Managerial Auditing JournalDeterminants of voluntary formation of risk management committees: Evidence from anemerging economyNkoko Blessy Sekome Tesfaye Taddesse Lemma

Article information:To cite this document:Nkoko Blessy Sekome Tesfaye Taddesse Lemma , (2014),"Determinants of voluntary formation of riskmanagement committees", Managerial Auditing Journal, Vol. 29 Iss 7 pp. 649 - 671Permanent link to this document:http://dx.doi.org/10.1108/MAJ-02-2014-0998

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http://dx.doi.org/10.1108/MAJ-02-2014-0998

Determinants of voluntaryformation of risk management

committeesEvidence from an emerging economyNkoko Blessy Sekome and Tesfaye Taddesse Lemma

School of Accountancy, University of Limpopo, Polokwane, South Africa

AbstractPurpose The aim of this paper is to examine the nexus between firm-specific attributes and acompanys decision to setup a separate risk management committee (RMC) as a sub-committee of theboard within the context of an emerging economy, South Africa.Design/methodology/approach The authors analyse data extracted from audited annualfinancial reports of 181 non-financial firms listed on the Johannesburg Securities Exchange (JSE) byusing logistic regression technique.Findings The results show a strong positive relationship between the existence of a separate RMCand board independence, board size, firm size and industry type. However, the authors fail to findsupport for the hypotheses that independent board chairman, auditor reputation, reporting risk andfinancial leverage have an influence on a firms decision to establish RMC as a separately standingcommittee in the board structure. The findings signify the role of costs associated with informationasymmetry, agency, upkeep of a standalone RMC, damage to the reputation of directors andindustry-specific idiosyncrasies on a firms decision to form a separate RMC.Research limitations/implications As in most empirical studies, this study focuses on listedfirms. Nonetheless, future studies that focus on non-listed firms could add additional insights to theliterature. Investigating the role of firm-specific governance attributes other than those considered inthe present study (e.g. gender of directors, ownership structure, etc.) could further enhance theunderstanding of antecedents of risk-management practices.Practical implications The findings have practical implications for the investment community inassessing the quality of risk management practices of companies listed on the JSE. Furthermore, theresults provide insights that are potentially useful to the King Committee and other corporategovernance regulators in South Africa in their effort to improve corporate governance practices.Originality/value The present study focuses on firms drawn from an emerging economywhich hasprofound economic, institutional, political and cultural differences compared to advanced economies,which have received a disproportionately higher share of attention in prior studies. Thus, the studycontributes additional insights to the literature on corporate risk management from the perspective ofan emerging economy.

Keywords Corporate governance, Emerging markets, Risk management committee

Paper type Research paper

JEL classification G34The work is based on an M Com minor dissertation submitted to University of Johannesburg,

South Africa, in 2013, by Nkoko B. Sekome

The current issue and full text archive of this journal is available atwww.emeraldinsight.com/0268-6902.htm

Determinants ofvoluntaryformation

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Managerial Auditing JournalVol. 29 No. 7, 2014

pp. 649-671 Emerald Group Publishing Limited

0268-6902DOI 10.1108/MAJ-02-2014-0998

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http://dx.doi.org/10.1108/MAJ-02-2014-0998

1. IntroductionIn recent years, the literature has witnessed a broad and intense interest on the subjectof corporate governance, both from academics as well as practitioners (Mardjono, 2005;Vaughn and Ryan, 2006; Filatotchev et al., 2007; Claessens and Yurtoglu, 2012).However, despite the intense interest, corporate governance research is characterized bythe lack of a unifying theory (Brown et al., 2009). Notwithstanding, we have gainedsignificant insights into corporate governance practice. For instance, most of the earliergovernance initiatives, and hence policy and academic research, consider boardcomposition as an important determinant of quality of corporate governance. This isbased on the assumption that attributes of boardmembers determine the boards abilityto monitor and control managers, provide information and counsel to managers,monitor compliancewith applicable laws and regulations and link the corporation to theexternal environment (Bebchuk and Weisbach, 2010; Carter et al., 2010). Nonetheless,John and Senbet (1998) argue that boards internal administrative structure is moreimportant in measuring boards effectiveness, as certain structures in the board couldallow it to delegate some of its authority to specific committeeswhich are responsible fora particular area in which the committee members specialize. John and Senbets viewwas also echoed by other studies which suggested that formation of separatecommittees within the board structure could have a [positive] bearing on boardeffectiveness (Jiraporn et al., 2009) and corporate performance (Klein, 1998).

Traditionally, when the risk exposures of a firm have been related primarily tofinancial and fraud risks, the role of monitoring and providing oversight regarding therisks to which a firm is exposed was considered as one of the functions of the auditcommittee (AC). Nonetheless, a series of corporate failures and scandals and increasingcomplexity of exposures linked to new technologies demands that our understanding ofrisk should be broadened. In fact, these developments cast doubt on the effectiveness ofACs in overseeing and executing risk management programmes, as their traditionalexpertise is in the areas of financial and fraud risk (Ng et al., 2012; Bates and Leclerc,2009). Echoing a similar sentiment, Brown et al. (2009) remark that the task of riskmanagement, in many if not all organizations, has become beyond the scope andcapabilities of ACs alone. Likewise, Yatim (2010) and Zaman (2001) submit that ACmembers may lack the expertise and time needed to perform in-depth risk managementduties, especially given the ever-increasing demand imposed on them by various codeson corporate governance. In light of this observation, the recent literature recommendsthat an riskmanagement committee (RMC) be established as a committee separate fromthe traditional AC (Bugalla et al. (2012); De Lacy (2005) cited in Ng et al. (2012) andBrown et al. (2009)).

Concurrently, the increased concern regarding risk management practices hasprompted legislative reforms with significant emphasis on the role of risk management(Ng et al., 2012; Subramaniam et al., 2009; etc.). For instance, in the UK, the CombinedCode of Conduct outlines the risk monitoring and oversight responsibilities of the boardof companies listed on the London Stock Exchange. Likewise, the SarbanesOxley Act(2002) of the USA details the risk management responsibilities of the board of directorsof all firms registered on the Securities and Exchange Commission (Brown et al., 2009).In the same vein, the Corporate Governance Council of the Australian Stock Exchange(ASX) sets out the guidelines for risk management within Australian public-listedorganizations and implementation of proper risk management systems

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(Subramaniam et al., 2009). Following the trend internationally, the King III report inSouth Africa outlines the responsibilities of board of directors of firms listed on theJohannesburg Securities Exchange (JSE) and also suggests that firms establish separateRMCs at the board level (PricewaterhouseCoopers, 2010). Overall, corporate governancecodes and guidelines suggest that the use of board sub-committees specializing on riskmanagement may be the most effective way to assist boards in discharging their riskoversight responsibility (Ling Liew et al., 2011).

