AUDIT COMMITTEE ATTRIBUTES, FINANCIAL DISTRESS

AND THE QUALITY OF FINANCIAL REPORTING IN MALAYSIA

Wan Nordin Wan-Hussin

Noor Marini Haji-Abdullah

College of Business

Universiti Utara Malaysia

Sintok 06010

Kedah

Email: wannordin@uum.edu.my

November 2009

JEL code: G32

Keywords: Audit committee, financial reporting quality, Malaysia

Electronic copy available at: http://ssrn.com/abstract=1500134

 AUDIT COMMITTEE ATTRIBUTES, FINANCIAL DISTRESS

AND THE QUALITY OF FINANCIAL REPORTING IN MALAYSIA

ABSTRACT

Audit committee effectiveness is one of the significant themes in corporate governance

debates. We contribute to the debate by examining empirically whether audit committees

imbued with the prime features are associated with reliable financial reporting in

Malaysia. By using a more direct measure of financial reporting quality, this study is one

of the few studies that overcome the imprecision inherent in the abnormal

accruals/earnings management. The evidence suggests that the desirable characteristics

which the policy makers believe would enhance the effectiveness of the audit committee

in carrying out its financial oversight responsibilities do not seem to yield the intended

consequence. We find an association between financial distress and financial reporting

quality, consistent with Rosner (2003) and Garcia-Lara, Garcia-Osma, & Neophytou

(2009). This reinforces the importance of including the distress variable in future

corporate transparency studies.

Electronic copy available at: http://ssrn.com/abstract=1500134

 INTRODUCTION

In the wake of a series of highly publicized accounting scandals around the world (see,

for example, Enron and Worldcom in the US, Parmalat, Ahold, Gescartera and BBVA in

Europe and Transmile in Malaysia), the effectiveness of the audit committee in

monitoring the financial reporting process is one of the significant themes in corporate

governance debates (Gendron & Bedard, 2006). These high profile governance failures

have led to the introduction of significant corporate governance regulatory reforms,

which focused on the structures of the audit committee, so as to improve the quality of

governance over financial reporting. For example, the Blue Ribbon Committee (1999) in

the US recommends a minimum size of three audit committee members, the

independence of the board members who serve on the audit committee, and financial

expertise of the audit committee members1. The Sarbanes Oxley Act (2002) or SOX

brings further improvements in the corporate governance environment with audit

committees that are substantially more active and diligent and possessing greater

expertise and power to fulfill its expanded responsibilities (Cohen, Krishnamoorthy, &

Wright, 2009). SOX requires that all audit committee members be independent and that

the company’s annual report discloses whether a member of the audit committee is a

financial expert (Engel, Hayes, & Wang, 2009). SOX also stipulates that audit

committees appoint, compensate, and oversee the external auditor (Section 301).

1
The Blue Ribbon Committee (BRC) was established by the National Association of Securities Dealers
and New York Stock Exchange at the behest of Arthur Levitt, the then Chairman of the Securities and
Exchange Commission (SEC). SEC subsequently adopted certain recommendations by the BRC with effect
from Dec 15, 2000.

3
 The situation in Malaysia with regards to audit committee is not very different

from the US. Since 1994, the Bursa Malaysia Listing Requirements have required a listed

company to appoint an audit committee which meets the following requirements; (1)

must be composed of not fewer than three members; (2) a majority of the audit

committee members must be independent directors; and (3) at least one member of the

audit committee must be a member of the Malaysian Institute of Accountants (MIA) or

possesses sufficient accounting experience and qualification, or deemed “financially

literate” by the Stock Exchange.2 In the 2007 enhancements to the voluntary Malaysian

Code on Corporate Governance (2001), it is stipulated that all audit committee members

must be nonexecutives and financially literate with at least one of them is a member of an

accounting association or body.

Beasley, Carcello, Hermanson, & Neal (2009) note that the bulk of past studies

which examine the efficacy of the audit committee attributes as proposed by the

regulators mainly focused on the association between certain audit committee inputs (e.g.

audit committee member independence, expertise and diligence) and financial reporting

outputs. They conclude that these quantitative studies generally find that a more

independent, expert and diligent audit committee is associated with higher quality

financial reporting and auditing. However, the recent corporate governance disaster at

Hollinger International Inc. despite having audit committee members who possess all the

desirable attributes (financially literate, independent and meeting frequently) and Enron

where “The audit committee followed all the rules – but it let the shareholders down”

2
The Bursa Malaysia Corporate Governance Guide (2009) defines a member of the audit committee as
financially literate if he/she has the ability to read and understand financial statements, ability to analyze
financial statements and ask pertinent questions about the company’s operations against internal controls
and risk factors, and ability to understand and interpret the application of approved accounting standards (p.
56).

4
(Business Week, 2002, p. 28), triggers them to probe deeper into “Do audit committees

appear to provide substantive oversight of financial reporting, or do they appear to be

primarily ceremonial bodies designed to create legitimacy?” Through in-depth interviews

with audit committee members, they reveal that audit committee practices contain a

mixture of substantive monitoring of financial reporting and ceremonial practices,

consistent with Cohen, Krishnamoorthy, & Wright (2002) who document that audit

partners generally perceive that “audit committees are ineffective and are not powerful

enough to resolve contentious matters with management” (p. 586).

Another stream of emerging research focused on whether audit committee

members who are independent in form are also independent in substance (Gendron &

Bedard, 2006; Cohen et al., 2009). These studies reveal that senior management has a

significant role in board and audit committee appointment, and it is possible that

management appoints passive, compliant audit committee members who satisfy

regulatory requirements but provide minimal oversight over management’s actions. This

suggests that at least some changes in governance may have been more form than

substance. We continue with this line of investigation and examine whether firms imbued

with the prime features needed by audit committee members are associated with reliable

financial reporting in Malaysia.

Previous Malaysian studies provide mixed results on the desirability of the audit

committee attributes, as proposed by the regulators. For example, Bradbury, Mak, & Tan

(2006) and Mohd-Saleh, Mohd-Iskandar, & Rahmat (2007) document that independent

audit committee enhances financial reporting quality, whereas Abdullah & Mohd-Nasir

(2004) and Abdul-Rahman & Mohamed-Ali (2006) show otherwise. Ismail, Mohd-

5
Iskandar, & Rahmat (2008) and Abdul-Rahman & Mohamed-Ali (2006) do not find any

evidence to indicate that audit committee activeness and financial literacy significantly

impact financial reporting quality. However, Ismail, Mohd-Iskandar, & Rahmat (2008)

find that audit committee multiple directorship impacts corporate reporting quality.

