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The Implication of Board Composition towards External Auditor Choices.


External auditors not only play a monitoring role for the company, but also as an important component of the corporate governance (Lin and Liu, 2009). Chang, Dasgupta, and Hillary (2009) theorizes that all external auditors may not offer the same quality of service. The boards are directly accountable to the shareholders to provide a report on the performance of the company during Annual General Meeting (AGM) especially regarding the Audit Report. They are responsible in providing information that is free from any error or material misstatement. The study done by Alfraih (2017) found that board independence, board diversity and board size are significantly increase the likelihood of the Kuwait Stock Exchange (KSE) listed companies to choose a high quality audit firm. However, there is a limited study about this research in Malaysia.

In the circumstances of external auditor unable to deliver high-quality audits will plummet the confidence of the stakeholders especially the investors thus lead to negative consequence for the company. Therefore, the choice of external auditor has an impact towards the delivery of high-quality audits. Hope, Kang, Thomas, and Yoo (2008) discussed that high-quality audits reduce the information asymmetric and agency conflicts between the company and its stocks and debt holders. According Alfraih (2017), it is shown that the composition of board of directors has influential relationship in choosing an external auditor.

Besides the contribution of this study to literature review for future studies, the findings of this study redound to the benefit of society considering that board composition plays an important role in choosing an external auditor in a firm. In addition, it makes a clear statement on the effectiveness of the composition of the board of directors that provides strong practical in choosing the qualified external auditor for a firm especially the board interlocking characteristic. Thus, indirectly it will benefits the shareholders as a whole. This study also contributes to the companies in choosing their external auditor wisely, because it helps them in finding out the influence of the composition of their board of directors in the selection of the external auditor for the firm. In other point of view, the policy maker will earn benefit from this study relating to the board composition policy that has been outlined whether need to be refined and improvised especially the policy regarding the interlocking of director towards a better governance in Malaysian PLCs. Therefore, the objective of this study is to identify the factors (board independence, board diversity, board interlocking, board size and CEO duality) that influence the external auditor choices among Malaysian PLCs.

Literature Review

External auditors are independent parties that responsible to audit the financial statement of an entity in accordance with specific laws, rules and regulations. They are offering services such as audit, assurance services, taxation, advisory, management consulting, and corporate finance, actuarial and legal services. There are four largest professional services networks in the world which is known as Big Four that comprise of Klynveld Peat Marwick Goerdeler (KPMG), PricewaterhouseCoopers (PWC), Ernst and Young (EY) and Deloitte. External audit process is to provide credibility to financial statements and independence is the main means by which the external auditor demonstrates that this process was carried out in an objective manner.

Board independence is a corporate board in which the majority of the directors have no close relationship and personal interest with the top management of the entity. Berghe and Levrau (2004) found that the role and proportion of internal, external and independent directors will focus on the board of directors' efficiency. There is a likelihood of a firm to employ a specialised and good auditor with the percentage of independent board members found in a study of the role of independent auditors in the selection of external auditors (Beasley and Petroni, 2001). Board diversity refers to in which the board member positions are occupied by a proportion of men and women in the board. The mixed diversity of board will enhance board effectiveness and corporate governance (Adam and Ferreira, 2009).

Dezso (2012) has stated that the interlocking directorate refers to the practice of board of directors in corporate organisation in serving on the boards of multiple corporations that are presumed to transfer the information between boards, thus increasing information available to the interlocked firms. The roles of large board size are supply enough people to deliver the goods work of the board easily and collecting fund becomes less of a burden when the duty is separated among numerous individuals (Francis, 2004). On behalf of the shareholders, the board of directors is set up to monitor managers such as CEO. A CEO with multiple aspects on company and giving them the authority to act with resolution is among the advantages of CEO duality. Nevertheless, this considers little straightforwardness of the CEO's actions, and their activities can go unmonitored because the CEO will dominate and has the ruling power in BOD meetings as they also works as a the chairman simultaneously.

Theoretical Framework

In modern corporation, the demand for auditing can be understandable through the need of accountability when the business owners who play the role of principals in hiring the agents to manage their business. Auditing is a necessary instrument in monitoring the relationships between the entity and its stakeholders (Messier, Glover and Prawitt, 2008). The external auditor choice studies use management ownership and audit firm size to represent the agency problems between managers and shareholders and auditor quality respectively (Francis and Wilson 1988; DeFond 1992). Hayes, Dassen, Schilder and Wallage (2005) has showed that the agency theory explains the demand for audit services. This is because a company is viewed as the result of relatively formal contracts, in which several groups can make some kind of contribution to the company with a certain price. Thus, a reputable auditor is appointed according to the interest of third parties and for the interest of management as well.