Notwithstanding the recommendations in the academic literature and codes ofpractice, firms vary in their approaches, structures and processes adopted towardsmanaging risks. While some firms rely on ACs to carry out risk managementresponsibilities, others opt to have a standalone RMC (Subramaniam et al., 2009; Yatim,2010). Understanding the drivers behind such differences is of interest to researchersand practitioners. Subramaniam et al. (2009) investigated firm-specific factors thatdetermine a companys decision to set up a separate RMC using data drawn from firmslisted in the ASX and report that separate RMCs tend to exist in companies with anindependent board chairman and larger boards. In two related but separate works thatfocused onMalaysian listed firms, Yatim (2010) and Ling Liew et al. (2011) investigatedthe nexus between board characteristics and voluntary formation of standalone RMCsand confirmed that firms with larger, more independent, expert and diligent boards arelikely to establish standalone RMCs. More recently, Ghazali (2012) investigated factorsinfluencing the establishment of standalone RMC in Malaysian firms and reported thatmore than a third of the sample firms have separate RMCs and firm size is positivelyassociated with the establishment of RMC.

We observe in the hitherto literature thatmost empirical efforts have been directed atfirms in advanced economies, which tend to have manifest economic, political andcultural differences compared to developing/emerging countries (Waweru et al., 2004).According to Waweru (2014), for instance, the highly collectivist culture that epitomizeAfrican countries may require a different corporate governance arrangement than is thecase in North America, which is characterized by highly individualistic culture. Inanother paper, Waweru et al. (2011) observe the fact that firms in developing/emergingeconomies, compared to their counterparts in developed countries, experience ashortage of qualified people with requisite skills to appoint to their audit and othergovernance committees. In addition, emerging economies are epitomized by relativelyinefficient and incomplete capital markets and noticeably higher informationasymmetry compared to markets in advanced economies (Eldomiaty, 2007; Lemma andNegash, 2011, 2012). All of these differences in country characteristics betweenadvanced and developing/emerging countries are likely to lead to differences incorporate governance practices (Black et al., 2012). Thus, conclusions based on studiescarried out in advanced countries may not be portable to emerging marketcircumstances. The present study aims to fill the void in the empirical literature byexamining the extent to which JSE-listed companies have standalone RMCs and factorsinfluencing the establishment of standalone RMCs. It provides the opportunity to assessthe relevance of theories developed and testedwithin the context of advanced economiesto developing/emerging economies.

We analyse data drawn from audited annual financial reports of 181 JSE-listednon-financial firms by using logistic regression procedures. The results indicate thatfirm-specific attributes, such as board independence, board size, firm size and industry

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type increase the likelihood that a firm listed on the JSE will have a separate RMC.Nonetheless, our results do not support the hypotheses that independent chairman,auditor reputation, reporting risk and financial leverage enhance the likelihood that afirm would establish a separate RMC. Our findings signify the role of costs associatedwith information asymmetry, agency, upkeep of a standalone RMC, damage to thereputation of directors and industry-specific idiosyncrasies on a firms decision to forma separate RMC. To our knowledge, there has not been any empirical work that hasexamined factors associated with voluntary formation of separate RMCs within thecontext of South Africa. Such a study is important, given that a well-designed boardstructure including the existence of appropriate sub-committees have implications fororganizational accountability and performance (Hutchison and Tao, 2012;Subramaniam et al., 2009; Ruigrok et al., 2006; Roberts et al., 2005). Thus, this studybrings additional insights by examining the factors associated with the formation ofstandalone RMCs within the context of an emerging market South Africa.

The remainder of the paper is organized as follows. Section 2 presents a briefbackground to the study, a review of the relevant theoretical perspectives andhypotheses development. Section 3 discusses the empirical framework used to executethe study. Section 4 presents the results and discussions, while Section 5 concludes.

2. Literature review2.1 Background and theoretical perspectivesIn the three decades leading up to 1994, South Africa was virtually isolated from theglobal economy and, consequently, its corporate practices and regulations laggedbehind international norms. However, due to the confluence of market forces, thegovernment, regulatory agencies, the accounting profession, the stock exchange,changes in corporate ownership structures and crises in other similar emergingmarkets, the decades that followed 1994 witnessed a considerable makeover in thecorporate governance practice of companies in South Africa (Vaughn and Ryan, 2006).Presently, the King Report on Corporate Governance III (issued in 2009), the PublicFinanceManagementAct, theMunicipal FinanceManagementAct, the Insider TradingAct (passed in 1998), the listing requirements of the JSE, the Auditing Profession Act(passed in 2005), the Corporate Laws Amendment Act (passed in 2006) and theCompanies Act No. 71 of 2008, all provide the foundation for corporate governance inSouth Africa. These legislative and reform initiatives, especially King III, stipulate thatthe board is responsible for, inter alia, the governance of organizational risk. Incognizance of the unique expertise and resource requirements of the risk managementtask, King III recommends that boards of larger entities shall establish a separatestanding RMC.

Consistent with Daily et al. (2003), we argue that the agency theory alone may notsufficiently inform risk management research in diverse contexts and from diverseperspectives. A multi-theoretic approach to corporate governance research in general,and that of RMCs in particular, is essential for recognizing the many mechanisms andstructures that might reasonably enhance organizational functioning. Thus, we identifyfour alternative theories that have relevance to the study of formation of governancemechanisms of a firm. These include:(1) agency;(2) corporate legitimacy theory;

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(3) signalling theory; and(4) institutional theory.

Although we note that the agency theory is the dominant perspective, in tandem withDaily et al. (2003); Ruigrok et al. (2006); Subramaniam et al. (2009) and others, the presentstudy triangulates all the four theories. Triangulation of the theories gives us anadvantage in that it enhances flexibility and opens up a diverse range of insights ininterpreting our findings and also enables us to test competing theories (Bennett, 1997;Ryan et al., 2002). In what follows, we present a synthesis of each of the theories.

