Financial Reporting Quality, Auditor Remuneration and Corporate Governance: UK Evidence

Abstract

The recent global financial crisis has added fuel to the heated debate on whether boards of directors in general and audit committees in particular are effective in curtailing aggressive financial reporting practices and maintaining a transparent audit process. Specifically, UK regulators raised widespread concerns about the criteria of revenue recognition and the role of external auditors during and after the crisis, and re-emphasize the crucial role that audit committees could play in ameliorating financial reporting quality and safeguarding the quality of external audit. Despite this intense emphasis on the financial reporting and external audit oversight roles of internal governance mechanisms, there is still no empirical evidence confirming the effectiveness of these roles after the financial crisis. As such, this thesis contributes to the literature by using a sample of FTSE 350 firms listed on the London Stock of Exchange during the period between 2008 and 2010 to address two main empirical questions in two investigations. The first empirical investigation deals with the impact of audit committee and board characteristics on financial reporting quality. Two measures are employed to serve as surrogates for financial reporting quality. The first measure, which contributes to the uniqueness of this study, is discretionary revenues used to address misleading revenue recognition concerns by UK regulators, and discretionary accruals employed to account for the possibility of firms shifting from one earnings management method to another. The results reveal significant associations between a number of governance characteristics and discretionary revenues, but not discretionary accruals. This suggests that in response to UK intense regulatory scrutiny over the criteria of revenue recognition, firms’ revenue recognition process was subject to increased monitoring by boards in general and audit committees in particular, leading to better quality financial reporting. The second empirical investigation of this thesis examines the association between audit committee and board characteristics on the one hand and audit fees and non-audit fees on the other. The findings reveal that audit fees are positively related to governance mechanisms indicating that the oversight roles of audit committees and boards have positive impact on enhancing audit quality through demanding wider audit scope from external auditors. However, non-audit fees are also found to be positively related to audit committee meetings and board size, suggesting that the committee and the board support the simultaneous provision of audit services and non-audit services to facilitate a beneficial knowledge spill-over between the two services which in turn results in a better audit quality. Comparing the main results with those obtained from an additional analysis of a sample of firms listed in the pre-financial crisis period between 2005 and 2007 indicates that the effectiveness of governance mechanisms in enhancing financial reporting quality differs between regular and recession periods. Overall, most of the findings are consistent with the agency perspective. Those which are not consistent open avenues for future research to explore a multi-theoretical approach which takes into consideration the complexities of firms and their environmental circumstances.