Thus, to help inform policy makers on the efficacy of their regulatory reforms,

this study investigates whether audit committee characteristics such as the size of audit

committee, independence of audit committee, audit committee meeting frequency and

attendance, financial literacy of audit committee and multiple directorships held by audit

committee members in other public listed companies would affect the quality of financial

reporting.

Malaysia provides another suitable setting to evaluate the efficacy of prescribing

certain “best practices” for audit committees since all listed companies in Malaysia are

required to include in their annual reports, a report on the profile, composition, frequency

and attendance of meeting, terms of reference and summary of activities carried out by

the audit committee and summary of internal audit activities. We indicate the quality of

financial reporting as high when the company has won prestigious annual awards given

by the Stock Exchange, and low when the company has been publicly reprimanded by

the Stock Exchange for violating the Listing Requirements pertaining to mandatory

corporate disclosures, or the company has received disclaimer audit opinion because the

auditors were not able to ascertain the accuracy of the financial statements. In overseeing

the financial reporting, the audit committee is responsible, among others, in assessing the

appropriateness of management’s selection of accounting policies and disclosures in

compliance with approved accounting standards, ensuring timely submission of financial

6
statements by management, reviewing significant or unusual transactions and accounting

estimates and assessing whether the financial report presents a true and fair view of the

company’s financial position and performance and complies with regulatory

requirements (Bursa Malaysia Corporate Governance Guide, 2009, para 2.2.2).

Thus, our study which uses a more direct measure of financial reporting quality is

one of the few studies that overcome the imprecision in using the earnings management

models as a proxy of financial reporting quality. The main problem with the abnormal

accrual models is the presence of measurement error in detecting whether earning

management has or has not taken place (Dechow, Sloan, & Sweeney, 1995; Guay,

Kothari, & Watts, 1996; McNicholls & Wilson, 1998; Dechow & Dichev, 2002).

In addition, following Rosner (2003) and Garcia-Lara, Garcia-Osma, &

Neophytou (2009), we incorporate financial distress indicator in the financial reporting

quality model. Most earnings management studies in the past probably suffer from

omitted variable bias as they do not include the distress variable. Given that the role of

the audit committee chairperson is highlighted in the Malaysian Code on Corporate

Governance (2007)3, Bursa Malaysia Corporate Governance Guide (2009)4 and the

Malaysian Corporate Governance Index 2009 endorsed by Minority Shareholder

Watchdog Group, we also include the background of the audit committee chairperson in

3
Under the Code, the best practices in corporate governance include:
The chairman of the audit committee should engage on a continuous basis with senior management, such as
the chairman, the chief executive officer, the finance director, the head of internal audit and the external
auditors in order to be kept informed of matter affecting the company. Through the engagements, relevant
issues affecting the company can be brought to the attention of the audit committee in a timely manner.
4
The Guide emphasizes that a key element for a successful audit committee is a strong chair demonstrating
depth of skills and capabilities. The audit committee chairman should assume, among others, the following
responsibilities: planning and conducting meetings, overseeing reporting to the board, encouraging open
discussion during meetings and developing and maintaining an active ongoing dialogue with senior
management and both the internal and external auditors. The chair is also accountable for the agenda of the
audit committee meeting and should not delegate it to management.

7
terms of degree of independence, accounting financial expertise and multiple

directorships in the robustness tests. An empirical study by Engel et al. (2009) shows that

the quality of audit committee, proxied by the accounting financial expertise of the

chairperson, is positively related to the level of audit committee compensation.

The findings show that audit committee size and financial distress influence the

quality of financial reporting. The other audit committee attributes such as independence,

board seats in other companies, frequency of and level of attendance at audit committee

meetings and financial literacy are not significantly related to the quality of financial

reporting. There is also no association between financial reporting quality and the audit

committee chairman independence, financial literacy and multiple directorships. All in

all, the evidence suggests that the desirable characteristics which the policy makers

believe would enhance the effectiveness of the audit committee in carrying out its

financial oversight responsibilities, do not seem to yield the intended consequence.

The rest of the paper is organized as follows. The next section reviews the

relevant studies and presents the research hypotheses. Then we describe the research

method and discuss the results. The concluding section is devoted to the implication of

our study for investors, regulators and academics who would want to examine audit

committee oversight process.

PRIOR STUDIES AND HYPOTHESIS DEVELOPMENT

Agency theory suggests that shareholders require protection because management

(agents) may not always act in the interests of the absentee owners (principals) (Jensen &

8
Meckling, 1976; Fama & Jensen, 1983). To deal with this agency problem, the board

assumes an oversight role that typically involves monitoring the Chief Executive Officer

(CEO) and other top executives, approving the company’s strategy, and monitoring the

internal control over financial reporting. Given board diverse responsibilities, the board

of directors delegates some of its oversight responsibilities to the audit committee and

other committees of the board.

The issue of audit committee’s effectiveness in monitoring the financial reporting

process was examined by, among others, DeZoort, Hermanson, Archambeault, & Reed

(2002), Klein (2002), Felo, Krishnamurthy, & Solieri (2003), Xie, Davidson, & DaDalt

(2003), Abbott et al. (2004), Bedard, Chtourou, & Courteau (2004), Persons (2005), Lin,

Li, & Yang (2006), Qin (2007) and Archambeault, DeZoort, & Hermanson (2008). They

examine the association between audit committee characteristics and incidence of fraud

or restatements or extent of earnings management or disclosure quality. We summarize

below the arguments that link audit committee characteristics and financial reporting

quality and provide the empirical evidence on the relationship. In addition, we also

discuss the financial reporting behavior among financially distressed firms to illustrate

the vital need to include the distress variable in any study on financial reporting quality.

Size of Audit Committee

As mentioned earlier, the Bursa Malaysia Listing Requirements require a listed company

to appoint the audit committee from amongst its directors which must be composed of not

9
fewer than three members. A larger audit committee may make it more likely that

potential problems in the financial reporting process will be uncovered and resolved. This

could arise if a larger committee size increases the resources available to the audit

committee and improves the quality of oversight. Felo et al. (2003) document a positive

relationship between financial reporting quality and audit committee size in a univariate

analysis but this relationship does not hold in the multivariate analysis. In Malaysia,

Ahmad-Zaluki & Wan-Hussin (2009) provide evidence that audit committee size is

positively associated with the quality of financial information disclosure, proxied by the

accuracy of IPO management earnings forecast. Based on the above, the following

hypothesis is proposed:

H1: Larger audit committee size is associated with higher quality of financial

reporting.

