith University, Australia. The focus of her research is auditing and corporate governance. She publishes papers on materiality judgements and audit committee in both national and international journals. She is actively involved in the curriculum development of the undergraduate and graduate programmes at the University. She teaches and supervises students pursuing Master’s and PhD Degrees. Zuraidah Mohd Sanusi is an Associate Professor at the Faculty of Accountancy, Universiti Teknologi MARA (UiTM) and a Research Fellow at the Accounting Research Institute, UiTM. She holds a Doctorate in Business Administration (Accounting) from Universiti Kebangsaan Malaysia, and has a Master of Science Degree and a Bachelor of Science Degree in Accounting from Syracuse University, New York, USA. Her main research interest is auditing, corporate reporting, corporate governance, management accounting and management. She has presented a series of talks on data analysis and research methodology, and has been published in a number of national and international journals. She also supervises and advises Masters and Doctoral students.

1

Introduction

The establishment of an audit committee is critical in enhancing the effectiveness of the oversight of the financial reporting process and in improving users’ confidence in the quality of financial reporting (Chen and Zhou, 2007). In carrying out an audit committee’s functions, its members are involved in various judgements and decision activities relating to accounting, finance or auditing issues. Such judgements require an understanding of generally accepted accounting principles applicable to the preparation of financial statements. In fulfilling its responsibilities, the audit committee has to meet certain criteria, including independence, knowledge and the ability to solve problems relating to the controlling systems of an organisation (El-Sayed Ebaid, 2010; Read and Raghunandan, 2001; Verschoor, 1993; DeZoort and Salterio, 2001). Independence represents the state of mind of an individual in making objective judgements in any circumstances, while knowledge refers to literacy and experience in accounting and finance of the individuals that provide them with wisdom in making effective judgements. The ability to solve problems is one of the cognitive multi-traits of an individual that has a positive effect on the results of audit judgements and decisions (Abdolmohammadi and Wright, 1987; Bonner, 1990; Libby and Frederick, 1990; Bonner and Walker, 1994; Jeffrey, 1992).

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During the process of a company’s financial reporting, conflicts of opinion often occur between the company’s management and its external auditors. Differences in opinion mainly occur because of conflicts of interests between the two parties (Goldman and Barlev, 1974). The interest of management concerns the areas of company performance that brings personal benefits to them, while the external auditor always considers the interests of shareholders. When conflicts occur between management and external auditors, the audit committee has the obligation to deal with both parties on the matters arising. In this case, the audit committee plays the role of an arbitrator by giving professional and independent inputs to the board of directors to resolve the matter. The effectiveness of the audit committee in providing quality inputs is determined by the individual traits of the committee members, such as independence, knowledge and capability (Libby and Lewis, 1977, 1982; DeZoort, 1995, 1998). An audit committee must act independently in monitoring the financial reporting process to minimise the opportunities for managers to manage earnings (Raghunandan et al., 2001). Audit committee members must have the relevant knowledge to understand the business and accounting issues that require important accounting judgements by management, and have potential implications on financial reporting (BRC, 1999; Morse, 2004). The accounting literature provides evidence that knowledge and ability to solve problems improve audit committee judgements (DeZoort, 1995, 1998; DeZoort and Salterio, 2001). In line with the BRC (1999) recommendation, there is a need to examine the effect of independence of audit committee members together with their knowledge and ability to solve problems on the effectiveness of audit committee judgements. These three characteristics are necessary for the audit committee to perform effectively in meeting the oversight responsibility. However, evidence on this issue is still lacking. Prior studies (e.g., Beasley, 1996; Benston and Hartgraves, 2002; Carcello and Neal, 2000; McMullen and Raghunandan, 1996; DeZoort et al., 2008) provide inconsistent results on the effectiveness of the audit committees in carrying out their responsibility. The objective of this study is to examine the effect of three individual traits of audit committee members, namely, independence, financial knowledge, and the ability to solve problems concerning their judgements, arising from management-auditor conflicts on the application of accounting policies in the preparation of financial statements. This study contributes to the literature in the following ways. First, it recognises the importance of the problem solving ability for audit committee judgement, which has not previously been fully addressed (DeZoort and Salterio, 2001). Second, this study extends the Libby and Luft (1993) judgement performance model by adding the independence variable in the context of the audit committee. Third, this study examines the direct effect of knowledge, independence and problem solving ability and the mediating role of knowledge on audit committee judgements, which is consistent with Libby and Luft (1993). Knowledge in accounting and finance is expected to mediate the relationship between the ability of the audit committee to solve problems and audit committee judgement. The remainder of this paper is organised as follows. The next section discusses prior literature on audit committee judgement and the development of the hypotheses. This is followed by the methodology and the results of the study. Finally, the last section presents a discussion on the research findings, implications and suggestions for future research in audit committee practices, and a look at some limitations of the study.