Hypotheses Development

Board Independence

Leung and Cheng (2014) found that the presence of independent directors on a board give a significant influence on auditor choice. Furthermore, Carcello, Hermanson, Neal, and Riley (2002) found that the independent directors tend to choose the best auditor to maintain their firm's reputation and promote shareholder interests. Other than that, there is a likelihood of a firm to employ a specialized and brand name auditor with the presence of independent board found in a study in insurance company (Beasley and Petroni, 2001). Therefore:

Hypothesis 1 ([H.sub.1]): There is a significant relationship between board independence and external auditor choices.

Board Diversity

Gul (2012) shows that gender diverse boards are have higher probability to engage with high quality auditors. Srinidhi (2011) has stated that female board of directors are more motivated towards transparency and are more effective in monitoring management activities, which leads to selecting effective external auditors. In addition, Brooks and Zank (2005) have suggested that female directors are more opposed to risk and complexity in which why they always demand higher levels of monitoring to protect the firm's reputation capital. As a result, the female board of directors especially on the audit committee, are likely to increase board monitoring. In other words, a diverse boards are more likely to engage with higher quality auditors and demand higher audit effort. Therefore:

Hypothesis 2 ([H.sub.2]): There is a significant relationship between board diversity and external auditor choices.

Board Interlocks

Johansen and Pettersson (2013) found that board interlocks has allowed the sharing of knowledge related to auditors, thus the board interlocks can have impact on the choice of external auditors. In addition, according to Omer (2016), board interlocks are less likely to adopt reporting practices that reduce financial reporting quality. This is because, in the context of auditor choice, interlocking directorate is viewed as a connection between the focal board and the auditor appointed in the company of the interlocked board. Therefore:

Hypothesis 3 ([H.sub.3]): There is a significant relationship between board interlocks and external auditor choices

Board Size

Larger boards tend to choose a quality auditor to lessen company's problems, and improve the perceptions of users towards their financial statements (Ianniello, Mainardi and Rossi, 2015). According to investigation done by Lin and Liu (2009) presumed that companies with larger board will probably employ specialized audit firms, bringing about better monitoring and supervision of management actions. Ianniello et al. (2015) stated that the relationship between board size and external auditor choices that the size of the board is significantly associated with the choice of a Big 4 auditor. However, Beisland, Mersland and Strom (2015) found no significant relationship between board size and audit quality. Therefore:

Hypothesis 4 ([H.sub.4]): There is a significant relationship between board size and external auditor choices.

CEO Duality

Both the CEO and the chairman positions by the same person leads to decrease in the controlling and monitoring ability of the board over management's activities. It is expected that if CEO duality superior is present, the company expects to reduce the effort to hire a quality auditor. Ianniello et al. (2015) found CEO Duality lead to discourage the choice of a reputable auditor. Similarly, Karaibrahimoglu (2013) found a negative relationship between CEO duality and the choice of external auditor. Therefore:

Hypothesis 5 ([H.sub.5]): There is a significant relationship between CEO duality and external auditor choices.

Population and Sample

The population of this study is Malaysian Public Listed Companies in the Bursa Malaysia. For the year of 2016, there are about 805 public listed companies in the main market of Bursa Malaysia. The sampling technique used is simple random technique. The sample is collected randomly from the population of 805 public listed companies in the main market of Bursa Malaysia.

Measurement of Variables

Table 2 presents the Board of Directors Composition such as Board Independence, Board Size and Board Interlock by total which are analysed through descriptive analysis. The test was carried out on 260 companies out of 805 Malaysian PLCs. The range which describe the area of variation between the minimum value and the maximum value implies that the range of all the board of directors' composition is in between 8 to 11. Moreover, the maximum value of the board of directors' composition is more than 10 except board independence of which is 9. Besides, the average value per board independent, board size and board interlocks is 3.74, 8.02 and 4.42 respectively.

Table 3 shows the frequency distribution in board diversity indicates that 67.7 % of the sample has presence of women in their board of directors. Thus, in the current MCCG 2017 has stated that the company's policies to appoint women to the board while for large companies, the board has to comprise about at least 30 % women directors. Therefore, it is shown that most of the companies are following the current standards by the MCCG 2017. Referring to table 4, 88.5% companies have shown that the Chairman and the CEO is different person. As for the latest MCCG 2017, the position of chairman and CEO should be held by different individual and the chairman must be a non-executive member of the board. Where the chairman is not an independent director, the board should comprise a majority of independent directors. In addition, by referring to table 5; it is noticeable that among the sample, majority of 56.5% chooses Big 4 companies as their external auditors. Meanwhile, 43.5% choose Non Big 4 companies as their external auditors.