Independence of Audit Committee

The role of audit committee is to safeguard an organization through its authority to

question top management regarding the way financial reporting responsibilities are

handled, as well as to make sure that corrective actions are taken. In a famous speech by

Arthur Levitt entitled “The Numbers Game”, the former Chairman of the Securities and

Exchange Commission remarked that “qualified, committed, independent and tough

minded audit committees represent the most reliable guardians of the public interest”.

The Listing Requirements of Bursa Malaysia stipulates that all listed companies

must have audit committees comprising three members of whom a majority shall be

10
independent. The term independent in the Malaysian context refers to two crucial aspects,

independence from management and independence from significant shareholders. The

Revised Malaysian Code on Corporate Governance 2007 reinforces the desirability of

audit committee independence by excluding executive directors from membership.

Meanwhile, the SOX requires firms to have audit committees comprised solely of

independent director who is not an affiliate of the firm and not accepting any

compensation from the firm other than director’s fees.

Many studies have uncovered empirical regularities that audit committee

independence enhances the quality of financial reporting. Klein (2002), Abbott et al.

(2004), Bedard et al. (2004), Persons (2005) and Archambeault et al. (2008) show that

audit committee independence reduce earnings management, or the likelihood of

financial reporting restatement and financial reporting fraud. Krishnan (2005) finds that

independent audit committees are significantly less likely to be associated with the

incidence of internal control problems over financial reporting. These studies support the

view that independent audit committees contribute positively to the financial reporting

process, which motivate the following hypothesis:

H2: Higher percentage of independent directors in audit committee is associated

with higher quality of financial reporting.

Audit Committee Meeting Frequency and Attendance

The National Committee on Fraudulent Financial Reporting, also known as Treadway

Commission (1987), states that an audit committee, which intends to play a major role in

11
oversight, would need to maintain a high level of activity. The audit committee should

meet regularly, with due notice of issues to be discussed and should record its

conclusions in discharging its duties and responsibilities. In the same vein, the Malaysian

Code on Corporate Governance (2001) posits that audit committees which do not meet or

meet only once are unlikely to be effective financial monitors. The Revised Code (2007)

advocates an increase in the frequency of meetings to at least twice a year between the

audit committee and the external auditor without the executive board members present.

This encourages a greater exchange of free and honest views and opinions between both

parties.

The Guidelines for Audit Committees in the UK are particularly useful on the

issue of timing of audit committee meetings. The number of meetings required in a year

depends on the company’s terms of reference and the extent of the complexity of the

company’s financial operations. The Guidelines state that the main meetings are often

planned between the end of one year’s audit and the beginning of the next, before the

issue of the Interim Statements, after the Interim Results and after the year end, but

before the accounts are finalized.

Menon & Williams (1994) contend that the more often an audit committee meets,

the more active it is being perceived, which leads to fewer financial reporting problems.

Xie et al. (2003) and Vafeas (2005) document that when audit committees meet more

frequently, discretionary accruals are lower and there is lower likelihood of firm

reporting a small earnings increase, which indicates better financial reporting quality.

Abbott et al. (2004) document that higher levels of committee activity (measured by

holding a minimum of four meetings) are significantly related to a lower incidence of

12
financial restatement. These studies provide evidence in support of the view that audit

committees which meet more often are more effective in monitoring management and

can potentially enhance the quality of financial reporting.

There are several dimensions that can be used to indicate audit committee activity

such as meeting frequency, meeting duration and time allocation among different

functions, meeting regularity, information exchange at the meetings, and whether

executive directors are present at meetings and level of attendance of audit committee

members. Due to archival data constraint, the two dimensions of activity that are

examined in this study are frequency of audit committee meetings and the level of

attendance of audit committee members. Based on the above discussion, two sub-

hypotheses are formulated:

H3a: Higher frequency of audit committee meetings is associated with higher

quality of financial reporting.

Besides regular meetings, the level of attendance of audit committee members can

also be used to measure the activeness of audit committee members. Even though the

frequency of meeting is high but if the attendance levels are poor, this may impair the

effectiveness of the audit committee. It is posited that the higher the level of attendance

of audit committee members, the more active and participative the audit committee is,

therefore the better is the quality of financial reporting.

H3b: Higher level of attendance of audit committee members is associated with

higher quality of financial reporting.

13
Financial Expertise of Audit Committee

Audit committees are responsible for numerous duties that require a high degree of

accounting sophistication such as, understanding auditing issues and risks as well as the

audit procedures proposed to address them, comprehending audit judgments and

understanding the substance of disagreement between management and external auditor,

and evaluating judgmental accounting areas. DeZoort & Salterio (2001) show that audit

committee members with previous experience and knowledge in financial reporting and

audit are more likely to make expert judgments than those without. Xie et al. (2003),

Abbott et al. (2004) and Bédard et al. (2004) document that audit committee financial

expertise reduces financial restatements or constrain the propensity of managers to

engage in earnings management. DeFond, Hann, & Hu (2005) document that

appointment of accounting financial experts generates positive stock market reaction, in

line with market expectation that the audit committee members’ financial sophistication

are useful in executing their role as financial monitors. Krishnan (2005) and Zhang,

Zhou, & Zhou (2007) find that firms are more likely to be identified with deficiencies in

internal control over financial reporting, if their audit committees have less financial

expertise. All in all, these studies suggest that financially knowledgeable audit committee

members who possess accounting qualifications are more likely to prevent and detect

material misstatements. Thus, the following hypothesis is proffered:

H4: Higher percentage of audit committee members who are financial experts

is associated with higher quality of financial reporting.

14
Audit Committee Members with Board Seats in Other Companies

Morck, Shleifer, & Vishny (1988) state that monitoring of top officers requires time and

effort. As the additional directorships on other firms’ board increase, demands on the

individual board member’s time decrease the amount of time available for the director to

effectively fulfill monitoring responsibilities at a single firm. Shivdasani (1993) contends

that multiple directorships held by board members is a double edged sword. On the one

hand, it is important in terms of adding to the experience, but on the other hand, it can

cause limitation of time and commitment for board members to perform effectively.