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Literature review and hypotheses development

Making an optimal decision is the main goal of every rational decision maker. Lee (1971), a psychologist, explains that an optimal decision is the main focus of human information processing research. Studies in the area of psychology found that some personality factors, such as intellectual capacity, intelligence and personality, would influence the judgements and decisions individuals make (Libby and Lewis, 1977, 1982). More recent studies relate judgement and decisions to performance, especially among experts (Bouwman and Bradley, 1997). The studies found that judgement performance varies according to the varying levels of knowledge, skill and experience of the experts.

2.1 Independence and audit committee judgements The independence of audit committee members is an important factor for effective oversight and monitoring tasks of financial reporting. Audit committees are considered independent when they do not have any link to the company or its management, such as may exert undue influence on them, preventing them from working independently (BRC, 1999; MICG, 2001). Therefore, audit committee members must not be appointed from among company executives. Non-executive members are perceived to be more independent than those who are involved with or participate in the company’s management (NCFFR, 1987; BRC, 1999). An audit committee member is less independent if she or he currently has, or during the past five years has had, a work relationship with the company, its subsidiary, or other counterparts. An audit committee member is also less independent when she or he receives rewards from the company or its subsidiary in addition to her or his service fee, or works for the company or becomes a partner of the controlling shareholder or executive of any business organisation that has a link to the company (BRC, 1999). A violation of any of the above requirements makes an audit committee member less independent, and causes the oversight mechanism of the company’s financial report to be ineffective (BRC, 1999; MICG, 2001). The audit committee’s independence is important in monitoring the process of preparing the company’s financial statements and evading the creation of manipulated financial information by management (Raghunandan et al., 2001). Independent audit committee members make more objective judgements on accounting related matters, such as the application of general accounting practices, evaluation of internal controls, and review of financial reporting processes (Raghunandan et al., 2001). Audit committees comprising independent members tend to take no sides in making judgements and decisions in a particular situation. However, as the percentage of audit committee members who are involved in the company’s management increases, the influence of the committee on external auditors also increases. As a result, a going concern audit opinion is not given to clients with financial problems (Carcello and Neal, 2000). Thus, independence of audit committees improves the credibility of the financial report and enhances the effectiveness of internal audit and external audit (Scarbrough et al., 1998; Birkett, 1986). Audit committee members who are independent from management would ensure that the independence of the internal and external auditors is not corrupted by management (Vicknair et al., 1993). DeZoort et al. (2008) found that the audit committee’s support for an auditor-proposed adjustment was significantly

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higher in the post-SOX period. They also argued that support for the proposed adjustments was higher for an audit committee with CPA members than one with non-CPA members. Stock exchanges around the world including the NYSE, NASDAQ and Bursa Malaysia require the majority of the members of audit committees to be independent. Evidence shows that companies that practice fraudulent financial reporting have fewer independent audit committee members than those that practice non-fraudulent reporting (Beasley, 1996). Audit committees with only external directors as members are able to influence the committee’s activities by holding more regular meetings with the internal audit chief and reviewing the internal audit programme and findings (Scarbrough et al., 1998). The external auditor’s behaviour is subject to the influence of management pressure (Knapp, 1987). An imbalance of power between management and external auditors motivates management to put pressure on external auditors to compromise on some important issues (DeAngelo, 1981; Goldman and Barlev, 1974). The Cohen Commission argued that independent audit committees provide the best tool to achieve and keep a balanced relationship between external auditors and management (AICPA, 1978). This is consistent with Klein (2002), who argued that an independent audit committee helps reduce management pressure by giving external auditors support in resolving differences of opinion. These discussions lead to the following hypothesis. H1: Independent audit committee members tend to support external auditors when differences of opinion on accounting policy occur between management and external auditors.

