Proceedings

cig.ase.ro

Proceedings

THE BUCHAREST

ACADEMY OF ECONOMIC

STUDIES

Proceedings

of the International Conference

ACCOUNTING AND MANAGEMENT

INFORMATION SYSTEMS

AMIS 2011

The sixth edition

June 8-9, 2011

The Bucharest Academy of Economic Studies

Piaţa Romană No. 6, Sector 1

Bucharest, Romania

ISSN 2247 − 6245

ISSN-L 2247 − 6245

FACULTY OF ACCOUNTING

AND MANAGEMENT INFORMATION

SYSTEMS


President

Pavel NASTASE

Members

Organizing Committee

Pavel NASTASE ASE Bucharest

Vasile RAILEANU ASE Bucharest

Catalin ALBU ASE Bucharest

Nadia ALBU ASE Bucharest

Dana BOLDEANU ASE Bucharest

Daniela CALU ASE Bucharest

Costin CIORA ASE Bucharest

Iulia JIANU ASE Bucharest

Florin MIHAI ASE Bucharest

Iuliana SANDU ASE Bucharest

Andrei STANCIU ASE Bucharest

Scientific Committee

ASE Bucharest

Romania

David ALEXANDER

University of Birmingham

United Kingdom

Alain BURLAUD INTEC Paris France

Raluca DIMITRIU ASE Bucharest Romania

Robert FAFF University of Queensland Australia

Nicoleta FARCANE University of the West of Timisoara Romania

Liliana FELEAGA ASE Bucharest Romania

Niculae FELEAGA ASE Bucharest Romania

Andrei FILIP ESSEC Paris France

Philippe GERMAK INTEC Paris France

Oktay GÜVEMLI Marmara University Turkey

Allan HODGSON University of Amsterdam The Netherlands

Bogdan IONESCU ASE Bucharest Romania

Dorin LIXANDROIU Transilvania University, Brasov Romania

Alan LORD Bowling Green University United States of America

Dumitru MATIS University “Babes-Bolyai”, Cluj Romania

Ana MORARIU ASE Bucharest Romania

Mihaela MUNTEAN University of the West of Timisoara Romania

Marc NIKITIN University of Orléans France

Recep PEKDEMIR Istanbul University Turkey

Bernard RAFFOURNIER HEC Geneva Switzerland

Vasile RAILEANU ASE Bucharest Romania

Mihai RISTEA ASE Bucharest Romania

Vasile ROBU ASE Bucharest Romania

Camelia STOICA ASE Bucharest Romania

Donna STREET Dayton University United States of America

Claudia Elena SERBAN ASE Bucharest Romania

Brândusa STEFANESCU ASE Bucharest Romania

Petru STEFEA University of the West of Timisoara Romania

Ilie TAMAS ASE Bucharest Romania

Adriana TIRON TUDOR University “Babes-Bolyai”, Cluj Romania

Alexandru TUGUI University “A.I. Cuza”, Iasi Romania

Eugeniu TURLEA ASE Bucharest Romania

Eddy VAASSEN University of Amsterdam The Netherlands

Lee YAO Loyola University United States of America


CONTENTS

Preface

PS1 Auditing

Chairperson: David PROCHAZKA, University of Economics, Prague, Czech Republic

AUDIT COMMITTEES AS INCREASING VECTORS OF FINANCIAL

INFORMATION QUALITY

Neluta MITEA

THE FINANCIAL AUDITOR’S RISK BEHAVIOUR – THE INFLUENCE

OF AGE ON RISK BEHAVIOUR IN A FINANCIAL AUDIT CONTEXT

Iancu Octavian IONESCU

Eugeniu TURLEA

THE INVESTIGATION OF ROMANIAN AUDITORS' PERCEPTIONS

OVER THE INTERNAL AUDIT PRACTICES -

AN ATTEMPT TO IDENTIFY THE BEST PRACTICES

IN THE CONTEXT OF CORPORATE GOVERNANCE

Cristina BOTA-AVRAM

PS2 Public accounting

Chairperson: Răzvan MUSTAŢĂ, Babes-Bolyai University, Romania

PUBLIC SECTOR PERFORMANCE FROM THE PERSPECTIVE

OF CORPORATE SOCIAL RESPONSIBILITY – A EUROPEAN

AND NATIONAL APPROACH

Eugeniu TURLEA

Aurelia STEFANESCU

Monica DUDIAN

Mihaela MOCANU

Adriana CALU

IMPROVEMENT IN ACCOUNTING SYSTEM AND PERFORMANCE

MANAGEMENT OF IRAN’S UNIVERSITIES IN THELIGHT OF

CONTINGENCY THEORY

Martin BROAD

Abbas ALIMORADI

THE ERA OF INTERNAL AUDIT IN THE PUBLIC FINANCE SECTOR

IN POLAND

Agnieszka SKOCZYLAS

Wojciech NOWAK

BOUNDRIES REGARDING THE IMPLEMENTATION

OF THE NATIONAL STRATEGY FOR THE FINANCIAL REPORTING

OF THE PRIVATE SECTOR ENTITIES

Ramona LAPTES

Adriana Florina POPA

~ 3 ~

3

12

14

15

32

45

68

69

91

114

133


PS3 Financial analysis I

Chairperson: Petru OPRIS, West University of Timişoara, Romania

FINANCIAL RATIOS AND MARKET VALUATION

ON EMERGENT MARKETS: THE ROMANIAN CASE

Bogdan DIMA

Petru OPRIS

A HYBRID DEVICE OF SELF ORGANIZING MAPS (SOM)

AND MULTIVARIATE ADAPTIVE REGRESSION SPLINES (MARS)

FOR THE FORECASTING OF FIRMS’ BANKRUPTCY

Javier de ANDRES

Fernando SΑNCHEZ-LASHERAS

Pedro LORCA

Francisco Javier DE COS-JUEZ

THE RELEVANCE OF COMPANY EVALUATION METHODS

IN CONDITIONS OF ECONOMIC INSTABILITY. EMPIRICAL STUDY

ON THE COMPANIES QUOTED IN THE BUCHAREST STOCK

EXCHANGE

Marilena MIRONIUC

Mihai CARP

Ioan-Bogdan ROBU

FINANCIAL RISK ANALYSIS AT THE STOCK EXCHANGE LISTED

COMPANIES IN THE PASSENGER ROAD TRANSPORTATION

INDUSTRY

Vlad IORDACHE

Vasile ROBU

Costin CIORA

PS4 IFRS I

Chairperson: David ALEXANDER, University of Birmingham, UK

BENEFITS AND COSTS OF PREPARING IFRS STATEMENTS

BY NON-LISTED COMPANIES: EVIDENCE FROM THE CZECH

REPUBLIC

David PROCHΑZKA

PS5 Fair value

Chairperson: Mihaela DUMITRANA, Academy of Economic Studies, Bucharest,

Romania

THE IMPACT OF THE ED/2009/5 FAIR VALUE MEASUREMENT

ON THE PROFESSIONALS

Mirela PAUNESCU

Mirela NICHITA

PS6 Management information systems I

Chairperson: Pavel NASTASE, Bucharest Academy of Economic Studies, Romania

AN ENTERPRISE ONTOLOGICAL APPROACH FOR SEMANTIC WEB

Adrian COZGAREA

Gabriel COZGAREA

Delia BABEANU

~ 4 ~

149

150

162

183

201

210

211

229

230

248

249


ENTERPRISE 2.0 – IS THE MARKET READY?

Dragos Marian MANGIUC

NON-TECHNICAL CHALLENGES IN ADOPTING ENTERPRISE 2.0

Dragos Marian MANGIUC

CRITICAL SUCCESS FACTORS FOR THE ORACLE DATABASE

AUDIT

Simona Felicia UNCHIASU

Pavel NASTASE

PS7 Financial instruments

Chairperson: Florin VASVARI, London Business School, UK

USE OF FINANCIAL SECURITIES IN THE CZECH REPUBLIC: SOME

EVIDENCE FROM SMES

Jiřν STROUHAL

Marie PASEKOVÁ

Eva HRUBOŠOVΑ

Carmen Giorgiana BONACI

THE FINANCIAL INNOVATION AND THE DYNAMIC CAPITAL

MARKET

Flavia Mirela BARNA

Miruna Lucia NACHESCU

A SELECTION FUZZY MODEL INVOLVING ASSETS AND PROJECTS

Adrian Victor BĂDESCU

Radu Nicolae CRISTEA

Dana-Maria BOLDEANU

THE ROLE OF FINANCIAL DESCRIPTORS IN THE OPTIMAL

PORTFOLIO SELECTION

Bogdan DIMA

Flavia BARNA

Horatiu REGEP

PS8 Intellectual Capital

Chairperson: Niculae FELEAGA, Bucharest Academy of Economic Studies, Romania

INTELLECTUAL CAPITAL DISCLOSURE: EUROPEAN EVIDENCE

Liliana FELEAGA

Niculae FELEAGA

Voicu Dan DRAGOMIR

Luciana Maria RABU

INTELLECTUAL CAPITAL: THE ANNUAL REPORTING PRACTICES

Nicoleta Maria IENCIU

Dumitru MATIŞ

DETERMINANTS OF INTELLECTUAL CAPITAL DISCLOSURE IN

THE CASE OF ROMANIAN COMPANIES

Maria Cristina MORARIU

~ 5 ~

258

275

287

302

303

317

334

347

368

369

380

395


PS9 IFRS II

Chairperson: Dumitru MATIS, Babes-Bolyai University, Romania

IMPACTS AND CHANGES IN THE ACCOUNTING POLICIES AFTER

THE IAS ADOPTION: A COMPARISON BETWEEN THE

MANUFACTURING AND THE COMMERCIAL SECTOR IN GREECE

Sotirios KARATZIMAS

Stella ZOUNTA

Vagia KYRIAKIDOU

PS10 Performance management

Chairperson: Petru STEFEA, West University of Timisoara, Romania

VALUE AND PERFORMANCE IN A REGULATED ENVIRONMENT:

THE CASE OF TELECOMMUNICATIONS IN ROMANIA

Alina Carmen ALMASAN

Corina GROSU

QUO VADIS IN MEASURING BUSINESS PERFORMANCE? A

PRACTICAL SOLUTION FOR THE IT SECTOR

Claudia Elena SERBAN

Oana-Adelina FLORICIOIU

Radu-Daniel LOGHIN

EFFECTIVE AND EFFICIENT TOOLS IN HUMAN RESSOURCES

MANAGEMENT CONTROL

Mihaela Adriana DUMITRANA

Gabriel RADU

Mariana Elena GLAVAN

Gabriel JINGA

FLEXIBILIZING THE TERMINATION OF THE EMPLOYMENT

CONTRACT: PROS AND CONS

Raluca DIMITRIU

PS11 Management information systems II

Chairperson: Iuliana IONESCU, Bucharest Academy of Economic Studies, Romania

A CASE STUDY FOR START-UP COMPANIES IMPLEMENTING E-

BUSINESS TECHNOLOGIES

Carmen TIMOFTE

ANALYZING E-COMMERCE PROTOCOLS

Carmen TIMOFTE

MODELING ON A SEMANTIC-BASED REPRESENTATION OF

PEDAGOGICAL OBJECTS E-LEARNING-TYPE IN

ORGANIZATIONAL MEMORY: CONNECTING ONTOLOGY WITH

LOM META-DATA

Iuliana IONESCU

Vasile FLORESCU

Bogdan IONESCU

Ofelia Ema ALECA

~ 6 ~

416

417

431

432

444

458

466

481

482

488

496


SEMANTIC ANNOTATION AND ASSOCIATION OF WEB

DOCUMENTS: A PROPOSAL FOR SEMANTIC MODELING IN THE

CONTEXT OF E-RECRUITMENT IN THE IT FIELD

Bogdan IONESCU

Iuliana IONESCU

Vasile FLORESCU

Andrei TINCA

DECISIONS DRIVE SUCCESS

Dragos STOICA

Pavel NASTASE

PS12 Corporate governance and ethics

Chairperson: Nicoleta FARCANE, West University of Timisoara, Romania

CORPORATE VALUES, THE COMPANIES’ FRAMEWORK

OF ETHICAL BEHAVIOUR

Elena Roxana ANGHEL-ILCU

HOW CAN CORPORATE GOVERNANCE MITIGATE FRAUD?

Victoria STANCIU

Ali EDEN

Veronica IVANCENCO

ETHICS AND RESPONSIBILITY IN IT

Valerica MARES

Marius Daniel MARES

CORPORATE GOVERNANCE PRINCIPLES: AN EVOLUTIONARY

APPROACH IN TERMS OF DIRECTORS-MANAGERS RELATIONSHIP,

IN THE DEVELOPING ECONOMIC CONTEXT OF 21ST CENTURY

Maria GROSU

Roxana-Manuela DICU

Daniela MARDIROS

PS13 Issues in financial accounting

Chairperson: Tudor GRECU, KPMG Romania

IMPACT OF FUNDED STATUS OF PENSIONS ON BORROWING

COSTS OF STATES

Maria-Iuliana SANDU

THE IMPACT OF UNREALISED FOREIGN EXCHANGE

DIFFERENCES

Georgiana TOADER

Mihaela Adriana DUMITRANA

VALUE RELEVANCE OF CONSOLIDATED VERSUS PARENT

COMPANY FINANCIAL STATEMENTS

Victor-Octavian MULLER

THE ADVANTAGES VS. THE DISADVANTAGES OF OUTSOURCING

THE ACCOUNTING AND FINANCIAL SERVICE

Vasile-Daniel PAVALOAIA

Ioan ANDONE

~ 7 ~

514

532

544

545

565

580

593

612

613

619

629

650


PS14 Management information systems III

Chairperson: Javier DE ANDRES, University of Oviedo, Spain

AUDITING NEW INFORMATION TECHNOLOGY SOLUTIONS FOR

ECONOMIC GROWTH

Delia BABEANU

Gabriel COZGAREA

Adrian COZGAREA

Ilie TAMAS

Nicolae DAVIDESCU

A TEST OF DIFFERENT MODELS FOR THE ESTIMATION OF THE

LABOR COSTS OF SOFTWARE PROJECTS

Javier de ANDRES

Pedro LORCA

IT COMPLEXITY AND COSTS

Marius Daniel MARES

Valerica MARES

PS15 XBRL

Chairperson: Sorin BRICIU, 1 Decembrie 1918 University, Alba Iulia, Romania

THE EFFICIENCY OF SMALL AND MEDIUM ENTERPRISES BY

THE IMPLEMENTATION OF WEB-BASED ACCOUNTING

Sorin BRICIU

Florin MIHAI

Constantin GROZA

13 YEARS AFTER: AN XBRL LITERATURE REVIEW AND

OVERVIEW

Claudia URDARI

Adriana TIRON TUDOR

THE INFLUENCE OF FIRM-SPECIFIC CHARACTERISTICS ON THE

EXTENT OF VOLUNTARY DISCLOSURE IN XBRL: AN EMPIRICAL

ANALYSIS OF SEC FILINGS

Devrimi KAYA

PS16 SMEs

Chairperson: Jiri STROUHAL, University of Economics Prague, Czech Republic

OBLIGATION OR OPPORTUNITY FOR DRAWING THE CASH-FLOW

STATEMENT. THE CASE OF ROMANIAN SMALL AND MEDIUM

ENTERPRISES

Adina POPA

Rodica BLIDISEL

Nicoleta FARCANE

Dan STIRBU

ROMANIAN PROFESSIONAL ACCOUNTANTS’ PERCEPTION

ON THE DIFFERENTIAL FINANCIAL REPORTING FOR SMALL

AND MEDIUM-SIZED ENTERPRISES

Stefan BUNEA

Marian SACARIN

Mihaela MINU

~ 8 ~

659

660

679

694

702

703

720

732

758

759

770


ACCOUNTING PRINCIPLES AND BOOK-TAX (DIS)CONNECTION

IN ROMANIA

Costel ISTRATE

PS17 Financial analysis II

Chairperson: Sotirios KARATZIMAS, University of Aegean, Greece

FUNDAMENTAL DETERMINANTS OF CAPITAL STRUCTURE

CHOICE: A SURVEY OF ROMANIAN COMPANIES

Marilen PIRTEA

Cristina NICOLESCU

Claudiu BOTOC

IMPACT OF LONG-TERM INVESTMENT DECISIONS ON

PROFITABILITY AND COMPETITIVE ADVANTAGE IN BUSINESS.

CASE STUDY IN THE MINING INDUSTRY IN ROMANIA

Claudia Elena SERBAN

Oana-Adelina FLORICIOIU

Radu-Daniel LOGHIN

INCLUDING BEHAVIOURAL ELEMENTS IN ASSET ALLOCATION

PROCESS

Aurora MURGEA

PS18 Education

Chairperson: Alain BURLAUD, INTEC Paris, France

ACCOUNTING STUDENTS’ ACADEMIC PERFORMANCE: A BATTLE

BETWEEN PERCEPTIONS? A ROMANIAN RESEARCH NOTE

Carmen Giorgiana BONACI

Razvan V. MUSTATA

Alexandra MUTIU

Dumitru MATIS

PERCEPTION OF THE ROMANIAN ACCOUNTANTS REGARDING

THE FINANCIAL ACCOUNTING EDUCATION

Paul DIACONU

Vasile GORGAN

Catalina GORGAN

Nicoleta COMAN

Codrina SANDRU

MANAGEMENT VIEW RELATED TO HIGHER EDUCATION –

AN ANALYSIS OF THE ROMANIAN BUSINESS PERCEPTIONS

Mihaela STET

Alexandra ROSU

SOCIAL NETWORKING IMPACT ON EDUCATIONAL PROCESSES

IN ROMANIA

Florin MIHAI

Andrei STANCIU

Ofelia Ema ALECA

~ 9 ~

787

804

805

821

833

860

861

880

892

900


THE BEGINNINGS OF TRANSYLVANIAN CLUJ ACCOUNTING

SCHOOL

Teodora Viorica FARCAS

Adriana TIRON TUDOR

PS19 Financial markets

Chairperson: Andrei FILIP, ESSEC Paris, France

FINANCIAL MARKET EFFICIENCY AND PERSPECTIVES

ON IFRS ADOPTION. CASE STUDY FOR THE UNITED KINGDOM,

THE UNITED STATES OF AMERICA AND JAPAN

Stefana DIMA (CRISTEA)

Bogdan DIMA

Otilia ŞĂRĂMĂT

PROPERTIES OF ANALYSTS’ FORECASTS FOR ROMANIAN LISTED

COMPANIES: HOW MUCH DO FIRM-SPECIFIC FACTORS MATTER?

Mihaela IONASCU

NET INCOME VERSUS COMPREHENSIVE INCOME FOR

PROFESSIONAL INVESTORS

Iulia JIANU

Ionel JIANU

Ionela GUSATU

PS20 Environmental accounting

Chairperson: Massimo POLLIFRONI, University of Turin, Italy

EXPLORATORY STUDY ON SOCIAL AND ENVIRONMENTAL

REPORTING OF EUROPEAN COMPANIES IN CRISES PERIOD

Camelia Iuliana LUNGU

Chirata CARAIANI

Cornelia DASCALU

Raluca Gina GUŞE

A COMPLEX APPROACH TO CLIMATE CHANGE EXTERNALITIES

Florian COLCEAG

Cornelia DASCALU

Chirata CARAIANI

Camelia Iuliana LUNGU

Raluca Gina GUŞE

DIFFERENCES REGARDING ENVIRONMENTAL REPORTING:

THE CASE OF ROMANIAN ORGANIZATIONS

Ionel-Alin IENCIU

ENVIRONMENTAL SUSTAINABILITY AND SOCIAL

RESPONSIBILITY: A THEORETICAL PROPOSAL

FOR AN ACCOUNTING EVALUATION

Massimo POLLIFRONI

THE IMPACT OF THE SUSTAINABLE DEVELOPMENT

ON THE FINANCIAL STATE OF THE COMPANY – SECTOR STUDY

Petru STEFEA

Cristina CIRCA

~ 10 ~

916

939

940

959

966

988

989

1006

1024

1042

1061


EMPIRICAL STUDY REGARDING KEY INDICATORS

CORRELATIONS FOR SUSTAINABLE PERFORMANCE BUDGETING

Violeta CIMPOERU

Maria RADU

Valentin CIMPOERU

PS21 Management information systems IV

Chairperson: Felicia ALBESCU, Bucharest Academy of Economic Studies, Romania

MANAGEMENT INFORMATION SYSTEMS –

AN APPROACH INSIDE AND OUTSIDE THE ORGANIZATIONAL

Georgiana Andreea CIOANĂ

Ilinca HOTARAN

BEYOND REPORTING IN BUSINESS INTELLIGENCE:

INTELLIGENCE THROUGH ANALYTICS

Irina Bogdana PUGNA

Felicia ALBESCU

Robert SOVA

PS22 Management accounting

Chairperson: Mathew TSAMENYI, University of Birmingham, UK

SURVEY OF THE PRODUCT COSTING METHODS USED

IN CZECH REPUBLIC

Boris POPESKO

Petr NOVAK

THE ROLE OF COSTS AND CONTROL IN ENSURING A

SUCCESSFUL MANAGEMENT IN THE DECISIONAL PROCESS

Stefania-Eliza BANA (PANCIU)

Florinel Marian SGARDEA

THE CHANGE IN MANAGEMENT ACCOUNTING IN ROMANIA

Madalina DUMITRU

Daniela CALU

Gorgan CATALINA

Adriana CALU

Georgiana TOADER

~ 11 ~

1075

1089

1090

1110

1125

1126

1135

1149


Accounting and Management Information Systems (AMIS)

International Conference

The AMIS International Conference organized by the Faculty of Accounting and

Management Information Systems of the Bucharest Academy of Economic Studies,

Romania, has already become an established milestone within the Romanian

accounting research environment. As such, it has already reached its 6 th edition since

its inception in 2006. All submissions/reviewing processes are handled on-line, with a

high-quality double-blind review process ensured by esteemed national and

international reviewers. For this year’s edition, we have attracted 155 participants

from various parts of the world (including Europe, USA, Asia and Australia), thus

ensuring good geographical coverage. Only full papers in English are to be submitted

for the conference, in various domains such as: financial reporting, managerial

accounting, auditing, financial analysis, management information systems, and

business law. The criteria considered in the review process are: the technical

correctness, the novelty and originality, the importance to the field, the organization

and the clarity of the paper, the relevance of references, and the quality of results. For

each criterion a mark is awarded, and a weighted average is then produced

electronically. Comments from the reviewers are also mandatory and are available in

the on-line system to authors, who can then incorporate them in the revisions of their

work. All editions have websites that can be accessed via www.amis.ase.ro/.

We have continued to obtain for this year’s edition of the conference the participation

of many international scholars. These are:

� Professor Mary BARTH, Stanford University, United States of America, the

conference keynote speaker;

� Professor David ALEXANDER of the University of Birmingham, United

Kingdom;

� Professor Alain BURLAUD, Director of INTEC/CNAM of Paris, France;

� Professor David CAIRNS – London School of Economics, the United Kingdom;

� Assistant Professor Andrei FILIP – ESSEC (Ecole Superieure des Sciences

Economiques et Commerciales) Business School, Paris;

� Professor Donna STREET, University of Dayton, United States of America;

� Professor Mathew TSAMENYI – University of Birmingham, United Kingdom;

� Assistant Professor Florin VASVARI – London Business School, United Kingdom.

Their participation is extremely encouraging and beneficial to our delegates. They

have offered extensive feedback and have ensured a good conference experience to

conference participants.

This year’s keynote speaker is Dr. Mary Barth, the Joan E. Horngren Professor of

Accounting at the Stanford University, Graduate School of Business (GSB). Prof.

Barth was a member of the International Accounting Standards Board (IASB) from its

inception in 2001. Currently, she serves as the Academic Advisor to the IASB.

Professor Barth’s research is published in a variety of journals and has won several

awards, including the American Accounting Association’s (AAA) Competitive

Manuscript Award and, on two occasions each, the AAA Wildman Medal Award and

the Best Paper Award of the Financial Accounting and Reporting Section of the AAA.


She is the Accounting Department Editor of Management Science, has been an

Associate Editor of The Accounting Review, and is on the Editorial Boards of several

other academic journals. Professor Barth is a recipient of the GSB’s MBA

Distinguished Teaching Award and PhD Faculty Distinguished Service Award, and

served as a Senior Associate Dean for Academic Affairs at the GSB from 2002 until

2009. Professor Barth is a Vice President of the International Association for

Accounting Education and Research and is active in the AAA, having served as Vice

President and as Chair of several committees. Professor Barth’s research focuses on

financial accounting and reporting issues, particularly topics of interest to accounting

standard setters. Such topics include using fair values in financial reporting, stockbased

compensation, recognition versus disclosure, asset securitizations, asset

revaluations, the information roles of accruals and cash flows, the relation between

financial statement quality and cost of capital, and issues related to global financial

reporting and convergence.

All the other international guests have extensive experience and have published in top

journals in a variety of fields related to accounting. Prof. Donna Street, Prof.

David Alexander and Assist. Prof. Andrei Filip published their work in the field of

financial reporting with a focus on International Financial Reporting Standards, Prof.

Alain Burlaud and Prof. Mathew Tsamenyi are especially focused on managerial

accounting, while Prof. David Cairns is additionally interested in the field of auditing.

It already became customary for our conference to introduce new events every

edition. In this respect, we are proud to host in conjunction with this year’s edition:

� a Joint IAAER - IFRS Foundation IFRS Framework-Based Teaching Workshop,

in which three teams of authors guided the audience through the designing of

Framework-based IFRS teaching cases;

� an ACCA IAAER Seed Grant Program for Early Career Researchers

Deliverable, that continues and extends on the last year’s IAAER-ACCA-KPMG

Early career researcher consortium. Five teams of authors who received funding

from the ACCA and mentorship from internationally recognized mentors

reported now on the development of their research;

� an Academic Performance and Evaluation Panel, during which panelists

discussed various aspects related to evaluation the work of academics, in an

internationalized and competitive context.

The next year’s edition is scheduled to take place on June 13-14 2012. We are

committed to continue to play an increased role in advancing accounting research in

Central and Eastern Europe, and we will continue to collaborate in this respect with

the International Association for Accounting Education and Research (IAAER),

whose Director of Research and Educational Activities, Dr. Donna Street, is a

constant presence at and support to our events. Our collaboration has continued on the

same fruitful grounds with the Association of Chartered Certified Accountants

(ACCA) and KPMG Romania. All these organizations are dedicated to the

development of accounting research and practice worldwide, and are committed to

strengthen the collaboration with our institution for the years to come. I am convinced

that our partnership will be one of many satisfactions.

~ 13 ~

Prof. univ. dr. Pavel NASTASE

Conference Chair


PS1 Auditing

Chairperson:

David PROCHAZKA, University of Economics, Prague, Czech

Republic

AUDIT COMMITTEES AS INCREASING VECTORS OF

FINANCIAL INFORMATION QUALITY

Neluta MITEA

THE FINANCIAL AUDITOR’S RISK BEHAVIOUR –

THE INFLUENCE OF AGE ON RISK BEHAVIOUR IN A

FINANCIAL AUDIT CONTEXT

Iancu Octavian IONESCU

Eugeniu TURLEA

THE INVESTIGATION OF ROMANIAN AUDITORS'

PERCEPTIONS OVER THE INTERNAL AUDIT

PRACTICES - AN ATTEMPT TO IDENTIFY THE BEST

PRACTICES IN THE CONTEXT OF CORPORATE

GOVERNANCE

Cristina BOTA-AVRAM


AUDIT COMMITTEES AS INCREASING VECTORS

OF FINANCIAL INFORMATION QUALITY

Neluta MITEA 1

Andrei Şaguna University in Constanţa, Romania

ABSTRACT

Capital markets feel a current need to dispose of high quality information. As a response to

this need, this paper proposes the intervention of audit committees whose main objective

consists in monitoring the financial activity. The present study offers interesting insights by

examining the relevant ideas developed previously in the literature with the scope of

understanding, reinterpreting and rediscovering from interesting points of view the audit

committee’s major role in increasing the quality of financial information. Audit committee

represents one of the mechanisms controlling managers’ opportunistic behavior, under the

circumstances of agency theory and information asymmetry. By conducting this study I

wanted to reinforce the role of specialized literature and of empirical researches in

determining new solutions and hypothesis regarding audit committee effectiveness.

KEYWORDS: audit committee, audit committee effectiveness, agency theory, information

asymmetry, financial information

INTRODUCTION

In the last years we have been witnessing a significant increase of general interest in

corporate governance. The reason for this interest lies on the economic environment’s

concern regarding the multitude and the deep consequences of the financial scandals

that started, in general, from the accounting and financial frauds. Notable

bankruptcies are also a consequence of the lack of integrity characterizing the

accounting professionals and companies’ management. It is well known that, under

managers or shareholders’ pressures, they used to practice a creative accounting and

also fraudulent financial reporting. Their purpose was to manipulate stock prices for

listed companies. Therefore, at present, we could all notice a strong concern in the

economic environment for the way by witch managers are controlled and supervised

in their actions and decisions taken. In this respect, the audit committees’ role

becomes essential for the right functioning of financial reporting process. Although

the responsibility for annual financial statements comes to the management of the

organization, a major role in securing the financial information users of statements’

reality comes to auditors.

Financial scandals generated a number of deep debates at national and international

levels, on themes like: the importance of corporate governance, the structure of

supervising committees, the relations between audit committees and the participants

to financial reporting process. However, the financial information crisis tends to

1

Correspondence address: Neluţa MITEA, “Andrei Şaguna” University in Constanţa, Romania; email:

nelutamitea@yahoo.com

~ 15 ~


discredit the audit function whose role consists in monitoring the quality of published

financial statements. In this context characterized by the loss of financial information

credibility, we are witnessing a significant effort aiming to redefine the internal

governance bodies, by introducing audit committees in the bosom of companies’

boards. The genesis of audit committees suggests that their inclusion in the structure

of corporate governance should be understood as part of the reaction to corporate

abuses occurring over the last three decades. The audit committee was an attempt to

specifically designate responsibility for accounting-related matters, to provide a

reporting structure for insiders that would circumvent managerial retribution and to

supervise relations with the external auditors. Comprehensive regulatory changes

brought on by recent corporate governance reforms have broadly redefined and reemphasized

the roles and responsibilities of all participants to the financial reporting

process. Therefore, the international academic environment is nowadays preoccupied

by the concept of audit committee, because it is used to affirm that the quality of

financial reporting depends on the characteristics of audit committees. This committee

has as objectives, the increase of financial statements’ credibility, and the assistance

of enterprises’ boards in the exercise of their actions and diligences, but also the

protection of internal and external auditors’ independence from managers’ pressures.

The present paper proposes an analysis framework concerning audit committee’s

contributions, in terms of audit quality and financial information quality too. On the

other hand, this study intends to inform the accounting professionals about the present

existent perception concerning the role of audit missions. I also studied the audit

committee’s tasks and its imperative characteristics (independence, expertise and

competence, financial experience, involvement degree). All these factors do influence

the reduction of failures in audit work. The different criteria enounced form altogether

the measures for audit committee effectiveness. By having appeal to the empirical

research studies, I arrived to assess the main action levers of audit committee. An

independent audit committee offers the premise to get reliable accounting information

and also relevant and pertinent financial statements. The originality of this paper

consists in evaluating the circumstances under which the audit committee might

improve the quality of financial information. The orientation of this approach

supposes a confrontation of economic theories, namely the agency theory and the

information asymmetry. In the conditions of agency relations, the audit committee is

supposed to act effectively.

In theory, this study continues the research directions of authors like Knapp (1991),

Pigé (2003), Chemangui (2004), Manita (2008) and also those of Turley and Zaman

(2007) and others. However, the originality of this paper consists in studying the audit

committee by conducting the research demarche towards the audit process analyzes.

Turley and Zaman (2007) addressed audit committees especially by the perspective of

agency relations. The purpose of Turley and Zaman’s researches focused on the

identification of conditions and processes affecting the audit committees’ potential

effectiveness. The results of the researches highlight the importance of informal

processes around the audit committees and also the impact of this committee on

corporate governance. The informal connections between the members of audit

committees and management, could serve at the maximization of audit committee

effectiveness. These qualitative researches do not foresee a generalization of the

results, but they support us to perceive exactly the factors influencing the

effectiveness or the lack of effectiveness concerning audit committees. For this goal, I

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took into account the essential role of audit committee manifested by the virtue of its

privileged access to the accounting and financial information and of its central place

in the companies’ control and supervising process.

RESEARCH METHODOLOGY

From an operational viewpoint, I was interested in choosing an adequate research

method which could have helped me in tracing potential solutions aiming to improve

financial information credibility, by the means of audit committees. Because of the

fact that this paper does not represent an empirical study, but a fundamental research

item, I proceeded to a history of literature addressing the subject of audit committees

and of financial information quality in order to draw conclusions highlighting the

research results. Especially the results of this study could participate at the

identification of future research perspectives. First of all, I identified the theme chosen

in the specialized literature. As a consequence, I used as research methodology, the

inductive research which supports the main idea concerning the generalization of

conclusions as a result of the literature analysis. The summary of scientific documents

was realized by having consulted specialized magazines, other sources of

documentation and also an important number of items and research studies. On the

basis of this synthesis, I proved the capacity of the audit committee to increase the

integrity of internal and external audit functions and, in the same time, I analyzed the

relations between the audit committee and its attributes concerning the quality of

financial information. At the end of this study, I proceeded to draw some conclusions

in order to highlight the contribution of the present paper to a better understanding of

the audit committee’s role according to its own limits.

1. AUDIT COMMITTEE – AN INCREASING VECTOR OF FINANCIAL

INFORMATION QUALITY

Recent financial scandals have disrupted both the concept and techniques for

measuring the audit quality. These scandals have led international professionals and

also the academic environment to redefine regulations and assessing mechanisms

concerning audit quality. Therefore, in the middle of professionals’ preoccupations,

there is audit committee, because it is considered that its characteristics do influence

the quality of financial statements. The scandals dating from the early 2000s sowed

doubts connected to the effectiveness of those committees. Famous cases with strong

impact on the credibility of financial information transmitted to investors, in addition

to Enron case, are also those of dot-com series and Credit Lyonnais (2001), Toshihide

Iguchi and Daiwa Bank (1995), Hollinger International Inc. (2004), Flaming Ferraris

(1999), Parmalat (2003), World Com (2001). Among the main causes of financial

scandals there are the information asymmetry and the opportunistic behavior of the

agents. Studying the causes and effects of these failures in question, specialists arrived

to propose possible solutions to agency problems, including audit monitoring and

performances measurement. As regards monitoring activity, the problems which are

held to be taken into account, concern internal and external bodies involved and their

independence (especially for financial audit). For the measurement of performances,

the latter depends on information entered and on instruments used.

As a result of financial scandals, the Sarbanes-Oxley Act arises in the U.S.A (2002,

SOX). Its purpose consists in establishing improved standards for all American public

~ 17 ~


companies (including non-American companies that are listed on U.S. stock market),

for their management and for public accounting firms. The law covers such issues as

auditor independence, corporate governance, internal control and the improved

disclosure of financial statements. There are similar regulations in other countries

such as: the so-called J-SOX in Japan, CLERP9 in Australia, LSF (La Loi de Sécurité

Financière) in France, Bill 198 in Canada. This concept occurs more often in Romania

too, because of the multinationals. With the Sarbanes-Oxley Act, audit committee

became the legal body responsible for monitoring and control (Prat dit Hauret &

Komarev, 2005). The audit committee’s responsibilities consist in supervising

financial reporting issued by the entities, monitoring the relations with internal and

external auditors, supervising policies and practices of detecting and preventing

financial errors and frauds, respecting business ethics. In Europe, by the means of the

8 th Directive revised by the European Parliament, listed companies are required to

establish audit committees starting from July 2008. Romania feels also the necessity

to strengthen the role of audit committee in supervising risks management and in

improving the communication with entities’ management. Nowadays Romania is in

line with international practices in risk management and corporate governance by the

means of an entire series of legislative acts. Thus, according to Ordinance no 90/2008,

entities of public interest are required to monitor the effectiveness of the internal

control system; this monitoring activity will be included in the audit committee’s

tasks.

According to the International Standard on Auditing no 260 (ISA 260),

“Communication of audit matters to those charged with governance”, the auditor

should communicate audit issues of governance interest, issues arising from the audit

of financial statements. In the respect of this ISA, the term of governance will be used

for describing the role of persons in charge with supervising, control and management

of an organization. Those charged with governance should be sure that the entity is

able to achieve its objectives regarding the reliability of financial reporting, the

effectiveness and the efficiency of operations, the compliance with the applicable law.

The auditor must prove professional reasoning in order to communicate audit matters

of governance interest, considering the structure of every entity, the circumstances of

audit engagement and any relevant legal issue. Audit committee’s members are

supposed to know the best practices for this vital function of the organizations.

The objective of this paper is not only to achieve a synthesis of international empirical

researches studies that approached the subject of audit committees. The present study

intends to fix the conditions under which audit committee could improve the quality

of the financial information. In this regard, I considered as dominant current, positive

inspiring and interpreting works. Positive studies are based, in general, on the

qualitative analysis of information about the subject matter, information from archives

and databases. The goal of the positive studies consists in identifying statistical

regularities between the audit committee’s characteristics, on the one hand, and the

quality of audit process and of financial information, on the other hand. There are

authors who dedicated their studies to the functioning of audit committees. Therefore,

we could appreciate that audit committee’s activity should be regarded in function of

its effectiveness and performance and, that is why, an important role in such a context,

comes to the questioning process adopted by the audit practitioners (Spira, 2003).

Other authors have tried to identify the factors influencing the “potential”

effectiveness of audit committees. The members of audit committee must demonstrate

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independence, competence, professional and moral tenure. In spite of some

shortcomings, the informal links between audit committee’s members and

management could serve to the effectiveness maximization. Therefore, audit

committee might be seen as a valuable tool interfering in governance (Magrane &

Malthus, 2010). There are certain complementarities between the independence and

the competence of audit committee’s members: independence is viewed according to

audit committee’s involvement in taking decisions, while competence is foreseen in

the committee’s obligation to review tasks and activities connected to internal audit

(Goodwin, 2003). Following the systemic vision of the authors discussed above, we

could notice that the role of audit committees consists in coordinating the obligations

of internal and external auditors in order not to affect the integrity of audit process,

but to increase its usefulness. The introduction of the Sarbanes-Oxley Act was an

occasion to oblige responsible bodies to announce the internal control errors and

weaknesses. Therefore, entities that have published the cases connected to the

weaknesses of the internal control have formed the basis for numerous research

studies. Starting from them, we could conclude that there is a possible link between

the internal control weaknesses and the audit committee effectiveness. Studies that

followed the introduction of SOX consider the audit committee as a preventive factor

for internal control weaknesses. There are some studies confirming those results

(Zhang et al., 2007). Audit committee’s size and its competences are the factors

influencing the rapid and effective correction of internal control weaknesses (Goh,

2009). In the meantime, auditors’ professional reasoning is proportional to their

expertise (DeZoort, 1998). This author assumes that the members of audit committees

proving experience in auditing and internal control, are able to make judgments closer

to those coming from the external auditors, the latter being considered the truest

specialists in the field. Moreover, less experienced individuals, might make difficult a

rigorous control. In a more recent study, the researchers highlight that audit

committees’ members are mainly based on intuition in the process concerning the

establishment of professional reasoning and that the key element of committee’s

effectiveness consists in members’ ability to put challenging questions (Gendron et

al., 2004). The research models I’ve studied prove that financial and extra-financial

expertise of audit committees’ members does represent the key factor of this body

effectiveness, the internal control quality depending on this factor. In this respect, the

members of audit committees are required to orient internal audit efforts towards the

detection of financial errors and weaknesses.

There are research studies indicating the positive effects of the Sarbanes-Oxley Act on

the financial reporting process, on capital cost and on company’s value (Bedard,

2006; Ashbough-Skaife et al. 2007; Cohen et al. 2008). The authors examine the SOX

impact by having appeal to a comparison between external auditors’ current

experiences and their interactions with the various mechanisms of corporate

governance (board, audit committee etc.). As well as the auditors’ experience, that of

management reveals the fact that the compliance to legislative acts has a positive

impact on the relation between audit committee and external auditors and also

between audit committee and company’s board. Cohen et al. (2008) notice that, in

general, audit committee does not participate directly to the resolution of conflicts

between auditors and management, preferring to be just informed about the eventual

misunderstandings that could appear. In case of a conflict, audit committee becomes a

true relay of spontaneous information for internal audit responsible (Turley & Zaman,

2007). The improvement of internal costs effectiveness resulting from SOX adoption,

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contributes to the decrease of information risk as well as to that of capital (Ashbaugh-

Skaife et al, 2007). Concerning the relation between audit committee and external

auditors, research studies show us that this relation is more formalized. This aspect

starts from the premise that external auditor represents the main actor of certification

process. Therefore, the quality of the audit mission depends on the external auditor’s

independence. The Sarbanes-Oxley Act limits a parallel consultancy activity

conducted by external auditors within the same organization. Audit committee will

intervene in the conflict arising between external auditor and management, protecting

auditor’s independence. When audit committee’s members prove serious auditing

knowledge and a strong economic formation, they tend to sustain external auditors

(DeZoort, 1998). On the other hand, when the audit committees’ members were

managers of companies in the past, is much easier for them to fraternize with the

audited entity’s management (DeZoort, 1998). Globally, studies point out that audit

committee’s members are increasingly tempted to defend external auditors’ opinion

when we observe an increase of their competences in auditing but also a manifestation

of their independence. Therefore, this paper highlights the idea that audit committee

must have a financial expert as member who possesses either professional

qualification or experience in preparing, auditing, analyzing or evaluating financial

statements but also it should have an understanding of audit committee functions.

Audit committee’s members should make every effort to promote the audit quality, by

imposing specific conditions to external auditors aiming to cover risk areas. In the

meantime, audit committee should optimize external control program. According to

SOX, audit committee is responsible for external auditor remuneration. Therefore, the

committee is held to prove its effectiveness, by establishing an agreed price justifying

the work and also the results. From research studies, we could notice that in the

U.S.A. there are accentuate complementarities between audit committee’s

independence and external audit expenditures. The presence of an audit committee

increases fees corresponding to the global audit effort and reduces the fee to be paid

for the complexity of the mission (Collier & Gregory, 1996).

As a conclusion for this first part of the paper, I sustain that audit process is a complex

one and that audit committee has a vital role for determining the quality of audit

mission and of financial information. An audit committee could be defined as subcommittee

in the governing body that will make arrangement for internal audit and

facilitate the completion of external audit. Audit committees try to enhance the ability

of the board to fulfill its legal responsibilities and ensure the credibility and

objectivity of the financial reporting. The quality of audit process depends largely on

auditor’s quality (independence, competence, expertise and ethics), but also on the

organization of this process. Audit committee’s members seem to break down audit

process considering established procedures and proposed accounting adjustments.

However, a particular attention should be paid to the relationship between audit

committee and external and internal auditors. Audit committee’s expertise in auditing

and economics could influence the quality of audit mission and also the quality of

financial information.