The agency theory points to a potential conflict that may exist between the agent andthe principal in an agency relationship. The policy prescription resulting from thistheory is usually a mechanism to align the interests of the agent, who is likely to act inher own best interest and the principal (Jensen and Meckling, 1976). According to thistheory, there are twoways of aligning the interests of agents and those of the principals:(1) The first is monitoring the agents behaviour to prevent her/him from engaging

in opportunistic behaviour.(2) The second is provision of incentives and rewards for the agent to entice her/him

into a behaviour that is aligned to the interest of the principal.

Also, one of the often-cited monitoring mechanism is the board of directors(Subramaniam et al., 2009). Furthermore, Jiraporn et al. (2009); John and Senbet (1998)and Klein (1998) share a view that instituting a separate RMC in a firm enhances aboards effectiveness in discharging its monitoring and oversight role. Thus, based onthe hitherto reasoning, as the agency cost of a firm climbs up, it is more likely that a firmwill have a separate RMC as a monitoring tool to align the two interests.

According to Suchman (1995), legitimacy refers to a generalized perception orassumption that the actions of an entity are desirable, proper or appropriate and arewithin some socially constructed system of norms, values, beliefs and definitions. Thecorporate legitimacy theory is founded on the notion that stakeholders deliberate onthose firm activities which are acceptable, whereas firms as a member of thatcommunity are expected to carry out their activities within the boundaries of what isdeemed acceptable by that community (Wilmshurst and Frost, 2000). According to Liuand Taylor (2008) and Meyer and Rowan (1977), firms achieve corporate legitimacywhen they adopt proper organizational structures that comply with social norms andvalues. Thus, according to this theory, firms have to manage their organizationalstructures to earn corporate legitimacy. If they fail to adopt appropriate organizationalstructures, stakeholders and resource providersmay threaten towithdraw the resourcesneeded for the firm to carry out its normal activities (Wilmshurst and Frost, 2000;Elsbach and Sutton, 1992).

Industry or securities regulators usually issue codes of best practice, which typicallycontain recommendations about the appropriate organizational processes andstructures. For example, in South Africa, while the King III report containsrecommendations for companies to establish separate RMCs in their board structures,JSE requires that listed companies should have RMCs. In recent years, there has been anincreasing focus on the structure and strategies adopted by a board in meeting variousstakeholder needs and the adoption of monitoring sub-committees may be viewed as astrategy for maintaining corporate legitimacy (Subramaniam et al., 2009). Based on

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corporate legitimacy, we posit that having a separate RMC in a firms board is likely toenhance corporate accountability, by providing amechanism for independent oversightof corporate activities, thus promoting corporate legitimacy.

The signalling theory, which emanated from the study of the economics ofinformation, suggests that signals representing a firms actions and announcementsconvey important information about a firms intentions and abilities (Spence, 1973).While Spence (1973) initially used the signalling theory in the context of labourmarkets,the theory can be meaningfully applied to the study of corporate governance structuresand processes. The central tenet of the signalling theory, in the present studys context,is that information asymmetry results in external stakeholders relying on varioussignals in forming judgement about the firms corporate governance structures andprocesses. Thus, the signalling theory posits that a firm has incentives to disclose goodor improved corporate governance initiatives and practices or the fact that its corporategovernance structures are compliant with relevant legislations and best practices, as sodoing would create a favourable image of the firm in the market. For example, a firmmay set up a separate RMC in its board structure so as to flag its commitment to goodgovernance, which may result in a favourable valuation of the firm by externalstakeholders (Subramaniam et al., 2009).

The institutional theory too provides important insights into the potential impact ofboard structures and processes on corporate image (Meyer and Rowan, 1977). In thecontext of board structures and processes, the institutional theory arguments suggestthat firms are likely to adopt certain practices, given their desire to conform toinstitutional norms (DiMaggio and Powell, 1983). In doing so, firms that are unsure ofwhat constitutes good practice are likely to seek legitimacy by imitating boardstructures and processes of firms they perceive as being successful, to convey to theconstituents the notion of responsiblemanagement, please external observers and avoidclaims of negligence if anything goes wrong (Meyer and Rowan, 1977). As argued byKing and Whetten (2008), when firms approach what the institutional field considersideal standards of behaviour, it not only enhances their legitimacy but also theirreputation.

2.2 Hypotheses developmentThe literature on corporate governance routinely considers several firm-specificattributes as proxies for agency costs, degree of information asymmetry anduncertainty, an entitys desire for compliance, etc. In this section, we draw on the fourtheoretical perspectives to develop specific hypotheses on the nexus between thoseattributes and a firms decision to set up a separate RMC.

Board independence from management is considered to be crucial for a boardsmonitoring ability. Several studies (Dalton et al., 1998; Shleifer and Vishny, 1996)indicate that boards that are not sufficiently independent from management are lesslikely to enquire, dissent and resist the power of the executive management. Moreover,a boards monitoring ability is hampered by information asymmetries betweenexecutive and non-executive directors, as the former have more information about thefirms operations (Roman-Martinez et al., 2012, Willekens et al., 2004). Existence of aseparate RMC couldmitigate this problem, asmembers of such a committee are likely toestablish contactswith insiders at various levels and additional support from experts. Inaddition, non-executive directors tend to be more concerned about their reputation (i.e.

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the legitimacy theory), and as such, will more actively enquire about risks and seekhigher quality governance than executive directors (Subramaniam et al., 2009).Subramaniam et al. (2009) further contend that non-executive directors are likely toprefer a separate RMC over a combined committee, as the former will have greater focusand capacity to more fully review the organizations risk-management policies andprocedures. Thus, the forgoing arguments based on agency, information asymmetryand reputation costs to directors (i.e. legitimacy theory) lead us to formulate ahypothesis that:

H1. Firms with more independent boards are more likely to have a separate RMC intheir board structures.

