[FULL] Article 6, Volume 1 Issue 1

Audit expectation gap: fraud detection and other factors

Author

Ramon Saladrigues – (University of Lleida)

Marta Grañó – (University of Lleida)

DOI:

10.26595/eamr.2014.1.1.6

Abstract

Financial information is an essential element in our society and in our economic system, as it plays a decisive role in the relationship between the various social agents. Therefore, this financial information must have a high level of quality, transparency and credibility. The expectation gap is the difference between the responsibility that auditors believe they have in developing their professional activity, and that which the users of the financial information attribute to them. Numerous analysed studies confirm that the audit expectation gap exists. Among the profusion of possible causes, the studies coincide in highlighting fraud detection, independence, erroneous expectations, nature of the audit process and the “going concern” analysis. Once the main factors have been presented, the article takes an in-depth look at one of these factors: the role of the auditor when fraud is detected.

Keywords

1. Introduction

Account audits have the social function of attesting that the financial information is adequate, correct, sufficient, and good quality. And this is a very significant aspect for the users of this information. Account audits have a very specific purpose, according to current legislation: reviewing and checking the financial information, within a specific framework of rules.

However, several empirical studies carried out in recent decades, show that the perception of the aims of an audit, held by users of financial information, does not coincide with the idea auditors have regarding the development of their work, and this has been called the “audit expectations gap”.

The appearance of certain company irregularities after the auditor has issued a favourable audit report, has called the audit activity into question and has led to doubts about whether audit tasks are carried out adequately.

This work, firstly, introduces the audit expectations gap concept, by outlining the legal audit framework, identifying audit users and searching for proof of the existence of the expectations gap, so as to, subsequently identify its determining factors. Once the main factors have been presented, the article takes an in-depth look one of these factors: the role of the auditor when fraud is detected. Finally, the study ends with the corresponding conclusions.

2. The audit expectations gap

As indicated in the introduction, the expectations gap is the difference between the expectations of auditors and the expectations of those who use the account audit. So, the study on the expectation gap cannot advance without first analysing a) the legal framework in which audits are developed, and according to which the auditor will act; b) the interest of the audit users; and c) finally, the proof of the existence of the audit expectations gap.

2.1. The legal account audit framework

The aim of the audit, according to the provisions of the Account Audit Act, is to verify that the financial statements reflect the true image of the equity or assets, the financial situation and the profits and losses of the going concern, according to the Generally Accepted Accounting Principles (PCGA) and the rules in the country where they are applied.

Account audit regulations are a dense, lively set of rules that are updated constantly. It is important to highlight that the auditing activity is highly regulated and must obey very specific procedures and models.

While discussing the legal audit framework, it is worth indicating that, on the one hand, the rules are not very well known to audit users. In fact, it is difficult for the general public to be informed on the provisions in audit legislation. Okafor et al. (2013) analyzed the expectation gap in auditing and their conclusions were that “the public appears ignorant of what is expected of the auditors as enshrined in the statute books and other documents issued by regulatory and professional bodies. This public’s lack of knowledge no doubt is responsible for their unreasonable expectations from the auditors”. Nevertheless, the ruling framework defining the audit activity is firmly upheld, and the globalisation of the economy is leading to establishing a more uniform regulation framework on an international level. This is all manifested by the enactment of the International Audit Standards, which the various countries have been adapting to gradually.

Account audit legislation particularly indicates that the audit has public importance, since it is a professional service not only intended for the going concern, but also for third parties who have, or may have, a business relationship with it.

This social purpose of an audit is the most important part of the work, and it is the reason why it is essential to understand the expectations it creates within the company and to check to what extent these are fulfilled or not.

2.2. Audit users

Audit users, as a group, are very extensive and heterogeneous.

The main users of a company’s economic-financial information are its own shareholders, who have a legitimate interest in knowing the company’s situation, particularly in the case of shareholders who are not involved in the company administration. However, audit users also include other groups: possible investors, creditors and suppliers, banks and financial entities, the State and its various Public Administration offices, or the staff working in the actual company.

The user of the financial information of a going concern expect that the entity’s financial information is correct, true and sufficient, and therefore financial information users have a series of very specific expectations regarding the account audit task.

Our society is used to the term “account auditing” being used in many conversations, and being the focus of certain news items in the media.

Many news items regarding account audits appear every day. Therefore it is important to look into the expectations of financial information users and to try and see what it is they trust they will obtain from an account audit. Logically, the response is varied. User expectations can be very different, according to each person’s particular interests.

However, several authors agree about highlighting some factors as expectation gap generators, as we can see that they are repeated in many of the works analysed.

The first aim of an audit is to offer guarantees regarding the truthfulness of the information vis-à-vis third parties, as mentioned above. This important desideratum is one of the great audit expectations: audited accounts have a certificate of guarantee indicating that they have been drawn up adequately and include the necessary information. After conducting a supervision, auditors express an opinion on the company’s financial statements.

Following this global aim (where users and auditors converge), the general public trusts that the audit will provide other guarantees of the audited information.

In spite of this coincidence regarding the general aim of the audit, it is equally true that account audits have a very specific aim: to check that the company follows the accounting criteria set out in each particular country. This does not include reviewing documents one hundred percent, instead it means analysing the business and its relevant sector to determine whether or not there are any risks, as well as checking the company control systems, which is used as a basis for planning the work to be done.

However, a majority of financial information users do not know neither how the auditing process is developed (materiality, or how the audit evidence is obtained) nor the performance of audit. Humphrey et al. (1993) examined the expectation gap by ascertaining the perceptions of individuals of audit expectations issues. The results confirmed that an audit expectation gap exists, specifically in areas such as the nature of the audit function and the perceived performance of auditors.

In the same sense, other authors as Chandler et al. (1993) and Cameron (1993), suggested that a general confusion over the audit work has existed.

Consequently, we are witnessing a distancing between how the auditing process and how the performance of audit is developed and the Knowledge that users have of this work.

2.3. Proof of the expectation gap

When the aim of the account audit is to specifically review and check the financial information within the framework of the applicable standard, for the audit users the audit must provide greater guarantees, and they trust that the going concern has been reviewed in-depth.

This distance, or gap, between the expectations of public users of the financial information of an account audit and the actual auditor’s vision of what the auditing task must be, is called the “audit expectation gap”, and this term was coined by Liggio (1974).

Since the expectation gap was analysed for the first time, the term has been widely debated in professional circles. It has also been an important topic in the field of empirical research, and numerous studies have been conducted on the subject.

In the 70’s various works were undertaken on the audit expectation gap. In the United States, Baron et al. (1977) conducted a study to compare the point of view of auditors and the general public using an empirical study based on questionnaires. Their work concluded that there are significantly different beliefs regarding the extent of the auditor’s responsibility in detecting and exposing material errors, and illegal acts. In particular, audit users expect greater responsibility from auditors in detecting fraud than the actual professionals believe they should have.

This aspect is probably one of the most significant factors in the audit expectation gap: fraud detection, which is understood to be intentionally including misstatements in financial statements.

The definition of “expectation gap” gradually evolved and, in 1978 in New York, the “Commission on Auditor’s Responsibilities” extended it further, by considering that a gap can exist between what the public expects or needs and what the auditors should be able to fulfil from a reasonable point of view.

As you can see, there are different descriptions and, over the years, different authors have been broadening the various nuances.

Most studies carried out on the subject are quantitative, and have been developed using surveys, questionnaires and interviews. The result of these studies confirms what we have already mentioned in the section introducing the definition of the term.

Since the 90’s, research has been conducted on the differences in audit expectations in different countries. Therefore, in 1993, García Benau et al. (1993) did a comparative study on the nature of audit expectations in Spain and Great Britain.

Also, studies have been done to analyse third party perception, of judges in particular. Thus Lowe (1994) concluded that judges systematically expect more from the auditors than the auditors believe that they must provide. This is a very significant aspect that must be taken into account when analysing the expectation gap: the actual auditor’s consideration of the scope of their work, particularly where fraud detection is concerned.

The phenomenon was also analysed in Bangladesh by Chowdhury and Innes (1998), in a study where they explored the possible differences in the audit expectations in the Public Sector between the auditors and those who use their reports.

The literature on the expectation gap has continued to grow in recent years. In USA, Frank et al. (2001) analysed the different audit expectations of auditors, juries and students. Lin and Chen (2004) researched the increase in the audit expectation gap in the context of businesses in China. Alleyne and Howard (2005) explored how auditors and users have a different perception of the auditor’s responsibility to discover fraud. Okafor and Otalor (2013) ran an in-depth study on how to reduce the expectation gap via the role of the auditor profession, developing a quantitative work using questionnaires targeted at university lecturers and students.

So, in the light of a multitude of publications, it looks like the audit expectation gap does exist, and that is has generated enough interest to be the subject of a whole range of scientific research around the world. This interest has not only been maintained, it has actually tended to expand in recent years, with different perceptions existing between what audit users “desire” and what auditors understand to be their role. The empirical studies conducted have revealed the distance between the various points of view of the auditors and the public regarding the main reason for account audits and the auditor’s responsibility in the auditing process.

After introducing the audit expectation gap concept, the following section will be dedicated to identifying the factors determining this gap.

3. Identifying the factors determining the expectation gap

After noting that numerous studies have confirmed that the audit expectation gap does exist (in different countries and different socio-cultural environments), we think that it is important to identify which factors can be considered the causes of this expectation gap.

Simply observing the above-mentioned studies, will enable us to highlight the factors determining the expectation gap, where the authors have given greater emphasis.

Among the profusion of possible causes, the studies coincide in highlighting the following aspects as the main factors creating the expectation gap. We do not intend compiling an endless list of these causes, and merely want to highlight the ones that are referenced most in the studies:

Figure 1. Identification of factors that can contribute to creating the expectation gap

3.1. Fraud detection

The general public believe that one of the fundamental functions of the audit is to detect fraud, although really this is not its main aim.

Auditors and users have different convictions about the scope of the auditors’ work and responsibility regarding the detection of irregularities and fraud. Users consider that an auditor’s review should extend further in this area, whereas auditors think that user expectations are “unrealistic” or “excessive.

In recent years, certain cases where going concerns have “collapsed” have made headline news, have put auditors in a delicate position vis-à-vis public opinion which, probably, is more predisposed to criticising the audit task and less towards trusting of the results this task offers.

3.2. Auditor independence

Auditor independence is a basic aspect of their professional work. Their mission is to guarantee the truthfulness of the financial information, and this mission can only be duly fulfilled if the professional auditor maintains a fully independent position from the going concern.

Obviously any circumstance linking an auditor to the company it is auditing can affect their impartiality when working. Therefore, Independence is one of the essential requirements.

Auditors are in a delicate position, between their role as an independent guarantor of financial information and as the professional hired by the actual going concern. This aspect is erroneously perceived by the general public.

3.3. The existence of erroneous expectations on auditing

This factor is highlighted by auditors, who express the need for the user public to confine themselves to reasonable expectations of the auditing process. This is because they think that, on many occasions, the public’s expectations can be excessive.

Erroneous expectations can occur, basically, for 2 reasons:

Because of excessive perceptions of the auditor’s scope and responsibility.

A relatively frequent example of this is the conviction that auditors supervise all the financial information. The general public do not know some of the terms used, like “materiality” or “sampling techniques”.

Because of confusion (which is relatively frequent) between the responsibilities relating to auditors and those corresponding to company administrators.

Here we can quote the example of the relatively generalised public belief that auditors are responsible for drawing up the annual accounts, whereas legally, this is the responsibility of the company administrators.

These are samples of the erroneous beliefs regarding auditing which must be clarified and explained by positioning the terms at their corresponding level.

3.4. The actual nature of the auditing process

Many users of financial information think that the nature of the auditing process is “complicated” and they find it difficult to understand what an account audit process actually involves.

There are two aspects to take into account regarding the complexity of audits: first of all, understanding the actual audit process. Empirical studies show that a high percentage of users do not know the nature or scope of auditing tasks, and this is linked to the excessive expectations mentioned in the previous point. Users do not know how an audit is carried out, and so it is difficult for them to understand how the sampling techniques are carried out to do certain tests, or how the task to be carried out in each case is determined.

Secondly, the language used in the audit report does not help the comprehension process either. It is widely proved that most people who read (not experts) an audit report find it complicated to identify the various parts, and also the language used is often confusing to them.

3.5. The auditor’s responsibility with respect to the going concern principle.

International Audit Standard 570 relates to the auditor’s responsibility with respect to applying the going concern principle. Said going concern principle considers that the company, or concern, will continue operating normally over the next 12 months. In practice, this standard refers to the auditors’ capacity to anticipate problems within the going concern.

This has been one of the major debate topics in recent years, particularly within the context of the economic recession. In an environment where some companies are closing, or where others are forced to alter their staff numbers or a particular line of business, audit users expect that the auditor will inform them on whether or not the audited company is going to continue operating normally.

The work involved in an audit process is useful but, logically, it has its limitations. As we have already pointed out, not all the financial information is supervised, the tests are not always able to detect all the problems a company may have, or appropriately assess the deterioration that may occur, and these tests may even make it harder to anticipate future conflicts in uncertain economic situations.

Additionally, there is the risk that highlighting a problem of this kind,” in the audit opinion of a company, technically called a “going concern”, very significantly increases the danger of it really happening. Therefore it is a particularly delicate part of the auditor’s technical task, and it would be convenient to analyse it in greater depth given its importance and impact.

With respect to detecting those circumstances that can introduce doubts about an entity continuing its normal activity in the following financial year, there are two possible scenarios, as set out in the following figure:

Figure 2. Scenarios when identifying problems of continuity

It is possible that the auditor does not detect any possible problems of continuity, but there is also the possibility that the auditor does adequately detect the possible continuity problems. The issue here is how will this be reflected in the audit report?

Two possible scenarios must be distinguished:

where the company has factors that mitigate any doubts over its continuity
where the company does not have sufficient arguments to counteract the possible operating problems

In the first scenario, we have a company that has no doubts about the continuity of its activity over the next 12 months, because although there are factors raising doubts, the company can argue mitigating factors:

Figure 3. Cases of companies with factors that cause doubts over continuity

In the cases where there are doubts over the continuity of a company, and the mitigating factors do not succeed in diminishing these doubts, or cases where the company is already in compulsory liquidation:

Figure 4. Cases of companies with doubts over continuity

This shows that it is the technical standard that determines the way in which it must be reflected in the annual accounts: via information in the company report, a reservation or an uncertain fact in the report.

The paragraph containing the emphasis of matter due to uncertainty follows the opinion paragraph and begins with the text “without affecting our opinion…”. The way the report is structured and written may lead readers to just retain what is indicated in the opinion paragraph and consider that the paragraph of emphasis merely corresponds to secondary aspects, whereas in fact we are talking about a crucial aspect such as a company’s continuity.

In some cases, audit reports can be interpreted incorrectly by third parties, because for the report to be “decoded” appropriately, it is necessary to know the content of the technical standard, and this fairly unlikely.

Here we are not just talking about whether the auditor has done his or her job properly and has adequately assessed the going concern principle (which is an essential part of the job). It is also important to consider the application of the standard, and this could be a factor of confusion or, at least, difficulty, when third parties try to understand an entity’s financial information. This widens the gap between what users expect from an audit and the final result of said audit.

Until now, we have listed some of the main factors contributing to the creation of the expectation gap. To determine them, we have based our arguments on the most frequently mentioned causes in the scientific publications we have analysed.

The factor mentioned the most in the analysed literature is: “the auditor as a fraud detector”, which is quoted in 67% of the indicated publications. Consequently, we consider that it is a very relevant factor in the expectation gap analysis. This is a leading factor because, on the one hand, it is credited as such by the empirical studies carried out in various countries and at different times and, on the other hand, because the international scientific literature has repeatedly discussed the auditor’s responsibility vis-à-vis fraud. There is a certain amount of controversy over this factor, and it is discussed not only at scientific level, but also in the general media, which just goes to show that it is a very contemporary issue, that triggers considerable interest among the general public.

As for the auditor’s independence, this is obviously a very important factor for developing the auditing activity correctly, but it does not seem to be such a major issue in debates. Probably, since it is a legally imposed requirement in the auditing sector, nobody doubts that it is an essential aspect and it therefore does not spark as much interest as the preceding point. Therefore, we cannot go further in-depth into this factor.

The erroneous expectations that arise over account audits is a proven fact, based on an ignorance of the standards governing audits. We think that this aspect is associated with the lack of information, and this does not allow for a very extensive analysis, and so neither will we reflect upon this aspect.

The difficulty that the general public have in understanding the nature of the audit process is a clear factor. However, like the point above, it could be solved with greater information on account auditing. We believe that going further in-depth into this factor would lead us to discussing procedures and rulings more than the actual distance between the general public and auditors.

Finally, as for applying the going concern principle, which is understood to be the auditor’s ability to predict the future evolution of companies, this factor is not often quoted, even though it is probably a very topical issue. In a recession environment, where some companies must close or significantly reduce their business, the public expect auditors to inform them on the viability of the company’s future. Therefore we think that it is a factor to be taken into consideration, and which we will discuss in greater detail.

Based on the arguments raised, we are going to go further into analysing the most quoted factor, due to its important effect on the audit expectation gap: fraud detection, due to its proven high profile in numerous studies and analyses.

4. The auditor as a fraud detector

The factor quoted most in literature due to its influence on the audit expectation gap is “the auditor as a fraud detector”.

Several scientific studies have shown that users of financial information expect auditors to be fraud detectors, even though this is not the essential aim of account audits.

In the business world an infinite number of situations can occur with numerous causes. When problems that may lead to fraudulent situations are detected, the general public expects the audit to detect these irregularities and warn about them. And this is particularly expected by company investors who are not directly involved in the company administration.

In fact, there is no account audit regulation that indicates fraud detection as the main aim. The only thing that is stated clearly is that the auditor must design his or her work plan so that, if there is any significant fraud, it can be detected.

So, there seems to be a dichotomy in the way account audits are understood. For most of the public, account audits must be a fraud detection system, whereas the standard sets out that the purpose of audits is to check that the financial statements adapt to accounting standards.

In fact, fraud detection is a field that corresponds to the so-called « forensic audit», which is not the same as an account audit. Forensic audits do specialise in obtaining proof to be submitted as evidence, generally in legal proceedings. A greater number of professionals are involved in forensic audits, apart from the account auditor – lawyers, IT technicians or writing experts, etc.

It is to prove alleged economic and financial crimes, like administrative corruption or corporate fraud. Account audit procedures, however, are more specific and the task is more defined, since it is limited to the evidence associated with the irregular fact that has been detected.

In view of this set of factors, it is important to specify what is meant by an account audit: a process for checking that a company’s financial information adapts to the Generally Accepted Accounting Principles and the applicable General Accounting Plan.

If there is significant fraud, it must be detected in an audit study.

Although it is true that an account auditor must make a maximum effort to produce work that is independent and reviewed with high quality standards, given the social dimension of his or her work and the implications for third parties, it is also true that he or she must point out what an account audit involves, so that their clients and society in general are aware of its purpose and work scope.

Having reached this point, we can review two aspects concerning fraud detection in audits:

Research work that has been carried out on fraud detection in audits and
International Auditing Standard 240 “The auditor’s responsibilities relating to fraud in an audit of financial statements”

4.1. Research work on fraud detection

International scientific literature has repeatedly discussed the auditor’s responsibility relating to fraud, as indicated above. One factor that has undoubtedly led to this increased interest has been the financial scandals that have occurred in the economic world, associated with audits.

Sometimes auditors have failed to detect very significant cases of fraud. The role that audits must develop in relation to fraud is not an issue to be minimised, because they have a very important social and economic impact.

The appearance of certain business irregularities after the auditor has issued his favourable audit report, has led many users to question the validity of the account audit process.

This is a controversial point, and it is even discussed in the media and it can be summarised in this quote by Singleton-Green^[1] (1990):

“The real issue behind fraud … The fact is that if the auditors were not responsible for detecting fraud, people would not waste time and money asking for what they cannot find. Auditors must accept their responsibilities and take a positive position”.

The author indicates that there must be a coincidence between what auditors do and what is expected of them. And it is probably in the field of fraud detection where we have to make the greatest effort.