2. AUDIT COMMITTEE FACE TO FRAUDULENT FINANCIAL

STATEMENTS

The emergence of a financial accounting is historically connected to the development

of corporations inducing the need to communicate financial information towards

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shareholders as companies’ owners and also towards other interested parties. In

literature there are a number of studies that place financial information in its real

context, marked by constraints and imperfections. Seen as a typical information

system, accounting differs from other information systems on three levels: “by the

specificity of the principles supporting the profession; by the specificity of processed

data and by the specificity of processing methods” (Grenier, 2000: 1122). Therefore,

Grenier and Bonnebouche are the promoters of a scheme including accounting

principles in the representation process. “These principles interpose between the

reality to be represented and the observer (at the level of observation principles –

prudence, quantification), between the reality and the information’s user (at the level

of principles concerning representation’s construction), or between the user and the

observer (at the level of deontological principles – sincerity, regularity)” (Grenier,

2000: 1123). Listed companies from modern economy surpass the legal reporting

duties and develop a true “financial communication strategy” (Guimard, 1997: 342).

Fraudulent financial statements represent a threat for users’ trust. Those statements

have captured the attention of business community, accounting professionals,

academic environment and also of regulators. At present, we could notice the

necessity to prevent financial frauds and to detect those strategies able to keep away

this type of incidents. Fraud risk could be reduced by combining detection and

prevention measures. Michael R. Young (2003) who has spent almost twenty years

defending accounting firms accused of fraud recognizes that the introduction of the

Sarbanes-Oxley Act could be useful. Experience proves us that violation of laws and

regulations is, in general, the result of deficiencies within corporate governance and

internal control. Independence and financial sophistication of members are regarded

as challenges for audit committees. Therefore, in order to get a future success, audit

committees should ensure that the organization has determined initially a viable audit

function.

However, audit committees’ presence in the bosom of companies aims to prevent the

production and transmission of fraudulent financial statements. Audit committee is

held to make sure that financial statements are not the result of accounting errors or

frauds. Some authors have studied the usefulness of an audit committee in preventing

frauds. Audit committee could play a significant role in preventing, detecting and

investigating frauds. As long as we are talking about prevention, the main aspect for

audit committees in preventing frauds consists in observing management and external

auditors’ expectations. In addition, it is necessary for an audit committee to manifest

zero tolerance when it detects errors; audit committee should take seriously into

account any attempt to defraud, to investigate it subsequently and to act accordingly

to the importance of the event.

Two empirical studies validate the audit committee usefulness (McMullen, 1996;

Uzun et al., 2004) and other two deny this usefulness (Beasley, 1996; Carcello &

Nagy, 2004). McMullen (1996) detects a significant negative relation between the

presence of an audit committee and fraud. The lack of reliability regarding financial

information has less severe consequences. However, not the same thing occurs when

correcting accounting results. Firms with audit committees are associated with fewer

shareholder lawsuits alleging fraud, fewer quarterly earnings restatements, fewer SEC

(Security Exchange Commission) enforcement actions, fewer illegal acts and fewer

instances of auditor turnover when there is an auditor-client accounting disagreement

(McMullen, 1996). Research studies follow various types of measures when they

~ 21 ~


address audit committee independence. Uzun et al. (2004) discuss about frauds, while

other authors are preoccupied with the measure of correcting the results (Agrawal &

Chadha, 2005). However, no less important are the contributions of entirely

independent audit committees regarded as a factor of fraud prevention (Abbott et al.,

2000). They show that companies getting audit committees composed of independent

directors are less sanctioned for fraudulent reporting. Audit committee’s

independence affects both companies’ management earnings and investors’

perceptions. A good audit committee would affect shareholders’ perception

concerning auditors, especially in those circumstances in which shareholders might

experience a greater threat to auditors’ independence (Raghunandan & Rama, 2003).

Audit committees are held to select auditors. If the reputation of audit committee’s

members depended on the quality of audit mission results, surely audit committees

would be interested in selecting the best auditors. An auditor could be appreciated

according to his capacity to detect and to report errors and omissions in financial

statements (Chersan, 2009). There are other research studies demonstrating that audit

committee’s discipline is strongly linked to the organization of internal governance.

An entirely independent audit committee will allow the prevention of accounting

irregularities, unless the CEO is not involved in selecting board members (Carcello &

Nagy, 2004). Further studies present less extreme consequences. The presence of a

financial expert in audit committee might reduce the likelihood of correcting the

accounting results (Abbott et al., 2004; Agrawal & Chadha, 2005). Herdman (2002),

chief accountant of SEC (Securities and Exchange Commission) highlighted the

importance of audit committees in post-SOX era sustaining that the role of audit

committee is one essential for enduring the integrity of published financial statements

on which investors are based. At a different level, Sheela Thiruvadi (2008) examined

the impact of gender differences on audit committee’s characteristics. The authors

have shown that those committees managed by women, act differently from

committees managed by men. The composition of audit committees evolves according

to company’s nature (size, growth etc) and to the environment in which it operates

(Deli & Gillan, 2000). The likelihood that there is an entirely independent audit

committee is associated in a negative way to company’s growth opportunities and in a

positive way to company’s size (Deli & Gillan, 2000). Some researches results might

help the policy-makers, the investors and companies’ management to focus on audit

committee’s characteristics which could be crucial for the ethical behavior of the

entire body (Persons, 2009).

Without going too far with frauds cases or that regarding the violation of accounting

principles, some authors have studied only the practices of the opportunistic

management. If an audit committee was equipped with a rigorous capacity to follow

the accounting policies, it should provide constraints on opportunistic and

discretionary behavior. From the analysis I conducted, I arrived to conclude that

accounting practices are less discretionary when the audit committee’s level of

financial experience is higher (Bedard et al., 2004). An accounting manipulation with

an opportunistic purpose could represent, in extremis, a case of financial fraud.

Examples on this subject are the situations in which the management of the results

permits to companies’ managers to increase financial information relevance by

highlighting false future returns. In order to reduce risks, audit committee’s members

are supposed to communicate in time to managers, to internal and external auditors

the accounting problems and shortcomings. However, other studies go further, taking

into account different competence forms of audit committee, such as governance

~ 22 ~


expertise which could control the management of the accounting result (Bedard et al.,

2004; Yang & Krishnan, 2005). As a consequence, the level of expertise, and

especially the accounting expertise of audit committee’s members, does represent an

important element in preventing the results manipulation which will influence the

quality of the financial information. The reliability of financial information is thus

considered a fundamental attribute depending on a series of factors. The mere

presence of the audit committee is able to improve both the financial information

reliability (fewer accounting irregularities and cases of results manipulations) and its

relevance.

As a conclusion of this second part of the paper, I appreciate that audit committee’s

role is not one neutral to the quality of audit process and of financial information. So,

audit committee could play a very important role for mitigating agency problem. It

could also replace many deficiencies of a particular company which are the causes of

agency problem. Deficiency may be lack of independence of external auditor or lack

of efficiency in the internal control systems. Although audit committees could not

have prevented the financial scandals, the empirical research studies confer to those

committees a certain effectiveness and usefulness for company’s governance systems.

The members of audit committees should cultivate closes relations with the CEO and

the CFO, with internal and external auditors in order to solve the difficulties and

shortcomings. Therefore, it is imperative for audit committees’ members to be

informed of all significant matters relating to financial reporting. The prevention of

accounting errors and frauds depends on audit committee’s characteristics. However,

a fully independent audit committee does not succeed in entirely eliminating

fraudulent financial reporting.

3. THE QUALITY OF AUDIT COMMITY IN CONDITIONS OF AGENCY

THEORY AND INFORMATION ASYMMETRY

The researches on audit committee’s role and on financial information quality get new

meanings for positive theories. On this line, this paper retains the agency theory and

the information asymmetry. Financial information’s characteristics are strongly

linked, in this case, to interest conflicts arising between actors involved in the

economic process. Auditing is a solution to information asymmetry problems which

occur between managers and shareholders or between managers and the others.

Jensen and Meckling (1976) start their research from the hypothesis that auditing

represents a monitoring activity contributing to the increase of company’s value. On

the basis of its role as corporate governance’s mechanism, auditing is focused on the

reduction of agency costs (Jensen & Meckling, 1976; Fama & Jensen, 1983) and on

guarantying information’s reliability and relevance to the information’s users. This

information is supposed to correspond to the true and fair view. Research demarches

started, usually, from the premise that economic actors do not have a free access to

financial information. The consequences of this observation highlight the idea that

information itself has a cost. Information available on market is partial and

asymmetric. The theory of information asymmetry is based on Akerlof’s study (1970)

which “analyses buyers and sellers’ behavior by abandoning the hypothesis of perfect

information in order to suppose consumer’s uncertainty regarding the quality of

purchased goods” (Raimbourg, 1997: 190). The hypothesis of information asymmetry

is strongly linked to the agency theory and to the existence of agency relations. The

agency theory was established by Jensen and Meckling in 1976. The authors offered a

~ 23 ~


new vision on organizations, with significant consequences at the analyzed level of

financial communication. The agency theory is concerned with “a contractual

relationship between two or more persons under which, one or more persons, called

the agent(s), is (are) supposed to perform some services on behalf of the principal”.

Both the agent and the principal are assumed to be rational economic persons

motivated by self-interests (Jensen & Meckling, 1976). And agency theory suggests

that, owing to the separation of corporate management and ownership, shareholders

require protection because managers may have agendas different from their owners,

and thus they might not always act in the owners’ best interests (Fama & Jensen,

1983; Jensen & Meckling, 1976). These authors define the agency relation as “a

contractual relation whereby one or more persons named principal employ/s another

person named the agent in order to exercise in his/their name a certain task implying

the delegation of decision-making power to the agent” (Jensen and Meckling, 1976).

According to this theory, it is supposed that agents act on behalf of the shareholders,

respecting the interests of the latter. However, management could prove an

opportunistic behavior, putting the spotlight on their interests, looking for getting

personal advantages, such as remuneration, financial benefits and professional

prestige. Those advantages seem unprofitable for the entity because of the fact that

they increase company’s costs. In order to minimize the risks, the principal will put in

application a number of measures intended to determine the agent to reveal all the

information. There are some empirical studies confirming the fact that, in general,

shareholders are interested in maintaining entities’ control by reducing the

information’s transparency (Haniffa & Cooke, 2002; Makhija & Patton, 2004).

By analyzing the agency problem, this paper aims to show that Jensen’s agency

theory has evolved continuously, arriving to present itself as an organizational theory

including two different research currents: a purely economic theory centered on

market’s functioning and a research theory associated to psychology, sociology,

anthropology and biology. The research theory highlights human behavior both on

individual level and on the social one. The studies in the field show that managers

arrive to build a set of opportunities, at the expense of the principal (the shareholders).

This paper considers that the principal is disadvantaged because of information

asymmetry. The sources of the conflicts arisen between the principal and the agent are

externalities coming from asymmetries of information, differences in attitudes

towards risk, differences in decision-making rights. This paper proposes a solution in

order to solve the organizational shortcoming, by finding cheaper ways such as the

effective and useful audit committees. The latter is held to provide accurate, complete

and fair information to the shareholders concerning enterprise’s situation, starting

from the moral obligation of audit committee’s members to manifest independence

(Domnişoru & Vânătoru, 2008). However, there are other authors who expressed their

skepticism about auditors’ independence within audit process, because of company’s

superior position (Nichols & Price, 1976). The conflict arising between managers and

auditors has been associated by researchers to the imbalance characterizing the

rapport of forces between them (Nichols & Price, 1976). We could notice that, behind

the closed doors of listed companies, there is the true and fair view or the so-called

faithful image “guarded” by managers as a result of audit committee’s intervention.

The correspondence between the true and fair view and the economic reality depends

on audit committee. At this point, it is the turn for morality, competence (Gendron et

al., 2004) and for audit committee’s independence to enter the game of the

~ 24 ~


information asymmetry. According to those characteristics enounced above, the

companies’ destiny will be decided soon.

There are also authors considering that the agency relation appears when “an

individual (or an enterprise) entrusts to another part the management of its own

interests” (Raimbourg, 1997: 188). Agency theory becomes crucial when we add the

context of information asymmetry. As shown in some research studies (Marois &

Bompoint, 2004), agency theory has sense only under the circumstances of an

imperfect and asymmetric information between the parties involved (the agent has a

superior knowledge of the task to be fulfilled than the principal). In such a framework,

the authors address a particular importance to agency costs (including expenditures’

supervision by the principal, expenditures incurred by the staff in order to keep in

touch with the principal; eventual losses). The agency costs in any enterprise will

depend on the lack of information about the agent’s activities, on the costs of

monitoring and analyzing the management’s performance, on the costs of devising a

bonus scheme which rewards the agent maximizing the principal’s welfare and on the

costs for determining and enforcing policy rules. An audit committee is a solution to

reduce the problem of incentives (Fama & Jensen, 1983). The greater is the proportion

of outside dispersed shareholders, the more likely it is, that the company will form an

audit committee in order to reduce agency costs. However, there are a number of

uncertainties linked to agent’s behavior (risk and moral hazard) (Raimbourg, 1997:

189). Moral hazard with hidden actions occurs when the agent can determine to a

degree the outcome of his or her action, and the principal can not directly observe the

agent’s effort, or perfectly infer it from the company’s information system. Even

Romanian literature acknowledges the existence of agency relationships between

financial information’s users. Decoupling control of property led to the increase of

agency problems. The relationships between managers and shareholders, as well as

the levers the latter has to control managers’ activity (by the means of audit), have

been frequently discussed by the researchers.

In theory, this paper can afford to go beyond the indirect approaches concerning the

assessment of audit quality and to propose, following the examples of authors like

Knapp (1991), Carcello et al. (1992), Pigé (2003), Chemangui (2004), Manita (2008),

a direct analyze of audit process. The present study aims to emphasize the audit

quality indicators and also the way by which they could be influenced. For such a

research demarche I took into account the privileged role of the audit committee’s

members. However, when information transmitted to audit committee does not prove

useful, the committee’s role becomes a ceremonial one (Gendron et al, 2004). The

fact that the members of audit committee occupy the central place in the control

process helped me to better understand the indicators measuring audit quality. Despite

all these, audit quality is not uniform at all and, therefore, it has represented the

research theme for a lot of authors. When the researchers reveal bankruptcies

situations, a great attention would be paid to audit quality (Wooten, 2003). However,

it is very difficult for us to know the real number of audits proving a poor quality

because of the fact that not all of them have been published. To observe audit process

requires a sustainable effort; consequently, researchers studied audit quality by the

means of auditor’s quality (DeAngelo, 1981; Nichols & Smith, 1983; Kaplan, 1995;

Lennox, 1999). De Angelo (1981: 183) defined the audit quality as “market’s

assessment on the adjacent likelihood that an auditor would discover simultaneously a

significant anomaly or irregularity in the enterprise’s accounting system and that he

~ 25 ~


would make public this anomaly”. In this regard, some authors conclude that an audit

report would be qualitative only if it is the result of a competent audit process and of

an independent one, technically speaking (Citron & Taffler, 1992). Research studies

of Nichols and Smith (1983), Knapp (1991), Kaplan (1995), Lennox (1999) retained

this demarche defining audit quality according to technique competence (the quality

to detect frauds and errors) and to auditor’s independence (the quality to reveal errors,

to make them known). The Big 8 CPA firms supply a higher level of audit quality

than do smaller CPA firms because the Big 8 possess technological advantages that

lead to the detection of more material errors in client financial statements (DeAngelo,

1981). Furthermore, Big 8 auditors are viewed as being more independent as they

have greater reputation at stake. Committee’s members could understand the

difference between the oversight function of the committee and the decision-making

function of management and must be willing to challenge management when

necessary (Blue Ribbon Commission Report, 1999). In other words, DeAngelo (1981)

argues that larger audit firms have a greater investment in the reputation capital. In

order to protect their investment, audit firms are likely to provide higher quality

audits. There is a lower incidence of litigation against Big Eight auditors than against

non-Big Eight ones (Palmrose, 1988) and also a positive relation between board size

and financial fraud (Beasley, 1996). A smaller board is more effective at fulfilling a

controlling function whereas larger boards are easier for the CEO to control. The

characteristics of audit committees influence negatively the significance when board’s

characteristics are included (Carcello & Nagy, 2004). The reports of the

ineffectiveness in audit quality evaluation have driven both the professional and

academic world to rethink the current rules and mechanisms for audit quality

assessment and to debate this subject and its measurability.

From another perspective, Chemangui (2004) arrives to assess audit quality according

to auditor’s quality, the auditor being viewed as an individual or as a group of

individuals. By extending the approach area, other researchers have studied the

indicators of audit quality according to auditor’s fees (Malone & Roberts, 1996;

David et al., 2006) or to his reputation (McNair, 1991; Palmrose, 1988; Moizer,

1997). At the same time, audit quality could depend on organizational characteristics

of audit committee. The members of audit committee could have different motivations

for improving the quality of audit process (Power, 1995). The authors cite a number

of quality indicators such as: human resource (Wooten, 2003), quality control (Prat dit

Hauret, 2000; Malone & Roberts, 1996), expertise (Wooten, 2003), professional

negligence affecting audit quality (Malone & Roberts, 1996; McNair, 1991). Even

audit committee’s size has a significant impact on financial reporting (Felo et al.,

2003). Their results highlight the idea that there is a positive relation between the

audit committee’s size and the quality of financial reporting, although studies realized

by Abbott et al. (2004) as well as those of Bedard et al. (2004) infirmed the

affirmation above. On the other hand, a company could have problems connected to

its financial statements when there is not a frequency in meetings of audit committee’s

members (McMullen, 1996). Therefore, this paper sustains that the frequency of this

meetings could improve and intensify the control of financial reporting process.

The assessment of audit quality imposes some conceptual and empirical limits

influencing financial information credibility. Some limits are linked to the risk of

compliance with management (Fama & Jensen, 1983a; Craswell, 1988); others are

reported to the characteristics of identified indicators (very simplistic indicators or

~ 26 ~


indicators reducing audit quality), and also to their incapacity to determine the

solution for audit quality improvement (Sutton, 1993). In this sense, the last quoted

author tried to validate a number of key factors on which audit quality depends. He

identified 19 factors. Further, Manita (2008) developed a tool for assessing audit

quality which is composed of 49 quality indicators assigned to different stages of

auditing. The author shows clearly that audit process is a complex one which needs to

be understood and observed on several dimensions. Manita’s study (2008) proves the

fact that the quality of audit process is not tributary only to technical aspects

characterizing auditors, but also to their quality characteristics (independence,

competence, expertise, ethics) as well as to organizational characteristics of audit

firms (audit team, organization of audit mission etc.). However, it is necessary to

specify the fact that the quoted study refers to a period prior to SOX introduction; this

event forced listed companies to establish audit committees. Manita has realized a

quantitative research using a sample of auditors which could not have had the same

education and perception on audit quality, as future audit committees’ members.

Cohen et al. (2002) interviewed 36 auditors in connection with corporate governance

influence on audit process, including the role of audit committees. After the

interviews, he concluded that auditors perceive management as the main header of

corporate governance. An important number of auditors interviewed considered audit

committees weak and ineffective. However, financial scandals and particularly the

failure of Arthur Andersen auditing firm, confirmed the insufficiency of this indirect

approach of audit assessment. Therefore, subsequent authors have addressed this

research question from a different perspective in order to make clear the way by

which this control system could be effective. They also intended to clarify audit

committee’s relevance for contributing to the reduction of audit failures. In this

respect, the paper draws attention to the need for studying an important aspect which

could influence the quality of financial information: that of communication and

collaboration between auditors and audit committees (Spira, 2003; Turley & Zaman,

2007). It seems that companies’ owners are very sensitive about the way in which

auditors communicate with audit committee’s members, about the identified risks and

the released results. On the other hand, this paper highlights the idea that audit

committees’ members prove respect to those auditors that take into account the risks

in question and the sensitive areas noticed during the audit process. This fact denotes,

in the eyes of audit committees’ members, the effectiveness and competence of

auditors.

This part of the present study concludes that company’s integrity depends, to some

extent, on the independence and competence of audit committees’ members.

However, independence and competence are not the only criteria to be taken into

account in measuring the quality of audit process.

DISCUSSION AND CONCLUSIONS

By making a review of literature addressing audit committee’s theme, I arrived to

better understand the audit committee’s role but also to propose some solutions for

improving financial information quality. This paper also takes into account the

problem of increasing the accuracy, integrity and conformity of financial statements

transmitted to the users from all levels. Audit committee has preoccupied researchers

for a long time. However, by studying a large part of the published works on this

subject, I noticed almost the absence of clear solutions concerning the effective

~ 27 ~


intervention of audit committees in the increasing of financial information quality. For

this paper, I started from the unanimous need of capital markets to dispose of high

quality information. As a response to this need, regulators introduced the obligation

for listed companies to dispose of audit committees. The main role of these audit

committees consists in monitoring financial situations. Therefore, audit committees

should supervise the quality of the applied accounting principles and also the way by

which these principles affect financial situations. By the contribution of this paper, we

could appreciate that audit committee represents one of mechanisms controlling the

opportunistic behavior of managers, under the circumstances of the agency theory and

information asymmetry. From the empirical research studies, I found that the major

function of audit committees consists in reducing financial reporting risks.

The results of this fundamental research highlight some possible solutions by which

we could increase audit committee effectiveness in corporate governance and in

financial reporting. Audit committee effectiveness depends on the financial and extrafinancial

expertise of the members. At the same time, the members of audit

committees should be “champions” in ethics and they must prove independence,

competence, morality and professional reasoning. Audit committee’s characteristics

are crucial for preventing frauds and accounting errors. However, the results of this

research paper indicate the fact that a fully independent audit committee is not able to

eliminate the entire fraudulent financial reporting. Generalizing, we could consider

that the intention of the Sarbanes-Oxley Act or of a Blue Ribbon Committee Report

seems insufficient for preventing fraudulent behavior manifested by companies’

management. As a consequence, all the persons involved in corporate governance

should be more vigilant to the importance of financial information’s quality. Unlike

the employee fraud, management fraud is more difficult to be detected because of

managers’ manipulation attempts and because of their opportunistic behavior. The

internal control systems can not be made entirely responsible for managerial frauds.

Therefore, we could appreciate that we need independent audit committees

monitoring the integrity of financial reporting and ceasing managers’ manipulations.

In order to achieve this goal, the present paper proposes to the audit committees’

members to protect external auditors from the pressures exercised by managers. Audit

committees should possess real and sufficient information and should assume their

responsibility to fraud detection and prevention. However, this paper contains some

doubts linked to the ability of audit committees’ members to prevent all potential

frauds. This study sustains that the members of audit committees should cultivate

close relationships with the CEO and the CFO, with internal and external auditors in

order to solve the difficulties. In is imperative for the members to be informed of all

significant matters concerning financial reporting. Also, the frequency of audit

committee’s meetings could improve and intensify the control of financial reporting

process. Even the informal relations between the members of audit committees and

management could serve to maximize audit committee effectiveness. Agency problem

is and will be there as long as there are organizations based on corporate type. During

this study I observed that not only agency problem but also the failure of different

corporate governance instruments creates difficulties. An independent audit

committee is one of the most important mechanisms for minimizing these types of

problems. The establishment of an audit committee has a lot of value to different

types of users which could ensure the credibility of the financial information.

~ 28 ~


This study reflects my own opinion about the importance of audit committees. I

consider that a clarification of independence definition, could subsequently lead to a

manifestation of a truly audit committee independence. This positive consequence

will enhance its effectiveness and will improve the quality of financial information.

This paper gives me the possibility to affirm that it is necessary to find as soon as

possible real solutions concerning agency and corporate governance issues marking

the financial communication. The study provides the premises for identifying future

research perspectives extremely generous. In this sense, I propose to explore several

directions such as: the empirical studies on the information asymmetry phenomenon

or agency relations manifested on Romanian market at different levels; intercultural

studies concerning governance shortcomings within companies; empirical research

studies based on the corporate governance impact on audit process within Romanian

enterprises. Future studies could investigate the circumstances under which, by

changing audit committee’s characteristics, by increasing the meetings number of

audit committee’s members, by increasing also the number of financial experts within

audit committees or even that of women as members in those committees, we could

affect audit value and quality, including the quality of financial information

transmitted on the market.

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THE FINANCIAL AUDITOR’S RISK BEHAVIOUR –

THE INFLUENCE OF AGE ON RISK BEHAVIOUR

IN A FINANCIAL AUDIT CONTEXT

Iancu Octavian IONESCU 1 & Eugeniu TURLEA

Bucharest Academy of Economic Studies, Romania

ABSTRACT

A main issue in the audit process is the risk faced by the decision makers in every aspect of an

audit process decision. The decision makers’ risk behaviour and their attitude towards risk is

considered to be central to the way business risk, in general, and audit risk, in particular, is

managed but no conclusive theory as to what influences the decision makers’ risk behaviour

is commonly accepted. Although previous studies have brought arguments in favour of

different factors considered to have an influence on the decision makers’ risk behaviour, what

is not known is whether age has an influence on risk behaviour. This article advances the

hypothesis that the auditor’s attitude towards risk is influenced by the auditor’s age, in a

financial audit context. The methodological approach used was the survey of a representative

sample using a carefully designed questionnaire and the use of statistical software to

investigate the responses. The analysis of data collected revealed that there is a strong

correlation between the financial auditor’s risk behaviour and the financial auditor’s age,

confirming the research hypothesis as well as setting a starting point for future research.

KEYWORDS: risk, age, financial audit, risk behaviour, correlation

INTRODUCTION

Throughout his work the financial auditor uses an element that is central to all audit

activities: risk assessment. The activity of risk assessment is closely linked to the

auditor’s risk behaviour and risk attitude, as well as professional judgement. The

validity and quality of the financial auditor’s professional judgement as well as his

risk behaviour are critically important elements which work together to strengthen the

reputation of the auditing profession. Generally, the academic literature related to

professional judgement, risk and decision making in audit showed that professional

judgement and decision making are inherent to any audit stage, that the risk

preferences and risk behaviour varies widely between auditors and that a wide

spectrum of factors influence professional judgement and risk behaviour. The

relationship between professional judgement and risk is a direct and constant one

because professional judgement in audit is exercised in a risk context. In exercising

professional judgement, the auditor makes initial risk assessments which are

consequently modified in the light of the new audit evidence gathered throughout the

audit process. Any risk assessment in audit implies professional judgement to some

extent. However, despite the fact that there are a significant number of empirical

studies on risk behaviour and decision making, these studies did not produce uniform

1

Correspondence address: Iancu Octavian IONESCU, Bucharest Academy of Economic Studies,

Romania; email: octavian.i.ionescu@gmail.com


findings. As the audit process is at the heart of the business world and while the audit

firm itself is a business, general characteristics of risk can be extrapolated to embrace

a more general business risk view. There are solid grounds to argue that the financial

auditor is a business decision maker. Moreover, while the audit process is basically a

team work led by the audit firms’ managers and partners, risk theory that applies to

business managers will certainly apply to the audit field as well. Risk is a concept

whose definition has not generated a consensus in the academic or business circles but

is generally accepted that it relates to issues of unpredictability, decision making and

potential loss. Risk is intrinsically linked with decision-making and every decision

made in business implies a certain degree of risk. According to March and Shapira

(1987), the importance of risk to decision making is attested by its position in decision

theory and by the high level of interest in risk assessment in audit. Kendrick (2004)

underlines the importance of understanding the personal attitudes to risk and considers

the attitude and behaviour dimension one of the key dimensions to understanding risk.

The rationale of the importance of understanding the decision makers’ risk behaviour

as underlined by Kendrick (2004), is that, to a certain extent, the strategies of an

organisation reflect the dispositions of their managers in terms of their background,

beliefs, attitudes and problem-solving styles. This behavioural aspect of risk taking in

decision making introduces the fundamental question about the determinants of risk

behaviour. What exactly determines or influences a decision maker’s risk behaviour

when making a decision? There are currently several views accepted. The most

popular are those articulated by Kogan and Wallach (1967): the dispositional view,

which considers the personal characteristics of a decision maker such as natural

predisposition towards taking or avoiding risk to be determinant of the type of

decision taken and the situational view, which considers the context in which the

decision is taken to be determinant of the decision maker’s risk behaviour,

irrespective of dispositional preferences. There are also integrative views accepted

which suggest that the dispositional risk propensity interacts with situational factors in

determining risk taking behaviour (Baird and Thomas, 1985; Sitkin and Pablo, 1992;

Das and Teng, 2001; Kendrick, 2004). This study follows the integrative lines and

proposes that age is a transcending factor which influences the decision makers’ risk

behaviour irrespective of dispositional or contextual factors. The purpose of this

article is to establish the relationship between the auditor’s age and the auditor’s risk

behaviour in a financial audit context, contributing to the understanding of risk

behaviour and adding to the literature on the relationship between age and risk. The

research question is whether the auditor’s age can influence his/her risk behaviour.

The research method is the hypothesis testing using questionnaires on a sample of

practising financial auditors, active members of The Romanian Chamber of Financial

Auditors (CAFR). The data will be analysed using the SPSS statistical software. The

main contribution of this work will be to complement the academic research on risk

and help to better understand the financial auditor’s risk behaviour in a financial audit

context.

1. LITERATURE REVIEW

In this chapter, theories and previous research in the field of risk behaviour is

explored. All the relevant theories and literature regarding risk and its relationship

with age will be discussed. The chapter begins with a discussion of the theories

regarding risk behaviour, followed by a discussion of the academic literature on the

~ 33 ~


elationship between age and risk. This approach will analyse the theories of risk from

different angles and will enable a multidimensional view on previous literature.

1.1. Theories on the determinants of risk behaviour

Academic theories which attempted to explain the risk behaviour of decision makers

date back as far as 1738 (Bernoulli, 1738) and there are a significant number of

empirical studies in the area of risk taking behaviour. However, these studies have not

produced uniform findings. The theories of risk taking behaviour are split into two

major competing paradigms: one which emphasizes the importance of individual

dispositional differences, which is called the dispositional view, and one which

emphasizes the importance of situational factors, called the situational view. The

dispositional view focuses on the individual differences in risk taking behaviour. For

this school of thought, the general traits and general dispositional tendencies of the

decision makers are believed to dictate their risk taking attitude. It argues that some

people have a natural predisposition to be more risk-seeking or more risk-averse than

others, irrespective of the situation or the context of the problem. In support of this

theory, a significant number of empirical studies have reported on individual

differences in risk taking behaviour. Alderfer and Bierman (Alderfer and Bierman,

1970) use two questions from Kogan and Wallach’s (Kogan and Wallach, 1964)

Choice Dilemma Questionnaire relating to financial investment, alongside other types

of questions, to substantiate considerations regarding individual differences in

attitudes towards risk choice in financial investment. However, Alderfer and Bierman

(Alderfer and Bierman, 1970), among many other scholars (Bromiley and Curley,

1992; Weber, Blais and Betz, 2002), raise doubts as to the appropriateness of using

Kogan and Wallach’s (Kogan and Wallach, 1964) Choice Dilemma Questionnaire to

extract generalities about any attitude behaviour relationship. It is interesting to

observe that by using the Kogan and Wallach’s (1964) Choice Dilemma

Questionnaire and by being critical of it at the same time, Alderfer and Bierman

(Alderfer and Bierman, 1970) are actually raising doubts about the validity of their

own findings. In a study that directly examined the consistency of dispositional risk

taking behaviour in two groups, one risk-seeking and one risk-averse, Schneider and

Lopes (Schneider and Lopes, 1986) found that the risk-seeking group tended to prefer

riskier choice on a consistent base when compared with the risk-averse group.

Bromiley and Curley (Bromiley and Curley, 1992) observed that some people were

more tolerant towards risk than others and found that individuals tend to be consistent

in their attitudes towards risk. In an experiment in which the roles of risk attitude and

tolerance for ambiguity in predicting choice were jointly assessed, Ghosh and Ray

(Ghosh and Ray, 1997) found that both risk attitude and ambiguity intolerance

determined choice behaviour. Based on individual differences in risk taking as an

individual attribute, scholars have introduced the concept of risk propensity, defined

by Sitkin and Weingart (Sitkin and Weingart, 1995) as “an individual’s current

tendency to take or avoid risks” (Sitkin and Weingart 1995, p.1575). Rowe (Rowe,

1977) and Fischhoff et al. (Fischhoff et al., 1981) have used the term risk propensity

with reference to a consistent individual trait towards taking or avoiding risks. Das

and Teng (Das and Teng, 2001) observe that Sitkin and Weingart (Sitkin and

Weingart, 1995) believe that even the critics of the dispositional approach to risk

“have employed the traditional conception of risk propensity as a stable individual

attribute” (Sitkin and Weingart 1995, p.1575). However, this view is questioned by

Weber, Blais and Betz (Weber et al., 2002). In their study, Weber, Blais and Betz

~ 34 ~


(Weber et al., 2002) present a psychometric scale that assesses risk taking in five

content domains – financial decisions (separately for investing versus gambling),

health/safety, recreational, ethical and social decisions – and find that the degree of

risk taking was highly domain specific, not consistently risk-averse or consistently

risk-seeking. The findings of Weber, Blais and Betz (Weber et al., 2002) are contrary

to those of Rowe (Rowe, 1977), Fischhoff et al. (Fischhoff et al., 1981), Schneider

and Lopes (Schneider and Lopes, 1986), Bromiley and Curley (Bromiley and Curley,

1992) and Sitkin and Weingart (Sitkin and Weingart, 1995), making it one of the

findings supporting the situational view. Many empirical studies suggest that

situational factors such as the framing of the problem and the context in which the

decision on risk is taken have a greater influence on risk taking behaviour. Slovic

(Slovic, 1972) argues that high correlations between risk-taking measures in

structurally different settings are highly unlikely, suggesting that different settings in

which decision on risk is made will have different decisional outcomes. March and

Shapira (March and Shapira, 1987) find that managers, as decision makers, make a

sharp distinction between taking risk and gambling, which implies that the context or

situation of the decision plays a major role in risk taking behaviour. In line with these

findings, a very strong argument in favour of the situational view of risk taking

behaviour comes from a seminal study conducted by Kahneman and Tversky

(Kahneman and Tversky, 1979) in which the authors advance an alternative theory of

choice under risk – the prospect theory. Essentially, the prospect theory suggests that

individuals tend to interpret the outcomes of a risky decision according to a reference

point – such as the status quo - which changes depending on whether the outcome is

framed as a gain or as a loss. In line with this view, March (March, 1988) introduces

the term adaptive aspirations as a complement to Kahneman and Tversky’s

(Kahneman and Tversky, 1979) reference point. In the prospect theory, Kahneman

and Tversky (Kahneman and Tversky, 1979) and later Tversky and Kahnemann

(Tversky and Kahnemann, 1991) contradict the expected utility model (Bernoulli,

1738; von Neumann and Morgestern, 1947) and argue that, in evaluating risk, value is

assigned to gains and losses rather than to final assets, and probabilities are replaced

by decision weights. Kahneman and Tversky (Kahneman and Tversky, 1979) argue

that the carriers of value or utility are the actual changes of wealth rather than the final

asset positions that include current wealth. In particular, Kahneman and Tversky

(Kahneman and Tversky, 1979) observe that people under weigh outcomes that are

only probable in comparison with outcomes that are obtained with certainty and call

this the certainty effect. Consequently, Kahneman and Tversky (Kahneman and

Tversky, 1979) argue that the certainty effect contributes to decision makers being

risk averse in choices involving sure gains and risk seeking in choices involving sure

losses. There is evidence to support this view in a study by Highhouse and Yüce

(Highhouse and Yüce, 1996) who investigated the attempt to empirically separate

threat and opportunity perceptions from loss and gain perspectives. Highhouse and

Yüce (Highhouse and Yüce, 1996) found that when in the loss domain, most decision

makers perceived the risk alternative as an opportunity and when in the gain domain,

most decision makers perceived the risk alternative as a threat. However, it is

interesting to observe that Kahneman and Tversky’s (Kahneman and Tversky, 1979)

prospect theory, although demonstrates several phenomena which violate the

principles of expected utility theory, it is based on responses of students and faculty to

hypothetical choice problems of the type that resembles a gambling situation and

therefore their arguments may be questionable in the light of the findings by Schubert

et al. (Schubert et al., 1999) which suggests that abstract gambling experiments might

~ 35 ~


not be adequate for the analysis of risk attitudes. The main conclusion of the risk

literature review is that since Kogan and Wallace (Kogan and Wallace, 1967) first

articulated the fundamental question about the determinants of risk behaviour in terms

of whether they are dispositional or situational, the issue remains unresolved.

1.2. Relationship between age and risk behaviour

While conventional wisdom suggests that individuals take fewer risks as they age, the

evidence from empirical studies yields contradictory results. In an early study on the

relationship between age and risk behaviour, Wallach and Kogan (1961) compared

risk-taking behaviour of college age and elderly men and women, and found that the

older subjects, both males and females, were significantly more conservative than the

college students. Recognizing the shortfalls of examining two extreme age groups,

Kogan and Wallach (1967) comment in a later review article on the need for further

exploration of age – risk–taking relationship using less extreme age groups. In an

attempt to satisfy this need, Vroom and Pahl (1971) investigate the age-risk behaviour

relationship on a sample of almost 1,500 managers with age ranging from 22 to 60

years. After plotting the data obtained using the Kogan and Wallach (1964) choice

dilemma questionnaire as a measure of risk propensity, Vroom and Pahl (1971) found

that the slope of the relationship between mean riskiness and age is greatest in the age

range 22 to 32 years, flattens out in the age range 33 to 48 years and increases again in

the age range 48 to 58 years. This means that for the managers used in Vroom and

Pahl’s (1971) study, the age group 22 to 32 years and 48 to 58 years appears to be

more risk seeking whereas the age group 33 to 48 appears to be more risk averse.

Vroom and Pahl (1971) also find evidence that the value people place on risk

decreases with age in a linear relationship. The results from Vroom and Pahl (1971)

study offer evidence that there is a significant relationship between age and measures

of both risk taking and of the value placed on risk. However, caution must be

exercised in interpreting the findings of Vroom and Pahl (1971) as the instrument

used to measure risk propensity – Kogan and Wallach’s (1964) choice dilemma

questionnaire – has been subject to a number of criticisms (Cartwright, 1971;

MacCrimmon and Wehrung, 1984; Shaver and Scott, 1991; Kamalanabhan, Sunder

and Vasanthi, 2000). There is also the possibility that the sample used may have had

unique properties which might render the results artifactual. Despite these limitations,

the findings of Wallach and Kogan (1961) and Vroom and Pahl (1971) are supported

by those of Morin and Suarez (1983) who conclude that, on average, risk aversion

increases with age. However, these findings do not seem to hold unconditionally -

while on average and for those individuals with low levels of net worth risk aversion

increases with age, for those individuals with high levels of net worth risk aversion

decreases with age (Morin and Suarez, 1983). This is in line with Kahneman and

Tversky’s (1979) prospect theory - in which age may be a factor that alters the

“objective” assessment of risk – and which could represent an alternative theoretical

explanation for how age may affect financial decision making. The views presented

by Wallach and Kogan (1961), Vroom and Pahl (1971) and Morin and Suarez (1985)

that risk taking decreases with age, are challenged by the findings of Bellante and

Saba (1986), Wang and Hanna (1997) and Bellante and Green (2004) who argue that,

on the contrary, risk tolerance increases with age. It appears that, similarly to the risk

behaviour theory, the relationship between age and risk behaviour is not conclusive

and that additional variable factors must be taken into account.

~ 36 ~


2. RESEARCH METHODOLOGY

The research philosophy of this study is based on the positivist deductive approach

embracing a critical realism epistemology. In the deductive approach of this study

there are several stages of the research: hypotheses are presented following the review

of the literature, the hypotheses are expressed in operational terms which propose a

relationship between two specific variables and, finally, testing the hypothesis and

examining the outcome of the test. If necessary, the theory is modified in the light of

the findings. The research in this explanatory study will be cross-sectional and the

quantitative mono method using questionnaires, together with analysis of quantitative

data, will be used to establish causal relationships between the variables contained in

the hypotheses.

2.1. Research hypothesis

Based on the literature review on age and risk behaviour while pursuing the research

objective, the following main hypothesis together with two deriving secondary

hypotheses is advanced:

Hypothesis 1. The financial auditor’s age influences his risk behaviour in a financial

audit context.

Hypothesis 1a. There is a significant correlation between the financial auditor’s age

and his risk behaviour, in a financial audit context.

Hypothesis 1b. The financial auditor’s risk tolerance is negatively correlated with his

age, in a financial audit context.

2.2. Research strategy

The objective of the present research is to answer the research question and identify

whether the auditor’s risk behaviour is influenced by his age. Due to time and

economic constraints, in answering the research question, the survey method is

selected for the purpose of this study in order to collect a sufficient amount of primary

data. The use of questionnaires is the most widely used data collection technique in a

survey and, in this study, a questionnaire containing 4 questions will be distributed to

a representative sample of 650 practising financial auditors, active members of The

Romanian Chamber of Financial Auditors (CAFR), for primary data collection. The

data collected will then be analysed using graphic representations and SPSS statistical

software and the results will be used to validate or invalidate the hypotheses. The

findings will be discussed and conclusions will be drawn. The design of the

questionnaire is essential for the reliability and validity of the data, hence great care

has been given to the framing and wording of questions. In this study, the

questionnaire which will be administered to the chosen sample will consist of 4

questions (see Appendix 1). Question 1 is a quantity type question to determine the

age of the respondent. Questions 2, 3 and 4 are rating type questions using a four

point Likert scale in which the respondent is asked how strongly he or she agrees or

disagrees with a statement. Four points were used for the Likert scale (strongly agree,

tend to agree, tend to disagree and strongly disagree) to eliminate the possibility that

the respondent will ‘sit on the fence’ by ticking the middle ‘not sure’ category which

will render the response ambiguous. We choose the four point Likert scale because we

wanted the respondent to express a clear opinion on the statements, which enabled us

~ 37 ~


to clearly determine whether the respondent is more or less risk seeker or more or less

risk averse in certain situations.

3. FINDINGS AND DISCUSSION

In August 2011 the questionnaires were distributed to 650 practising financial

auditors, active members of The Romanian Chamber of Financial Auditors (CAFR).

There were a total of 368 responses received which means a 56.6% actual response

rate. This actual response rate is above the expected 50% response rate for which we

have hoped at the design stage of the study. Out of a total of 368 actual responses, 16

responses had to be left aside because in these three cases the questionnaire has not

been filled in properly and responses to some of the questions were either missing or

incomplete. However, 352 responses were valid which means a total effective

response rate of 54.1%.

3.1. Data coding

The responses to the Questions 2, 3 and 4, which are rating type questions using a

four point Likert scale, were coded by assigning to each response option representing

a point on the Likert scale a number value from 1 to 4, with 1 representing the highest

preference towards risk and 4 representing the least preference towards risk. Risk will

be represented by the Total Risk Score variable arrived at by adding the

corresponding values for each respondent’s answer to questions 2, 3 and 4. Therefore,

the more preference for risk a person would show in his/her risk attitude or behaviour,

the lower the Total Risk Score would be. For a clearer picture of the coding

procedure, see Table 1 below.

Table 1. Illustration of the coding of responses for the questions using the four point

Likert scale

For Questions 2, 3 and 4:

Tend to Tend to Strongly

Strongly Agree Agree Disagree Disagree

1 2 3 4

__________________________________________________________________

3.2. Hypotheses testing

Testing Hypothesis 1a. There is a significant correlation between the financial

auditor’s age and his risk behaviour, in a financial audit context.

In order to test Hypothesis 1a the respondents’ answers to Question 1, 2, 3 and 4,

which tests the risk propensities of the respondents in a specific financial audit

context, are investigated. Running a correlation test for the two variables of age and

~ 38 ~


isk behaviour using the SPSS statistical software will show the following results (see

Table 2).