2.2 Problem-solving ability and audit committee judgements In the field of psychology, studies on performance found that besides knowledge, ability is one of the most important factors influencing performance (Simon, 1979). For knowledge acquiring and judgement performance studies, ability relates to an individual’s cognitive characteristic or personal trait, also known as problem solving ability (Joanna and Waymond, 1993). Previous studies in psychology recognise the importance of the ability to solve problems and its effects on expert performance (Simon, 1979). A problem-solving ability includes the capability to identify various relationships, to interpret data, and to formulate analytical reasoning (Bonner and Lewis, 1990). Similarly, in auditing, the ability to solve problems would directly affect audit expertise (Bonner and Lewis, 1990), and, in turn, affect performance (Libby and Luft, 1993). Ability and knowledge are considered to be very important factors of performance (Libby and Tan, 1994). In performing the oversight responsibility, BRC (1999) views ability as a personal trait that may influence the performance of the audit committee. The ability to solve problems is an important feature of audit committees, which are engaged in various judgements to oversee and monitor management (DeZoort and Salterio, 2001; BRC, 1999). This study proposes that audit committee members with the ability to solve problems are likely to support auditors when conflicts of opinion arise between auditors and management. This is because audit committee members with the ability to solve

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problems are more competent and wiser in considering various aspects prior to making judgements. Thus, an in depth understanding of the relationship between the ability to solve problems and audit committee judgements is very useful to improve the audit committee judgement performance. Discussions on the effect of the ability to solve problems on audit committee judgements and decisions led to the following hypothesis. H2: Audit committee members with high problem-solving ability tend to support external auditors when differences of opinion on accounting policy occur between management and external auditors.

2.3 Effects of knowledge on audit committee judgements Financial knowledge is needed for an audit committee to function effectively (Morse, 2004). In his study, DeZoort (1997) found that an audit committee believes that all its members must have knowledge of accounting and audit. Bull and Sharp (1989) also gave a similar opinion, whereby knowledge of accounting and audit enhances audit committee performance. The findings of both DeZoort (1997), and Bull and Sharp (1989) are in line with BRC (1999), which emphasises the importance of relevant accounting and audit knowledge to audit committee members. Knowledge is a personality trait of decision makers that has a significant influence on expert performance (Bouwman and Bradley, 1997). Knowledge represents a significant component in the human decision and information process (Chase and Simon, 1973). In the area of psychology, knowledge has been widely studied, particularly in relation to performance (Chase and Simon, 1973; Bonner and Lewis, 1990). Empirical evidence shows that knowledge is a requirement for expert decision performance (Bouwman and Bradley, 1997; Glaser and Chi, 1988 in Bouwman and Bradley, 1997). BRC (1999) suggested that members of audit committees must acquire financial knowledge covering the area of financial and audit reports. Knowledge on financial reports is necessary to understand how business activities are reported in the financial statements. Knowledge on audit reports helps understand the results of an audit on financial statements as well as to appreciate the responsibility of external auditors. Thus, financial knowledge enables audit committees to appreciate and analyse technical reports (Green, 1994; Braiotta, 1986). Audit committee members must have sufficient knowledge of accounting and audit to provide a good oversight, because the oversight role occupies them with making independent judgements on various issues reported to them (Knapp, 1987). Bull and Sharp (1989) and DeZoort (1997) found that audit committees subscribe to the idea that their members need to have knowledge of accounting and audit to help make effective judgements and decisions relating to the company’s financial statements. This knowledge helps understand the responsibility of external auditors to the company that they audit. During the preparation of financial statements, the management may sometimes have a different opinion from that of the external auditor on certain technical accounting and audit matters, such as the application of accounting principles. When this happens, the audit committee would act as a mediator. The financial knowledge and professional attitude of audit committees are expected to enable audit committee members to give fair judgements on disagreements (DeZoort and Salterio, 2001). An audit committee with a broad financial knowledge is expected to enjoy a better understanding of the technical,

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procedural and regulatory aspects of accounting preferred by external auditors in forming their audit opinions. Therefore, financially knowledgeable audit committees are expected to make fair judgements on external auditors, and are more likely to agree with external auditors on the interpretation of accounting policy and understanding of financial reporting. In making judgements, auditors are expected to recall and apply their accumulated knowledge to the decision tasks they undertake (Libby, 1985; Weber, 1980). In contrast, financially less literate audit committees are more likely to agree with the management, whose judgements may be influenced by personal rather than knowledge factors (Goldman and Barlev, 1974). Based on this discussion, it is argued that audit committees with strong financial knowledge would support external auditors when a conflict of opinion on accounting policy occurs between management and external auditors. Therefore, the third hypothesis is developed as follows. H3: Audit committee members with high financial knowledge tend to support external auditors when differences of opinion on accounting policy occur between management and external auditors.