Generally speaking, users expect auditors to protect the interests of shareholders, creditors, employees and the general public so that, inter alia, they assure that there has been no fraud.

GarcíaBenau et al. (2013) summarised the most important empirical literature published between 1986 and 2008, showing that there is notable interest and lively debates on the auditor’s role in detecting and informing on business fraud.

It is also significant that a larger number of studies on the subject were detected after 2001, following scandals in the auditing world, like Enron and WordCom.

They also highlight the concern over how to improve fraud detection techniques. All because of the effect fraud detection has on the audit function, and, particularly, on the auditors’ image.

In recent account auditing history there have been some significant financial scandals, and at these times, the question on everyone’s lips has been: how come the auditors did not detect it?

The most significant occurred in 2001: the Enron case, which put an end to the audit firm, Arthur Andersen, and the WordCom case, which affected the firm KPMG.

Khurana and Raman (2004) planned a study to analyse the quality of the audit work by the Big 4 and the non-Big 4, to ascertain whether the quality of an audit is related to the auditor’s reputation or to the auditor’s exposure in lawsuits. The study results suggest that the possible exposure to lawsuits is the aspect that most influences the quality of audit work.

Lai (2005) studied the position of the auditors who replaced Arthur Andersen in the audit reports, following the Enron scandal, to see if they were issuing more conservative reports, and they drew the conclusion that this was in fact the case.

And more recently, during the financial crisis that began in 2008, numerous audit reports have been questioned for not having detected any possible solvency problems that certain financial entities may have been experiencing. In Spain the most significant cases were Bankia and Pescanova.

It is difficult to determine the extent of the auditor’s responsibility in not detecting irregularities leading to fraud. However, certain business growth models must make people take full precaution, since an audit is an essential guarantee element for investors who have no other means of comparing the truthfulness of a company’s information.

Proof of the importance that is given to this aspect is also found in the development of International Standard on Auditing 240.

4.2. International Standard on Auditing 240

International Standard on Auditing (ISA) 240 includes the “The Auditor’s responsibilities relating to fraud in an audit of financial statements”.

Said ISA 240, in its introductory section defines the characteristics of fraud in relation to account audits:

“Misstatements in the financial statements can arise from either fraud or error. The distinguishing factor between fraud and error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional.

Although “fraud” is a broad legal concept, for the purposes of the ISAs the auditor is concerned with the fraud that causes a material misstatement in the financial statements. Two types of intentional misstatements are relevant to the author: misstatements resulting from fraudulent financial information and misstatements arising from misappropriation of assets. Although the auditor may suspect or, in rare cases, identify the occurrence of fraud, the auditor does not make legal determinations of whether fraud has actually occurred.”

We can now see that the factor differentiating between fraud and error lies in whether it is intentional or not, highlighting that the auditor’s aim is to detect significant misstatements in the financial statements.

The standard even dedicates Appendix I to listing some examples of fraud risk factors, indicating that they are merely provided by way of illustration, and are not intended to be a detailed list. The risk factors are presented according to the type of fraud relevant to the auditor and we have illustrated them in the following figure:

Figure 5. Types of fraud and risk factors

Based on the definition of the concept of fraud, the Standard moves on to specify the auditor’s responsibility regarding the prevention and detection of fraud. In this respect, it points out that the auditor’s aims must be:

“to identify and assess the risks of material misstatements in the financial statements arising from fraud;
to obtain sufficient and appropriate audit evidence regarding the assessed risks of material misstatements arising from fraud, by designing and implementing appropriate responses; and
to respond appropriately to the fraud or the indications of fraud identified during the audit”

These aims introduce specific requirements in the audit study, which affect the need to maintain the necessary professional scepticism, discussions between the members of the commissioned audit team, procedures for assessing the risk, identifying and assessing the risks of material misstatements arising from fraud, a response to the assessed risks of material misstatements arising from fraud, assessment of the audit evidence, cases where it becomes impossible for auditors to continue their commission, written contributions, communication sent to the management and those responsible for running the company, communication sent to the regulating, supervising and documenting authorities.

As well as considering these conditions, it provides an application guide for each requirement mentioned.

It is important to point out that point 4 of the Standard establishes that the first ones responsible for avoiding fraud are the company administrators and managers. They must be responsible for preventing and detecting fraud. However, the auditor must be reasonably sure that the financial statements are free of material misstatements arising from fraud or error.

The risk of not detecting material misstatements arising from fraud is greater, because the fraud may involve sophisticated planning to hide or even “collude”^[2] it, which can “lead the auditor to think that the audit evidence is sufficient when, in fact, it is false”.

It also specifies that the risk of the auditor not detecting fraud committed by the company management is greater than the cause of fraud committed by employees, since their hierarchical position allows them to avoid control procedures designed to prevent employees from committing fraud.

Therefore, by establishing the audit procedures in response to different risks, ISA 240 sets out some specific procedures for analysing the risks associated with the management avoiding the controls.

The Standard also refers to the content of the representation letter, and indicates that the auditor is to obtain written statements from the management and, when applicable, from those responsible for running the company, indicating that they admit their responsibility in designing, implementing and maintaining internal control to prevent and detect fraud.

One of the most relevant sections of ISA 240 relates to the “impossibility of auditors continuing their”. In this section, the standard indicates that if, after detecting fraud or indications of fraud, auditors must consider whether they continue with the commission or reject it.

If the auditor rejects continuing, this must be communicated appropriately to the company management and administration body, and it must be analysed whether there is any professional or legal requirement which demands the information from the regulating authorities.

In spite of the auditor’s duty to keep the information confidential, in some circumstances, the auditor’s legal responsibility to inform the regulating authorities can prevail over the duty of confidentiality.

All this gives a view to the importance that is given to fraud detection which, as the ISA indicates, does not only include the undue misappropriation of assets, but also the submission of fraudulent financial information, which is what essentially worries the financial information users.

Fraudulent information implies intentional misstatements, including omitting amounts or information from the financial statements in order to mislead those who use them. This manipulation of the results can start with small actions or undue adjustments of the hypothesis and changes in the management’s judgement.

The actual ISA 240 indicates that elements of pressure and incentives can make these actions increase to the point that fraudulent financial information is provided. A situation like this can occur when the management, due to pressures it is under to comply with market expectations, or the desire to maximise payments based on results, adopts, intentionally, postures that lead to fraudulent financial information by introducing material misstatements in the financial statements.

Consequently, we have been able to ascertain the importance of fraud detection in audits: it has been a widely studied term over recent decades. Investigations have shown that there is a wide gap between what the general public expect regarding fraud detection and what auditors consider they must cover.

This concern has been included in the international standard, by means of its consideration in the International Auditing Standards, in ISA 240. This all proves that an effort is needed regarding fraud detection in audits and to implement more effective procedures that make it possible to offer more guarantees over financial information.

5. Conclusions

Numerous analysed studies confirm that the audit expectation gap exists.

There are differences between the responsibility that auditors believe they have in developing their professional activity, and that which the users of the financial information attribute to them.

The factors that contribute most to creating said gap are as follows: fraud detection, auditor independence, erroneous expectations by users, the nature of the audit process, and the capacity to anticipate possible operating problems in the going concern. Out of these factors, the one that is analysed the most in literature is fraud detection by auditors.

Being aware of the main factors separating user and auditor expectations regarding account audits, is important for developing measures to help minimise these differences, succeeding in offering more reliable financial information, and for giving audits a leading role that contributes to financial stability. As indicated by the European Commission^[3] “an audit is a key factor for recovering the market’s confidence, as it helps to protect the investor and reduces the capital cost for companies”.

According to current legislation, auditors are not obliged to guarantee that the audited accounts are absolutely free of any misstatements. But certainly, the auditor must provide the greatest possible guarantees of truthfulness and correction for the interested parties.

These reflections on the future of auditing, in one sense or another, are made in a society that is changing at a very fast pace, and auditing must adapt to the new situations.

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[FULL] Article 5, Volume 1 Issue 1

Audit firm tenure and audit qualifications in Spain: a multinomial approach

Author

Josep Garcia-Blandon – (IQS School of Management, Universitat Ramon Llull)

Josep Mª Argiles – (Universitat de Barcelona)

Monica Martinez-Blasco – (IQS School of Management, Universitat Ramon Llull)

DOI:

10.26595/eamr.2014.1.1.5

Abstract

The Green Paper on Audit Policy by the European Commission has questioned the current regulatory framework of audit rotation in the European Union and it has encouraged additional research about the effects of long audit firm tenures on independence. Prior research has mostly limited to examine audit qualifications for reasons of going concern with samples of financially distressed firms. Such approach presents limitations in terms of the generalization of results. The approach we propose allows, on the one hand, for the inclusion of all types of audit qualifications in the analysis; while, on the other hand, it takes into account the particularly serious implications of going-concern qualified opinions for both, the auditor and the audited firm. Our results show that auditors seem willing to sacrifice independence in lengthy engagements, but only regarding non-going-concern qualified opinions. This result might have some interesting implications for policy makers, particularly in the current discussion about the necessity of mandatory audit firm rotation. If, as most papers do, we measure auditor independence only through the issuance of going-concern opinions, a mandatory firm rotation rule does not seem to be necessary. However, if all types of qualifications are considered, mandatory firm rotation could increase independence.

Keywords

1. Introduction

As far back as in the early sixties, Mautz and Sharaf (1961) pointed out that extended auditor-client relationships could negatively affect independence, because an auditor’s objectivity about a client would be reduced with the passage of time. Since then, lengthy auditor-client relationships have been regarded as a major issue in the conflict of interest faced by the auditor. Long relationships might cause auditor complacency about and possibly complicity in the decisions that management makes regarding the presentation of financial statements (e.g., Shockley, 1982; Myers et al., 2003). As a result, the mandatory rotation of external auditors has long been suggested as a way of strengthening independence. Even though the Sarbanes-Oxley Act did not impose the mandatory rotation of the audit firm, it required a study by the Comptroller General of the United States (GAO, 2003), about the potential effects of imposing the mandatory rotation of auditors. The study did not show a negative effect of extended audit tenures on the quality of financial reports, and thus, it did not recommend rotation. However, the regulator finally established audit rotation at a partner level, which could not provide audit services for the same client for more than five consecutive fiscal years. It also established a minimum five-year time-out period before a partner could re-audit a client. Many countries have adopted similar audit rotation rules. For example, for the year 2008, the 27 States Members of the European Union (EU) were required to adapt national law systems to the revised 8^th Company Law Directive (hereinafter, the revised 8^thDirective). A main feature of this Directive was to enforce audit rotation at a partner level, although each State Member could voluntarily establish the maximum length of the auditor-client relationship. At present, several maximum periods coexist within the EU: five years in the United Kingdom, six years in France or seven years in Germany and Spain¹.

Nevertheless, only four years after the approval of the revised 8^thDirective in 2006, the European Commission (EC) has explicitly questioned whether the current regulatory framework could sufficiently guarantee independence. In its first paragraph, the Green Paper on Audit Policy states: “(…) limited attention has been given so far to how the audit function could be enhanced in order to contribute to increase financial stability. (…) It seems thus appropriate that both the role of the audit as well as the scope of audit are further discussed and scrutinised in the general context of financial market regulatory reform”. One of the major threats to the real independence of external auditors is that mandatory rotation has been established only at a partner level. Regarding this issue, the Green Paper (EC 2010: 11) states: “Situations where a company has appointed the same audit firm for decades seem incompatible with desirable standards of independence. Even when “key audit partners” are regularly rotated as currently mandated by the Directive, the threat of familiarity persists. In this context, the mandatory rotation of audit firms – not just of audit partners – should be considered”. Similarly, in the US, the Public Company Accounting Oversight Board (PCAOB) issued in 2011 a concept release about mandatory audit firm rotation (PCAOB, 2011) and initiated the process of examining its merits and drawbacks. The main concern, as expressed by PCAOB Chairman Mr. Doty, was about auditors’ lack of professional skepticism². The PCAOB is currently considering whether long audit firm tenures align auditors’ interests with management instead of protecting investors.

In this article, we examine the effects of audit firm tenure on the likelihood of qualified opinions with a sample of public Spanish companies for the period 2001-2009. This research is mainly motivated by the current regulatory discussion on the convenience of a mandatory audit firm rotation rule. In this line, the EC (2010) Green Paper on Audit Policy has explicitly encouraged additional investigation on auditor independence in EU countries. Moreover, empirical research is not only inconclusive but also refers mainly to the US. Since litigation risk plays a major role in audit literature as a determinant of the auditor reporting decision (e.g., Melumad and Thoman, 1990; Narayanan, 1994), the relatively high-litigation risk of the US makes it difficult to extrapolate results to other settings³. In addition, most previous research has limited to examine the effects of tenure on the issuance of going-concern modified opinions (GCMO) to financially distressed firms. This approach presents, in our view, two shortcomings. Firstly, financially distressed firms are not representative of the population of audited firms and the same can be said of GCMO with respect to the whole universe of audit qualifications. Therefore, results are difficult to be generalized, either to the whole population of firms or to the whole universe of qualifications. Secondly, focusing exclusively on GCMO does not account for the traditional role of the auditor in the corporate governance scheme, as information verifiers (Simunic, 1984). Nevertheless, when auditors issue GCMO, they do not perform this information verifier role, but act as substitutes of bankruptcy prediction models. On the other hand, the few articles that have included all types of qualifications and firms in the analysis (Vanstraelen, 2000; and Ruiz-Barbadillo et al., 2005), have failed to account for the particularly serious implications of GCMO for both, auditor and client.

We contribute to the literature by providing a new framework which overcomes the abovementioned shortcomings. The multinomial logistic approach we propose allows to include all types of qualification into the analysis, but at the same time, acknowledges for the different implications of different types of audit qualifications. A second contribution is that for the first time in the literature, accounting quality is included as a determinant of audit qualifications. We consider this an important issue, because without including accounting quality in the analysis, any reported negative effect of tenure on audit qualifications (as for example in Vanstraelen, 2000) could mean either loss of independence with tenure, or higher accounting quality (and thus, lower likelihood of audit qualifications) with tenure. Evidently, the regulatory implications of each situation would be opposite.

Our results show that long tenures make non going-concern modified opinions (NGCMO) less likely, while do not affect GCMO. This finding highlights the limitations of the general approach followed in the literature to capture the loss of independence through the issuance of GCMO to financially distressed firms.

The remainder of the paper is organized as follows. In section two, we review the literature on the association between tenure and audit quality. Section three summarizes the regulation of the auditor-client relationship in the Spanish market. In section four we define our model and describe our dataset. Results are discussed in sections five and six. Finally, conclusions are presented in section seven.

2. Review of the literature

The issuance of qualified audit reports has been used in the literature as a proxy of auditor independence. The rationale of this approach would be that since the probability of switching the audit firm increases after a qualified report (e.g., Krishnan, 1994; Lennox, 2000), qualified opinions suggest an exercise of independence by the external auditor. Therefore, following Shockley’s (1982) concerns about the negative effects of tenure on independence, we should expect a lower likelihood of qualified reports in lengthy auditor-client relationships. Empirical research, though particularly prolific during the last two decades, does not support that independence would be threatened by long tenures. Louwers (1998) and Carcello and Neal (2000), with samples of US financially distressed firms, did not find a negative effect of tenure on the auditors’ reporting decision. A similar conclusion was reached by Vanstraelen (2002) and Knechel and Vanstraelen (2007) for the Belgian market, and by Ruiz-Barbadillo et al. (2004) and (2006) for the Spanish market. This evidence supports that the litigation risk faced by the auditor when an unqualified report is issued to a company which deserves an audit report with GCMO would offset the ‘familiarity threat’ associated to long tenures with the audit firm. However, more recent research has provided somewhat contradictory results. Lim and Tan (2010) reported a positive effect of tenure on audit quality. The authors measured audit quality through several proxies, including the propensity for auditors to issue GCMO to financially distressed firms. Conversely, Gul et al. (2011) for the US and Firth et al. (2012) for China, concluded that auditors were willing to forgo their independence by issuing fewer going-concern reports when auditor tenure was long. Without limiting the analysis to financially distressed companies or to GCMO, while Vanstraelen (2000) reported that long tenures significantly increased the likelihood of unqualified audit reports in the Belgian market, Ruiz-Barbadillo et al. (2005) found that GCMO were more likely in longer tenures in Spain.

With the only exception of Vanstraelen (2000), the effects of tenure on the likelihood of qualified reports have been studied in the context of GCMO and financially distressed firms. Such approach faces a serious shortcoming regarding the generalization of the reported results. Financially distressed firms are not representative of the total population of audited firms, and the same can be said regarding GCMO with respect to the whole universe of audit qualifications. Therefore, results reported by previous research are difficult to be generalized either to the whole population of firms, or to the whole universe of audit qualifications. On the other hand, results reported by Vanstraelen (2000), although more generalizable because of the inclusion of all type of audit qualifications and firms, do not differentiate between GCMO and other types of qualified opinions. This distinction is meaningful becausefirstly, GCMO and NGCMO represent different dimensions of the audit activity; and secondly, GCMO involve relatively higher levels of litigation risk compared with NGCMO. Regarding the first issue, as posed by Simunic (1984), the auditors’ traditional role in the corporate governance scheme is to verify the information produced by managers. However, when auditors issue a qualified report for reasons of going concern, they are not performing the information verifier role, but acting as a substitute of bankruptcy prediction models⁴. Regarding the different levels of litigation risk of GCMO and NGCMO, the decision of issuing a qualified opinion is influenced by the perceived consequences in the economic trade-off between the expected cost of the potential loss of a client, on the one hand, and the probability of being exposed to third-party lawsuits and loss of reputation, on the other. The risk of litigation faced by the auditor is particularly high when it fails to issue a GCMO to a company that subsequently goes bankrupt [e.g., Palmrose 1987; Krishnan and Krishnan, 1997]. Therefore, Vanstraelen’s (2000) approach fails to account for the different levels of litigation risk of GCMO and NGCMO. If, for example, auditors were willing to forego independence regarding relatively low risky NGCMO but not regarding comparatively riskier GCMO, the inclusion of the two types of audit qualifications into a single variable could cause misleading results.

3. Audit regulation in Spain

With the main goals of enhancing transparency and making financial statements more comparable internationally, the first audit law in Spain was enforced in 1988 as a result of the implementation of the 8^th Directive on Company Law. Following the approval of the Spanish Audit Law, companies above a certain size were required to appoint an external auditor to issue a report about the company’s financial statements. The law imposed some conditions to regulate the auditor-client relationship in order to strengthen independence. For example, a multi-year contract with the audit firm, with duration between three and nine years, was established. It also imposed the mandatory rotation of the audit firm since, independently of the length of the initial contract, the same audit firm could not be reappointed. Nevertheless, as a result of a subsequent legal reform, both the maximum limit in the number of consecutive years to be audited by the same firm and the prohibition to reappoint the audit firm were abolished in 1995. After this reform, auditors could be engaged for an initial period ranging between a minimum of three and a maximum of nine years, but after the expiration of the initial contract the company could renew the contract with the same auditor on a yearly basis. The 1988 Spanish Audit Law imposed the mandatory rotation of the audit firm after nine years, being 1988 the first year to be subject to the mandatory rotation rule. Thus, 1997 would have been the first year in which those companies which had not changed the audit firm since 1988 would have to. However, since the rotation rule was removed in March 1995, it was in fact never applied.

With the same aim as the Sarbanes-Oxley Act in the US, the Spanish Financial Law was passed in 2002 as a reaction to corporate financial scandals. An amendment was included during the Law’s approval process including the mandatory rotation of the audit firm, after a maximum period of twelve years. Besides, a minimum three-year period was required to re-hire the audit firm. Similarly to the 1995 reform avoiding mandatory rotation, largely the result of pressures induced by audit firms, this amendment led to strong criticism from the auditing profession, which caused its eventual withdrawal. Finally, mandatory rotation was limited to change the audit team after seven years, but not the audit firm. The maximum partner tenure of seven years has also been maintained by the 2010 reform of the Spanish Audit Law, however, without imposing the rotation of the audit team⁵.