Assigning board chairmanship and executive management to different individuals is abasic governance architecture suggested by the academic literature (Cadbury, 1993;Carson, 2002) and governance guidelines (for example, King III, the Combined Report,etc.), as such separation is considered to be an indicator of the relative balance of powerin the upper echelons of an organization. Carson (2002) andmany others emphasize thatthe person leading a board the board chairman should be independent ofmanagement, as the boards role is to monitor the actions of management. A situationwhere the chairmanship is not sufficiently independent from management is likely toweaken the boards ability to perform its monitoring role (Yatim, 2010; Denis andMcConnell, 2003) and lead to concentration of power in the hands of the top executive.This in turn could lead to the top executive making decisions in her/his own interest,instead of taking into account the interests of other stakeholders (Jensen and Meckling,1976). Such power concentrationmay even lead to a situationwhere the executive blocksthe creation of separate RMC, as she might see such committees as hindrances to herfreedom (Collier, 1993).

On the contrary, a firm with an independent chairman is generally viewed to havelower agency costs (Roberts et al., 2005; Yatim, 2010). In addition, if a boards chair isindependent from the executive, he/she is likely to take an independent check on theexecutive and have a strong incentive to seek high-quality monitoring to maintain her/his own reputation (Jensen and Meckling, 1976; Subramaniam et al., 2009). Thus, anindependent board chairman is more likely to promote the formation of an RMC, as itwould enable better monitoring of risks of the entity. Furthermore, because a separateRMC is likely to be specifically focused on risk-management matters when compared toa combined RMC, it is expected that a separate RMC would be significantly andpositively associated with an independent chairperson (Yatim, 2010). Thus, from anagency and reputational cost perspective, we hypothesis that:

H2. Firms with independent board chairpersons are more likely to establish aseparate RMC in their board structures.

Another board attribute that prominently features in corporate governance literature isboard size (Dalton et al., 1999). Larger boards allow the inclusion of members withdifferent backgrounds, skills and representing various stakeholders. Thus, large boardspresent greater opportunities to find directors with the necessary skills to coordinateand be involved in a sub-committee devoted to risk management. Furthermore, greaterthe resources offered by larger boards, lesser the pressure to form a combined RMC(Subramaniam et al., 2009). Thus, it follows that:

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H3. Firms with larger board size are more likely to establish a separate RMC in theirboard structures.

Wallace and Kreutsfeldt (1991) identify firm size as one of firm-specific attributes thatcould influence a firms decision to setup an internal control mechanism. We contendthat monitoring devices have costs which may be subject to economies of scale. That is,the absorption of upkeep costs, such as RMCmember compensation, is relatively easierfor larger firms than smaller ones (Pincus et al., 1989; Willekens et al., 2004).Furthermore, Subramaniam et al. (2009) submit that the complexity of operations inlarger firms could compel directors to rely on structures, such as separate RMCs, to helpthem improve their oversight on key business units, which would have otherwise beenimpractical. In the same vein, Dunerv and Kim (2005) argue that larger firms tend toattract more attention and may be under greater scrutiny by other stakeholders (i.e.institutional and legitimacy theories). Thus, we examine the following hypothesis:

H4. Larger firms are more likely to establish a separate RMC in their boardstructures.

Carson (2002) suggests that auditors are vitally interested in corporategovernance-related issues of their client because any improvements in the governance ofa client could improve the quality of financial statements, and therefore, reducelitigation risk. It could be argued that an auditor would have a strong incentive toencourage its clients to form a separate RMC, as so doingwould help the auditor rely lessonmanagement andmore on an independent group of non-executive directorswho formpart of the RMC (i.e. the institutional theory). Such an RMC is likely to be considered anadditional internal control mechanism by the auditor in evaluating the overall internalcontrol system of the client (Subramaniam et al., 2009). Yatim (2010); Subramaniam et al.(2009); Carson (2002); Michaely and Shaw (1995), all share the view that audit firmswithhigh reputational capital at stake, such as the big-four-firms, are more likely to beassociated with clients who are in good standing in the business community (i.e. thelegitimacy theory). Along similar lines, Watts and Zimmerman (1986) and DeAngelo(1981) remark that big audit firms tend to influence clients towards best practice, andmost codes of best practice recommend that the formation of RMC is best practice inthe governance of firms (i.e. the institutional theory).

It could further be argued that small audit firms are not likely to favour the formationof an RMC, as they would fear that an RMC might be more likely to appoint a larger,well-known auditor (Eichenseher and Shields, 1985). Also, it is possible that entitiesengaging big audit firms are also likely to be committed to a holistic risk managementframework (Beasley et al., 2005; Yatim, 2010). In sum, there will be greater pressureamong firms whose auditor is a big auditor (i.e. big-four-firm) to form an RMC, and byextension a standalone RMC, than in firms whose auditor is a small auditor (i.e. non-bigfour firm). We could thus deduce that legitimacy in the business community andpressure from audit industry may have a vital role in a firms decision for a separateRMC. Thus, we hypothesis that:

H5. Firms which use big-four auditors are more likely to establish a separate RMCthan those which use non-big-four auditors.

The literature on corporate governance highlights that firmswhich have higher leverageentail higher financial risk and uncertainty about future prospects (Lemma andNegash,

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2011; Musteen et al., 2010; Goodwin and Kent, 2006). Thus, from a corporate legitimacyand signalling perspective, it could be argued that firmswith a high level of leverage arelikely to want to demonstrate their commitment to the existing and future creditors thatthey have a better mechanism to handle their firms risk exposures (Yatim, 2010;Liebenberg andHoyt, 2003). Along similar lines, Khanchel (2007) andAnand et al. (2006)remark that firms with greater needs to obtain external financing have the incentive toadopt good corporate governance practice. Also, in line with institutional theory, Choand Kim (2003) contend that highly leveraged firms could be pressured by their lenders,such as banks, to enhance their corporate governance. In a similar vein, Subramaniamet al. (2009) suggest that highly leveraged firms are more likely to have debt covenantsand higher going concern risk that lenders tend to demand better internal control andmonitoring mechanisms. Therefore, we contend that there will be a greater pressure onsuch companies to have an RMC to oversight such risks. Furthermore, a separate RMCmay function more effectively in risk oversight. Hence, our hypothesis goes as follows:

H6. Firmswith higher levels of leverage aremore likely to have a separate RMC thanthose with lower levels of leverage.