Persons (2005) finds that the likelihood of financial statements fraud is lower when audit

committee members hold fewer directorships with other firms. Meanwhile, Song &

Windram (2004) and Vafeas (2005) find that multiple outside directorships may not

undermine audit committee effectiveness. One possible interpretation of this result is that

under a certain limit, outside directorships enable directors to acquire specific experience

from other companies. Given the inconclusive finding, the following hypothesis

(nondirectional) is proposed:

H5: The number of outside directorships per audit committee member affects the

quality of financial reporting.

Financial Distress

For an entity experiencing financial distress, the quality of financial reporting is often

proxied by the tenor of the relevant financial statement notes and of the liquidity section

of the Management Discussions & Analysis (MD&A). Carcello & Neal (2003) find that

15
there is a significant positive relation between the percentage of affiliated directors on the

audit committee and the optimism of both the financial statements notes and MD&A

discussions for financially distressed entities. This evidence corroborates the finding by

Jones (1996) that managers in financially distressed firms would prefer no disclosure or

optimistic disclosure because they believed that disclosure of the going concern problems

may adversely affect the entity’s stock price. Similarly, Koch (2002) contends that

management earnings forecasts issued by distressed firms exhibit greater upward bias and

are viewed as less credible than similar forecasts made by nondistressed firms.

Meanwhile, Holder-Webb & Cohen (2007) in their study of firms entering financial

distress, find that the firms increase the disclosure quality of MD&A in the year of initial

distress. However, sustained increases in the disclosure quality are limited to firms that

subsequently recover from distress.

Apart from examining the MD&A, very few studies have compared the accruals

quality between financially distressed firms and nondistressed firms. Rosner (2003)

shows that financially distressed firms are more likely to exhibit signs of material income

increasing earnings manipulation than those of nondistressed firms. Likewise, Garcia-

Lara et al. (2009) show that managers resort to both accrual manipulation and real

activity manipulation in the years leading up to bankruptcy. Based on the above

discussion that points to the low reliability of financial report emanating from financially

distressed firm with propensity to camouflage its real performance, the following

hypothesis is derived:

H6: Firms experiencing financial distress are associated with low financial

reporting quality.

16
 METHODOLOGY

According to Cohen, Krishnamoorthy, & Wright (2004) and Pomeroy & Thornton

(2008), there is a lack of consensus on how to operationalize financial reporting quality.

Dimensions of financial reporting quality that have been used by previous researchers

include incidence of financial restatements and fraudulent financial reporting, weaknesses

in internal controls, and earnings quality using constructs such as earnings response

coefficient and discretionary or abnormal accruals. Given that the public disclosure of

financial restatements due to misrepresentation, fraudulent financial reporting and

weaknesses in internal controls are rare in Malaysia, this study proxies the quality of

financial reporting according to whether the company is a winner of the Stock Exchange

Corporate Award (KLSE Award) or is meted disciplinary action by the KLSE for

deficient corporate reporting, or is a recipient of disclaimer audit opinion.5

The KLSE Corporate Awards recognize listed companies which have shown

exemplary corporate conduct in complying with the Listing Requirements. In addition,

the Award recognizes public listed companies which have demonstrated high standards

of corporate governance, disclosure and transparency coupled with proactive investor

relations efforts. Importantly, these Awards also seek to promote international best

practices by public listed companies. In February 2004 it was announced that 40

companies won the 2003 KLSE Corporate Awards, the last year the Awards were given

since they were started in 1999, including four financial institutions. In this study, the

5
KLSE is the abbreviation for Kuala Lumpur Stock Exchange, which is now known as Bursa Malaysia.

17
winners of the KLSE Awards, excluding financial institutions, are deemed to have good

quality financial reporting (see Appendix 1).

On the other hand, companies which were fined and/or publicly reprimanded by

the Stock Exchange for failure to comply with certain provisions in the Listing

Requirements are considered to have poor financial reporting quality. In 2003,

disciplinary actions were taken against 21 companies, and the nature of the offences of

each company are described in Appendix 2. These companies are considered to have low

quality of financial reporting because they failed to comply with some of the qualitative

characteristics of financial information such as timeliness and relevance. Another

dimension of poor financial reporting quality used in this study is when the auditors are

not able to express an opinion on whether the financial statements give a true and fair

view. For financial year ended 2003, we identify 11 such companies (see Appendix 3).

Thus, unlike previous studies, our research design which focuses on companies with

extremely high and low financial reporting quality provides us with a more competent

and powerful test to identify characteristics of an audit committee that matters in

enhancing financial reporting quality.

The study uses logistic regression analysis to test the hypotheses. Maddala (1991)

states that logistic regression is appropriate where disproportionate sampling from two

populations occurs. Studies on the effectiveness of audit committee that have used

logistic regression include and Felo et al. (2003), Abbott et al. (2004), Song & Windram

(2004), Lin et al. (2006), Pucheta-Martinez & De Fuentez (2007) and Archambeault et al.

(2008). The regression is specified as follows:

Dependent Variable = α + ∑βAudit Committee Attributes + πDistress

18
 + ∑µControls + ε (1)

If a nonfinance company has been awarded the KLSE Awards, the dependent

variable = 1. If a company has received a public reprimand (with or without fines

imposed) by the Stock Exchange or disclaimer audit opinion, the dependent variable = 0.

The variables associated with audit committee attributes are defined as follows: ACSIZE

denotes audit committee size, ACIND denotes the proportion of audit committee

members who are independent directors, ACLIT denotes the proportion of audit

committee members who are financial experts i.e. members of professional accounting

bodies, ACFREQ denotes the number of audit committee meetings held during the year,

ACATT denotes the percentage of members who attended the audit committee meetings

during the year, ACMULT denotes the percentage of audit committee members with

board seats in other listed companies, ACCHINDLIT is a dummy variable which takes the

value of 1 if an audit committee chairperson is both independent and a financial expert

and 0 otherwise, ACCHMULT is a dummy variable which takes the value of 1 if the audit

committee chairperson has directorship in other listed companies and 0 otherwise, and

DISTRESS is a dummy variable which takes the value of 1 if the Z-score is below 2.07

based on the widely used Altman (1993) distress model6 and 0 otherwise. The control

variables are BIG-3, which takes a value of 1 if the company is audited by Ernst and

Young, KPMG or PricewaterhouseCoopers and 0 otherwise, ROA which is net income

divided by total assets, and FIRMSIZE which is the natural log of total assets.