Table 2. The sample correlation test for the two variables of age and risk behaviour

Age

Total Risk Score

~ 39 ~

Age Total Risk Score

Pearson Correlation 1 .680 **

Sig. (2-tailed) .000

N 352 352

Pearson Correlation .680 ** 1

Sig. (2-tailed) .000

N 352 352

For the selected sample, the correlation coefficient between age and risk behaviour is

0,680 which indicates that the correlation is significant. The value of the correlation

coefficient (0,680) is not close to zero, so there is evidence of a linear relationship

between the two variables. It is positive, so the slope of the straight line resulting from

the linear relationship is also positive. That is, as total risk score increases, indicating

a more risk adverse person, age also increases. Finally, the value of the correlation

coefficient is close to 1 or -1 indicating that the relationship is a strong one. As a

consequence of the result of the test, there is evidence to retain Hypothesis 1a and

conclude that there is a significant correlation between the financial auditor’s age and

his risk behaviour, in a financial audit context.

Testing Hypothesis 1b. The financial auditor’s risk tolerance is negatively correlated

with his age, in a financial audit context.

In order to test Hypothesis 1b the respondents’ answers to Question 1, 2, 3 and 4,

which tests the risk propensities of the respondents in a specific financial audit

context, are investigated. This time, though, the data will be presented in a scatter

plot, with Total Risk Score plotted against age (see Figure 1).

From the scatter plot it appears that when age is high, total risk score is also high

which suggests that as age increases, total risk score may also increase. It is therefore

a positive correlation between Total Risk Score and age, a fact which is confirmed by

the positive value of the correlation coefficient (0,680) obtained in the statistic test

performed when testing Hypothesis 1a. However, bearing in mind that a high value of

Total Risk Score means a decreased risk tolerance, the higher the age, the more

decreased risk tolerance appears to be. In other words, risk tolerance tends to be

associated with lower age of the respondents and as age increases, risk tolerance

decreases. This is equivalent with the conclusion that there is a negative correlation

between risk tolerance and age. As a consequence of the result of the test, there is

evidence to retain Hypothesis 1b and conclude that the financial auditor’s risk

tolerance is negatively correlated with his age, in a financial audit context.


As both Hypothesis 1a and Hypothesis 1b are retained, there is evidence to support

the main Hypothesis 1, which is retained, and conclude that the financial auditor’s age

influences his risk behaviour in a financial audit context.

CONCLUSION

Figure 1. Scatter plot with Total Risk Score plotted against Age

This study investigated the relationship between financial auditor’s age and his risk

behaviour in a financial audit context. The study concentrated on the analysis of risk

behaviour and on the identification of a relationship between risk behaviour and the

age of the financial auditor. The responses of 352 practising financial auditors, active

members of The Romanian Chamber of Financial Auditors (CAFR), to the 4

questions contained in the questionnaires were analysed using a series of statistical

tests. The design of the questionnaire centred on carefully wording the questions

together with the data coding method represent the pivotal point of the study. The

responses’ analysis and findings provide significant evidence in favour of the main

research hypothesis. Consequently, the results of this study demonstrate that the

auditors’ risk behaviour is influenced by his/her age. However, one limitation of this

study is the relatively small sample size. Although statistically a sample number of

352 respondents is considered to be enough to draw conclusions about the population,

a larger number of participants would not only improve the validity and reliability of

the findings, but it might also indicate slightly different results, especially in the

borderline results. A second limitation refers to the way risk propensity was measured

by using a four point Likert scale. The four point Likert scale was chosen because it

translates the risk propensity showed by a respondent into different measurable and

analysable grades. The use of a Likert scale with more points would have resulted in a

more finely graded scale of measurement of risk propensity. Finally, the main

~ 40 ~


conclusion of this study, that age is a personal factor that influences the auditor’s risk

behaviour, could be used as a starting point for future research on the auditor’s

judgement and decision making process.

ACKNOWLEDGEMENTS

This article is a result of the project „Doctoral Program and PhD Students in the

education research and innovation triangle”. This project is co funded by European

Social Fund through The Sectorial Operational Programme for Human Resources

Development 2007-2013, coordinated by The Bucharest Academy of Economic

Studies.

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APPENDIX 1

The research questionnaire

You are asked a series of questions, some requiring you to make a decision in

hypothetical situations, others requiring you to express your view.

All the information you provide will be used for research purposes only and will be

treated in the strictest confidence. You will not be identified from the information you

provide.

I hope you find completing the questionnaire enjoyable and thank you for taking the

time to answer it. A summary of the findings will be emailed to you.

Question 1.

What is your age?

Question 2.

You are the recently appointed the auditor of ABC Ltd., about which you know that it

is a medium size developer with one shareholder that also represents the company’s

management. You know that the company has invested a substantial sum of its

financial reserves in the development of a residential area which is now finalised. You

know that if the company manages to sell all the houses in the residential area in the

current financial year, there will be substantial success, not only financially but also in

market share. But if the company will not manage to sell all of its houses from its

residential area, it will be faced with serious liquidity and reputational problems. You

also know that there are 60% chances that the company will manage to sell all the

houses and 40% chances to be unable to sell all the houses.

Assuming that these are the only information available, please express your opinion

on the following statement:

The inherent risk at the ABC srl level is small.

Answer:

(please tick only one box)

Tend to Tend to

Strongly agree Agree Disagree Strongly disagree

Question 3.

A recent approach in financial audit is the one based on business risk. The business

risk audit approach is based on a company’s objectives: a certain level of profitability,

obtaining a certain market share, maintaining a certain level of liquidity, brand


improvement etc. In essence, audit business risk approach is about the cost that a

company could incur if it doesn’t meet its strategic objectives.

Considering the case of company ABC srl, presented in the previous question

(Question 2), please express your opinion on the following statement:

The business risk in the case of ABC srl (the risk that it will not meet its objectives) is

small.

Answer:

(please tick only one box)

Tend to Tend to

Strongly agree Agree Disagree Strongly disagree

Question 4.

Assuming you are solvent and living in a comfortable lifestyle, in addition to

whatever you own you have been given 1,000 on condition that you choose one

option from the following two:

� You may gamble the 1,000 - with a 50% chance of winning, in which case

you keep the whole 1,000, and a 50% chance of losing, in which case you lose

all the money

Or

� You may keep 500 of the 1,000 without gambling

Please express your opinion on the following statement:

Gambling the 1,000 is a better choice.

Answer:

(please tick only one box)

Tend to Tend to

Strongly agree Agree Disagree Strongly disagree

~ 44 ~


THE INVESTIGATION OF ROMANIAN AUDITORS'

PERCEPTIONS OVER THE INTERNAL AUDIT

PRACTICES - AN ATTEMPT TO IDENTIFY THE BEST

PRACTICES IN THE CONTEXT OF CORPORATE

GOVERNANCE

Cristina BOTA-AVRAM 1

Babes-Bolyai University, Romania

ABSTRACT

The main purpose of this study is to explore based on an empirical study, the Romanian

auditors’ perceptions over the internal audit practices that should be included into an

integrated framework of good audit practices in the context of corporate governance. It is

also aims to investigate the actual applicability of the proposed internal audit practices. The

research tool used was represented by the e-mail questionnaire, addressed to a sample of

members of Chambers of Financial Auditors of Romania. Even if the response rate was not

quite significant, the value of the paper is argued by the fact that these first results, combined

with other research tools (probably more effective) that could be used in the next research

activities, could represent a significant starting point in developing an integrated framework

of good internal audit practices in the context of corporate governance.

KEYWORDS: internal auditing, Romanian auditors, corporate governance, good practices,

auditors’ perception

INTRODUCTION

The events that characterise the end of 20 th century and the beginning of 21 st century

had been generated big pressures over the internal audit’s role and developments in

the context of latest developments of corporate governance concept. In the last years,

there are more and more specialists that all are agreed about the significance of

internal audit position in the context of corporate governance (Leung, 2003; Whitley;

Paape, 2007; Allen, 2008). Internal audit’s position is even more important as it is

strategically located at the meeting point of the interests of management, board of

directors and other stakeholders (Allen, 2008). Also, there are big pressures over the

chief internal auditor who should be in full knowledge of all the key elements of

corporate governance framework in order to be able to identify those areas where

internal audit could provide a real added value by enhancing the effectiveness of

corporate governance process (Leung, 2003).

In the context of latest developments of corporate governance process, it is more and

more highlighted the idea of internal’s audit approach as an integral part of the

1

Correspondence address: Cristina BOTA-AVRAM, Babeş-Bolyai University, Romania; email:

botaavram@gmail.com

~ 45 ~


corporate governance framework, so internal audit should become more active,

playing a significant role as one of the key role players in the effectiveness of

managing businesses (Paape, 2003; Allen 2008). The expectations of management

and board of directors and not only from the chief internal auditor and his department

are strongly increasing. It’s become absolutely necessary for the internal auditors to

develop a global vision over the key elements of corporate governance, looking for

solutions that could ensure the enhancing of their activities and their skills and

abilities for the assessment and monitoring of those key elements, in order to ensure

the effectiveness of corporate governance mechanisms.

Also, the global economic crisis that strongly affected the world economy starting

with 2008 was another reason that put the light over the real added value provided by

internal audit, especially in the context of corporate governance and risk management.

From the beginning of global economic crisis, there were many organisms and

organisations that tried to identify the major factors as being determinant in issuing

this economic crisis. A report realized by a group of seven supervisory agencies like

the French Banking Commission, the German Federal Financial Supervisory

Authority, the Swiss Federal Banking Commission, the U.K. Financial Services

Authority, and, in the United States, the Office of the Comptroller of the Currency,

the Securities and Exchange Commission, and the Federal Reserve Bank of New York

(Senior Supervisors Group, 2008) emphasized the weakness and shortcomings of risk

management and its failure in the in the process of identifying and effective

management of various groups of risks, due to an increasing complexity of services

offered and because of risky nature of business conducted as a relevant negative factor

that was determinant in issuing the present economic crisis.

The impact of such factors like weak management and inefficient corporate

governance was also underlined at the European Conference on Corporate

Governance (8th European Corporate Governance Conference), held in Stockholm in

December 2009, where it had been given important critics to the audit function about

its weakness and ineffectiveness in fighting against to a poor corporate governance

and against to a weak risk management process. In this context, the role of internal

audit should be to provide a reasonable assurance over the effectiveness of risk

management. But it is not internal audit’s responsibility to take some actions response

in order to face the negative risks identified. So, internal audit is not responsible to

implement the action response to prevent the identified risks, but its main

responsibility is to provide to management relevant reports over the assessment of key

risks and the effectiveness of all these categories of risks (Leech, 2008).

The above were presented only few factors that increased the pressures over internal

audit function to look for developing of a set of good audit practices, especially in the

context of corporate governance, so internal audit to be able to prove its quality of real

added value provider. The investigation over the auditor’s perception over the good

audit practices could provide a significant starting point in developing such a

framework that could integrate relevant internal audit practices, especially in the

context of the necessity to improve those audit practices within an emergent economy

like the Romanian one.

~ 46 ~


1. ROLE AND PRACTICES OF INTERNAL AUDIT IN CORPORATE

GOVERNANCE – BACKGROUND LITERATURE

The International Standards for the Professional Practice of Internal Auditing

(Standards) issued by The Internal Auditing Standards Board of The Institute of

Internal Auditors (IIA) – last version issued in October 2008 and revised in October

2010 states in the Glossary part that the value added provided by internal audit

activity is proved “when it provides objective and relevant assurance, and contributes

to the effectiveness and efficiency of governance, risk management and control

processes” (IIA, 2011). In fact, Standard 2110 - Governance emphasized more

exactly which must be the role of internal audit in the process of corporate

governance.

Figure 1. Role of internal audit in governance – vision of IIA standards

(Source: adaptation after Standard 2110 – Governance)

Also, the previous versions of IIA internal auditing standards were emphasizing the

role and contribution of internal audit in the context of ensuring good corporate

governance. Under these circumstances, in the international speciality literature there

could be identified a lot of relevant papers and articles with relevant findings in the

highlighting of internal audit’s contribution and good practices in the corporate

governance (Baker and Owsen, 2002; Vinten, 2002; Melville, 2003; Paape et al.,

2003; KPMG, 2003; Gramling et al., 2004; Yakhou and Dorweiller, 2005; Whitley,

2005; Sarrens and De Beelde, 2006; Gramling and Hermanson, 2006; Zain and

Subramaniam, 2007; Allen, 2008; Archambeault et al., 2008; Ray, 2009; Sarrens,

2009; Arena and Azzone, 2009; Sarrens et al., 2009; Sarrens and Abdolmohammadi,

2011). Next, our intention is to summarize the most significant internal audit practices

identified in the context of corporate governance from author’s point of view, without

claiming that it’s a global and exhaustive synthesis.

Whitley (2005) highlights through his study the main steps that internal audit should

fulfil in order to provide its contribution to the corporate governance system, of which

the most important are:

• Internal audit must assist the board in the self assessment of its governance;

~ 47 ~


• Internal audit has to promote to the audit committee best ideas on good

practices for internal controls and risks management processes;

• Internal audit has to include in its audit plan some major objectives like

information and transparency in the annual audit plan.

• Internal audit should be preoccupied to review the ethical code and ethical

politics of the company in order to ensure there are correctly and delivered

timely to the employees of the company.

• Internal audit should look for the solutions to enhance the effectiveness of

assurance activities focused on compliance, aiming to reduce the long terms

costs.

A valuable synthesis of the main good practices through internal audit could deliver

more added-value to the corporate governance it is also realised by Allen (2008). In

his vision, internal audit should be approached as “a stronger player in the

governance team, and smart boards could obtain a highly valuable source of

expertise by assuring this position to the internal audit function” (Allen, 2008). In the

context of new challenges that internal audit have to face it in the light of recently

economic turbulences, Allen (2008) highlights the main good internal audit practices

through the effectiveness of corporate governance could be really enhanced:

• Internal auditors should occupy a strategic position where the interests of

management, boards and stakeholders intersect. In this way, internal auditors

could identify what could be done for companies to become more risk

intelligent.

• Internal auditors could contribute to better governance by highlighting

significant connections between various parts of the organization and different

kinds of risks.

• Internal auditors could serve as advocates for using non-financial metrics to

help manage risk and to help discover new value and develop competitive

advantage. In this direction, Allen (2008) points out the vital role that internal

audit could play by consulting with management on which nonfinancial

metrics may be more useful.

• Also, internal audit could have a strong contribution for the enhancing of

entity’s ethical conscience.

Analysing the internal audit’s role in modern corporate governance, KPMG developed

a relevant report through there are proposed some significant guidelines in the

developing of internal audit good practices in the context of modern corporate

governance. Most relevant internal audit good practices promoted by KPMG’s report

(KPMG, 2003) are including:

• The necessity to assure the independence guidelines for internal audit which

are referring at least at:

� Internal audit function must be independent of the audited activities and

also must be independent from every day internal processes.

� Internal audit must be able to exercise its mission on its own initiative in all

departments, establishments and functions of the entity.

� Internal audit must be free to report and to disclose all its findings.

� The head of internal audit department should have the authority to

communicate directly and on his initiative to the board, to the chairman of

the board and to the audit committee and its chairman.

~ 48 ~


• Internal audit assist the board in fulfilling its corporate governance

responsibilities. In this direction, KPMG’s report emphasizes the key roles of

internal audit in assisting the board and its audit committee in accomplishing

its governance responsibilities, these key roles assuming at least a deliverance

of next issues like:

� An objective evaluation of the existing risk and internal control framework.

� Systematic analysis of business processes and associated controls.

� Reviews of the existence and value of assets.

� A source of information on major frauds and irregularities.

� Ad hoc reviews of other areas of concern, including unacceptable levels of

risk.

� Reviews of the compliance framework and specific compliance issues.

� Reviews of operational and financial performance.

� Recommendations for more effective and efficient use of resources.

� Assessments of the accomplishment of corporate goals and objectives.

� Feedback on adherence to the organisation’s values and code of

conduct/code of ethics (KPMG, 2003).

• Also, KPMG’s report states that internal audit should have the ability to

transcend all departments without fear of limitation of scope.

• The board/audit committee should have the ability to directly and critically

analyse and evaluate the internal audit function about its contribution to the

fulfilment of the board’s responsibility for internal controls.

One of the most significant organizations at European level from internal audit’s point

of view – European Confederation of Institutes of Internal Auditing (ECIIA)

developed a survey at European level over the role of internal audit in corporate

governance in Europe aiming to identify its current status, the necessary

improvements and future tasks that should be accomplished. Based on a survey

realised between all national institutes of internal auditing in Europe, ECIIA (2007)

report realised to develop a widespread picture of corporate governance activities and

internal audit developments in European context, in the same time looking for the

answers at some questions over the current involvement of internal audit in corporate

governance process, and finally to develop a set of proposals for good practices in

order to improve the role of internal audit in European corporate governance.

It’s obviously the amplitude and the increasing number of researches dedicated to

the investigation of the role of internal audit in corporate governance at international

level. A strong preoccupation could be also identified at national level, even if it is

not as well debated as at international level. Through their papers, Romanian

researchers (Dobroteanu and Dobroteanu, 2006; Manolescu and Roman, 2007;

Stanciu and Eden, 2007; Weaver, 2008; Morariu et al., 2008; Zapodeanu et al.,

2009; Morariu et al., 2009; Sgardea et al., 2009; Manolescu et al., 2010; Dobroteanu

et al., 2011) aim to identify essential aspects of corporate governance according to

its latest evolutions at international level.

~ 49 ~


Figure 2. Proposals for enhancing the role and practices of internal audit in European

corporate governance

(Source: an adaption after ECIIA, 2007)

~ 50 ~


But there are only few papers that follow to identify the good internal audit practices

in the context of corporate governance. In this direction, a relevant contribution is

given by Stanciu and Eden (2007), which discussed in their paper the increasing role

of internal audit in corporate governance, but also the management expectations

related to the internal audit’s added value at corporate governance. Based on their

practical experience on internal audit activity and a strong background literature,

Stanciu and Eden (2007) deliver a lot of relevant suggestions for enhancing internal

audit activity, especially in national context, in order to ensure internal audit is

providing real added-value to risk management and corporate governance processes.

In the same direction, Morariu et al (2009) emphasizes the necessity of building a

strong partnership between internal auditor and management, as a premise for the

increasing real added-value delivered by internal audit, in the context of developing

the competencies supported by the implementing of a rational internal control

system.

From author’s knowledge till that moment there aren’t developed papers over the

investigation of auditors’ perception regarding the good internal audit practices that

should be taken in consideration especially in Romanian context. From this point of

view, the author’s opinion is that a research dedicated to the identifying of good

internal audit practices from corporate governance’s point of view deserves to pay a

lot of attention in research efforts, even if a research like the one developed within

this paper could be considered only a starting point due to the difficulty and

complexity of discussed subject.

2. RESEARCH METHODOLOGY DEVELOPMENT

2.1. Scientific approach

The present study is based on fundamental type of scientific research, under the

auspices of mainstream research, in the construction of research methodology being

included both quantitative and qualitative elements. Based on the relevant literature

that was reviewed with a focus on mainly research developments with significant

theoretical and practical implications for the internal audit’s role and practices in the

field of corporate governance it was develop a summary of main internal audit

practices that should be taken in consideration into an integrated framework of good

audit practices in the corporate governance’s area.

These internal audit practices were, then, tested based on empirical study developed in

order to highlight the Romanian auditors’ perception over the internal audit practices

in corporate governance area. For the internal audit practices tested through this

survey, there were tested two main criteria like:

• Proposals for good practices - The agreement or disagreement of inclusion of

identified internal audit practices into a set of good practices from

respondents’ point of view

• Applicability - The actual applicability of the proposed internal audit

practices.

~ 51 ~


2.2. The purpose and objectives of the empirical study

The purpose of this study was to develop a starting point in the process of identifying

the good internal audit practices in the context of corporate governance, without

claiming that there were identified the most relevant internal audit practices. More

specifically, the main objectives of the present study were:

• To obtain a synthetic view from the Romanian auditors’ point of view regarding

the good internal audit practices that should be taken in consideration.

• To test the real applicability of the proposed internal audit practices from the

respondents’ point of view

• To try to obtain other proposals of good practices from respondents, that should

also be taken in consideration.

Based on literature review develop until this moment, it was made a selection of the

most significant and relevant audit practices, all these being included in questionnaire

used to develop this present study. In Table no.1 are summarised all these internal

audit practices over it was tested the auditors’ perception from their proposal but also

from their applicability point of view.

Table 1. The synthesis of internal audit practices proposed and tested

within this present study

No. The internal audit practices proposed within this study

1. Internal audit should be placed in the hierarchical structure of the entity in order to ensure the greatest

independence as possible.

2. Internal audit should develop a strong partnership with external audit, based on mutual trust.

3. Chief of internal audit department should have regular meetings with the chairman of the audit committee,

so that between them being developed a relationship based on mutual trust.

4. Internal audit carries out its activities taking in consideration the strategic and operational risks identified at

the level of each major function within the entity.

5. Internal audit communicate to the external auditor the risk categories identified at the level of financialaccounting

function, the deficiencies discovered and also the recommendations issued.

6. Internal audit should provide the support in the reviewing of ethical code and politics for ensuring there are

correctly and timely communicated to the employees.

7. Internal audit should realise an analysis and systematically assessment of the main functions within the

entity, but also to the internal control procedures related to them.

8. Internal audit should be a relevant source of information on major fraud and irregularities.

9. The recommendations issued by internal audit should be focused firstly for more effective and efficient use

of resources.

10. Internal audit should made an assessment of the accomplished of corporate goals and objectives.

11. Internal audit assists board/audit committee in self-assessment of its corporate governance effectiveness.

12. Internal audit should develop an internal audit charter complementary with the one of the audit committee.

13. Internal audit should promote to the audit committee the best practices over the internal controls procedures

and risk management.

~ 52 ~


14. Internal audit should discussed with the audit committee the internal audit plan, major findings that have

resulted from internal audit work activities, but also major information about the monitoring of follow-up of

audit findings.

15. Internal audit should include in the internal audit plan, the objectives that are referring at the providing of

accurate and transparent information.

16. Internal audit is preoccupied by the identification of relevant opportunities for the ensuring of assurance

activities from compliance’s point of view, aiming to reduce long term costs.

17. Chief of internal audit department should communicate to the audit committee the illegal acts or

irregularities perpetuated or tolerated by management.

18. Internal audit should develop a balanced partnership with management, based on mutual trust.

19. Internal audit should have regular meetings with management in order to inform over the entity’ strategies,

the changes in risks profiles, but also over the major changes in entity’ policies and procedures.

20. Internal audit is not responsible for implementing a good corporate governance, risk management or internal

control system, but it should provide a strong support for the increasing of their effectiveness.

21. Internal audit is consulted about the choice/changing of external audit firm that would realise the external

audit.

22. Internal audit should monitor the follow-up of internal audit, but also external audit recommendations,

communicating the results to the audit committee.

23. Internal audit, with the audit committee’s approval might propose the internal audit report’s publication for

the ensuring a greater transparency required by a good corporate governance.

(Source: a projection made by author based on relevant literature review)

2.3. The tools and sample used

This empirical study was based on a emailed questionnaire sent to members of

Chambers of Financial Auditors of Romania (CAFR) working in various positions:

external auditor or internal auditor. The questionnaire as research technique was used

in conjunction with the sample as a tool research. The sample used in this research

was determined starting from the members of professional body which coordinates the

audit activity (internal and external) at national level. Thus, our statistical population

included the active members of CAFR, whose email and contact details were

available on the CAFR’s website. The period for developing this research was

February – March 2011. In spite of its disadvantages, the option for using the e-mail

questionnaire was argued by the necessity of including in the sample a large number

of respondents, while an alternative direct approach would be quite difficult.

The questionnaire used was developed on next sections:

1. Part I – General Information

2. Part II – Perceptions over internal audit’s role and practices in corporate

governance

3. Part IV - Perceptions over external audit’s role and practices in corporate

governance

4. Part V - Perceptions over audit committee’s role and practices in corporate

governance

The specific objective of this paper is to analyse the results of Part I and Part II, more

exactly, the respondent’ perceptions over the internal audit’s contribution and good

practices in the context of corporate governance. It is necessary to mention that for

~ 53 ~


each section, the respondent had the possibility to propose another good audit

practices, beside the ones mentioned within the questionnaire, because as it was

mentioned before, this study claims to be only a starting point in the identifying the

best audit practices in the field of corporate governance. The sample used in this

survey is presented in Table no.2.

Table 2. Sample used and response rate obtain in the present study

Sample of members CAFR selected 1 924

Invalid email contacts 2 386

Valid contacts 3=1-2 538

Respondents with no audit experience 4 67

Final sample 5=3-4 471

Questionnaires received 6 44

First response rate 7= 6/5*100 9,34%

Invalid questionnaires 8 20

Final number of valid questionnaires 9=6-8 24

Final response rate 10= 9/5*100 5,10%

(Source: projection made by the author)

Unfortunately, from the first sample, a quite big numbers of selected contacts proved

to be invalid due to the failures messages received at the mail delivery. After the

questionnaire was sent there were some respondents that honestly admitted they have

the quality of member CAFR, but they don’t have enough or not all audit experience

(67 respondents). From the total of 44 received questionnaires, a significant number

of 20 questionnaires were considered invalid due to some errors in proper fulfilling of

questionnaires. The first part was included general information about the respondents,

especially about their professional experience. In the final lot of valid questionnaires

there were not included the questionnaires completed by the respondents with no audit

experience, starting from their statement about their professional experience.

3. DISCUSSION OF RESULTS

3.1. The analysis of results

Even if the statistic literature admits as being reasonable a rate of response of at least

5 % (Rotariu and Ilut, 2006), our common sense can’t afford us to accept the obtained

response rate (only 5,10%) as being a quite relevant one. But in spite of this great

disadvantage, that we have to admit we were aware from the very beginning when we

decided to use such a research tool, we still believe that the relevancy of our findings

are consistent in the manner they will be considered as a starting point in developing

more complexes researches by using also in conjunction with other research tools.

Shih and Fan (2009) develop an interesting meta-analysis of comparing response rates

in email and paper surveys. Their meta-analysis showed that e-mail survey mode

generally has considerably lower response rate than traditional mail survey mode

regardless of other survey characteristics (e.g. target population, use of reminders for

non-respondents, use of incentives). Also, another supposition of Shih and Fan (2009)

is that lower response rate in e-mail survey might partially be the result of prevalent

junk/spam e-mails nowadays, which may have caused many potential respondents to

ignore legitimate e-mail surveys. But in spite of these disadvantages, Shih and Fan

(2009) are agreed that this does not necessarily mean that e-mail survey should not

~ 54 ~


have its place in the repertoire of survey researchers. There shouldn’t be ignored the

advantages of e-mail survey like:

� a shorter response time,

� considerably lower survey cost,

� capability of reaching a large sample of respondents,

� knowledge about whether an e-mail survey has been delivered to the correct email

address, etc.

Shih and Fan (2009) sustain that these unique characteristics of e-mail survey make it

a significant tool for survey researchers in some research situations, in spite of its

inferiority in terms of survey response rate currently shown in the recent literature.

As could be noticed from Table no.3, from the total of our final sample of

respondents, 70,8% were represented by members of Chambers of Financial Auditors

of Romania (CAFR) working on internal auditor position, while 29,2% state they are

working as external auditor. From the final sample, there had been removed the

questionnaires completed by respondents working on other positions like manager,

due to the main objectives of this study – the investigation of auditors’ perception

over the internal audit’s role and good practices.

Analysing their professional experience, as it is presented in Table no.3, over 70% of

our respondents state they have a professional experience on the audit activity over 5

years. We assume that this significant proportion of the respondents with relevant

professional experience could be considered as an important argument in considering

the findings of this survey as a good starting point in developing an integrated

framework of good practices in the context of corporate governance.

The respondents’ position

Table 3. The professional experience of respondents

under 2 years

Professional experience

~ 55 ~

between 2 and 5

years over 5 years Total

Internal auditor 8,3% 12,5% 50,0% 70,8%

External auditor

8,3%

0.0%

20,8% 29,2%

Total 16,7% 12,5% 70,8% 100,0%

(Source: a projection made by the author by using SPSS 16)

For all internal audit practices mentioned above in Table no.1, the purpose of this

study was to investigate the auditors’ perception from the point of view of:

� Their proposal for inclusion into a set of good practices for internal audit

activity. Thus the respondents had the possibility to express their agreement or

disagreement about the proposals of internal audit practices by using Likert

Scale where:

(1) – Strongly disagree;

(2) – Disagree;

(3) – Not sure;

(4) – Agree;

(5) – Strongly agree.


� Their actual applicability was tested by using also Likert scale, where:

(1) – Unknown;

(2) – Known, but never applied;

(3) – Known, but rarely applied;

(4) – Known and often applied;

(5) – Known and always applied.

Next, in Table no.4 and Table no.5 there are presented the frequencies obtained for

the tested internal audit practices from both point of view: their proposal and their

applicability.

No. Proposals for internal audit practices

1 Internal audit should be placed in the

hierarchical structure of the entity in

order to ensure the greatest

2

independence as possible.

Internal audit should develop a strong

partnership with external audit, based

on mutual trust.

3 Chief of internal audit department

should have regular meetings with the

chairman of the audit committee, so that

between them being developed a

relationship based on mutual trust.

4 Internal audit carries out its activities

taking in consideration the strategic and

operational risks identified at the level

Table 4 Proposals for internal audit practices

of each major function within the entity.

5 Internal audit communicate to the

external auditor the risk categories

identified at the level of financialaccounting

function, the deficiencies

discovered and also the

recommendations issued.

6 Internal audit should provide the

support in the reviewing of ethical code

and politics for ensuring there are

correctly and timely communicated to

the employees.

7 Internal audit should realise an analysis

and systematically assessment of the

main functions within the entity, but

also to the internal control procedures

related to them.

8 Internal audit should be a source of

information on major fraud and

irregularities.

9 The recommendations issued by

internal audit should be focused firstly

for more effective and efficient use of

resources.

10 Internal audit should made an

assessment of the accomplished of

corporate goals and objectives.

~ 56 ~

Response options

(1) (2) (3) (4) (5)

Total

0% 0% 17% 13% 71% 100%

0% 0% 17% 17% 67% 100%

0% 8% 21% 13% 58% 100%

0% 0% 13% 17% 71% 100%

0% 0% 29% 17% 54% 100%

0% 4% 17% 29% 50% 100%

0% 0% 13% 17% 71% 100%

0% 0% 21% 13% 67% 100%

0% 0% 21% 25% 54% 100%

0% 8% 17% 25% 50% 100%


11 Internal audit assists board/audit

committee in self-assessment of its

corporate governance effectiveness.

12 Internal audit should develop an

internal audit charter complementary

with the one of the audit committee.

13 Internal audit should promote to the

audit committee the best practices over

the internal controls procedures and risk

management.

14 Internal audit should discussed with the

audit committee the internal audit plan,

major findings that have resulted from

internal audit work activities, but also

major information about the monitoring

of follow-up of audit findings.

15 Internal audit should include in the

internal audit plan, the objectives that

are referring at the providing of

accurate and transparent information.

16 Internal audit is preoccupied by the

identification of relevant opportunities

for the ensuring of assurance activities

from compliance’s point of view,

aiming to reduce long term costs.

17 Chief of internal audit department

should communicate to the audit

committee the illegal acts or

irregularities perpetuated or tolerated by

management.

18 Internal audit should develop a

balanced partnership with management,

based on mutual trust.

19 Internal audit should have regular

meetings with management in order to

inform over the entity’ strategies, the

changes in risks profiles, but also over

the major changes in entity’ policies

and procedures.

20 Internal audit is not responsible for

implementing a good corporate

governance, risk management or

internal control system, but it should

provide a strong support for the

increasing of their effectiveness.

21 Internal audit is consulted about the

choice/changing of external audit firm

that would realise the external audit.

22 Internal audit should monitor the

follow-up of internal audit, but also

external audit recommendations,

communicating the results to the audit

committee.

4% 13% 33% 13% 38% 100%

8% 13% 21% 25% 33% 100%

0% 8% 29% 8% 54% 100%

0% 4% 13% 13% 71% 100%

0% 8% 13% 33% 46% 100%

0% 4% 17% 33% 46% 100%

0% 0% 17% 8% 75% 100%

0% 4% 12% 29% 54% 100%

0% 4% 17% 29% 50% 100%

0% 0% 29% 17% 54% 100%

8% 13% 29% 25% 25% 100%

0% 0% 17% 25% 58% 100%

23 Internal audit, with the audit

committee’s approval might propose

the internal audit report’s publication

for the ensuring a greater transparency

4% 8% 38% 17% 33% 100%

required by a good corporate

governance.

(Source: a projection made by the author by using SPSS 16)

~ 57 ~


Table 5 Application of the proposed internal audit practices

No. Actual application of internal audit practices

1

Internal audit should be placed in the

hierarchical structure of the entity in order to

ensure the greatest independence as possible.

2 Internal audit should develop a strong

partnership with external audit, based on

mutual trust.

3 Chief of internal audit department should have

regular meetings with the chairman of the audit

committee, so that between them being

developed a relationship based on mutual trust.

4 Internal audit carries out its activities taking in

consideration the strategic and operational risks

identified at the level of each major function

within the entity.

5 Internal audit communicate to the external

auditor the risk categories identified at the level

of financial-accounting function, the

deficiencies discovered and also the

recommendations issued.

6 Internal audit should provide the support in the

reviewing of ethical code and politics for

ensuring there are correctly and timely

communicated to the employees.

7 Internal audit should realise an analysis and

systematically assessment of the main

functions within the entity, but also to the

internal control procedures related to them.

8

Internal audit should be a source of information

on major fraud and irregularities.

9 The recommendations issued by internal audit

should be focused firstly for more effective and

efficient use of resources.

10 Internal audit should made an assessment of the

accomplished of corporate goals and

objectives.

11 Internal audit assists board/audit committee in

self-assessment of its corporate governance

effectiveness.

12 Internal audit should develop an internal audit

charter complementary with the one of the

audit committee.

13 Internal audit should promote to the audit

committee the best practices over the internal

controls procedures and risk management.

14 Internal audit should discussed with the audit

committee the internal audit plan, major

findings that have resulted from internal audit

work activities, but also major information

about the monitoring of follow-up of audit

findings.

15 Internal audit should include in the internal

audit plan, the objectives that are referring at

the providing of accurate and transparent

information.

~ 58 ~

Response options

(1) (2) (3) (4) (5)

Total

0% 4% 37% 42% 17% 100%

0% 4% 50% 29% 17% 100%

8% 17% 38% 29% 8% 100%

0% 4% 38% 33% 25% 100%

0% 8% 42% 38% 13% 100%

13% 17% 33% 29% 8% 100%

4% 8% 33% 46% 8% 100%

4% 4% 42% 29% 21% 100%

0% 4% 42% 25% 29% 100%

8% 8% 54% 21% 8% 100%

17% 17% 42% 21% 4% 100%

21% 8% 46% 25% 0% 100%

8% 13% 38% 42% 0% 100%

8% 4% 17% 42% 29% 100%

13% 4% 38% 33% 13% 100%


16 Internal audit is preoccupied by the

identification of relevant opportunities for the

ensuring of assurance activities from

compliance’s point of view, aiming to reduce

long term costs.

17 Chief of internal audit department should

communicate to the audit committee the illegal

acts or irregularities perpetuated or tolerated by

management.

18 Internal audit should develop a balanced

partnership with management, based on mutual

trust.

19 Internal audit should have regular meetings

with management in order to inform over the

entity’ strategies, the changes in risks profiles,

but also over the major changes in entity’

policies and procedures.

20 Internal audit is not responsible for

implementing a good corporate governance,

risk management or internal control system, but

it should provide a strong support for the

increasing of their effectiveness.

21 Internal audit is consulted about the

choice/changing of external audit firm that

would realise the external audit.

22 Internal audit should monitor the follow-up of

internal audit, but also external audit

recommendations, communicating the results

to the audit committee.

~ 59 ~

8% 8% 50% 25% 8% 100%

8% 4% 21% 42% 25% 100%

0% 8% 42% 42% 8% 100%

0% 17% 46% 29% 8% 100%

0% 8% 46% 33% 13% 100%

8% 8% 50% 25% 8% 100%

4% 13% 25% 38% 21% 100%

23 Internal audit, with the audit committee’s

approval might propose the internal audit

report’s publication for the ensuring a greater

transparency required by a good corporate

governance.

21% 33% 38% 8% 0% 100%

(Source: a projection made by the author by using SPSS 16)

Analysing the above tables, it could be noticed there are some internal audit practices

like the internal audit practice no.1 (“Internal audit should be placed in the

hierarchical structure of the entity in order to ensure the greatest independence as

possible”) for which 71% of respondent are strongly agree, but only 17% state they

are known and always applied, and 42% say that they are known and often applied.

The same situation is also available for other practices like practice no.2 (“Internal

audit should develop a strong partnership with external audit, based on mutual

trust.”) or practice no.17 (“Chief of internal audit department should communicate to

the audit committee the illegal acts or irregularities perpetuated or tolerated by

management.”). For many of those practices there seems to be significant differences

between the respondent’s perception over their proposals and their current

applicability at this moment. We consider it as a sign that it’s time to review our

current internal audit practices currently applied and see what changes are really

necessary, especially in this difficult and volatile economic context. Next, in table

no.6 and table no.7 for each internal audit practices it was calculated the basis

statistical parameters, for both table the display order being descending means.


Table.6 Statistical parameters for proposals of internal audit practices

Proposals of internal audit practices N Minimum Maximum Mean

Internal audit carries out its activities taking in

consideration the strategic and operational

risks identified at the level of each major

function within the entity.

Chief of internal audit department should

communicate to the audit committee the

illegal acts or irregularities perpetuated or

tolerated by management.

Internal audit should realise an analysis and

systematically assessment of the main

functions within the entity, but also to the

internal control procedures related to them.

Internal audit should be placed in the

hierarchical structure of the entity in order to

ensure the greatest independence as possible

Internal audit should discussed with the audit

committee the internal audit plan, major

findings that have resulted from internal audit

work activities, but also major information

about the monitoring of follow-up of audit

findings.

Internal audit should develop a strong

partnership with external audit, based on

mutual trust.

Internal audit should be a relevant source of

information on major fraud and irregularities.

Internal audit should monitor the follow-up of

internal audit, but also external audit

recommendations, communicating the results

to the audit committee.

The recommendations issued by internal audit

should be focused firstly for more effective

and efficient use of resources.

Internal audit should develop a balanced

partnership with management, based on

mutual trust.

Internal audit should provide the support in

the reviewing of ethical code and politics for

ensuring there are correctly and timely

communicated to the employees.

Internal audit communicate to the external

auditor the risk categories identified at the

level of financial-accounting function, the

deficiencies discovered and also the

recommendations issued.

Internal audit is not responsible for

implementing a good corporate governance,

risk management or internal control system,

but it should provide a strong support for the

increasing of their effectiveness.

Internal audit should have regular meetings

with management in order to inform over the

entity’ strategies, the changes in risks profiles,

but also over the major changes in entity’

policies and procedures.

~ 60 ~

Std.

Deviation

24 3,00 5,00 4,5833 ,71728

24 3,00 5,00 4,5833 ,77553

24 3,00 5,00 4,5833 ,71728

24 3,00 5,00 4,5417 ,77903

24 2,00 5,00 4,5000 ,88465

24 3,00 5,00 4,5000 ,78019

24 3,00 5,00 4,4583 ,83297

24 3,00 5,00 4,4167 ,77553

24 3,00 5,00 4,3333 ,81650

24 2,00 5,00 4,3333 ,86811

24 2,00 5,00 4,2500 ,89685

24 3,00 5,00 4,2500 ,89685

24 3,00 5,00 4,2500 ,89685

24 2,00 5,00 4,2500 ,89685


Chief of internal audit department should have

regular meetings with the chairman of the

audit committee, so that between them being

developed a relationship based on mutual

trust.

Internal audit is preoccupied by the

identification of relevant opportunities for the

ensuring of assurance activities from

compliance’s point of view, aiming to reduce

long term costs.

Internal audit should made an assessment of

the accomplished of corporate goals and

objectives.

Internal audit should include in the internal

audit plan, the objectives that are referring at

the providing of accurate and transparent

information.

Internal audit should promote to the audit

committee the best practices over the internal

controls procedures and risk management.

Internal audit, with the audit committee’s

approval might propose the internal audit

report’s publication for the ensuring a greater

transparency required by a good corporate

governance.

Internal audit assists board/audit committee in

self-assessment of its corporate governance

effectiveness

Internal audit should develop an internal audit

charter complementary with the audit

committee’s charter.

Internal audit is consulted about the

choice/changing of external audit firm that

would realise the external audit.

24 2,00 5,00 4,2083 1,06237

24 2,00 5,00 4,2083 ,88363

24 2,00 5,00 4,1667 1,00722

24 2,00 5,00 4,1667 ,96309

24 2,00 5,00 4,0833 1,10007

24 1,00 5,00 3,6667 1,16718

24 1,00 5,00 3,6667 1,23945

24 1,00 5,00 3,6250 1,31256

24 1,00 5,00 3,4583 1,25036

Valid N (listwise) 24

(Source: a projection made by the author by using SPSS 16)

Table 7 Statistical parameters for application of internal audit practices

Application of internal audit practices N Minimum Maximum Mean

Internal audit should discussed with the audit

committee the internal audit plan, major findings that

have resulted from internal audit work activities, but

also major information about the monitoring of

follow-up of audit findings.

The recommendations issued by internal audit should

be focused firstly for more effective and efficient use

of resources.

Internal audit carries out its activities taking in

consideration the strategic and operational risks

identified at the level of each major function within

the entity.

Internal audit should be placed in the hierarchical

structure of the entity in order to ensure the greatest

independence as possible

Chief of internal audit department should

communicate to the audit committee the illegal acts or

irregularities perpetuated or tolerated by management.

~ 61 ~

Std.

Deviation

24 1,00 5,00 3,7917 1,17877

24 2,00 5,00 3,7917 ,93153

24 2,00 5,00 3,7917 ,88363

24 2,0 5,0 3,708 ,8065

24 1,00 5,00 3,7083 1,16018


Internal audit should develop a strong partnership

with external audit, based on mutual trust.

Internal audit should monitor the follow-up of internal

audit, but also external audit recommendations,

communicating the results to the audit committee.

Internal audit should be a relevant source of

information on major fraud and irregularities.

Internal audit communicate to the external auditor the

risk categories identified at the level of financialaccounting

function, the deficiencies discovered and

also the recommendations issued.

Internal audit should develop a balanced partnership

with management, based on mutual trust.

Internal audit is not responsible for implementing a

good corporate governance, risk management or

internal control system, but it should provide a strong

support for the increasing of their effectiveness.

Internal audit should realise an analysis and

systematically assessment of the main functions

within the entity, but also to the internal control

procedures related to them.

Internal audit should include in the internal audit plan,

the objectives that are referring at the providing of

accurate and transparent information.

Internal audit should have regular meetings with

management in order to inform over the entity’

strategies, the changes in risks profiles, but also over

the major changes in entity’ policies and procedures.

Internal audit is preoccupied by the identification of

relevant opportunities for the ensuring of assurance

activities from compliance’s point of view, aiming to

reduce long term costs.

Internal audit should made an assessment of the

accomplished of corporate goals and objectives.

Chief of internal audit department should have regular

meetings with the chairman of the audit committee, so

that between them being developed a relationship

based on mutual trust.

Internal audit should promote to the audit committee

the best practices over the internal controls

procedures and risk management.

Internal audit should provide the support in the

reviewing of ethical code and politics for ensuring

there are correctly and timely communicated to the

employees.

Internal audit assists board/audit committee in selfassessment

of its corporate governance effectiveness

Internal audit should develop an internal audit charter

complementary with the audit committee’s charter.