2.4 The mediating role of financial knowledge on problem-solving ability As hypothesised in H2, the ability to solve problems may directly affect judgements and decision making (Bonner and Lewis, 1990; Libby and Luft, 1993; Libby and Tan, 1994). Hypothesis 3 predicts that financial knowledge enhances the support for external auditors when differences of opinion on accounting policy occur between management and external auditors. According to Bonner and Lewis (1990), a problem-solving ability facilitates an individual’s acquiring more knowledge. Libby and Tan (1994) argued that the ability to solve problems not only affects performance, but also influences performance indirectly through knowledge as a mediator. This study proposes a mediating role for the financial knowledge of audit committee members in their problem-solving ability to make judgements on conflicts of opinion on accounting policy. Audit committee members with high problem-solving ability are expected to have a better opportunity to acquire more financial knowledge. The ability to solve problems enhances the acquisition of knowledge, which, in turn, improves judgement performance. Rose and Rose (2008) demonstrated that audit committee members with high financial knowledge are less likely to accept insufficient client explanations for accounting judgements. Rose et al. (2010) also found that audit committee members are more likely to give support for auditor-proposed adjustments. They are less likely to support the management’s arguments when they perceive that the management is less credible and more inclined to ‘manage’ earnings. This evidence lends further support to the argument that audit committee members with high financial knowledge would have more trust on auditors’ opinions. In this situation, financial knowledge mediates the problem-solving ability to affect audit committee judgements. Thus, the ability to solve problems enhances the acquisition of knowledge, which, in turn, improves judgement performance. Based on the above discussion, the following hypothesis is developed. H4: A high problem-solving ability enhances the support of audit committee members to external auditors and is mediated by financial knowledge.

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2.5 Proposed model of the study Based on the discussion above, this study proposes a model, as shown in Figure 1. Figure 1

Proposed model of the study

Knowledge is the base for expertise and an expert is an individual who has a broad domain of specific knowledge (Bouwman and Bradley, 1997). Besides knowledge, experts must have the necessary ability that enables them to perform better (Shanteau, 1992). Research on the performance of external auditors shows that the ability to solve problems has a direct impact on performance, particularly in diagnostic tasks (Bonner and Lewis, 1990). Thus, knowledge mediates the relationship between problem-solving ability and performance (Libby and Tan, 1994). Individuals with high problem-solving ability are capable of acquiring more knowledge, which, in turn, improves their performance (Libby and Tan, 1994). Previous studies examined the mediating role of knowledge in explaining the Libby and Luft (1993) model of the relationship between problem-solving ability and performance in the context of external audit work (Libby and Tan, 1994). However, the Libby and Luft (1993) model has not been applied to the audit committee judgement context. In this study, the Libby and Luft (1993) model is adopted to examine the judgement performance of audit committees by adding the independence of audit committees as an additional variable. There is evidence that audit committee independence has an influence on its judgement performance. Thus, this study extends the Libby and Luft (1993) judgement performance model in the context of audit committees.

3

Methodology

This study uses the DeZoort (1995) design for a modified (quasi) field experiment or a partial modified field experiment to assess audit committee judgements in an environment of conflict of opinion between management and external auditors. This design enables participants to perform the assigned task in a normal working environment. A field experiment is commonly used for research in other areas, such as psychology and education (Kerlinger, 1986), auditing (Eden and Moriah, 1996; O’Donnell and Schultz, 2003), and marketing (Kim et al., 2002).

