Corporate Governance and Modified Audit Opinion: Evidence from State Owned Enterprises in Kenya

Findings: The study findings established negative and significant effect of both board size and board independence on modified audit opinion. This results suggest board size and percentage of independent directors significantly influenced the likelihood of state owned enterprises receiving modified opinion. Results on the effect of control variables; leverage and return on assets were statistically insignificant.


Introduction
The subject of transparency accountability is a topic of great interest in both private and public sectors. Different countries have attempted to improve corporate governance in order to advance accountability and transparency. Sarbanes Oxley act (2002) put the responsibility of quality in financial reporting in United states on the board of directors. The world Bank (2014) tool kit for corporate governance argues that external audit can ensure transparency and accountability in state owned enterprises. In Kenya Mwongozo (2015) code of corporate governance for state corporation similarly puts the responsibility of accountability and transparency in the board of directors. Mwongozo (2015) outlines how boards of state corporation should be structured to ensure transparency and accountability in state owned enterprise in Kenya. A world Bank report (2014) indicated that SOEs greatly contributed to the economy of many countries including provision of critical services. Boards of directors are responsible for monitoring and supervision of information presented by management.
Consequently, if done correctly it could lead to improved quality of financial reporting. This means that well managed enterprises are less likely to receive modified audit opinion from independent auditors. Tian and Xin (2017) observed that audit opinion was important because it offered a reflection, whether financial statements presented by management offered a true and fair view. This information would be beneficial to diverse stakeholders. Farinha and Viana (2009) observed that modification of audit reports was a sign of poor quality in financial reporting. Hsiao, Lin and Hsu (2010) observed that various forms of modification include; qualified opinion, adverse opinion and disclaimer opinion. Unmodified audit opinion can bring trust and confidence in financial reporting by the agent. This is likely to convince investors and lenders to provide more finances (Green & Singleton, 2009). In the public sector the public who pay taxes and investors may want to know through audit reports how the state owned enterprises use their taxes and investments.
Empirical evidence on the effect of corporate governance practices on modified opinion was mixed and inconclusive. Saaydah (2019) established positive association between board size and modified opinion, however the results on effect of independent directors was insignificant. In contrast Farinha and Viana (2009) established negative effect of board independence on modified opinion while the results for board size were insignificant. Ishak and Yusof (2015) established board independence had a negative association, with modified audit opinion in Malasyia. The contrasting findings on the determinants of audit modification means that the subject remains unsetled hence the need for furthur research. This study aims to establish the effect of corporate governance variables of board size and percentage of independent directors on modified audit opinion.

State owned enterprises in Kenya
According public financial management act 2012 state owned enterprises (SOEs) in Kenya are entities where the government of Kenya has a controlling state or a case whereby there is specific legislation classifying the entity as state owned entity. The control and direction of SOEs in Kenya is guided by Mwongozo (2015) code of governance of state corporations. In terms of board independence Mwongozo code guidelines requires that at least thirty percentage of board members be non-executive board members. In terms of board size Mwongozo guidelines recommends a board size of 7-9 members to govern these entities effectively. Article 229 (6) of constitution of Kenya 2010 puts the office of the auditorgeneral of Kenya as the supreme audit institution(SAI) responsible for checking for accountability in SOEs in Kenya.

I.
To establish the effect of board size on modified audit opinion in commercial and manufacturing state owned entities in Kenya.

II.
To establish the effect of board independence on modified audit opinion in commercial and manufacturing in state owned entities in Kenya III.
To establish the effect of leverage as a controlling variable on relationship between corporate governance and modified audit opinion.

IV.
To establish the effect of return on assets as a controlling variable on relationship between corporate governance and modified audit opinion.

