The financial statement fraud has become a popular topic in accounting in the recent past attributed to the collateral damage that would otherwise lead to company failure (Mohamed & Handley-Schachelor, 2014). Such a situation is unfortunate since the financial statement is one of the reliable tools that the shareholders use to make investment decisions in a company asset (Edogbanya & Kamadin, 2015). When a business enterprise portrays itself with such fraudulent actions, the public loses its trust and loyalty in the brand. Following a literature review on the topic of fraud, there are three primary types of fraud. They are asset misappropriation, fraudulent financial reporting and corruption (Aris et al., 2013).
The most noticeable impact of fraud risk is the collapse of a company. Such a collapse is evidenced by Razali and Arshad (2014) when they assert that some of the world’s largest businesses and corporations including WorldCom, Enron, and Global Crossing were closed down because of financial statement fraud. The Collapse of firms and scandals are the prices most companies and organizations have to pay for indulging in fraudulent activities. Even if not, such organizations are bound to experience some of the extreme financial losses.
Based on analysis from Lau and Ooi. (2016) article, it can be confirmed that the level of fraud is highly prevalent in Malaysia. Lau and Ooi. (2016) state that the most common type of fraud found incorporations is misleading financial reporting i.e. overstate their reported revenue. The cases of fraud are sensitive and most importantly, fatal to the organization’s economic health. Following the study by Mohammed and Knapkova (2016), it was discovered that there exists a positive association between the risk management of an organization and its performance. This observation was made in companies that have invested higher levels of intellectual capital. Several reasons could be attributed to this, but it can be summarized by the fact that cutting down fraud risk also reduces the costs of the company and improves the public perception of the enterprise.
Simply put, internal controls are activities and policies that manages risks to an organization. They are significant to organizations since they play an important role in preventing and detecting fraud (Dabbagoglu, 2012). In order to effectively accomplish its objectives, these policies and procedures are put in place, which safeguard an organizations assets to prevent fraud risk. A study has been done among banks in Kisii found that, there is a positive relationship between the quality of control environment and fraud risk management (Gesare, Michael & Odongo, 2016). Ineffective internal controls systems, caused by unclear definition of policies guiding employee actions, have been proven to be a source of amplifying risk of material misstatements of financial statements that increase fraud risk (Smith et al., 2005).
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) notes that internal control has five components: risk assessment, control activities, control environment, information and communication, and monitoring. Therefore, it is essential for an organization’s management to have a holistic approach when dealing with fraud. As noted by COSO, this approach entails ensuring that the environment factors that may promote fraud, such as weak policies are strengthened, monitoring in order to detect fraud, implementing control measures, and training.
The essence of risk management committee and its role in organizational performances is without a doubt vital. Since risk is innate in every business activity, it is vital for institutions to apprehend them and adopt adequate measure towards preventing, reducing or dealing with the risks. Monitoring risks is essential because unforeseen circumstances could make organizations experience losses. Previous researches have anticipated that Risk Management Committee (RMC) could significantly influence firm performance (Mohammed & Knapkova, 2016; Krause & Tse, 2016; Kallamu, 2015; Edogbanya & Karmardin, 2015). In these studies, it is clear that having RMC will result to enhance monitoring of risks that will lessen losses as well as promote performance due to internal policies to help in managing the same.
The risk management committee of any organization is charged with the responsibility of managing the internal control including those that control fraud. As shown, fraud has lots of adverse outcomes of the organization and as such everyone tries to mitigate the fraud risk. Ng et al. (2012) carried out a research whose key objective was to assess whether there is any statistically significant relationship between a business’ risk taking and the characteristics of the risk management committee. The three principle features of the RMC include size, independence of the board, and the number of meetings it holds. The number of RMC meetings were found to be insignificant in the study as opposed to the size and independence features which depicted a negative relationship with risks (Ng et al., 2012). Similarly, experience has been found to be an important factor in managing risks. Arioglu and Tuan (2014) and Ng et al., (2012) argue that professional expertise is needed as an approach to show intensive attention to oversight effectiveness. The other essential characteristics are the number of women on the RMC board which can be simply defined as gender diversity. Several studies have asserted that gender diversity offers an organization better performance (Zenzem & Kacemb, 2014; Campbell & Vera, 2008). Campbell and Vera (2008) carried out a study where they sampled Spanish firms, and their discovery was that gender diversity would lead to more economic gains and greater performance.