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3.1 Participants Participants are audit committee members of randomly selected Bursa Malaysia listed companies. The total population of audit committee members of 800 listed companies is estimated to be 2400 (i.e., 800 companies with three audit committee members each). The estimate is made based on the minimum size of three members for an audit committee, as required by the Malaysian Code on Corporate Governance of March 2000. Two hundred and forty audit committee members were randomly identified from the membership information disclosed in the annual reports of the selected companies. The sample size, which represents 10% of the estimated population, is considered appropriate for a total population of between 1000 and 10,000 (Neuman, 1997). The sample represents independent and non-independent members in a ratio of 2 : 1, in line with the requirements of the Code. Via mail, the selected audit committee members were sent research instrument booklets containing a judgement task on revenue recognition policy. They were requested to participate in the experiment by responding to the judgement task. A total of 40 audit committee members participated in the experiment by returning the completed research instruments. The mean value of experience of participating audit committee members is 2.25 years, with a minimum of one year and a maximum of five years. Most of them have experience of between one to 21 years as members of boards of directors.

3.2 Research instrument The research instrument consists of four parts. The first part contains the judgement case on the conflict between management and external auditor on revenue recognition policy. The second part contains questions on the demographic details of the participants. The third part contains questions measuring the knowledge of the audit committee members and their ability to solve problems. The research instrument was pilot tested to ensure the clarity and appropriateness of the questions. The booklets containing the research instrument together with prepaid self-addressed envelopes to the researchers were distributed to respondents via the postal service.

3.3 Judgement case The judgement case was adapted from DeZoort and Salterio (2001). The case provides a scenario on the differences of opinion between management and external auditors on the company’s revenue recognition policy concerning a wholesale trade in electronic products, which the company has practiced for the last five years. The case involves a change in the accounting policy on the recognition of revenue and commission on retail sales of electronic products. The judgement case involves a change of accounting policy from treating sales transactions as separate sources of revenue to combining them as one source of revenue. To ensure a match between expense and revenue under the proposed policy, the estimated amount of warranty expense to be incurred over the life of the extended warranty period is treated as an expense for the year of sales. The external auditors disagree with the new revenue recognition policy, and argue that sales of electronic items and the after-sales warranty for customers are two different items, although they are both part of the sale price. The external auditors are of the opinion that

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the two items in the sale price should be identified as separate sources of revenue under a proper revenue recognition policy. Given the scenario of differences in opinion between management and external auditors, as discussed above, the audit committee members were requested to decide whether to support the management or the external auditors. The decision made by the external auditors was used to benchmark the appropriateness of audit committee judgements because of the external auditors’ recognised expertise and credibility in the field of auditing and accounting by other parties, including shareholders and the government. The judgement case was amended to account for the international accounting standards applicable to Malaysia, and the Ringgit Malaysia was used as the reporting currency in the financial statements.

3.4 Measurement of variables The dependent variable of this study is the audit committee’s judgement when faced with a conflict of opinion between management and external auditors. The audit committee’s judgement is measured based on the responses to a case study, which provides a scenario relating to a conflict of opinion between management and external auditors on revenue recognition accounting policy. The respondents were required to give judgements on whether they agreed with the external auditors or the management on a Likert scale between –5 for ‘highly disagree’ (i.e., with the external auditors) to +5 for ‘highly agree’ (i.e., with the external auditors). This Likert scale has been widely used in behavioural studies (Cooper and Emory, 1995). A negative score indicates support for the management, while a positive score indicates support for the external auditors. A bigger negative score means greater support for the management, while a larger positive score means higher support for the auditors. A score of 0 (zero) shows that the respondent is indifferent to either party. This study uses support for the viewpoint of the external auditors as a proxy for good judgement for three reasons. First, the external auditor is an independent party appointed by the Ministry of Finance to audit companies by virtue of the Companies Act 1965. Second, the external audit practice is governed by the Professional Conduct and Ethics issued by the Malaysian Institute of Accountants (MIA), requiring the auditors’ compliance. Third, the process of external auditing is subject to compliance with the requirements of the Malaysian Standards on Auditing (MSAs), issued by the MIA. External audit practices are subject to the above-mentioned legal as well as professional requirements, and, therefore, are expected to give a fair judgement during any conflict between them and the management, so that the standards of the profession are upheld.