4. Methodology

4.1. Research design and hypothesis development

This research addresses the effects of tenure on auditors’ independence, measuring independence through the ability of the auditor to issue qualified audit reports. The approach we propose extends prior research as it allows, on the one hand, to include all types of audit qualifications in the analysis while, on the other hand, to account for the potentially different implications of GCMO and NGCMO.

As discussed in section two, prior research has generally measured auditor independence through the issuance of GCMO to financially distressed companies. The election of GCMO as a proxy of independence is generally justified on the grounds that available evidence (e.g., Chow and Rice, 1982 and Krishnan, 1994 for the US; Craswell, 1988 for Australia) supports the view that the probability of switching audit firms is higher following the issuance of a qualified opinion. Similarly, Ball et al. (1979) argued that auditors were reluctant to qualify their reports, since the publication of audit qualifications would adversely affect the interests of corporate participants, and Levinthal and Fichman (1988) claimed that a qualified opinion is an indicator of conflict within the auditor-client relationship. Besides, audit qualifications have negative effects for the audited company in terms of negative stock price reactions (Chow and Rice, 1982b; Dopuch et al., 1987; Loudder et al., 1992; and Ameen et al., 1994), lower market responses to earnings announcements (Choi and Jeter, 1992) and higher costs of debt (Chen et al., 2012). However, all the above-mentioned articles do not limit the analysis to GCMO, but include all types of audit qualifications. Therefore, empirical evidence supports the use of all types of audit qualifications (not only GCMO) as a proxy for independence. Nevertheless, the results by Krishnan (1994) support the necessity to differentiate between GCMO and NGCMO. The author reported that although auditor switching significantly increased after both GCMO and NGCMO, the switching rate was almost double for GCMO than for NGCMO.

Accordingly, the research question states:

Does the likelihood of qualified audit reports decrease with tenure?

Based on the concerns expressed by the Green Paper on Audit Policy about the effects of long tenures on independence; the results of Vanstraelen (2000) in a low litigation risk country; and considering the relatively low litigation risk profile of the Spanish audit market, we expect a higher likelihood of unqualified audit reports in longer tenures.

Therefore, we hypothesize that:

Hypothesis 1: ceteris paribus, the longer the auditor-client relationship, the less likely the issuance of ‘unclean’ audit reports (qualified opinion, adverse opinion or disclaimer of opinion).

Litigation risk constitutes a major motivation in the auditor reporting decision. According to our discussion in section two, this risk is particularly high when the auditor fails to issue a GCMO to a company that subsequently goes bankrupt. Thus, auditors will be expected to be less willing to compromise their independence regarding GCMO compared with NGCMO. Therefore, we hypothesize that:

Hypothesis 2: the loss of independence in lengthy audit engagements should be lower regarding the issuance of GCMO compared to NGCMO.

Prior research on the effects of tenure on the likelihood of audit qualifications has been carried out through the classical logistic regression approach (e.g., Vanstraelen, 2000; Ruiz-Barbadillo et al., 2004, 2005; Knechel and Vanstraelen, 2007) with a dependent binary variable coded 0 in case of an unqualified audit report and coded 1 in case of an ‘unclean’ report. While most papers only account for GCMO, when this is not the case, all types of audit qualification are coded 1, independently of their nature. In such cases, the different implications of the two types of audit qualifications are not properly addressed. In order to overcome this limitation we follow a multinomial logistic approach in which, the dependent variable is coded 0 in case of an unqualified report; coded 1 in case of NGCMO; and coded 2 in case of GCMO⁶.The experimental variable is the length of the auditor-client relationship. Control variables are similar to the ones used in prior research as determinants of the auditor’s reporting behavior (particularly in DeFond et al., 2002 and Carey and Simnett, 2006). In addition, we also include an independent variable accounting for periods of economic downturns as a determinant of the auditor’s reporting decision.

Accordingly, we propose the following model to carry out the multinomial analysis.

Model 1:

OPINION = f (PBANK, SIZE, LEVERAGE, LIQUIDITY, STOCKS, LOSSES, AUDFIRM, CRISIS, TENURE), where:

Dependent variable:

OPINION is the variable accounting for the auditor’s opinion: unqualified (coded 0), NGCMO (coded 1), and GCMO (coded 2).

Experimental variable:

TENURE is the natural log of the number of consecutive years the company has been audited by the same firm.

Control variables:

PBANK is probability of bankruptcy as measured by adjusted Zmijewski (1984) score, with the weights proposed by Carcello et al. (1995).

SIZE is the natural log of the firm’s total assets in book values at the end of the year as a proxy for firm size.

LEVERAGE is the firm’s level of financial leverage calculated as total debt divided by total equity, both in book values, at the end of the year.

LIQUIDITY is a measure of the firm’s liquidity at the end of the year, calculated as the sum of its cash positions divided between its current liabilities.

STOCKS are computed as the firm’s inventories divided by total assets at the end of the year, both in book values.

LOSSES is a binary variable with score 1 if the company’s net profit on year t is negative and 0 otherwise.

AUDFIRM is a binary variable with score 1 if the company is audited by a non-Big 4 audit firm and 0 otherwise.

CRISIS is a binary variable with score 1 for years 2001, 2002, 2008 and 2009, and 0 otherwise. Years 2001 and 2002 correspond to the dotcom crisis, while years 2008 and 2009 indicate the beginning of the financial crisis.

Next, we discuss the expected effects of control variables on the probability of ‘unclean’ audit reports.

PBANK measures the probability of bankruptcy based on Zmijewski (1984), where higher values indicate a greater probability of bankruptcy, and therefore higher litigation risk for the incumbent auditor. Thus, we expect a positive effect of PBANK on the likelihood of audit qualifications. Since previous research (e.g., Lys and Watts, 1994; Shu, 2000) has documented a positive relationship between the size of the audited firm and litigation costs, the probability of qualified reports should be higher for large firms. Nevertheless, DeAngelo (1981) pointed out that auditors’ incentives to compromise independence were a function of client importance. As litigation risk is relatively low in the Spanish audit market, we predict a negative effect of SIZE on the probability of qualified reports. Financial leverage increases the probability of bankruptcy, and consequently raises litigation risk. Accordingly, we expect a positive effect of LEVERAGE on the likelihood of audit qualifications. Liquidity has been usually found a significant determinant in predicting bankruptcy (e.g., Hopwood et al., 1989). Therefore, poor liquidity is expected to increase the likelihood of qualified reports since it increases auditor’s litigation risk. In addition, firms with liquidity problems might be more willing to manipulate financial statements (e.g., Butler et al., 2004), thus making audit qualifications more likely. Therefore, a negative coefficient is expected for variable LIQUIDITY. The auditing of the company’s inventories may represent serious difficulties, because it involves two audit assertions: valuation and completeness (McDaniels, 1990). Consequently, as posed by Simunic (1980), audit fees are higher for those firms with relatively large amounts of inventories. In addition, audit errors (Firth, 2002) and lawsuits against auditors (St. Pierre and Anderson, 1984) are also often caused by inventories. Accordingly, we hypothesize a positive effect of inventories on the probability of NGCMO, and therefore a positive coefficient for variable STOCKS regarding NGCMO. However, we do not expect a significant effect of inventories on the issuance of GCMO. Following previous research (e.g., Dopuch et al., 1987; Firth, 2002) companies suffering losses should face higher probabilities of having qualified reports. The explanation is quite straightforward and similar to the one proposed to justify the expected negative relationship between liquidity and audit qualifications. Within the litigation risk framework, since litigation risk is higher when auditing firms with losses, so it should be the probability of audit qualifications. In addition, firms experiencing losses will more likely incur in earnings management activities, therefore making audit qualifications more likely.AUDFIRM accounts for a potential lower propensity of qualified reports by non-big 4 auditors.As the risk of bankruptcy is particularly high during periods of economic downturns, we include the variable CRISIS to account for the differential levels of litigation risk during these periods. We expect a positive effect of periods of crisis on the likelihood of audit qualifications.

4.2. Sample and dataset

Empirical analysis is performed on the basis of all the companies quoted in the Spanish Stock Exchange (Sistema de InterconexiónBursátilEspañol) during the research period 2001-2009. Data about the independent variables in the model are provided by Thomsom Reuters Knowledge. Regarding the nature of audit reports, information is provided by the ComisiónNacional del Mercado de Valores (CNMV). Our model includes liquidity and debt ratios among the explanatory variables. Thus, following prior research, banks and financial companies are removed from the sample. Our dataset is formed by 112 firms. Considering the nine-year research period, that makes 1008 firm-year observations. Nevertheless, in 127 cases information about at least one variable in our model was not available. Therefore, our sample is finally formed by 881 firm-year observations.

According to the Spanish legislation, the audit report has to include the opinion of the auditor about the firm’s accounting reports. This can be: unqualified, qualified, unfavorable or disclaimer of opinion. Nevertheless, audit reports with unfavorable or disclaimer of opinion are in practice very unusual in Spain, at least for quoted companies. In this research, we examine 881 audit reports, 758 of them with an unqualified opinion and 123 with a qualified opinion. GCMO are relatively scarce in our research period: only in 19 out of the 123 qualified audit reports, qualifications were for reasons of going concern. Finally, none of the 881 audit reports showed an unfavorable or disclaimer of opinion.

The supervisor of the Spanish stock market (CNMV, 2009) classifies audit qualifications into two major groups: quantified and unquantified. In addition, quantified qualifications are also classified into two subgroups, depending on whether they affect profit and losses or equity. Similarly, unquantified qualifications are also classified in ‘Uncertainty and others’ and ‘Limitations’. Among qualifications due to uncertainties, the most serious are those concerning the continuation of business, the so-called GCMO, in which the auditor expresses doubts about the ability of the company to continue doing business. However, uncertainties can also have less dramatic effects; for example, they might be associated with the firm’s ability to recover some tax credits. On the other hand, qualifications for limitations on scope show that the auditor has not had enough information to apply the procedures required by the technical auditing standards. Therefore, while GCMO are issued when the auditor has doubts about the future of the company and have little to do with the firm’s accounting quality, NGCMO would be indicators of low accounting quality.

In table 1 we show the 881 audit reports classified by year and type of opinion, in percentage of total reports of each year.

Auditor Opinion	2001	2002	2003	2004	2005	2006	2007	2008	2009
Unqualified	79%	82%	86%	87%	91%	92%	90%	82%	82%
NGCMO	21%	17%	14%	13%	8%	7%	10%	10%	11%
GCMO	0%	1%	0%	0%	1%	1%	0%	9%	7%
Number of Reports	80	89	92	102	103	105	104	104	102

Table 1. Classification of audit reports by year and auditor opinion

The percentage of unqualified reports steadily increases during the subperiod 2001-2006 and decreases afterwards. The maximum value corresponds to year 2006, when 92% of the total reports are unqualified. Since GCMO were very rare before the financial crisis, the rise of unqualified reports in the 2001-2006 subperiod strongly corresponds to a fall of NGCMO. However, after 2007, while the number of NGCMO remains stable, GCMO show a dramatic surge. Thus, the fall of unqualified reports during the financial crisis is caused by the increase of NGCMO.

Table 2 shows some descriptive statistics about independent variables. The average company SIZE is 6.67, corresponding to total assets of 4.7 billion of euros. The statistics for variable LEVERAGE indicate that for the companies in our sample, on mean terms, the amount of debt is four times the amount of equity. Regarding LIQUIDITY, firms’ cash positions represent 18% of current liabilities, on mean terms. STOCKS account, on average, for the 16% of firms’ total assets. In one company, however, this percentage increases up to 97%. The mean value of 0.16 for variable LOSSESindicates that companies with negative net income account for the 16% of our dataset. The table also shows the extreme level of concentration of the Spanish audit market by Big 4 firms, as companies audited by non-Big 4 auditors only represent seven percent of the sample. Regarding our main variable of interest, TENURE, auditor-client relationships in our dataset show an average duration of nine years, with a maximum value of 23 years.

Variable	MEAN	MEDIAN	ST. DEV.	MAXIMUM	MINIMUM
PBANK	-1.70	-1.58	4.34	79.56	-67.05
SIZE	6.67	6.47	1.85	11.6	0.10
LEVERAGE	4.16	1.91	31.63	922.77	0.00
LIQUIDITY	0.18	0.08	0.32	5.55	0.00
STOCKS	0.16	0.11	0.18	0.97	0.00
LOSSES	0.16	0.00	0.37	1.00	0.00
AUDFIRM	0.07	0.00	0.26	1.00	0.00
CRISIS	0.42	0.00	0.49	1.00	0.00
TENURE (in years)	9.26	9.00	5.79	23	1.00

Table 2. Descriptive statistics

PBANK is probability of bankruptcy as measured by adjusted Zmijewski (1984) score, with the weights proposed by Carcello et al. (1995).

SIZE is the natural log of the firm’s total assets in book values at the end of the year as a proxy for firm size.

LEVERAGE is the firm’s level of financial leverage calculated as total debt divided by total equity, both in book values at the end of the year.

LIQUIDITY is a measure of the firm’s liquidity at the end of the year, calculated as the sum of its cash positions divided between its current liabilities.

STOCKS are computed as the firm’s inventories divided by total assets at the end of the year, both in book values.

LOSSES is a binary variable with score 1 if the company’s net profit on year t is negative and 0 otherwise.

AUDFIRM is a binary variable with score 1 if the company is audited by a non-Big 4 audit firm and 0 otherwise.

TENURE is the natural log of the number of consecutive years the company has been audited by the same firm.

Graph 1 shows the histogram of the number of consecutive years a firm has been audited by the same audit firm. As can be seen, the distribution is far from normal. Our sample is characterized by a relatively high concentration of firms in the two extremes of the variable. It therefore supports our definition of variable TENURE in natural log terms.

Figure 1. Histogram of audit tenure

Table 3 shows Pearson’s correlation coefficients, with significance levels, for the independent variables in the model. Variable SIZE shows the strongest levels of correlation with the remaining independent variables. Interestingly, the positive correlation with TENURE shows that larger companies tend to engage in lengthier audit contracts. Similarly, the negative correlation between TENURE and LOSSES indicates that firms with losses show relatively short-term audit engagements. Finally, firms audited by non-Big 4 auditors are relatively smaller and tend to show shorter tenures. Since correlation coefficients are rather low (a maximum of 0.28 in absolute values), multicollinearity will hardly affect our estimation. Nevertheless, variance inflation factors (VIF) have been calculated to rule out the negative potential effects of multicollinearity in our results. As expected, VIF (not reported) are rather low (the maximum value is 1.21 for variable SIZE), thus supporting our initial opinion that multicollinearity will not affect our results.

	PBANK	SIZE	LEVERAGE	LIQUIDITY	STOCKS	LOSSES	AUDFIRM	CRISIS
PBANK	1
SIZE	0.208*	1
LEVERAGE	0.283*	0.004	1
LIQUIDITY	-0.101*	-0.101*	-0.024	1
STOCKS	-0.261*	-0.261*	0.006	-0.165*	1
LOSSES	0.145*	-0.167*	0.018	0.047	0.157*	1
AUDFIRM	0.042	-0.224*	-0.002	0.032	0.183*	0.123*	1
CRISIS	-0.003	0.037	0.052	-0.030	0.008	0.157*	0.007	1
TENURE	-0.037*	0.176*	-0.050	0.013	-0.134*	-0.143*	-0.220*	0.050

*Significant at the 1% level

Table 3. Pearson correlations between independent variables

5. Results

Firstly, we present and discuss the results of the univariate analysis and afterwards we address the results of the multivariate analysis.

5.1. Univariate analysis

We perform a univariate analysis of differences of means for the three groups of firms according with the nature of the audit report: unqualified; NGCMO and GCMO. As expected, the Shapiro-Wilk test rejects the hypothesis of normality for each independent variable. Thus, the Mann-Whitney test of differences of medians is performed in order to assess the statistical significance of these differences. Median values of independent variables for each subsample, and significance levels from the Mann-Whitney test for the continuous variables and the Pearson chi-square test for the dichotomous variables LOSSES, AUDFIRM and CRISIS, are shown in table 4.

Variable	UNQUALIFIED	NGCMO	GCMO
PBANK	-1.78	-1.24	0.50*
SIZE	6.57	5.83*	6.74
LEVERAGE	1.88	1.84	5.21*
LIQUIDITY	0.09	0.05*	0.01*
STOCKS	0.11	0.12	0.20*
LOSSES	0.13	0.28*	0.89*
AUDFIRM	0.07	0.06	0.11
CRISIS	0.40	0.51	0.89*
TENURE (in years)	9.00	6.00*	4.00

*Significant at the 1% level

Table 4. Median values of independent variables according with auditor opinion. (For non-continuous variables LOSSES and CRISIS mean values instead of medians have been provided)

Results from table 4 strongly fit our expectations. Regarding our experimental variable TENURE, firms with qualified reports (either GCMO or NGCMO) show shorter audit tenures compared with firms with unqualified reports, although only for the NGCMO subsample is this difference statistically significant. Thus, the univariate analysis seems to support a negative effect of tenure on auditor independence, although only regarding NGCMO. Results concerning control variables indicate that firms with GCMO show significantly higher probability of bankruptcy, higher levels of financial leverage and inventories and lower levels of liquidity. On the other hand, those firms NGCMO are relatively smaller and, similarly to the going-concern subsample, they also show lower levels of liquidity. Audit qualifications, both GCMO and NGCMO, are positively associated to the reporting of losses. Finally, audit qualifications are more frequent during economic downturns, although only for the GCMO subsample is this difference statistically significant.

5.2. Multivariate analysis

The joint effect of tenure and the proposed control variables on the likelihood of audit qualifications is addressed through a pooled multinomial logistic regression. As expected, heteroskedasticityis detected in our data, thus reported z-values are calculated with robust standard errors. Following post-estimation analyses based on bivariate models, four influential observations were identified (with Pregibondbeta higher than 0.2). Results reported in table 5 are obtained after the re-estimation of the model without these influential observations. Table 5 reports estimations for NGCMO and GCMO; being firms with unqualified reports the comparison group.

	Predicted sign	NGCMO (Z-value)	GCMO (Z-value)
PBANK	+	0.06 (1.93)	0.10* (2.26)
SIZE	–	-0.65**	-0.03
SIZE	–	(-3.26)	(-0.07)
LEVERAGE	+	0.40*	0.60*
LEVERAGE	+	(2.42)	(2.51)
LIQUIDITY	–	-4.61**	-22.84*
LIQUIDITY	–	(-4.19)	(-2.05)
STOCKS	+	-1.61	1.49
STOCKS	+	(-1.87)	(1.00)
LOSSES	+	0.59*	3.51**
LOSSES	+	(2.08)	(4.44)
CRISIS	+	0.24	2.03*
CRISIS	+	(1.00)	(2.41)
AUDFIRM	–	-1.04* (2.28)	-1.84 (-1.15)
TENURE	–	-0.43**	0.24
TENURE	–	(-3.33)	(0.54)
INTERCEPT		0.69	-7.05**
INTERCEPT		(0.98)	(-3.03)
N	877
Chi-Square	122.30**
Pseudo R²	0.226

*, ** Significant at the 5 percent and 1 percent levels, respectively

Table 5. Regressions results on the association of tenure with auditor’s opinion

Based on the likelihood ratio Chi-square test, the null hypothesis that all predictors’ regression coefficients in the model are simultaneously zero is rejected. According to the McFadden’s pseudo R², our model explains 23% of the total variance. A main issue regarding multinomial logistic models is whether some categories of the dependent variable could be combined into a single one. To address this question properly, we perform a log-likelihood ratio test for combining dependent categories. Our main interest is to check if the two categories of audit qualifications, GCMO and NGCMO, could be combined into a single category. In all three possible combinations: ‘unqualified versus NGCMO’; ‘unqualified versus GCMO’ and ‘NGCMO versus GCMO’, the null hypothesis that the specified categories are indistinguishable with respect to the variables in the model is rejected (P-Value <0.01). This result supports our choice of a multinomial logistic model over the traditional bivariate approach.