Internal audit is consulted about the choice/changing

of external audit firm that would realise the external

audit.

Internal audit, with the audit committee’s approval

might propose the internal audit report’s publication

for the ensuring a greater transparency required by a

good corporate governance.

24 2,00 5,00 3,5833 ,82970

24 1,00 5,00 3,5833 1,10007

24 1,00 5,00 3,5833 1,01795

24 2,00 5,00 3,5417 ,83297

24 2,00 5,00 3,5000 ,78019

24 2,00 5,00 3,5000 ,83406

24 1,00 5,00 3,4583 ,93153

24 1,00 5,00 3,2917 1,16018

24 2,00 5,00 3,2917 ,85867

24 1,00 5,00 3,1667 1,00722

24 1,00 5,00 3,1250 ,99181

24 1,00 5,00 3,1250 1,07592

24 1,00 4,00 3,1250 ,94696

24 1,00 5,00 3,0417 1,16018

24 1,00 5,00 2,7917 1,10253

24 1,00 4,00 2,7500 1,07339

24 1,00 5,00 2,4167 1,05981

24 1,00 4,00 2,3333 ,91683

Valid N (listwise) 24

(Source: a projection made by the author by using SPSS 16)

~ 62 ~


Based on the above tables, we propose to develop a ranking for the good practices

and uncertain practices, from both their proposal and their application, starting from

the display order by descending means (first 5 means and last 5 means).

From the point of view of their proposals, the good practices from the respondents’

point of view are:

� Internal audit carries out its activities taking in consideration the strategic and

operational risks identified at the level of each major function within the entity.

� Chief of internal audit department should communicate to the audit committee

the illegal acts or irregularities perpetuated or tolerated by management.

� Internal audit should realise an analysis and systematically assessment of the

main functions within the entity, but also to the internal control procedures

related to them.

� Internal audit should be placed in the hierarchical structure of the entity in

order to ensure the greatest independence as possible.

� Internal audit should discussed with the audit committee the internal audit plan,

major findings that have resulted from internal audit work activities, but also

major information about the monitoring of follow-up of audit findings.

� Internal audit should develop a strong partnership with external audit, based

on mutual trust.

� Internal audit should be a relevant source of information on major fraud and

irregularities.

� Internal audit should monitor the follow-up of internal audit, but also external

audit recommendations, communicating the results to the audit committee.

From the point of view of their proposals, the uncertain practices from the

respondents’ point of view are (their mean is around 3,4-3,6 ):

� Internal audit should include in the internal audit plan, the objectives that are

referring at the providing of accurate and transparent information.

� Internal audit should promote to the audit committee the best practices over the

internal controls procedures and risk management.

� Internal audit, with the audit committee’s approval might propose the internal

audit report’s publication for the ensuring a greater transparency required by a

good corporate governance.

� Internal audit assists board/audit committee in self-assessment of its corporate

governance effectiveness.

� Internal audit should develop an internal audit charter complementary with the

audit committee’s charter.

� Internal audit is consulted about the choice/changing of external audit firm that

would realise the external audit.

From the point of view of their application, the good internal audit practices which

are more applied, taking in consideration their mean (around 3,5-3,7, which means

these practices are between rarely and often applied):

� Internal audit should discussed with the audit committee the internal audit plan,

major findings that have resulted from internal audit work activities, but also

major information about the monitoring of follow-up of audit findings

� The recommendations issued by internal audit should be focused firstly for

more effective and efficient use of resources.

~ 63 ~


� Internal audit carries out its activities taking in consideration the strategic and

operational risks identified at the level of each major function within the entity..

� Internal audit should be placed in the hierarchical structure of the entity in

order to ensure the greatest independence as possible

� Chief of internal audit department should communicate to the audit committee

the illegal acts or irregularities perpetuated or tolerated by management.

� Internal audit should develop a strong partnership with external audit, based

on mutual trust.

� Internal audit should monitor the follow-up of internal audit, but also external

audit recommendations, communicating the results to the audit committee

� Internal audit should be a relevant source of information on major fraud and

irregularities.

From the point of view of their application, the mostly unapplied internal audit

practices taking in consideration their mean (between 2,3-3 which means these

practices are never or quite rarely applied):

� Internal audit should provide the support in the reviewing of ethical code and

politics for ensuring there are correctly and timely communicated to the

employees.

� Internal audit assists board/audit committee in self-assessment of its corporate

governance effectiveness.

� Internal audit should develop an internal audit charter complementary with the

audit committee’s charter.

� Internal audit is consulted about the choice/changing of external audit firm that

would realise the external audit.

� Internal audit, with the audit committee’s approval might propose the internal

audit report’s publication for the ensuring a greater transparency required by a

good corporate governance.

Analysing the good means from both their proposal and their application, it could be

observe that, generally speaking, the mean obtain when speaking about their

application is lower than the mean when speaking about their proposal, which could

be understand as an agreement of the respondents for inclusion of those practices into

an integrated framework of good internal audit practices in corporate governance, in

spite of the fact that now there are only rarely or sometimes applied. The same

situation seems to be available for the practices that from their proposal’s point of

view are not so well agreed by the respondents, but in the same time they are never or

quite rarely applied, even if these are known for the respondents.

3.2. Limits of the developed study and suggestions for further research

A major disadvantage of this study is represented by the response rate, which even is

over 5% (as recommended in statistical literature), still our common sense couldn’t

afford us to consider this response rate as being sufficient relevant. But, in spite of this

great disadvantage, we still believe the value of this paper is proved by creating the

necessary premises to develop a good starting point in the construction of an

integrated framework of good audit practices in corporate governance.

Also, another limit of our study is the short period for developing such a study,

because we are perfectly aware that through the extension of the period for obtaining

~ 64 ~


the answers and resending some follow-up mails to the respondents that didn’t answer

at this questionnaire, it would be possible to obtain a greater response rate.

Because of the small number of respondents, it wasn’t possible to develop a separate

analysis over two distinct subsamples: internal auditors and external auditors, all

having the quality of member of CAFR. But we are strongly convinced that such a

separate analysis but of course in case of greater number of respondents could provide

interesting results over the internal auditor but also external auditors’ perception over

good audit practices in the corporate governance’s area.

CONCLUSIONS

From the results obtained it can be noticed that Romanian auditors are not quite open

for the practices that could determine perhaps too much transparency necessary for a

good corporate governance. Quite clear examples in that direction is given by the

small mean obtain for the practice: “Internal audit, with the audit committee’s

approval might propose the internal audit report’s publication for the ensuring a

greater transparency required by good corporate governance” that mostly of the

respondents were not sure about the utility of such a internal audit practice. If this

result would be correlated with the current applicability of this practice, the

conclusion would be the same, this practice obtaining the small mean from its

application’s point of view.

Also, there are other practices of internal audit that were not very well received by the

respondents, neither from their proposal, nor from their application like the ones that

are referring at the specific role of internal audit in corporate governance (for example

“Internal audit assists board/audit committee in self-assessment of its corporate

governance effectiveness”). The big question is: Romanian auditors aren’t perfectly

aware about their contribution to the corporate governance system or they don’t want

to assume it? We hope that future researches dedicated to such a subject will provide

more clearly the perspectives that Romanian internal audit should follow for

developing the audit practices in the right direction identified also at international

level.

ACKNOWLEDGEMENTS

This paper was supported from the European Social Fund through Sectorial

Operational Programme Human Resources Development 2007-2013, research project

POSDRU/89/1.5/S/59184 “Performance and excellence in postdoctoral research

within the field of economic sciences in Romania”, Babeş-Bolyai University, Cluj-

Napoca being a partner within the project.

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~ 67 ~


PS2 Audit Public accounting

Chairperson

Răzvan MUSTAŢĂ, Babes-Bolyai University, Romania

PUBLIC SECTOR PERFORMANCE

FROM THE PERSPECTIVE OF CORPORATE SOCIAL

RESPONSIBILITY – A EUROPEAN AND NATIONAL

APPROACH

Eugeniu TURLEA, Aurelia STEFANESCU, Monica DUDIAN

Mihaela MOCANU, Adriana CALU

MANAGEMENT OF IRAN’S UNIVERSITIES IN

THELIGHT OF CONTINGENCY THEORY

Martin BROAD, Abbas ALIMORADI

THE ERA OF INTERNAL AUDIT IN THE PUBLIC

FINANCE SECTOR IN POLAND

Agnieszka SKOCZYLAS, Wojciech NOWAK

BOUNDRIES REGARDING THE IMPLEMENTATION

OF THE NATIONAL STRATEGY FOR THE FINANCIAL

REPORTING OF THE PRIVATE SECTOR ENTITIES

Ramona LAPTES, Adriana Florina POPA


PUBLIC SECTOR PERFORMANCE FROM THE

PERSPECTIVE OF CORPORATE SOCIAL

RESPONSIBILITY – A EUROPEAN AND NATIONAL

APPROACH

Eugeniu ŢURLEA 1 , Aurelia ŞTEFĂNESCU, Mihaela MOCANU,

Monica DUDIAN & Adriana CALU

Bucharest Academy of Economic Studies, Romania

ABSTRACT

The analysis of the current state of the public sector reveals the dependence on political

changes, the interaction of a great number of actors, the gap between offer and demand, a

chronic deficit of financial resources and failure in the efforts to achieve performance. By

means of fundamental research, corporate social responsibility (CSR) is integrated into the

equation of performance of public sector entities. The research endeavour consists of a

synthesis of the literature in the field, as well as of the relevant regulations. The present paper

defines the CSR concept, identifies the characteristic features of the public sector as argument

for implementing CSR in this sector and proposes a CSR framework for the Romanian public

sector. Moreover, we point out how CSR issues are disclosed and perceived in the public

sector of the European Union countries, with reference to the particular case of the

healthcare system.

KEYWORDS: corporate social responsibility, public sector, performance, Romania,

European Union, public healthcare system

INTRODUCTION

The current environment dominated by repeated changes of governmental policies,

significant decrease of public resources, impairment of the public service quality, and

reduced capacity of the public sector to respond to the expectations of the community

require that the performance of public sector entities is approached from the

perspective of corporate social responsibility. Starting from the variety of

connotations of the corporate social responsibility present in the relevant literature,

from the characteristic features of the public sector of European Union countries, as

well as from the way corporate social responsibility is perceived in the public sector

of the Member States, we propose a general corporate social framework for the public

sector of Romania. We consider that such an approach strengthens the commitment of

public sector entities to the benefit of society, environment, and economic welfare and

contributes to improving public sector performance.

The research is interpretative in nature and consists of three dimensions: conceptual

clarifications of corporate social responsibility (CSR), characteristics of the public

1

Correspondence address: Eugeniu TURLEA, Bucharest Academy of Economic Studies, Romania;

email: eturlea@yahoo.com

~ 69 ~


sector and arguments for implementing corporate social responsibility, namely the

proposal of a CSR framework in Romania’s public sector. Additional to approaching

CSR in the public sector, authors performed a qualitative analysis consisting in the

investigation of the websites of different relevant institutions from countries in the

European Union. The purpose of this analysis was to find to what extent these

organisms publish information on the social responsibility of the health system in that

country and the way they perceive social responsibility. The research endeavour

consists in a synthesis of the ideas published in the literature on this topic, as well as

of the regulations developed by the organisms in the field.

1. APPROACHES OF THE CONCEPT OF CORPORATE SOCIAL

RESPONSIBILITY. LITERATURE REVIEW

In the literature, the understanding of the concept of „corporate social responsibility”

is wide and translates into different labels. Since this concept is barely approached

from the perspective of the public sector, we will relate to the perspective of the

private sector. Gjølberg (2009), Walker & Parent (2010) and Vasilescu et al. (2010)

suggest related concepts such as “corporate social responsiveness”, “sustainable

development”, “corporate sustainable development”, “corporate citizenship”,

“corporate philanthropy” and “corporate social rectitude”, which hinder consensus on

the definition of CSR. Contrary to this statement, Siltaoja (2009) considers that

corporate social responsibility covers these and other related terms, thus serving as an

umbrella term.

Merali (2006) defines the concept of corporate social responsibility from a complex

perspective and considers that it “includes a commitment to altruistic values for the

benefit of society in general”. A different approach is that of Albareda et al. (2008),

who analyze corporate social responsibility in relationship to the role of government

in promoting this type of mentality. Starting from the assumption that businesses

operate beyond national boundaries and that their impact on society needs to be taken

more into account, authors claim that corporate social responsibility is “a useful

framework, within which new ways of collaborating between corporations,

governments and civil society can be found, creating innovative mechanisms for

governance”. A similar vision is supported by Sahlin-Andersson (2006), who

considers CSR a global trend that incorporates business corporations, states,

international organizations and civil society organizations. The author conveys the

following meanings to social responsibility:

� A regulatory framework that places new demands on corporations, whereby

self-regulations as well as globally applicable standards represent a significant

proportion of this framework;

� A mobilization of corporate actors to assist states and international

organizations, on the background that corporations become increasingly

important in the world and thus are co-opted by states in their efforts to build

global welfare.

� A management trend that conveys to organisations an image of legitimacy,

modernity and attractiveness in the opinion of potential employees,

collaborators, customers and other factors.

Štreimikienė & Pušinaitė (2009) approach social responsibility from the perspective

of management, considering it a management strategy option. Authors think that by

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integrating social responsibility in strategic planning, companies maintain or improve

their financial performance. An opposed opinion is that of Kakabadse & Rozuel

(2006), who claim that corporations perceive differently corporate social

responsibility, and when two corporations claim they are socially responsible, their

commitment is not comparable. Proponent of the existence of differences in the

perceptions of corporate social responsibility depending on the geographical area is

also the International Institute for Sustainable Development (2004).

The analysis of perceptions on corporate social responsibility in the Anglo-American

and in the European environment emphasizes the existence of differences. In favour

of the characteristic features of the Anglo-American area plead Carroll (1991) &

Gjølberg (2009). Carroll (1991) defines social responsibility with reference to the

economic, legal, ethical and philanthropic responsibilities of companies, while

Gjølberg (2009) considers that the US tradition of corporate philanthropy has

influenced the CSR discourse and practices. In the European area, as opposed to the

Anglo-American environment, corporations understand CSR as responsibility in all

their activities, as Porter (2003) states. By means of a bidimensional analysis,

Gjølberg (2009) considers that the European approach is focused on integrating CSR

into the management of core business operations. In this context, Juholin (2004)

brings the argument that Europe adopted the triple bottom line approach of Elkington

(1997), who distinguishes between people (social), the planet (environment) and

profit (economics).

Formulating a definition for the concept of corporate social responsibility proves to be

a difficult endeavour, even from an official perspective. By reference to the ideas

published by the entities involved in this direction, we present an official approach of

the concept of corporate social responsibility. For the European Commission, CSR is

“a concept whereby companies integrate social and environmental concerns in their

business operations and in their interaction with their stakeholders on a voluntary

basis.” In the view of the World Business Council for Sustainable Development,

corporate social responsibility is “the continuing commitment by business to behave

ethically and contribute to economic development while improving the quality of life

of the workforce and their families as well as of the local community and society at

large.” The International Institute for Sustainable Development represented by the

ISO Strategic Advisory Group (SAG) on Social Responsibility argues the difficulty of

defining “social responsibility”, considered “a balanced approach for organizations to

address economic, social and environmental issues in a way that aims to benefit

people, communities and society.” In particular, according to ISO 26000 (2010),

social responsibility is the responsibility of an organization regarding the impact of its

decisions and activities on the society and the environment, translated into an ethical

and transparent behaviour which contributes to sustainable development, to the health

and welfare of society, takes into account the expectations of stakeholders, follows the

laws in force and agrees to the international behaviour norms, is integrated within the

organization and implemented in its relationships.

In our opinion, the complexity of the CSR concept is also due to the principles of

accountability, transparency, ethical behaviour, following the interests of all

stakeholders, and obeying the laws, the international behavioural norms and the

human rights. The analysis of these principles emphasizes that CSR comprises not

only economic and legal aspects, but also ethical aspects. The economic aspect of

social responsibility refers to achieving a correct output regarding the quality-price

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atio, while the legal aspect refers to following formal norms, both domestic and

international. The ethical component goes beyond the legal framework and consists in

respecting al socially recognized behavioural norms. In the view of Lantos (2001), the

ethical aspect means the organization makes what is „right, just and fair”. In order to

eliminate confusions between ethical and altruistic, Lantos (2001) excludes the

synonymy ethical-altruistic, because when an organization follows the social

responsibility principles, this leads to an increase in the social welfare, without the

welfare of the organization’s owners being diminished.

The research of the connotations of the corporate social responsibility concept points

out its complexity and diversity. The absence of a consensus on the understanding of

this concept does not reveal the low interest of researchers, but the major concern to

identify new perspectives, in accordance with the development of society as a whole.

2. CHARACTERISTICS OF THE PUBLIC SECTOR VERSUS THE PRIVATE

SECTOR REGARDING SOCIAL RESPONSIBILITY

Identifying the boundaries between the public sector and the private sector proves to

be a difficult process, due to numerous overlaps, but at the same time a process which

is extensively dealt with in the relevant academic literature. Fryer et al. (2007)

explains the interest shown in this subject through the existence of blurred boundaries

between the public sector and the private sector, which in some areas overlap.

However, we consider that the features of the public sector can be derived based on a

comparative approach, namely by comparison with the private sector.

From the perspective of economic theory (Angelescu et al, 2001), the public sector is

the totality of public companies and public administrations. A similar endeavour in

defining the public sector – based on the structure of the organizations – is also

supported by Fryer et al. (2007). Accordingly, public organizations are organizations

that deliver governmental goods and services at local or national level. The traditional

assumption underlying the understanding of public organizations is that they deliver

services to the public and are publicly funded, owned and operated.

From another perspective, Broadbent & Guthrie (2008) argue that this assumption is

nowadays debatable, due to the phenomena of privatization and corporatization which

spread more and more in the public sectors worldwide. On one hand, privatization can

be defined as the process of selling state-owned assets, whereas management control

passes to private shareholders. On the other hand, corporatization consists in the

efforts to make public organizations function similar to how private firms function

when facing a competitive market or efficient regulation – if they were monopolies.

In an approach that considers the type of decisions made, Dascălu et al. (1996) defines

the public sector as an entity consisting of institutions where collective or political

decisions are made (whereas these institutions are the central and local public

administrations with their subordinated public entities) or institutions which

accomplish objectives and tasks of public interest.

National regulations (Public Finance Law no. 500/2002) do not define in a

comprehensive manner the public sector. It is defined indirectly by referring to the

generic term of public institutions, which comprise the Parliament, the Presidential

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Administration, the Ministries, other bodies of public administrations, other public

authorities, autonomous public institutions, irrespective of their financing sources.

At international level, the International Public Sector Accounting Standards (IPSAS)

use the term of Government Business Enterprise. According to IPSAS 1 Presentation

of Financial Statements, Government Business Enterprise means an entity that has all

the following characteristics:

� Is an entity with the power to contract in its own name;

� Has been assigned the financial and operational authority to carry on a business;

� Sells goods and services, in the normal course of its business, to other entities at

a profit or full cost recovery;

� Is not reliant on continuing government funding to be a going concern (other

than purchases of outputs at arm’s length); and

� Is controlled by a public sector entity.

With reference to the characteristics of the public sector, Fryer et al. (2007) considers

that their main feature is the absence of the goal of profit maximization, unlike private

organizations. In our view, this characteristic does not offer simplicity to the sector,

but complexity, taking into account that the public perceives the performance of the

public sector by reference to the quality of service. Based on the dual comparative

approach (public sector – private sector), but in an exhaustive manner, Sundin &

Tillmar (2008) identify the following characteristics of the public sector entities:

� Are guided by political and social objectives;

� Their main source of funding is the taxes collected, which they allocate based

on equity principles;

� The services delivered by them have a direct impact on the public, but also an

indirect impact on the community;

� Are subject to public scrutiny, their decision making process must be as

transparent as possible and the consensus among interest groups must be

ensured.

In our opinion, involving the public in the control of public sector entities and

ensuring the transparency of the decisional process are characteristics in favour of the

need to ensure a general social responsibility framework in this sector.

From another perspective, Heracleous & Johnston (2009) define public organizations

through the association of two main dysfunctions: bureaucracy and inertia. Authors

consider that this prejudgment is so deeply rooted into the minds of the public

opinion, that businesses which develop bureaucracy and inertia are frequently

classified as businesses with an “almost public sector mentality”. Although the

balance between the invested value for each resource unit from the private sector, on

one hand, and from the public sector, on the other hand, inclines towards the private

sector, the public sector should go beyond this limit by assimilating the experience of

the private sector. Heracleous & Johnston (2009) highlight that the public sector is

constantly encouraged to adopt models and practices which proved successful in the

private sector, so that its performance can be improved. Strategic management

models, change management processes, quality management, performance

measurement are only some examples of such private sector practices.

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Fryer et al. (2007) completes the picture of the public sector characteristics with their

regional and temporal fluctuations, which they support through arguments. The

authors think that temporal fluctuations are due to the fact that public sector is subject

to “the whims and fancies of government”. Regional fluctuations is generated by

changes in administration, which lead to changes in the organization of at least one

area of the public sector, since each administration has its own approach, ideas,

interests and visions. The overly dependence on administration change results in

uncertainty, requires time for the acceptance and assimilation of the new visions and

reduces the quality of services, by increased time of response to public inquiries and

by the reduction of service offer. Although due to its nature, the private sector does

not face such challenges, this characteristic is important for it, too, since it is

indirectly impacted by the decisions of the administration.

An interesting approach of the public sector belongs to Talbot (2003). He postulated

that public services are three-dimensional: there is the policy, the managerial and the

professional domain. According to this approach, the employees of the public sector

are challenged to frequently switch between these often conflicting domains. For

instance, in a single day, it may happen that the manager of a public organization must

switch from the role as manager to the role of professional or policy-maker. Each of

these three domains differs through its own patterns and values, which are almost

always contradictory with each other. Thus, by comparison with the private sector,

where managers are almost exclusively dedicated to the managerial field, in the public

sector, employees in governing positions are challenged to accept the inherent

contradictions between these three domains, to get over the resulting conflicts and

uncertainties and to find a satisfactory balance.

A fundamental characteristic of public service is identified by Marobela (2008). In his

opinion, the boundary between the public sector and the private sector is drawn not

only by the objectives pursued but also by the manner in which the service is

delivered. Moreover, Parasuraman et al. (1985) quoted by Fryer et al. (2007)

approaches the characteristics of the public sector from the perspective of the quality

of the services in the public sector, namely intangibility, heterogeneity, and

inseparability, which he defines as following: intangibility means that no precise

definition and measurement of the services is possible; heterogeneity means that

services suffer from lack of consistency, since they depend on the interaction between

the individual service provider and the customer; inseparability refers to the

simultaneous occurrence of the delivery and the “consumption” of the service and the

potential influence of the customer on the outcome of the service provided

Fryer et al. (2007) identify the features of the public sector from the perspective of the

demand, by comparison with the private sector. Through the bidimensional analysis

(public sector – private sector) of the number of customers, authors conclude that

unlike the public sector where in the absence of the profitability objective the increase

of the customers’ number means an increase of the efforts, in the private sector the

increased demand leads to profit maximization and therefore it is a major objective.

We think that in present times, characterized by the limitation of public resources and

the increase of the demand for services, this feature means that the public sector

should identify and adopt alternative measures in order to fulfil public expectations.

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The research points out that there are several approaches in the relevant literature with

regard to the characteristics of the public sector. By referring to the public sector in

Romania, we add to the above characteristics its complexity, which is generated by

the nature of the provided services and by the following actors which interact within

the system: entities with competences in the regulation, coordination, strategy and

oversight of public policies; financing entities; buyers; public service suppliers;

consumers (taxpayers, public). Moreover, we consider that a thorough analysis of the

characteristics of the public sector reflects the causes of the difficulties this sector

faces, by comparison with the private sector.

3. ARGUMENTS IN FAVOUR OF CORPORATE SOCIAL RESPONSIBILITY

IN THE PUBLIC SECTOR

CSR being approached only limitedly in the public sector, as well as the absence of

the goal of profit maximization are counterarguments for developing CSR in this

sector. But, if we consider that the goal of profit maximization, although belonging to

the private sector, is circumscribed to the performance goal (convergent with the

public sector), as well as that the objective of public sector entities is to fulfil the

expectations of the public (the citizens), we can state that social responsibility is

implicitly present in the public sector. Kakabadse & Rozuel (2006) feel that

approaching ethical, social and environmental issues is more appropriate in the public

sector than in any other sector, since by their very nature, public organizations are

expected to contribute to the citizens’ welfare and solve social problems.

For Siltaoja (2009), legitimacy and reputation represent pertinent arguments in favour

of corporate social responsibility in the public sector. The author considers that an

entity of the public sector becomes legitimate when it promotes corporate social

responsibility at the level of the entire entity. Walker& Parent (2010) give to CSR the

role to protect reputation, because it mitigates the attempts to discredit the public

organization.

Kakabadse and Rozuel (2006) argue the need for social responsibility in the public

sector from the perspective of the globalization of economies. Authors think that the

globalization of the activities of the entities from the private sector leads to the

prevalence of the economic over social interests. Consequently, limiting this impact is

a responsibility for both the private and the public sector, because governance should

get involved twofold: to develop a proper environment that enables private

organizations to act with social responsibility, namely to ensure that public service

entities are responsive to the needs of the community, show concern for the

environment and efficiently and effectively support economic growth.

Norway and Denmark are persuasive examples for the dual involvement of their

governments in the field of corporate social responsibility. Starting with 2008,

Norway has the first independent policy in the area of CSR, common for both the

entities of the private sector and the entities of the public sector, public funds (pension

fund) and public acquisitions. The main objectives of this policy are: clearly defining

the state’s expectations from the private sector and establishing the role of the

authorities and private entities, increasing the motivation and the ability of companies

for CSR, and the Norwegian state taking an international role in promoting and

implementing CSR. If we refer strictly to the corporate social responsibility of the

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state, the main aspects taken into consideration by the policy are: long-term

sustainable management of the resources of public entities, responsibility in managing

the pension fund, applying CSR principles in public acquisition, environmental

protection and ensuring that human rights are respected. For elaborating and adopting

the CSR model, the Norwegian government relates to the international norms and

experience, complemented by public consultations with social partners. In its action

plan for implementing CSR, Denmark defines similar goals as Norway and is based

on public consultations and international experience. The areas targeted for applying

CSR principles are as follows: public acquisitions, companies in which the state is

major shareholder (they must report on CSR compliance), public investments, public

funds, environment and climate changes.

In relationship to the characteristic features of the public sector, we consider that

another argument in favour of CSR is the intercorelation between the social

responsibility and the performance of public sector entities. In our opinion, CSR is a

driver for the financial and non-financial performance of the entities of the public

sector. For supporting this statement, we present the following aspects:

� Social responsibility implies the voluntary agreement of the entity to be

assessed, to answer for its actions and to implement corrective measures for

eliminating the found deficiencies;

� Transparency acts as an incentive mechanism against the potentially

opportunistic behaviour of management, promotes monitoring and eliminates

informational asymmetry between the public sector and the constituencies (the

public) with regard to the use of resources.

� Ethical behaviour eliminates the conflicts of interests from the entity, which

could generate lack of trust regarding the manner in which public resources

are built and used;

� Following the interests of all stakeholders implies the used of economic

resources as efficiently as possible, on the general background of sustainable

development;

� The ethical, legal and environmental issues, as well as the issues regarding the

social context accompany all steps of the process of design and delivery of

public services/ products.

4. RESEARCH ON THE DISCLOSURE WITH RESPECT

TO CORPORATE SOCIAL RESPONSIBILITY

IN THE PUBLIC SECTOR OF THE EUROPEAN UNION COUNTRIES.

THE CASE OF THE HEALTH SYSTEM

The research endeavour takes into account the result of the empirical study

performed by Ştefănescu et al (2010) on identifying the extent to which the concept

of performance is used and quantified in the entities of the public healthcare system

of the European Union member states. Based on the research performed by

investigating the websites of the relevant institutions from the EU member states,

authors concluded that there are concerns on defining performance in the public

healthcare system, but the disclosures on performance, due to the fact that there are

no explicit and exhaustive requirements.

Starting from the assumption of the intercorrelation corporate social responsibility –

performance, we continued the research in order to identify to what extent these

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odies disclose information on the social responsibility within the health system of

that country and the way they perceive social responsibility. Moreover, the research

had in view to identify the information disclosed in the three areas of social

responsibility, namely society, environment and economy. For this purpose, we took

into consideration only the information disclosed in English. The extent to which

those countries offer such disclosure was diverse, an overall view of that situation

being presented in Appendix 1.

The performed research emphasizes that the relevant national bodies of the Member

States show concern for corporate social responsibility issues, but the disclosure of

such information is limited. We consider that an argument for this state of facts is

that this concept is relatively recent and, at international level, the public sector has

not shown great interest for disclosing information on social responsibility issues.

None of the investigated countries uses this phrase in the exact above-mentioned

form. The only country that uses a similar term is Ireland, designating it „corporate

accountability”. Moreover, some countries (Austria, Germany, Great Britain,

Denmark, Ireland, Lithuania, and Malta) use related terms: „responsibility”,

„accountability”, and „sustainability”.

Related to the social dimension of the corporate social responsibility concept, the

research points out that the entities involved in the public healthcare system are aware

of their responsibility towards the public and the time horizon over which they assume

this responsibility. Thus, Austria and the Nordic countries (especially Sweden) are

those most concerned for the short- and long-term responsibility towards the public.

As a sign of short-term responsibility towards the population we considered the

disclosure of information on the patient rights, on the importance given to their

individual needs and to the possibilities given to them to express their dissatisfaction

with the system. European countries that show such an orientation towards the

patients are: Austria, Belgium, Cyprus, Denmark, France, Ireland, Italy, Sweden and

the Czech Republic. As a sign of long-term responsibility towards the public in social

matters we took into consideration the measures taken for promoting a healthy

lifestyle and for preventing health problems. Numerous European countries have

stated their concern for health promotion and prevention: Austria, Belgium, Estonia,

Finland, Hungary, Malta, The Netherlands, Slovenia, Sweden and Romania. Germany

is the country that surprises by the fact it does not disclose information in English on

social responsibility. However, there are countries that demonstrate a wider vision on

the responsibility towards the public: Italy and Latvia. They both go beyond the

general discourse on the responsibility of public institutions and take into

consideration the responsibility of the employees in the system, whose part is critical

and complements the responsibility of policy-makers. By the use of the concept

„Clinical Governance”, Italy gives prominence to the role and the responsibility of the

employees of the healthcare system. Latvia guides the employees of the State Agency

of Medicines by publishing a Code of Ethics.

A particular case is the responsibility of the entities towards the environment.

Denmark is the only country in which the responsible bodies from the healthcare

system take responsibility towards the environment by reducing their energy

consumption and CO2 emission. The concern for the environment of other countries

(Spain, Estonia, Finland, and Hungary) is limited to the impact of the environment on

public health.

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The research of the economic dimension of social responsibility shows that Denmark,

Germany and Great Britain are the only countries with explicit concerns in this area.

Denmark has in view the affordability of the treatments, while Great Britain declares

that the provided services should be available to all, no matter the ability to pay of the

beneficiaries. In Germany, the importance of medicinal products and medical devices

as economic goods is also recognized, although the protection of public health is in

the foreground. An interesting initiative is that of Great Britain, which launched in

March 2011 “The Public Health Responsibility Deal”, with the purpose to involve the

business environment in achieving public health goals.

5. PROPOSAL OF A GENERAL CSR FRAMEWORK FOR THE ROMANIAN

PUBLIC SECTOR

The assumption underlying the proposal of a general CSR framework is based on its

limitation in the Romanian public sector, with impact on the performance of the

entities within this sector. From a structural point of view, the general framework

includes the following components: defining the CSR concept; internal and external

pressures on the public sector; external and internal stakeholder; responsibility areas;

the process of CSR implementation in the public sector and communication on CSR

matters.

The definition of corporate social responsibility in the public sector

Since public sector organizations differ from their private sector counterparts, it is

necessary to formulate a definition of corporate social responsibility that is welladapted

to this kind of entities. For the purposes of this paper, the following definition

of CSR is considered to be most appropriate: „CSR of public sector organizations is

their commitment to altruistic values for the benefit of people, environment and

economic welfare”.

The external environment of the public sector

In the view of Nutt (2005), political considerations are an important part of the

external environment of the public sector. Changes in policy and the imposition of

short time-horizons on public managers are permanent challenges for public entities.

Short-time objectives are the consequence of political changes that constrains

politicians to achieve quick results in order to ensure success in the next round of

elections. From a political perspective, political issues become more important than

economic issues, and entities must adapt to the political environmental factors. Thus,

we feel that political pressures make the development of CSR in the public sector

necessary.

In addition to political pressures, the external environment of the public sector is

characterized by complexity, dynamism, munificence. Dynamism is generated by

knowledge development, technological innovations, as well as by the constant

changes of regulations within the public sector. The munificence is understood by

Kearney et al. (2009) as a multidimensional concept that includes dynamism, industry

growth, technological opportunities, and the demand for new products or services. We

consider that a munificent environment influences the public sector entities twofold.

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On one hand, it helps them to build slack resources and to access external resources in

difficult times, and on the other hand, it stimulates them to choose CSR practices,

because social, human and ecological issues are more pregnant than in stagnant

environments.

The internal environment of the public sector

Whereas the external environment influences the public sector organization and

implicitly its attitude towards CSR, the internal environment actively participates and

completes the integration of CSR within this sector. For Kearney et al. (2009),

internal environment consists of the following components: structure/formalization,

decision making process, control, and rewards/motivations. By referring to the

characteristic features of the Romanian public sector, we develop the components of

the internal environment, as follows:

� Formalization refers to the existence of explicitly formulated and written

procedures that guides the activity of the entity, as well as the existence of

specific organization charts, job descriptions, strategic and operational plans.

Although a high degree of formalization has the disadvantage of a low

flexibility in the decision-making process, we consider that it favours the

implementation of corporate social responsibility due to the already existing

customized patterns.

� The decision-making process is characterized by rigidity, because the

resources are mainly public, have the tendency to diminish and are limited

with regard to their allocation for investments that would significantly

contribute to enhancing the ability to respond to economic, social,

humanitarian and ecologic issues of the community. We consider that the

inflexibility of the decision-making process is the main impediment in

implementing CSR within the Romanian public sector;

� The existence of adequate control systems facilitates the implementation of

CSR, because they can tightly monitor behaviour and resource utilization and

support a responsible attitude within the public sector entities;

� Rewards are an obstacle for CSR success in the public sector. We support this

statement by the fact that the current ways of rewarding human capital within

the public sector are limited both financially and motivationally. Therefore,

the human resource does not have the motivation to get involved into CSR-

related activities. In our opinion, rewarding human capital should be

rethought, so that it takes into consideration the objectives, their level of

achievement and their usefulness.

Stakeholders

Due to its nature, in the public sector interact numerous actors who a stake in its

activity, namely: entities with responsibilities in the regulation, coordination, strategy

and oversight of public policy; financing entities; buyers; suppliers of public services;

consumers (taxpayers, public). The identification of stakeholders in establishing a

CSR framework in the public sector is necessary, although even in case of the

“stakeholder” concept, there is no consensus on its definition. Regarding the

classification of the stakeholders, Kakabadse & Rozuel (2006) suggest the

classification provided by Fottler et al. (1989), who identify three broad categories of

stakeholders: internal stakeholders, interface stakeholders, and external stakeholders.

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Internal stakeholders are those who belong to the entity and typically include

management, professional, and non-professional staff. Interface stakeholders are those

with double membership, they function both internally and externally to the

organization and include the taxpayers. External stakeholders can be divided into

three subgroups, as follows: those who provide inputs into the organization (e.g.

suppliers, service beneficiaries and funds providers), those who compete with the

public entity (e.g. other institutions or related organizations operating in the same

field as the public sector entity), and those who have a special interest in how the

organization functions (e.g. professional associations, government regulatory

agencies, labour unions, the media or the local community).

Responsibility areas

In a traditional sense, “responsibility” reflects the state or fact of being accountable or

to blame for something (http://www.dexonline.news20.ro). Thus, it is necessary to

identify the responsibility areas, so that appropriate processes and controls can be

implemented in each of them. Responsibility areas of the public sector entities differ

depending on the activity type, but also present overlapping areas that refer to:

environmental issues (mitigation of environmental damage; eliminating waste and

emissions; maximization of the efficiency and productivity of resources etc.), social

issues (contribution to arts, education and cultural matters, involvement in the

community, ensuring appropriate labour practices, respecting human rights etc. and

economic issues (maintaining economic efficiency; monitoring the impact on the

economic well-being of the stakeholders etc.).

Implementation process

Additional to the external and internal factors that affect the attitude of the public

sector organizations towards corporate social responsibility and the overlapping

responsibility areas of the entity (ecological, social and economic), this component of

the proposed CSR framework is the process of implementation itself. We think that

successfully implementing CSR requires a systematic approach that is in accordance

with the public organization’s activity, culture, environment, risk profile and

operating conditions. The endeavour of designing a model for CSR implementation in

the public sector is based on the CSR implementation framework elaborated by

Hohnen (2007) for businesses, synthesized in Table. 1.

Table 1. Model for CSR implementation in the public sector

Steps Description

� Plan

Assess CSR Define CSR

Identify external and internal influences

Identify stakeholders

Develop a CSR strategy

� Do Develop CSR commitments

Establish persons involved in strategy development

Research on existent CSR practices at other organizations

Prepare a list of CSR actions

Develop and support ideas for proceeding

Decide on direction, approach, boundaries and focus areas

Identify main potential CSR commitments

Discuss with major stakeholders

Prepare a draft of CSR commitments

Consult on the draft with the relevant stakeholders

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Steps Description

Implement CSR

commitments

Develop a CSR decision-making structure

Set performance targets

Engage persons to whom CSR commitments apply

Design and conduct CSR training

Communicate CSR commitments externally and internally

� Check Measure performance

Report on performance

� Improve Identify opportunities for improvement

Improve

� Cross-check Return to plan and start the next cycle

(Source: own design after Hohnen, 2007)

Communication on CSR matters

Due to the role of corporate social responsibility practices in matters of legitimacy and

reputation of public sector organizations, the communication of how the entity

implements CSR is almost as important as the implemented practices themselves.

Therefore, the choice of the channels and forms of communication that are most

adequate to the specificity of a certain public sector entity is a critical part of the

proposed CSR framework. In reality, the interest of public managers is not to act

responsibly, by taking into consideration social, environmental and economic issues,

but to be perceived as acting in accordance with CSR practices. A similar idea is

supported by Owen (2008), who states that managers are more concerned over issues

related to image rather than true commitment to transparency and accountability. The

choice for a certain communication channel (booklets, trainings, electronic

communication, internal publications, staff meetings, verbal communication, policy

manual etc.) depends on the addressees of the CSR practices and the exact nature of

the public sector entity that decides to implement CSR practices.

CONCLUSIONS

The present research points out that defining the concept of corporate social

responsibility is difficult in the literature, due to its multiple facets. However, the

economic, environmental and social aspects are elements that overlap in most of the

meanings conveyed to the concept of corporate social responsibility. The limited

approach of this concept in the national and international public sector was the

starting point for identifying the characteristics of the public sector in order to argue

the opportunity of implementing CSR in this sector.

The complexity of the public healthcare system and the difficulties it faces were the

arguments that guided our research on the CSR disclosure and perception in the EU

states. Following the research carried out we found there are concerns for the social,

environmental and economic dimension of social responsibility. Denmark is the only

country that has a full vision on corporate social responsibility and discloses complete

information on its three dimensions. Austria and Germany show concern for the social

and economic side of CSR. Sweden, Belgium, Cyprus, France, Ireland, Italy and the

Czech Republic disclose information that shows only responsibility to the public and

the time-horizon for which they take responsibility, while Italy and Latvia also focus

on the responsibility of the employees of the public healthcare system. In Belgium,

Estonia, Finland, Hungary, Malta, Netherlands, Slovenia, Sweden and Romania,

concerns for corporate social responsibility are limited to health promotion and

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protection. At the opposite side, Germany and Great Britain disclose information on

the economic dimension of CSR (Great Britain supports the accessibility and

availability of healthcare services, irrespective of the ability to pay of the

beneficiaries, initiated a programme in order to involve the business environment in

fulfilling public health goals, while Germany recognizes the importance of medical

products and devices as economic goods).

In Romania, corporate social governance is not a major objective of the persons in

charge in the public sector. On this background, we consider that adopting a general

corporate social responsibility framework will respond socially, environmentally and

economically to the real needs of the community, will improve the performance of

public sector entities and will consolidate their orientation towards the public.

ACKNOWLEDGEMENTS

This work was supported by CNCSIS–UEFISCDI, project no.955/19.01.2009 PNII –

IDEI, code ID_1827/2008, Panopticon on the performance connotations in the public

sector entities in Romania – creation versus dissemination.

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~ 84 ~


ANNEX 1

Disclosures on social responsibility in the public healthcare system of the

European Union countries

Country Name of

Institution

Site Disclosure

language

Information on social responsibility in the

healthcare system

Germany The Federal http://www.bmg.bund.de - German There is no information in English on social

Ministry

Health

of

- English responsibility issues.

Federal http://www.bfarm.de/cln - German Its mission statement shows a degree of concern

Institute for _103/EN/Home/home_no - English for social and economic issues: Their

Drugs and de.html

(partially) responsibility is to protect human health, but they

Medical

also recognize the importance of medicinal

Devices

products and medical devices as economic goods.

However, there is no other information in English

on social responsibility issues.

Paul-Ehrlich- http://www.pei.de/EN/ho - German There is no explicit information in English on

Institut me/nodeen.html?__nnn=t - English

rue

social responsibility issues.

Austria Federal http://www.bmg.gv.at/cm - German There is information about the Austrian Health

Ministry of s/site/thema.html?channe - English Care System. The Austrian state is aware of its

Health l=CH0993

(partially) responsibility to provide the best possible health

care services to all citizens.

Orientation towards the patient: Quality,

Belgium Federal Public http://www.health.belgiu - Dutch

transparency and orientation towards patients play

an important role. The opinions of the patient

advocacy groups matter in decision making. The

rights of the patients are legally defined and can

also be enforced by law.

Efficient use of resources: They recognize the

importance of efficiently using the available

resources in providing health care of high quality.

However, no explicit concern for the environment

is stated.

Health promotion and prevention are also

important issues. There are several free of charge

preventive services, such as the mother-child-pass

examination programme, which exists since 1974.

In October 2010, the report “Assessing Socio-

Economic Impacts of GMOs. Issues to Consider

for Policy Development” was issued by the

Ministry. Additionally, annual reports on the Drug

Situation in Austria were issued.

Information on various environmental issues.

Service (FPS) m.be/eportal

- French Useful information on health issues for the

Health, Food

- German population: risks and diseases, care, patient rights

Chain Safety

- English and intercultural mediation, healthy life, end of

and

Environment

life, social issues etc.

Bulgaria Bulgarian http://www.bda.bg/index. - Bulgarian There is no information in English on social

Drug Agency php?lang=en

- English responsibility issues.

– Ministry of

Health

(partially)

Cyprus Ministry of http://www.moh.gov.cy/ - Greek The Mission of the Ministry is to continuously

Health moh/moh.nsf/index_en/in - Turkish improve the health of the population through the

of the dex_en

- English prevention of disease and the provision of high

Republic of

level health care.

Cyprus

Booklet on Patient’s Rights and Citizen’s Charter

not available in English.

There is no other information in English on social

responsibility issues.

Great Department of http://www.dh.gov.uk/en/ - English The concern for accountability issues towards

Britain Health index.htm

public health is evident.