3.5 Independent variables The three independent variables in this study are the audit committee members’ independence, problem-solving ability and financial knowledge. Independence of the audit committee is measured based on a six-question instrument requesting ‘yes’ (coded 0) or ‘no’ (coded 1) responses on the members’ involvement with the client as an employee; relationship with any employee; receipt of any form of compensation; consultation, legal counselling, and other forms of affiliation; such partnership or shareholdings. A ‘yes’ response means the audit committee member is

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involved with the client’s activity; hence, he or she is not independent. However, a ‘no’ response means the audit committee member is not involved with the client activity; hence, he or she is independent. Scores for ‘no’ responses are aggregated to determine the level of independence of audit committees in terms of percentage of the total scores obtained by the participant over the maximum total score of six. The independence of the audit committee is reduced if the number of links of audit committee members with the company increases. Any form of relationship between the audit committee members and the company reduces the level of independence. Problem-solving ability of the audit committee is measured using a five-question instrument adapted from DeZoort and Salterio (2001). This part of the instrument also includes the measurement of the auditors’ ability to solve problems. Each question carries a score value of two. The total score of correct answers is 10. Any wrong answer reduces the score value by two points. The correct answers on the ability to solve problems are relative. Thus, there is no fully correct or fully wrong answer. Participants with the ability to solve problems are able to identify the problem when there are some alternatives to the situation (Baril et al., 1998). Financial knowledge of the audit committee members is a latent construct relating to two dimensions, namely, knowledge of audit reports and knowledge of financial report, as adapted from DeZoort and Salterio (2001). Knowledge of audit reports is measured by six questions on the responsibility of the external auditor, while knowledge of financial reports is measured by 11 questions on the business and financial report requirements. Knowledge of audit reports enables audit committee members to gain an understanding of the responsibility of the external auditors with regard to audit procedures and audit opinion (BRC, 1999). Knowledge of financial reports enables audit committee members to read the company’s financial statements including balance sheet, income statement, and cash flow statement (BRC, 1999). In a situation where differences in opinion occur between management and external auditors concerning accounting policy, audit committee members must have sufficient financial knowledge to resolve the issue. Each question is coded 1 and each wrong answer is coded 0. For each participant, the score is determined by the correct answers obtained as a percentage of the overall possible score in the instrument. Some questions on the background of participants, such as education, job position and age are also included.

3.6 Validation tests of research instruments Although the study adapts the DeZoort and Salterio (2001) instrument, further validations of the research instrument are required to determine that the instrument measures the concept or construct of the study (Neuman, 1997; Kerlinger, 1986; Singarimbun, 1995). First, a face validity test was conducted by asking five randomly selected members of audit committees for their judgement to ensure the clarity and accuracy of information in the research instrument. Based on the feedback, improvements were made to the clarity and consistency given the requirements of accounting standards in Malaysia. Second, the construct validity tool that can measure the observed concept or construct of various indicators is tested by PLS, using convergent validity and discriminant validity. Convergent validity is shown when each measurement item correlates strongly with its assumed theoretical construct, while discriminant validity is

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shown when each measurement item correlates weakly with all other constructs except for the one to which it is theoretically associated (Gefen, 2005). Construct validity requires a clear definition, which shows the limitation of a concept or a construct relating to convergent validity and discriminant validity (Neuman, 1997). PLS performs a Confirmatory Factor Analysis (CFA). In CFA, the pattern of loadings of the measurement items on the latent constructs is specified explicitly in the model. Then, the fit of this pre-specified model is examined to determine its convergent and discriminant validities. This factorial validity deals with whether the pattern of loadings of the measurement items corresponds to the theoretically anticipated factors.

4

Results of the analysis

4.1 Results of Partial Least Squares (PLS) analysis The study uses PLS to analyse data. PLS is preferred to other SEM techniques, such as LISREL, because of its flexibility in the requirements for random sample collection, sample size, and normal distribution (Wold, 1985). The use of PLS involves, first, evaluations of the measurement model describing construct-to-measures relationship, and, second, evaluations of the structural model reflecting the relationship between the latent variable and observed variable (Barclay et al., 1995). The following framework explains the procedure, which is used to measure the two models. The convergent validity of the measurement model is evaluated by checking the loading factor. The convergent validity exists when items of each construct have a loading factor above 0.5 and are significant at p < 0.05 (two tail; >1.96). See Table 1 for details. The table shows that convergent validity is not a problem in this study, since the values of the loading factor are above 0.5. Table 1