Theoretical Foundation
Hay and Cordery (2017) reviewed history of public sector audit and observed that agency theory was the dominant theory guiding of audit and corporate governance in both public and private sectors. Board of directors are responsible for monitoring and supervising management of SOEs. If done effectively it will result to quality financial reporting that will attract unmodified audit reports from independent auditors.
The agency theory as argued by Ross (1973); Jensen and Meckling (1976) holds that as result of separation of ownership and control managers are likely to make decisions that maximize their own utility at expense of owners. This arises due to information asymmetry between management and the owners. Agency theory proponents argue that through corporate governance mechanisms including independent audit and board structure the agency costs can be reduced. Independent board, large boards with independent auditors will bring trust and confidence by reducing information asymmetry between management and the agent. If dove correctly this is likely to results to quality in financial reporting. Stream (1994) observed that the agency problem was more complex in the public sector when compared with private sector due multiple relationships. Between the citizens and Legislation, Legislations and executive and between the executive and CEOs of various entities. Wallace (1980) observed that even in the public sector auditing was valued because it helped reduce the agency costs. Hermalin and Weisbach (1998) observed that board effectiveness in terms of monitoring was a function of board independence.
Stakeholder theory as argued by Freeman (1984) offers another perspective in corporate governance and audit opinion. The theory holds that through governance mechanisms including board of directors' interest of diverse stakeholders would be protected. Based on stakeholders' theory perspective audit opinion will be of great interest to various stakeholders to ensure their interests are protected.

Figure 1
Control Variable

Independent Variable Dependent Variable
Based on empirical and theoretical framework .The study conceptualized relationship as depicted in Figure1. Sound corporate governance mechanisms could lead to quality financial reporting hence determining the type of audit opinion to be issued by the independent auditor. Leverage and return of assets were used as control variables.

Research Design
This study employed correlational research design. Correlational research design uses statistics to describe and measure the degree of association among the study variables (Cresswell, 2014).

Data collection
The study collected data from 25 companies of the 33 enterprises in commercial and manufacturing sector as categorized by (SCAC,2020). The data was obtained from annual reports covering the period 2013 to 2016. Data on board size, and non -executive directors was obtained from governance statements in the annual reports. Data on the audit opinion was obtained from audit reports published by the auditor general of Kenya. Data on leverage and return on assets ware calculated from financial data obtained from financial statements in the annual reports.

Model Specification
To measure the level of association among the study variables the study adopted logistic regression. A logistic regression model is an extention of generalised model. Logit models are flexible and able to accommodate categorical dependent variable (Francis, 2017).      between modified opinion and return on assets.  Table 5 presents collinearity statistics. Multicollinearity problem occurs when the explanatory variables are highly correlated. This creates a problem in the relationship between the response and explanatory that will be distorted leading to incorrect interpretation. Multi collinearity problem is tested using the variance inflation factor whereby VIF > 5 will mean highly correlated. The results reveal VIF values below < 5 meaning the no multicollinearity problem (Mela & Kopalle , 2002).  Overall Percentage 71.0 Table 7 presents the classification results that shows the prediction accuracy of the model.

Model Accuracy Prediction Statistics
The result indicates overall prediction accuracy of 71%. This proves that the model had high prediction success.

Conclusions
The study examined the relationship between board structure and modified opinion in commercial and manufacturing state owned entities in Kenya. The results reveal board size has negative and significant association with modified audit opinion. This finding suggest that the size of the board will influence the likelihood of a firm receiving modified opinion.
Consequently, firms with large boards were less likely to receive modified opinion due monitoring effectiveness of large boards. Similarly, the results indicate negative and significant relationship between board independence and audit opinion. This finding suggest that enterprises with more independent directors were less likely to receive modified audit opinion. The negative association between both board size, board independence and modified opinion is in agreement with Agency theoretical perspective on importance corporate governance practices. The results effect of controlling variables; leverage and return of assets was statistically insignificant. This means that both leverage and return on assets as control variables did not influence the odds of state owned enterprises receiving modified audit opinion in Kenya.
The findings in this study will prove useful to those charged with corporate governance in SOEs in Kenya. There is evidence that board size and independent directors significantly influenced the likelihood of a firm receiving modified audit opinion. This study significantly contributed to development of literature on effectiveness corporate governance practices in the public sector in Kenya. In addition, the study contributed to methodology on operationalization and testing variables in the public sector context.