Amended Proposal

Table of content

TOC o “1-3” h z u HYPERLINK l “_Toc319675887” CHAPTER 1 PAGEREF _Toc319675887 h 3

HYPERLINK l “_Toc319675888” 1.0 Background of the Study PAGEREF _Toc319675888 h 3

HYPERLINK l “_Toc319675889” 1.1 Statement of the Problem PAGEREF _Toc319675889 h 3

HYPERLINK l “_Toc319675890” 1.2 Objectives of the Study PAGEREF _Toc319675890 h 4

HYPERLINK l “_Toc319675891” 1.2.1 General Objective PAGEREF _Toc319675891 h 4

HYPERLINK l “_Toc319675892” 1.2.2 Specific Objective PAGEREF _Toc319675892 h 4

HYPERLINK l “_Toc319675893” 1.3 Hypotheses PAGEREF _Toc319675893 h 4

HYPERLINK l “_Toc319675894” 1.4 Significance of the study PAGEREF _Toc319675894 h 5

HYPERLINK l “_Toc319675895” 1.5 Scope of the Study PAGEREF _Toc319675895 h 5

HYPERLINK l “_Toc319675896” CHAPTER 2 PAGEREF _Toc319675896 h 6

HYPERLINK l “_Toc319675897” LITERATURE REVIEW PAGEREF _Toc319675897 h 6

HYPERLINK l “_Toc319675898” 2.1 Empirical Review PAGEREF _Toc319675898 h 6

HYPERLINK l “_Toc319675899” 2.1.1 Corporate Governance PAGEREF _Toc319675899 h 6

HYPERLINK l “_Toc319675900” 2.1.2 Benefits of Corporate Governance PAGEREF _Toc319675900 h 6

HYPERLINK l “_Toc319675901” 2.1.3 Corporate Audit PAGEREF _Toc319675901 h 7

HYPERLINK l “_Toc319675902” 2.1.4 Issues in Corporate Governance PAGEREF _Toc319675902 h 7

HYPERLINK l “_Toc319675903” 2.2 Theoretical Review PAGEREF _Toc319675903 h 8

HYPERLINK l “_Toc319675904” 2.2.1 Overview of Audit Quality PAGEREF _Toc319675904 h 8

HYPERLINK l “_Toc319675905” 2.2.2 Audit Committee and Corporate Governance PAGEREF _Toc319675905 h 9

HYPERLINK l “_Toc319675906” 2.2.3 Board Structure and Audit Quality PAGEREF _Toc319675906 h 9

HYPERLINK l “_Toc319675907” 2.2.4 Ownership Structure and Audit Quality PAGEREF _Toc319675907 h 10

HYPERLINK l “_Toc319675908” 2.2.5 CEO Duality and Audit Quality PAGEREF _Toc319675908 h 11

HYPERLINK l “_Toc319675909” 2.3 Corporate Governance in Kenya PAGEREF _Toc319675909 h 11

HYPERLINK l “_Toc319675910” 2.4 Gap PAGEREF _Toc319675910 h 12

HYPERLINK l “_Toc319675911” 2.5 Conceptual Framework PAGEREF _Toc319675911 h 12

HYPERLINK l “_Toc319675912” CHAPTER 3 PAGEREF _Toc319675912 h 14

HYPERLINK l “_Toc319675913” METHODOLOGY PAGEREF _Toc319675913 h 14

HYPERLINK l “_Toc319675914” 3.1 Research Design PAGEREF _Toc319675914 h 14

HYPERLINK l “_Toc319675915” 3.2 Population PAGEREF _Toc319675915 h 14

HYPERLINK l “_Toc319675916” 3.3 Sample and Sampling Design PAGEREF _Toc319675916 h 14

HYPERLINK l “_Toc319675917” 3.4 Data Collection PAGEREF _Toc319675917 h 15

HYPERLINK l “_Toc319675918” 3.5 Data Analysis PAGEREF _Toc319675918 h 16

HYPERLINK l “_Toc319675919” Reference PAGEREF _Toc319675919 h 18

HYPERLINK l “_Toc319675920” APPENDIX PAGEREF _Toc319675920 h 23

HYPERLINK l “_Toc319675921” 1 Questionnaire PAGEREF _Toc319675921 h 23

HYPERLINK l “_Toc319675922” 2 Study Timetable PAGEREF _Toc319675922 h 24

HYPERLINK l “_Toc319675923” 3 Budget PAGEREF _Toc319675923 h 24

CHAPTER 11.0 Background of the StudyAuditing in public corporations is aimed at protecting shareholders who are members of the public by virtue of being taxpayers. Legally, public corporations are required to make available to any interested party the most recent audit results and financial fillings upon request. In this context, auditing is designed to act in a regulatory capacity, keeping public corporations fiscally responsible and honest about their financial practices and economic situation (Economist, 2004).