We decipher from the earningsmanagement literature that entities face risks associatedwith erroneous financial reporting, in addition to the usual business risks they areexposed to (Goodwin and Kent, 2006). Firms face the risk of material misstatements infinancial reports with regard to balance sheet items, which allow for accounting policydiscretions by management (Francis and Stokes, 1986; Korosec and Horvat, 2005;Subramaniam et al., 2009; Simunic, 1980; Lemma et al., 2013). For example,Subramaniam et al. (2009) contend that entities which have higher proportions ofaccounts receivables or inventories (i.e. higher likelihood of engaging in earningsmanagement), face higher risk of their bad debt expenses or inventory obsolescence notbeing reported properly. Thus, we conjecture that the formation of an RMC, and astandalone RMC in particular, will facilitate better oversight of such risks. We thus testthe following hypothesis:

H7. Firms with higher likelihood of earnings management are more likely toestablish a separate RMC in their board structure than those with lowerlikelihood of engaging in earnings management.

Anecdotal evidence suggests that certain industries aremore likely to adopt holistic riskmanagement approach than others (Beasley et al., 2005; Yatim, 2010) due to severalreasons. First, agency problems and the monitoring mechanisms needed may bedifferent across industries (Willekens et al., 2004). Second, the level of business andrelated risks towhich companies are exposed vary across industries (Beasley et al., 1999,as cited in Subramaniam et al., 2009). For instance, Beasley et al. (2005) andWallace andKreutsfeldt (1991) are of the view that firms in the banking, education and insuranceindustries are faced with more regulatory and other risks than those in other industries.From an institutional theory perspective, it could also be argued that entities may beestablishing an RMC to conform to institutional norms in the industry, which in turnmay enhance their social legitimacy within the industry (DiMaggio and Powell, 1983).Thus, we hypothesize as follows:

H8. Firms in the technology industry are more likely to establish a separate RMCthan those in other sectors.

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3 The empirical framework3.1 Model specification and estimationTo determine which firm-specific attributes determine voluntary formation of separateRMC in the context of companies listed on the JSE, we develop a baseline model (Model 1)that links presence (or absence) of separate RMC (the dependent variable) tofirm-specific attributes identified in the previous section:

SRMC f [BOARDSIZE, INDPDIR, INDPCHAIR, SIZE, REPUT,LEVERAGE, EARNINGSMNG, INDUSTRY]

where SRMCdenotes a dummy variable, which takes a value of 1 if a firm has a separateRMC on its board and 0 otherwise; BOARDSIZE refers to board size and is measured bythe number of directors (excluding alternative directors) on the board of a firm;INDPDIR refers to independence of directors and is measured by the proportion ofindependent directors to that of the total board size[1]; INDPCHAIR denotesindependence of board chairman and is measured by a dummy variable which takes avalue of 1 if the board chairman is independent and 0 otherwise[2]; SIZE refers to firmsize and is computed as the natural logarithm of total assets of a company[3]; REPUTdenotes auditor reputation and is represented by a dummy variable which takes a valueof 1 if the firms auditor is one of the big-four audit firms (i.e. PricewaterhouseCoopers,Ernst & Young, Deloitte or KPMG) and 0 otherwise; LEVERAGE refers to the ratio oftotal long-term liabilities to total assets; EARNINGSMNG refers to the ratio of the sumof total receivables and inventories to total assets[4]; and INDUSTRY denotes a dummyvariable, which takes a value of 1 if the firm is from the technology sector and 0otherwise.

The fact that firm size (SIZE) and board size (BOARDSIZE) are highly correlated(see Table V) variables that is, correlation coefficient between the two variables is circa57 per cent makes the concomitant inclusion of both variables into a regressionequation difficult, as so doing could lead to problems of multicollinearity (Gujarati,2003). Thus, to mitigate multicollinearity and related dummy-variable trap problems,we develop two slightly different versions of our baseline model. Model 2 definespresence (or absence) of SRMC as a function of all the firm attributes identified, butboard size (BOARDSIZE). On the other hand, Model 3 is identical with the baselinemodel, except that it does not include entity size (SIZE) as its explanatory variable.

The literature identifies two types of probability distributions which are apt forestimating the parameters for relationships involving a dichotomous dependentvariable that is, the presence (or absence) of SRMC and a set of independent variablescomprised both dichotomous and continuous variables, namely, the probit and logisticdistribution. The difference between the two functions shows up in the tails ofthe distributions, with the probit distribution approaching the axes faster than thelogistic distribution does. The logistic approximation is usually preferred over probit,given its convenientmathematical properties (Peng et al., 2002a; Bagley et al., 2001; Penget al., 2002b; Cabrera, 1994). Thus, in this study, we use the logistic regression procedureto examine the role of firm-specific characteristics on a firms decision to setup aseparate RMC. In addition, we use the 2 test to assess the omnibus hypothesis that theindependent variables as a group have no effect on the dependent variable, as

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recommended by Menard (1995). Also, we use the p-values to assess the significance ofindividual hypotheses (Cabrera, 1994).

3.2 The sample and dataWe focused on companies listed on the JSE. The decision to focus on companies listed onthe JSE was motivated by two reasons:(1) Although section 30(1) of Companies Act of 2008 in South Africa requires that

companies produce and publish annual financial statements, it is mainly thelisted firms that aremore likely tomake such information available to the public.

(2) Information provided by listed firms is more reliable and relevant due to themore stringent disclosure requirements to which such firms are subjected.

Thus, our sampling framework is all of the firms listed on the JSE as of 31May 2012, andthe data pertains to the 2011 fiscal year. As firms in the financial sector operate undersevere regulatory environment (e.g. Banks Act, South African Research Bankregulations, Financial Services Board regulation, etc.), which in turn may affect riskmanagement activities and structures of firms in the sector, we exclude all the firms inthe financial sector from our sample (Pathan and Skully, 2010; Lemma and Negash,2011). Furthermore, firms which did not provide published financials on their websites,or those which have inaccessible websites, are also excluded from the sample. Finally,firms which provided insufficient information about any of the independent variableshave also been dropped from our sample (see Table I for details regarding sampleconstruction).

Our final sample comprises 182 non-financial firms listed on the JSEs main board asof 31May 2012, which comprises 87 per cent of the target sample. Initially, as illustratedin Table I, the JSE had 293 companies listed on its main board of which 83 were firms inthe financial sector, thus making the sample target for the study to be 210 firms. Inaddition, 21 more firms were eliminated either due to lack of published financials ontheir websites or difficulty in accessing their websites. Seven more firms were excludedeither due to non-disclosure of governance information or insufficient informationregarding one (or more) of the independent variables.