The Department of Health published in July 2010


Country Name of

Institution

Denmark

Ministry of

the Interior

and Health

Site Disclosure

language

http://www.sundhedsmin

isteriet.dk/English.aspx

- Danish

- English

~ 86 ~

Information on social responsibility in the

healthcare system

a White Paper called “Equity and Excellence:

Liberating the NHS”. The core values are to

provide “a comprehensive service, available to all,

free at the point of use, based on need, not ability

to pay”. Regular reports of the Department of

Health on the progress in following the Structural

Reform Plan are published monthly. They promote

transparency and accountability across

Government and allow people to check that the

department is meeting its commitment.

Moreover, in March 2011, the Department of

Health launched “The Public Health

Responsibility Deal”. The main idea behind it is

that businesses can contribute to public health

goals. Businesses are invited to sign up the pledges

in the Responsibility Deal and to fulfil the

monitoring and evaluation requirements for each

pledge.

Brief information on patients’ rights in a

publication regarding healthcare in Denmark,

(partially) issued in 2008.

Information on the reform programme “Welfare

and Choice”, launched in May 2002 by the Danish

Government. The programme aims at enhancing

the competition and quality of public-sector

services through choice. A great emphasis is

placed on the freedom of choice citizens have.

Danish http://www.dkma.dk/1024-

Danish The mission of the Danish Medicines Agency is to

Medicines visUKLSForside.asp?artik-

English ensure the availability of effective and safe

Agency elID=728

(partially) healthcare products – medicinal products, medical

devices and new therapies and to promote the

proper use of such products.

Clear concern for social responsibility issues,

revealed in the publication “Perspectives and

challenges 2011-2016”. They focus on the health

and welfare of people and animals, but also take

into consideration economic issues, such as

affordability of the treatments. They also recognize

their responsibility as public institution towards the

environment. For instance, they take measures for

reducing their energy consumption and CO2 emission.

Spain The Ministry http://www.msps.es/en/h - Spanish There is no information in English on social

of Health and ome.htm

- Catalan responsibility issues.

Consumer

- Basque However, there is information in Spanish on issues

Affairs Spain

- Galician such as patient safety and environmental and

Estonia State Agency http://www.sam.ee/

- Valencia occupational health.

- French

- English

(partially)

- Estonian The main responsibility of the Agency is the

of Medicines

- English protection and promotion of public and animal

The Ministry http://www.sm.ee/eng.ht

(partially) health, through the supervision of medicines for

human and veterinary use.

However, there is no information in English on

social responsibility issues.

- Estonian Information on the Esthonian National Health Plan

of Social ml

- Russian 2009-2020. Clear orientation towards social

Affairs

- English responsibility issues:

(partially) - the plan is meant to ensure that the people of

Estonia live longer, happier, healthier lives;

- overall objective: long life and quality of life;

- plans activities in five different fields: social


Country Name of

Institution

Finland The Ministry

of Social

Affairs and

Health

Site Disclosure

language

http://www.stm.fi/en/fron - Finnish

tpage

- English

~ 87 ~

Information on social responsibility in the

healthcare system

cohesion; children’s and young people’s health;

the environment; healthy lifestyles; and health

care.

Clear orientation towards social responsibility

issues. Information in English on the client and

France The Ministry

(partially) patient rights (including legislation on the topic).

Information in English on the promotion of

welfare. The Ministry supports the welfare of

people: by social and health services; by ensuring

income security; by increasing and maintaining

their social welfare, security and participation in

society, and by reducing poverty and social

exclusion; by using health promotion; by using

prevention work; by safeguarding a healthy living

environment and safe work environment.

http://www.santesports.g - French There is no information in English on social

of Health and ouv.fr/

responsibility issues.

Sport

However, there is information on the rights of the

patients, as well as a list of answers to frequently

asked questions.

Greece The National http://www.eof.gr/web/g - Greek No explicit information in English on social

Organization uest

- English responsibility issues.

for Medicines

(partially) EOF is a public entity of the Ministry of Health.

(EOF)

EOF mission is to ensure public health and safety

with regard to several products, marketed in

Greece: medicinal products for human and

veterinary use; medicated animal foods and food

additives; foodstuffs intended for particular

Hungary The Ministry

nutritional uses and food supplements; biocides;

medical devices and cosmetics.

http://www.eum.hu/engli - HungarianThe

summary of the national public health

of Health of sh

- English programme from 2006 shows concern for the

the Republic

(partially) lifestyle of the population (whereas nutrition,

of Hungary

smoking, HIV/AIDS, alcohol and drug prevention

are important issues), for health education and for

the environment. In 2004, Hungary was the host

country of the Fourth European Ministerial

Conference on Environment and Health.

Information on the international relations with

OECD, WHO and the Council of Europe.

Ireland The http://www.dohc.ie/ - Irish The mission of the department is to improve the

Department

- English health and well-being of people in a manner that

of Health and

promotes better health for everyone, fair access,

Children

responsive and appropriate care delivery, and high

performance.

Customer-orientation: Principles of Quality

Customer Service, issued in July 2000 and given

effect by the Department’s Quality Customer

Action Plan.

Concern for sustainability: The Minister

established the Expert Group on Resource

Allocation and Financing in the Health Sector in

April 2009. In July 2010, the group issued a report

on resource allocation, financing and

sustainability in health care.

A variety of other information: fact sheets,

publications, statistics, legislation, press releases

etc.

No explicit information in English on social

responsibility issues. However, the Statement of

Strategy 2008-2010 discusses the need for

commitment to people-centred services, and the

need to develop a modern, effective and transparent


Country Name of

Institution

The Irish

Medicines

Board (IMB)

Site Disclosure

language

http://www.imb.ie/ - Irish

- English

Italy The Ministry http://www.salute.gov.it/ - Italian

of Health

- English

~ 88 ~

Information on social responsibility in the

healthcare system

framework of legislation, regulation and

accountability.

In 2007 the Commission on Patient Safety and

Quality Assurance was established. Its mission was

to develop proposals for a health service wide

(encompassing both the public and the private

sectors) system of governance based on corporate

accountability for the quality and safety of health

services.

The Framework for Public & Service User

Involvement in Health and Social Care Regulation

in Ireland, issued in December 2009, emphasizes

the importance of involving service users and

members of the public in health and social care

services. This follows the recommendation of

OECD that the Irish Public Service place greater

focus on citizens and their expectations, and on

targeting delivery of services from their

perspective to achieve broader societal goals.

No information in English on explicit social

responsibility issues. However, information in

(partially) English on clinical governance, quality and safety

in health care.

Clinical Governance is an integrated approach to

modernize the health system, placing at the centre

of programming and health management the

citizen’s needs. It also places importance on the

role and responsibility of healthcare workers thus

promoting healthcare quality.

Information on patient safety and risk

management, including information on stakeholder

involvement in safety promotion and

Latvia The State http://www.vza.gov.lv/ - Latvian

recommendations for healthcare workers.

Information on the objective of the Agency: to

Agency of

- English ensure availability of efficient, safe and qualitative

Medicines

(partially) medicines to the Latvian population.

Code of Ethics for the purpose of guiding the

Agency employees.

Quarterly informative bulletin 2003-2010 in

Latvian.

Annual Report in English with no explicit

information on social responsibility issues.

Lithuania The State http://www.vvkt.lt/ - LithuanianDeclared

main responsibility is the protection of

Medicines

- English public health. Information on the policy of quality,

Control

(partially) on its vision, mission and principles.

Agency

The motto is: “To consumer only high quality, safe

(SMCA)

and effective medicines”.

Annual reports partly drafted in English for the

period 2003-2007 with no explicit reference to

social responsibility issues.

LuxembouThe

Ministry http://www.ms.public.lu/ - French No information in English on social responsibility

g of Health fr/index.html

issues.

Information in French on the Governmental Health

Programme 2009.

Information, including regulatory initiatives, on

topics such as school medicine, promoting health

and preventing diseases, health when travelling and

immigrating, public health protection.

Malta The Ministry https://ehealth.gov.mt/He - English General information: The stated mission is to

of Health, althPortal/default.aspx

protect and promote the health of the people of the

Elderly and

Islands of Malta. The Health Division is committed

Community

to assuring the accessibility, quality and

Care

sustainability of the public health services and


Country Name of

Institution

The The Ministry

Netherlandof

Health,

s Welfare and

Sport

Poland The Ministry

of Health

Portugal The Ministry

of Health

Slovakia The Ministry

of Health of

the Slovak

Republic

Slovenia The Ministry

of Health

Site Disclosure

language

http://english.minvws.nl/

en/

http://www.mz.gov.pl/w

wwmzold/index?mr=m0

&ms=&ml=en&mi=535

&mx=6&ma=239

http://www.minsaude.pt/portal

http://www.health.gov.sk

/

- Dutch

- English

- Polish

- English

(partially)

~ 89 ~

Information on social responsibility in the

healthcare system

resources.

Information on the structure and responsibilities of

the Strategy and Sustainability Division,

established in 2006.

Information on the mission statement, objectives

and services of the Elderly Care Department.

Information on the Health Promotion Unit, which,

among others, offers counselling and organizes

mass media campaigns on health issues. It

additionally organizes aerobic sessions, weight

management clinics and smoking cessation clinics.

Information on different themes and if the case,

information on the Ministry’s policy and measures

regarding those themes: abortion, alcohol, blood,

disabled people, drugs, EU-Health Portal,

euthanasia, Exceptional Medical Expenses Act,

food and food safety, health insurance system, ICT

in healthcare, infectious diseases, long-term care,

medicines, mental health care, patient safety,

prevention, professionals in health care, senior

citizens, sexually transmitted infections, smoking,

social support, sports and youth.

Different documents, publicly available in English,

such as:

- the lecture “In pursuit of sustainability”, held in

2005 by a representative of the Ministry.

- the paper “Health Care in an Ageing Society, a

Challenge for all European Countries”, 2004

- parliamentary document on measures to be taken

to guarantee the sustainability of long-term care,

2008

No information in English on social responsibility

issues.

- PortugueseNo information in English on social responsibility

issues.

Information in Portuguese on the national health

policy.

- Slovak No information in English on social responsibility

issues.

http://www.mz.gov.si/en/ - Slovene Information on its activities, namely health

- English improvement and preventive activities. The basis

(partially) for these activities is the understanding of health as

something of value both to individuals and to

society as a whole, and as a precondition for the

successful economic and social development of the

country.

The national programme of food and nutrition

policy 2005-2010, describing the three pillars of

nutrition policy (food safety, healthy nutrition,

local sustainable supply), as well as the evaluation

of programmes and health indicators.

The plan for upgrading the health care system by

2020 (issued February 2011).

Sweden The Ministry http://www.sweden.gov.s - Swedish The Swedish Social Policy Model emphasizes the

of Health and e/sb/d/2061

- English role of the public sector in contributing to people's

Social Affairs

welfare, such as health and medical care. The

governmental support by means of social

insurance is provided in different phases of life.

Moreover, the support and service of the public


Country Name of

Institution

Site Disclosure

language

The Swedish http://www.fhi.se/en/ - Swedish

National

- English

Institute of

Public Health

National http://www.socialstyrelse - Swedish

Board of n.se/english/aboutus - English

Health

Welfare

and

Czech The Ministry http://www.mzcr.cz/En

of Health of

the Czech

Republic

Romania

The Ministry

of Health

National

Medicines

Agency

- Czech

- English

~ 90 ~

Information on social responsibility in the

healthcare system

sector are based on individual needs.

Information on the results of an analysis

performed by the Ministry regarding possible

developments of the elderly population's needs for

health care and elderly care over the next forty

years.

Other policy areas that demonstrate social

responsibility: children rights, dental treatment,

disabilities, elderly care, sickness insurance and

public health.

Regarding public health, there are numerous

measures taken by the Government in order to

promote citizens’ ability to make healthy choices,

such as:

- a forum for dialogue on ways in which society

can contribute to healthy eating-habits and

physical activities;

- an advisory board to give advice on alcohol,

drugs, doping and tobacco policy, and a secretariat

to coordinate its work;

Domains of public health objectives: participation;

economic and social prerequisites; conditions

during childhood and adolescence; health in

working life; environments and products; healthpromoting

health services;

Protection against communicable diseases;

sexuality and reproductive health; physical

activity; eating habits and food; tobacco, alcohol,

illicit drugs, doping and gambling

Information on the role to co-ordinate, develop and

follow up the communicable disease prevention

and control in Sweden.

Information on how to report malpractice or

dissatisfaction in Health Care or Social Services.

Main principles of the health service in the Czech

Republic: solidarity, high degree of selfadministration,

multisource financing with major

share of public health insurance, equal availability

of health care for all insured persons and

obligatory vaccination against infectious diseases.

Information on the procedure for filing a

complaint and the authorities to which one can

complain.

Ethical code of patient rights including eleven

main points. A list of ten rights of children patients

as well as of foreigners as parents

http://www.ms.ro/ - RomanianGuide for Healthy Eating, 2006

No clear concern of the Ministry Strategic Plan

2008-2010 for social responsibility

http://www.anm.ro/en/ho

me.html

No information on social responsibility issues

- RomanianQuarterly

informative bulletins in Romanian from

- English within the period 1999-2010

The informative bulletin 2/2010 states the strategic

objectives of the National Medicines Agency,

among which the protection of public health.


IMPROVEMENT IN ACCOUNTING SYSTEM

AND PERFORMANCE MANAGEMENT

OF IRAN’S UNIVERSITIES IN THE LIGHT

OF CONTINGENCY THEORY

Martin BROAD 1 & Abbas ALIMORADI

University of Southampton, United Kingdom

ABSTRACT

Many external factors have affected Governmental Universities of Iran in the past six years.

Decentralization in terms of delegation of authority, financial pressure, and competitive

position for better quality and higher performance in teaching and research are the main

factors. This study investigates the effects of the aforementioned variables on the accounting

systems of Iran’s higher education institutions. According to Contingency Theory in

accounting, there is no identical management accounting system or control system to fulfil the

needs of all organizations in every situation (Chenhall, 2003, Otley, 1980). Based on the

Contingency Theory literature a theoretical model has been developed and empirically tested.

Data were collected from the Governmental Universities in Iran during the latter part of 2009

through a postal questionnaire. All 126 Governmental Universities in Iran were sent the

questionnaire and responses were obtained from Financial, Education, and Research

Departments in each university. Fully completed and usable questionnaires were collected

from 246 Departments (65.1 percent response rate) and Structural Equation Modelling

(SEM) was used to test the model. The preliminary results and analyses support the existing

literature in the most parts. Present study contributes in methodology and theory areas by

several points as well as proposing some suggestions for policy makers of Iran’s Higher

Education and Universities’ Management.

KEYWORDS: Accounting System, Performance Management, Contingency Theory,

Higher Education, Structural Equation Modelling, Developing Countries, Iran

INTRODUCTION

Iran has two big categories of universities namely Governmental and Nongovernmental

Universities. Still the main load of higher education is on the

Governmental Universities which are funded by the Government for the majority of

their activities. Four basic reasons encouraged the researcher to undertake this study.

First, Iran’s Parliament passed the Forth Five-year Development Plan Act in 2004,

thereby proposed a reform for the universities and delegated them authority for

decision-making more than before. Second reason is the low performance of higher

education institutions in Iran in term of international ranking, as the best universities

in Iran are not ranked within the first 500 universities. Third, financial pressure and

competitive positions as other factors have been imposing on the universities during

1 Correspondence address: Martin BROAD, Director MSc Accounting and Finance, University of

Southampton, UK; email: aas1e08@soton.ac.uk

~ 91 ~


ecent years. Finally, the researcher’s involvement as a lecturer and deputy-chancellor

of administrative and finance in a popular university was a key motivation for

undertaking this study. Many external factors have affected Iran’s universities in the

past six years. Decentralization in terms of delegation of authority, financial pressure

or budget constraint and competitive position for better quality and higher

performance in teaching and research are the main factors.

This study investigates the effects of aforementioned variables on the accounting

system and performance management of Iran’s higher education institutions by the aid

of Contingency Theory. The remainder of this paper consist of five sections. The next

section is about literature review and hypothesis development followed by the section

of variable measurement, and then the methodology section. The fourth section

presents the results of SEM analyses and hypotheses tests. In final section the

implications of the results are discussed and some conclusion and contribution is

explored.

1. RELATED LITERATURE AND HYPOTHESES DEVELOPMENT

According to Contingency Theory in accounting, there is no an identical management

accounting system or control system to accomplish the requirements of all

organizations in all situations (Otley, 1980). There are many studies having looked at

the effect of different external and contextual variables on design or change in

management accounting system or (in a wider area) management control system.

Most of these studies are in private sector organizations context. Chapman (1997),

Chenhall (2003), and Langfield-Smith (1997) have reviewed the contingency based

studies in accounting almost comprehensively. Looking at those reviews reveals that

there are many inconsistent findings and equivocal postulates concerning the effect of

contextual and environmental variables on design and use of management control

systems as well as organizational performance (Chenhall, 2003). In addition, in spite

of loads of contingency-based researches regarding the private companies’ context,

the field of public organization has not attracted sufficient attention in this matter

(Chapman, 1997). On the other hand, there are many differences between public and

private organizations so usefulness of contingency propositions which have been

confirmed in the context of private companies, needs further investigations and

evidence for public sector (Miah and Mia, 1996).

Based on the Contingency Theory and Performance Management literature, three

external variables namely “competitive position”, “financial pressure” and

“decentralization” and three aspects of accounting system including “improvement”,

“budgetary participation”, and “emphasis on budget controls” were chosen in order to

their effects on universities’ departmental performance be tested. In Performance

Management part, using some parts of the framework proposed by Otley (1999), the

interaction amongst those external variables, accounting system and two dimensions

of performance management, namely performance measures and reward system, are

investigated. Ten hypotheses are developed to assess the interactions between abovementioned

variables and to support these hypotheses, some instances of evidence in

the literature are stated as below.

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1.2. Improved accounting system (H1)

Decentralization has been considered as on of the prevalent causes for development in

management accounting systems. It is believed that broad scope and comprehensive

information with predictive characteristic could better serve organizations with

decentralized structures (Gordon and Narayanan, 1984). Level of sophistication in

management accounting system and decentralization are positively associated in UK

firms (Abdel-Kader and Luther, 2008). Budding (2008) conducting a research in

Dutch municipalities, found that decentralization is related to design and use of more

sophisticated management accounting system.

Competition is known as another motive for improvement in accounting systems.

Organizations which feel more intense competition would try to change their

management control system and adopt some new techniques to help them surviving

under competition pressure (Cooper, 1995). Khandwalla (1972) found that in the

circumstance of competition demand for control in organization would increase and

organizations are likely to spend more money on their control systems. He also

discovered that grater competition leads the companies to change their accounting

systems to more sophisticated ones and much more use of accounting information.

Cavalluzzo et al.’s findings (1998) highlighted the importance of external competition

and its effect on governmental efficiency and accounting system design and use.

Financial pressure has also been considered as one of the causes of cost accounting

system development in hospitals (Orloff et al., 1992). Reid and Smith (2000) found

that most of the companies in their research sample had started to develop their

management accounting systems during the period of cashflow crisis, deficit of

finance, or innovation. The association between financial pressures and evolution in

one section of UK universities’ accounting systems – former Polytechnic sector – was

confirmed (Broad, 2001). Based on aforementioned studies and situation of Iranian

universities the hypothesis below is proposed:

H1. Universities which are (a) more “decentralized” and (b) facing more intense

“competition” and (c) higher “financial pressure” have more “improved accounting

system”.

1.3. Budget control and participative budgeting (H2 and H3)

Impact of decentralization on budgetary behaviour including participative budgeting

and more emphasis on budget control has been assessed in contingency-oriented

researches. It was confirmed that decentralized companies mostly are interested in

emphasis on formal management control systems (Burns and Waterhouse, 1975).

Miah and Mia’s (1996) collected data from governmental organizations in New

Zealand showed that in the case of delegating more responsibility and authority from

top managers to the lower managers, more control and financial activities evaluation

is needed. Kempkes and Pohl (2008) argue that universities’ autonomy not only is

related to the better research performance, but also it is associated with increase in the

efficiency of budget consumption in those institutions. On the other hand,

decentralization, in term of autonomy in decision-making, is considered as one of the

antecedents of participative budgeting (Modell et al., 2000). Several studies have been

looked at the relationship between these two variables. For example Merchant (1981)

~ 93 ~


found that for large, divers, and decentralized organizations stress on sophisticated

and participative budgets is of high importance. Gul et al. (1995) found some

confirming evidence regarding the association between decentralization and

participative budgeting in Hong Kong companies. The results of another study

confirmed also the facilitative role of decentralization to boost budgeting practices

such as participative budgeting in the public sector of a developing country (Awio and

Northcott, 2001).

Also environmental hostility has a significant relationship with putting more stress on

performing in the boundaries of budgets (Otley, 1978). Financial pressure might be

alleged as an external restriction and hostility from the Government on Iranian

universities. In more hostile environment resulted from resource limitations and

intense competitions, there will be much more reliance on formal control (Imoisili,

1989). No direct evidence could be found to confirm the negative association between

financial pressure and participative budgeting, however several papers have looked at

the effects of participative budgeting and budgetary slack (Young, 1985, Awasthi,

1988, Dunk, 1993a, Van der Stede, 2000, Davila and Wouters, 2005, Kren and Maiga,

2007). On the other side, it has been confirmed that rigid budget control could

negatively affect the slack in budgets (Merchant, 1985a, Dunk, 1993a). If

aforementioned relationships are true, it is expected that budget constraints would

hamper the participative budgeting practices. So it seems reasonable to propose

hypotheses 2 and 3 as below.

H2. Universities which are (a) more “decentralized” and (b) facing “higher financial

pressure” put more “emphasis on budget control”.

H3. “Participative budgeting” in Iran’s universities are (a) positively associated with

“decentralization”, but (b) negatively with “financial pressure”.

1.4. Effect of accounting and budgetary system on performance (H4 to H6)

It seems evident as well as has been claimed by many researchers that accessing to

more information would assist managers to make decision much more effectively (for

example see: Chenhall, 2003, Baines and Langfield-Smith, 2003). Cadez and

Guilding (2008) found that there is a positive association among the degree of usage

of strategic management accounting techniques and performance. Several researchers

have proposed that in an uncertain environment, the information provided by

management accounting system is much more useful (for example see: Gordon and

Narayanan, 1984). Competition has been identified as an index of uncertain

environment (Mia and Clarke, 1999). Simons (1990) doing a two year field study in

two competing companies, tried to investigate the extent and process of formal

management control system effects on strategy formulation to be assured that

competitive advantages would be saved. It is almost an accepted expectation of

accounting systems as a part of management control system to help organizations in

gaining competitive advantages (Bromwich, 1990). Then following hypothesis is

suggested:

H4. “Universities’ departmental performance” is (a) positively related to “improved

accounting system” (b) mediating by “competitive advantage”.

~ 94 ~


Shields and Shields (1998) have reviewed 47 published papers which had

investigated the effects of participative budgeting on several dependent variables.

Performance with 31 frequencies is the most frequent dependent variable in those

researches. Although organisational scholars such as Argyris (1952) and Becker and

Green (1962) have proposed positive relationship between participative budgeting

and performance (Kren, 1992), results of the studies in management accounting in this

regard are somehow equivocal (Chenhall, 1986). Therefore, many of the studies in

this field have looked at a mediating variable which may affect the relationship

between participation and performance. While the definition of budgets proposed by

King et al. (2010) can also be employed for public organizations, participative

budgeting in a public organization is not quite similar to a private organization, so it is

expected that its mediating variable may also vary. In public sector organizations, at

least in context of Iranian universities budgeting system is mainly about distribution

of funds between different departments and activities. Thus, it seems that if

participative budgeting could improve the Departments’ satisfaction with budgets it

might improve their performance, otherwise it may do not have any positive

consequence on performance or even negative, as it might create extra duty for each

department and employee. A significant association has been confirmed between

participative budgeting and both of job satisfaction and satisfaction with budgets

(Chenhall, 1986). So it can be expected to:

H5. “Universities’ departmental performance” is (a) positively related to

“participative budgeting”, (b) mediating by “satisfaction with budgets”.

Hopwood (1972) proposed three different styles of performance evaluation so called

Profit Conscious and Budget Constrained as well as Non- accounting Measures. He

concluded that use of Profit Conscious style is more related to the improved

organizational performance and less job-related tension amongst employees and their

supervisors, however Otley (1978) could not confirm this results in another company

and tried to justify the contradictory results by proposing the difference between main

activity centres in those companies. Many other studies in Finance Theory framework

found that budget control which is resulted from financial pressure in state-owned

enterprise which are production firms could have negative effects on employment,

pay rise, and sustainability in market, but a positive effect on productivity (Bertero

and Rondi, 2000, Nickell and Nicolitsas, 1999, Musso and Schiavo, 2008).

Nonetheless, it should be borne in mind that budget control in Iranian universities

mainly is about cash and fund, so it is somehow different with budget control in

private organizations. Shen (2003) found that budget constraint in US hospitals is

adversely related to the quality of their performance. In higher education field also

many studies have discussed consequences of budget constraint on their performance.

Reform in universities’ funding resulted in more budget control in Ghana’s

universities could reduce their efficiency and create many problems for them (Brock,

1996), this is also the case for the universities in Sri Lanka (Chandrasiri, 2003).

Greenaway and Haynes (2003) argue that budget constraint in UK universities

resulted in poorer performance in at least four aspects of activities namely class size,

recruitment and remuneration, research, and social exclusion, although universities

have endeavoured to compensate this problem by increasing their productivity. So the

sixth hypothesis is proposed as below:

~ 95 ~


H6. “Universities’ departmental performance” is negatively associated with “more

budget control”.

Figure 1, concisely, illustrates hypothesis 1 to 6 in a schematic expression.

Figure 1 Effects of external variables on Iranian universities’ accounting system

and performance (proposal)

Competitive

position

H1b H1c

Improved

accounting system

Competitive

advantage

H4b

H1a

1.5. Comprehensive performance measures (H7)

Financial pressure Decentralization

H2a H2b

More emphasis on

budget control

H6

University’s departmental

performance

According to the balanced scorecard notion (Kaplan and Norton, 1993) it seems

evident that in a new situation such as competitive position organizations are more

likely to employ new and comprehensive measures to evaluate their performances.

Use of qualitative measures besides quantitative measures in the competitive positions

appears to be prevalent to lead organizations in a better point compared to their rivals

(Amir and Lev, 1996). As a result of another empirical study, it is claimed that there is

a positive and significant association among the magnitude of market competition and

use of multiple performance measures in manufacturing organizations (Hoque et al.,

2001). Recently this idea was confirmed in Taiwanese high-tech manufacturing firms

as well (Schulz et al., 2010). Although Kaplan (2001) giving several evidence, claims

that use of non-financial performance measures alongside with the traditional

measures is also useful in non-for-profit organizations, little empirical investigation

has been conducted in the context of public organizations. Thus, it seems interesting

to below hypothesis be tested in some public organizations:

H7. Use of “comprehensive performance measures” is more important for the

universities which are facing more intense “competition”.

~ 96 ~

H5b

Participative

budgeting system

H4b H5a

H5b

H4a

H3b

H3a

Satisfaction with

budgets


Flamholtz (1983) argues that accounting and budgeting system could not be seen as a

complete control system and they should be linked with other parts of holistic

management control system, including an appropriate reward system, to be able to

meet their ultimate objectives. It was confirmed, empirically, that localization in

designing reward system could better benefit organizations (Thompson and Richter,

1998). Shelley (1999) argues that there is high level of autonomy for each university

in the UK to specify its own appraisal system, whereas it has not been the case for

Iran’s universities for many years. As it was mentioned earlier, following the new

legal reform it was supposed to universities be delegated more authority and

autonomy to change, legislate and administrate most of regulations that they think

should be corrected or there is ambiguity on them. So it may be claimed that:

H8. “Improvement in the universities’ reward system” is associated with their level

of “decentralization”.

1.6. Use of accounting in performance management (H9)

It is still hard to deny the importance and usefulness of accounting information to help

the management in performing their main tasks especially in decision-making and

control (Zimmerman, 1995).There are some evidence in the literature that support the

direct association among decentralization and usage extent of accounting information

(for example see: Miah and Mia, 1996, Budding, 2008) and indirect relationship

between competitive position and usage degree of accounting systems after changing

it to a more efficient system (for example see: Khandwalla, 1972, Simons, 1990).

Although Gordon and Narayanan (1984) could not find a significant association

among structure and usefulness of accounting information system, findings by

Chenhall and Morris (1986) confirmed the existence of such a relationship. Based on

this inconsistent results Miah and Mia (1996) endeavoured to test some propositions

in this regard at governmental organizations in New Zealand and found positive

association among them. Abernethy and Vagnoni (2004) performing an exploratory

study in two Italian teaching hospitals, found that decentralization in sense of

authority delegation directly affects the extent of usage of accounting systems in

decision-making and control aspects. On the other side, findings by Mia and Clarke

(1999) confirmed the association between intensified competition and increased use

of management accounting information. Therefore, proposition below is stated:

H9. The extent of “use of accounting information in performance management” by

the universities is related to (a) their level of “decentralization” and (b) intense of

“competition”.

1.7. Performance management and performance (H10)

In relation with the influence of two chosen aspect of performance management as

well as usage of accounting information in PM, on organizational performance several

confirming evidence could be found in the literature. Regarding the effect of

improved reward system, Ittner and Larcker (1995) tried to assess the association

amongst TQM practices, reward system, and level of performance. They found

supporting evidence for positive relationship between emphasis on non-traditional

information and reward system with performance just for the companies using TQM

practices less broadly. Gomez Mejia (1992) found positive association between

reward system, diversification, and performance. Bonner and Sprinkle (2002)

reviewed and proposed the relationship of monetary incentives, effort (direction,

~ 97 ~


duration, intensity, and strategy development) , and task performance. In a recent

study, it was also confirmed that performance-based payment would affect

employees’ effort which consequently improve organizational performance (Schulz et

al., 2010). However, no study could be found investigating the direct association

between improvement in reward system and organizational performance. In addition,

there are many empirical studies confirming positive relationship between

“comprehensive performance measures” and “organizational performance” (Kaplan

and Norton, 1993, Chenhall, 1997, Lee and Yang, 2010). Widener (2006) also found

some evidence supporting the positive association between importance of

performance measures and firms’ performance. Schulz et al. (2010) also found that

employing comprehensive performance measures would increase organizational

performance. Comprehensive performance measures is also crucial for governmental

organizations as it has been proved that behavioural aspects of performance

management practices are not less important than their financial aspects in public

organizations (Verbeeten, 2008).

Finally, it has been claimed by many researchers that accessing to more information

would assist managers to make decision much more effectively (for example: Miah

and Mia, 1996, Baines and Langfield-Smith, 2003, Chenhall and Langfield Smith,

2003). Mia and Clarke’s (1999) findings showed that the improvement in

performance of business units is related to the extent of usage of information provided

by management accounting system in the competitive situations. Miah and Mia

(1996) also found positive relationship between grater usage of accounting

information and performance. So the final hypothesis is as below:

H10. Universities’ departmental performance is positively related to (a)

“improvement in reward system”, (b) importance of “comprehensive performance

measures” and (c) “use of accounting information in performance management”.

The schematic diagram below, Figure 2, summarizes the hypotheses 7 to 10 of this

research.

Figure 2 Interaction between external factors, accounting system and performance

management at Iran’s universities (proposal)

Competitive

positions

H7

Comprehensive

performance

measures

H9b H9a

H10b

Usage of accounting

information in PM

H10c

University’s departmental

performance

~ 98 ~

H10a

Decentralization

H8

Improvement in

reward system


2. VARIABLE MEASUREMENT

For variable measurement, it has been attempted to use and modify extant instruments

as far as possible. To measure the 12 main variables of this study, 66 indicators

(questions) were employed by use of a six-point Likert type scale questionnaire. To

measure “Competitive Position” the instrument of Khandwalla (1972) has been

adapted , so the extent of competition tension in education, research, and overall

issues has been asked. For measuring “Financial Pressure” 4 questions designed by

the researcher as no existing questionnaire could be found in this regard. The extent of

financial pressure, how often they need to postpone or ignore some expenditure due to

budget constraint, trend of budget growth, and their overall opinion regarding the

existence of financial pressure are the content of those 4 questions. There are several

kind of instrument for “Decentralization” measurement, however the instrument of

Inkson et al. (1970) has been modified in this study. The degree of authority for two

aspects of activities namely decision making and legislation in five areas of research,

education, financial, administrative, and recruitment have shaped the 6 questions

concerning the decentralization. Another question tried to gauge the effect of new

reform on delegating more authority to the universities.

To quantify “Improvement in Accounting Systems” a question with 11 section was

designed using the instruments of Khandwalla (1972), Chenhall and Morris (1986) ,

and Martí and Vía (2007). The content of this question is about the changes in

accounting systems in some attributes of the system such as frequency, accuracy, and

qualification of accounting reports, speed of preparing accounting reports, demand for

different accounting reports, use of internal and independent auditing, use of nonfinancial

information in accounting reports, use of new techniques of management

accounting, and computerising accounting practices, as well as automatic reporting.

“Participative Budgeting” was measured by 6 questions adapted from Milani (1975).

Involvement in finalizing their budgets, their influence on finalizing budgets, the

importance of participative budgeting for them to have reasonable budgets, the

frequency of their contacts with and from budgeting department, and the

convincement of reasoning by Budget Department after changing some parts of their

budgets are the content of those questions. As “Budget Emphasis” in public

organizations is somewhat different with private companies, no instrument could be

found for this variable as well. Therefore 3 questions were employed for this purpose

including the extent of budget emphasis, authority to transfer budget funds between

headings, and importance of compliance between actual performance and budget

figures.

To gauge “Satisfaction with Budgets” the respondents were asked to express their

satisfaction with completeness, fairness, and flexibility of budgets. In another question

their opinion about other staff’s satisfaction with budgets were questioned.

“Competitive Advantage” was measured by employing Guilding (1999) instrument

and requesting the recipients about the extent of their use of accounting information in

competitors’ cost assessment and position monitoring, strategic costing, and offering

competitive price in proposals. To evaluate “Use of Comprehensive Performance

Measures” the instruments of Hopwood (1972) and Otley (1978) have been modified

and a combination of quantitative and qualitative common measures were asked. The

extent of effort put into their jobs, their concern with quality, the extent of students’

satisfaction with them, their attitudes to their tasks and university, the punctuality and

~ 99 ~


length of their presence at their workplace, their task accomplishment on time, and

their concern with costs and budgets have been the indicators for this variable.

As reward system of faculty members and other staff are slightly different in Iran’s

universities, it has been endeavoured to measure “Improvement in Reward System”

separately in two questions. Proper relationship between amounts of salary, other

earning, and annual promotion with job performance were common in two questions.

The question regarding other staff has a fourth section to obtain their opinion about

proper link between staff’s overtime payment and their job performance. Using the

formats and anchors employed by Cravens and Guilding (2001), Guilding (2002), and

Cadez and Guilding (2008) a four-section question was asked from all managers to

assess the extent of their “Usage of Accounting Information for Performance

Management”. The aspects of performance management were adapted to the Iran’s

circumstances based on the framework proposed by Otley (1999) including goal

definition and standard setting, performance measurement and comparing to the

targets, expenditure controlling and decision-making, and rewarding and

compensation.

For measuring “Universities’ Departmental Performance” the instrument of Merchant

(1981) which has been used by other researchers such as Brownell and Merchant

(1990) and Dunk (1995) was employed. To avoid from massive subjectivity bias, five

key performance indicators which are normally used by different departments in

Iranian universities were placed in the questionnaires. For Education Departments the

indicators are the rate of graduation during the planned period, quality of instructors

which can be measured based on combination of faculty members (more lecturers=1,

more full professor=6), graduates’ success in passing entrance exams to study in

upper levels, graduates success in finding jobs compared to other universities, and

quality of programmes and courses. Employed key performance indicators for

Research Departments include “number of national publications”, “number of

international publications”, “number of applied research projects and contracts”,

“number of registered patents and inventions”, and “amount of research income”. Key

performance indicators for Financial Departments are ability to pay for expenses and

liabilities on time, new investment in constructing or purchasing new buildings, new

investment in teaching, research, and experimental assets and facilities, growth in

other revenues other than governmental budgets, and percentage of saved budgets at

the end of each year. All of them were requested to rate their overall performance

compared to their counterparts in other universities as the sixth questions.

3. METHODOLOGY

The suitable philosophy and paradigm for this study seemed to be positivism and

functionalist and, as it was mentioned earlier, Contingency Theory was adopted as the

underlying theory for it. Choosing cross sectional survey as research strategy, data

were collected from the Governmental Universities in Iran during the latter part of

2009 through a postal questionnaire. Three main divisions of activity namely

Research Department, Education Department, and Financial Department of all 126

Governmental Universities in Iran were sent the questionnaire. Therefore, the

population of this study was 378 departments of Iranian State Universities.

~ 100 ~


To analyse the data, Structural Equation Modelling (SEM) technique has been

employed as the main tool, and it has been run by a computer programme called

Amos, version 17. SEM is a systematic approach that employed for test of models fit

by doing factor analysis and linear regression at the same time (Williams et al., 2009).

This technique could take the measures directly from questionnaire as indicators or

observed variables to estimate the relevant concepts or latent variables (Hoyle, 1995).

By using this technique combination of moderating and intervening models can also

be tested and some changes in initial model would be possible.

4. PRELIMINARY RESULTS

275 completed questionnaires were collected from the universities (72.8 percent

response rate), but only 262 of them were fully completed without any missing data,

as it is necessary for SEM, then the real response rate is 69.3 percent. Finally by

screening the data and in order to gain an acceptable level of normality of distribution

16 questionnaires were set aside as outliers, so final response rate is 65.1 percent. The

brief results of descriptive analysis have been shown in the table 1 as below.

Table 1 Descriptive statistic results of the data, using SPSS 17.

Variables Min* Max* Mean Std.

Dev.

Skew. Kurt.

No. of

Items

Cronbach’s

Alpha

Competitive position 2 6 4.21 0.74 -.200 -.415 3 .74

Financial pressure 2 6 4.58 0.64 -.302 -.464 4 .77

Decentralization 1 6 3.19 0.84 .094 -.852 7 .91

Improved

accounting system

2 6 4.26 0.75 .170 -.757 11 .87

Participative budgeting 1 6 3.01 0.94 .100 .291 6 .88

More emphasis on budget

control

2 6 4.45 0.83 -.508 .141 3 .85

Competitive advantage 1 5 2.25 0.96 .455 -.645 4 .95

Satisfaction with budgets 1 6 2.95 0.88 .146 -.093 4 .87

Comprehensive

performance measures

1 6 4.38 0.87 -.445 .208 7 .91

Appropriate

reward system

1 6 3.21 0.96 .477 .575 7 .88

Usage of accounting

information in PM

1 6 3.16 1.03 .264 -.336 4 .91

Departmental performance 1 6 3.45 0.72 .133 -.046 6 .76

* Theoretical Min and Max are 1 and 6 respectively.

To analyse the data by SEM, two phases should be performed , namely measurement

model and structural model (Williams et al., 2009). By running the first phase which

is actually a kind of confirmatory factor analysis the reliability of indicators has been

tested and confirmed, of course to gain a better model some of the indicators have

been dropped out of the model by the indication of the initial results (Shook et al.,

2004). After running the two proposed models by SEM, based on the outcomes of the

first phase, the indices of “Model Fit” showed that the collected data are fit to the

models.

~ 101 ~


4.1. Accounting System Model

According to the first model’s results (Figure 3) most of the indices of fit are good, for

instance CMIN/DF is 1.224, CFI equals .975, NFI is .881, and RMSEM is .030, so all

indices other than NFI which is slightly less than acceptable amount of .9, are at a

good status (higher than acceptable). Table 2 concisely illustrates the indices of fit for

the first model run by SEM.

Figure 3. Effects of external variables on Iranian universities’ accounting system and

performance (outcome)

e12

e11

e10

e9

e8

e7

e6

e5

e4

e3

e2

e1

DECENT1

DECENT2

DECENT3

DECENT4

PARBUD1

PARBUD3

PARBUD5

PARBUD6

.84

.66

.82

.90

.77

.59

.68

.70 .83

.84

.80 .63

.79

.62

e19

FINPRE1

DECENT

PARBUD

BUDEMP1

e13 e14 e15

.18

e30

SATBUD1

.56 .75

.17

SATBUD2

.67 .82

.72

SATBUD3

.52

.75

SATBUD

SATBUD4

.56

.92

.81

DEPPER1

e36

.61

.41

Accounting System Model

.37

e33

.78

DEPPER2

e37

.83

.12

-.22

FINPRE2

FINPRE

e20

BUDEMP

.56

.91 .75 .85

.05

.08

.21

.82 .81 .70

.68

.65

.33

.31

.15

.04

.44

BUDEMP2

-.06

e31

DEPPER

.32

.70 .81 .64

.50

.66

DEPPER3

e38

.13

~ 102 ~

FINPRE4

.08

.07

.72

COMPOS

IMPACC

BUDEMP3

e34

.40

e32

COMADV

e35

.81

DEPPER4

e39

.41

e21

.18.80

.49

.04

COMPOS3

.46

.68 COMPOS1

.64

.80

.71COMPOS2

.50

.64

IMPACC8

.77

.88

IMPACC9

.85

.72

.88

IMPACC10

IMPACC11

COMADV3

.78

.73

.00

.85

COMADV1

.82

.91 COMADV2

.79

.63

.86

DEPPER6

e40

.66

.74

e16

e17

e18

e22

e23

e24

e25

e26

e27

e28

COMADV4 e29

By comparing the real values with acceptable figures of indices proposed in the

literature (Byrne, 2001) it can be concluded that the structural model is sufficiently


eliable. Of all indices in Table 2 just NFI is slightly less than acceptable range and it

is due to the complexity of the model (Kline, 2005), however for assessing the fitness

of a model reliance on the combination of indices (not just one index) has been

recommended (Byrne, 2001, Shook et al., 2004). Figure 3 indicates the graphic results

of the run of this model. In that Figure, rectangles represent observed variables and

ellipses show the latent variables. Factor loadings (between observed and latent

variables), common variances (as indicators of strength of relationship), and

regression coefficients (between latent variables or factors) can be found on figure

below in standardized form.

Table 2. Indices of fit for the Accounting System Model

The abbreviations that have been used in Figures 3 (previous page) and 4 and Tables 3

Index

Model

and 5 mean as below:

CMIN DF CMIN/DF CFI NFI RMSEA

Real values 624 510 1.224 .975 .881 .030

Acceptable

values

N/A N/A Less than 3 More than .9 More than .9 Less than .05

DECENT = Decentralization

COMPOS = Competitive Position

FINPRE = Financial Pressure

IMPACC = Improved Accounting System

BUDEMP = More Budget Control

PARBUD = Participative Budgeting

SATBUD = Satisfaction with Budgets

REWSYS = Appropriateness of Reward System

USACPM = Use of Accounting in Performance Management

COMPME = Comprehensive Performance Measures

Based on the estimations resulted from SEM analysis (presented in Table 3) which are

mostly consistent with the literature, it can be claimed that “improvement of

accounting system” is related to “competitive position” (+.40); however this

relationship could not be confirmed with “decentralization” (+.04) and “financial

pressure” (+.08). On the other hand the association of “participative budgeting” with

“decentralization” (+.37) and “financial pressure” (-.22) was supported. Moreover, it

was confirmed that the universities with higher “financial pressure” and more

“decentralization” (more delegated authority) put more “emphasis on budget

controls”, though the association with “financial pressure” (+.44) was found stronger

than “decentralization” (+.12). In addition, the positive effect of “improved

accounting system” (+.13) and “participative budgeting” (+.31) on “universities’

performance” was confirmed, nevertheless the negative effect of “budget control” was

not found so significant (-.06). Furthermore, “competitive advantage” does not seem

to mediate the relationship between “improved accounting system” and “universities’

performance” (+.003), but partial mediation of “satisfaction with budgets” on

association between “participative budgeting” and “performance” was found

significant (+.14).

