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Review of Quantitative Finance and Accounting

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13-11-2019 | Original Research

The impact of audit committee expertise on auditor resources: the case of Israel

Authors: Omer Berkman, Shlomith D. Zuta

Published in: Review of Quantitative Finance and Accounting | Issue 2/2020

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Abstract

We investigate the association between internal audit resources and both audit committee financial expertise and independence using hand-collected data on firms traded on the Tel Aviv Stock Exchange in 2010–2014. This period follows the full implementation of SOX (and a similar regulation in Israel), a law that increased the burden of responsibility of audit committee members. Since expertise allows for a better appreciation of the risks inherent in the firm’s operations and the appropriate audit scope, we believe that expert committee members are more likely to require additional audit hours. Thus, we expect and document a significant and positive association between internal audit resources and audit committee expertise. This relation contrasts with the findings in Barua et al. (J Acc Public Pol 29(5):503–513, 2010), a study conducted on data gathered in the midst of the implementation of SOX. However, we fail to find any significant association between internal audit resources and audit committee independence. Our paper is the first to use publicly available data on internal audit resources, based on mandatory disclosures that are required in Israel but not in the US. Our analysis is thus not subject to non-response and self-selection biases existing in previous studies using survey data. Moreover, our study uses the number of hours worked by internal audit, a more direct measure of internal audit effort than budget or number of employees.

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In most cases researchers attempt to minimize the non-response bias. An example of such an attempt is sending two mailings of the survey a few months apart and controlling for the difference between early and late respondents. Nevertheless, in all survey-based papers we discuss later, response rates to the surveys are in the range of 15–35 percent.

Throughout the years a few committees were appointed in order to examine various aspects of Israeli corporate governance and develop recommendations for improvement. One of the most important of these committees was the Goshen Committee, appointed in 2005. The committee focused on improvement of director independence, the workings of audit committees and accountability, as well as the establishment of a court specializing in Corporate and Securities Law. Its recommendations were adopted in 2007.

Recall that we refer to data from 2001 to 2002, the period before the full implementation of SOX, as pre-SOX data.

The number of employees of internal audit was chosen by the researchers as their measure of the extent of internal audit due to their assessment that it was less sensitive than internal audit budget used in Carcello et al. (2005) and Barua et al. (2010), and was therefore less likely to have a negative impact on the response rate of the survey.

However, some papers question these findings (see, e.g., Carcello and Neal 2003; Badolato et al. 2014). For conflicts of interest involving specific types of directors with financial expertise see Guner et al. (2008), Dittmann et al. (2010) and Kroszner and Strahan (2001). See also Hayes (2014) for a critique of Badolato et al. (2014) research design as well as for a detailed description of the literature on audit committee financial expertise.

TASE started publishing historical data regarding index composition in 30.6.2010, so the index with respect to the end of 2009 is from that date.

See also the analysis in Khanna and Yafeh (2007) regarding the ownership structure throughout the world. Additional analyses of Israeli corporate governance include Lauterbach and Shahmoon (2010) and Schwartz-Ziv and Weisbach (2013), both analyzing research questions different from ours. Lauterbach and Shahmoon (2010) find a positive association between the quality of a firm's corporate governance and its Tobin's Q, using an index ranking the corporate governance of Israeli firms. Schwartz-Ziv and Weisbach (2013) find that Israeli boards spend most of their time on supervisory activities, but that in many instances they do take on a managerial role.

Jaggi et al. (2016) provide an insightful discussion of the influence of ownership structure on financial reporting in Italy, that shares the feature of concentrated ownership and the ensuing agency problems with Israel.

It has been pointed out by Hwang and Kim (2009) that social ties, not captured in the formal definition of independence, also have an effect on decisions made by the board of directors.

In terms of the number of members and composition of the audit committee, Israeli law sets the minimum number of audit committee members at three and requires that a majority of them be independent. While there is no explicit requirement for the committee to have members with financial expertise, other requirements imposed on the board effectively produce the requirement of at least one financial expert on the committee.

Out of the 0.97 held by related parties for the company with maximum value, 0.43 were held by institutional investors.

One company in our sample has both the minimum ROA and the maximum ROA (in different years). Without this company the mean remains almost the same and the range is − 0.14–0.66. We ran our regressions without this company and the results were materially unchanged.

We ran our regressions without the Weak variable and the results were virtually unchanged.

The company with 129 subsidiaries operates in real estate in many countries, and many of its subsidiaries consist of one project. Removing it from the sample, as well as another company with many subsidiaries, did not materially alter the results.

Recall that in the sample selection process we exclude banks, insurance companies, cross-listed firms and Gas & Oil partnerships. Thus, the single company in the Financial Services sector in our sample is not a bank or an insurance company and the single company in the Gas & Oil Exploration industry is not a partnership.

A case where related parties may prefer smaller number of audit hours is related party transactions which is routinely examined by internal audit.

Many firms did not report the number of business segments. In addition, the number of business segments is highly correlated with LN assets (r = 0.573). For these two reasons, we did not include this variable in our main regressions.

For a discussion of the concentrated nature of the Israeli economy see Kosenko (2008). For a description of the attempts to improve the corporate governance environment, including setting up special committees to review its shortcomings, see OECD (2011).

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Title: The impact of audit committee expertise on auditor resources: the case of Israel
Authors: Omer Berkman
Shlomith D. Zuta
Publication date: 13-11-2019
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 2/2020
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-019-00853-0

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