6
The Altman distress model is computed as follows:
Z = 1.2*(working capital/total assets) + 1.4*(retained earnings/total assets) + 3.3*(EBIT/total assets) +
0.6*(market value of equity/total liabilities) + 1.0*(net sales/total assets).
It is used in Malaysian studies by Nor and Chin (2002), Gul (2006) and Hasnan et al. (2009).

19
 Our data sources are Bursa Malaysia website, and the annual reports of the

respective companies for financial years ended 2002 and 2003. We used the annual

reports ended 2002 for companies that won the 2003 KLSE Corporate Excellence

Awards having financial year ending in October, November and December. We used the

annual reports ended 2003 for all the remaining companies.

FINDINGS

Table 1 shows the sample partitioned by quality of financial reporting, type of auditor,

distress indicator and the background of the audit committee chairperson. Out of 36

nonfinancial firms that won the KLSE Awards, 26 (or 73 percent) were audited by the

Big-3 firms of Ernst and Young, KPMG or PricewaterhouseCoopers. On the other hand,

out of the 32 firms that were reprimanded for violating the Listing Requirements or

issued disclaimer audit opinion, 17 (or 53 percent) were audited by non Big-3. Almost

two third of companies with good financial reporting quality do not have distress

indicator, whereas 88 percent of companies with poor financial reporting quality have

distress indicator.

About two-thirds of the sample firms have an audit committee chairperson who is

also a director in other listed companies. The instances of audit committee chairperson

who is both independent and a financial expert are lower among the high quality financial

reporting firms compared to the low financial reporting firms (22 percent vs. 34 percent).

The chi-square tests (not shown in Table 1) indicate there are associations between the

20
quality of financial reporting and type of auditor and between the quality of financial

reporting and distress indicator.

(Insert Table 1 here)

Table 2 shows the descriptive statistics of the sample partitioned by quality of

financial reporting, either good or poor. Univariate analyses (t-test) showing comparison

between poor financial reporting companies and good financial reporting companies are

also shown for each of the variables of interest, and control variables. The average audit

committee size for the full sample is 3.8. The average audit committee size for the good

quality companies is slightly higher than the poor quality companies (4.1 vs. 3.5). All the

companies in the sample have an audit committee with at least three members, which is

in accordance with the Listing Requirements. On average, 73 percent of audit committee

members are independent. All companies in the sample have audit committees where the

majority is independent directors. The difference in means on audit committee

independence between poor and good quality companies (0.69 vs. 0.76) is statistically

significant. With regards to financial expertise of audit committee members, on average,

one third of audit committee members is considered expert.

The average audit committee meeting frequency is the same for good and poor

financial reporting companies at 4.75 times. Another way to measure the activeness of

audit committee is to look at the attendance at audit committee meetings. The level of

attendance is higher (although insignificant) for good quality companies over poor

quality companies whereby on average 94 percent of members attended the audit

21
committee meetings of high financial reporting quality companies, as compared to 91

percent for poor financial reporting quality companies.

On average, nearly 60 percent of audit committee members are also directors in

other listed companies, with good financial reporting quality companies having higher

multiple directorships than their counterparts (64 percent vs. 56 percent), although the

difference is not significant. High financial reporting quality companies also have higher

Z-score, albeit insignificant, compared to low financial reporting quality companies. In

terms of firm’s performance, high financial reporting firms perform significantly better

than low financial reporting firms, with their average ROAs at 5.3 percent and -40 percent

respectively.

To summarize, the evidence from Tables 1 and 2 shows that firstly, the incidence

of engaging Big-3 audit firm is significantly higher for good financial reporting

companies than for poor financial reporting companies, and secondly the audit committee

size and audit committee independence for good financial reporting companies are

significantly higher than for poor financial reporting companies. More companies in the

poor financial reporting quality category have distress indicator than their counterparts in

the good financial reporting quality category, although the difference in the Z-score

means between the two categories is not statistically significant. Poor financial reporting

firms are also smaller and have lower returns on assets than their counterparts.

(Insert Table 2 here)

Table 3 shows the correlation analysis between the independent and control

variables. Based on the correlation matrix, the correlation coefficients among the

22
variables are all less than 0.6 except for the Spearman correlation between DISTRESS and

ROA which is -0.62, which indicates that multicollinearity problem is not a cause for

concern. This is further supported by the variance inflation factors of less than 2, when

ordinary least square regressions are run for all the various models

(Insert Table 3 here)

Table 4 presents the regression results. In all the models the common variables are

audit committee size, financial distress and the control variables. In Model 1, the

additional audit committee attributes tested are the degree of independence and

accounting financial expertise of audit committee members, In Model 2, we include the

diligence of audit committee in terms of frequency of meeting and level of attendance at

meetings, alongside with audit committee member with multiple directorships. In Model

3, we focus on the background of the audit committee chairperson. Based on the results,

none of the audit committee attributes influence the quality of financial reporting, except

for audit committee size in Model 2. Good financial reporting companies are more likely

to have larger audit committee size than poor financial reporting companies. This is

consistent with the evidence by Lin et al. (2006) who show that a larger audit committee

provides more oversight over the financial reporting process and reduces the probability

of restatements after their original filings with the SEC, but is in contrast with the

evidence from Felo et al. (2003), Abbott et al. (2004) and Bédard et al. (2004).

Our finding that independent audit committee is not associated with the quality of

financial reporting is in contrast with previous Malaysian studies such as Abdullah &

Mohd-Nasir (2004) and Abdul-Rahman & Mohamed-Ali (2006) that use abnormal

23
accruals as proxy for financial reporting quality. However, it is in tandem with Bradbury,

Mak, & Tan (2006) and Mohd-Saleh, Mohd-Iskandar, & Rahmat (2007). Similar to

previous Malaysian studies such as Ismail, Mohd-Iskandar, & Rahmat (2008) and Abdul-

Rahman and Mohamed-Ali (2006), we do not find any evidence to indicate that audit

committee activeness and financial literacy significantly impact financial reporting

quality. We also find no association between audit committee multiple directorship and

corporate reporting quality, which challenges previous finding by Ismail, Mohd-Iskandar,

& Rahmat (2008).

Poor financial reporting companies are also more likely to have distress indicator

consistent with the univarite results presented in Table 1 earlier. Consistent with Table 2,

the results in Table 4 also indicate that larger and better performing firms are more likely

to exhibit higher financial reporting quality. Overall, there is very little support for

hypotheses 1 to 6. Although the variables associated with the hypotheses are not

statistically significant, the signs of the coefficients are in the predicted directions.