We are primarily concerned with the sign and statistical significance of the coefficients of TENURE. If lengthy auditor-client relationships impair independence, the coefficient should be negative and statistically significant. As shown by table 5, this is the case regarding NGCMO, but not regarding GCMO. In the first case, TENURE shows a negative and statistically significant coefficient (P-Value <0.01), while in the second case the coefficient is positive, although non-significant. Therefore, regarding the two hypotheses posed in section 4, hypothesis 1 stating that longer auditor-client relationships make ‘unclean’ reports less likely is rejected for GCMO but not for NGCMO. Therefore, as regards hypothesis 2, affirming that auditors would be less willing to compromise independence regarding the issuance of GCMO compared to NGCMO, it cannot be rejected. Taken together these results suggest that external auditors seem willing to sacrifice independence in lengthy engagements, but only regarding the issuance of NGCMO. Following our discussion in section 4, the different results regarding both types of audit qualifications could be explained by the higher risk of litigation associated to GCMO compared to NGCMO. This result had been anticipated by the univariate analysis. Evidence reported about the lack of a negative effect of tenure on independence measured through GCMO supports available evidence for the Spanish market (Ruiz-Barbadillo et al., 2004 and 2006).

Results regardingcontrol variables show that, in all cases, when a significance effect is reported it shows the predicted direction. PBANK is statistically significant regarding GCMO (P-Value < 0.05) and marginally significance for NGCMO, in both cases with a positive sign. SIZEhas a negative effect on the likelihood of NGCMO (P-Value <0.01), while it does not affect GCMO. This result puts forward that the economic incentives of the auditor with the audited company more than offset the potential increase in litigation costs faced with large clients, regarding the issuance of NGCMO. The lack of significance of SIZE regarding GCMO would suggest that, even in the low litigation risk Spanish audit market, while auditors would be willing to impair independence with large and, presumably,more rewarding clients, regarding relatively low litigation risk NGCMO; they would not do it about high litigation risk GCMO. As expected, financial leverage positively affects the issuance of audit qualifications. Coefficients of LEVERAGE are negative and statistically significant for both NGCMO and GCMO (P-Value <0.05). Following our expectations, the likelihood of qualified reports decreases with the firms’ cash positions. LIQUIDITY shows negative and significant (P-Value <0.01 for NGCMO and <0.05 for GCMO) coefficients regarding both types of qualified opinions. As predicted, both types of qualified opinions are more likely when firms report ordinary losses. Coefficients associated to LOSSES are positive and statistically significant (P-Value <0.05 for NGCMO and <0.01 for GCMO). Being audited by a Big 4 firm makes NGCMO more likely, while it does not affect GCMO. This would suggest that non-Big 4 auditors would be more willing to impair independent in lengthy engagements regarding relatively low risky NGCMO but not regarding GCMO. Also as expected, the likelihood of GCMO increases during economic downturns (P-Value <0.05). However, the effect of CRISIS on NGCMO, although positive, is non-significant. From our discussion in section 4 we had assumed positive coefficients associated to STOCKS regarding NGCMO. However, the coefficient isnegative and marginally significant.

We check the robustness of results to a different measure of audit tenure. Accordingly, we define the dichotomic variable LONGTENURE coded 1 when audit tenure was above the median value and zero otherwise. Afterwards, we re-estimate model 1 with LONGTENURE instead of the original variable TENURE. Results (not provided) remain largely unchanged. The new variable LONGTENURE shows a negative and statistically significant coefficient (P-Value <0.01). Coefficients of control variables show in all cases the same signs and levels of significance as those reported in table 5.

There is some evidence (Levinthal and Fichman, 1988; Vanstraelen, 2000) that auditors are more willing to issue unqualified reports during the first two years of engagement (the so-called ‘honeymoon’ period). To test this effect, we re-estimate our model including HONEYMOON,a dichotomous variable with score 1 for the first and second year of the audit contract and 0 otherwise, among the explanatory variables. Under a ‘honeymoon’ effect, the coefficient of HONEYMOON should be negative and statistically significant. Results (not reported) show that the effect of HONEYMOONis not statistically significant for either GCMO or NGCMO. Coefficients and significance levels ofTENURE and control variables remain largely unchanged. Therefore a ‘honeymoon’ effect in the Spanish audit market is rejected.

6. Additional results: controlling for accounting quality

Both, the univariate and multivariate analyses indicate that the likelihood of NGCMO decreases with tenure. This finding suggests a loss of independence in long-term audit engagements. Thus, in order to enhance independence the mandatory rotation of the audit firm should be considered⁷. Nevertheless, following the classical definition of audit quality provided by DeAngelo (1981), there is an alternative explanation for the reported negative relationship between tenure and audit qualifications. As the ability to detect misstatements is higher when the auditor has a better client’s knowledge, and given that this knowledge increases with tenure, it could be argued that the reported negative effect of tenure on NGCMO is not the result of lower independence but of higher accounting quality achieved in lengthy engagements. Furthermore, under the latter interpretation, the implications for policy makers would be completely different: mandatory rotation would impoverishaccounting quality. Vanstraelen’s (2000) previous research reporting a negative effect of tenure on the likelihood of audit qualifications did not control for accounting quality. Therefore, her main conclusion suggesting a loss of independence in extended audit contracts could be misleading, since it could be alternatively explained by higher levels of accounting quality achieved in lengthy engagements.

	Predicted sign	NGCMO (Z-value)	GCMO (Z-value)
PBANK	+	0.06 (1.76)	0.11** (3.44)
SIZE	–	-0.84**	-0.65
SIZE	–	(-2.77)	(-1.26)
LEVERAGE	+	0.47*	0.68**
LEVERAGE	+	(2.31)	(3.66)
LIQUIDITY	–	-5.57**	-22.69*
LIQUIDITY	–	(-3.72)	(-2.47)
STOCKS	+	-1.14	1.84
STOCKS	+	(-0.95)	(0.96)
LOSSES	+	0.59	3.00**
LOSSES	+	(1.60)	(4.36)
CRISIS	+	-0.02	2.34**
CRISIS	+	(-0.05)	(2.77)
AUDFIRM	–	-0.94 (-1.81)	-1.61 (-0.65)
TENURE	–	-0.49**	0.28
TENURE	–	(-2.70)	(0.54)
ACCRUALS	+	-0.09 (-0.14)	0.02 (0.01)
INTERCEPT		1.13	-4.96
INTERCEPT		(1.10)	(-1.76)
N	610
Chi-Square	165.31**
Pseudo R²	0.3032

*, ** Significant at the 5 percent and 1 percent levels, respectively

Table 6. Regressions results on the association of tenure with auditor’s opinion, controlling for accounting quality

High levels of accruals are usually associated to high levels of earnings management and therefore to poor accounting quality (e.g., Bradshaw et al., 2001; Myers et al., 2003). If the negative relationship between tenure and NGCMO is explained by higher accounting quality associated to longer tenures, once accruals are included in the model, TENURE should not significantly affect the likelihood of NGCMO. Conversely, if the effect of TENURE remains negative after controlling for accounting quality, our main conclusion that longer tenures make NGCMO less likely would not be explained by changes in accounting quality, and thus, the alternative explanation of a loss of independence in long-term engagements would prevail. We compute the firm’s total accruals (ACCRUALS) as the absolute value of the difference between operating income and cash flows from operations, scaled by lagged total assets. Data is obtained from the Thomson Reuters Knowledge database. The Pearson’s correlation coefficient between ACCRUALS and TENURE is -0.125 and it is statistically significant (P-Value <0.01), thus, suggesting higher accounting quality in longer tenures. We include the new variable ACCRUALS in model 1 to obtain model 2.

Model 2:

OPINION = f (PBANK, SIZE, LEVERAGE, LIQUIDITY, STOCKS, LOSSES, AUDFIRM, CRISIS, TENURE, ACCRUALS)

Table 6 shows the estimates of model 2. After removing those observations without data for the new variable ACCRUALS, the sample size drops to 610 firm-year observations. As a proof of robustness, results do not change much with this subsample compared with those reported in table 5 with the whole sample. The model’s pseudo R² increases from 23% to 30% and coefficients and significance levels for control variables are largely unchanged⁸. Focusing on NGCMO, the coefficient of TENURE remains negative and statistically significant (P-Value <0.01) while the coefficient of ACCRUALS is negative but non-significant. Accordingly, our main previous finding that the likelihood of NGCMO decreases with tenure is robust to the inclusion of accounting quality in the model. Thus, we rule out that the explanation of the relatively lower probability of audit qualifications associated to long-term engagements could be an increase in accounting quality. Therefore, our empirical evidence supports that independence is impaired in longer tenures.

7. Conclusions

Supporting the concern expressed by the Green Paper on Audit Policy, long-term engagements seem to compromise the independence of external auditors in the Spanish low litigation risk audit market. Besides, consistent with the litigation risk framework, auditors seem to be willing to compromise independence in lengthy engagements regarding relatively low-risk NGCMO, but not about high-risk GCMO. These findings, in conjunction with the available evidence for the US high litigation risk market, mostly failing to support a negative effect of tenure on auditor independence, strengthen the soundness of the litigation risk framework to explain auditor’s reporting decisions.

This research shows that auditors seem willing to sacrifice independence in lengthy engagements, but only regarding the issuance of NGCMO.This result might have some interesting implications for policy makers, particularly in the current discussion about the necessity of mandatory audit firm rotation. If, as most papers do, we measure auditor independence only through the issuance of GCMO, a mandatory firm rotation rule does not seem to be necessary. However, if we take into account all types of audit qualifications, a mandatory rotation rule could increase independence. Although our findings support a mandatory rotation rule at a firm level in order to strengthen the value of audit reports for external users, the negative potential effects of such a rule, for example on the costs of audits, would require a more careful analysis.

The tests performed support our multinomial approach over classical bivariate logistic models. Moreover, results are consistent with the different implications of GCMO and NGCMO on the litigation risk faced by the auditor, and cannot be explained by higher levels of accounting quality supposedly achieved in longer tenures. Therefore, a natural extension of this research would be to re-examine available international evidence at the light of this new approach. In addition, given the serious concern about the negative effects of tenure on independence expressed by the European Commission and the different levels of litigation risk within the European Union, a multi-country research with a European focus would be particularly meaningful.

The most important limitation of this research is due to the uncommonness of GCMO in our sample. Since our conclusions regarding GCMO are based on a too low number of qualified reports, they should be carefully taken. In such a case, the reported results are too dependent on particular observations and the effect of a given variable in the model could more easily be captured by another variable, making results to be misleading.

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[FULL] Article 4, Volume 1 Issue 1

An exploratory analysis of the board composition in Spanish innovative firms

Author

Juan Pablo Gonzales-Bustos – (Rovira i Virgili University)

Ana Beatriz Hernández-Lara – (Rovira i Virgili University)

DOI:

10.26595/eamr.2014.1.1.4

Abstract

The main goal of this work is to develop an exploratory analysis of the board composition of Spanish companies that belong to innovative economic sectors. We seek to contribute to the inconclusive literature that analyses the relationship between board composition and innovation, exploring the characteristics of the board in an organisational context of innovative behaviour. To do so, we collected data from 86 Spanish companies belonging to innovative sectors from 2003 to 2011. The results confirm the relevance of medium size boards with a majority of affiliated directors and CEO duality; male directors are predominant, but the proportion of women, despite its minimum level, is significantly growing. There are relevant differences in the board composition of different Spanish innovative sectors. However, its evolution over time is quite stable, with the exception of the proportion of women on the board. This board composition is characteristic in situations in which the innovative behaviour of companies is significantly improving.

Keywords

1. Introduction

Previous research has established the relevance of innovation for the success and survival of firms (Kor, 2006; Morgan &Berthon, 2008; Stopford& Baden-Fuller, 1994; Torchiaet al., 2011). It is frequent that the search for competitiveness makes companies bet on innovative actions to obtain new or improved products and services (O’Brien, 2003), and to enhance their market shares (Ettlie, 1998).

There are different and varied factors that influence companies’ innovation strategies, both at an external and internal level (Cassiman&Veugelers, 2006; Tsai & Wang, 2007). Internally, research has emphasised the effects of different aspects of corporate governance on innovation because corporate governance explains how the power for decisionmaking is distributed and exercised in companies, affecting the strategies planned and finally implemented (Lacetera, 2001). Amongst the different mechanisms of corporate governance, management teams and board of directors have a direct responsibility in decision making. In fact, boards are the formal representation of ownership, and exert their influence on managerial decisions and strategies, exercising their main functions as monitors and supervisors of managers (Petrovic, 2008), and as advisors and support agents on strategy formulation (Kemp, 2006; Wu, 2008).

However, boards of directors are not homogenous groups always with the same characteristics, performance and results. Thus their effects and influences on corporate strategies, including innovation, cannot be predicted in a simple way. This explains the interest of research in trying to ascertain what the determinants and characteristics of boards are that might explain their functions and performance, and lastly their influence on strategies like innovation. One of the board elements more frequently analysed by research has been the board composition, considering aspects like the optimal board size (Cheng, 2008; Peasnellet al., 2005; Zahra & Pearce, 1989), gender diversity (Burke, 1997, 2003; Cassell, 2000; Singhet al., 2001), typology of directors (Coles et al., 2008; Hillman et al., 2002; Kor, 2006; Markarian&Parbonetti, 2007), CEO duality (Guilletet al., 2013; Lan& Lee, 2008; Penget al., 2010), tenure diversity of directors (Galia&Zenou, 2012), etc. However, despite the previous efforts, there is not a high consensus about the real influence of board composition on innovation and what should be the optimal board composition to assure appropriate innovative behaviour of companies (Galia&Zenou, 2012; Hernándezet al., 2010; Kor, 2006; Torchiaet al., 2011; Zonaet al., 2013). This has led researchers to doubt whether or not there is a direct influence of board composition on innovation (Bianchi et al., 2012; Galia&Zenou, 2012).

These results justify the main objective of this study, which is to develop an exploratory analysis of the board composition of Spanish companies that belong to innovative economic sectors. That way, we aim to contribute to the literature not by trying to explain or predict innovation through board composition, but by analysing the main characteristics of the board in companies whose innovative behaviour has been improving, and seeing how these characteristics have been evolving over time, and if there is a characteristic variability profile in the board composition of Spanish firms belonging to innovative sectors.

2. Literature review on the effects of board composition on innovation

There are many studies that suggest and try to demonstrate what the effects of board composition on innovationare, but few conclusive results have been obtained.

In fact, past researchers do not consider the same theoretical framework to describe this relationship. Their theories propose different, and at some point, contradictory assumptions. One of the most popular theoretical frameworks to analyse the relationship between board of directors and innovation is the agency theory (Galia&Zenou, 2012; Zona, 2012). It states that the separation of ownership and control causes agency costs, due to the different interests and objectives of owners and managers (Fama& Jensen, 1983; Jensen, 1989). According to this theory, there could be an opportunistic behaviour in managers (Lee & O’Neill, 2003), and the board should monitor the management team to reduce agency costs. Minority shareholders are likely to be risk-neutral because they usually have diversified portfolios (Wiseman & Gómez-Mejia, 1998). Managers and large shareholders, on the other hand, might have a negative attitude towards innovation (Franks & Mayer, 2001) because they normally assume greater risks with their employment and investments concentrated in a single or few companies (Daily et al., 2003; Letzaet al., 2004).

However, agency theory is not the only theoretical framework used by research to explain the relationship between board of directors and innovation. Another relevant theory on this topic is the stewardship theory (Fox & Hamilton, 1994). According to this perspective, managers are trustworthy individuals who act in the best interest of the company, thus managers’ and owners’ interests are aligned (Davis et al., 1997). From this point of view, the relevance of the board would not be related to the monitoring function but to the strategic one, and the most valued directors would be those with expertise, information and knowledge on management and business (Petrovic, 2008).

Following these different theoretical assumptions, it is not strange that research has stated different propositions and lastly has arrived at contradictory results on the effects of board composition on innovation. The following table (Table 1) shows some of the main findings on this relationship.

Variable	Authors and year	Sample	Main findings
Board size	Cheng, 2008	1252 US firms (1996-2004)	Board size exerts a negative impact on innovation
	Ocasio, 1994	114 US firms (1960-1990)	Big boards positively affect innovation
	Zonaet al., 2013	225 Italian firms (2004)	Firm size moderates positively the negative relationship between board size and innovation
Gender diversity	Miller &Triana, 2009	326 US firms (2002-2005)	Women positively affect innovation
	Østergaardet al., 2011	1600 Danish firms (2003-2005)	Women positively affect innovation
	Galia&Zenou, 2012	176 French firms (2006-2008)	A high percentage of women on boards positively influences innovation in marketing
	Hillman et al., 2002	275 US firms (1993-1997)
	Torchiaet al., 2011	317 Norwegian firms (2005-2006)	Over three women on the board, the effects of gender diversity on innovation are positive
	Galia&Zenou, 2012	176 French firms (2006-2008)	Women on boards influence product innovation in a negative way, although there is no effect with organisational innovation
	Bianchi et al., 2012	69 Italian firms (2006-2010)	There is no relationship between gender diversity and innovation
Executive directors	Baysingeret al., 1991	176 companies (1981-1983)	High percentage of executive directors has a positive influence on R&D
	Dalzielet al., 2011	221 US firms (2001-2003)	Expertise and knowledge of executive directors are beneficial to R&D
	Hernández et al., 2010	86 Spanish firms (2003-2005)	Executive directors exert a negative influence on R&D
	Malatesta& Walkling, 1988	132 US firms (1982-1986)	Executives without ownership are expected to take short-term actions to increase their personal wealth
Affiliate directors	Jones et al., 2008	403 US firms (1994-2001)	Affiliated directors exert a positive effect on the proliferation of products
External or independent directors	Bianchi et al., 2012	69 Italian firms (2006-2010)	High percentage of outside directors has a positive influence on innovation
	Dalzielet al., 2011	221 US firms (2001-2003)	Technical expertise and knowledge of external directors are beneficial to R&D
	Zonaet al., 2013	225 Italian firms (2004)	External directors positively affect innovation, especially in big firms
	Zahra, 1996	127 Fortune 500 companies	External directors negatively influence innovation
	Zahra et al., 2000	239 US firms (1991-1997)	External directors negatively influence innovation
	Dalzielet al., 2011	221 US firms (2001-2003)	Outsider entrepreneurial, finance experience, and advanced education were shown to be negatively related to R&D spending
	Zonaet al., 2013	225 Italian firms (2004)	There is a negative effect of independent directors on innovation even worst in small firms
	Hoskissonet al., 2002	234 US firms (1985-1991)	There is no association between independent directors and innovation
	Kor, 2006	77 US firms (1990-1995)
CEO duality	Kor, 2006	77 US firms (1990-1995)	Board independence is positively associated with innovation
	Van Essen et al., 2012	86 studies covering nine Asian countries	CEO duality is positive for innovation
	Chen & Hsu, 2009	369 Taiwan firms (2002-2007)	Non-duality moderates the negative relationship between family ownership and R&D
	Zona, 2013	2000 Italian firms (2004)	The choice of board structures should be contingent upon CEO tenure, with duality structures more effective early in CEO tenure, and non-duality structures more effective later on

Table 1. Results of previous research on the relationship between board composition and innovation

2.1. Board size

There is not a clear consensus about the optimal size of the board (Cheng, 2008; Galia&Zenou, 2012; Torchiaet al., 2011). In spite of this, literature states that the efficient functioning of the board depends on its size (Zahra & Pearce, 1989).

Some studies highlight a negative association of board size on innovation (Cheng, 2008; Mezghanni, 2011; Zahra & Pearce, 1989), arguing that small boards are more efficient to monitor and control the management team and also more easily reach the consensus needed to adopt risky strategies.

On the other hand, some authors suggest that there can be a positive relationship between board size and innovation (Coles et al., 2008; Linck et al., 2008; Ocasio, 1994), in this case, emphasising the strategic and advisory function of the board and the empowerment of big boards against top management teams.

Recent research usually proposes contingent explanations, trying to reconcile both positions (Raheja, 2005; Zonaet al., 2013), and underscores that not always is a big board or a small onebetter. Also, the association between board size and innovation could be moderated by other variables, like the size of the company (Zonaet al., 2013).