~ 103 ~


Table 3. Regression coefficients based on Maximum Likelihood (ML) for Accounting

System Model

Variables Estimate S.E. C.R. P

DECENT ->IMPACC

COMPOS->IMPACC

FINPRE ->IMPACC

DECENT->PARBUD

FINPRE ->PARBUD

FINPRE ->BUDEMP

DECENT->BUDEMP

PARBUD->SATBUD

IMPACC->COMADV

SATBUD->DEPPER

PARBUD->DEPPER

BUDEMP->DEPPER

COMADV->DEPPER

IMPACC->DEPPER

.055

.723

.116

.323

-.219

.489

.114

.412

.033

.270

.259

-.047

.049

.078

4.2. Performance Management Model

~ 104 ~

.082

.143

.092

.059

.066

.080

.066

.073

.057

.064

.062

.048

.045

.037

.673

5.053

1.259

5.464

-3.313

6.094

1.721

5.638

.578

4.240

4.175

-.984

1.100

2.132

In relation to the outcomes of second model (Figure 4) the indices are approximately

the same as the previous model. CMIN/DF is 1.285, CFI is .974, NFI is .894, and

RMSEM equals .034, so for this model also all indices except NFI are higher than

acceptable level. As it can be discovered from the comparison between NFI indices of

these two models, NFI for this model (.894) is slightly better than NFI for the

previous model (.881). This point supports this idea that NFI is quite sensitive to the

complexity of the model (Kline, 2005), as the later model is slightly simpler than the

previous one. Indices of fit for this model can be seen in Table 4.

Index

Model

Table 4. Indices of fit for the Performance Management Model

.501

.000

.208

.000

.000

.000

.085

.000

.563

.000

.000

.325

.271

.033

CMIN DF CMIN/DF CFI NFI RMSEA

Real values 367 287 1.285 .974 .894 .034

Acceptable

values

N/A N/A Less than 3 More than .9 More than .9 Less than .05

Having had a fit model; it might be reasonable to trust on the results of the structural

relationships between latent variables. Regression coefficients resulted from SEM

analysis regarding the Performance Management Model (Table 5) show the

association between proposed latent variables.


e10

e9

e8

e7

e6

e5

e4

e3

e2

e1

Figure 4. Effects of external variables on Iranian universities’ Performance

Management and Performance (outcome)

.84

DECENT1

.66 .91

DECENT2 .81

.91 .82

DECENT3.77

.59

DECENT4

DECENT

.47

.30

REWSYS2 .69

.74.86

FREWSYS

.29

REWSYS3

.74

USACPM1

.65

.86

USACPM2 .81

.66 .81

USACPM3.79

.62

USACPM4

.60

DEPPER1

e26

Performance Management Model

.12

.32

e14 e15

USACPM

e23

DEPPER

.20

~ 105 ~

COMPOS

.10

SREWSYS

.78 .70 .82 .65 .81

.48

.67

.42

DEPPER2 DEPPER3 DEPPER4

e27

.12

.27

.16

.49

.14

.04

e28

.04

.32

e25

e29

.14

COMPME

e24

.67

.45

COMPOS1 e11

.66

.81

COMPOS2 e12

.70

.49

COMPOS3 e13

.65

.80 REWSYS5 e16

.82

.91

.37 .63

REWSYS6 e17

.40

REWSYS7 e18

.87

.75

COMPME1

.88

e19

.94 COMPME2

.60

.36

e20

.55COMPME3

.31 e21

COMPME4 e22

.66

DEPPER6

Table 5. Regression coefficients based on Maximum Likelihood (ML) for

Performance Management Model

Variables Estimate S.E. C.R. P

DECENT ->FREWSYS

DECENT ->SREWSYS

DECENT->USACPM

COMPOS ->COMPME

COMPOS->USACPM

FREWSYS -> DEPPER

SREWSYS -> DEPPER

COMPME->DEPPER

USACPM->DEPPER

.145

.330

.278

.621

.201

.033

.023

.202

.199

.085

.073

.067

.130

.105

.052

.059

.045

.053

e30

1.700

4.490

4.145

4.781

1.909

.635

.391

4.538

3.782

Therefore, it can be asserted that based on this model which is fit with the collected

data there is a significant association between “competitive position” and employing a

“comprehensive set of performance measures” (+.81), but not so strong association

with the “usage of accounting information for performance management” (+.14). On

the other side, although the effect of “decentralization” on more “usage of accounting

information in performance management” was explored significant, its effect on better

“reward system” appears to be different for faculty members (+.12) and other staff

(+32). It seems vital to be mentioned here that based on the exploratory and

.089

.000

.000

.000

.056

.526

.696

.000

.000


confirmatory factor analysis, it seemed inevitable to distinct between “reward system”

for faculty members and other staff and treat them as two separate variables in the

model. Finally, consistent with main stream of Balanced Scorecard researches,

association between use of “comprehensive performance measures” and

“performance” was supported (+.32), nevertheless the relationship among “better

reward system” and higher “performance” neither for faculty members (+.06) nor for

other staff (+.03) could be proved. Nevertheless, the association among “usage of

accounting information in performance management” and “performance” appears to

be significant (+.27). Figure 4 shows the results of this model in more details

schematically.

Table 6 and 7 below, summarise the results of test of proposed hypotheses including a

brief description of hypotheses contents, confirmation or rejection, and the level of

significance for supported hypotheses.

Table 6. Results of hypotheses testing, Accounting System Model

H no. Content of hypothesis Result of test

H1 Association between “improved accounting system” and:

a. “decentralization”

Rejected

b. “competitive position”

Confirmed***

c. “financial pressure”

Rejected

H2 Association between “emphasis on budget control” and:

a. “decentralization”

Confirmed***

b. “financial pressure”

Confirmed***

H3 Association between “participative budgeting” and:

a. “decentralization” (positively)

Confirmed*

b. “financial pressure” (negatively)

Confirmed***

H4 Association between “departmental performance” and:

a. “participative budgeting”, directly

Confirmed***

b. “participative budgeting” via “satisfaction with budgets”

Confirmed***

H5 Association between “departmental performance” and:

a. “improved accounting system”, directly

Confirmed**

b. “improved accounting system” via “competitive advantage”

Rejected

H6 Association between “departmental performance” and “emphasis on budget controls” Rejected

*** = .01, ** = .05, and * = .10 level of significance

Table 7. Results of hypotheses testing, Performance Managements Model

H no. Content of hypothesis Result of test

H7 Association between importance of “comprehensive performance measures” and “

competitive position”

Confirmed***

H8 Association between “decentralization” and “improvement in reward system” of:

a. faculty members

b. other staff

H9 Association between “usage of accounting reports in PM” and:

a. “decentralization”

H10

b. “competitive position”

Association between “departmental performance” and:

a. “improved reward system”

b. “comprehensive performance measures”

c. “usage of accounting reports in PM”

*** = .01, ** = .05, and * = .10 level of significance

~ 106 ~

Confirmed*

Confirmed***

Confirmed***

Confirmed*

Rejected

Confirmed***

Confirmed***


DISCUSSION AND CONCLUSION

By looking at the new situations such as delegation of authority from the Government

to the Universities in Iran, competitive positions and financial limitations which the

universities in Iran are facing with, it seemed that Contingency Theory can explain

and predict some changes in their accounting system and performance management.

Although the vast majority of the contingency-based studies have been done in private

sector, the results of this study showed that most of the contingency postulates are

somehow true in public organizations such as the state universities even in a

developing country like Iran.

As the results of hypotheses testing indicate (Tables 6 and 7) just one hypothesis out

of ten was fully rejected and three more were partly refused. It means that the findings

of this research mostly confirm the existing literature; however in some parts they are

not consistent with the expectations stem from the literature. Firstly, according to this

results, of three proposed factors which could cause improvement in accounting

systems of Iran’ universities only competitive positions found to be influential, but not

decentralization and financial pressure. So in relation to “decentralization”, the result

supports Baines and Langfield-Smith (2003), but contradicts some others (Miah and

Mia, 1996, Budding, 2008). It might be due to the deletion of some of the observed

variables underlying “improved accounting system” by the SEM. This removal left

just those variables that emphasis on the technical aspects of improvement in

accounting systems. Contradiction with the literature regarding the effect of “financial

pressure” is more justifiable because those evidence are mostly about cashflow crises

as proxy of financial pressure (Reid and Smith, 2000) or improvement just in costing

system (Orloff et al., 1992) whereas the case in Iran’ universities is about “budget

constraint” and its effect on improvement of overall accounting system not just

costing system.

Secondly, not only no indirect association could be found between “improved

accounting system” and “universities’ performance” via creating “competitive

advantage” for them (in contrary with the findings of Bromwich, 1990, Simons, 1990,

Hoque et al., 2001), but also the direct effect is not as strong as the effect of

“participative budgeting” on “universities performance”. This might imply two points

at least. First, the nature and objectives of use of accounting system in public

organizations is different with private companies (Miah and Mia, 1996, Jackson and

Lapsley, 2003) as they may use that information mainly for control purposes

(Abernethy and Vagnoni, 2004). In addition, it supports this notion that in public

organization still budgeting aspects of accounting system is more important than

other aspects such as technical improvements in those systems (Goddard, 2005,

Ramadhan, 2009).

Thirdly, test of the sixth hypothesis showed that there is, unexpectedly, no significant

negative relationship between “more budget emphasis” and “universities’

performance”. Although it was against the proposed hypothesis, however there are

many contradictory findings in the literature around this matter (Hopwood, 1972,

Otley, 1978, Hirst, 1981, Lau and Tan, 1998). Studies in the area of Finance Theory

suggest that more budget control could increase the productivity of organizations,

although it may negatively affect their employment, pay rise, and sustainability in

market (Bertero and Rondi, 2000, Nickell and Nicolitsas, 1999, Musso and Schiavo,

~ 107 ~


2008). On the other hand, it is argued that in organizations with domination of

professionals (Abernethy and Stoelwinder, 1995, Broadbent, 2007), sever stress on

budget controls could be considered as an obstacle of performance improvement

while another study showed that more budget control in US hospitals is adversely

related to the quality of their performance (Shen, 2003). So it seems that several

variables are acting in the area of that relationship that they may counteract and offset

the effect of one another.

Finally, as expected and consistent with previous studies, the positive association are

confirmed amongst two proposed contingent variables (decentralization and

competitive position) with two aspects of performance management (improvement in

reward system and use of comprehensive performance measures), respectively

(Kaplan and Norton, 1996a, Chenhall, 1997, Perera et al., 1997, Schulz et al., 2010,

Shelley, 1999). Also relationship between aforementioned external variables and

extent of “usage of accounting information in performance management” is supported

as so did implicitly other researches (Simons, 1990, Miah and Mia, 1996, Ballantine

et al., 1998, Budding, 2008). On the other hand the effect of those changes in

performance management practices, except for “improved reward system”, on

universities’ performance proved to be remarkable based on this study and supports

the literature (Kaplan, 2001, Karathanos and Karathanos, 2005, Widener, 2006, Cadez

and Guilding, 2008, Schulz et al., 2010).

However, some explanations could be provided for not finding significant positive

association between “improved reward system” and “universities’ performance”.

First, most of the studies which found positive association between reward system and

performance, have been conducted in private organizations where there are more

objective criteria of performance to be linked with employees’ rewards (Modell et al.,

2000). Second, it is argued that there is no perfect linkage between individuals’

performance evaluation and organizational performance evaluation, so improving

reward system by better linking with individuals’ performance does not necessarily

mean it would improve organizational performance (Metawie and Gilman, 2005). In

addition, some studies suggest that connecting performance measures to the reward

system could create some side effects such as gaming, task negligence, tunnel vision,

and short-termism (Ittner et al., 1997, Goddard et al., 2000, Ittner et al., 2003) which

they may hamper the organizational performance. Moreover, it has been claimed that

incentive-based reward system could boost quantitative performance, but not

qualitative performance (Verbeeten, 2008), whereas in public organizations especially

in universities quality of performance seems to be more important. Finally, many of

studies which found positive association among reward system and performance have

inserted some kind of intervening variables such as efforts (Bonner and Sprinkle,

2002), and strategy diversification (Gomez Mejia, 1992), therefore devising a

mediating variable such as motivation or job satisfaction might have better been

explained the association between reward system and universities performance.

This study contributes to the literature in several ways including methodological,

theoretical, and practical contributions. Design, adapt, and test of an instrument with

high degree of reliability and validity regarding the accounting system and

performance management of universities, conducting a nation-wide and large scale

survey in the area of performance management of public organizations whiles prior

studies in this regard are mostly qualitative and case-based (Verbeeten, 2008), and use

~ 108 ~


of SEM as the main data analysing procedure to overcome some previous statistical

problems in this kind of researches as well as opening a new avenue for Iranian

researchers (as this technique is not well-known in Iran) are the main methodological

contributions of this study. In term of theoretical, this research contributes by several

points such as investigating about dissemination of knowledge concerning

management accounting and performance management in developing countries

(Hopper et al., 2008), extending and testing the contingency postulates in public

sector organizations particularly in Higher Education of a developing country

(Chenhall, 2003), acting as one of the rare studies that broadened contingency notions

from the accounting area to the performance management realm (Cuganesan and

Donovan, 2011), and explicitly proposing and testing “financial pressure” in term of

budget constraint as a new contingent variable (Chenhall, 2003, Abdel-Kader and

Luther, 2008) as well as proposing it as a hindering antecedents for participative

budgeting (Shields and Shields, 1998).

Finally, policymakers in Iran’s Higher Education can use the outcome of this research

to understand the extent of success in implementation of new reform in Iran Higher

Education and justify the priority of decentralization to the centralized decisionmaking

concerning the universities’ activities as well as the consequences of

participative budgeting on the performance of universities. In addition, universities’

management also may learn some lessons from this study such as implementing

participative budgeting at least at internal level, doing more amendments in their

reward system, and design and use of broader range of performance measures for

evaluating the performance of their employees rather than relying just on traditional

measures such as punctuality or length of presence at the workplace.

Care should be taken for use of the results of this study due to some limitations such

as the problems related to questionnaire-based studies, relatively small sample size (as

SEM needs larger sample size), not including all variables affecting universities’

performance such as strategy and political environment, and ignorance of students’

perspective. In the future, many replications could be undertaken in this matter in Iran

or other developing country’s context. Moreover undertaking a qualitative research

methodology could increase the understandings around the result of this study and

may add to the robustness of these findings. In this research just three department of

the universities, namely Education, Research, and Financial Divisions were

investigated, future studies could take into the account the Students Affair Division

and look at the students’ perspective too.

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~ 113 ~


THE ERA OF INTERNAL AUDIT IN THE PUBLIC

FINANCE SECTOR IN POLAND

Agnieszka SKOCZYLAS 1 & Wojciech A. NOWAK

University of Lodz, Poland

ABSTRACT

The modern internal audit was introduced to the Polish Public Finance Sector in 2002. From

this moment the evolution of internal auditing in Poland is progressing from the

implementation of strict financial functions through the assessment of compliance of public

sector entities, until the assessment of the effectiveness and efficiency of the institution. The

aim of this paper is to present the development of internal audit in the Polish Sector of Public

Finance. In this study the following are presented: Polish legislation in the internal audit, the

scope of its operation in the public finance sector, as well as the direction of its changes.

KEYWORDS: internal audit, countries in transition, public finance sector, management

control, internal audit development and evolution, internal audit regulation, EU accession

INTRODUCTION

Statehood in Poland has a thousand-year old tradition, after all, intermittent periods of

its absence. Modern, independent Polish state was reborn in 1918, as a result of

processes of surmounting the First World War. It covered the lands, which for over

120 years were under the rule of Russia, Prussia and Austro-Hungarian Empire. Its

first task was to merge into one state organism the systems of government and local

government which derived from nineteenth-century tradition, respectively: Russian,

Prussian and Austro-Hungarian. This tumultuous process took more than 20 years,

until the outbreak of World War II in September 1939. The already mentioned process

comprised adoption of the Polish Constitution (in 1921) as well as its extensive

change (in 1935), and building (in 1933) the legal foundations of a uniform system of

local government functioning under the supervision of state authorities.

Within the central as well as local government of the reborn state certain control and

inspection functions in the financial and economic affairs were to be fulfilled. On the

national level, their implementation was assigned to the heads of state offices and the

Supreme Chamber of Control while on the level of local government the role was

performed by the management of local government units, revision committees of

representative councils, the inspection union of local government and national

supervisory authorities. Control and inspection functions fulfilled by the heads of state

and local government boards were focused on issues relevant to contemporary internal

audit in financial and operational affairs (aspects). This situation was maintained –

except for the period of World War II - without substantial changes to the early 2000s,

until the beginning of preparations for accession to the European Union, except that in

1 Correspondence address: Agnieszka SKOCZYLAS, Accounting Department, University of Lodz,

Matejki 22/26, 91-360 Lodz, Poland, email: agnieszka.skoczylas@uni.lodz.pl, wanowak@uni.lodz.pl

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a centrally planned economy era and at the beginning of the period of the last political

transition (to 1992) revision of local government associations did not work and their

functions were performed by the local government units.

Pattern of existence and mechanism of control and inspection functions in the

government sector were governed by the law in the rank of Acts and Directives, while

approaches and procedures of control and inspection functions were not standardized.

Internal audit activity was not so much advanced as in other highly developed

countries. Therefore, one of the first tasks to be undertaken in preparation for Polish

entry to the European Union was the introduction of modern internal audit in the

public finance sector. The most significance in this process was given to ensuring

consistency in polish system of control and inspection with the internal audit system

in the European Union. The article is presents an analysis of its development since its

introduction in 2002 to the present day.

1. ADJUSTMENT OF THE INTERNAL AUDIT IN THE POLISH PUBLIC

FINANCE SECTOR

As a result of integration with the European Union and to ensure the proper

functioning of the public finance sector, Poland was obliged to build a system that

would guarantee the accuracy and efficiency of the collection and disbursement of

public funds and management of the property, known as the public internal financial

control (PIFC) (Robert de Koning, 2007) In accordance with European guidelines

(Agenda 2000, 1997), one of the major components of the system of public internal

financial control is "an independent internal audit functioning in all required by law

public institutions responsible for the creation of audit on the basis of international

standards for internal audit, as well as the central body responsible for harmonizing

and coordinating system auditorium in the country" (Chojna-Duch E., 2002, p. 59).

Adaptation to EU requirements made it necessary to regulate the issue of internal

financial control and internal audit in order to improve efficiency, transparency and

openness of public administration and better use of public funds (Chojna-Duch E.,

2002, pp. 58-59).

The internal audit was introduced to the Polish law in 2002. The universally binding

legal instrument in this respect was, and still is, the Public Finance Act (Law Gazette

No. 155, item. 1014). It regulates not only the definition and rationale of the internal

audit, but also introduces the principles of organization and coordination of internal

audit, as well as eligibility requirements which must be met by internal auditors. The

Public Finance Act is accompanied by other acts which complement the provisions of

the Act, so-called executory provisions. These include:

� directives concerning the detailed method and procedures for conducting

internal audit,

� announcements of the Internal Audit Standards, the Code of Ethics and

Internal Audit Charter in the public finance sector.

The Directives apply to the conduct of internal audit, depending on the nature of the

services provided, and also indicates the most important documents that should be

created as a consequence of audit. Announcements, in turn, provide a set of

constructions and guidelines relating to the functioning of the audit and the activities

of internal auditors.

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Each of the existing documents is subject to continuous evolution. List of legislation

on internal audit activity in the public finance sector since its inception to the present

time is presented in Table 1.

Table 1. List of legislative acts in force in the Polish sector of public finances

in the years 2002-2009

Year Acts Directives Announcements

2002 Act of 26 November 1998 on Directive of the Minister of

2003

2004

public finance (Law Gazette

No. 155, item. 1014).

Finance of 5 July 2002 on the

detailed method and procedures

for internal audit (Law Gazette

No. 111, item. 973).

Announcement No. 2 Minister of

Finance dated 30 January 2003

concerning the announcement of

"Standards for Internal Audit in the

2005 Act of 30 June 2005 on public

finance ( Law Gazette

No. 249, item. 2104)

public finance sector" ( Official

Journal MF No. 3, item. 14)

2006

2007

2008

2009 Act of 27 August 2009 on

public finance ( Law Gazette

No. 157, item. 1240)

Directives of the Minister of

Finance dated 24 June 2006 on

the detailed method and

procedures for internal audit

(Law Gazette No. 112, item.

765).

Directive of the Minister of

Finance dated 10 April 2008 on

the detailed method and

procedures for internal audit (

Law Gazette No. 66, item. 406).

2010 Directive of the Minister of

Finance on 1 February 2010 on

the conduct and documentation

of internal audit (Law Gazette

No. 21, item. 108).

(Source: Authors' research)

~ 116 ~

Announcement No. 6 of the

Minister of Finance dated 28 April

2004 on the announcement of "Code

of Ethics of the internal auditor in

the public finance sector, " and the

"Charter of internal audit units of

public finance" ( Official Journal

MF No 6, item. 28)

Announcement No. 11 of the

Minister of Finance dated 26 June

2006 on internal audit standards in

the public finance sector ( Official

Journal MF No. 7, item. 56)

Announcement No. 8 Ministry of

Finance dated 20 April 2010 on the

standards of internal audit in the

public finance sector. (Official

Journal MF No. 5, item. 24)

The most important changes in individual acts in force in respect of internal audit

were related to the modification of the perception of its role in the organization and

the nature of the services provided by it. The breakthrough came at the time of

introduction in the Polish public finance sector the International Standards for the

Professional Practice of Internal Auditing developed by the Institute of Internal

Auditors in the United States (The Institute of Internal Auditors). These standards are

considered the most important guidelines for the functioning of the internal audit and


are used and respected by the majority of public and private institutions in the world.

In Poland, from 26 June 2006, the standards were introduced as mandatory for use by

public sector institutions. This resulted in a change in existing law. The key change

was introduced, however, in 2009. It was associated with a significant extension of

services provided by the internal auditors, as well as a new perspective on the role and

place of audit in public sector organizations.

2. RIGHT INTERNAL AUDIT APPROACH - DEFINITION AND SCOPE

OF SERVICES PROVIDED BY IT

The internal audit was introduced to the public finance sector units for the first time in

the amended Public Finance Act of 26 November 1998. Given the need to fulfil the

provisions in providing pre-public system of internal financial control, basic

definitions, principles, and also organization and coordination of internal audit have

been included alongside those relating to the functioning of financial control in

Chapter 5 of the Public Finance Act of 1998, "Control of financial and internal audit

in the public finance sector". This Act defined the internal audit as "all activities

through which a manager of a unit receives an objective and independent assessment

of functioning in the field of finance in terms of legality, economic prudence,

efficacy, reliability, and transparency and openness".

The statutory duties of the main tasks of the internal auditor were:

• examination of accounting documents and records in the accounts,

• evaluation system for the collection of public funds and their availability as

well as management of the property,

• assessment of efficiency and economy of financial management.

The internal audit activity in its initial phase of development was equated with

financial control. The audit was at that time seen as a mechanism for checking the

functioning of transactions and financial procedures. It included the verification of the

accounting operations and aimed at reviewing and highlighting errors, as well as

evaluation of internal regulations in this regard. This resulted in an audit that was seen

as a kind of financial control, which resulted from the tasks assigned to it.

In 2005, the Public Finance Act was changed, which resulted in the change of the

definition of internal audit. During this period the internal audit was a collective term

comprising "all activities, such as:

• an independent assessment of the management and control systems within a

unit including the financial control procedures, which aim at providing the

manager with an objective and unbiased evaluation of the adequacy, efficiency

and effectiveness of these systems,

• consulting services, including the submission of proposals aimed at improving

the functioning of the organization".

The principle activity of the audit remained within the financial area. However, the

auditor was entitled to perform certain additional services related to the provision of

consulting activities, as well as proposals for improving the functioning of the

organization. Thus, the catalogue of the activities within which the auditor could

perform their duties was extended. Its tasks were to assess:

• business compliance with the law and the applicable procedures in the unit,

~ 117 ~


• efficiency and economy of activities undertaken in the field of management

and control systems,

• reliability of financial statements and reports on budget implementation.

The last, very significant substitution in the functioning of the internal audit took

place in 2009. Not only did the Public Finance Act published in 2009 introduce a new

concept of internal audit, much closer to the international auditing standards, but it

also replaced the concept of financial control and management control. According to

the above mentioned Act "Internal auditing is an independent and objective activity

designed to add value and improve organizations. Internal audit assists the unit in

carrying out its activity through a systematic assessment of the management control

and operations consultancy" (Act of 27 August 2009).

Based on the above definition, the role of modern internal audit in the Polish public

finance sector is the management control assessment, which according to the current

law on public finance means the whole of the action taken to ensure that the

objectives and tasks are consistent with the law, efficient, cost-effective and timely

(Act of 27 August 2009, art. 68.). The most important aspects, according to the Polish

legislature, which should be included in management control, are (Act of 27 August

2009, art. 68.):

• business compliance with laws and internal procedures,

• effectiveness and efficiency of operations,

• the reliability of financial statements,

• protection of resources,

• upholding and promoting the principles of ethical conduct,

• effectiveness and efficiency of information flow,

• risk management.

The concept of management control is associated with the implementation of relevant

activities by the managing of the institution through which the organization achieves

its goals. These activities should proceed in a timely manner, in accordance with the

law and procedures, and thus contribute to obtaining the greatest possible advantage,

while making the most economical use of outlay. The legislature, therefore, did not

resign from the current tasks assigned to internal audit, namely financial control,

which is much narrower than the term management control, and it is a part of it. In the

current Public Finance Act financial control was left at the discretion of heads of

units, by keeping the record of director's responsibilities for financial management of

the institutions. This does not mean, however, that managers were exempt from the

implementation of the remaining tasks of the exercise of financial control. On the

contrary, the scope of the management of public organization has a significant

extension, through the introduction of management control, which covers all types of

activities and all areas and processes operating in the unit, including financial one as

well. We can say that the management control absorbed the financial control

and proper financial control became one of the elements of management control

(Figure 1).

~ 118 ~


Financial

control

Figure 1. Management control and financial control

Management

control

concerns the processes of collecting and distributing

public funds and management of property.

means all actions taken to ensure that the objectives

and tasks are accomplished in a manner consistent

with the law, efficient, cost-effective and timely.

(Source: Authors' research)

Management control in relation to the functioning of Polish public sector, refers to the

concept of internal control, which was defined by international organizations such as

COSO (The Committee of Sponsoring Organizations Treadway Commission) or

INTOSAI (International Organization of Supreme Audit Institutions by The

International Standards of Supreme Audit Institutions - ISSAI). According to them,

internal control is a tool or a management process used to obtain reasonable assurance

that management objectives have been achieved. It is performed by a board of

institutions, management and other employees of the organization (Risk Management

- Integrated Framework, COSO, 2004). Internal control, from the standpoint of

international organizations is perceived in a much broader way than internal control,

which was formed in the culture of the Polish public organizations. So far, the internal

control functioning in polish units meant comparing the actual state with the required

one and was performed by a specially established organizational units (so-called

institutional control).

A guideline to implementation and evaluation of management control in the public

finance sector are the management control standards established by the Minister of

Finance (Journal of Law MF No. 15, item. 84). It is "an ordered set of guidelines that

those responsible for the operation of management control should use to create,

evaluate and improve management control system" (Journal of Law MF No. 15, item.

84). Their purpose is to promote the implementation of a coherent and uniform model

of management control in public finance sector, in accordance with international

standards, taking into account the specific tasks of the implementing institution.

The standards include five elements that correspond to each management control

tasks, which is presented in Figure 2.

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Figure 2. Elements of management control according to the Standards

of management control in the Polish Public Finance Sector

Compliance Operations

Financial Strategic

MONITORING AND EVALUATION

INFORMATION AND COMMUNICATION

CONTROL MECHANISMS

OBJECTIVES AND RISK MANAGEMENT

INTERNAL CONTROL

(Source: Authors' research)

Taking into consideration the international guidelines on internal control, as well as

American literature in this field, one should emphasise that the definition of

management control which is presented in the Polish Public Finance Act is not

significantly different from the recognition of internal control by international

organizations. Its role and scope of activities are important elements in terms of public

sector institutions. The exercising of management control in terms proposed by the

legislator can contribute not only to improvement of the quality of the management of

these bodies, but also to the entire system of public finance.

The correctness of functioning of the management control system in the public

finance sector, in accordance with the current law, should be supervised by the

internal audit. It is its duty to assess the adequacy, efficiency and effectiveness of its

functioning. From the standpoint of the Polish law there are new tasks for internal

auditors. Analysing this issue with reference to international guidelines, it should be

said that the internal audit functioning in the Polish sector of public finances has

finally come closer to a global perspective on the role of internal audit in the

management of the organization. The evolution of internal audit is shown in Table 2.

Apart from the range of the internal audit services in public sector entities, which

were required by the legislature, auditors are required to apply some general

principles in their operations. They are carrying out their tasks on the basis of an

annual audit plan, which has to be prepared by the auditor by the end of the calendar

year. The auditor is also required to prepare a report presenting the realisation of

audit activities. For 8 years of audit activity, the model of audit plan and audit report

were prepared by the Minister of Finance. In 2010, the idea of common model was

abandoned and a list of positions required in both the plan and the report was

published. Planning of the internal audit is based on documented risk analysis. In

determining the scope of areas to be surveyed in a given year the internal auditor is

obliged to take into account the results of risk analysis, managers attentions, the

priorities of the audit committee, the number and qualifications of auditors working in

auditing, as well as the time needed for implementation of planned activities.

~ 120 ~

PUBLIC SECTOR ENTITY


Table 2. The evolution of the definition and scope of internal audit units of the Polish

public finance sector

Years

Definition of Internal Audit Scope of services

2002-2005 Internal audit is all activities through which The statutory duty of the main tasks of the

manager of a unit receives an objective and internal auditor was:

independent assessment of functioning in the � examination of accounting documents and

field of finance in terms of legality, economic records in the accounts,

prudence, efficacy, reliability, and transparency � evaluation system for the collection of public

and openness.

funds and their availability as well as

management of the property,

� assessment of efficiency and economy of

financial management.

2006-2009 Internal audit is all activities, such as:

� an independent assessment of the

management and control systems within a

unit including the financial control

procedures, which aims at providing the

manager with an objective and unbiased

evaluation of the adequacy, efficiency and

effectiveness of these systems,

� consulting services, including the

submission of proposals aimed at improving

the functioning of the organization.

From 2010 Internal auditing is an independent and objective

activity designed to add value and improve

organizations. Internal audit assists the unit in

carrying out its activity through a systematic

assessment of the management control and

operations consultancy.

~ 121 ~

Internal audit task was to assess:

� business compliance with the law and the

applicable procedures in the unit,

� efficiency and economy of activities

undertaken in the field of management and

control systems,

� reliability of financial statements and reports

on budget implementation.

The correctness of functioning of the

management control system in the public units,

in accordance with the current law, should be

supervised by the internal audit. It is its duty to

assess the adequacy, efficiency and effectiveness

of its functioning.

(Source: Authors' calculations based on the Public Finance Act in Poland between the years

2002-2009)

The internal audit units of the Polish sector of public finance provide various services.

Until 2005 in the first phase of its development the auditors were able to accomplish

the tasks included in the annual audit plan and audit commission (assigned task). The

people to delegate tasks were the head of the unit in which auditor was employed and

the responsible minister. Since 2005, the internal auditor can also carry out

consultancy services. To achieve this aim auditors, while are preparing the annual

plan, have to assign sufficient amount of time to complete it.

In 2009, according to International Standards of IIA, a provision that the internal

auditor performs assurance and consulting services was introduced. Assurance

services are meant by a group of activities undertaken to provide an independent and

objective assessment of the functioning of management control. Consulting services

comprise all activities aiming at improving the institution's activities. Despite the

adoption of International Standards and their nomenclature, interpretation of Polish

legislature is not entirely consistent with them.

Internal auditors can perform their tasks providing they receive a personal

authorization issued by the head of the public organization. Assurance services

provided by the auditor should be based on risk analysis and an audit programme. The

audit programme must include a subjective and objective study, which define who and

what will be subject to assessment. Completion of the activities finishes with

preparation of the audit report, which is subject to appeal. As far as consulting

services are concerned auditors have the right to prepare different audit documents,


depending on type and nature of services provided. It should be emphasize that the

methodology of implementation of audit assignments adopted in Poland in accordance

with the national legislation does not differ significantly from the techniques

presented in the International Internal Audit Standards.

3. THE ORGANIZATION OF INTERNAL AUDIT SECTION IN PUBLIC

FINANCE SECTOR UNITS

Organization of Internal Audit in the Polish public finance sector is diverse

(Kaczurak-Kozak, M., 2006, p. 97). It can be perceived in two ways:

� depending on the environment in which the institution employing an internal

auditor is functioning,

� the place of the internal audit unit within the organizational structure.

In the first point internal auditing in public finance sector operates on three levels:

central, local government and public unit, which is presented in Figure 3.

Figure 3. Organization of Internal Audit in the Polish public finance sector

Central level

(government administration)

Public finance sector

Level of public finance units

(Source: Authors' research)

Since the beginning of internal audit in the public finance sector, the coordinating

body on the level of government (central) is the Minister of Finance. Initially,

between 2002-2005, the Ministry of Finance performed his/ her tasks with the

assistance of Chief Internal Auditor, working in the Ministry of Finance and his/her

subordinate organizational unit. The Minister's tasks included the setting of standards

of audit and financial control, cooperation with foreign institutions, collecting

information on the performance of audit and financial controls as well as improving

the functioning of these areas. At the end of 2006 the position of Chief Internal

Auditor was defuncted, and by mid-2009, the Minister of Finance performed the tasks

associated with coordinating the audit, only with the assistance of an organizational

unit in the form of the Audit Department of the Public Sector. Since September 2009,

individual ministers have been obliged to appoint an audit committee in all the

ministries supervised by them. The Committees' responsibility is to advise the

Minister in the area of internal audit and management control in public bodies

subordinate to him/her. The committee must consist of at least three members,

including a person appointed by the responsible minister, having the rank of secretary

or undersecretary, who will perform the function of a chairman and at least two

independent members who are not employees of the ministry, or its subordinate units.

In accordance with International Standards for the Professional Practice of Internal

Auditing IIA committees should operate in each unit having an internal audit. In

~ 122 ~

Level of local government


Poland, a different solution has been introduced, which means the committees operate

on the level of ministries, not the local units.

On the level of local government the internal audit organization and coordination is

the responsibility of the borough leader, mayor, or the city president. It should be

noted that as far as these institutions are concerned, a certain degree of freedom was

given by the Minister of Finance, which results in a variety of internal auditor

activities in the whole public finance sector. This is due to decentralization, and

consequently the ability of the management to take decision on certain issues in a

manner independent of the government.

The third level of internal audit organization in the public sector consist of, listed in

the Act, public sector entities and local government units which accumulate

substantial public funding or carry out significant public expenditure. Conducting

internal audit in those institutions is a requirement imposed by the legislature. The

coordinating body of their activities are individual ministers and appointed by them

audit committees.

Another important issue in the functioning of internal auditing in public finance sector

is the position of internal auditor and internal audit unit within the organizational

structure (Winiarska K., 2006, p. 261). According to the Public Finance Act,

institutions of this sector were obliged to ensure that the internal audit unit has

organizational autonomy through direct subordination to the head of the organization

in which this unit operates. Internal audit activities, in accordance with the Public

Finance Act, are coordinated by an internal auditor employed by the head of the

institution (Art. 277, 280). Subordination of business in this area is shown in Figure 4.

Figure 4. Organizational subordination of internal audit in public sector

organizations

Internal Audit

Unit

Internal auditors

Head of organization

The chief audit executive

Tasks of the Audit Coordinator

(Source: Authors' research)

The organizational structure presented in the figure should operate in any public

sector institution. In fact, the organization and place of internal audit and the internal

auditor in the organizational structure of units is varied. This mainly concerns the

subordination of the internal audit unit and the subordination of the internal auditor.

An analysis of data collected in Poland by the Audit Department of Public Finance

Sector, Ministry of Finance shows that (Kubik A., 2005, No. 1, p. 35):

� single positions of internal auditor is mostly created,

~ 123 ~

other people called

Assistants Internal Audit


� there are cases of mergers of units or positions of the internal audit with

internal control unit or another (the overwhelming trend in this area is in units

of local government).

IIA Standards raise questions related to the organization of internal audit, as well as

the tasks performed by internal auditors. According to them, the internal audit unit,

precisely the chief audit executive should be on the level of the organization which

will give him/her the organizational and functional independence in performing their

audit activity (Kubik A., 2005, p. 6). According to the Institute of IIA the chief audit

executive should report directly to a functional internal audit committee or its board.

For administrative purposes, however, the chief audit executive should report directly

to the President or the Director of the organization (Gleim I.N., 2004, p. 38). IIA

Institute in its Standards emphasizes a need to establish the committee and council

audit which they believe should be composed of people independent of the

management unit and whose responsibility is to assist internal auditors in carrying out

their duties independently and objectively. Standards indicate the position of the chief

audit executive in the organizational structure but do not designate the place for other

internal auditors. As a result of above mentioned managers are given the freedom to

shape the function of the audit. One should be remember though that each institution

is different, has its own regulations and organizational structure. The Standards are

meant to provide guidance and assistance in the era of internal audit organization but

do not impose a ready and unambiguous solution.

Another important issue is the number of internal auditors working in institutions of

the public finance sector. Some organizations employ from 1 to 5 or even 20 auditors

and other auditors work half or quarter-time. There are no guidelines to regulate this

issue. On the other hand, if such guidelines were to occur, it is worth considering their

content. According to E.J. Saunders, there are no established standards for the

construction, organization of internal audit and the number of people that should be

employed in it. This decision may be taken based on the assessment of the

organization, its structure and specificity of function. Number of employed internal

auditors should reflect the needs and development of an institution. The above cited

author recommends that their number in the unit should account for 2% of the

employees in the organization (Saunders E.J., 2003, p. 47). However, the quality of

the human factor should be considered there because, as K. Czerwinski points out,

employing even a large number of internal auditors in the organization will not

compensate for the lack of experienced people in the field of internal auditing, which

may lead to limiting the scope of audit work (Czerwinski K., 2004, p. 32). It should be

also noted that each institution operates in a changing environment and, therefore, an

internal audit of the unit must keep pace with these changes, and even overtake them

(See E.J. Saunders, p. 47).

Without questioning any of the listed solutions for the internal audit organization it

should be emphasized that while creating the internal audit unit one should take into

account the needs resulting from the necessity to ensure the supervision and control

over the functioning of the institution. This unit should be adjusted to the size,

structure and needs of individuals and consist of highly qualified people to ensure a

variety of performed tasks (Czerwinski K., 2004, p. 24). The main objective

underlying the introduction of internal audit in any institution should be to strive for

high quality of its operations by streamlining management processes, to stimulate

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continuous quality improvement by supporting the activities of the management,

including increased efficiency of the internal control system, reducing operating costs

and the elimination of waste of financial resources (Chojna-Duch E., p. 61).

4. AUDIT – STILL INTERNAL OR ALREADY EXTERNAL –

ORGANIZATIONS OF PUBLIC FINANCE SECTOR OBLIGED

AND EMPOWERED TO CONDUCT INTERNAL AUDIT

The obligation to conduct an internal audit from the moment of its existence in the

Polish sector of public finances concerned most of the institutions belonging to this

sector. These included in particular: the ministries, central offices, regional offices,

customs offices, tax offices, earmarked funds, health insurance. Other organization

obliged to conduct internal audit were public sector organizations that gather

substantial public money or make a considerable expense. On this basis, the Minister

of Finance defined the amounts of revenue and expenditure which, if exceeded during

the year, shall be subject to internal audit (This amount was 40 000 000). In 2005,

when the Public Finance Act was amended, the list of public organizations obliged to

conduct an internal audit was extended and included: Treasury of the Chamber,

Chamber of Customs, prosecution, or regional audit chambers. The number of entities

obliged to conduct audit increased from year to year, as shown in Table 3.

Table 3. The number of public sector entities obligated to conduct internal audit

and internal auditor jobs

Number of public sector

entities, including:

- number of units of a

central government

Year The obligation to conduct

internal auditor

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Obligation to employ

an internal auditor

2002 1600 No information

2003 1600 No information

2004 2200 No information

2005 2200 No information

2006 2400 No information

2007 2557 1269

2008 2643 1358

2009 2751 1455

2006 1300 577

2007 1936 648

2008 1959 674

2009 1975 690

- number of units of local 2006 1100 No information

government

2007 621 621

2008 684 684

2009 776 776

(Source: Authors' research based on reports of the Ministry of Finance, Internal Audit in the

public sector in 2006-2009)

In 2009 the legislature modified the list of public sector entities obliged to conduct

internal audit and their number decreased. Currently, they are such units as: the Prime

Minister's Office, ministries, provincial offices, chambers of Customs and Revenue,

Department of Social Insurance, the Agricultural Social Insurance and National

Health Fund. Individuals (art. 272, Act of 27 August 2009), such as: state budgetary

units, public universities, independent public health care, executive agencies, state-


appropriated funds and local government units are required to conduct an internal

audit when a certain amount of income or expenditure is exceeded. In the remaining

institutions internal audit can be conducted if the head of this organization has the

will, or when it is imposed by the responsible minister.

According to the European guidelines (Agenda 2000), mentioned at the beginning of

the article, the concept of public internal financial control is associated with the

provision of "an independent internal audit, acting in all the public institutions by

law". It should therefore be considered whether the legislative requirement should

differentiate internal audit units in the Polish public sector due to the amount of

revenues or expenditures made. So should the financial aspect be the factor

determining the proper and effective functioning of public institutions? On the one

hand, internal auditing in Poland is developing through the implementation of

international standards and change of policies, on the other hand it always remains in

the area of financial control, by limiting the directory of units required to conduct the

audit using a single criterion - the amount of revenue or expenditure.

Another key issue in the field of auditing in public finance sector organizations is the

obligation to employ an internal auditor. Until 2009, each public sector entity obliged

to conduct an internal audit was required to hire an internal auditor. According to

current legislation some institutions are given the choice between the internal audit

being conducted by an employed internal auditor or by an auditor working for several

organization. This alternative results in public organizations using external audit.

External service provider may be either a natural or legal person who must meet

certain requirements imposed by law on public finance. These include in particular:

• the need to meet eligibility requirements governing the profession of internal

auditor in the public finance sector,

• the obligation to conduct an audit under the provisions of the Public Finance

Act and its implementing legislation.

When an organization decides to use the services of an external audit it is required to

sign a contract for at least a year. The possibility of using external service is accepted

by the responsible minister. The local government organizations can use external

audit services only if the amount of income and the amount of revenues and expenses

and expenditures is less than 100 000 000.

From an organizational point of view of internal audit, one should also mention the

protection of people employed as auditors in the public finance sector. In 2002-2005,

the body authorised to terminate the contract with an internal auditor or to change

conditions of contract was the Chief Inspector of Internal Audit. After the liquidation

of the position of Chief Internal Auditor the responsibilities were taken over by

Minister of Finance. In 2009, the amended Finance Act retained the entry defining

employment and change of working conditions of the internal auditor, but limited the

circle of auditors, only to chiefs audit executives.