The accuracy of the model indicates that the percentage of correct classification is

very high at above 85 percent. The Nagelkerke R squared also indicates that about 75

percent of all variation in the quality of financial reporting is explained by the models.

Although not tabulated in Table 4, when we include all the hypothesized variables and

the control variables, the results are qualitatively similar. The significant variables are

DISTRESS, ROA and FIRMSIZE, whilst all of the audit committee attributes are

insignificant.

(Insert Table 4 here)

24
 CONCLUSION

Audit committee effectiveness remains one of the significant themes in corporate

governance debates (Gendron and Bedard, 2006). The main objective of the study is to

examine the relationships between audit committee characteristics and the quality of

financial reporting. The characteristics of audit committee that are examined are size,

independence, literacy, multiple directorships, level of activities which is proxied by

meeting frequency and attendance, and background of the audit committee chairperson.

The evidence that firms with more members in the audit committee are more

likely to have good quality financial reporting is in contrast with the evidence from

previous studies such as Felo et al. (2003), Abbott et al. (2004) and Bedard et al. (2004),

but consistent with Lin et al. (2006). This suggests that larger audit committees are more

likely to be able to devote adequate time and effort to ensure that the information

disclosed in the financial statements is accurate and timely and hence increase the quality

of financial reporting.

This study also documents that financial distress is associated with the quality of

financial reporting. This implies that previous studies that exclude financial distress in the

financial reporting quality model may be mis-specified.

Overall the findings can provide guidance to users of accounting information such

as investors and regulators. For users, our findings serve as a reminder that audit

committees may appear to comply with regulatory requirements on independence,

financial expertise and minimum number of meetings, yet in actuality they only play a

ritualistic role with no substantive monitoring in the financial reporting process, in

25
tandem with the institutional theory prediction (Cohen, Krishnamoorthy, & Wright,

2008). To help users make an informed decision on the quality of audit committee and to

facilitate a sound assessment of “independence in substance”, more qualitative disclosure

is required on the activities of audit committees and the extent to which they have

fulfilled their responsibilities. For the regulators, the efficacy of prescribing certain “best

practices” for the audit committee remains an open question.

It is also fruitful for future research to consider moderating factors that may blunt

the ability of audit committee members to promoe corporate transparency. An

independent audit committee member’s lack of seniority on the board may adversely

affect his/her ability to scrutinize top management and raise concern over questionable

accounting practices. An audit committee member who is appointed by the incumbent

CEO may face obstacles in becoming an effective financial monitor. One of the

limitations of this study is the possibility of error in the archival measure of audit

committee diligence. Audit committee compensation may be a better proxy for diligence

than number of meetings and level of attendance at such meetings. We also ignore

nonaccounting financial expertise when measuring the level of audit committee financial

literacy.

26
 APPENDIX 1

The recipients of KLSE Corporate Awards 2003

NO. COMPANY NAME - MAIN AWARDS’ CATEGORY SECTOR

BOARD
1. AIC Corporation Berhad KLSE Corporate Excellence
Awards 2003
2. British American Tobacco KLSE Corporate Sectoral Consumer Products
(Malaysia) Berhad Awards 2003
3. Petronas Gas Berhad KLSE Corporate Sectoral Industrial Products
Awards 2003
4. Road Builder(M) Holdings KLSE Corporate Sectoral Construction
Berhad Awards 2003
5. Telekom Malaysia Berhad KLSE Corporate Sectoral Trading/Services
Awards 2003
6. Island & Peninsular Berhad KLSE Corporate Sectoral Property
Awards 2003
7. Golden Hope Plantations Berhad KLSE Corporate Sectoral Plantation
Awards 2003
8. Puncak Niaga Holdings Berhad KLSE Corporate Sectoral Infrastructure
Awards 2003 Project Companies
9. Computer Systems Advisers (M) KLSE Corporate Sectoral Technology
Berhad Awards 2003
10. Shangri-La Hotels (Malaysia) KLSE Corporate Sectoral Hotels
Berhad Awards 2003
11. Malaysia Mining Corporation KLSE Corporate Sectoral Mining
Berhad Awards 2003
12. UMW Holdings Berhad KLSE Merit Awards 2003 Consumer Products
13. Carlsberg Brewery Malaysia KLSE Merit Awards 2003 Consumer Products
Berhad
14. Top Glove Corporation Berhad KLSE Merit Awards 2003 Industrial Products
15. Tractors Malaysia Holdings KLSE Merit Awards 2003 Industrial Products
Berhad
16. IJM Corporation Berhad KLSE Merit Awards 2003 Construction
17. Gamuda Berhad KLSE Merit Awards 2003 Construction
18. Genting Berhad KLSE Merit Awards 2003 Trading/Services
19. Malaysia International Shipping KLSE Merit Awards 2003 Trading/Services
Corporation Berhad
20. Sunrise Berhad KLSE Merit Awards 2003 Property
21. S P Setia Berhad KLSE Merit Awards 2003 Property
22. Kumpulan Guthrie Berhad KLSE Merit Awards 2003 Plantation
23. Guthrie Ropel Berhad KLSE Merit Awards 2003 Plantation
24. Unisem (M) Berhad KLSE Merit Awards 2003 Technology

27
NO. COMPANY NAME - SECOND AWARDS’ CATEGORY SECTOR
BOARD

1. Pharmaniaga Berhad KLSE Corporate Excellence Awards 2003

2. SEG International Berhad KLSE Corporate Excellence Awards 2003
3. Khind Holdings Berhad KLSE Corporate Sectoral Awards 2003 Consumer Products
4. Tien Wah Press Holdings Berhad KLSE Corporate Sectoral Awards 2003 Industrial Products
5. Kumpulan Jetson Berhad KLSE Corporate Sectoral Awards 2003 Construction/
Property/Plantation
6. PJI Holdings Berhad KLSE Corporate Sectoral Awards 2003 Trading/Services
7. Industronics Berhad KLSE Corporate Sectoral Awards 2003 Technology
8. Hunza Consolidation Berhad KLSE Merit Awards 2003 Consumer Products
9. Malaysian AE Models Holdings KLSE Merit Awards 2003 Industrial Products
Berhad
10. Wong Engineering Corporation KLSE Merit Awards 2003 Industrial Products
Berhad
11. Ahmad Zaki Resources Berhad KLSE Merit Awards 2003 Construction/Property/
Plantation
12. Nationwide Express Courier KLSE Merit Awards 2003 Trading/Services
Services Berhad