2.2. Gender diversity

Gender diversity is a relevant recent topic in studies on board composition (Kang et al., 2007; Mahadeoet al., 2012). Although there are many arguments in favour of a greater number of women on boards (Burke, 1997, 2003; Cassell, 2000; Singhet al., 2001), in most of the companies, their presence continues to be purely symbolic (Daily & Dalton, 2003; Singh et al., 2001; Terjesenet al., 2009).

Some of the arguments that highlight the benefits of counting with a relevant percentage of women on board are focused on improvements in board behaviour and functions (Bilimoria, 2000). These benefits include a better working environment (Bilimoria&Huse, 1997), a valuable experience in public relations and relational capital (Hillman et al., 2002), a better comprehension of consumers behaviour and needs (Kang et al., 2007), and more diligence than their male counterparts (Huse& Solberg, 2006).

However, few studies have tried to explain how gender diversity might influence innovation (Galia&Zenou, 2012; Miller &Triana, 2009; Torchiaet al., 2011). Some exceptions are the studies of Miller &Triana (2009) or Galia&Zenou (2012) that state gender diversity has a positive effect on R&D due to women’s better knowledge of consumers and markets, which might positively affect innovation, especially innovation in marketing. In addition, Hillman et al. (2002) and Østergaardet al. (2011) suggest that women bring new perspectives, different experiences and knowledge useful for innovation. Torchiaet al. (2011) statethat the number of women needs to be enhanced to reach a critical mass that could exert a relevant positive influence on innovation.

In contrast to these arguments, Galia&Zenou (2012) find that gender diversity could benefit some kinds of innovation, but not others, and highlight the negative influence of gender diversity, for example, on product innovation. Other studies, on the other hand, do not find any kind of relationship between gender diversity on boards and innovation (Bianchi et al., 2012; Galia&Zenou, 2012).

2.3. Typology of directors

Directors can be classified into different categories. One of these groups is formed by executive directors, members of the board who are current or past managers of the organisation (Judge &Zeithaml, 1992; Pearce & Zahra, 1992). Some previous research has indicated a positive relationship between the proportion of executive directors and innovation (Baysingeret al., 1991; Dalzielet al., 2011), especially in R&D intensive firms (Coles et al., 2008; Markarian&Parbonetti, 2007) and in the case of internal innovation. On the contrary, some other authors argue that executives are expected to take short-term actions to not assume risks and increase their wealth, provoking a negative effect on innovation (Hernández et al., 2010; Malatesta&Walkling, 1988).

More research has been conducted on external, independent or outside directors, including affiliated directors who are those representing large shareholders (De Andrés et al., 2005). Their relevance in research might be motivated because they are usually a large percentage of the board (Coles et al., 2008; Peasnellet al., 2005) and good governance codes recommend a high proportion of this kind of director to protect shareholders’ interests (Fama, 1980). However, despite the relevance of this kind of director in research, few conclusive results have been obtained regarding their effects on innovation. Some arguments in favour of a positive relationship between the proportion of external directors and innovation are their potential for monitoring and controlling managerial actions, their freedom of thought and cognitive diversity for decisionmaking (Bianchi et al., 2012; Dalzielet al., 2011). Besides, this positive association between external directors and innovation can be even stronger in certain cases, for example, in big companies (Zonaet al., 2013). Other studies, on the other hand, emphasise a negative relationship (Zahra, 1996; Zahra et al., 2000), which could be motivated by the low operating knowledge and background on the company, low cohesiveness provoked by diversity and conflict (Gibson &Earley, 2007). Zonaet al. (2013) also suggest that this negative relationship between the proportion of external directors and innovation is stronger in small firms. Finally, there are also several studies that do not find any kind of relationship between external directors and innovation (Hoskissonet al., 2002; Kor, 2006).

2.4. CEO duality

Duality describes a situation where the CEO also serves as the chairman of the board. Agency theory advocates for the separation of functions to reduce managerial discretion (Guilletet al., 2013; Lan & Lee, 2008; Penget al., 2010). However, there is little research to support the positive association of the separation of the CEO and the chairmanof the board, and the firm performance (Boyd et al., 2011). On the other hand, stewardship theory states a positive influence of duality on firm performance (Donaldson & Davis, 1989; Van Essen et al., 2012).

Regarding innovation, arguments supporting the benefits of non-duality for innovation underscore that independent boards, with separated functions, might better control and monitor managers and incentive innovative actions of companies, which could be key for their success and survival (Kor, 2006). In addition, duality can exert a moderator role in certain companies, like family firms, where family ownership might exert a negative impact on R&D investment, but attenuated when there are separated functions of the CEO and the board chairman (Chen & Hsu, 2009). On the contrary, some research findings highlight that sometimes duality favors R&D investments (Van Essen et al., 2012), when the CEO supports risky strategies and also concentrates a high power as manager and chairman of the board. Finally, some authors claim no better board structure, because it should be contingent upon CEO tenure, with duality best working when CEO tenure is low.

After reviewing these different assumptions and inconclusive findings of previous research, we don’t seek to establish a predictive model of the innovative behaviour of companies depending on board composition. Especially, in the Spanish context, where innovation intensity in companies is below the average of EU and OECD countries (COTEC, 2012), we think that it would be very complicated to construct an effective model to explain this complex process of innovation through few board composition characteristics. On the other hand, we aim to develop an exploratory data analysis to contribute to the existing literature in three ways. First, we describe the main characteristics of the board composition in terms of its size, directors’ gender, typology of directors, and CEO duality; and determine, if any, the differences of board composition amongst economic sectors. Second, we study the evolution of these main characteristics of board composition over time. And finally, we analyse the variability profile of board composition in Spanish companies belonging to innovative sectors.

3. Methodology

3.1. Data collection

The data for this study came from Spanish companies listed on the Spanish stock exchange between 2003 and 2011. We select these nine years because we were interested in analysing the effects of the good governance practices proposed by corporate governance codes in Spain. We initiated the data collection in 2003 coinciding with the publication of the Aldama report (2003).There had been some years since the appearance of the first Olivencia code of 1998, and companies have had time to be used to good governance practices. On the other hand, 2011 was the last year with available information.

Using information from the Spanish Institute of Statistics, we selected firms from sectors that showed significantly high innovation indicators, such as the percentage of innovative firms (above 50%), innovation intensity (above 1.5%), and the percentage of income generated by new or improved products (above 10%). Considering the first two digits of the National Classification of Economic Activity (NACE 2009) in Spain (INE, 2009), 78 sectors were chosen because they accomplish at least one of the innovation indicators explained above. In order to simplify comparisons, we consider not the divisions, which refer to the first two digits of the code, but the sections because they allow us to aggregate economic activities related to the same section. Finally, five sections or sectors were included: energy and water supply, extractives, construction, industry and services. The final sample comprised 86 Spanish-listed companies from the chosen sectors, with data covering nine years, so we could construct an imbalanced data panel of 706 observations (69 observations belong to the construction sector, 33 to the energy and water supply sector, 22 to extractives companies, 308 to industry firms and 274 to companies in the service sector).

We conduct this study using secondary sources of information. The database of the CNMV (Spanish Security Exchange Commission) was the main resource used to gather information on corporate governance. We were also interested in determining the innovative behavior of companies in the period considered. Data related to innovation was obtained from the European network of patent databases for gathering the number of patents registered by the companies.

3.2. Measurement of variables

Board size is measured by the number of directors on the board (Coleset al., 2008).

The proportions of male and female directors were obtained by dividing the number of men and women respectively by the board size (Nekhili&Gatfaoui, 2013).

The proportion of inside or executive directors is determined by dividing the number of insiders by the total number of directors (Judge &Zeithaml, 1992). The proportion of affiliate directors is determined by dividing the number of affiliates by the total number of directors (Unified Code on Good Corporate Governance, 2006). The same occurs with the proportion of independent and other external directors. The proportion of independent directors is computed by dividing the number of independent directors by the total size of the board, and the proportion of other external directors is calculated by dividing the number of external directors by the board size (Unified Code on Good Corporate Governance, 2006).

CEO duality is a board characteristic frequently related to the independence of the board. Duality is considered as a dichotomous variable, coded “0” when the CEO also serves as chairman of the company’s board and “1” when the CEO and the chairman of the board are two different individuals (Daily & Dalton, 1997).

This study also includes a measure of innovation, just to analyse if the innovative behaviour of the companies considered has been improved or not during the studied period. There are different indicators of innovation directly related to innovative activity (Alegreet al., 2004; Flor&Oltra, 2004). In our case, we decided to use the number of registered patents because, as a legal mechanism for protecting inventions, patents have served as a basis for developing innovation indicators in many studies and can be easily accessible (Flor & Oltra, 2004).

4. Results

The statistical analyses of this work were carried out using R, version 3.0.2 (R Core Team, 2013). We developed three different analyses to address each of the three research propositions.

The first question is analysed in Tables 2 and 3. Table 2 shows descriptive statistics of the main characteristics of the board composition in terms of size, typology of directors, gender and duality. In order to relate board composition with innovation, we consider also data on patents of the companies in the sample.

Variables	Min	Max	Mean	Sd
Board size	1	24	10.4	4.11
Proportion of men	0.25	1	0.93	0.10
Proportion of women	0	0.75	0.07	0.10
Proportion of insiders	0	1	0.21	0.16
Proportion of affiliated directors	0	1	0.46	0.25
Proportion of independent directors	0	0.88	0.29	0.20
Proportion of external directors	0	0.67	0.05	0.11
Duality	‘0’=294 (0.42)	‘1’=391 (0.55)
Patents	0	29	1.04	3.06

N=706

Table 2. Board composition and innovation

As Table 2 shows, the mean values of board characteristics indicate that boards of directors of Spanish companies in innovative sectors have around 10 members and are basically composed of men. Most of the directors are affiliated ones, meaning they represent great shareholders. We can see that duality exists in the majority of the boards analysed. Finally, we observe great differences between the minimum and maximum value in the number of registered patents, although the mean value is quite low, around 1.04.

We were also interested in analysing the differences in board composition and innovation considering different sectors (Table 3). We included also on Table 3 one-way ANOVA analyses to determine the existence of significant differences in the mean values of the variables considered amongst sectors.

Variables	Mean					F
Variables	Energy and water suppy	Extractives	Construction	Industry	Services	F
Board size	13.20	6.70	12.63	9.22	11.17	131.5***
Proportion of men	0.91	0.97	0.98	0.94	0.91	5.04**
Proportion of women	0.09	0.03	0.02	0.06	0.09	5.04**
Proportion of insiders	0.11	0.31	0.16	0.25	0.17	25.85***
Proportion of affiliated directors	0.51	0.33	0.58	0.44	0.44	30.6***
Proportion of independent directors	0.23	0.12	0.22	0.27	0.34	22.31***
Proportion of external directors	0.15	0.24	0.03	0.04	0.04	66.64***
Duality (proportion of ‘yes’)	0.27	0.59	0.46	0.59	0.56	372.04***
Patents	0.37	0	1.40	0.98	1.21	2.63*

***p<0.001; **p<0.01; *p<0.05; +p<0.1

Table 3. Board composition and innovation by sectors

As Table 3 shows, the activity with the biggest boards is energy and water supply, and with the smallest ones is the extractive industry. The proportion of men is much higher than the proportion of women in all sectors, but the activity with more men on the board is construction and the activities with more women (although the number is still very low) are energy and water supply, and services (around 9%). Relating to the typology of directors, we can observe in Table 3 that the proportion of affiliated directors is the highest in all sectors, followed by the proportion of independent directors, with the exception of the extractive industry where the proportion of executives on the board is higher. The economic activity with the highest proportion of executive directors or insiders (31%) is the extractive industry, while construction has more affiliated directors (58%), services has more independent directors (34%), and the extractive industry has more other external directors (24%). This kind of other external director is the less common type of director in our sample of Spanish companies. Duality is especially high in two different economic activities, extractives and industry, where, in 59% of companies, the CEO and the chairman of the board is the same person. The number of registered patents is the highest in construction (1.40), followed by the service sector (1.21). We can also conclude that there are significant differences amongst economic sectors in all the variables taken into account.

The second question of this work is focused on the evolution of the characteristics of board composition and innovation over time. To this end, we develop graphical analyses of how the mean values of the variables considered have been evolving over time, and also by sectors.

Figure 1. Evolution of board size

Figure 2. Evolution of board size by sector

Graphs 1 and 2 refer to board size. They show little changes in the number of members on Spanish boards in the firms analysed, moving around 10 members during all the years considered. We can observe few changes in general terms although the tendency of these changes has been quite irregular, decreasing until 2006 and growing afterwards. By sectors, Graph 2 shows that energy and water supply is the sector with biggest boards (around 13 members) whilst the extractive industry has the smallest ones (around 7 or 8 members). We can also observe little oscillations in the board size of the different sectors and the tendency becomes closer over time.

Figure 3. Evolution of the proportion of women

Figure 4. Evolution of the proportion of women by sector

Graphs 3 and 4 are related to the proportion of women on boards. As we can see, the evolution of the percentage of women on Spanish boards is continuously increasing since 2003, however its mean value at the highest moment scarcely arrives at 10%. The evolution is positive also in all sectors, although the sector with the major growth is the extractive industry, followed by services and energy and water supply. On the other hand, the sector with fewer women on its boards is construction.

Figure 5. Evolution of the proportion of executive directors

Figure 6. Evolution of the proportion of executive directors by sector

Graphs 5 and 6 refer to the proportion of executive directors on boards. Graph 5 indicates that the percentage of executive directors has not been the majority in the period considered, and even more, it has been descending since 2006. As Graph 6 shows, the sector with more executive directors on its boards is the extractive sector and the one with fewer is energy and water supply, but in none of the economic activities considered is this kind of director predominant.

Figure 7. Evolution of the proportion of affiliated directors

Figure 8. Evolution of the proportion of affiliated directors by sector

Graphs 7 and 8 are related to the proportion of affiliated directors on boards. The percentage of this kind of director has evolved positively since 2004. In addition, the evolution of this percentage has been quite irregular in all sectors over time. Construction has been the sector with a major proportion of affiliated directors and extractives isthe sector with the fewest.

Figure 9. Evolution of the proportion of independent directors

Figure 10. Evolution of the proportion of independent directors by sector

Graphs 9 and 10 show the evolution of the independent directors’ proportion. This evolution has been quite irregular with successive ups and downs over time. By sectors, the services sector has the highest level of these kinds of directors and the extractive industry has the lowest.

Figure 11. Evolution of duality

Graph 11 is related to the evolution of the proportion of companies with CEO duality. The analysis of this variable is different due to its nature as a categorical variable with two levels. We can observe that the proportion of companies in the sample with CEO duality has been a majority and quite stable over time, with a decreasing tendency since 2008. By sectors, as data in Table 4 shows, the extractive industry has the highest percentage of companies with CEO duality, whilst water supply and energy is the economic sector with the lowest percentage of firms with CEO duality. If we consider each sector separately, the major variations have occurred in sectors with few firms included in our sample.

Figure 12. Evolution in the number of registered patents

Figure 13. Evolution in the number of registered patents by sectors

Finally, Graphs 12 and 13 show the evolution in the number of registered patents. This variable related to innovation is included to analyse if the innovative behaviour of the companies considered has improved or not during the studied period. To do so, we could establish some conclusions about the coincidence of certain composition in the board and the innovative behaviour of companies. Graph 12 indicates that Spanish firms are not particularly well-known by their number of registered patents. The mean values are really low in all sectors but we can observe a maintained increase since 2008. By sectors, Graph 13 shows that companies of the sample in the extractive industry do not have any registered patent in the period considered. On the other hand, construction is the sector with the highest number of registered patents, especially in the last years.

Table 4 indicates the mean values by sector and year of each of the variables of this study, and also includes statistics tests to analyse the effects of time and the economic activity on the mean values of the variables considered. As we can see, the mean values of all the variables are significantly different amongst sectors. On the contrary, the effect of time is not always significant. The results confirm that time yields significant differences in the proportion of women, and in the number of registered patents. It means that the positive evolution of patents and the proportion of women is significant over time, although their absolute values are really low. On the other hand, for the rest of the characteristics in the board composition, we have not detected significant differences over time.

Variables	*Sectors*	Mean									ANOVA analysis F test
Variables	*Sectors*	2003	2004	2005	2006	2007	2008	2009	2010	2011	ANOVA analysis F test
Board size	Energy and water suppy	15.25	14.5	14.25	13	12.5	12	12.67	12.33	12.33	3.51**
	Extractives	6.33	6	6	6	7	7	7	7.5	7.5
	Construction	13.12	13	13.12	13.12	12.87	12.87	12	11.86	11.71
	Industry	9.33	8.97	8.61	8.78	9.06	9.43	9.65	9.66	9.46
	Services	10.87	10.70	10.78	10.67	11.24	11.68	11.5	11.31	11.81
	ANOVA analysis F test	0.79
Proportion of women	Energy and water suppy	0.02	0.04	0.04	0.08	0.08	0.1	0.13	0.16	0.13	5.29***
	Extractives	0	0	0	0	0	0	0	0.03	0.03
	Construction	0	0	0.01	0.02	0.02	0.04	0.04	0.04	0.05
	Industry	0.05	0.05	0.07	0.07	0.06	0.08	0.06	0.06	0.06
	Services	0.04	0.05	0.04	0.05	0.09	0.12	0.13	0.14	0.15
	ANOVA analysis F test	14.09***

Variables	*Sectors*	Mean									ANOVA analysis F test
Variables	*Sectors*	2003	2004	2005	2006	2007	2008	2009	2010	2011	ANOVA analysis F test
Proportion of inside directors	Energy and water suppy	0.06	0.32	0.09	0.09	0.07	0.07	0.09	0.09	0.09	4.89***
	Extractives	0.25	0.3	0.3	0.37	0.36	0.36	0.36	0.26	0.26
	Construction	0.18	0.18	0.17	0.16	0.15	0.15	0.14	0.15	0.17
	Industry	0.28	0.29	0.28	0.29	0.25	0.22	0.22	0.20	0.20
	Services	0.17	0.19	0.19	0.19	0.19	0.16	0.17	0.15	0.14
	ANOVA analysis F test	2.05
Proportion of affiliated directors	Energy and water suppy	0.64	0.37	0.54	0.55	0.51	0.50	0.48	0.49	0.49	18.03***
	Extractives	0.41	0.22	0.22	0.22	0.36	0.36	0.36	0.43	0.36
	Construction	0.56	0.56	0.57	0.54	0.63	0.58	0.58	0.59	0.60
	Industry	0.43	0.43	0.45	0.44	0.46	0.45	0.45	0.44	0.41
	Services	0.43	0.43	0.40	0.43	0.44	0.46	0.47	0.47	0.48
	ANOVA analysis F test	0.09
Proportion of independent directors	Energy and water suppy	0.12	0.12	0.19	0.21	0.26	0.28	0.30	0.30	0.30	14.30***
	Extractives	0.19	0.13	0.20	0.27	0	0.07	0.07	0.12	0.12
	Construction	0.25	0.25	0.24	0.24	0.20	0.20	0.21	0.22	0.19
	Industry	0.28	0.26	0.25	0.25	0.24	0.27	0.26	0.29	0.31
	Services	0.34	0.35	0.38	0.35	0.33	0.35	0.32	0.32	0.33
	ANOVA analysis F test	0.39
Duality (proportion of ‘yes’)	Energy and water suppy	0.25	0.25	0.25	0.25	0.25	0.25	0.33	0.33	0.33	Chi square test 15.04**
	Extractives	0.33	0.33	0.66	0.66	0.5	0.5	0.5	1	1
	Construction	0.37	0.37	0.5	0.5	0.5	0.5	0.57	0.43	0.43
	Industry	0.58	0.61	0.61	0.61	0.6	0.63	0.61	0.55	0.54
	Services	0.52	0.52	0.52	0.55	0.6	0.62	0.59	0.62	0.56
	Chi square test	1.88
Patents	Energy and water suppy	0.5	0.25	0.75	0	0	0.5	0	0.67	0.67	11.13***
	Extractives	0	0	0	0	0	0	0	0	0
	Construction	0.12	0.25	0.62	0.37	0.87	0.25	0.57	2	7.57
	Industry	1.32	1.08	1.03	1.06	0.94	0.60	0.94	0.97	0.93
	Services	0.82	0.97	1.06	0.8	1.38	1.50	1.25	1.07	2.04
	ANOVA analysis F test	2.92+

***p<0.001; **p<0.01; *p<0.05; +p<0.1

Table 4. (Continued) Mean values over time of board composition and innovation by sectors and ANOVA

The third question of this study seeks to determine the variability profile of board composition in the companies of the sample. To do so, we have developed a principal component analysis (PCA) including the numeric variables of board composition.