Procedural audit covers various aspects of a corporation including compliance with environmental laws, laws to protect workers’ safety, and all other types of laws relating to management of corporations. Procedural audit may also involve an evaluation and assessment of practices and procedures at a corporation, usually with the objective of improving operational performance. Usefulness of audit reports largely depends on two aspects namely quality of audit and integrity of auditors. Audit quality can be ascertained looking for presence of critical information like accurate financial statements and indicators of organization’s performance. These two are dependent on the extent of auditors’ willingness to issue qualified and independent report (Chen et al., 2005).

Though a number of studies have been undertaken on the topics of corporate governance and corporate audit, not much has been said about implications of corporate governance on audit quality. This study will attempt to examine possible explanations as to why public corporations in Kenya which though promptly publish their audit reports as require by law, continue to perform dismally compared to private corporations. One of the assumptions guiding this study includes possible explanations that quality of audit reports from these public corporations could be significantly compromised.

1.1 Statement of the ProblemPoor corporate governance is perhaps the most important factor blamed for poor performance of public corporations. There is much that can be done to improve the integrity of financial reporting through greater accountability, the restoration of resources devoted to audit function, and better corporate governance practices (Saudagaran, 2003). This thesis will extend and contribute to existing research using data from public corporations in Kenya to investigate the likely impact of corporate governance on audit quality. The thesis is motivated by the interests surrounding the appropriateness of public sector reforms instituted by the government of Kenya in response to public corporate failures, global best practice and their implied efficacy in the face of significant implementation and audit quality.

1.2 Objectives of the Study1.2.1 General ObjectiveThe general objective of this research is to assess the effectiveness of corporate governance practices on the quality of audit reports.

1.2.2 Specific ObjectiveTo assess the relationship between the strength of audit committee and the quality of audit report.

To assess the relationship between the existence of an internal audit function and quality of audit report.

To assess the relationship between the strength of corporate code of conduct and quality of audit report.

1.3 HypothesesThe research proposal intends to test the following hypotheses:

There is a significant relationship between the strength of audit committee and the quality of audit report.

There is a significant relationship between the existence of an internal audit function and quality of audit report.

There is a significant relationship between the strength of corporate code of conduct and quality of audit report.

1.4 Significance of the studyThis study will provide useful insights into improving audit quality of public corporations in Kenya. It will further contribute to audit literature given that it will provide additional empirical evidence on the impact of governance practices on audit quality. The study will also reflect the quality of audit services between different audit firms in Kenya. This study will be useful to taxpayers in Kenya as it will provide evidence on the relationship between corporate governance and audit quality and the reforms instituted by the government in formulating the Code of Corporate Governance for public corporations.

1.5 Scope of the StudyThis study will be premised on the appraisal of audit quality in Kenya. Therefore, data on public corporations in Kenya will be sought to provide answers to the problems and questions that have been raised for the study. The study will cover selected public corporations listed under the Public Corporations Act, Laws of Kenya that are physically located in Nairobi.

CHAPTER 2LITERATURE REVIEW2.1 Empirical Review2.1.1 Corporate GovernanceCorporate governance is the way in way everyday activities of a corporation are being run, or technique by which corporations are directed and managed. The governance of corporations is entrusted to the board of Directors as well as concerned committees, all as per shareholders’ interests. Governance activities include balancing individual and societal goals and economic and social goals. In corporate governance, there exist elaborate interaction of stakeholders including shareholders, board of Directors, and management. All the stakeholders work collectively in shaping corporations’ performance. For success to be realized in any corporation there is need to foster healthy working relationships between shareholders and management. Shareholders must ensure actual performance is as per the standards of performance (Management Study Guide, 2012).