28
 APPENDIX 2

Companies that were reprimanded/fined by the KLSE

COMPANY'S NAME DATE NATURE YEAR ENDED AMT OF FINE

SINDORA 23-Aug-03 LS OF AAA 30 APRIL 2003 RM2,000
SELOGA 23-Oct-03 LS OF AAA 30 APRIL 2003 RM16,000
SOUTHERN PLASTIC 9-Jan-04 LS OF QR 31 MAY 2003 RM22,000
DATUK KERAMAT 9-Jul-04 LATE ANNOUNCEMENT OF WINDING UP
AMTEK 7-May-04 FAIL TO ANNOUNCE TRANSACTION
LATE ANNOUNCEMENT OF RELATED PARTY
DISCCOMP 20-Aug-04 TRANSACTION
PILECON 20-Feb-04 LATE ANNOUNCEMENT OF WINDING UP
TANAH EMAS 19-Mar-04 OTHER RM200,000
TIMBERWELL 5-Nov-04 LS OF AR 31 DEC 2003 RM72,000
TIMBERWELL 5-Nov-04 LS OF AAA 31 DEC 2003 RM126,000
CHUAN HUAT 26-Nov-04 INFORMATION NOT FACTUAL, CLEAR RM50,000
SITT TATT 9-Jul-04 INFORMATION NOT FACTUAL, CLEAR
KSU 25-Jun-04 LS OF AAA 31 JULY 2003 RM200,000
KSU 9-Jul-04 LS OF AR 31 MARCH 2003 RM200,000
KSU 20-Aug-04 LS OF QR 30 SEP 2003 RM200,000
KSU 20-Aug-04 LS OF QR 31 DEC 2003 RM200,000
ANTAH 2-Mar-04 LS OF AAA 30 JUNE 2003 RM14,000
JIN LIN WOOD 24-Sep-04 LS OF QR 30 SEP 2003 RM100,000
JIN LIN WOOD 24-Sep-04 LS OF QR 31 DEC 2003 RM47,500
JIN LIN WOOD 24-Sep-04 LS OF AAA 30 JUNE 2003 RM100,000
JIN LIN WOOD 24-Sep-04 LS OF AR 30 JUNE 2003 RM125,000
SETEGAP 17-Sep-04 LS OF AAA 31 DEC 2003 RM5,000
LIEN HOE CORP. 20-Aug-04 LS OF QR 31 DEC 2003 RM3,000
GLOBETRONICS 03-Oct-03 OTHER
GENERAL SOIL 9-Feb-04 LATE ANNOUNMENT OF WINDING UP
CONSOL. FARM 5-Nov-04 OTHER
31 DEC 2003 &
AVANGARDE 3-Jan-05 LS OF AR 2002 RM165,000
31 DEC 2003 &
AVANGARDE 3-Jan-05 LS OF AAA 2002 RM160,000
BUKIT KATIL 11-Mar-05 LS OF AR AR 30 JUNE 2003 RM200,000
BUKIT KATIL 11-Mar-05 LS OF AAA AAA 30 JUNE 2003 RM200,000

INDICATOR
LS OF QR = LATE SUBMISSION OF QUARTERLY REPORT
LS OF AAA = LATE SUBMISSION OF ANNUAL AUDITED ACCOUNT
LS OF AR = LATE SUBMISSION OF ANNUAL REPORT

29
 APPENDIX 3

The recipients of Qualified Audit Report for the year 2003

NO. COMPANY’S NAME AUDITORS AUDIT OPINION

1. Anson Perdana Berhad HLB I. M. Chieng & Co Unable to form an opinion/Disclaimer

2. Aokam Perdana Berhad KPMG Unable to form an opinion/Disclaimer

3. Ekran Berhad Ernst & Young Unable to form an opinion/Disclaimer

4. Geahin Engineering Berhad Ernst & Young Unable to form an opinion/Disclaimer

5. Hotline Furniture Berhad Horwath Mok & Poon Unable to form an opinion/Disclaimer

6. Innovest Berhad BDO Binder Unable to form an opinion/Disclaimer

7. Kemayan Corporation Berhad PricewaterhouseCoopers Unable to form an opinion/Disclaimer

8. Metroplex Berhad P.C. Chan & Partners Unable to form an opinion/Disclaimer

9. Omega Holdings Berhad Ernst & Young Unable to form an opinion/Disclaimer

10. Pica (M) Corporation Berhad KPMG Unable to form an opinion/Disclaimer

11. Tru-Tech Holdings Berhad PricewaterhouseCoopers Unable to form an opinion/Disclaimer

30
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35
 Table 1- Sample Characteristics

Type of external AC chairperson AC chairperson

is also director in is both independent
Distress other listed and financial expert
auditor** indicator*** companies
NonBig-

3 Big-3 No Yes No Yes No Yes

Good n 10 26 24 12 10 26 28 8
quality
financial 28 72 78 22
percent 27 73 67 33
reporting*
Poor n 17 15 4 28 11 21 21 11
quality
financial 53 47 12 88 36 66 66 34
percent
reporting

n 27 41 28 40 21 47 49 19
Total
percent 40 60 41 59 31 69 72 28

* Companies with good quality financial reporting are winners of 2003 KLSE Awards, whilst companies with poor

quality financial reporting are violators of the Stock Exchange Listing Requirements or recipients of disclaimer audit

opinion,

**Big-3 consists of Ernst and Young, KPMG or PricewaterhouseCoopers.

***Distress companies have Altman Z-score below 2.07 (see footnote 6).

36
 Table 2 - Descriptive Statistics

ACSIZE ACIND ACLIT ACFREQ ACATT ACMULT Z-SCORE ROA FIRMSIZE

Good Mean 4.08 0.76 0.31 4.75 0.94 0.63 3.86 0.053 13.74

N=

36 Minimum 3.00 0.50 0.17 4.00 0.80 0.00 0.67 -0.07 11.00

Maximum 6.00 1.00 0.67 8.00 1.00 1.00 14.24 0.38 17.14

Poor Mean 3.47 0.69 0.33 4.75 0.91 0.56 -13.11 -0.40 11.81

N=

32 Minimum 3 0.5 0.00 2.00 0.40 0.00 -345.00 -4.15 7.22

Maximum 5 1.0 0.67 11.00 1.00 1.00 9.69 1.05 14.47

Good t-test #

vs. (difference 3.59* 2.49* -0.70 0.00 1.43 0.90 1.67 2.94* 4.97*

Poor in means) 3.64* 2.54* -0.69 0.00 1.37 0.89 1.57 2.77* 4.99*

Total Mean 3.79 0.73 0.32 4.75 0.93 0.60 -4.12 -0.16 12.83

N= Minimum 3.00 0.50 0.00 2.00 0.40 0.00 -345 -4.15 7.22

68 Maximum 6.00 1.00 0.67 11.00 1.00 1.00 14.24 1.05 17.14

# The top figure is for equal variances assumed and the bottom figure is for equal variances not assumed.

* p < .05 (2-tailed).