Results for outer loadings Original sample estimate

Mean of sub samples

Standard deviation

t-statistic

Ability 1

0.697

0.697

0.042

6.198

Ability 2

0.830

0.816

0.035

7.759

Ability 3

0.650

0.679

0.038

5.876

Ability 4

0.860

0.864

0.041

7.323

Ability 5

0.817

0.799

0.029

8.255

Independence*

1.000

1.000

1.000

Problem solving ability

Knowledge Finance reporting knowledge

0.664

0.670

0.072

9.261

Audit reporting knowledge

0.551

0.574

0.079

7.013

Judgement*

1.000

1.000

1.000

*Represents a single measure of the variable.

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The composite reliability of each item is tested using the Fornell and Larcker (1981) approach. The discriminant validity is tested to see if the square root Average Variance Extracted (AVE) significantly exceeds the value of correlation coefficient between the constructs (Chin, 1998). The results of the test in Table 2 show that the composite reliability of each of the above variables is 0.7, which is considered acceptable (Nunnally, 1978). Table 2

Composite Reliability and Average Variance Extracted (AVE), and correlation from PLS model Composite reliability

Variable

AVE

Problem Independence solving ability Knowledge Judgement

Independence

1.00

1.000

1.000

–

–

Problem solving ability

0.882

0.601

0.561

0.775

–

–

Knowledge

0.804

0.673

0.580

0.743

0.820

–

Judgement

1.000

1.000

0.668

0.829

0.876

1.000

Diagonal elements are the square root of the AVE statistics. Off diagonal elements are the correlations from the PLS model.

Results of this test demonstrate adequate discriminant validity. Overall, the results of the tests of the PLS measurement model indicate that each construct exhibits satisfactory reliability and validity.

4.2 Test of hypotheses Table 3 presents the results of the PLS. The results show that independence of the audit committee significantly affects the audit committee’s judgement at p < 0.05, with a path coefficient of 0.173 and a t-statistic of 2.343. The results provide support for H1, suggesting that independent audit committees agree with the external auditor in the event of conflicting opinions between management and external auditor about accounting policy. Table 3

Path coefficients, t-statistics and R2

Hypothesised relationship

Expected sign

Path coefficient

R2

Independence and judgements

+

0.173 (2.343)*

Problem solving ability and judgements

+

0.346 (2.909)**

Problem solving ability and financial knowledge

+

0.743 (10.457)**

Financial knowledge and judgements

+

0.519 (4.087)**

Financial knowledge

-

n/a

0.552

Judgements

-

n/a

0.857

Number in parentheses indicated t-value (two tail tests). *p < 0.05; **p < 0.01.

The results of the analysis show that the problem-solving ability has a significant effect on audit committee judgements at p < 0.01; the value of the path coefficient is 0.346 and

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the value of the t-coefficient is 2.909. The results support the second hypothesis (H2). The results suggest that in making judgements, an audit committee member is influenced by his or her problem-solving ability. The higher the level of problem-solving ability, the higher the level of support given to external auditors. The third hypothesis states that audit committee members who have a high level of financial knowledge tend to support the external auditor when management and external auditors have a different opinion on account policy. The results of the PLS analysis in Table 3 show a significant effect of financial knowledge on the judgement of audit committee members at p < 0.01, with a path coefficient of 0.519 and a t-coefficient of 4.087. The results suggest that financial knowledge influences audit committee judgements. The results provide support for the third hypothesis (H3). This means that an audit committee member who has high financial knowledge tends to support the external auditor when differences in opinions on account policy occur between management and external auditors. The fourth hypothesis (H4) attempts to establish evidence for the indirect impact of the ability to solve problems on the judgement of audit committee members. The objective of H4 is to determine whether financial knowledge has any mediating role on problem-solving ability and audit committee judgements. The results of the PLS are presented in Figure 2. Figure 2

Results of Partial Least Squares analysis for judgements

The fourth hypothesis is tested using the procedure recommended by the Sobel test (Baron and Kenny, 1986); the results show that financial knowledge mediates the audit committee members’ ability to solve problems and their judgements. Such a conclusion is arrived at based on the fulfilment of the requirement of the significant path coefficients between: •

the independent variable (ability) and the dependent variable (judgement)

•

the independent variable and the mediator variable

•

the mediator variable and the dependent variable (judgement) (Wold, 1985).