Put into broader perspective, corporate governance focuses the manner shareholders guarantee themselves of getting fair return on their investment. This requires distinguishing between shareholders and management. Management should be solely responsible for decision making and authority of the corporation. To ensure shareholder interests are protected, corporate governance ensures transparency which in turn ensures strong and balanced economic development. Demand for good corporate governance is driven by emergence of market-oriented economies and globalization. Corporate governance ensures corporations emphasize trustworthiness, morality, and ethics (Management Study Guide, 2012).

2.1.2 Benefits of Corporate GovernanceA number of benefits can be realized from corporate governance. These include lowering of capital costs, positive impact on corporation’s share prices, ensuring corporate success and economic growth, and helping in brand formation and development. Other benefits of corporate governance include providing proper inducement to shareholders and management to achieve objectives that are in interests of the owners and the organization, and minimizing wastages, corruption, risks and mismanagement (Management Study Guide, 2012).

2.1.3 Corporate AuditCorporate audit refers to examination of financial and operational procedures at a corporation. These examinations are either conducted by internal or external corporate audit teams, and they can serve a variety of functions. The sole purpose of auditing is to confirm that corporations are operating within the law, and that their stated ethical standards are upheld by their practices. Corporate audit takes various forms; in the financial sense it involves detailed inspection of accounts and financial practices of a corporation. Auditors will mainly look at possible financial irregularities which may indicate tax evasion, funds embezzlement, as well as other illegal activities. Financial audits may also be concerned with ways of helping a corporation operate more efficiently and effectively by suggesting ways in which a corporation may cut costs and improve performance (Economist, 2004)

2.1.4 Issues in Corporate GovernanceSuccessful corporations are those that experience financial stability such that interests of shareholders and the corporation itself are effectively addressed and enhanced. Financial stability of a corporation can be achieved by the interaction of three basic necessities namely sound leadership at the corporation level, strong prudential regulation and supervision, and effective market discipline. Sound leadership begins with good corporate governance consisting capable and experienced board of Directors and management staff, a coherent strategy and business plan, and clear lines of responsibility and accountability (McDonough, 2002).

Since the board of Directors is mandated to develop overall strategy development within a corporation, it is important that only individuals with necessary skills and competencies are represented in the board. It is necessary that clear guidelines establishing independence of the board are established. The top management should be constituted by individuals capable of setting prudent business strategies and can pursue decisions that would ensure long-term objectives and policies set by the board are realized (McDonough, 2002).

To ensure financial stability, execution of the overall objectives of a corporation must be supported by rigorous internal controls and effective risk management. An effective internal control apparatus is critical to provide reasonable assurance that the information produced by the corporation is timely and reliable and that errors and irregularities are discovered and corrected promptly. Such an apparatus is also needed to promote the firm’s operational efficiency and to ensure compliance with managerial policies, laws, regulations, and sound fiduciary principles. This is where corporate governance associates with audit quality (McDonough, 2002).

Past years have brought widespread questioning of the quality and integrity of the information that corporations make available to the market and the behavior of some corporate executives. Although the developments that gave rise to this questioning are regrettable, there has, in fact, been a positive side. The public uproar that these developments have created and the turmoil they have generated in the financial markets have been immensely powerful as forces for meaningful public sector reform. These painful experiences should help educate a generation

of younger managers about the importance of integrity and sound corporate governance based on independent oversight and good audit quality (Konczal, 2009).

2.2 Theoretical Review2.2.1 Overview of Audit Quality

The various changes in accounting, financial reporting and auditing were all designed to provide protection to investors. This is being achieved by imposing a duty of accountability upon the managers of a company (Crowther and Jatana, 2005). In essence, auditing is used to provide the needed assurance for investors when relying on audited financial statements. More precisely, the role of auditing is to reduce information asymmetry on accounting numbers, and to minimize the residual loss resulting from managers’ opportunism in financial reporting. Effective and perceived qualities (usually designated as apparent quality) are necessary for auditing to produce beneficial effects as a monitoring device. The perceived audit quality by financial statements users is at least as important as the effective audit quality. Conceptually, DeAngelo (1981) defined audit quality as the market-assessed joint probability that the auditor discovers an anomaly in the financial statements, and reveals it. Agency theory recognizes auditing as one of the main monitoring mechanisms to regulate conflicts of interest and cut agency costs. Therefore, assuming a contracting equilibrium in the monitoring policy, a change in the intensity of agency conflicts should similarly involve a change in the acceptable quality of auditing.