The independent variables are defined as follows: ACSIZE denotes audit committee size, ACIND denotes the proportion
of audit committee members who are independent directors, ACLIT denotes the proportion of audit committee members
who are financial experts i.e. members of professional accounting bodies, ACFREQ denotes the number of audit
committee meetings held during the year, ACATT denotes the percentage of members who attended the audit
committee meetings during the year, ACMULT denotes the percentage of audit committee members who are also
directors in other listed companies, Z-SCORE is based on Altman model (see footnote 6), ROA is net income divided
by total assets, and FIRMSIZE is the natural log of total assets.

37
 Table 3 - Correlations

1 2 3 4 5 6 7 8 9 10 11 12
1. ACSIZE -0.04 -0.10 0.01 -0.30 0.20 -0.18 0.03 -0.15 0.22 0.19 0.46
2. ACIND 0.22 -0.18 0.05 0.05 0.25 -0.05 0.12 -0.25 0.11 0.20 0.19
3. ACLIT -0.32 -0.28 0.10 0.09 -0.05 0.25 0.04 0.05 0.18 -0.12 -0.23
4. ACFREQ 0.00 0.08 0.07 0.05 -0.03 0.23 -0.01 0.05 -0.09 0.06 -0.02
5. ACATT -0.30 -0.16 0.18 -0.14 -0.05 0.12 0.11 -0.15 -0.12 0.04 0.02
6. ACMULT 0.24 0.28 -0.13 0.02 -0.08 -0.04 0.57 -0.10 0.02 0.05 0.28
7. ACCHINDLIT -0.16 -0.02 0.27 0.30 0.06 -0.05 0.13 0.12 -0.10 -0.12 -0.15
8. ACCHMULT 0.02 0.20 -0.02 0.06 0.00 0.54 0.13 -0.11 -0.02 -0.14 -0.01
9. DISTRESS -0.14 -0.24 0.11 -0.08 -0.12 -0.09 0.12 -0.11 -0.13 -0.26 -0.20
10. BIG‐3 0.24 0.13 0.07 -0.04 -0.06 0.03 -0.10 -0.02 -0.13 0.29 0.28
11. ROA 0.29 0.27 -0.24 -0.06 0.21 0.11 -0.25 0.04 -0.62 0.35 0.31
12. FIRMSIZE 0.43 0.22 -0.37 -0.02 -0.04 0.26 -0.15 -0.01 -0.20 0.27 0.47

Pearson (diagonal up) and Spearman (diagonal down).

Correlation in boldfaced indicates significant at the 0.05 level (2-tailed).

The independent variables are defined as follows: ACSIZE denotes audit committee size, ACIND denotes the proportion of audit committee members who are independent
directors, ACLIT denotes the proportion of audit committee members who are financial experts i.e. members of professional accounting bodies, ACFREQ denotes the number of
audit committee meetings held during the year, ACATT denotes the percentage of members who attended the audit committee meetings during the year, ACMULT denotes the
percentage of audit committee members who are also directors in other listed companies, ACCHINDLIT takes a value of 1 if audit committee chairman is both independent and a
financial expert and 0 otherwise, ACCHMULT takes a value of 1 if audit committee chairman is also director(s) in other listed companies and 0 otherwise, DISTRESS takes the
value of 1 if the Z-score is below 2.07 based on the widely used Altman (1993) distress model (see footnote 6), BIG-3 takes a value of 1 if the company is audited by Ernst and
Young, KPMG or PricewaterhouseCoopers and 0 otherwise, ROA is net income divided by total assets, and FIRMSIZE is the natural log of total assets.

38
 Table 4 - Logistic Regression

Dependent Variable = α + ∑βAudit Committee Attributes + πDistress + ∑µControls + ε

Model 1 Model 2 Model 3

Hypotheses
and Expected Coefficient Coefficient Coefficient
sign estimate estimate estimate

ACSIZE H1 (+) 1.35 2.06* 1.25

ACIND H2 (+) 6.80

ACFREQ H3a (+) 0.21

ACATT H3b (+) 10.44

ACLIT H4 (+) 3.81

ACMULT H5 (?) -1.40

DISTRESS H6 (-) -2.68* -2.86* -2.76*

ACCHINDLIT 0.44

ACCHMULT -0.11
Control
BIG-3 -0.07 -0.08 0.11
Control
ROA 6.41* 6.10* 5.96*
Control
FIRMSIZE 1.07* 1.14* 0.99*
Constant -22.75* -29.70* -15.25*
Nagelkerke R squared 0.76 0.77 0.74
Hosmer-Lemeshow chi-square 9.35 7.95 2.74
Percentage correct 88.2 86.8 86.8

* p < .05.

The dependent variable = 1, if the company has been awarded the KLSE Awards, and 0 if the company has
received a public reprimand (with or without fines imposed) by the Stock Exchange or disclaimer audit
opinion. The independent variables are defined as follows: ACSIZE denotes audit committee size, ACIND
denotes the proportion of audit committee members who are independent directors, ACLIT denotes the
proportion of audit committee members who are financial experts i.e. members of professional accounting
bodies, ACFREQ denotes the number of audit committee meetings held during the year, ACATT denotes
the percentage of members who attended the audit committee meetings during the year, ACMULT denotes
the percentage of audit committee members who are also directors in other listed companies, ACCHINDLIT
takes a value of 1 if audit committee chairman is both independent and a financial expert and 0 otherwise,
ACCHMULT takes a value of 1 if audit committee chairman is also director(s) in other listed companies and 0
otherwise, DISTRESS takes the value of 1 if the Z-score is below 2.07 based on the widely used Altman (1993) distress
model (see footnote 6), BIG-3 takes a value of 1 if the company is audited by Ernst and Young, KPMG or

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PricewaterhouseCoopers and 0 otherwise, ROA is net income divided by total assets, and FIRMSIZE is the natural log
of total assets.

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