Hypothesis Development

Now we comes to the hypothesis development part, this part is about what are the main theory driving to the development of hypothesis.

The first item drives the hypothesis development is the BRC recommendation 1& 2, that is the independence requirement.

The BRC define the independence directors as not the formal or current employee of the company, has no relative with company’s management and not receive compensation from the company. The second recommendation is BRC state that all listed company with more than 200 million market capitalizations should have audit committee composed entirely of independence directors.

Prior research suggest that independence of audit committee can reduce the likelihood of restatement in two ways.

First, the independence and effectiveness of the internal audit function are strengthened when it reports directly to an audit committee that instead of report to member of management.

Independence allows internal auditor to assess the internal control more objective.

Second, independence audit committee may demand greater external audit scope to avoid financial restatement, increase the likelihood the external auditor to detect the misstatement.

So with all these, the author believe that the audit committee can strengthen a firm’s internal control structure and increase the effectiveness of external audit. With these expectation, the author comes to first hypothesis, that is the presence of an audit committee comprised entirely of independence directors is associate with lower incidence of financial reporting restatement

The second Hypothesis is develop based on BRC’s third recommendation require. That is the audit committee size.

This recommendation require at least 3 audit committee member in the board. The power of the audit committee is related to the size of audit committee, more larger the board, more likely to be  acknowledged as an authoritative body by the external and internal audit function. The increase of power status can lead to internal audit function enhance, this will result in prevent and detect material misstatements

With these expectation, that lead to the Send Hypothesis, The presence of an audit committee with at least three directors is associated with a lower incidence of restatement.

The third hypothesis is develop based on the BRC’s expertise recommendation. The BRC assertion that effective audit committee should include at least one member who is financial expertise.

The prior research suggests that audit committee with at least one member with financial expertise is more likely to comprehend the internal audit program. This can ensure the internal control system are in place then lead to increase the effectiveness of internal control in preventing material misstatement.

Second, audit committee expertise allows for better understanding of audit issue and risks, then this will increase the likelihood that detected material misstatements.

With this expectation, leading to the third hypothesis: The presence of an audit committee with at least one director possessing financial expertise is associated with a lower incidence of restatement.

And the last hypothesis is driven by BRC’s other recommendations, the other recommendation is related to diligence of the audit committee.