The classification on themain board of JSEwas used to determine the sector/industrytowhich afirmbelongs. This informationwas obtained fromMcGregorBFAdatabasewhich maintains, among other things, the financials for JSE-listed firms per sector. Theinformation contained in the corporate governance and financial statement sections ofthe 2011 integrated annual reports of individual firms were used to obtain other

Table I.Construction of sample

size

Particulars Number of companies

Total number of JSE companies 293Less: financial sector companies (83)Total non-financial firms 210Less: companies with no published financials or difficulties in accessingtheir websites

(21)

Less: companies with no governance information or insufficientinformation regarding the independent variables

(7)

Total sample size 182

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necessary firm-specific attributes. We note that some companies have a differentyear-end date than 30 June. Following similar practices in the literature (Lemma andNegash, 2011, 2012), we adjust differences in fiscal years of firms in the sample toprovide a more accurate empirical work. Hence, if the accounting year of a companyends on or before 30 June, its year is stamped as one year prior to its fiscal year, and if afirms fiscal year is after 30 June, that same year is stamped as the firms fiscal years.

4 Results and discussions4.1 Preliminary resultsTo gain a basic insight into the sample, we review the sectorial distribution of firms inthe sample (see Table II). In terms of sectorial distribution, companies from basicmaterials and industrial sectorsmay have heavily influenced the sample; they constitutecirca 61 per cent of firms included in the sample. On the other hand, those from oil andgas and telecommunications have little influence on the sample, as they constitute only3.8 per cent of firms included in the sample. However, a comparison of the last twocolumns of Table II shows that the sectorial distribution of firms in our sample closelymirrors the overall distribution of firms listed on JSE. Furthermore, in five of the eightsectors on JSE, the sample comprised 80 per cent of the firms listed on JSE. Thus, thesample permits us to have a reasonable picture of the risk management practices offirms listed on the JSE.

Table III shows that 98.9 per cent of the companies had establishedRMCs in one formor another, while only 37.6 per cent had established them as standalone RMCs.While theprevalence of separate RMCs in JSE listed firms is lacking compared to that of combinedRMCs, it is comparable to Malaysia where only 35.7 per cent of companies listed onBursa Malaysia have such committees (Yatim, 2010). However, the prevalence ofseparate RMCs in JSE-listed firms compares favourably with those in Australia whereonly 25 per cent of companies listed on the ASX had separate RMC (Subramaniam et al.,2009).

The results also indicate that the proportion of firms listed on JSE, which are led byindependent board chair, is smaller than the proportion of those listed on ASX and theMalaysian Stock Exchange.Whereas only 56 per cent of companies listed on the JSE areled by an independent board chair, 84.1 per cent and 75 per cent of firms listed onMalaysian andAustralian Stock Exchanges, respectively, are led by independent boardchairmen. In addition, we observe that 74.2 per cent of the JSE-listed firms are audited by

Table II.Analysis of a sample perindustry sector

Industry sector[1] Number ofJSE-listed firms [2] Sample firms

[2] [1] Sample firmsrelative to number of

listed firms

Firms in a sectorrelative to totallisted firms

(%)

Sample firmsrelative tosample size

(%)

Basic materials 64 55 86 30.5 30.2Telecommunications 5 5 100 2.4 2.7Technology 13 9 69 6.2 5.0Oil and gas 3 2 67 1.4 1.1Industrial 59 56 95 28.1 30.8Health-care 8 6 75 3.8 3.3Consumer goods 24 21 88 11.4 11.5Consumer services 34 28 82 16.2 15.4Total 210 182 87 100 100

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the big-four audit firms, compared to 69.1 per cent and 89.0 per cent of companies listedon Malaysian and Australian bourses, respectively, being audited by such auditors(Subramaniam et al., 2009; Yatim, 2010). While the prevalence of independent chairmanon JSE-listed firms is somehow shy, the use of big audit firms is comparable to thosereported in similar studies.

Table III also shows that there were 9 companies, 4.97 per cent of the total sample, inthe technology sector, the referent group. All of the companies in this sector have RMCs,while only 55 per cent formed them as separately standing committees. In an unreportedresult, we note that 67 per cent of the firms listed on the JSE were having majoritynon-executive directors, of which 71 per cent were independent directors. In this respect,the data suggest that boards of companies listed on the JSE fairly meet or surpass theboard independence requirements stipulated in King III code of governance. Similarempirical endeavours report that 75 per cent for firms listed on ASX (Subramaniamet al., 2009), 75 per cent of firms listed on the New York Stock Exchange (Beasley et al.,2005), 63 per cent of firms listed onBursaMalaysia (Yatim, 2010) and 44 per cent of firmson the London Stock Exchange (Guest, 2008) have majority non-executive directors ontheir boards. Thus, our results suggest that board independence of companies listed onthe JSE is at the middle of the range. In terms of a stricter definition of boardindependence used in this study, we note that the average percentage of independentdirectors to board size is 46 per cent. We also find board independence ranging fromboards with literally no independent directors to those with a staggering 83.3 per cent oftheir membership taken up by independent boards.

The average board size of the companies on the JSE is about 9.60 directors, with aminimum of 2 directors and amaximum of 19 directors. In terms of board size, boards ofJSE-listed companies appear to be bigger than those in the ASX and Bursa Malaysia,which reportedly have an average board size of 7.24 and 7.40, respectively (Ling Liewet al., 2011, Subramaniam et al., 2009). Also, the leverage variable measured by the ratioof total long-term liabilities to total long-term assets was about 16 per cent, which iscomparable to results reported in Lemma and Negash (2011). Furthermore, inunreported results, we note that the total book value of assets of companies included inthe sample is ZAR8.87 trillion, with the smallest company having R0.19 billion and thelargest having ZAR4.14 trillion book value of assets. As noted earlier, a firm with the

Table III.Frequency distribution

Variable Value Frequency Per cent

RMC 0 2 1.101 179 98.90

SRMC 0 113 62.431 68 37.57

INDEPCHAIR 0 79 43.651 102 56.35

INDUSTRY 0 172 95.031 9 4.97

REPUT 0 46 25.411 135 74.59

Total (for each) 181 100

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largest book value was dropped from the regression model, as it has the potential toinfluence the regression model results.

