Saudi Arabia and Auditing Standards Literature Review Chapter

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audit committee characteristics affect firm performance in Saudi Arabia?

What are audit committees?

Many studies have been carried out to demonstrate the manner in which audit committees reports affect the overall performance of companies in Saudi Arabia and elsewhere in the world. The interest in conducting audit of accounts in different firms peaked in the early 1960's. Two main approaches of doing accounts investigations have emerged in financial literature. The first one is mainly based on sending out questionnaires to a pre-determined number of financial accounts users, asking them to rank a number of specific accounting items based on how important the item is to the decision making process (Buzby, 1974; Firth, 1978; Chandra, 1974; Turkey, 1985). The second approach was based on the link between a disclosure index of voluntary or mandatory or even total disclosure and specific company characteristics (source Alsaeed). The first step in conducting financial audit is the establishment of audit committees. Audit committees are essential components of corporate governance (Green, 1994). When defining an audit committee a lot of weight is usually placed on its functions and composition. For example, the Canadian Institute of Chartered Accountants (CICA, 1992: 20) defines an audit committee as a group or team of directors of a firm whose task is to review or examine the annual financial statements of the organization before presentation to the firm's board of directors. The committee is basically a link between the auditor or auditing firm and the board of directors. The responsibilities of the board of directors may also include participation in the selection of the auditor, definition of the scope of the audit, implementation of internal financial controls, and the generation of financial reports for publications (Al-Lehaidan, 2006).

Development of audit committees in Saudi Arabia

The initial step to the creation of audit committees in Saudi Arabia was implemented in 1991 after it was given a Royal Consent. This step was the creation of the Saudi Organization of Certified Public Accountants (SOCPA). This organization was created to regulate the overall field of financial accounting and auditing (Al-Lehaidan, 2006). In Saudi Arabia, banks are regulated by two government institutions, the Saudi Arabia Monetary Agency (SAMA) and the Ministry of Commerce (Al-Moataz 2003). In the year 1994, SAMA issued new rules and regulations to Saudi banks concerning the formation of audit committees (Saudi Arabian Monetary Agency 1994). The regulations stated that the board of directors in each bank were to elect from among themselves the chairmen of audit committees to serve a minimum term of three years and that their independence from the banks' management was of paramount importance to ensure their effectiveness (1994: 3). The selection of the chairmen was regarded as an important activity because they are the ones who set the agenda, scope, tone and manner of operations for the audit committees. For the above reason the individual who was to lead the audit committee, the chairman, had to meet the following requirements:

1. He should not be a relative or be associated in any way to the bank's senior management.

2. The chairman of the board of directors could not be elected to this position.

3. He should not be associated in any way, financial or otherwise, to other members of the board of directors.

The regulations further specified that the audit committees should be comprised of 3 to 5 board members and that a majority (3 members) were required for a meeting to be properly constituted. Audit committees members may be chosen from the board, ex-members of the board and qualified outsiders. However, the majority of the committee members should be outsiders who are not directors, senior managers, employees or major clients of the bank or affiliates of the bank (Al-Lehaidan, 2006).

The current state audit committees in Saudi Arabia

In the year 2003, the SOCPA came up with a draft of new rules and regulations that were to further regulate the audit committees so as to increase their level of success. The rules included:

That all public firms were required to form audit committees

That the audit committees were required to have a minimum of four members all of whom were supposed to be independent directors.

It was recommended that audit committees meet a minimum of four times per year.

That the chairman of the audit committee should not be a member of the board of directors.

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That the audit committee should have among its members at least one individual who has a minimum of an undergraduate degree in financial accounting or finance.

That each audit committee was supposed to have a formal charter.

IAC (International Audit Committee) sent this draft to interested parties including auditors both internal and external and academics with expertise in accounting so that they could provide further input so as to finally draft the best practices and regulations for financial auditing.

However, to this day no changes were made to the initial rules and regulations and it is not certain if the input of all these other non-governmental concerned parties will be adopted by the Saudi Arabia Ministry of Commerce (SMC) or the Saudi Stock Exchange Commission (SSEC).

The structures of the audit committees in Saudi Arabia are in such a way that they are regulated by laws and codes of best practice including recommendations and guidelines. Thus such structures are not regulated directly by the SSEC listing rules regarding the set up and framework of audit committees (Al-Lehaidan, 2006).

Effects of structures and composition (characteristics) of audit committees on performance

Many surveys and studies done in the past have investigated the link between cooperate governance (including audit committees) and performance in terms of developed countries (Sueyoshi, et al., 2010). A recent study conducted between 2008 and 2009 found that there was a statistically significant positive correlation between structures and composition of audit committees and the financial performance of companies' listed in the Amman Stock Exchange in Jordan (Hamdan). The study also concluded that there was no link between audit committee characteristics and the operational performance of the same listed companies.

The characteristics of Audit Committees that affect company performance include:

1. Size of Audit Committee and the performance of the firm

One of the most important characteristics of an audit committee is its size. It is determined by the number of members that constitute the audit committee of a firm (Bauer et al., 2009; Hsu & Petchsakulwong, 2010; Nuryanah & Islam, 2011; Obiyo & Lenee, 2011).

In the late 20th century, in response to the mega corporate scandals at WorldCom and Enron, the American legislature drafted the Sarbanes-Oxley Act which has become a document of reference with regards to internal controls and corporate disclosure, especially with regards to the responsibilities and tasks of an audit committee. Several recommendations were made by the Blue Ribbon Committee (BRC) for the purposes of improving effectiveness of financial audit committees (BRC, 1999). The BRC had three main recommendations that they thought needed to be strengthened in every audit committee including effectiveness, accountability and most importantly independence. Another commission, i.e. The Cadbury Commission recommended the formation of audit committees in firms and it also recommended a minimum of three members to the committees all of whom should be solely non-executive directors (NEDs). Similarly, the Omani government's code of corporate conduct also mandated that audit committees should be comprised of a minimum of three members all of whom had to be NEDs and independent. The code also recommended that the committee chairman should not be in any way affiliated with the firm and that there should be at least a member who was an expert in financial accounting. Furthermore, audit committees should be the link between internal and external auditors and that these committees should play a key role in selection of auditors and in reviewing the scope of the audit, the results and the drafting of financial reports for publishing (Chanawonge, Poonpol, & Poonpool, 2011). Within that same context, the establishment of audit committees is essential for monitoring and regulating the role of management activities resulting in better financial performance of companies (Mohd et al. ., 2011; Xu et al., 2005). The audit committee also can assist the board of directors in monitoring and implementing better corporate governance that will benefit the company and its stakeholders (Saibaba & Ansari, 2011; Al-Matari, Al-Swidi & Binti Fadzil, 2014a).

Lipton and Lorsch's (1992) study recommended that board members should be about seven to eight. This study was also seemingly backed by another one that was conducted by Jensen (1993). Firstenberg and Malkiel (1994) suggested that a board with fewer than eight members would improve concentration, participation and would lead to more interactive and helpful discussions. Similarly, Shaver (2005) also argued that boards composed of many members (more than.....

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