5. LICENCE TO PRACTICE AS AN INTERNAL AUDITOR

Since 2002, namely the emergence of internal audit in the Polish law, the internal

auditor could be anyone who (Art. 35k, Act of 26 November 1998 ) :

• has the Polish citizenship (January 2006),

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• has full legal capacity and makes full use of public rights,

• has not been penalized,

• has a higher education,

• passed the test organized by the Examination Commission.

These conditions gave, on the one hand, the possibility of applying for internal

auditing to a large numbers of Polish citizens, on the other hand imposed an

obligation to pass a state exam. The legislature, taking into account the impossibility

of finding suitably qualified auditors, in the first phase of the internal audit activity in

Poland, introduced a so-called transitional period. The period meant that anyone who

wanted could be employed in the internal audit but the guarantee of employment was

obtain only after passing the state exam by the end of 2004 year.

The examination was held by a specially appointed Examination Committee, which

began functioning to 2003 and finished its activity in 2006. It consisted of two parts,

written and spoken and its requirements were clearly defined by law. As a result of it

the right to work in internal audit in the public finance sector was gained by 2,181

people. It is noted that the period between 2003-2006 was the moment when

significant financial resources, including the EU, were involved, internal Audit in the

Polish public sector developed and qualification of auditor were substantially

improved.

In 2006 numerous changes in access to the profession of public sector auditor were

introduced. The idea of state exam was abandoned but people who previously passed

the state exam preserved their rights. Promotion, however, was given to people who

(art. 58 Act of 30 June 2005):

• completed controller application and passed an exam conducted by the

Examining Board appointed by the President of the Supreme Chamber of

Control,

• passed an exam qualifying for the post of inspector of fiscal control,

• were certified accounting auditors.

These alterations resulted in changing number of auditors employed in the public

finance sector, which is presented in Table 4.

Table 4. Number of auditors working in the public finance sector required

to maintain an internal audit

Year Audited units (approximately) Number of people employed in Internal Auditing

Total Internal auditors Auxiliary

2004 2200 663 415 118

2005 2200 709 537 137

2006 2400 1054 859 107

2007 2550 980 742 67

2008 2640 972 821 123

2009 2751 918 800 118

(Source: Authors' research based on reports of the Ministry of Finance, Internal Audit in the

public sector in 2006-2009)

The results presented in the table show a significant increase in the number of internal

auditors by the end of 2006, an average of more than 200 people a year. Since 2007

the decreasing trend can be observed, while the number of staff employed in the

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sections of the internal audit units of public sector finance increased at fairly rapid

pace.

Finally, in 2009, another modification in acquiring audit rights was introduced. As a

result, the Supreme Chamber of Control controllers and fiscal control inspectors were

deprived of the right to work as internal auditors and the right to work in this

profession was given to whose who have obtained a post-graduate diploma in internal

auditing and have a two-year practice. The legislator defined the practice in internal

audit as: conducting audit, performing control activity in the area of UE funds by tax

inspectors and supervising and performing inspection activities by the auditors of the

Supreme Chamber of Control. The legislator did not, however, define the scope of

law which should be included in the programme of postgraduate studies in this area,

but pointed out that units entitled to issue diplomas were the ones with the right to

award the degree Ph.D. in economics or law.

It is difficult to assess the impact of these changes on the profession of internal

auditor, and the functioning of public sector entities. There is currently no available

data on the number of auditors employed in these institutions, or providing services to

them in 2010. However, taking into account the provisions and requirements of laws,

and thus the possibility of resigning from audit given to selected units, one can expect

a further decline in these numbers. However, taking into consideration changes in the

qualifications for the job of internal auditor - post-graduate studies in the field of

internal auditing, you can count on a significant increase in the number of people

interested in gaining permission to perform the profession. But will the public sector

respond to this interest with proper supply, will there be the managers of public

entities who will want to hire an auditor, or use such services.

6. EVALUATION AS A DETERMINANT OF THE DIRECTION

OF INTERNAL AUDIT DEVELOPMENT IN POLISH PUBLIC FINANCE

SECTOR

Changes in the economy necessitate the continued improvement of public

organizations and more efficient management of public funds. Depending on the

modification of rules for the functioning of public sector entities and the activities of

these organizations the nature and extent of services provided by auditors is also

subject to transformation. In order to assess the activities undertaken by public

organizations, thereby improving their performance evaluation process is used. It

involves a systematic examination of the value or characteristics of a particular

program, project, activity, subject to the usual criteria, the purpose of its improvement

and development (A. Haber, M. Szalaj, 2009).

The amended Public Finance Act of 2009 contains a number of conditions designed to

be introduce to the Polish public sector evaluation (A. Haber, M. Szalaj, 2009). One

of them is to modify the tasks assigned to internal audit. As mentioned earlier, the role

of internal audit since 2009, has been to assess the adequacy, efficiency and

effectiveness of management control in the public finance sector. These tasks are

associated with the implementation of a series of steps intended to measure the effects

of these institutions. They are defined in the literature as efficiency audit (called also

value for money audit). Its primary purpose is to focus on efficiency, effectiveness

and economy of operation of Polish public organizations. It uses a series of indicators

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and metrics to measure efficiency. From the perspective of the scope of internal audit

work in Poland it is certainly a significant progress. Internal audit, since its

introduction in the public finance sector, focused primarily on assessing the

compatibility of the organization with the applicable rules, guidelines, particularly

with regard to the financial area. Now its task is to verify the effectiveness and

efficiency of all processes in the organization. Taking into account the development

trends of internal audit in Poland, we can define its various forms, which have

appeared in Poland since its introduction to public finance sector. They are presented

in Table 5.

Table 5. Formation of various types of audits in the Polish public finances

Year Type of audit Description

2002 Financial audit Internal audit checks the functioning of transactions and financial

procedures. It included the verification of the accounting operations and

aimed at reviewing and highlighting errors, as well as evaluation of internal

regulations in this regard.

2005 Compliance audit Internal audit assess that the organization activity is adhering to law,

regulations and control standards and other guidelines

2006 Operational audit This type of audit falls within the category of services to facilitate the

management unit by evaluating four management functions: planning,

organizing, controlling and monitoring. The purpose of its conduct is to

answer the question why the problem exists and what is its cause.

2009 Efficiency audit

Value for money audit

Internal audit assess the adequacy, efficiency and effectiveness of

functioning of the public organizations.

(Source: Authors' research)

Using various types of audits by the internal auditors of the Polish sector of public

finances was dictated by the changes which occurred in the organization of this sector.

The public sector since the 80's of the last century has undergone a metamorphosis,

from the bureaucratic form defined by Weber in the direction of effective, efficient

and pro-quality systems. Following these changes, transformations are also subject to

internal audit role. The emergence of performance-audit related to the implementation

of performance budgeting in the public finance sector, whose idea is to improve

expenditure management in the public sector (More, Lubińska T., 2007, pp. 32-45 ) . In

the implementation of performance budgeting, it is necessary to appoint suitably

defined and hierarchical objectives for the collection and disbursement of public funds

and the identification of specific outcomes and indicators for their verification.

Budgeting allows you to determine which tasks are most important for achieving the

specific targets and using indicators shows the extent to which they were completed

(Bombik P.K., 2006, No. 437, p. 476). Similar basis governs the methodology used in

the implementation of the efficiency audit. Due to the constant changes taking place in

public finance sector, you can expect that the tasks and role of internal audit will be

subject to further change, so as to provide reasonable assurance on the functioning of

the institutions of this sector.

CONCLUSION

Internal Audit in the Polish sector of public finances appeared in the twenty-first

century, in the world it has a centuries-old tradition (Peemöller V.H., Kunowski S.,

1997, nr 27, Fach 28, s. 1264). It has gone a long way in shaping its position on the

international area. The evolution of internal audit in Poland and the world is presented

in Table 6.

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Table 6. Development of Internal Audit in the Polish sector of public finances

and the world

The development of internal audit in the world Development of Internal Audit in the Polish public

finances

1950

Control of the accounting records

1960 Control of the accounting records and

compliance with the basic operation

procedures

1970

Analysis of existing procedures

1980 Evaluation of existing procedures

concerning introduction of additional

control

2000

2001

2002

Evaluation of internal control and

reporting on its state managers.

Evaluation of risk management

Reducing risks and improving risk

management system

2002

~ 130 ~

Examination of accounting documents and

records in their accounts.

Evaluation system for the collection of

public funds and their availability and

management of the property.

2003

Assessment of compliance with applicable

procedures.

Evaluation of the effectiveness and

Add value 2005

economy of activities undertaken in the

field of management and control systems

and the reliability of financial statements.

Improving

organization.

the functioning of the

2006/2007 ??? 2009/2010 Add value.

Evaluation of the adequacy, efficiency and

effectiveness of management control

system.

(Source: Authors' research based on the K.H. Spencer Pickett, The Internal Auditor at Work:

A Practical Guide to Everyday Challenges, John Wiley & Sons, Inc.., Hoboken, New Jersey,

2004, p. 11, Winiarska K., 2008, p. 7).

Based on the information provided, we can conclude that the evolution of internal

auditing in Poland is progressing from the implementation of strict financial

functions, to evaluation of operations of the institutions, which assist managers in

managing the unit. This progress is reflected in the public sector very clearly, where

the definition of internal audit and the scope of services provided by it has changed

over 8 years in a significant way, starting from the evaluation of financial operations

through the assessment of compliance of public sector entities, until the assessment of

the effectiveness and efficiency of the institution. The evolution of internal auditing in

Poland took place in a similar way as in the world, however, started much later and

proceeded faster. The experience which the Polish sector of public finances has drawn

from the development trend of the audit in the world had significant impact.


Currently, internal audit is becoming an increasingly useful tool for the Polish sector

of the public finances units, it is not only used to gather information, but it evolves

towards the provision of ready-made applications and management arrangements,

which may result in increased efficiency of the organization. Given this rapid process

of change which is subjected to public entities in Poland, as well as having a

progressive pace of change in the world it is difficult to indicate what will be the next

stage of development of internal audit, both in Poland and abroad.

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~ 132 ~


BOUNDRIES REGARDING THE IMPLEMENTATION

OF THE NATIONAL STRATEGY FOR THE FINANCIAL

REPORTING OF THE PRIVATE SECTOR ENTITIES

Ramona LAPTES 1

Transylvania University of Brasov, Romania

Adriana Florina POPA

Bucharest Academy of Economic Studies, Romania

ABSTRACT

In the early 2000, the Romanian accounting entered in a new stage of reform, built in

connection to the international realities. In 2004, in Romania, the authorities have initiated a

national strategy to improve the financial reporting, considered to be a true catalyst for

developing a sustainable economy. The present demonstrates that the national strategy for

improving the financial reporting of the private economic entities, mostly based on the

elaboration of the individual annual financial statements of the public entities according to

the IFRS referential, has encountered some difficulties in the complex process of

implementation. The identification and the analysis of the difficulties, but also the highlight of

the progress of implementing the national strategy for improving the financial reporting of

the private sector entities, are the main objectives of this study.

KEYWORDS: accounting, financial reporting, Romania, national strategy, IFRS,

conformity

INTRODUCTION

It is a currently known fact that the world economy is shifting from a model built on

interdependent national economies to a model represented by a network of

multinational companies that operate globally. This economic climate imposed

reconsiderations and reorientations in the accounting area. In the late '90s, the general

trend in the accounting field was to reach the goal of standardization and

harmonization of the national accounting systems. The harmonization process didn’t

have the expected outcome and, in the recent years, internationally, there is a retreat

towards the national convergence (Lapteş, 2007).

The accounting evolved nowadays to another level of knowledge, a process caused by

the profound changes that took place in the economic field, under the inertia of the

globalization and the internationalization of the economies. The accounting experts

called the recent dynamic of the accounting as accounting postmodernism.

In Romania, the accounting postmodernism was described by professor Ionaşcu and

several meanings are reserved to it (Ionaşcu, 2003):

1 Correspondence address: Ramona LAPTEŞ, Transylvania University of Brasov,

Faculty of Economic Sciences and Business Administration, Romania; email address:

ramonalaptes@hotmail.com

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� The accounting theoreticians attempt to find answers to the current phenomena

(the globalization of the economies, the continuous deregulations of the markets,

the steady development of the consumer society and of the information society),

which raises issues in the business administration;

� The postmodernist society is seen in a continuous transformation that requires a

multidisciplinary approach to the economic management of the entity, a mix of

economics, sociology, philosophy and law;

� The accounting postmodernist researches, started in UK after 1980, and taken

over by the French specialists, are, in the vision of professor Ionascu, those

considered to be post –constructivist, the interpretative ones and the critical

radical current.

The accounting research oriented towards postmodernism show interest primarily in

the accounting language and the accounting information meaning, as a way of social

communication.

In this context, in 2002, IASB and FASB signed a memorandum and agreed to

complete a project named „The International Short Term Convergence”, with the

main goal of eliminating a series of differences between the IAS and the US GAAP

referentials, until the end of 2005. After that date, a second step was set, reflected in a

common project called „Draft of Common Checking of the International

Convergence” (Ristea et al., 2006).

Contrary to the normalization efforts of the two bodies, the convergence of the US

GAAP / IAS is not a simple process, primarily due to the disagreement regarding the

sphere of the influence between the two accounting referentials. If the US GAAP are

required to the companies seeking for funding from the U.S. capital markets, the IFRS

accounting referential is recommended to the companies seeking to be listed on the

international capital markets. Therefore, the IAS/IFRS referential is intended to cover

a larger area and it refers to companies with different structures (Lapteş, 2007).

Fully aware of this advantage of the IFRS referential, on 17 th of November 2007, the

SEC publicly announced that it recognizes, starting from the financial year 2007, the

financial statements of the foreign entities in accordance with the IFRS without prior

reconciliation to the U.S. GAAP. In this regard, Sarah Johnson made the following

affirmation in 2008: “Goodbye GAAP - It's time to start preparing for the arrival of

the international accounting standards” (Dumitrana et al., 2010).

At the European Union level, the process of the IAS/IFRS referential implementation

started on the 1st of January 2004, when two periods were identified (Ristea et al.,

2006):

� the interval between the 1st of January 2004 and the 31st of December 2004

represented the transition period, the period of the restatement of the financial

statements or the comparative period;

� the interval between the 1st of January 2005and the 31st of December 2005

represented the period of actual appliance or the period of the elaboration of the

first financial statements according to the IFRS referential.

Basically, at the European level, according to the Regulation 1606/2002 on the

application of the international accounting standards, known as “the IAS Regulation”,

starting the 1st of January 2005, all the companies listed on EU capital markets,

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including the credit institutions and the insurance companies, were required to publish

the consolidated financial statements under the IFRS. This approach led to the

development of two accounting systems in the European Union countries,

simultaneously applicable: an accounting system based on the IFRS and another one

based on the national GAAP. The member states chose the conformity with the IFRS,

both for the individual financial statements of the listed companies and for the

consolidated and individual financial statements of the unlisted companies. Therefore,

starting on the 1st of January 2005, 7000 listed European groups gave up the national

accounting regulations in favor of the appliance of the international financial reporting

standards (Ristea et al., 2010).

FEE (Federation of European Accountants) believes that countries and markets are

best served by high quality financial information and that this is best delivered by a

single independent global standard setter for accounting and corporate reporting. In

April 2009, the G20 (the Group of Twenty) called on the world’s accounting standard

setters to continue to work towards a single set of high-quality global financial

reporting standards. FFE believes that the G20 should urge the IASB to use all

existing high quality accounting standard setting expertise from around the world,

including those within FASB and EFRAG (the European Financial Reporting

Advisory Group), to work together on new global solutions in those areas that really

matter to investors (FEE, 2009).

Inside the European Union, the discrepancies signaled between the accounting

directives and the IFRS referential led to the necessity to adopt the Modernization

Directive 51/2003. This directive offered to the companies that organize their

accounting according to the European directives the possibility of appealing to the

IAS/IFRS accounting options. The directive amended the European directives

regarding the content of the annual statements, the balance sheet and the income

statement disclosure, the valuation rules, the issue of the provisions, the structure of

the audit report, the content of the annual report and others (Ristea et al., 2006).

Which is, though, the situation of the implementation of the IFRS referential in

Romania?

In Romania, the state authorities believe that the improvement of the financial

reporting in our country in the next period should have its pillars on the extension of

the IFRS referential. Therefore, in 2004, by the adoption of the Government Decision

no. 2170/2004, the Romanian Government approved the National Strategy Action

Plan in order to improve the financial reporting in Romania. This country action plan

includes the objectives regarding the development of the business environment,

arising from the program of measures agreed by the Romanian Government and the

International Bank for Reconstruction and Development, underlying the Loan

Agreement for programmatic adjustment (PAL), signed at Bucharest on 27 th of

September 2004.

The monitoring of the implementation of the Country Action Plan in order to improve

the Romanian financial reporting was initially the attribution of the Accounting

Advisory Board, which was organized and operated under the Government Decision

no. 1449/2002.

~ 135 ~


The Accounting Advisory Board, by the Ministry of Finance, informed the Romanian

Government on a quarterly basis about the progress made in achieving the objectives

of the Country Action Plan. In 2005, by Government Decision no 401/2005, the

Accounting Advisory Board was reorganized into the Accounting and Financial

Reporting Council (CCRF), an independent supervisory body, with attributions in the

insurance of the convergence of the national regulations and practices in the financial

accounting and auditing with the European Union regulations.

The Romanian Accounting Group (GRC), consisting of experts on accounting issues,

was set up inside the CCRF, in order to provide support, consulting, training and

informing services, in order to ensure the implementation of effective and efficient

processes used in the translation of the IFRS and the related materials, and to provide

a source for the development and the timely implementation of the IFRS in Romania.

The increase in the quality of the financial reports is considered a key component of

the sustainable economic development in Romania. This requirement has become, in

the last decades, the main priority for many countries and it presently represents the

subject of significant reforms in the field.

The quality of the financial reports, directly involving the accounting and auditing

standards, as a legal and institutional framework for implementing them, is an end in

itself. The ultimate goal is to bring added value to the financial reporting system in

order to support the stability of the financial system and the economic growth in the

private sector.

As part of the reform, from the end of 2002 until February 2003, the World Bank

experts conducted an assessment of the existing standards and practices related to the

accounting and the financial audit of the financial statements, in order to identify the

necessary reforms for improving the financial reporting by the private sector. The

recommendations from this evaluation were included in the Report on the Observance

of Standards and Codes (ROSC) adopted on the 9 th of May 2003.

The present shows that the initiative of bringing the national accounting regulations as

close as possible to the international financial reporting standards had no success. The

Order no. 907/2003 (amended by the Order no. 2001/2006) on the application of the

International Financial Reporting Standards require that the economic entities, listed

on a regulated market, which elaborate consolidated financial statements, have to

apply the international financial reporting standards starting 2007. The other

economic entities, considered of public interest, can apply the international financial

reporting standards in the elaboration of the individual or the consolidated financial

statements for their own information needs. However, in the relation with the state, all

the entities, including those applying the international financial reporting standards,

have to prepare the annual financial statements in accordance with the European

directives (Jianu et al., 2009).

1. RESEARCH METHODOLOGY

In the recent years, in Romania, the accounting of the economic entities has been

frequently reconsidered and submitted to a comprehensive reform process, initiated in

the early 2000. In 2004, the Romanian Government approved the National Strategy

for the Action Plan implementation, in order to improve the financial reporting.

~ 136 ~


What are the coordinates of this national strategy? What is present stage of the

National Strategy for improving the financial reporting in Romania? What are the

limits of applying the international financial reporting standards by the Romanian

economic entities? These are several questions that we intend to answer to in this

paper. In order to achieve this goal, we conducted a normative type of research, which

allowed us to identify and analyze the key issues of the National Strategy for

improving the financial reporting of the economic entities operating in the private

sector.

2. BOUNDARIES OF THE NATIONAL STRATEGY FOR IMPROVING

THE FINANCIAL REPORTING

The accession process to the European Union provided to the Romanian Government

a conceptual framework for the reform of the accounting, the financial auditing and

the financial reporting, represented by the community acquis. The acquis includes:

primary legislation (treaties), secondary legislation (directives, regulations, decisions,

recommendations, etc) and case studies.

The Accounting Advisory Board (CCC), which operated under the Ministry of

Finance and brought together representatives of the government, the regulatory

authorities, the accounting and auditing professions, the business environment and the

academics who showed interest in the financial reporting issues, was appointed to

develop a country action plan in order to improve the financial reporting in Romania.

The Council's activity aimed to increase the confidence of the users of accounting

information in the financial reporting and the corporate governance.

According to the GD no. 2170/2004, the country action plan to improve the financial

reporting in Romania is a detailed document which sets out the specific actions to be

completed in order to achieve the reform objectives.

This plan is a dynamic document, because it is based on the community acquis, which

is constantly evolving, and because Romania will change its ability to adopt and carry

out the reform as the objectives will be achieved.

In April 2004, the Accounting Advisory Board, with the World Bank’s assistance,

started to develop the Country Action Plan with the strategic goal “The fulfillment of

the major accounting and auditing obligations, arising from the community acquis

prior to 2007 - the accession date”.

Several alternative policies were identified in the Country Action Plan, including:

• establishing a program to introduce the International Financial Reporting

Standards (IFRS), according to the implementation capacity;

• a detailed definition of the public interest of the entities;

• selecting the most appropriate model for setting up an independent oversight

body of the audit and the accounting field, as a whole;

• the development of the professional training and the higher economic

education integration in the training programs reform.

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After the first stage of implementing the Country Action Plan, which ended in

September 2005, the Financial Reporting Council has concluded that the areas of

interest are:

• the insurance of the accounting and auditing Romanian legislation compliance

with the community acquis;

• the implementation of the IFRS and the International Standards of Audit (ISA)

at the public interest entities, for the financial year ended at 31 st of December

2006;

• the improvement of the operational capacity of regulatory bodies;

• the improvement of the oversight of the accounting and auditing professions,

the corporate governance and the public transparency, as outlined in the

community acquis, both at legislative level, as well as at the best practices in

the European Union level.

The implementation of the Country Action Plan implies a mix of short and medium

term projects.

According to the GD no. 2170/2004, the short-term objectives are:

• setting up the Steering Committee for the implementation of the Country

Action Plan;

• the amendment of the primary and secondary legislation;

• improving the organization of the Accounting Advisory Board and the

operational capacity of regulatory institutions: MFP (Ministry of Finances),

BNR (National Romanian Bank), CNVM (Romanian National Securities

Commission) and CSA (Insurance Supervisory Commission);

• the continuous improvement of the professional training;

• the assessment of the ways to enhance the quality and the credibility of the

financial audit.

The long-term objectives are:

• the compliance of the Romanian legislation with the accounting law based on

the IFRS and the European directives;

• the completion of the secondary legislation for the capital market;

• launching the implementation process to ensure an improved public

transparency of the financial statements of the listed companies and other

public interest entities;

• improving the organization and the development of the best practices for the

professional bodies in the accounting and financial audit field.

The IFRS adoption determines a major change in the accounting language for the

public interest entities, as well as for the accounting consultants, the auditors and the

analysts in the financial accounting field. Moreover, this approach, which is a major

national one, will determine additional responsibilities for all the regulatory bodies.

The transition to the IFRS is not exclusively regarding the accounting field, but it has

much wider implications - from the basic activity planning to the strategic

management of the business entities. The adoption of IFRS requires the following

(CSA, 2006):

• a new performance appraisal system;

~ 138 ~


• improving the quality of information for management in order to adopt the

most appropriate decision;

• increasing the competitiveness;

• changing the whole basis of reporting.

For the investors, the implementation of the IFRS referential will lead to the increase

of the credibility of the information submitted by the companies, a better

understanding of the risks and benefits and to the comparability of the results

achieved by the companies activating in the same domain.

In the transition to the IFRS, Romania joined the pilot group of countries that carry

out the ROSC program for accounting and auditing. The ROSC program and its

component for accounting and audit are a part of the initiative to strengthen the

international financial architecture. The current international economic context, under

the sign of the global economic crisis, demonstrates the understatement of the

importance of the pillar represented by the accounting and auditing standards.

For Romania, the World Bank experts have made an initial assessment of the existing

regulations and practices in the accounting and financial audit, in 2003, and the

findings were presented in the ROSC report on accounting and auditing, published in

May 2003. At that time, Romania's progress in accounting in the recent years was

highlighted and a number of basic policy recommendations were formulated,

including: the harmonization of the laws and standards; the financial reporting of the

credit institutions, the insurance companies and the pension funds; the consolidated

financial statements disclosure; the accounting and auditing surveillance; the Chamber

of Financial Auditors of Romania (CAFR) independence; a twinning agreement for

CAFR to help the transfer of knowledge, education and professional training (World

Bank, 2003).

In 2003, the strategic objective of the Country Action Plan for improving the financial

reporting in Romania was the "Fulfillment of the major accounting and auditing

obligations, arising from the community acquis before 2007 - the accession date". In

order to achieve this goal, five basic objectives were formulated in the action plan, as

follows:

• the compliance of the Romanian legislation in the field of accounting and

auditing with the community acquis;

• the implementation of the IFRS and ISA for the public interest entities (PIE)

from the 1st of January 2006;

• the improvement of the operational capacity of the insurance regulatory body

(CSA);

• improving the operational capacity of the regulatory body of the capital market

(CNVM);

• the improvement of the surveillance, the corporate governance and the public

transparency.

Although, in the recent years, Romania has made significant progresses in increasing

the quality of the financial reporting by implementing the National strategy for

improving the financial reporting of the private economic entities, in the ROSC report

on accounting and auditing, published by the World Bank experts in December 2008,

some issues to be corrected in the future were identified.

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3. CURRENT PROBLEMS OF THE NATIONAL STRATEGY

FOR IMPROVING THE FINANCIAL REPORTING OF THE PRIVATE

SECTOR ENTITIES

As noted, one of the goals of the National Strategy for improving the financial

reporting refers to the compliance of the Romanian accounting with the applicable

European Union regulations.

At the EU level, by the Regulation no. 1606/2002 (the so-called IFRS Regulation), the

mandatory IFRS application for the elaboration of the consolidated financial

statements by the listed companies was agreed only for those IFRS approved at the

Community level, by the European Commission's regulations, starting the 1 st of

January 2005. The Member States had the option of extending the scope of

application of the IFRS for other categories of companies, and for the individual

financial statements.

In what follows, we intend to present the sticking points, actual and potential, of the

National Strategy for improving the financial reporting of the private economic

entities, as identified by the representatives of the World Bank and the International

Monetary Fund in the ROSC report on accounting and auditing, published in

December 2008 (World Bank, 2008):

� the process of setting the accounting regulations in Romania is supervised by the

Ministry of Finances, which issues the accounting regulations for the Romanian

trade sector. The main accounting rules are discussed in the Accounting and

Financial Reporting Council (CCRF), which brings together the key monitoring

bodies and the stakeholders interested in the Romanian financial and regulating

system. CCRF is chaired by the Ministry of Finances and includes

representatives from: BNR, CNVM, CSA, CSSPP (Private Pension System

Supervisory Commission), the Ministry of Justice, CAFR, CECCAR (The Body

of Expert and Licensed Accountants of Romania), academics and professional

associations for the commercial sector. However, CCRF doesn’t bring together

representatives of the banking and insurance sector, any of those who elaborate

or use the financial statements or the technical staff of the member firms of the

international audit networks;

� compared to the Ministry Order no. 94/2001, Accounting regulations

harmonized with the European directives and the International Accounting

Standards, the explicit reference to the IFRS referential was removed from the

Ministry Order no. 3055/2009, Accounting regulations in accordance with the

EU directives. The absence of an explicit reference to the IFRS, when the

Romanian Accounting Regulations don’t provide detailed guidance, is seen by

the accounting and auditing professions and by those who prepare the financial

statements as a problem. According to the Ministry Order no. 94/2001, the

IAS/IFRS referential was applied when no other specific treatment was

indicated. In the content of the Ministry Order no 3055/2009, there is no explicit

reference to the IFRS.

� if the banks and the listed companies prepare consolidated financial statements

according the IFRS approved by the European Commission, the banks and the

listed companies without subsidiaries are not required to prepare financial

statements in accordance with the approved IFRS. This reality leads to a

potential lack of comparability between the listed entities and the banks: while

~ 140 ~


the parent companies prepare the consolidated financial statements according to

the IFRS, other banks and listed companies without subsidiaries prepare the

financial statements according to the Romanian accounting regulations;

� according to the Accounting law no 82/1991, the insurance companies prepare

the consolidated financial statements using either the approved IFRS or the

Romanian accounting regulations in the insurance sector, which is a

transposition of the Insurance Accounts Directive. For 2006, the Romanian

insurance companies didn’t prepare the consolidated financial statements in

accordance with the IFRS. The CSA should require all the insurance companies

to publish their financial statements prepared in accordance with the approved

IFRS, because they are public interest entities. Moreover, the CSA should allow

the insurance companies to supplement the provisions of the IFRS 4 Insurance

Contracts with other accounting standards. Currently, the IFRS 4 Insurance

Contracts is incomplete and some insurance companies include provisions of

U.S. GAAP in their accounting policies, to the extent they are consistent with

the IFRS 4;

� the Emergency Ordinance no. 90/2008 on the statutory audit introduced a

system of public oversight by the establishment of the Public Oversight Board

of the Statutory Audit Activity (CSPAAS), which will have to undertake

external quality assurance for the statutory auditors and the audit firms that audit

public interest entities;

� although the CECCAR and CAFR professional bodies have changed in the

recent years the governing principles, the agreements and the governance

practices, they are not fully understood or known. Therefore, an independent

person should conduct a review of the governance arrangements of both

professional bodies;

� particular attention should be paid to the program of quality assurance and

review, initiated by CAFR in 2003: the department of monitoring and

professional competence activates with 7 hired persons (5 inspectors and 2

assistant inspectors) under the responsibility of an authorized inspector. The

inspectors were intensively trained on the IFRS and ISA issues by experts from

the Institute of Chartered Accountants of Scotland (ICAS). However, the work

quality reviews take, on average, only one or two days and are conducted by

inspectors who don’t have significant experience in auditing. Two of the

inspectors are students of ACCA (Association of Chartered Certified

Accountants) and the other five are qualified financial auditors. Although the

inspectors from the CAFR monitoring department have received adequate

training, their minimal professional experience as auditors, is a shortcoming that

can’t be neglected. The lack of practical experience in auditing could affect their

ability to review the audit working papers, especially when reviewing the audit

working papers for banks or insurance companies. One solution would be to

include auditors with experience in these areas in the monitoring teams, on an ad

hoc basis. Furthermore, the average time allocated to the review and quality

assurance activities in the field of the financial audit varies from one to two

days. The period of time for the individual controls must be extended

significantly for a better quality review of the audit work performed by the

auditors. In the coming years, CAFR could consider limiting the frequency of

checking the work of auditors who are not involved in the public interest

entities, to only once every six years, in favor of improving the quality of

reviewing the work of the auditors inside the public interest entities. According

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to the 8th Directive, as amended, the auditors of public interest entities should

be checked at least once at every three years;

� the small number of specialists in accounting and financial audit, as required by

IFRS, is doubled by a lack of skilled graduates in accounting. Traditionally, the

audit firms staff rotation is very high and it often happens that a graduate, who

has only two years of experience within a member firm from an international

network of audit firms, to be offered a manager position in the financial or

accounting department. Therefore, there is a clear need for the Romanian

universities to demonstrate their ability to produce graduates able to meet new

market requirements;

� the consultation process for issuing the accounting and auditing regulations

could be improved. In Romania, there is a lack in terms of implementing an

effective process of consultation with those who prepare the financial

statements, the auditors and the users of financial statements. It is possible that

the consultation process is not efficient as long as the entities feel that their

opinion does not influence the body that regulates and supervises their activity;

� in Romania, both the CAFR and CECCAR independently translated all the ISA

and the IFAC Code of Ethics in the relative context of their own activities. A

single quality translation of the ISA and the IFAC Code of Ethics for Romania

would reduce the confusion about the source and availability of the applicable

standards and would eliminate the differences of terminology that may exist in

the multiple translations. The multiple translations are a waste of resources and

are a good example for the lack of cooperation between the two professional

bodies. In the following period, a real cooperation between CAFR and

CECCAR is needed in order to avoid the multiple translations and to agree on

the terminology used;

� although the auditors are the subject to some civil, disciplinary, administrative

and criminal sanctions, in Romania legal actions against auditors were not

initiated;

� in general, the surveillance bodies focus more on monitoring the prudential

criteria than on the financial reporting, as follows:

• the focus of the monitoring department of the CSA appears to be more on

the prudential requirements than on the financial reporting. No case of

infringement of the financial reporting requirements was communicated or

published;

• the monitoring unit of the CNVM, which reviews the financial statements of

listed companies, include six people who were prepared, particularly on

IFRS, under a project funded by the European Union, in particular IFRS

(Phare 2005 "The strengthening of the institutional capacity of CNVM”).

The monitoring unit began its activity in May 2008 and, among other duties,

it reviews the consolidated financial statements of the listed companies

prepared according to the approved IFRS. The quick implementation of the

knowledge acquired in the EU project, to ensure an effective review of the

financial statements in accordance with the IFRS, challenged to the newly

established unit. Although the penalties stipulated by the securities law

include the civil liability of those who prepare the financial statements, the

directors and the auditors, no action has been reported in court till now. The

Bucharest Stock Exchange reviews the financial statements of the listed

companies to see if they have the complete documentation, but in the

absence of an overall review of the annual reporting, including the financial

~ 142 ~


statements and the audit report, it doesn’t assess the quality of the

information provided by them. Furthermore, the CNVM is required to

monitor and implement the financial reporting of the listed companies. The

CNVM has never asked about the restatement of the financial statements and

has limited only to setting fines for their late filing;

� the Romanian Accounting Regulations provides little or no information about

the matters covered by the following IFRS: IFRS 2, Share-based payment;

IFRS 6, Exploration for and evaluation of mineral resources; IFRS 8, Operating

Segments; IAS 40, Investment Property and IAS 41, Agriculture.

Although Romania has implemented the relevant accounting directives, the absence of

many necessary elements for supporting the infrastructure, combined with the

Romanian tradition of the rules-based accounting, is challenging in terms of ensuring

that the principles set out in EU legislation are applied in a such a manner that the

quality the financial reporting is ensured.

The International Financial Reporting Standards are based on concepts and not on

rules, calling for the professional reasoning of the accountants and the auditors. At the

same time, in obtaining financial information, the emphasis is placed on the

evaluation before the accounting recognition of a transaction, but also on the principle

of materiality and on the cost-benefit ratio. All these requirements were new

approaches to the Romanian accounting since the passage to the international

financial reporting standards, even if a partial one, involved not merely a change in

the accounting rules but a whole process of change at the company’s level (Jianu et

al., 2009).

Studies that have been conducted in Romania in the recent years on the opening of the

economic entities to the accounting based on IFRS show the reluctance of the

majority towards the reform of the financial reporting system in this direction, the

main justification being related to charging the companies with additional costs (costs

of audit, staff training costs, software costs etc).

A study conducted in 2009, shows the reluctance of most professional accountants

involved in the research to the reform of the financial reporting, based on the

philosophy of IFRS: 84.8% of the respondents considered that the harmonization of

the Romanian accounting regulations the IFRS for the large firms during 2000-2005,

was purely dictated by political decision. Only 12.1% of the respondents saw in the

process of harmonization of the Romanian accounting regulations with the IFRS

referential a necessity imposed by the development and the globalization of the capital

markets (Lapteş and Popa, 2009). Regarding the delimitation of an area of application

of the IFRS referential in the Romanian accounting, we find, from the same study, the

following (Lapteş and Popa, 2009):

� 45,4% of the respondents considered that the IFRS referential should be adopted

by all the economic entities;

� 15,1% of the respondents considered that the IFRS referential should be adopted

only by the listed companies, both for the consolidated and the individual

financial statements;

� 15,1% of the respondents considered that the IFRS referential should be adopted

only by the big companies by the public interest entities;

~ 143 ~


� 12,1% of the respondents considered that the IFRS referential should be adopted

only by the entities that want choose so;

� The other respondents consider IFRS referential is useful for the economic

entities that are interested in financing their activity from the international

market.

Another study, done in 2009, in the companies providing accounting and audit

services, referring to the opportunity of the IFRS referential implementation in

relation to the professional accountants level of training in this area, demonstrates that

at the implementation date most of the Romanian accounting professionals didn’t

know this referential, the awareness degree being an alarming one, less than 20%.

Nowadays, 75% of the respondents who were the object of the research consider that

the accounting professionals master the IFRS referential, but the other respondents,

25%, believe that the Romanian accounting professionals are not ready to apply the

IFRS referential (Jianu et al., 2009).

The training of the staff involved in the IFRS application is a long-term goal. The

public interest entities must train their own experts, because, presently, there aren’t

enough experts on the IFRS application. On the other hand, the IFRS are in a

continuous development process which involves a continuous training of the

professional accountants.

In Romania, although there were some progresses compared to 2003, the quality

assurance system and the enforcement mechanisms for the general purpose financial

statements and the audit requirements are still insufficient. For example, the system

adopted by the CAFR in order to ensure the quality is operational, but the monitoring

team, which includes five professional auditors, lacks the experience and the

professional skills in auditing, especially in the financial sector. The Chamber of

Financial Auditors Romania needs to significantly improve the monitoring team and

the quality assurance system in order to achieve the objectives set by the 8th Directive

(World Bank, 2008).

In this respect, in Romania, a Strategy for the public oversight of statutory audit work

was developed in 2010, being initiated by the Public Oversight Board of the Statutory

Audit Activity (CSPAAS), an organization founded in 2008 by the transposition of

the Directive 2006/43 / EC. The key strategic objective of the CSPAAS is to promote

and to follow the increase in the public confidence in the statutory auditing of the

annual financial statements and the consolidated financial statements (CSPAAS,

2010).

If the Romanian National Bank monitors and adopts the financial reporting

requirements applicable to the banks and the non-banking financial institutions, the

insurance supervisory bodies haven’t published any example of application of the

financial reporting requirements. In this context, the effectiveness of the Insurance

Supervisory Commission (CSA) in monitoring the quality of the general purpose

financial statements issued by the insurance companies becomes questionable.

~ 144 ~


The Insurance Supervisory Commission (CSA) welcomed the following approach to

the national strategy for the transition to the IFRS implementation by the insurance

companies (CSA, 2006):

� starting from the financial year 2007, the insurance companies listed on a

regulated market or being prepared for listing at the balance sheet date, and

which elaborate consolidated financial statements, had to elaborate such

financial statements according to the IFRS;

� for the financial years of 2008 and 2009, the insurance companies had to prepare

annual and consolidated financial statements according to the IFRS, as the

second set of financial statements for the information needs of the CSA, the

market and other categories of users;

� based on the assessments made referring to the IFRS application in the

individual financial statements, a decision was going to be adopted regarding the

possibility of elaborating the financial statements of insurance companies

according to the IFRS, as a single set, since 2010.

For the economic entities in the insurance sector, the IASB decided to implement a

specific standard for this activity, which will be gradually applied over two-stages. In

the first stage, this specific standard was not used, the applicable principles being

those provided by: IAS 32, Financial Instruments: Disclosure and Presentation, IAS

39, Financial Instruments: Recognition and Measurement and the IFRS 4, Insurance

Contracts. The second phase ended in the late 2010 with the adoption of the specific

standard to the insurance domain (CSA, 2006).

On the other hand, the unit responsible for monitoring the listed companies, set up

inside CNVM, began its activities in May 2008 and is challenged to review the

consolidated financial statements prepared in accordance with the International

Financial Reporting Standards.

Moreover, the Romanian National Bank, by the BNR Order no. 9/2010 on the

application of the International Financial Reporting Standards by the credit

institutions, as a basis of accounting, decided the elaboration of the annual individual

financial statements in accordance with the IFRS starting from the fiscal year 2012.

In conclusion, in Romania, the national strategy for improving the financial reporting

of the private economic entities is mostly based on the elaboration of the individual

annual financial statements of the public entities under the IFRS referential, but the

experience of the recent years demonstrates unequivocally that in our country, there

are some difficulties in implementing the IFRS, as follows (Toma, 2010):

� the misinterpretation of the IFRS or the terminology problems, sometimes

generated by the translation errors or the multiple translations;

� the confusion that occurs between the standards and the regulations; wrongly,

we come to equate the two concepts, even if they are different issues: the

standards have a recommendation character, they aren’t mandatory and are

issued by non governmental bodies, while the regulations are mandatory and are

issued by government institutions;

� the IFRS nature is another issue for the Romanian accounting professionals:

when reading an International Financial Reporting Standard, the Romanian

accounting specialists are particularly concerned about the accounting

~ 145 ~


investigation, rather than the elements regarding the accounting information

disclosure in the financial statements;

� the financial reporting refers to the general financial statements, the same way

the IFRS treat this subject, while the accounting regulations in Romania

laconically question the general financial reporting;

� the confusion connected to the applicability of the IFRS: the international

financial reporting standards are issued in order to be applied by the economic

entities and can’t be brought to a governmental level in order to consolidate a

nationally centralized accounting;

� the relationship between taxation and accounting, which is not settled at the

European level, because two issues can be identified in this area: first, issues of

cost, generated by drawing two sets of financial statements, second, drawbacks

related to the reliability (when information from balance sheets prepared

according to different accounting referentials are read, it's hard to believe that no

question was raised: what are the actual results?);

� internationally and nationally no clear import pattern of the IFRS emerged:

taking over the IFRS, adopting some national standards of financial reporting or

setting up of national standards based on the IFRS principles?;

� difficulties in applying the IFRS for the small and medium enterprises,

considering that in the Romanian law these entities are not clearly defined small

and medium enterprises;

� issues related to IFRS implementation costs, while the Romanian state is facing

difficulties in applying the international financial reporting standards in the

public sector system;

� in the context of implementing the IFRS, the human factor, that is the

accounting professional, should not be neglected, considering that at his level,

possible training, ethical and professional reasoning issues can be identified, due

to his universally recognized subordination to the taxation.

DISCUSSION AND CONCLUSIONS

The accounting professionals have repeated on various occasions that, nowadays, the

accounting community is driven by the strong desire of standardization and

harmonization of the international accounting practices and, more recently, of

convergence in the accounting field, in order to increase the comparability and the

credibility of the information disclosed in the financial statements.

In order to achieve these aims, the national standard setters must give their input into

draft IFRS pronouncements in order to ensure that IFRS meet the needs of the

stakeholders in their countries and to contribute to the thought process as to how to

develop the best accounting and financial reporting solutions (FEE, 2009).

Since 1990, the Romanian accounting theory and practice is in a constant search for

an identity. Since then we have witnessed the "import" of accounting solutions that

have been transformed into genuine referentials that helped us to react in every

moment of change.

Year 2000 was for the Romanian accounting the beginning of a large process of

reconstruction, especially in the conceptual field. Furthermore, as the accounting

~ 146 ~


eform went ahead the economy reform, the supply of accounting information did not

follow, but anticipated the demand.

Since 2001, with the adoption of the Ministry Order no. 94/2001, Romania

experiences the implementation of the IFRS referential and, presently, a national

Strategy of improving the financial reporting of the economic entities is now outlined.

It remains to be seen whether, contrary to all the difficulties, the path that we intend to

follow, will lead to the increase of the quality and the reliability of the financial

reporting of the economic entities. Certainly, an important role in achieving this goal

belongs to the accounting professional, whose difficult mission is to keep up with the

frequent reconsiderations of the accounting rules, largely decided at the international

level.