A perusal of the correlation matrix in Table V indicates that the proportion ofindependent directors on the board (INDPDIR), auditor reputation (REPUT), board size(BOARDSIZE) and firm size (SIZE) are positively correlated with the establishment of aseparate RMC. It also shows that firm size is positively correlatedwith the independenceof directors, reputation of the audit firm, level of leverage and board size. We alsoobserve that the independence of directors is positively correlated with the reputation ofthe auditor, board size and firm size, while the industry variable is negatively correlatedwith leverage, earnings management and firm size.

4.2 Logistics regression resultsIn this section, we present discussion and synthesis of the results from the regressionmodels reported in Table VI. The significantly positive (p 0.05) and robustrelationship between board independence and a companys decision to set up a separateRMC confirms our hypothesis (H1). It supports the theory that independent boardmembers would encourage the formation of a separate RMC to reduce problems ofinformation asymmetry between executive and non-executive directors and also to savetheir reputation from potential damage (Subramaniam et al., 2009; Roman-Martinezet al., 2012; Willekens et al., 2004). Similar results were reported in studies that werecarried out within the context of the USA (Beasley et al., 2005) and also Malaysia (Nget al., 2012).

Consistent with our expectation (H3), we find a significantly positive (p 0.05 inModel I and p 0.01 in Model III) and robust relationship between board size and thelikelihood that a firm on the JSEwould establish a separate RMC. This is consistent withthe findings of prior studies that examined the influence of board size on the presence ofmonitoring committees (Carson, 2002; Bradbury, 1990). In a study involving the top 300firms drawn from the ASX, Subramaniam et al. (2009) also report similar results. Ourfinding demonstrates that larger boards offer more diversification in terms ofbackground, experiences, skills and values, which enhance the performance of itscontrolling role. It also provides evidence that larger boards demonstrate greatercapacity to devote human capital resources needed to involve in board-level monitoringcommittees.

The results also indicate that there is a significantly positive relationship betweenfirm size and the likelihood that a firm in our sample would set up a separate RMC (p 0.05). In particular, the results indicate that for every one unit change in SIZE variable,the log of odds of establishing a standalone RMC increases by 0.446 (see Model II inTable IV-VI). This evidence is in tandemwith our expectation (H4) and corroborates theargument that larger firms find it easier to establish a separate RMC than smaller ones,as the former enjoy economies of scale in absorbing compensation costs for RMC

Table IV.Descriptive statistics

Statistics BOARDSIZE INDPDIR EARNINGSMNG LEVERAGE SIZE

Mean 9.626 0.460 0.294 0.159 6.432SD 3.205 0.165 0.218 0.146 0.907Minimum 2.000 0.000 0.000 0.000 4.281Maximum 19.000 0.833 0.914 0.709 9.617

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members (Pincus et al., 1989; Willekens et al., 2004). It is also consistent with theconjecture that larger firms are more likely to establish a separate RMC, as topmanagement in such firms is more likely to lose direct control of the firms operationsand risk-taking activities (Subramaniam et al., 2009). Similarly, our finding is in syncwith the argument that larger firms tend to attract more attention and may be undergreater scrutiny by stakeholders, and hence, are likely to yield to the pressure to earnlegitimacy by forming a separately standing RMC. Our finding is consistent with thosereported in the context of Australia (Goodwin-Stewart and Kent, 2006), Malaysia(Yatim, 2010) and the USA (Pathan and Skully, 2010).

In tandem with our expectations (H8), we observe that the INDUSTRY variable hasa significantly positive (p 0.1) and robust influence on a firms decision to setup aseparate RMC. This result suggests that agency problems and monitoring mechanismsneeded by firms in technology sector might be different from those in other industries(Willekens et al., 2004); the level of business and related risks faced by firms intechnology sector might be different from those in other sectors (Beasley et al., 1999 ascited in Subramaniam et al., 2009); and the institutional norms faced by firms in thetechnology sector might be inducing those firms into having a standalone RMC(DiMaggio and Powell, 1983). This finding is in line with anecdotal evidence, which

Table V.Correlation matrix

Variables INDEPCHAIR INDPDIR REPUT INDUSTRY LEVARAGE EARNIN BOARDSIZE SIZE

INDEPCHAIR 1.000INDPDIR 0.326* 1.000BIGFOUR 0.012 0.185* 1.000INDUSTRY 0.099 0.022 0.096 1.000LEVERAGE 0.007 0.065 0.096 0.159* 1.000EARNINGSMNG 0.110 0.084 0.100 0.211* 0.273* 1.000BOARDSIZE 1.036 0.152* 0.218* 0.075 0.120 0.034 1.000SIZE 0.022 0.281* 0.386* 0.166* 0.308* 0.111 0.572* 1.000SRMC 0.007 0.205* 0.147* 0.085 0.059 0.080 0.317* 0.233*

Notes: *p 0.10; **p 0.05; ***p 0.01

Table VI.Regression results for the

three models

Dependent variable: SRMC Expected Sign Model I Model II Model III

INDEPCHAIR 0.393 0.404 0.392INDPDIR 2.808** 2.241** 2.773**BIGFOUR 0.365 0.358 0.354INDUSTRY 1.182* 1.204* 1.187*LEVERAGE 0.872 0.514 0.84EARNINGSMNG 1.156 1.048 1.155SIZE 0.024 0.446**BOARDSIZE 0.219** 0.215***CONSTANT 4.426*** 4.948*** 4.517Number of Observations 181 181 181LR 2(7) 30.4*** 19.91*** 30.4***Pseudo R2 0.1269 0.0831 0.1269

Notes: *p 0.10; **p 0.05; ***p 0.01

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suggests that certain industries are more likely to adopt a holistic risk managementapproach than others (Beasley et al., 2005; Yatim, 2010).

The results for all the models (i.e. Models I, II and III) fail to confirm our predictionthat an independent board chairman would have a positive influence on an entitysdecision to form a separate RMC (H2). This, however, is contrary to findings reported byYatim (2010) for Australia and Subramaniam et al. (2009) for Malaysia and is also incontrast to recommendations by codes of corporate governance. A possible explanationfor this lack of significant influence of the independence of a board chairman on theformation of a separate RMC is that board chairmen of companies listed on the JSEmaynot be truly independent. It might as well be that independence itself is not sufficient tomake an effective board. As argued by supporters of a unitary leadership structure,timely and accurate flow of information allows the board to perform more effectively(Fosberg, 2004).