Variables	PC1	PC2	PC3
Board size	0.358	0,511	-0.298
Proportion of women	-0.138		0.892
Proportion of insiders	-0.486	-0.480	-0.287
Proportion of affiliated directors	0.676	-0.211	0.170
Proportion of independent directors	-0.400	0.681
Proportion of variance	0.38	0.27	0.21
Cumulative proportion of variance	0.38	0.65	0.86

Table 5. Principal components analysis on board composition

Table 5 shows the three principal components obtained, which capture 86% in data variance. From Graph 14, we observe that in the first principal component, the highest variability depends on the proportion of affiliated directors, which covariates with the board size, the proportion of inside and independent directors, and the proportion of women. Thus, the major variability in data is explained by the variance in board size, and in the directors’ typology. Board size and the proportion of affiliated directors covariate in a similar manner and are opposed to the proportion of independent and inside directors.

From the third principal component, which captures 21% of data variance, we observe that this variability is influenced by the proportion of women on boards, although it is a board characteristic of third order and, as it is observed in Graph 14, this variability depends especially on certain firms with a good practice in terms of including women on boards. Again, values of the loadings in Table 5 indicate that the proportion of women covariates with board size in opposite ways.

5. Discussion

The main findings of this study show that boards of directors of Spanish companies in innovative sectors have around 10 members, with members ranging between 1 and 24. Most of directors are affiliated ones and are basically men. In addition, CEO duality is a common structure on boards. These results mostly agree with those of previous research. For example, regarding the board size, studies of other countries have shown board sizes between 3 and 24 members in the UK (Peasnellet al., 2005), with an average size of 8 members (Osma, 2008; Peasnellet al., 2005); or between 4 and 26 members in the USA (Cheng, 2008), with an average number of 7 directors (Lincket al., 2008). The medium numbers in Norwegian and Australian companies respectively (Kang et al., 2007; Torchiaet al., 2011) are 7 or 8 directors. . Whilst in France, between 11 and 15 members are the most common medium number of directors on boards (Galia&Zenou, 2012; Godart&Schatt, 2005). Our results indicate an average number of 10 members, which is in line with boards of these other countries, with little and non-significant changes over time. Also, this study has demonstrated that amongst Spanish innovative sectors, the activity with the biggest boards is energy and water supply, and the one with the smallest boards is the extractive industry.

Related to gender diversity, not surprisingly, Spanish boards are composed of a majority of men. It is a quite generalised characteristic of boards all around, as we can see in other studies, like the work of Carter et al. (2010) who found an average of 1% of women on boards in USA firms. Other examples show that women represented around 6% of the board in French companies (Galia&Zenou, 2012), 7% in Norwegian firms (Torchiaet al., 2011), and 10% in Australian companies (Kang et al., 2007). In our study, the average proportion of women is around 7%. This average is low but its increase over time is statistically significant. The proportion of men is much higher than the proportion of women in all sectors, but the activity with more men on the board is construction and the activities with more women are energy and water supply, and services.

Regarding the typology of directors, executive directors do not represent a majority in the period considered, and even more, their percentage has been descending since 2006. The sector with more executives on its boards is the extractive sector. On the other hand, affiliated directors are the most numerous. The addition of affiliated and independent directors represents an average of 75% of the board in our sample, although the evolution of both kinds has not been similar. Affiliated directors have evolved positively practically since 2004, whilst independent directors have had successive ups and downs over time. Previous literature on board composition agrees with these findings about the majority presence of independent and other external directors in the board composition. For example, Peasnellet al. (2005) found an average of 43% of outside directors on UK companies’ boards; Coles et al. (2008) reported that the average proportion of different kinds of outside directors is 80% of the total board in US companies. In a comparative study made between different countries by Aguilera (2005), the proportion of outside directors was over 50% in all the compared countries (US, UK, the Netherlands, Canada and Italy). Just Spain and South Africa, in this study, were below 50%.However, in those cases, only independent directors were considered within the group of outsiders, not affiliated ones. By sectors, we can observe many significant differences; for example, service sector and construction have the highest proportion of independent and affiliated directors respectively, whilst the extractive industry has the lowest of both. On the contrary, non-significant differences were observed in the evolution of the typology of directors over time.

In relation to duality, the proportion of companies in our study with CEO duality has been a majority and quite stable, with a decreasing tendency since 2008, although the findings show that changes over time are not relevant. Previous research, however, does not reach a clear consensus on this issue; thus, depending on the country and the moment of the study, data shed different information. For example, the study of Lincket al. (2008) shows that 58.3% of US companies had CEO duality. Aguilera (2005), comparing the separation of the CEO and the chairman of the board in different countries, concluded that this separation was majoritarian in Spain (contrary to our results), South Africa, the Netherlands, UK and Canada, whilst, in the US and Italy, the CEO duality is quite frequent. By sectors, again our results conclude that there are significant differences. The extractive industry has the highest percentage of companies with CEO duality, whilst water supply and energy is the economic sector with the lowest.

An analysis of the variability profile of board composition in the companies showed that board size and the proportion of affiliated directors covariate in the same way, but opposite to the proportion of inside and independent directors. Also, the major variability in data is explained by the variance in board size, and in the directors’ typology. The variability in the proportion of women is not really relevant amongst board composition, although it captures some variability especially motivated by the behaviour of specific companies with a high proportion of women on their boards.

These conclusions on board composition of Spanish companies converge with a situation in which innovation, determined through the number of registered patents, although low in absolute terms, grows significantly over time, with relevant differences between economic sectors.

6. Conclusions

The objective of this work was to develop an exploratory analysis of the board composition of Spanish companies in innovative sectors to respond to three different research questions. First, we seek to study the main characteristics of the board composition in terms of its size, gender, typology of directors, and CEO duality amongst different innovative economic sectors in Spain. The mean values of board characteristics indicate that boards of directors of Spanish companies in innovative sectors have around 10 members and are basically composed of men. Most of the directors are affiliated directors, those who represent great shareholders. The CEO duality is a common option in Spanish boards of companies in innovative sectors. The analysis by sectors reveals significant differences in the mean values of all the characteristics considered on board composition. These results, with the exception of the CEO duality, match quite well with the recommendations of corporate governance codes (Unified Code on Good Corporate Governance, 2006) on boards’ composition, in terms of medium sized boards, with a number of directors ranging between 5 and 15, and a balanced composition with a high proportion of outside directors distributed between independent and affiliated directors. The proportion of independent directors in our sample is close but does not arrive at 1/3, as recommended by the Spanish corporate governance code, showing the relevance of the capital concentration in the Spanish companies of innovative sectors.

Second, we analyse the evolution of the main characteristics of the board composition. The results confirm that board composition does not change a lot over time. There is just a characteristic of the board, the proportion of women, whose positive evolution has been significant. Although the percentage of women is still very low, at least it has begun to appear that there is some concern for encouraging gender diversity on boards. This characteristic of board composition begins to be relevant in some specific companies (Unified Code on Good Corporate Governance, 2006).

Third, we determine that the major variability in board composition appears in board size and the directors’ typology. Also, board size and the proportion of affiliated directors covariate in the same way, but opposite to the proportion of inside and independent directors.

These are the main board composition characteristics of companies that also show an active role in innovation strategies, as confirmed by their significant growing number of registered patents.

This research that compares the board composition and the innovative behaviour of some Spanish companies does not pretend to explain or predict innovation through board composition.Our purpose is more limited, as we try to contribute to the literature and corporate governance practices by showing how the majority of Spanish boards in innovative companies are actually composed and whether this composition is prominent in a situation in which the innovation results of these companies are growing. The findings obtained could serve to propose more ambitious future research that establishes what possible effects board composition could have on innovation.

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[FULL] Article 3, Volume 1 Issue 1

New facets of quality. A multiple case study of green cosmetic manufacturers

Author

Inma Duran – (University of Girona)

Andrea Bikfalvi – (University of Girona)

Josep Llach – (University of Girona)

DOI:

10.26595/eamr.2014.1.1.3

Abstract

Despite the recent concern about social, environmental and economic perspectives of sustainability, the issue is relatively under-researched and very little is known about the drivers of sustainability. There is no doubt that innovation is one of those drivers. The aim of the present article is to analyse the technological (product and process) and non-technological (marketing and organisational) innovation, R&D strategy, marketing and competitiveness position of the chemical companies that are engaged in the manufacture of green, natural or conventional cosmetics with the ultimate aim of achieving high quality products and business excellence. The study reported here is qualitative in approach and uses empirical evidence from six case studies representing companies located in Catalonia, Spain, one of the main cosmetic producers of Europe. The results are discussed in the light of structural and managerial perspectives with the aim of drawing implications for both practitioners and policy-makers.

Keywords

1. Introduction

Nowadays, the concept of natural is gaining importance across all economic sectors. This new concept involves using only organic or natural ingredients in products, avoiding toxic, DNA altering or carcinogenic substances. The cosmetic industry is not unaware of this trend. In fact, the use of natural ingredients is one of the many challenges that the cosmetic industry has faced since the 90s, including regulatory changes, product safety concerns, calls for scientific data to document product claims, increasing environmentalism, pressure from the growing animal rights movement, economy and market channels for product distribution (Kumar, 2005).

The use of natural cosmetic products involves the use of sustainable agriculture, namely, organic farming. It focuses on the optimal use of natural resources and does not employ synthetic chemical products or genetically modified organism (GMOs) and produces organic products while preserving the fertility of the land and respecting the environment.

According to Soulioti (2013) the use of cosmetics is rapidly increasing on an international scale. This has subsequently brought about an increase in the production of new raw materials as well as the manufacture of new kinds of cosmetics which are being used by beauty salons today.

At the same time, this has led to the development of research into the positive and the negative effects of both the raw materials and the final products. Nowadays, the raw materials used for the manufacture of cosmetics are basic substances. Scientific research has proved that many of them can cause problems such as allergic dermatitis, acute inflammation dermatitis and so on. For this reason, laws have been passed that ban the use of certain substances and or limit the level of their use. These measures have been embodied in the legislation of each European country, for example RD 1559/1997 in Spain. However, from July 2013, there is only one new law, 1223/2009.

Cosmetic products are highly regulated, but not exempt from possible adverse reactions. The aim of the law creates a free European market for cosmetic products and to guarantee the health and safety of the consumers through the establishment of (i) a number of technical limitations on cosmetic composition, and (ii) requirements for the information that must be available to the authorities and the general public. The beauty industry has two characteristics: high regulation and high consumer trust, which is built on well-established, world-wide manufacturing brands (Burt et al., 2005).

Although the consumption of natural cosmetics is lower than the consumption of conventional cosmetics, studies indicate a growth rate of 15% for natural products compared with 5% for conventional cosmetic products (Alcalde, 2008). However, there are some barriers which prevent the consumption of natural products. Most obvious among these barriers is identifying the difference between natural and other products, and checking that supposedly natural products conform to the necessary standards.

This paper has two objectives. It reports a quantitative and qualitative research study of the technological innovations introduced by manufacturers of cosmetics in general and particularly manufacturers of green and natural cosmetics. It also contrasts differences in structural and operational characteristics. The target of cosmetic industries analysed are located in Catalonia (north-east of Spain) which is home to 42% of the industry in Spain in terms of employment and value added (STANPA, 2013).

The present paper describes different key success factors in Catalan manufacturers of cosmetics. The study employs the concepts of key success factors (KSF), type of innovation, economic sector, type of industry, geographic zone and type of cosmetic.

This paper is organised as follows. After the first, introductory section, the main features of the cosmetic industry in general, and the green producers in particular, are described. Next, in Section 3 present a review of the literature about the topic. The fourth section explains the sample and the methodology used. The fifth part contains the main results. The papers end with conclusions.

2. Cosmetic industry background

This section presents the types, definitions and composition of cosmetic products. According to the new regulation UE 1223/2009, the definition of a cosmetic product is any substance or mixture intended to be placed in contact with the external parts of the human body (epidermis, hair system, nails, lips and external genital organs) or with the teeth and the mucous membranes of the oral cavity with a view exclusively or mainly to cleaning them, perfuming them, changing their appearance, protecting them, keeping them in good condition or correcting body odours.

Three types of cosmetic products must be considered: conventional, green and natural cosmetics. Conventional cosmetics are the most well-known and include chemical ingredients that are usually of low quality.

Green cosmetics have ingredients from organic cultivation without pesticides or chemical fertilizers that have not been genetically modified. These cosmetics are free of preservatives, colorants, synthetic fragrances, silicones or mineral oils derived from the petrochemical. Natural cosmetics use natural active ingredients but without guaranteeing either their quality or origin. Natural cosmetics may include chemical ingredients.

Green and natural products are fashionable because they avoid toxic, DNA altering or carcinogenic substance. For this reason, brands introduce green lines of products in order to attract new customers who prefer the green alternative. Natural and green cosmetics are an alternative to conventional cosmetics and achieve a privileged position in the beauty market.

Cosmetic products have three components: active ingredients, a base and additives. The active ingredients are the most important component and it is the activity of the ingredients (moisturizing, reaffirm, regenerate, etc.) that gives visible results and determines the price of the cosmetic. These active ingredients may be vegetable, mineral, animal or synthetic. The base is the component that gives texture, but it may cause allergies. The principle ingredient of the base is water, but may also include alcohol or products derived from petrochemicals. The percentage of active ingredients, which is usually lower than 3%, and the quality of the base make the product more or less efficient.

The additives are colorants, preservatives and perfume. According to Roquero (2010) the additives are responsible for cosmetic smell, good appearance and protection. These additives can also cause allergies in the same way as the base. Therefore, the trend is to reduce this component to avoid allergies.

3. Trends in the cosmetic industry

Currently, the concept of innovation has an important influence on the competitiveness of companies. Innovation is crucial to the growth of a company because companies that do not generate good new products or processes lose competitiveness. For this reason, the companies focus on the implementation of business strategies that retain competitiveness in the market, such as good business management, a process of continuous innovation and detection of improvement points and good practice.

Manufacturers apply innovative developments to all the products in the market. Innovation has been a crucial element in cosmetics products since they were first developed for sale and innovations have been possible because of the application of science to the manufacture of cosmetics products.

Łopaciuk and Łoboda (2013) present an overview of the global beauty care products industry at the beginning of the XXI Century, tracking product categories, main geographic regions and mass/premium cosmetics segments. They classify the trends in the cosmetic industry in four categories: marketing trends, distribution trends, product trends and emerging market trends.

In terms of marketing trends, Lennard (2011) highlights how organic beauty products – natural cosmetics, manufactured in accordance with fair-trade philosophy – have gained importance in the market, spreading from a niche occupied by a small number of companies to being incorporated into the mainstream market and distributed through standard channels such as supermarkets and department stores.

Łopaciuk and Łoboda (2013), Barbalova (2011) and Moulin (2012) emphasize how a change in distribution channels has occurred since the beginning of the present century. Their main conclusion is that the Internet is growing in importance as a retailing channel. According to Euromonitor International (2011), online sales accounted for 3% of global cosmetic sales in 2010, while in the top three online markets – South Korea, France and the United States – they accounted for between 5.8% and 7.5%.

Kumar (2005) affirms that four important trends in technology and innovation are setting the pace in today’s cosmetics market. The first one is related to distribution, because, as noted above, information systems are used to enhance market share. The other three trends relate to products: (i) the growing proportion of transitive cosmeceuticals in the cosmetic market, (ii) special cosmetic products for aging populations and (iii) special products for ethnic groups.

Łopaciuk and Łoboda (2013), identify two trends in product innovation in recent years: time-saving and the long-lasting products. Time-saving products are a response to the needs of today’s ever-busy consumers who want to limit the amount of time spent on their daily beauty routine. As a result, a lot of research has been conducted on products such as quick drying nail polish or multi preparations like 3-in-1 shower gel, facial wash with shaving foam or hybrid products for the face that incorporate elements of make-up, skincare and sun protection. In recent years the most dramatic, world-wide market growth took place in Brazil and China, which are both lucrative markets (Łopaciuk and Łoboda, 2013). Euromonitor International (2011) predicts that the Latin America will become the third largest region globally.

The cosmetic industry needs to respond to the specific demands from emerging countries, customizing their products. Euromonitor International (2011) gives some examples, including skin whitening creams in Asia, men’s skin care in India and hair straightening creams in Latin America.

In addition, there is a growing demand for organic products, manufactured in a sustainable way, often according to the fair trade philosophy, mainly from the traditional markets of Europe and the US.

The overall conclusion about the current trends in the cosmetic industry can be summarized in three points: (i) the future demand of cosmetics will be fuelled mostly by the emerging markets of Asia and Latin America, (ii) the cosmetic industry must adjust its distribution strategy to new retailing channels like the Internet and, (iii) there is a need to create customized products for the emerging markets and natural products based on technology for the traditional markets of Europe and the US.

The Spanish cosmetic industry is characterized by a high level of innovation in luxury brands and also by generic brands and secondary brands. Innovation focuses on product differentiation. The sector has been boosted by major companies that have managed to convert personal care cosmetic products into their own brand to drive growth. This is the case of Mercadona supermarket with Deliplus and DIA supermarket with the recent acquisition of the Iberian subsidiary of the German company Schlecker. This strategy is becoming a trend in the industry. All types of brands, from low-cost generic brands to high quality exclusive brands, have a strong investment in innovation.

While almost all subsectors in the cosmetics industry have been affected by crisis, luxury brands, including green and natural cosmetics, have been resilient. According to STANPA (2013), the Spanish luxury market had € 4.2 m of revenues, an increase of 20% on last year. Therefore, this segment has great potential and must be analysed in detail because they represent a growth segment and this trend will continue and will influence the whole cosmetics market.

4. Methodology

In this section, we describe the method followed for collecting empirical evidence. A qualitative approach was used to identify patterns of innovative behaviour in sustainable and value-added products. The case study approach enables researchers to immerse themselves in rich data and reflect the longitudinal or dynamic progress of an establishment or phenomenon. Cases are descriptions of particular instances of a phenomenon that are typically based on a variety of data sources (Yin, 2009).

The main methodological instrument used was a semi-structured interview guideline. The interview was developed based on the questionnaire of the Community Innovation Survey (EUROSTAT, 2014) and the European Manufacturing Survey (ISI, 2014), which are both relevant innovation surveys. Regular technological and non-technological survey items were adapted into an interview sequence. Additional aspects, characteristic to cosmetic companies, were added after an extensive review of the literature and sector-specific report.

The main criterion for case selection is diversity. Cases were selected to present variety in products, operations and differentiation factors, while remaining within the same industry, namely manufacturers of cosmetic products. Each case adds some specific feature and contributes to sector-specific idiosyncrasy. These aspects are illustrated in Table 1.

Face-to-face interviews took place in the habitual work place of respondents, who were production or innovation managers. Interviews lasted approximately one hour, which was long enough for a discussion ranging over five thematic areas: i) general operational and structural characteristics of the company, ii) natural ingredients/products and certification, iii) innovation and expected impacts, iv) technological innovation, and v) non-technological innovation. The full methodological details of the study are described in Table 2.