2.2.2 Audit Committee and Corporate Governance

Literature suggests that a valuable audit committee should play an important role in strengthening the financial controls of a business entity (Collier, 1993; English, 1994; Vinten and Lee, 1993). A number of studies have found that companies with an audit committee, particularly when that committee is active and independent, are less likely to experience fraud (Beasley, et al., 2000; Abbott, et al., 2000; McMullen, 1996) and other reporting irregularities (McMullen, 1996; McMullen and Raghunandan, 1996). Findings also suggest that audit committees are effective in reducing the occurrence of earnings management that may result in misleading financial statements (Defond and Jiambalvo, 1991; Dechow, et al., 1996; Peasnell, et al., 2000). Audit committee is also expected to enhance the effectiveness of both internal and external auditors (Simnett, et al., 1993). However, Cohen, et al. (2000) report that a number of audit practitioners involved in exploratory interviews expressed concern over the effectiveness of audit committees, with some partners suggesting that audit committees are not powerful enough to resolve conflicts with management.

It is generally agreed that, for an audit committee to be effective, a majority, if not all members, should be independent (Cadbury, 1992) and they should have an understanding of accounting, auditing and control issues (Cohen, et al., 2000; Goodwin and Seow, 2000; Hughes, 1999; Lear, 1998). Literature also linked audit quality with the boards of directors, and the audit committees of boards of directors. This shows that audit quality is positively related to boards and audit committees when they are more independent (that is, higher number of outside directors). Carcello and Neal (2000) show that auditors are more likely to issue going concern reports in the presence of more independent boards and are less likely to be fired by the company following the issuance of a going concern audit report.

2.2.3 Board Structure and Audit Quality

The linkage between the board and the quality of audit services performed may be formal or informal. In terms of formal linkage, the board of directors typically collaborates with management in selecting the external auditor, often subject to shareholder ratification. Since the auditor is to look to the board as its client, it is reasonable to expect the board to review the overall planned audit scope and proposed audit fee (Blue Ribbon Committee 1999; Public Oversight Board 1994). The board also may influence audit quality through informal means. The board’s commitment to vigilant oversight may signal to management and the auditor that the expectations placed on the audit firm are very high. If the auditor understands that the client (that is, the board) is particularly of high quality and demanding, the auditor may perform a higher-quality audit so as not to disappoint the client and jeopardize the relationship. Given the board’s oversight of the financial reporting and audit processes, as well as prior literature linking certain board characteristics to adverse financial reporting outcomes (Beasley, 1996; Dechow, et al. 1996), this current study explores the link between board characteristics and audit quality in Nigeria.

Fama and Jensen (1983) have theorized that the board of directors is the best control mechanism to monitor actions of management. The study explored board independence based on the agency theory. Studies of O’Sullivan (2000) and Salleh, et al. (2006) found that the proportion of non-executive directors had a significant positive impact on audit quality. They suggested that non-executive directors encouraged more intensive audits as a complement to their own monitoring role while the reduction in agency costs expected through significant managerial ownership resulted in a reduced need for intensive auditing.

2.2.4 Ownership Structure and Audit Quality

The relationship between outside shareholders and managers is marked by moral hazard and opportunism, which result from information asymmetry. The social role of financial reporting increases with the separation of ownership and control (Wan, et al. 2008). Indeed, accounting numbers are essential indicators to assess managers’ performance. However, the discretionary power of managers over the accounting policy being important in firms with diffused ownership, their propensity to manipulate the outputs of the accounting process is higher. In contrast to the directors’ ownership, an institutional ownership is an investment from a group of outside investors or investment from a certain institution. The percentage of ownership from institution is normally higher than individual investor. It is assumed that institutional investors have more influence than other individual investors. With the high portion of ownership, institutional ownership has the importance of monitoring role in the process auditing. It is rational that institutional investors demand high quality information from the company. Kane and Velury (2002) observed that the greater the level of institutional ownership, the more likely it is that a firm purchases audit services from large audit firm in order to ensure high audit quality.