Just as in Subramaniam et al. (2009), our evidence fails to provide support for theproposition that firms that use big audit firms are more likely to establish a separateRMC. This result stands in stark contrast with Yatim (2010) and Beasley et al. (2005),who report strong association between these two variables. Likewise, we find nosupport for the sixth (H6) and seventh (H7) hypotheses, suggesting that leverage andrisk of earnings management have no influence on a firms decision to voluntarily forma separate RMC. On the contrary, while all the aforementioned studies report findingsthat suggest that leverage is not a factor in an entitys commitment to riskmanagement,Goodwin-Stewart and Kent (2006) report that risk of earnings management has apositive influence on an entitys decision to establish an internal audit function. In asimilar vein, Subramaniam et al. (2009) report that the risk of earnings managementpositively influences a companys decision to voluntarily establish a standalone RMC.

4.3 Model fitness and regression diagnosticsWe conducted regression diagnostics to assess how the models fit the data and theirgeneralizability to other samples. In terms of adequacy of sample size, Field (2005,pp. 172-174) and Durrheim and Tredoux (2006, p. 356) suggest that there should be atleast ten times the number of cases than the variables in the model. In the present study,we have at least 22 cases per each independent variable in all of the models. Thus, oursample size is adequate to lend credibility to conclusions derived from the study. Field(2005, pp. 164-163) also underscores the importance of detecting outliers that might bebiasing model estimates. We carried out a host of regression diagnostics to assess theexistence of outliers and influential cases. We looked into such diagnostics asstandardized residuals (cut-off point 3); studentized residuals (cut-off point 3);studentized deleted residuals (cut-off point 3); Cooks distance (cut-off point 1);hat-value (cut-off point 0.1484)[5]; standardized DFBeta (cut-off point 2);standardized DFITS (cut-off point 3)[6]; and covariance ratios (upper boundary 1.1484; and lower boundary 0.8516)[7] in accordance with the guidelines provided byField (2005, p. 164-168) and Chatterjee and Hadi (2006, p. 100-107). Whereas we did notcome across influential cases in our sample, we noted that one data point was an outlierand removed it from the analysis. Also, in line with Peng et al. (2002), we assessed theoverall fitness of all the models using the likelihood ratio (LR) 2 test. This test statisticwas significant at a one per cent level in all of the models (see Table VI) suggesting that

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our models were appropriate for predicting a companys decision to setup a separateRMC.

5 Conclusions and implicationsThis paper sets out to examine the firm-specific attributes that influence a firmsdecision to establish a separate RMCwithin the context of an emerging economy, SouthAfrica.We analyse corporate governance and financial data pertaining to 181 JSE-listedfirms using the logistic regression procedure. The results were interpreted in light ofmultiple conditional theories which allowed flexibility in gaining better insights into thefindings. Several conclusions emerge. First, the prevalence of separate RMCs in theboard structures of JSE-listed companies is as widespread as the board structures ofthose listed on Bursa Malaysia and more prevalent than it is in ASX-listed companies.However, the fact that only about a third of the companies listed on the JSE haveseparate RMCs indicates that the majority of firms listed on the JSE are yet to establishseparate RMCs.

Second, the observed direct relationship between firm size and its decision to set upa separately standing RMC underscores the role that economies of scale in monitoringcosts play in an entitys decision to set up an RMC as a separate sub-committee.Furthermore, we deduce that the greater attention and scrutiny that larger firms arelikely to attract from stakeholders may also have induced larger firms into formingseparate RMCs. Third, firms with larger boards have greater opportunities to finddirectors with the necessary skills to coordinate and be involved in a sub-committeedevoted to riskmanagement. Fourth, the positive influence that board independence hason an entitys decision to set up a separately standing RMC signifies the greater concernthat independent directors tend to have about damage to their reputation. It alsoindicates that independent directors of firms listed on the JSE aremore inquisitive aboutthe risks to which the entity is exposed and seek higher-quality governance than theirexecutive counterparts. Finally, the higher propensity to form standalone RMCs byfirms in the technology sector highlights the role of industry-wide idiosyncrasies in afirms decision to voluntarily establish a separate RMC. The implication of all of thesefindings is that the King Committee, JSE regulators and other stakeholders shouldconsider firm size, board size, board independence and the sector in which the companyoperates as key factors in setting policies, legislation and codes of corporate governancepertaining to corporate risk management.

This study attempts to explore the association between certain firm characteristicsand the formation of stand-alone RMCs in the context of an emerging economy.However, it does not probe into the quality of the RMCs themselves. Assessing thequality of RMCs and their effectiveness in risk management would certainly add someadditional insight to the literature. Although the present study focused on companieslisted on the JSEs main board, cross-country studies that include data from otheremerging economies would [certainly] advance our knowledge in this area and maydirect debates in the governance sphere in as far as emerging markets are concerned. Inaddition, future studies that consider the role of other corporate governance attributes(such as directors gender and ownership structure), which were not considered in thepresent study, may enhance our understanding on the subject. Finally, our study onlyused cross-sectional data other studies that may use panel data may reveal deeper

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insights into the factors that influence board structures on the African continent,including the formation of RMCs.

Notes1. Within the context of South Africa, the King III report sets the attributes required for a

non-executive director also to be an independent director, and it requires that companies listedon the JSE shall disclose the independence status of their non-executive directors in theirannual governance reports.

2. We use the independence status of board chairs reported on the annual governance reports ofsample companies which generally adopt the independent non-executive director criteria ofKing III to determine the independence status of board chairs.

3. The literature suggests various alternative measures of firm size, including annual salesrevenue, economic value added, number of employees, entitys age, etc. However, we decidedto report results based on natural logarithm of total assets for the purpose of enhancingcomparability with similar studies. We find qualitatively similar result for natural logarithmof total sales revenue.

4. The literature on earnings management identifies a series of other measures of earningsmanagement but comparability with similar researches dictated our choice.

5. The hat-value is calculated using the following formula: 3 (p1)/n in which p is the number ofthe predictors in the regression model and n is the sample size.

6. Although Chatterjee and Hadi (2006) provide a cut-off point 2(p1)/(np1) for DEFITS,Field (2005) shows that this statistic depends on the units of measurement of the outcome.Hence, we resorted to using standardized DEFITS.

7. The upper and lower boundaries of covariance ratios were calculated using 1[3(k1)/n] and1 [3 (k1) / n] formula, respectively. K denotes the number of predictor variables, and ndenotes the sample size (Field (2005).

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