In the perspective of Malaysia, a diminutive amount of research has been conducted in order to determine the relationship or investigate the impact of RMC characteristics on performance as well as on risk-taking. However, there is no study has been conducted in order to determine the impact of the quality of RMC on the level of fraud risk through mediation of internal control. This study seeks to fill the gap by adding more to literature pertaining to this field. Keeping in account the limitations of a research, more studies have to be carried out in order to validate the relationship between the variables.
The Resource-Based View Theory
The resource-based view theory (RBV) requires that an organization to possess resources that can be manipulated to provide it with a competitive advantage over its competitors. Proper application of these resources can lead to better performance for extended periods of time. Therefore, acquiring and assigning a value to organizational resources is the ultimate path to gaining competitive advantage. According to Liu and Li (2002), in resource based view, the conception should emphasizes two properties. For one thing, recognition and measurement of strategic risk can’t exist unless there are specific organizations and managers that have relations with the organization. For another thing, the level and constitution of strategic risk are affected by enterprises’ resources and capabilities. In relation to the resource-based view theory, the RMC is a vital resource, particularly when fraud risk is involved. This theory will be useful in explaining the relationship between quality of RMC and fraud risk level.
This study is conducted to assess the quality of characteristics of RMC in predicting the fraud risk level through mediation of internal control in organizations. From this basic study objective, there are mainly three variables which are to be analyzed in this study
1) Quality of RMC (Independent Variable)
2) Fraud Risk level (Dependent Variable).
3) Internal Control (Mediator Variable).
The relationship between the quality of RMC and level of fraud risk with internal control as a mediator variable to prevent fraudulent activities in organizations is summarized by the framework below:
Quality of RMC
Level of Fraud Risk
As per the objectives of the study the impact of quality of characteristics of RMC is examined upon its ability to somehow mitigate the level of fraud risk in an organization. Implementation of the mediator variable, internal control defines the quality of RMC as well as its impact on fraud risk level. This means that quality of characteristics of RMC is the influencing or explanatory variable whereas level of fraud risk is the recipient variable. With this basic understanding of the approach and nature of variables, it is equally important as to explain the measurements of independent and dependent variables. Along with that, the measurement of mediator variable.
The assessment of characteristics of RMC can be explained through five major measurements, which cumulatively design a model of an appropriate RMC provided as under size of committee (SC), independent directors (ID), frequency of meeting (FM), expertise of directors (ED), and RMC gender diversity (GD) (Abdullah & Ismail, 2015; Kallamu,2015; Ng et al., 2012). Likewise, the dependent variables can be best understood with the following two measures of fraud risk, Beneish M-score model and F-Score (Razali & Arshad, 2014, Beneish, Lee & Nichols, 2013; Dechow, Ge, Larson, & Sloan, 2011). A mediator variable mediates between the dependent and independent variable serving to explain the relationship that exists between them. In this case, internal control act as an intermediary to provide the description of the association between the characteristics of the RMC variable and level of fraud risk. The control variables, on the other hand, refers to those that remain uncharged throughout the entire process of study. This study has two primary control variables which are film size (FS) and financial leverage (FL). Company size relates to the natural logarithm of total asset whereas financial leverage, as used in this study implies the long term debt over total equity (Andersen, 2008; Pagach & Warr, 2011; Mohammed & Knapkova, 2016).
Beneish M-score model = a + ß(SC) +ß2(ID) + ß(FM) + ß(ED) +ßs(GD) + ICPROB + FS+FL + Eo
F – score = a + ß(SC) +ß2(ID) + ß(FM) + ß(ED) +ßs(GD) + ICPROB + FS+FL + Eo
This study employs a quantitative research design. The data to be utilized in this study will be obtained from secondary sources, particularly from the Datastream financial database and companies’ financial reports, pertaining to the relevant companies of Bursa, Malaysia. In this sense, the sample will involve all non-financial companies of Bursa Malaysia since 2012 to 2016. The aim of doing so is to investigate the impact of mediator variable on the relationship between independent and dependent variables. Since all variables are in quantitative form, therefore the need of statistical technique is indispensable.
Structural Equation Modelling
This study will make use of Structural Equation Modeling, which is a diverse set of mathematical models, statistical methods, and computer algorithms that fit into an organization’s network and constructs data. It is usually applied in the analysis of unobservable (latent) constructs. This structural model will be useful in showing the causal dependency between independent (Quality of RMC) and dependent variables (Fraud Risk Level) and between RMC quality when it comes to internal controls aimed to control fraud risk level.
Liu, H., & Li, Y. (2002). From Strategic Risk Measurement to Strategic Risk Management—A Resource Based View. USA-China Business Review, 2(2).