From the Table 7 below, there is no multicollinearity problems were found since there is no value that resulted in high correlation, which means that the independent variables are not correlated to each other. Thus, no independent variable was dropped in this study.

According to Hair, Anderson, Tatham and Black (2010), multicollinearity may arise if two or more variables being tested is highly correlated and may affect the regression tests.

Multicollinearity can be detected by running the Variance Inflation Factor diagnostics (VIF). If the VIF for each or any of the independent variables used is less than 5, then it indicates low multicollinearity exists and the model is valid and vice versa. Therefore, it is seen that the variables are not highly correlated (<5) and the integrity of the model is not affected as there is no multicollinearity.

Regression Model:

External Auditor Choices = [[beta].sub.0] + [[beta].sub.1] CEO Duality + [[beta].sub.2] Board Independence + [[beta].sub.3] Board Size + [[beta].sub.4] Board Interlock + [[beta].sub.5] Board Diversity + [summation]t (1)

Table 8 presents the regression results between the dependant and independent variables. From the results, the independent variables were managed to explain 11.4 percent ([R.sup.2]=.114) of the variance in the external auditor choices. Five main hypotheses were developed in this study however the result shows that only board interlock has significantly affected the external auditor choices among PLCs in Malaysia. A significant relationship occurs when the increase in board interlock will lead to increase in external auditor choices. This is consistent with the study of Chin and Chan (2013) which shows that interlocked board influence the external auditor choices. Other than that, the result shown support the study of Johansen and Pettersson (2013) which founds that board interlocks will be able to share their knowledge as they are possessing different position in different company including the knowledge about the choices of external auditors, thus the board interlocks can have impact on the choice of external auditors. It is also because of the nature of interlocking director that have different nature of experience as they possess more than one position in one time, it will give more input and idea regarding the choices of external auditor in their company. Therefore, the hypothesis (H3) is supported.

However, the result does not support the study of Karaibrahimoglu (2013) and Lin and Liu (2009) which found that the presence of CEO duality in the organization will decreased demand for specialized audit firms. For the independence board, the finding is not consistent with the previous study done by Leung and Cheng (2014) that the presence of independent directors in a company give a positive impact on external auditor choices. The finding of the study also not support the study done by Ianniello et al. (2015) which founds that that larger board size tend to choose the best auditor in order to improve perceptions of the users towards their financial statements. For board diversity, the finding is inconsistent with the prior study done by Gul et al. (2012) and Srinidhi (2011) that stated the female board of directors are more inclined towards transparency and are more effectual in monitoring management activities, which result selecting effective external auditors.

Discussion and Conclusion

The only significantly related to the choice of external auditor is Board Interlocking, while the others are not give any impact. It is anticipated that there might be any other factors that contribute to the decision made such as the performance of the company as the nature is concern, the Big 4 firms are come with the brand name, higher quality and the fees expected to be higher compared to small or medium firm. As a conclusion, the board of director characteristics may not be used as a single factor in deciding the choices of external auditor to their company. Company have to properly select the external auditor because the choice of external auditor is the most important in resolving agency conflicts since audit acts as a monitoring device (Houghton and Jubb, 2003). Therefore, agency theory predicts a positive relationship between agency costs and the employment of high quality audit firms (Watts and Zimmerman, 1983). The results of this study shows that only board interlocking has significant relationship towards external auditor choices while the other board characteristics does not. This research has achieved the significance of the study on the effectiveness of the board composition only on relating to the Board Interlocking and provides strong practical evidence that this characteristic give greater significance in choosing the qualified external auditor. Thus, it wills benefits to the company in terms of deciding the composition of their board of directors in ensure the interest of all the shareholders and stakeholders are remain intact.