Case	Employees	Markets	Type of cosmetic manufactured	Main activity	Mission statement/values
NATURAL1	Micro	Local 30% National 60% EU Market 10% Others Continents 0%	Green and natural	Plant based cosmetics and aromatherapy	A brand of facial and body products, a luxury for skin due to their quality
NATURAL2	Micro	Local 20% National 60% EU Market 10% Others Continents 10%	Green and natural	Hair and scalp disorder specialists	Our best guarantee is our customers’ trust
CONVENTIONAL1	Small	Local 0% National 70% EU Market 20% Others Continents 10%	Conventional	Cosmetics and treatment production	We work according to a quality management system continuously controlling for quality of both the raw materials and the final products
CONVENTIONAL2	Micro	Local 45% National 45% EU Market 10% Others Continents 0%	Conventional	Specialized in the dermocosmetic and fragrance markets	Distributes high value cosmetic actives… our portfolio only has technological and value added products, and we provide with all the technical and creative support
CONVENTIONAL3	Small	Local 45% National 30% EU Market 10% Others Continents 5%	Conventional	Develop, formulate and manufacture professional cosmetics and medical device	Quality, security and improvement of your product’s development and manufacturing
HYBRID	Medium	Local 4% National 35% EU Market 10% Others Continents 50%	Green, natural and conventional	Professional skincare products	Professionalism, quality, innovation and integrity are the values that constitute the essence of our company and that have persisted unaltered over half a century

Table 1. Interviewed companies

Geographic area	Catalonia (Spain)
Main sector of interest	Manufacturers of cosmetic products
NACE code	2042 – Manufacture of perfumes and cosmetics
Total number of companies	89
Documentation	Presentation letter, interview guideline
Average duration of interviews	60 minutes
Contacted companies	10
Valid interviews	6
Follow-up and reminders	E-mail and telephone
Period of interviews	May – August 2013
Interview management	Literal transcript
Data analysis	Within- and cross-case analysis

Table 2. Methodological summary

Initially a within-case interpretation was conducted as a first step in order to identify patterns of behaviour related to concepts previously identified in the literature. This step is important to immerse the researchers in the reality of each case and understand their complexity, priorities, vision and opinions. A cross-case analysis (Eisenhardt, 1989) was then performed, comparing and grouping cases in order to identify similarities and differences. In the following section we report the main findings from the case studies.

5. Results and discussion

Although the field work generated many insights, for the purpose of the present article we focus on the most interesting results that align with our objective. To be transparent, we include quotations from respondents to illustrate their opinions. Our results are presented in the same sequence as in the interviews.

5.1. Company characteristics

As shown in Table 1, the cases included two businesses manufacturing green and natural cosmetic products, three companies producing conventional beauty treatments and solutions and one hybrid combining both options. The green manufacturers are micro-firms, while the conventional manufacturers are small size businesses. The hybrid company was the biggest. This company is also the most experienced, with more than 50 years in the business. The green and natural producers are more locally oriented in their sales, while the other types have more sales to Europe and also external markets in other continents. As discussed above, green and natural aspects might add value and differentiation to products and produce a shift in the concept of quality, from achieving the minimum to a more sophisticated concept of quality in terms of sensation, value and respect (for society and the environment). This aspect can be observed in all the companies whatever their main product type.

5.2. Orientation and Strategy

Since orientation towards green and natural products and processes is a complex issue and implies a series of organisational and financial resources, strategy is a key aspect to consider. Given the current economic situation in the market, technological strategy deserves particular attention.

Companies were especially sensitive to this issue and the main products mark a visible difference between green and natural product manufacturers, on the one hand, and conventional manufacturers on the other. The most illustrative responses are shown below:

Natural cosmetic is more than a trend or fashion… it is a way of thinking and lifestyle (NATURAL1).

It is new trend and it has much potential for the future […] in our vision, mass consumption is not feasible right now (NATURAL2).

It is a growing business sector due to the trend to be more aware and protective of the environment (CONVENTIONAL3).

From the quotations in Table 3, it can be seen that all companies agree that natural and green cosmetics are a challenging business. From the interviews we conclude that companies that are involved in such activities have a stronger belief in this direction and their trajectory in the green and natural cosmetic field. But they are not without problems. Even if they have a good product, markets, consumers, regulations and cultural aspects are beyond their control and may hamper the spread of their sales. Conventional cosmetic producers, on the other hand, give the impression of being able to enter this market, but still do not engage in these activities.

Case	Green/Natural orientation	Innovation orientation	Market Strategy	Reasons	Who decides the strategies
NATURAL1	“We think that natural cosmetic is more than a trend or fashion … it is a way of thinking and lifestyle”.	“It is essential to be competitive in our sector”.	A, B, C	“All strategies are to expand the market.”	Mutual agreement with all departments
NATURAL2	“It is new trend and it has much potential for the future, but it is necessary to make improvements because organic actives are very expensive, that is to say, the processes of elaboration and extraction have a high cost and, in our vision, mass consumption is not feasible right now. Moreover, in this sector there are two important problems: 1) 100% organic packaging does not exist, 2) Evaluating the efficacy of the products in a natural way is impossible.”	“It is one of the key factors to achieve success.”	A, B, C, D, E	“All strategies are to expand the market and be more competitive.”	Mutual agreement with all departments
CONVENTIONAL1	“It is a big area of business and I think it has much future … but we do not dedicate to it.”	“It is fundamental to be competitive in our sector together R&D and quality control.”	A, B, C	“The strategies depend on the type of manufactured product but the objective is the same: to achieve to be more competitive and expand the market.”	Management team
CONVENTIONAL2	“It is a new trend in the market”	“It is necessary to obtain new, improved and cheaper products and process”	A, B, C, D	“Because these strategies are the most conventional in our sector and we want to be more competitive.”	Management team
CONVENTIONAL3	“It is a growing business sector due to the trend to be more aware and protective of the environment.”	“Our aim is to improve and update active cosmetics by mechanisms of action in the body focusing also on the presentation of finished product.”	A, B, C, D, E	“Because one of our main objectives is to expand the market.”	Technical manager
HYBRID	“In recent decades, the care for the ecology is a fact. Also in the field of cosmetics, R&D and creating products with ingredients based on sustainability and the correct use of resources are very important. I think in the future this trend will be stronger.”	“The cosmetic product has to be effective and safe, and it even has to be able to surprise the user, satisfying and responding to sensory consumer demands. Innovation has to be conducted in order to obtain products based on the latest technology with a good scientific base.”	A, C, D	“To diversify, improve competitive advantage, attract new customers, etc., are essential in order to ensure the sustainability of the company in a competitive and dynamic environment”	General manager

A – Develop new products in order to open new markets; B – Imitate the leaders in innovation; C – Adopt developed technologies; D – Develop existing technics, progressively; E – Change the production method

Table 3.Orientation and strategy

Technological strategy and innovation represents a vital aspect for all companies interviewed, and they use words such as “essential”, “fundamental”, “key”, and “necessary” and no obvious differences can be observed between different types of cosmetic products. The most relevant quotations came from the hybrid manufacturer:

The cosmetic product has to be effective and safe, and it even has to be able to surprise the user, satisfying and responding to the consumer’s sensory demands. Innovation has to be conducted in order to obtain products based on the latest technology with a good scientific base (HYBRID).

In terms of market strategy, and possibly accentuated by the current economic situation, all interviewed companies coincide in using a variety of at least three market strategies for improving their competitive position and expand their markets. The main market focus is on product development and technology adoption, all companies affirming that they develop new products in order to open new markets and adopt already developed technologies which support strong implementation of product and process innovation. No differences in behaviour pattern or strategic orientation were perceived. The situation is different when we look at how strategy is developed. Green and natural cosmetic manufacturers state that market strategy is developed following a mutual agreement between all departments, while in the conventional cosmetic manufacturers the (general, technical) manager or the managerial team decide marketing strategy. This result might suggest that green and natural manufacturers are less hierarchical, and strategy is a shared responsibility between all departments. This might also be influenced by the size of the companies.

5.3. Quality and certifications

In the case of end-user products, in general, and cosmetic products, in particular, quality is a must. ISO certifications 9000 and 14000 are the most frequent certifications of product and process quality. At present, they are predominant in the cosmetic sector and consequently they do not represent a differentiating factor. In parallel, sector-specific norms appeared, such as ISO 22716:2007 which gives guidelines for the production, control, storage and shipment of cosmetic products. Complementary to ISO, Ecocert was the first certification body to develop standards for natural and organic cosmetics, created in 2003. It currently supports and guides more than 1,000 companies through their certification processes. Among the companies interviewed only one case bears the Ecocert certification. It is interesting to observe that it is a hybrid company, producing both traditional and natural cosmetics.

In Table 4 we show the results of our interviews in terms of quality, certification, Ecocert and main barriers. As a piece of example, regarding quality one of the CEOs commented:

Quality in the natural cosmetic product is synonymous of quality in all stages of the value chain: starting with high quality raw materials having their origin in other continents -different from Europe-, produced by the means of ecological agriculture with a careful control against land overexploitation, continued with a cautious transformation, until the packaging using recycled and recyclable materials resulting in a product without perfumes, colorants and preservatives, non-tested on animals finally sold through special distribution points or channels such as eco shops, cooperatives or fair trade (NATURAL1).

Case	Certification and Awards	ECOCert	Relevant comment relative to ECOCert
NATURAL1	na	û	We do not have this certification … our main concern is to provide the latest innovations on the health of the skin … we do not discard the possibility to obtain this certification someday.
NATURAL2	ISO9000, ISO14000, ILE award – Best European Employment and Training Scheme	û	We do not have this certification because the company philosophy is to work well … namely, it is focused on achieving very effective cosmetics and certification in order to guarantee its products.
CONVENTIONAL1	ISO 9001:2008, ISO 22716:2007	û
CONVENTIONAL2	na	û
CONVENTIONAL3	ISO 22716:2007	û
HYBRID	ISO9000, ISO14000, ISO 22716:2007	ü	We have this certificate because our firm wants to meet the demand of a sector in a specific market. However, one should be aware that the ECOCERT products are not a line with high profitability due to the still low demand.

n/a: not available

Table 4. Certifications and awards

We also detect the existence of certificates, awards and recognitions. It is interesting to observe that there is no clear pattern regarding ISO certification. In terms of Ecocert, green and cosmetic producers were questioned about perceived barriers. From more important to less the ranking of factors hampering Ecocert certification –and ultimately also valid for barriers in producing green and natural products- are: too much documentation, special space for manufacturing, not economically feasible, low or lower consumption of this type of products, unavailability of raw materials and/or distributors. The only company holding this certificate comments:

We have this certificate because our firm wants to meet the demand of a sector in a specific market. However, one should be aware that the ECOCERT products do not necessarily and immediately translate into high profitability due to the still low demand (of ecological products). (HYBRID).

Overall, and to conclude this section, we perceive a state of maturity of cosmetic producers regarding the traditional quality concept. This reality is ultimately sustained by holding ISO certificates. New forms of quality, in the sense and essence of green and natural cosmetics, are also present, but they are not certified. However, rather than discarded, they remain under consideration for future possibilities, highly depending on the proved effectiveness of these products, user awareness and other determinant macro issues.

5.4. Research and sustainability

The strong strategic orientation towards new product development and the adoption of existing technologies puts special emphasis in the topic of R&D, research and sustainability activities. Again, expressions such as “essential”, “fundamental”, “important” and “useful” indicate companies’ commitment to these activities. Moreover, we questioned companies about concrete research and sustainability actions. As shown in Table 4, R&D is mentioned in relation to innovation, in terms of new products and significant improvements of existing ones, by the majority of participants. Companies mention a series of areas of interests: natural and green cosmetic and hybrid manufacturers mentioning alternative methods to replace testing with animals, while conventional manufacturers refer to new techniques for product development and specific areas of interest in the field of cosmetics, such as micro-pigmentation or cosmetology. All companies are interested in sustainable activities, including non-animal testing, while green and natural cosmetic manufacturers highlight sustainable packaging. In the words of one manager:

We want to be green and natural in all facets of our product from ingredients to packaging… in fact, packaging is very important… it contains relevant information about the product and it creates the first impulse in our customer (NATURAL1).

5.5. Innovation activities and outcomes

The continuously growing demand for cosmetic products, as well as a sensitive attitude towards sustainable products in general, moves manufacturers towards innovation. The cosmetic industry abounds in all types of innovation, including product, process, marketing and organisational (OECD, 2005). Companies were asked about all types of innovation in the items from the regular innovation survey, which deal with use/implementation, degree of novelty and impact.

The information in Table 5 shows that all companies have implemented new-to-the-firm innovations and market product innovations and marketing innovations in the three year period prior to our field work (2010-2012). Four of the six companies introduced process innovation and organisational innovation. There were many innovations in these companies and an ambition to develop better formulas and products, more efficient processes, improved and new packaging and work re-organisation.

Case	R&D	Research lines	Activities towards sustainability
NATURAL1	“R&D is essential to provide the latest innovations on the health of the skin.”	– New ingredients – Alternative methods of testing animals.	– Non-animal tests. – Sustainable packaging.
NATURAL2	“R&D is fundamental for the firm”	– Cosmetogenomic: innovation techniques. – Cosmeceutics: genetically manipulated actives. – Pharmacodynamics: study of the biochemical and physiological effects of drugs on the body. – Alternative methods of testing animals.	– Non-animal tests. – Sustainable packaging.
CONVENTIONAL1	“Depends on the product, but the most important is R&D in order to improve manufactured cosmetic products. “	– Micro-pigmentation: innovation technic.	– Non-animal tests. – Pollution control technologies. – Waste management technologies. – Recycling technologies. – Reduction of CO2 emissions.
CONVENTIONAL2	“Acquisition of equipment to improve methods of obtaining the purest active ingredients.”	– New obtaining technics in the process.	– Non-animal tests. – Reduction of CO2 emissions.
CONVENTIONAL3	“R&D useful for the formulation of new products with innovative actives.”	– Cosmetology: is the study and application of beauty treatment.	– Non-animal tests. – Reducing solvent consumption and waste. – Pollution control technologies. – Reduction of CO2 emissions. – Recycling technologies.
HYBRID	R&D in order to achieve new products according to demand market.	– Anti-aging products – Alternative methods of testing animals	– Certification of compliance with Good Manufacturing Practices Cosmetic. – Reduction of CO2 emissions. – Non-animal tests. – Sustainable packaging.

Table 5. Research and sustainable activitie

6. Conclusions

The aim of the present article is to present an analysis of innovation and sustainability as two important contributors to success in the cosmetic industry, depending on whether the main product line of a company is green and/or natural, conventional or hybrid. In all industries, and this industry in particular, there is a shift in the concept of quality from complying with the minimum or the norm, to a more sophisticated concept of quality that includes responsible users and exploitation of raw materials, recycled and environmentally-friendly packaging, new products in response to customers’ concern for their health and beauty, improved and more efficient processes and, not least important, with regard for employee well-being.

By analysing a series of cases, we identify general characteristics and innovative behaviour of green, natural, conventional and hybrid cosmetics manufacturers. Overall we find a high level of commitment to innovation in terms of strategy, and many types of innovation used to improve market position and improve competitive advantage. Green and natural cosmetic manufacturers mainly differ from other companies in terms of their size (they are smaller), their markets (more local), packaging (using more glass and paper as materials in primary packaging), have strategies agreed among all departments, and some common research interest and sustainable activities. All these aspects are fully in line with the trends described in the initial part of the present article.

Integrating strategy, R&D and innovation with sustainable aspects in a crucial sector, such as the chemical industry in general and cosmetics in particular, contributes an understanding of how companies manage their shift towards the greening of their products, which remains a future trend for most manufacturers.

Finally, this study has several limitations. The main limitation is the number of cases, especially in the green and natural cosmetic producer categories. This further translates into some difficulties in generalising the results. Among the interviewed companies there were no big corporations, and all the companies studied fall into the SME category.

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[FULL] Article 2, Volume 1 Issue 1

An ISO 10002:2004-based feedback-handling system for the emergency and inpatients care

Author

Mohammad Ashiqur Rahman Khan

Stanislav Karapetrovic

DOI:

10.26595/eamr.2014.1.1.2

Abstract

The development of an ISO 10002:2004-based system for handling unsolicited patient feedback within a continuum of care in a Canadian hospital is presented. Through interviews of registered nurses, unit managers and experts, patient encounters and existing feedback-handling activities were studied and the learning was incorporated in a Feedback Handling System (FHS). Guidance from ISO 10004:2012 was used in defining FHS maintenance activities. New activities and items that are not suggested in ISO 10002:2004 were introduced. The FHS follow-up component was validated through actual patient feedbacks. The usefulness and feasibility of the developed FHS were verified by interviewing research participants. According to the feedback-handling experts, the FHS could be useful at the unit–level. To our knowledge, this paper shows the first application of ISO 10002:2004 in integrated health care. It also demonstrates an example of the “augmentation” of ISO 10002:2004 with ISO 10004:2012-based monitoring of patient satisfaction in integrated health care.

Keywords

1. Introduction

Customer feedback provides a wealth of information about a customer’s expectations and perceptions about the received product and service. Customers of health care include the public in general and the patient in specific (Deffenbaugh, 1994). Furthermore, the patient family and friends, also considered as health care customers (O’Malley et al., 2008), provide useful feedback. Numerous studies can be found on the importance of feedback in health care (e.g., Stichler and Schumacher, 2003; Seelos, 1994; Levine et al., 1997). Feedbacks are important not only for understanding the patient perception, but also for identifying the problem areas and improvement opportunities. Complaints are considered a useful indicator of service quality (Kline et al., 2008). ISO 10002:2004, a customer satisfaction standard, provides guidance for the design and implementation of a complaints-handling process. Surprisingly, studies on the application of ISO 10002:2004 in health care are still rare.

Unlike the traditional health care that is provider-centered and focused on systems rather than patients (NHS, 2003; Friedman et al., 2001), Integrated Health Care (IHC) is “a coordinated organizational process that seeks to achieve seamless and continuous care, tailored to the patients’ needs” (Mur-Veeman et al., 2003). IHC advocates providing patient-centered care with well-connected services (Suter et al., 2009; Ouwens et al., 2005; Thomas, 2007; Kerberet al., 2007; Lamb, 1997; Armitage et al., 2009). With its patient focus, integration may reduce fragmentations within the organization and improve continuity and coordination of the care (Ouwens et al., 2005; Rygh, 2007). It is possible that patient feedback can be obtained and used more effectively and efficiently in an IHC system than in a traditional system, in which the feedback-handling can be isolated and discontinuous. Surprisingly, no work on handling unsolicited patient feedback within the IHC setup can be found in the literature. Nonetheless, it is an interesting problem to explore because the benefits of IHC should also be realized in feedback handling.

In this paper, the application of ISO 10002:2004 in developing a Feedback-Handling System (FHS) for IHC is illustrated. A care continuum consisting of the Emergency Department (ED) and inpatients care in a Canadian hospital was assumed as an IHC case. First, the significance of handling feedback in IHC is discussed and the existing frameworks found in the literature are reported. Then, the existing activities within the care continuum are identified and analyzed based on interviews with the research participants, which includes care providers and feedback handling personnel. Subsequently, the development of an ISO10002:2004-based FHS is presented with the details of the operational and maintenance processes. The maintenance process is further augmented by using ISO 10004:2012, a standard for monitoring and measuring customer satisfaction. The feasibility, usefulness and potential implementation of the FHS are analyzed with inputs from the research participants. The follow-up activities are verified by investigating actual feedbacks that were documented in a developed form. Conclusions are drawn regarding the findings and future research directions are proposed.

2. Feedback-handling: Significance and Frameworks

Feedbacks are “the opinions, comments and expressions of interest” (ISO 10002:2004, sub-clause 3.6). Interestingly, the expression of dissatisfaction is firmer and more reliable than that of satisfaction (Coyle and Williams, 1999; Mulcahy and Tritter, 1998). Therefore, patient dissatisfaction can indicate systematic issues and uncover potential improvement opportunities regarding the care quality and patient experience (Davis et al., 2008). However, a very small number of dissatisfied customers actually convey their dissatisfaction (Stichler and Schumacher, 2003), but may convey their bad experience to others (Stichler and Schumacher, 2003; Kress and Silversin, 1983; Eccles and Durand, 1998; Gingold, 2011). The study of complaints helps in identifying problem areas that are causing patient dissatisfaction (Stichler and Schumacher, 2003; Saravanan et al., 2007; Anderson et al., 2000) and opportunities for quality improvement (Anderson et al., 2000). Moreover, feedback data can act as the indicator of customer expectations and satisfaction (ISO 10004:2012, Clause 1). Complaints are sometimes conveyed by a third party such as a relative (Anderson et al., 2000). However, patients may refrain from raising their concerns fearing negative consequences (NHS, 2003). Therefore, patients, as well as their family and friends, need the encouragement and assurance to leave feedbacks. Additionally, staff members can be assigned to monitor that the customer needs are fulfilled (Eccles and Durand, 1998). Building capacity for having a proper feedback-handling system and treating complaints as improvement opportunities are strongly recommended (Seelos and Adamson, 1994; Hsieh et al., 2000). An appropriate system for handling feedback would also be significant in IHC, which is known for its focus of the patients and the continuum of care.