Full mediation is reached if the path coefficient of the independent variable (ability) to the dependent variable (judgement) is not significant. Values in parentheses represent the structural model, which includes knowledge as a mediating variable (n = 40). All path coefficients are statistically significant at p < 0.01.

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Table 4 shows the results of the test of the mediation of knowledge on the effect of the ability to solve problems on audit judgement performance. To test whether knowledge acts as a mediator variable, we conducted a post-hoc Sobel test (Sobel, 1982), which required two PLS models. The first model included a path from the independent variable (ability) to the mediator (knowledge), and yielded the path t-test values shown in Model A. The second model included the model from the mediator variable (knowledge) to judgement, and provided the t-test value shown in Model B. The results, shown in the final column of Table 4, demonstrate that knowledge significantly mediates the relationship between ability and judgement (Sobel = 14.048, p = 0.001). Table 4

Mediation results

Model A Path

Model B t

Ability → Knowledge 14.888

Path

t

Knowledge → Judgement

42.223

Sobel test

P

14.048

0.001

The results support the argument that financial knowledge becomes a mediator variable between the problem-solving ability and judgements relationship. It is evident that the wide financial knowledge acquired by audit committee members can mediate the effect of problem-solving ability on the judgements, particularly when a conflicting opinion happens between management and external auditors. This indicates that audit committee members with high problem-solving ability possess a wide knowledge of finance, which helps solve problems and gain support from the external auditors.

5

Conclusions and limitations

This study examines the effect of independence, problem-solving ability and knowledge acquired by audit committee members on their judgements when different opinions on accounting policy occur between external auditors and management. This study also investigates the role of financial knowledge as a mediator between problem-solving ability and judgements. By using PLS analysis, the study found that independence, ability to solve problems and financial knowledge have a significant influence on the judgements made by audit committees. Financial knowledge is shown to have a significant role as a mediator between problem-solving ability and judgement. Independence is a fundamental attribute necessary for audit committees to function effectively (BRC, 1999). Consistent with previous research, the results support the hypothesis on the effect of independence on the effectiveness of the audit committee function (i.e., Abbott et al., 2000; Archambeault and DeZoort, 2001; Carcello and Neal, 2000; Raghunandan et al., 2001; Scarbrough et al., 1998). As such, audit committees that are independent would choose external auditors’ opinions to make judgements, and, hence, improve the quality of audit. The findings of this study are also in line with previous studies on the differences in the ability to solve problems among audit committee members in making judgements (DeZoort and Salterio, 2001). The differences in their ability to solve problems are expected to result in audit committee members making different decisions on financial reports. The ability to solve problems is an important factor for any decision making,

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and it has been the focus for research in many fields, including accounting and audit (Libby and Frederick, 1990; Tan and Kao, 1999). This study contributes to the judgement and decision-making studies by demonstrating the effect of the problem-solving ability variable in the context of audit committee judgements. This study is subject to several limitations. Using the case adapted from DeZoort and Salterio (2001) on conflicts of opinion between management and external auditors to evaluate audit committee judgements, it may not be enough to provide for all scenarios relating to differences of opinion that always occur between management and external auditors. Therefore, future studies may consider using other similar cases in the research instrument, so that the process of decision making by the audit committee can be done comprehensively. The learning environment when audit committees are making judgements is not taken into account. Thus, this study does not take into consideration certain characteristics, such as the accounting environment or audit judgement guides or technology aids, hierarchical group setting, variables relationship, and multi-period tasks (Libby and Luft, 1993). This is because the authors believe such environments are not relevant to audit committees in performing their tasks. This study limits the measure of independence of audit committee members, as defined by the Securities Commission of Malaysia, and as disclosed in annual reports. Other types of relationship that may threaten the independence of audit committee members are not included. This may require further research. Other than the three personal traits of audit committee, future studies may also include other personal traits, such as self-confidence, communication skills and ability to adapt to the surroundings in the audit committee judgements model (Shanteau, 1992). Future studies of audit committee judgements may consider surrounding factors such as the accounting policy and audit system applied by the company. Intervention by senior management or senior auditors may also be considered in the model. The technical knowledge of the supervisors may influence the conclusions of the team (Peecher et al., 2010).

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