For the purpose of the current study, institutional ownership can be separated into two main categories which are financial institutional and non-financial institutional ownership. The main difference between both groups is related to core business of investor. The core business of financial institutions is investment but not for non-financial institutions. However, both institutions are expected not to have different influence on audit quality. Mitra, et al. (2007) found that diffused institutional ownership was significantly and positively related to audit fees. The study linked their finding to either institutional investor demand for the purchase of high quality audit services as safeguard against fraudulent financial reporting or firms’ endeavor to purchase high quality audits to attract institutional investment in common stock. It is expected that the portion of institutional ownership will have impact on audit quality of the company.

2.2.5 CEO Duality and Audit Quality

This study also intends to discover the relationship between the CEO duality and audit quality. The CEO duality refers to non-separation of roles between Chief Executive Officer (CEO) and the Chairman of the board. In the normal situation, boards with CEO duality are perceived ineffective because a conflict of interest may arise. This is often attributed to the nature of family owned business in developing countries. Yemark (1996) posits that large companies that have separate persons for both functions normally trade at higher price and have higher return on assets and cost efficiency ratios (Pi and Timme, 1993).

2.3 Corporate Governance in KenyaConcerns for good corporate governance in Kenya started taking shape in 1998 and was driven by a number of factors including; The quality of governance at all levels was increasingly being seen as the most important factor for the success of both the politico-economy and its institutions. Corporate governance was increasingly taking centre stage, with the privatization and corporatization of the economies globally. There was greater expectation from society that corporate organizations, especially private ones, should take a more leading role in the debate and implementation of economic revival strategies (Private Sector Initiative for Corporate Governance, 1999).

In the face of major scandals leading to the collapse of big corporations, especially state owned ones, with disastrous social and economic consequences, it was inevitable that the wider society, led by the mass media, would start questioning how these organizations were run. Shareholders, especially in publicly listed companies were becoming increasingly vocal demanding better transparency and disclosure of information from their directors. Regulatory bodies, notably the Capital Market Authority and the Nairobi Stock Exchange, were already hinting that they would require good corporate governance practices amongst the publicly listed companies (Private Sector Initiative for Corporate Governance, 1999).

2.4 GapThe concept of audit quality in the Kenyan Public Corporations has been ignored, as there are recorded cases of corporations collapsing and being put under receivership owing to insolvency yet the Auditor General usually conducts auditing of the same on a regular basis. Does the Office of the Auditor General perform its duties objectively and professionally? Are the audit reports a true reflection of the corporation’s actual financial status? Does the management of these corporations implement the audit and financial recovery recommendations appropriately? Why do the corporations collapse yet their accounts are audited and recovery recommendations given? The result of the research will attempt to give insight and an understanding into this entire dilemma in the Public Auditing process. The very fact that there is no local literature concerning audit quality research puts the study at a head start and the results are likely to stimulate further research and the area of audit quality within the context of Kenyan auditing system.

2.5 Conceptual Frameworkcenter0

Figure 2.1: Conceptual Framework (Source: Author of proposal)

Independent variables of the study are audit committee, CEO duality, business complexity, leverage, executive directors’ ownership, non-executive directors’ ownership, financial institution ownership, non-financial institution ownership and board independence. The dependent variable was audit quality which was measured by size of audit firm (big and non-big).

CHAPTER 3METHODOLOGY3.1 Research DesignThis study is an explanatory study. Saunders et al., (2007) stated that studies that establish causal relationships between variables may be termed explanatory studies. They emphasized that this has to do with studying a situation or a problem in order to explain the relationships between variables. This research strategy was considered necessary because of its ability to view comprehensively and in detail the major questions raised in

3.2 Target PopulationThe population for this study consist all the 177 public corporations in Kenya classified into the following categories:

Category of Corporation Number of Corporations

Financial 16

Commercial / Manufacturing 30

Regulatory 36

Public Universities 20

Training and Research 13

Service 50

Regional Development 6

Tertiary Education 6

Total 177

Table 3.1: Sampling Frame (Source: Author (2012))3.3 Sample and Sampling DesignSample selection depends on the population size, its homogeneity, the sample media and its cost of use, and the degree of precision required (Salant & Dillman, 1994, p. 54). The people selected to participate in the sample must be selected at random; they must have an equal (or known) chance of being selected. Salant and Dillman (1994) observed that a prerequisite to sample selection is to define the target population as narrowly as possible. In this study, a simple random sample will be drawn without replacement from a population of 177 public corporations classified into 8 categories.