This is another step taken in achieving a final goal of developing a functional model

for optimizing the national strategy regarding the financial reporting of the Romanian

private entities.

ACKNOWLEDGEMENTS

This research was financed through the research contract in partnership CNMP 92-

085/2008, Development of a functional model for optimizing the national strategy

regarding the financial reporting of the Romanian private entities.

REFERENCES

Dumitrana, M., Jianu, I. and Lapteş, R. (2010) „Panoptical on the financial statements – from

international to national”, Accounting and Management Information Systems, vol. 9,

no. 1: 72-91

Ionaşcu, I. (2003) The dynamic of the contemporary accounting doctrines, Bucharest:

Economic Printing House

Jianu, I., Lapteş, R. and Radu, G. (2009) „The financial-accounting audit, facilitator and

integrator of the harmonization process of the financial reporting with the European

directives and the IFRS”, Financial Audit, vol. 7, no. 10: 11-22

Lapteş, R. (2007) History, present and perspective regarding the company’s financial

statements in Romania, Bucharest: The Academy of Economic Studies

Lapteş, R. and Popa A.F. (2009) „The IFRS Standard for Small and Medium-Sized Entities –

Another Challenge for the Romanian Accounting?”, The Scientific Annals of the

Alexandru Ioan Cuza University of Iasi, Economic Sciences Section, LVI tome: 27-34

Ristea, M., Olimid, L., Calu, D. (2006) Compared Accounting Systems, Bucharest: CECCAR

Printing House

Ristea, M., Jianu, I. and Jianu, I. (2010) „The Romanian Experience in the Implementation of

the International Financial Reporting Standards and of the International Accounting

Standards for the Public Sector”, The Transylvanian Review of Administrative

Sciences, vol. 25, no. 1: 169-192

Toma, M. (2010) „Difficulties of the International Standards Implementation in Romania”,

Curierul Național, anul 15, no. 5634

World Bank (2003) „Report on the Observance of Standards and Codes (ROSC) –

Accounting and Audit, Romania, 2003”, available on-line at

www.siteresources.worldbank.org/.../Resources/Romania_ROSC_Rom.pdf, accessed

on January 05, 2011

~ 147 ~


World Bank (2008) „Report on the Observance of Standards and Codes (ROSC) –

Accounting and Audit, Romania, 2008”, available on-line at

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on January 06, 2011

FEE (2009) “Future approach to Setting Global Financial Reporting Standards”, available online

at http://www.ceccar.ro/_b/en/fee.pdf, accessed on March 31, 2011

C.S.A. (2006) „The Strategy for the Implementation of International Financial Reporting

Standards (IFRS) at the Insurance Entities”, available on-line at www.csaisc.ro/index.php?option=com_content,

accessed on January 07, 2011

CSPAAS (2010) „The Strategy on the Public Surveillance of the Statutory Audit Activity”,

available on-line at www.discutii.mfinante.ro/static/10/Mfp/cspaas/Strategie_CSPAAS

.pdf, accessed on January 07, 2011

GD 2170/2004 for approving the National Strategy for implementing the Country Action Plan

in order to improve the financial reporting in Romania and some measures for the

organization of the Accounting Advisory Board

GD 401/2005 for setting up the Accounting and Financial Reporting Council by the

reorganization of the Accounting Advisory Board

Regulation no. 1606/2002 of the European Parliament and the Council on the 19 th of July

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internal_market/accounting/officialdocs_en.htm, accessed on March 28, 2011

~ 148 ~


PS3 Financial analysis I

Chairperson

Petru OPRIS, West University of Timişoara, Romania

FINANCIAL RATIOS AND MARKET VALUATION ON

EMERGENT MARKETS: THE ROMANIAN CASE

Bogdan DIMA, Petru OPRIS

A HYBRID DEVICE OF SELF ORGANIZING MAPS

(SOM) AND MULTIVARIATE ADAPTIVE REGRESSION

SPLINES (MARS) FOR THE FORECASTING OF FIRMS’

BANKRUPTCY

Javier de ANDRES, Fernando SΑNCHEZ-LASHERAS,

Pedro LORCA, Francisco Javier DE COS-JUEZ

THE RELEVANCE OF COMPANY EVALUATION

METHODS IN CONDITIONS OF ECONOMIC

INSTABILITY. EMPIRICAL STUDY

ON THE COMPANIES QUOTED IN THE BUCHAREST

STOCK EXCHANGE

Marilena MIRONIUC, Mihai CARP, Ioan-Bogdan ROBU

FINANCIAL RISK ANALYSIS AT THE STOCK

EXCHANGE LISTED COMPANIES IN THE

PASSENGER ROAD TRANSPORTATION INDUSTRY

Vlad IORDACHE, Vasile ROBU, Costin CIORA

~ 149 ~


FINANCIAL RATIOS AND MARKET VALUATION ON

EMERGENT MARKETS: THE ROMANIAN CASE

Bogdan DIMA 1 & Petru OPRIS

West University of Timişoara, Romania

ABSTRACT

We are investigating the predictive relevance of the issuers’ financial ratios for the financial

instruments’ market prices. Using a sample of Romanian companies listed at Bucharest Stock

Exchange we are finding in a GMM- System framework that even in short run (5 years) there

is some room for considering such relevance. This result suggests that the standard finding in

literature according to which financial ratios usually displays weak predictive power in short

horizons and some predictive power in long horizons should be more clearly analyzed in the

context of the recent economic and financial instability..

KEYWORDS: Financial ratios; Returns predictability; Fundamentals; Market value;

GMM-System estimators

INTRODUCTION

We are testing the relevance of the financial ratios for the formation of stocks’ prices

on an emergent capital market such the Romanian one. Are these prices connected

with the fundamental variables linked to the issuer’s financial situation? Is there a

transmission process between the changes in this situation and prices adjustments? Is

this relevant for the valuation literature?

The key point is that both accounting data and share prices have as purpose to reflect

value (capital) and change in value (profit). Thus, one important issue arises when

questioning about the existence of relationship between these two and timing (lags

due to need for finishing reporting period).

The current stage of the research in this field is resumed by Cochrane (2001:388) as:

“Returns are predictable. In particular, (a) Variables including the dividend/price ratio

and term premium can in fact predict substantial amounts of stock return variation.

This phenomenon occurs over business cycle and longer horizons. Daily, weekly, and

monthly stock returns are still close to unpredictable …”.

However, this conclusion is criticized from several directions. For instance, it was

observed that in testing the connections between the descriptors of the issuers’

financial architecture and the evolutions of prices the statistical inference is

problematic since the highly persistent set of financial ratios displays frequently near-

1

Correspondence address: Bogdan DIMA, West University of Timişoara, Romania;

email: bogdan.dima@feaa.uvt.ro, http://www.feaa.uvt.ro

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to-unit root properties. Thus, there can appear uninformative inferences on predictive

relations (Valkanov, 2003; Lewellen, 2004).

Another observation underlines the fact that the process by which the

contemporaneous stock price reflects value relevant information (both accounting and

non-accounting) remains unchanged over time. In our opinion, this is a critical

hypothesis, since it is equivalent with the absence of any learning process in the

investors’ decisions, process that would be able to guide the adjustments in the

construction and management of financial assets’ portfolios. If this is presumed, then

it is possible to take into account more sophisticated inter-linkages between the

evolution of stocks and the financial performance of their issuers. A direct testable

consequence for such inter-linkages could be the manifestation of non-linear

connections between prices’ dynamics and the content of the financial statements. In

this sense, there are recent empirical evidence showing convexity in the relationship

between prices and accounting information. Empirical tests, although exploratory,

provide further evidence of a nonlinear relation between stock price and accounting

measures of earnings and book value (see, for instance, Riffe and Thompson, 1998).

In the mean time, it is not completely clear how much predictive power can be

attributed to financial ratios.

Summers (1986), Fama and French (1988), and Campbell and Shiller (1989, 2005)

suggest a simple theory of slow mean reversion to explain the predictive power. That

is, stock prices cannot drift too far from their fundamentals (e.g., dividend, earnings,

and book value) in the long run. The theory of slow mean reversion requires financial

ratios to be stationary.

As Chang et al. (2008) notes “The phenomenon of the mean-reversion discussed from

the literature explore whether the stock price followed random walk. If the stock

prices violate the trend of random walk, one possibility is the stock prices followed

mean-reversion process. If the stock prices followed mean reversion in the long-run,

the price movements should be predictable from the movements in firm fundamental

values. In this sense, determining whether stock prices are mean-reversion is a very

important issue for investors. Consequently, to analysis equity fundamentals, what is

important is to verify whether the stock price moves with its firm’s fundamental”.

Lamont (1998) argues that fundamentals predict returns in the short run, while prices

predict returns in the long run. Supplementary, the prediction relation between returns

and financial ratios appears to suffer from structural instability over time. Especially,

in the late 1990s, the prediction relation seems not robust (see, Goyal and Welch,

2003; Paye and Timmermann, 2006; Lettau and Van Nieuwerburgh, 2008).

Also, it should be considered the argument advanced by Lettau and Van

Nieuwerburgh (2008) who are suggesting that the puzzling empirical patterns in

return prediction are caused by the changes in the steady-state mean of financial ratios

and are estimating regime-switching models for the steady-state mean of financial

ratios.

Guan (2010) noticed that firm financial ratios can help identify stocks that outperform

other stocks during recessions, even after controlling for firm characteristics such as

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size, book-to-market ratio and past returns. Using a parsimonious composite score

based on the unadjusted and industry-adjusted financial ratios, firms with high scores

earn 1.29% per month more than firms with low scores during recessions. The return

differences are smaller but significantly negative during expansions. The strong

predicting power of financial ratios is not due to its ability to predict the beta (since

the high score firms and low score firms have similar betas). The findings suggest that

financial ratios provide valuable incremental information about stock systematic risk

at the business cycle frequency besides the size, book-to-market, momentum

characteristics and betas.

However, the emergent capital markets are characterized by lower levels of financial

instruments liquidity, imperfect transaction mechanisms, frequent situations of

information asymmetry and fragile institutional framework.

In this context, the objective of this study is to seek for some empirical evidences if or

if not there is an even limited predictive capacity of the issuers’ financial status

descriptors on emerging markets by examining a set of data for some companies

which are quoted on Bucharest Stock Exchange in order to identify if the financial

ratios are significant and positively correlated with the evolution of market values.

The paper is organized as follows: Section 2 describes the methodology. Section 3

reports on the data used for the empirical tests and on the results of these tests. Some

conclusions are formulated and some future research analytical directions are

indicated in Section 4.

1. METHODOLOGICAL FRAMEWORK

An initial step of our methodological approach consists in testing the relevance of the

financial ratios for the market values of the companies. If these ratios appears to be

connected to the dynamic of market values, then it can be argued that there

information content is relevant for the decisions of investors to incorporate the

financial instrument issued by the considered companies in their portfolio. In such

case, the market value is performance-driven and reflects some relevant fundamental

determinants of issuers’ financial situations.

Thus, we run preliminary regressions as:

Closeit , =β 0 +β iXit , +δ t+η i+ε it ,

Here, the dependent variation of market daily close prices (CLOSE) is linked to

individual X financial ratios. ηi is the unobserved time-invariant specific effects; δt

captures a common deterministic trend; εit is a random disturbance assumed to be

normal, and identical distributed (IID) with E (εit)=0; Var (εit) =σ 2 >0 .

In order to estimate the involved parameters, we apply the so-called GMM-System

estimation. The GMM-System methodology – as proposed by Arellano and Bover

(1995), Blundell and Bond (1998, 2000) and Windmeijer (2005) - is involved because

estimators like fixed and random effects, IV or standard GMM may yield to biased

results. Also, since a small panel sample may produce “downward bias of the

estimated asymptotic standard errors” in the two-step procedure (Baltagi, 2008: 154),

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( 1)


we use the “Windmeijer correction” for the estimated standard errors. More exactly,

Windmeijer (2000, 2005) observes that part of downward bias which can appear for

the standard errors in small samples is due to extra variation caused by the initial

weight matrix estimation being itself based on consistent estimates of the equation

parameters. In order to correct this bias, it is possible to calculate bias-corrected

standard error estimates which take into account the variation of the initial parameter

estimates. We employ a version of this correction applicable for GMM models

estimated using an iterate-to-convergence procedure.

There are several advantages of the GMM-SYS over other static or dynamic panel

estimation methods. Among these: static panel estimates, as the OLS models, are

subjected to the problem of dynamic panel bias (Bond, 2002); in our database, we

have 12 companies (N) analyzed over a short time span of 5 years (T) and the

literature includes several arguments for dynamic panel model being specially

designed for a situation where “T” is smaller than “N” in order to control for dynamic

panel bias (Bond 2002; Baltagi 2008); the problem of the potential endogeneity can be

easier addressed in dynamic panel models than in static and OLS models, since all

variables from the regression which are not correlated with the error term (including

lagged and differenced variables) can be potentially used as valid instrumental

variables; the dynamic panel model is able to identify short and long-run involved

effects (Baltagi 2008). Also, the GMM-System exploits the stationarity restrictions,

while the first-differenced GMM estimator can behave poorly when the time series

are persistent.

The GMM-System tries to simultaneous estimate the Equation 1 together with a respecification

designed to eliminate the company-specific effects by using first

differences of the involved variables as:

Δ Closeit , =βiΔ Xit , +δ t+η i+ΘΔ Zit

, +ε it ,

Z is a set of instruments for the dependent and explanatory variables. The system-

GMM approach estimates equations (1) and (2) simultaneously, by using lagged

levels and lagged differences as instruments. The presence of both lagged levels and

differences is justified by Arellano and Bover (1995) and Blundell and Bond (1998)

which showed that lagged levels can be poor instruments for first-differenced

variables, particularly if the variables are “persistent”. For comparison purposes, we

are reporting the results of a dynamic GMM (Arellano and Bond, 1991).

Further, the financial ratios that individually appear to be relevant for the formation of

market prices can be aggregated in a single indicator of issuers’ financial conditions

for instance by using the Principal Components Analysis applied on these ratios.

This procedure models the variance structure of a set of observed variables using

linear combinations of the variables. These linear combinations (components) may be

used in subsequent analysis, and the combination coefficients (loadings) can be used

for a subsequent interpretation of the components. The global indicator is constructed

by weighting the individual disclosure dummies with these loadings. Details on the

procedure are provided in Appendix. We are involving such approach since: (a) this is

a procedure of reducing the number of observed variables to a smaller number of

principal components which account for most of the variance of the observed

~ 153 ~

( 2 )


variables; (b) we are expecting the financial ratios to be highly correlated; (c)

component scores are a linear combination of the observed variables weighted by

eigenvectors and thus allows for considering the relative importance of individual

variables. Such global indicator is designed to be use for an overall assessment of the

impact exercised by the financial ratios on market values.

2. DATA AND EMPIRICAL RESULTS

2.1. Romanian capital market data

Our dataset consists in 12 companies from the first tier of the Bucharest Stock

Exchange over a time span between 2005 and 2009. These stocks have a maximal

degree of liquidity and are forming a significant fraction of the market. The variables

reflect the annual close prices, the business turnover, two liquidity ratios, the net

treasury ratio and the dividends per share. In our opinion, such financial ratios are

susceptible to capture in a synthetic manner the financial situations of the issuers as

well as the returns obtained by the investors. Consequently, these ratios are

presumably relevant for investment decisions even on an imperfect market such as the

Romanian one with slow prices adjustment mechanisms and their effects on longer

market cycles.

The data are provided by Bucharest Stock Exchange and represents the (log) last close

of the year indexes as dependent variable and a set of financial ratios computed based

on the financial statements of the issuers as explicative variables.

Table 1 reports on the main statistic characteristics of the data. The data displays nonnormal

distributions with significant fat-tails effects. The values of the dispersion as

well as the parameters of the distribution suggest the possibility of some significant

outliers in for the observation period.

Table 1. Main statistic characteristics of data (yearly values; variation, %)

Close prices Current liquidity ratioQuick ratioNet treasury ratio Dividends per share

Mean 62.65 96.37 119.06 24.44 -1.37

Median 30.00 -2.60 2.46 -0.23 0.00

Maximum 2145.22 2843.53 2430.21 1673.31 270.59

Minimum -94.05 -99.00 -99.07 -627.93 -100.00

Std. Dev. 287.44 421.74 468.11 275.25 63.07

Skewness 6.59 5.49 4.16 3.49 1.77

Kurtosis 48.35 33.97 19.23 23.63 9.00

Jarque-Bera 5482.73 2653.52 818.20 1165.79 119.37

Number of observations 60 60 60 60 60

Such potential heterogeneity requires an adequate methodology for dealing with the

induced bias in data and can be viewed as a supplementary argument for the involving

of the GMM-System approach.

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2.2. Results

Our preliminary evaluation reported in Table 2 indicates that all the considered

financial ratios are significant and positively correlated with the evolution of market

values.

Table 2. Market value of shares and financial ratios of issuers

Explanatory

Current liquidity ratio = 1.03*** (0.28)

Total current assets /

Total current liabilities

Quick ratio =

(Cash and short term investments+

Total receivable, net) /

Total current liabilities

Net treasury ratio =

Treasury, net / Total Assets

Dividends per share

~ 155 ~

0.99***(0.27)

0.25* (0.14)

0.98***(0.33)

M1 -2.42[0.02] -1.90[0.06] -2.14[0.03] -1.65[0.10]

M2 1.49[0.14] 1.23[0.22] 0.42[0.68] -0.52[0.68]

Sargan [0.74]

[0.77]

[0.64]

[0.61]

(Df=14) (Df=14) (Df=14) (Df=14)

Observations (balanced) 48 48 48 48

Standard errors (heteroskedasticity corrected) are in round brackets. The null that each

coefficient is equal to zero is tested using the second-step robust standard

errors.***/**/*- statistically significant, respectively at the 1%, 5%, and 10% level.

M1 and M2 are tests for first-order and second-order serial correlation in the firstdifferenced

residuals, asymptotically distributed as N(0,1) under the null hypothesis

of no serial correlation (based on robust two-steps GMM estimators). Sargan is a test

of the over-identifying restrictions, asymptotically distributed as χ2, under the null of

instruments’ validity (two-steps estimators).

Thus, the considered financial ratios can be viewed as providing for the investors a

synthetic description of the issuers’ performances and financial health as well as the

dividend policies. Based on their informational content, the investors can evaluate the

financial risks associated with holding and trading the stocks and, in caeteris paribus

conditions, the associated returns.

Consequently, Table 3 displays the results of a Principal Components Analysis on the

individual ratios in order to provide such a synthetic descriptor of the issuers’

financial status.

The first section of Table 3 summarizes the eigenvalues, showing the values, the

forward difference in the eigenvalues and the proportion of total variance explained.

Since we are performing principal components on a correlation matrix, the sum of the

scaled variances for the four ratios is equal to 4. The first principal component

accounts for 55% of the total variance while the second accounts for 28% of the total.

The first two components account for over 83% of the variation.


The second section describes the linear combination coefficients. One can notice that

the first principal component (labeled “PC1”) is a linear combination of all four ratios.

Thus, it might reasonably be interpreted as a global financial situation indicator. The

second principal component (labeled “PC2”) has negative loadings for the dividends

per share and it appears to represent an indicator of financial architecture’ descriptors

(without the investors remuneration component).

Table 3. Principal Components Analysis for financial ratios

Number Value Difference Proportion

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Cumulative

value

Cumulative

proportion

1.00 2.20 1.08 0.55 2.20 0.55

2.00 1.12 0.52 0.28 3.31 0.83

3.00 0.60 0.51 0.15 3.91 0.98

4.00 0.09 --- 0.02 4.00 1.00

Eigenvectors (loadings):

Variable PC 1 PC 2 PC 3 PC 4

Current liquidity ratio =

Total current assets /

Total current liabilities

0.64 0.00 -0.27 -0.72

Quick ratio =

(Cash and short term

investments+ Total receivable, net) /

Total current liabilities 0.64 0.00 -0.33 0.70

Net treasury ratio =

Treasury, net / Total Assets 0.29 0.71 0.63 0.03

Dividends per share 0.30 -0.70 0.65 0.03

Included observations: 59; balanced sample (listwise missing value deletion);

computed using: Spearman rank-order correlations; extracting 4 of 4 possible

components

For an evaluation of the first principal component in its hypostasis of overall indicator

of issuers’ financial situations and dividends policies, we run separate testing

regressions with the indicator against close prices as well as against business

turnovers (Table 4 and 5).

Table 4. Market value of shares and financial situation indicator

Explanatory GMM-DIF GMM-SYS

Close prices(t-1) -0.12*** (0.04) -0.20** (0.09)

Financial situation of issuers 39.40*** (4.07) 42.71*** (11.75)

M1 -1.87 [0.06]

M2 1.23[0.22]

Sargan [0.30]

[0.82]

(Df=12)

(Df=14)

Observations (balanced) 35 48

Standard errors (heteroskedasticity corrected) are in round brackets. The null that each

coefficient is equal to zero is tested using the second-step robust standard

errors.***/**/*- statistically significant, respectively at the 1%, 5%, and 10% level.


M1 and M2 are tests for first-order and second-order serial correlation in the firstdifferenced

residuals, asymptotically distributed as N(0,1) under the null hypothesis

of no serial correlation (based on robust two-steps GMM estimators). Sargan is a test

of the over-identifying restrictions, asymptotically distributed as χ2, under the null of

instruments’ validity (two-steps estimators). White period instrument weighting

matrix and White period standard errors & covariance (no degree of freedom

correction) are used for dynamic GMM. Transformation of the data in GMM-System:

Orthogonal deviations method.

Table 5. Business turnover and financial situation indicator

Explanatory GMM-DIF GMM-SYS

Business turnover(t-1) -0.28*** (0.06) 0.13(0.66)

Financial situation of issuers 9.50*** (1.47) 14.16*** (3.88)

M1 -2.16 [0.03]

M2 -0.48[0.63]

Sargan [0.33]

[0.49]

(Df=12)

(Df=10)

Observations (balanced) 35 48

Standard errors (heteroskedasticity corrected) are in round brackets. The null that each

coefficient is equal to zero is tested using the second-step robust standard

errors.***/**/*- statistically significant, respectively at the 1%, 5%, and 10% level.

M1 and M2 are tests for first-order and second-order serial correlation in the firstdifferenced

residuals, asymptotically distributed as N(0,1) under the null hypothesis

of no serial correlation (based on robust two-steps GMM estimators). Sargan is a test

of the over-identifying restrictions, asymptotically distributed as χ2, under the null of

instruments’ validity (two-steps estimators). White period instrument weighting

matrix and White period standard errors & covariance (no degree of freedom

correction) are used for dynamic GMM. Transformation of the data in GMM-System:

Orthogonal deviations method.

The results of such regressions suggest that the financial status of the issuers matters

both for the formation of stocks’ prices as well as for the business dynamic of the

issuers. This outcome remains robust to the change in estimation methodology as well

as to the inclusion as control variables of the lagged values of dependent ones.

However, our empirical model does not incorporate a formal description of the

implied transmission channels and does not examine the possible implications for a

more accurate description of such channels of the dual impact on financial ratios on

prices and turnovers. Thus, a broader analysis should consider these issues and should

extend the set of explanatory variables.

DISCUSSION AND CONCLUSIONS

The objective of the study is to seek for some empirical evidences if or if not there is

an even limited predictive capacity of the issuers’ financial status descriptors on

emerging markets by examining a set of data for some companies which are quoted

on Bucharest Stock Exchange in order to identify if the financial ratios are significant

and positively correlated with the evolution of market values.

~ 157 ~


Of course, there are some clear limits of the proposed analysis. Among them:

• The limited number of issuers / financial ratios considered;

• The heterogeneous structure of the data sample;

• The short data span;

• The possible disturbances induced by the nonlinear interactions among the

explanatory variables etc.

Further research directions should minimally: 1) considering an underlying

mechanism for the potential impact in the changes in financial status and policies

dividends at issuers level for both the market values and business turnovers; 2)

integrating a larger set of explanatory variables especially from the descriptors of

financial equilibrium and performances; 3) providing more conceptual explanations

for the signaling effects of the financial ratios and for their impact on investors’

decisions.

Despite such caveats, it can be argued that even such a limited study can highlight the

existence of some signaling mechanisms through which the informational variables

describing the issuers’ financial status can affect the prices even in a case of an

emergent market with significant informational imperfections such as the Romanian

one.

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GMM estimators”. Journal of Econometrics, Elsevier, 126(1): 25-51.

~ 159 ~


APPENDIX

Principal Component Analysis

Principal components analysis is a variable reduction procedure. Thus it is similar in

many respects to exploratory factor analysis but there are significant conceptual

differences between the two procedures. Perhaps the most important of these

differences deals with the assumption of an underlying causal structure: factor

analysis assumes that the co-variation in the observed variables is due to the presence

of one or more latent variables (factors) that exert causal influence on these observed

variables. In contrast, principal component analysis makes no such special

assumptions about an underlying causal model and allows for analysis of more

various empirical situations. Its central idea is to reduce the dimensionality of a set of

interrelated variables, while retaining as much as possible from the variation which is

present in dataset. The procedure is currently widely applied from climatology to

economics, genetics, psychology or quality control (see for details Jolliffe 2002).

This type of analysis models the variance structure of a set of observed variables by

using linear combinations of the variables. These linear combinations, or components,

may be used in subsequent analysis, and the combination coefficients, or loadings,

may be used in interpreting the components.

The principal components of a set of variables are obtained by computing the

eigenvalue decomposition of the observed variance matrix. The first principal

component is the unit-length linear combination of the original variables with

maximum variance. Subsequent principal components maximize variance among

unit-length linear combinations that are orthogonal to the previous components.

From the singular value decomposition, a ( nxp ) data matrix Y of rank r could be

represented as:

'

Y = UDV ( a.1.

)

U and V are orthonormal matrices of the left and right singular vectors, and D is a

diagonal matrix containing the singular values.

More generally, one could write:

'

Y = AB ( a.2.

)

A is an (nxr), and B is a (pxr) matrix, both of rank r, and

β

2 1−α

A= n UD

−β

B n 2 α

= VD a.3.

( )

Thus 0 ≤ α ≤ 1 is a factor which adjusts the relative weighting of the left

(observations) and right (variables) singular vectors, and the terms involving β are

scaling factors where β ∈ { 0,

α}

.

The basic options in computing the scores A and the corresponding loadings B involve

the choice of (loading) weight parameter α and (observation) scaling parameter β.

In the principal components context, let ∑ be the cross-product moment (dispersion)

matrix of Y, and let perform the eigenvalue decomposition:


'

∑ = LΛL ( a.4.

)

Here L is the pxp matrix of eigenvectors and Λ is the diagonal matrix with

eigenvalues on the diagonal. The eigenvectors, which are given by the columns of L,

are identified up to the choice of sign. It could be observed the facts that since the

' '

eigenvectors are by construction orthogonal, L L = LL = I m .

1

−1

There could be done some settings as U = YLD , V = L,

D = ( nΛ

)2,

so that:

β

2 −α

A= n YLD

β


B n 2 α

= LD a.5.

~ 161 ~

( )

A can be interpreted as the weighted principal components scores, and B as the

weighted principal components loadings.

Others detail of this procedure concerns an appropriate choice of the weight parameter

α and the scaling parameter β through which different scores and loadings with

various properties could be constructed.


A HYBRID DEVICE OF SELF ORGANIZING MAPS

(SOM) AND MULTIVARIATE ADAPTIVE REGRESSION

SPLINES (MARS) FOR THE FORECASTING OF FIRMS’

BANKRUPTCY

Javier de ANDRÉS 1 , Fernando SÁNCHEZ-LASHERAS,

Pedro LORCA & Francisco Javier de COS JUEZ

University of Oviedo, Spain

ABSTRACT

This paper proposes a new approach to the forecasting of firms’ bankruptcy. Our proposal is

a hybrid method in which sound companies are divided in clusters according to their

financial similarities and then each cluster is replaced by a director vector which summarizes

all of them. In order to do this, we use Self Organizing Maps (SOM). Once the companies in

clusters have been replaced by director vectors, we estimate a classification model through

Multivariate Adaptive Regression Splines (MARS). For the test of the model we considered a

real setting of Spanish enterprises from the construction sector because of the importance of

this branch of activity in the Spanish economy. It is also remarkable that in our dataset the

proportion of distressed firms is very close to that which is derived from Economic statistics.

With this procedure we intend to overcome the sampling-bias problems that matched-pairs

models often suffer.

KEYWORDS: Bankruptcy, Self Organized Maps (SOM), Multivariate Adaptive Regression

Splines (MARS), Construction firms

INTRODUCTION

During the last years the importance of bankruptcy forecasting models is very high

due to the current financial crisis, which demands an even more careful management

of financial resources. Furthermore, under Basel II Accord recommendations (Bank

for International Settlements, 2006), banks which choose to develop their own

empirical model to quantify required capital for credit risk (Internal Rating-Based

Approach) are required to maintain less capital than those using the Standardized

Approach.

According to Sueyoshi and Goto (2009a), research on bankruptcy-based performance

assessment can be classified into three broad categories. First, those studies centered

on a particular model, which test how such model performs in comparison with

others. Second, research focused on the selection of an appropriate set of variables to

implement a particular model. The third category comprises papers which investigate

the bankruptcy process.

1 Correspondence address: Javier de ANDRÉS, University of Oviedo, Faculty of Economy

and Business, Department of Accounting, Avda.del Cristo s/n, Oviedo 33006, Spain;

email: jdandres@uniovi.es

~ 162 ~


Among these categories, the first is the one which has received most attention by

researchers. The tested models are mainly statistical methodologies (for a review of

the most outstanding studies see Keasey and Watson, 1991; Balcaen and Ooghe,

2006, among others) and Artificial Intelligence techniques (for a review see, e.g., Aziz

and Dar, 2006; Ravi Kumar and Ravi, 2007).

Ravi Kumar and Ravi (2007) discuss the models which have been most frequently

used in studies focused in insolvency prediction via intelligent systems. These models

are Fuzzy Logic (FL), Neural Networks (NN), Genetic Algorithms (GA), Case-Based

Reasoning Systems (CBR), Rough Sets (RS), Support Vector Machines (SVM),

Decision trees (DT), Data Envelopment Analysis (DEA) and Hybrid Systems (HS).

Among these, HS are the most promising. These combine two or more intelligent

techniques in several forms to derive the advantages of all of them. HS have received

considerable attention from researchers as they amplify the advantages of the

intelligent techniques while simultaneously nullifying their disadvantages. Most HS

require a considerable amount of data to reach to accurate estimations. This is not a

problem nowadays, as there exist publicly available databases containing financial

information of listed and unlisted firms.

However, studies using HS for bankruptcy prediction suffer from a drawback which is

that the majority of them estimate the model upon the basis of a sample in which nonfailed

companies are underrepresented. In most cases a matched-pairs design is used.

The selection of non-failed firms is arbitrary, which makes the model to achieve a

high in-sample percentage of correct classifications but it is likely to be inaccurate for

failure prediction in new cases drawn from a real population.

Another strategy is to consider a “real” population as the sample. That is, to consider

all the companies for which we have financial information available. However, as

only a very small percentage of firms enter into financial distress in a normal

economic situation, such samples are very unbalanced. This causes coefficient

instability and leads to poor performance ability of the models.

As an alternative to both strategies we propose a HS model where, upon the basis of a

real population of firms, data are preprocessed to summarize the information of

healthy firms. So, the initial unbalanced sample is transformed into a balanced one

which retains the main features of the healthy firms. Self Organized Maps (SOM) is

used in this stage. Then a classification device is developed upon the transformed

sample, for which we use the Multivariate Adaptive Regression Splines (MARS)

approach. The results are compared with benchmarks which are popular in bankruptcy

prediction literature. As an important application of the combined approach, this paper

applies it to the solvency assessment of Spanish construction firms.

The remainder of the paper is structured as follows. Section 1 revises prior studies on

bankruptcy prediction using HS. Section 2 is devoted to build the database. Section 3

describes the algorithm and the analytical procedures we used. Section 4 comments on

the main results, including the benchmark techniques applied. Finally, section 5 is

devoted to the summary and main conclusions, including also some further research

avenues.

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1. PRIOR BANKRUPTCY RESEARCH USING HYBRID SYSTEMS

Basically, there are four types of HS which have been applied to financial distress

prediction:

• Hybrid Algorithms (HA), where two or more intelligent algorithms are tightly

integrated to form a new classification device (i.e., GA-trained NN, neurofuzzy

systems).

• Ensemble Classifiers (EC), which consist of multiple single classifiers whose

decision is combined to form that of the combined system, usually by applying

a voting scheme.

• Feature Selectors (FS). In these systems, an algorithm is used for the selection

of the predictors of failure among a list of feasible variables and another model

is used to predict the bankruptcy status using the selected indicators.

• Clustering and Classificatory devices (CC). These HSs preprocess the financial

information on the failed and non-failed firms and identify groups based on

similarities. The grouping information is used in the subsequent estimation of a

classification model.

Tables 1, 2, 3 and 4 contain a summary of a selection of the most outstanding studies

on financial failure prediction using each type of HSs.

Table 1. Studies on bankruptcy prediction using the HA approach

Authors Main tested method Sample composition Main results

Tseng and Lin

(2005)

Wang et al.

(2005)

Ahn and Kim

(2009)

Chuang and Lin

(2009)

Li and Sun

(2009)

Fuzzy sets integrated into a

logit model.

Hybrid algorithm of fuzzy

sets and SVM.

Instance selection for CBR

using GA.

Hybrid model of MARS, NN

and CBR.

Hybrid model of CBR and

ELECTRE outranking

method.

Yeh et al. (2010) Hybrid model of DEA, RS

and SVM.

904 companies, 353 of

them either failed or

acquired.

Dataset 1: 30 failed and 30

nonfailed firms.

Dataset 2: 653 data, with

357 cases granted and 296

cases refused.

Dataset 3: 1225 credit

applicants, of which 323

are observed bad creditors.

1335 solvent companies

and 1335 failed.

1000 credit applications,

300 of them bad.

81 healthy companies and

81 companies in distress.

76 healthy firms and 38

distressed.

~ 164 ~

The proposed model provides

more information than

conventional models.

The results are not conclusive

as they depend on the

characteristics of the datasets.

the prediction accuracy of the

proposed model is higher than

the best performance of

different NNs.

The hybrid model outperforms

single models and a hybrid

model of MARS and NN.

The hybrid model outperforms

other comparative CBR

models.

The proposed model performs

better than NNs.

Table 2. Studies on bankruptcy prediction using the FS approach

Authors Main tested method Sample composition Main results

Huang et al.

(2007)

Hybridization of F-score,

genetic algorithms (feature

selection) and SVM.

Dataset 1: 307

creditworthy applicants

and 383 not creditworthy.

Dataset 2: 700

creditworthy and 300 notcreditworthy.

With a small feature subset, a

hybrid SVM-GA system

obtains a good classification

performance.


Authors Main tested method Sample composition Main results

Chen et al.

(2009)

MARS for feature selection

and SVM for classification.

Tsai (2009) t-statistic analysis for feature

selection and NNs for

classification.

Chaudhuri and

De (2010)

Fuzzy clustering for feature

selection and SVM for

classification.

Cho et al. (2010) DTs for feature selection and

CBR for classification.

Li et al. (2010) GA and statistical methods

for feature selection, CBR

for classification.

Ravisankar and

Ravi (2010)

t-statistic analysis and Group

Method of Data Handling

(GMDH) (A SOM model)

for feature selection. GMDH

for classification.

1130 good and 870 bad

credit applications.

Five datasets: 3 approx.

balanced, 1 with a 2/1 ratio

of good to bad cases and 1

resembles a real

population.

50 bankrupt firms matched

with 50 non-bankrupt.

500 healthy and 500

bankrupt firms.

135 healthy companies and

135 distressed ones.

Dataset 1: 29 healthy banks

and 37 bankrupt.

Dataset 2: 22 healthy banks

and 18 bankrupt.

Dataset 3: 64 healthy banks

and 65 bankrupt.

Dataset 4: 30 healthy banks

and 30 bankrupt.

~ 165 ~

The hybrid system

outperforms both several

individual approaches (CART,

SVM and MARS) and a

hybrid system which combines

SVM and CART.

The proposed model

outperforms benchmarking

systems.

The rating estimation done by

the model does not depend on

heuristics.

The proposed models

outperform Logit and NNs.

If a true optimal feature subset

is not used CBR could

possibly produce lower

performance.

The proposed models

outperform other neural

architectures.

Table 3. Studies on bankruptcy prediction using the EC approach

Authors Main tested method Sample composition Main results

Alfaro et al. Adaptive boosting (adaboost) 590 failed and 590 non- Adaboost outperforms NN.

(2008)

of CT.

failed firms.

Kim and Cho Ensemble of NN using 307 instances of

The model outperforms non-

(2008)

evolutionary computation creditworthy applications evolutionary ensembles of

techniques.

and 383 where it is not. NN.

Tsai and Wu Ensemble of several NN. Dataset 1:307 creditworthy Multiple NN classifiers do not

(2008)

applications and 383 not outperform a single best

creditworthy.

neural network classifier in

Dataset 2: 700 good and

300 bad credits.

Dataset 3: 307 good and

383 bad credits.

many cases.

Yu et al. (2008) Bootstrap aggregating Dataset 1: 357 good credit The proposed model

(bagging) of NN.

cases and 296 refused. consistently outperforms

Dataset 2: 30 failed and 30

non-failed firms.

single models and other EC.

Hung and Chen Stacking of algorithms based 56 bankrupt companies and The ensemble performs better

(2009)

on bankruptcy probabilities. 64 non-bankrupt

than other ensembles which

companies.

use the weighting or voting

strategy.

Karthik Chandra Boosting of multi layer 120 failed and 120 healthy Boosting yields results

et al. (2009). perceptron NN, CART, companies.

superior to those reported in

RandomForests, SVM and

previous studies on the same

logistic regression.

data set

Nanni and Random subspaces, class Same as in Tsai and Wu Random subspaces perform

Lumnini (2009) switching and rotation

forests.

(2008).

better than the other EC.

Yu et al. (2010) Ensemble of SVM devices. 902 good loans and 323 The proposed ensemble

bad cases.

consistently outperforms other

ensemble models and five

single systems.


Table 4. Studies on bankruptcy prediction using the CC approach

Authors Main tested method Sample composition Main results

Alam et al.

(2000)

Foglia et al.

(2001)

Fuzzy clustering and SOM. 8 failed banks and 248

non-failed-banks.

Logit model for the

estimation of bank borrowers

default probabilities and

cluster analysis to assign

borrowers to credit scoring

grades.

Hsieh (2005) Clustering algorithms for

identifying unrepresentative

subsamples and NN using the

remainder of their samples.

Defu et al. (2008) Same as Hsieh (2005) but

using also classification

trees.

Hu and Wang

(2008)

Identification of clusters

prior to the training of a NN.

Abdou (2009) Genetic programming and

SOM.

Boyacioglu et al.

(2009)

De Andrés et al.

(2011)

k-means clustering and

SOM.

Fuzzy clustering and then a

MARS model is estimated on

the clusterized data.

3343 firms divided in

several credit scoring

grades.

Dataset 1: 700

creditworthy applications

and 300 not-creditworthy.

Dataset 2: 368 accepted

credits and 222 that were

denied.

Dataset 1: 307 good and

383 bad credits.

Dataset 2: 700 good and

300 bad credits.

300 piece of data divided

into 3 credit conditions.

851 good loans and 411

bad loans.

21 failed banks and 46

non-failed banks.

59336 healthy and 138

failed firms.

~ 166 ~

The estimated model provides

an ordinal rating of the data set

in terms of failing likelihood

possibility.

The ultimate choice in

defining a bank's internal

grading system relies on

empirical ground.

The model is efficient in

comparison with benchmark

methods.

GA and K-means algorithm

can effectively improve the

classification accuracy of a

credit scoring model.

The model offers a good rate

of correct classifications

although it lacks some

generalization power.

The best model depends on the

choice of misclassification

costs.

Neither methods can

outperform multilayer

perceptron NN.

The proposed model

outperform single

classification devices (NN,

LDA, MARS).

It must be pointed out that if the bankruptcy prediction models are eventually to be

used in a predictive context, the estimation samples of failing and non-failing firms

should be representative of the whole population of firms (Ooghe and Joos, 1990).

Nevertheless, in the great majority of the hybrid prediction models revised in tables 1

to 4, the samples are not representative of the whole population. Most studies

oversample failing companies because of the low frequency rate of failing firms in the

economy. A common strategy is the use of matched pairs samples (on the basis of

size, sector, and/or age). This can lead to biased parameter estimates especially if the

sample is made up of failed firms and very sound companies. In that case the model

will achieve a high percentage of correct classifications but it is likely to be inaccurate

for failure prediction in new cases drawn from a real population.

An alternate sampling strategy is to consider a real population. As Foglia et al. (2001)

point out, this procedure increases the variance of the estimates of coefficients due to

the data imbalance between sound and unsound firms. An additional drawback is that,

having into account that in a normal economy most companies are non-bankrupt, to

classify all the firms as “not-bankrupt” would let the model reach a high percentage of

correct classifications. To avoid this, the algorithm can be designed to consider the

different misclassification costs (the costs of classifying as insolvent a company

which is solvent are much lower than those of the opposite error). Such a model will


pay more attention to accurately classifying the failing companies at the expense of

more misclassifications of non-failing firms.

However, the estimation of the different misclassification costs is not straightforward

as it depends on the financial decision to be taken. Furthermore, such estimation is a

subjective task as it also depends on the risk profile of the agent who makes the

decision.

As an alternative to both approaches, we propose a method which enables the

formation of a sample which is representative of the main features of the population

but retains the balanced design and the stability of the coefficients.

Our proposal is a hybrid method in which sound companies are divided in clusters

according to their financial similarities and then each cluster is replaced by a director

vector which summarizes all of them. The clustering process is made by means of a

SOM procedure. The most relevant reasons for choosing SOM among the different

methods for clustering are the following two: first, this technique was specifically

designed for multidimensional datasets, and is able to take advantage of their

complexity and second, unlike other methods for data-reduction and clustering, this

family of algorithms is characterized by a learning process that is constantly updated

as it takes more information from the input data, improving the output dynamically

over the training stage and therefore producing more reliable results.

Prior to the calculation of clusters, sound companies are divided into two groups:

1. Companies which are actually sound but whose financial features have a certain

degree of similarity with those of failed ones. These are called “borderline”

companies.

2. Companies which are sound and whose financial features are clearly different

from those of bankrupt companies.

The clustering process is carried out separately for each group of firms. Although the

idea of considering a “grey zone” or group of doubtful firms has been previously

introduced by other researchers (see, i.e., Ooghe et al., 1992; Alam, et al., 2000;

Tseng and Lin, 2005), we made the discrimination between sound and doubtful firms

on a multivariate basis by using a non-euclidean distance measure (the Mahalanobis

distance).

Once the companies in clusters have been replaced by director vectors, we estimate a

classification model through MARS. The reason for choosing MARS as the second

part of the hybrid system lies in the fact that this technique is a flexible procedure,

which models relationships that are nearly additive or involve interactions with fewer

variables (Hastie and Tibshirani, 1990). MARS builds flexible models by fitting

piecewise linear regressions; that is, the nonlinearity of a model is approximated

through the use of separate regression slopes in a limited number of intervals of the

variable space. This is made by using a procedure which is inspired by the recursive

partitioning technique governing Classification And Regression Trees (CART)

algorithm (Breiman et al., 1984). Such features make it especially suitable for the

bankruptcy prediction problem, as the variety of indicators that can be computed upon