Limitation and Recommendation

This study place high reliance on annual report to collect all the information needed. It is suggested to the future research to obtain information from the various sources of data such as website, interview and etc. This is because finding about the result might be different. In addition, there is lack of previous research in this area of study. It appears that there are just a small number of previous researches that have been done in Malaysia within this area of study. It is highly recommended that this study to cover more than one financial accounting year. As it is noticeable that the data collected in this study is from the financial year of 2016. Therefore, future researchers should cover at least two years to gather further details in this study. Besides, this study should specialized in any industry to have different point of view. In addition, it is also due to the nature of business in other sectors, firm size, complexity of the firm, and the policies and requirement needed in the company that the result. Furthermore, this study should examine a specific dependent variable. It is suggested to conduct this field of study according to the market capitalization or company size this is due to the fair judgment and better result. This may also include the quality of the audit firm. This is because, studying whether the public listed companies in Malaysia chooses Big 4 as their external auditors may not be relevant as non-Big 4 companies such as Crowe Horwath may produce high quality audits.


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Nik Amalena Najebah Nik Azman (*)

Universiti Tenaga Nasional


Nor Farhana Selahudin

Universiti Tenaga Nasional

Elengeswaran A/L C. Ehambaranathan

Universiti Tenaga Nasional

Noratikah Patin

Universiti Tenaga Nasional

Nor Azwani Mohd Zawawi

Universiti Tenaga Nasional

Sharmilla A/P Nadarajah

Universiti Tenaga Nasional

(*) Corresponding Author
Table 1: Measurement of Variables

Variable              Measutemeat

Dependent Variable :  Dummy variable. It is equal to one (1) if a Big 4
Auditor Choices       auditing firm audits the companys financial
                      statements and zero (0) otherwise.
Variable :
Board Independence    Proportion of independent directors to the total
                      number of directors on the hoard of company.
Board Diversity       Dumny variable that equals 1 if women are
                      present on the board and 0 otherwise.
Board Interlocks      Proportion of directors on the board with
                      interlocks in other companies to total board size
                      of company.
Board size            Number of directors on the board of company.

CEO Duality           Dummy variable. 1 if the CEO of company is
                      also the Chairman of the board, and 0 otherwise.

Variable              Reference

Dependent Variable :  Tate (2007)
Auditor Choices

Variable :
Board Independence    Carcello et al.
Board Diversity       Adams &
                      Ferreira (2009)
Board Interlocks      Braam &
Board size            Berghe &
                      Levrau (2004)
CEO Duality           Lin & Liu

Table 2: Descriptive Statistics

                    N    Range  Minimum  Maximum  Mean  Std. Deviation

Board Independence  260  8      1         9       3.74  1.176
Board Size          260  10     4        14       8.02  2.019

Board Interlock     260  11     0        11       4.42  2.531

Table 3: Board Diversity

                   Frequency  Percent  Valid Percent  Cumulative Percent

Absence of Women    84         32.3     32.3           32.3
Presence of Women  176         67.7     67.7          100.0
Total              260        100.0    100.0

Table 4: CEO Duality

                  Frequency  Percent  Valid Percent  Cumulative Percent

Different CEO
and Chairman      230         88.5     88.5            88.5
CEO and Chairman
at the same
time               30         11.5     11.5           100.0
Total             260        100.0    100.0

Table 5: External Auditor Choices

                Frequency  Percent  Valid Percent  Cumulative Percent

Non Big 4 Firm  113         43.5     43.5            43.5
Big 4 Firm      147         56.5     56.5           100.0
Total           260        100.0    100.0

Table 6: Correlation

                    Correlation Coefficient  Sig. (2-tailed)

Board Independence   0.180 (**)              0.004
Board Diversity      0.075                   0.231
Board Interlocks     0.336 (**)              0.000
Board Size           0.168 (**)              0.007
CEO Duality         -0.072                   0.248

(**) Correlation is significant at the 0.01 level (2-tailed)
(*) Correlation is significant at the 0.05 level (2-tailed)

Table 7: Multicollinearity

Variables           Tolerance  Variance Inflation Factors

CEO Duality         0.991      1.009
Board Independence  0.647      1.545
Board Size          0.542      1.845
Board Interlock     0.665      1.503
Board Diversity     0.943      1.060

Table 8: Regression

Dependent Variable  External auditor choices

R square            0.114
Adjusted R square   0.097
F                   6.543
Sis                 0.000

Model               Beta    t       Sig

(Constant)                   2.073  0.39
CEO Duality         -0.51   -0.865  0.388
Board Independence   0.67    0.910  0.364
Board Size          -0.053  -0.665  0.506
Board Interlock      0.318   4.395  0.000 (***)
Board Diversity      0.047   0.773  0.440
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Author:Azman, Nik Amalena Najebah Nik; Selahudin, Nor Farhana; Ehambaranathan, Elengeswaran A/L C.; Patin,
Publication:Global Business and Management Research: An International Journal
Geographic Code:9MALA
Date:Apr 1, 2018
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