Desirable sample size of 72 corporations will be drawn from the various categories of public corporations (60 at an error margin of 7.5% and confidence level of 95%) as shown on Table 3.2. below:

Category of Public Corporation Population Sample Size

Error Margin = 7.5%

Confidence Level = 95%

Financial 16 8

Commercial / Manufacturing 30 10

Regulatory 36 12

Public Universities 20 10

Training and Research 13 6

Service 50 20

Regional Development 6 3

Tertiary Education 6 3

Total 177 72

Table 3.2: Sample Size (Source: Author (2012))3.4 Data CollectionBoth primary and secondary data will be used in this study. Primary data will be collected by used of questionnaires containing twenty close-ended questions and given to executive officers of the selected corporations. Secondary data will consist of audited financial reports of public corporations for the period 2010 year-end

3.5 Data AnalysisThe data collected will be analyzed using both descriptive and inferential statistics. The descriptive method described information relating to audit firm (categorized into big 4 and non-big 4) and CEO duality. The study will use frequency count, mean, standard deviation, minimum and maximum values of variables. Information relating to the composition of outside director members of board, audit committee composition, board ownership, CEO duality and firm characteristics (which are, company size, business complexity, institutional ownership and leverage) will be collected from company annual reports.

The hypotheses formulated for this study will tested with the use of logistic regression. This will be used to examine the relationship between dependent and independent variables. According to Field (2000), logistic regression is multiple regression but with an outcome variable that is a categorical dichotomy and predictor variables that are continuous or categorical. The logistic regression for this study takes the form:

AUDITQUAL = β0 + β1BODINDEP + β2EDOWN + β3NEDOWN +

β4FINOWN + β5NFINOWN + β6LEVERAGE + ………. (1)

β7COMPLEXITY + β8SIZE + β9CEOSHIP + ε

The dependent variable is audit quality. This variable is dichotomous in nature. Size of audit firm (big 4 and non-big 4) was used as proxy for audit quality. Audit quality was set equal to one (1) if the information obtained from companies audited reports show that it is audited by one of the “big 4” audit firms (KPMG; Ernst and Young; Akintola Williams Delloitte; PWC), otherwise zero (0). This operationalization follows the approach used in Kane and Velury (2002) where big audit firms are assumed to have quality audit services than other smaller audit firms.

The choice of the independent variables was informed by previous studies (Beasley and Petroni, 2001; Carcello, et al., 2002; Salleh, et al., 2006; Wan, et al., 2008 and Mitra, et.al., 2007). Board independence (BODINDEP) will be measured through the composition of non-executives in the board of directors in form of percentage. The non-executive directors’ ownership (NEDOWN) and executive directors’ ownership (EDOWN) will be based on percentage of share owned in relation to the issued capital of the company. Furthermore, financial institution (FINOWN) and non-financial institution ownership (NFINOWN) will be measured using percentage of shares owned in relation to the issued capital of the company. The variable of CEO duality (CEOSHIP) is a dichotomous variable that will operated as one (1) if the position of Chairman and Chief Executive Officer is occupied by same person and zero (0) if otherwise.

The inclusion of other variables like size of the company (SIZE), business complexity (COMPLEXITY) and leverage of the company (LEVERAGE) will be based on the findings of Kane and Velury (2002) & Wan et al. (2008). The studies noted that these variables have significant relationships with audit quality. The size of the company will be measured by total asset owned by each of the companies while business complexity was measured by the summation of total accounts receivable and total inventory divided by total asset. Furthermore, leverage will be measured by total debts divided by total assets. Upon improvements of the logistic regression (equation i), it will be observed that audit committee independence has collinearity problem while tests for outliers will suggest the removal of some variables which will then lead to the final model as given below:

AUDITQUAL=β0+β1NEDOWN+β4FINOWN+β6LEVERAGE+β8SIZE + ε ……… (2)

ReferenceAbbott, L. J., Park, Y., & Parker, S. (2000). The effects of audit committee activity a