In the literature, there are examples of complaints handling frameworks, as well as tools for the collection and analysis of feedback and its use (e.g., Zairi, 2000; Osborne, 2004; Nordlund and Edgren, 1999). Health care specific examples are discussed in Allen et al. (2000), Kress and Silversin (1983), HQCA (2007), NHS (2003), Smith and Swinehart (2001) and Hsieh et al. (2005). The only well-known international standard on complaints handling is ISO 10002:2004, which is a “guideline standard” that is not intended for certification. It includes guidance on the planning, designing, operation, maintenance and improvement of a complaints handling process. Applications of ISO 10002:2004 can be found in the literature in various areas, including an electrical utility (Hughes and Karapetrovic, 2006), fast-moving consumer goods (Ang and Buttle, 2012), university education (Karapetrovic, 2010; Honarkhah, 2010), health insurance (Ang and Buttle, 2012) and health care (Ang and Buttle, 2012; Fernandez et al.,2010; HQCA, 2007). To our knowledge, there has not been any research on standardized feedback-handling within IHC, and that provides the motivation for this research.

3. Methodology

This research was initiated as part of a project on customer satisfaction in IHC (Capital Health, 2008). Although the principles and components of IHC are identified and analyzed in the literature, “Patient centeredness” (O’Malley et al., 2008; Suter et al., 2009; Friedman et al., 2001) and “Comprehensive service across the continuum of care” (Suter et al., 2009; Friedman et al., 2001) are focused on in this paper because of their relevance to feedback-handling. The patient focus is engraved into the FHS by applying ISO 10002:2004 with its principles and guidance. An Emergency Department (ED) and inpatients care of a hospital was assumed as an example case of IHC. The experiences of patients who receive care in the ED and get admitted in the inpatients care were the focus of this research. The FHS was developedby considering this continuum of care as one system in an approach that is different from traditional feedback-handing at each stage of the continuum individually.

ISO 10002:2004 does not detail the validation of the feedbacks or the communication and reporting of the results from the feedback analysis. Therefore, in further defining these maintenance activities, ISO 10004:2012, was applied in addition to ISO 10002:2004.

This research involved the following steps, which are detailed in the next section:

Study the care continuum;
Determine the existing feedback-handling activities;
Develop an FHS;
Verify the FHS’s usefulness and feasibility.

As part of the first two steps, the hospital’s internal documents and publicly available reports were studied and the research participants were interviewed. The research participants included one Program Manager (PM), three Unit Managers (UMs) and four Registered Nurses (RNs) from the ED and inpatients care, as well as two feedback-handling experts. After the development of the FHS, its usefulness was verified by interviewing each group of participants. Based on the responses from one group, the FHS was modified and passed to the next group before their interviews. Additionally, the follow-up component of the FHS was tested through tracking actual patient feedbacks by one of the participants. The results are now discussed.

4 . Results

4.1. Study of the care continuum

Based on the interviews with participants, flowcharts depicting the care processes within the continuum were constructed. For each activity within the care flow, the “SIPOC” elements, i.e., “Supplier-Input-Process-Output-Customer” (Miller, 2005), and the care provider(s) were determined. The intent was to focus on a patient’s journey from the initiation to the end of the care, as well as to identify the “moments of truth” i.e., the service encounters during which a patient makes judgment on the quality of care (Osborne, 2004). Therefore, every patient encounter with the health care provider or organization can have the potential for feedback (Osborne, 2004). Because the higher the clinical complexity, the higher the likelihood that concerns may occur (Kline et al., 2008), patients who go through multiple procedures and stages are more likely to have feedback. For instance, the study of the care flowchart helped to identify two such points in the continuum for which there is a potential for concerns. They were: (1) patients waiting in the ED and (2) patients being handed-off from the ED to inpatients care. Patients wait for the next step of care at both these points and a long waiting time can initiate patient complaints.

4.2. Existing feedback-handling activities

Based on the interviews of the participants, as well as the study of the available reports, the following conclusions were drawn:

The ED and inpatients care patients may leave feedbacks with a feedback-handling department within the province. This department conveys the received feedback to the related health care unit of a hospital and records the follow-up activities. However, neither the ED nor the inpatients care units in the hospital have their own system of feedback handling. The feedbacks received within the units are typically handled individually by the UMs and the care providers.
No defined process exists in the hospital for the collection and follow-up of orally-conveyed feedbacks. However, in the Canadian province of Alberta, where the hospital is located, a large number of patients with serious complaints complain orally (HQCA, 2010).
Within the ED and inpatients care units, there are no defined feedback monitoring or feedback-based improvement activities.
Feedback follow-up activities may not be tracked effectively and consistently when the feedback involves personnel such as physicians, therapists, social workers and dietary staff, who are outside of the chain of command of the ED and inpatients care.
Issues may happen at the handing-off: a feedback received in the ED may not be communicated to the inpatients care even though the patient is handed off to the inpatients care.
The UMs of ED and inpatients care are responsible for their own units’ feedback follow-up activities. However, no defined process exists for helping the coordination among the UMs in their handling of feedbacks.

While the first three are gaps in the existing system, the remaining are continuum issues that should be addressed in an integrated system. Consistent with the idea of a provider-centered health care system, which typically cannot offer a complete view of a patient’s care experience along the entire care continuum (Lamb, 1997), the existing feedback-handling activities are discontinuous and isolated. Therefore, a unit-level FHS along the care continuum should be useful and efficient in addressing both the continuum issues and the identified gaps. The following sub-sections illustrate the development and a partial validation of the FHS.

4 .3. Development of the FHS

Guidance from ISO 10002:2004 was used in developing an FHS, with the focus on the unit-level handling of feedback. Complaints and recommendations were both considered as inputs. Hence, the scope of ISO 10002:2004, which is specific to complaints only, is augmented. The FHS components, which are illustrated below, include a policy (based on sub-clause 5.2, ISO 10002:2004), objectives (6.2), responsibility and authority of the personnel (5.3), operational process (7) and maintenance and improvement process (8). The latter process was further enhanced by applying guidance from ISO 10004:2012.

4.3.1. The FHS Policy

During the time of the research, the hospital did not have a specified feedback-handling policy. The intent of the half-page policy developed as part of the FHS was to build a culture of listening to the voice of patients and enhancing satisfaction. The policy was developed and worded based on the ISO 10002:2004 guiding principles in Clause 4. The policy included statements on the “visibility”, “accessibility”, “responsiveness”, “objectivity”, “confidentiality”, “customer-focused approach”, “accountability” and “continual improvement” of the FHS. “Charges” was the only principle not included, because there is no money is involved in the process of patients leaving feedback. As an example of how the FHS policy reflects the ISO 10002:2004 principles, the policy states:

“The patient focus is emphasized by encouraging and facilitating the collection and follow-up of patient feedback, sincerely committing to resolving issues, implementing corrective, preventive and improvement actions, and replicating the good practices and recommendations”.

Interestingly, patient focus (“Customer Focus”, as illustrated in sub-clause 4.8) is also a core principle of IHC. “Responsiveness” and “accountability” pertaining to the FHS are relevant to the continuum of care, both being improved by the integrated and collaborative handling of feedbacks by the personnel involved in multiple stages of the care.

4.3.2. The FHS objective

The core objectives of the FHS are to obtain feedbacks by involving the care providers closest to the patients in resolving concerns within the care continuum and to use the results from the feedback analysis in improving the care. Additionally, the FHS should help in providing a snapshot of patient satisfaction regarding the care received. By involving care providers, quicker resolution of complaints should be achieved. These objectives are connected with the IHC principles (i.e., patient centeredness and the continuum of care), are consistent with the policy, and are measureable through the suggested indicators (discussed in sub-section 4.3.5 below).

4.3.3. Responsibility and authority

The UMs from ED and inpatients care are responsible for leading and managing the feedback tracking activities. For a different setup, this responsibility can be assigned to other personnel as necessary. Thus, “accountability“ is established, which is a principle of ISO 10002:2004 (sub-clause 4.9). Communication and collaboration between the UMs of the two stages should help making the feedback-handling “seamless” and “coordinated” (Mur-Veeman et al., 2003) along the continuum, which are the attributes of IHC that distinguish it from the traditional care.

4.3.4. Operation of the FHS

The UM and nurses can inform the patients of the ways to leave feedback, including a feedback form designed to obtain written feedbacks from patients and the locations of the feedback drop boxes, as well as of the manner in which the feedbacks would be used (ISO 10002, sub-clause 7.1). The UM can check the drop boxes every day for feedbacks left by patients, or assign the duty to an assistant, such as the Unit Clerk. The locations of the drop boxes are determined following the study of the care continuum (see step 1 of the methodology). For the ED, the drop box should be placed in the waiting room and for the inpatients care, the locations chosen were next to the reception desk, inside a ward and on the wall of the corridor within the unit (Figure 1). In all three locations, patients may have to wait or are between procedures, which allow them opportunities to fill-out the feedback form.

Figure 1. Inpatients unit locations of the feedback drop boxes

Figure 2 illustrates the FHS’s operation, including the ISO 10002:2004 sub-clauses in parenthesis. Patients can leave feedback by informing the care provider (e.g., doctors and nurses), by filling the feedback form and dropping it into the feedback drop boxes, through emails, letters and phone calls, as well as by contacting external parties, such as the central feedback-handling department and the media. Consistent with the existing practices of the care continuum, patient feedbacks are handled by either the care provider or the UM.

Figure 2. FHS Operations

When a care provider receives a feedback, he/she thanks the patient and assesses the issue. The care provider passes the feedback to the UM if it needs the UM’s attention. Otherwise, the care provider investigates the issue, determines the action needed, performs the necessary action and communicates it to the patient.

Feedbacks from various sources eventually are conveyed to the UM, who tracks them till the closure. After receiving a feedback, the UM acknowledges the receipt, assesses it initially and determines the feedbacks for which subsequent activities should be documented and tracked in a “Feedback Follow-up Form”. This is because it may not be possible for the UM, with the limited available time and resources, to record all the feedback-handling activities for all feedbacks. The procedure to determine whether or not the follow-up form is to be created is further detailed in Figure 3.

Next, the UM categorizes the feedbacks. In the literature, there are examples of feedback categorizations (e.g., Allen, Creer and Leggitt, 2000; Baker, 2008; Montini, Noble and Stelfox, 2008). ISO 10002:2004 includes its own categories in the “Complaint follow-up form” (see Annex D). The central feedback-handling department already developed its own categorization that includes four “primary” categories: “access”, “delivery of care”, “environment” and “finance”, with sub-categories for each primary category. The research participants stated that this list had been validated through its use over the preceding several years and that the hospital personnel are familiar with it. After considering the options, the central feedback-handling department’s list was adapted in the follow-up form. For a different case, a customized list can be developed, or the existing one in ISO 10002:2004 can be used.

The UM investigates the feedback and determines and implements the required actions. Finally, the UM communicates to the patients the actions undertaken. Subsequently, the feedback is closed. If the patient is not satisfied and asks for further actions, the cycle is repeated. The follow-up form is updated with each activity.

The shaded diamond in Figure 2 is magnified in Figure 3, illustrating the criteria based on which feedbacks are selected for documenting their follow-up. ISO 10002:2004 does not specify any such procedure. This procedure is an additional component that should be useful for the feedback handing personnel. The criteria used in the procedure were developed and improved based on the comments from the research participants. More items can be included to the criteria based on the results from the implementation.

Figure 3. Decision procedure on creating a follow-up form

The “Feedback Follow-up Form” is adapted from the one provided by ISO 10002:2004, Annex D. Notable changes in the form from the original are:

– “Comment of the feedback receiver” is added, which should indicate the state of the patient and environment in which the feedback was conveyed.

– The “Problem category” is replaced by the adapted list.

– The 18-item checklist of “Complaint resolution” actions (ISO 10002: 2004, Annex D.6) is replaced by open-ended options to document “corrective”, “preventive” and “improvement” actions, thereby simplifying the use of the form.

– To simplify and quicken the documentation of feedback assessment, the open-ended options for “Severity”, “Complexity” and “Impact” (ISO 10002:2004, Annex D.5) were replaced by a close-ended score ranging from one to five.

4.3.5. Maintenance and improvement of the FHS

To measure the FHS performance in relation to the objectives (see 4.3.2), nine indicators were determined based on 10002:2004 Annex G.3.3 and ISO 10004:2012, sub-clause 7.3.2. Examples of indicators are:

Number of feedbacks received per category and sub-category;
Number of concerns resolved;
Number of corrective, preventive and improvement actions resulting from feedback analysis;
Wait times at various points of the continuum;
Number of received complaints regarding service coordination at the points of handing-off and discharge.

The ED and inpatients care aspects were considered in determining these indicators. For example, by studying the care flowchart, the specific point in the continuum where the waiting occurs can be identified (e.g., in the ED or at the handing-off to the inpatients). Waiting time at each of these points can be measured and monitored. Similarly, trends in the collected feedbacks can be determined, which can be related to patient satisfaction (ISO 10004:2012, sub-clause 7.3.2). By considering the entire care continuum as one system and monitoring the indicators across the continuum, intelligence can be obtained on patient satisfaction related to the received care. This may not be effectively done in the traditional feedback-handling because of its lack of focus on the continuum.

The feedback analysis can be validated (ISO 10004:2012, sub-clause 7.4.5) by comparing the consistency of the results against the existing surveys, reports and documents that are regularly generated by the hospital, as well as by the media. For instance, the public report on the HQCA’s 2009 ED survey results includes the number of complaints received and any identifiable trends. The FHS performance indicators can be compared against this existing survey report.

The feedback analysis should be reported with recommendations on areas for improvement (ISO 10004:2012, sub-clause 7.4.6). The UMs of both the ED and inpatients can discuss the findings, as well as develop and implement the action plans together. The results and learning can be communicated to colleagues and the management (ISO 10004:2012, sub-clause 7.5). The collaborations among the UMs and the dissemination of the findings among colleagues demonstrate the coordinated effort without redundancy, which is a key benefit of IHC (Ouwens et al., 2005).

5. Verification of the FHS

To verify the usefulness and feasibility of the FHS, two personnel involved in feedback handling, one UM from inpatients care and three RNs (Registered Nurses) from the ED, were interviewed. Their responses are summarized in Table 1.

Participants	Summary of findings
1. Feedback-handling experts	· The FHS provides the unit-level care providers with a set of useful tools for handling feedbacks · The challenge of its implementation is to prove its value and benefit to the care providers
2. Inpatients care	· Staff training specific to handling feedback should be conducted · The feedback follow-up form can be helpful for a new UM to anticipate what is expected from patients and how feedbacks are traditionally dealt with
3. ED	· The staff should be convinced with answers to the following questions about the FHS: a) What is the evidence from the literature to show the need of it? b) What difference would it make? How big would be its impact? · The need for the level of technology use is limited, which is a strength · It was suggested to omit the item related to adverse events from the decision procedure (Figure 3, “A”), because the hospital already has defined procedures for such events

Table 1. Findings from verifications interviews

Based on the verification interviews, a lack of interest on the FHS was identified among the unit-level staff (RNs and UMs). Being occupied with many responsibilities, the staff may have viewed it as additional work. However, the interviewed feedback-handling experts were optimistic that the FHS should provide the unit-level staff with useful tools to help in handling feedbacks, something they already do as a part of their jobs.

Two RNs from the ED and a UM from the inpatients care were requested to evaluate the FHS by using the follow-up form for tracking real feedbacks. Response was only obtained from the UM, who documented the follow-up activities regarding three feedbacks. The findings validated the usefulness of the tracking process and helped in further improving the form. For instance, a new primary category named “other (specify)” is introduced in order to account for the feedbacks that do not fall under the existing options (i.e., “access”, “delivery of care, “environment” and “finance”). Additionally, “billing” and “funding” as the secondary categories under “finance” were omitted, because they are not relevant to this particular care continuum. Overall, the follow-up process of the FHS worked satisfactorily, according to the UM. The form can be further improved by making it electronic, thereby more agile and efficient for the UM.

6 . Discussion

In the FHS, new activities and items, which are not in ISO 10002:2004, were introduced. One example is the decision procedure (see Figures 2 and 3), which may save time for the unit-level personnel by helping them in making prompt selections of feedback for the follow-up documentation. The follow-up form includes an additional field titled “comment of the feedback receiver”, which should help in capturing the state and tone of the patient at the point when the patient conveyed the feedback. This is an example of acknowledging the “moment of truth” (Osborne, 2004), as well as patient centeredness. Two additional notable changes made to the follow-up form are: (1) a different categorization of feedbacks is introduced and (2) the long list of complaint resolution actions from Annex D.6 of the standard (page 16) is replaced by the open-ended “corrective”, “preventive” and “improvement actions”. These actions were intended to make the recording of the maintenance activities less cumbersome for the already busy UMs.

The gaps listed in section 4.2 of this paper are all addressed in the FHS. The FHS provides an organized system for the “unit-level” handling of feedbacks (4.2.a) and includes orally-conveyed feedbacks (4.2.b). The gap regarding the use of the feedback (4.2.c) can be closed by integrating the efforts of the UMs from both care stages. Guiding all feedbacks from various sources and work groups to the UM and keeping the UM responsible for the tracking should lead to effective and consistent handling of feedbacks (4.2.d). Having the UMs of the two stages discuss and share feedbacks left at their own stages should result in better coordination and organization of the follow-up activities and less probability of lost feedbacks between stages (4.2.e and f). Therefore, the FHS can provide “a broad overview” (Deffenbaug, 1994) of patient feedbacks on the care, as well as reduce fragmentation and improve the continuity and coordination (Ouwens et al., 2005), all of which are key benefits of IHC and are included in the FHS objectives (see 4.3.2).

Successful implementation of the FHS will require commitment from the care providers and support staff, who should be made aware of the significance of patient feedback and trained on its proper handling. Presenting evidence to the staff on how their recommendations are implemented should make them feel more involved and dedicated to feedback handling. If the FHS seems to increase the workload of the UMs,olunteers and nursing students can be recruited for documenting the follow-up activities under the supervision of the UM.

7 . Conclusions

The implementation of the FHS can assist in closing the identified gaps in the existing feedback-handling activities of the hospital. Overall, a set of standardized processes are provided that should help health care personnel in handling feedbacks efficiently. By following the steps suggested in the methodology, the FHS can be applied in other care continua (e.g., maternity, chronic disease management and primary care), and can include other groups of personnel (such as doctors and therapists). The FHS can be implemented at the unit-level, where the interviewed experts suggested that it should be useful, even without the presence of an overarching feedback-handling body. This demonstrates the flexibility of ISO 10002:2004. Keeping the UMs responsible for overseeing the feedback follow-up processes is not a requirement of the standard, rather an example of having one responsible person from each stage of the care continuum. This should help in maintaining the coordination and flow of the follow-up activities between stages.

The paper illustrated that ISO 10002:2004 can be useful in IHC. The integrated use of ISO 10002:2004 and ISO 10004:2012 in health care is a novel approach, exemplifying how the maintenance and improvement activities in Clause 8 of ISO 10002:2004 can be “augmented” by sub-clauses 7.3 to 7.6 and Annexes D and E of ISO 10004:2012. To our knowledge, examples of such integrated applications have not yet been reported.

The FHS demonstrated how “patient centeredness”, a key principle of IHC (e.g., Friedman et al., 2001; O’Malley et al., 2008), can be implemented by applying the ISO 10002:2004 and ISO 10004:2012, two international standards focused on customers. The FHS also showed how the IHC principle regarding the “continuum of care” (e.g., Friedman et al., 2001; Suter et al., 2009) can be maintainedby the application of ISO 10002:2004, which should help integrate the handling of feedbacks at various stages of care that a patient experiences. Moreover, the literature still lacks examples of a comprehensive framework specific to IHC for handling both solicited (e.g., through surveys and focused groups) and unsolicited (e.g., through feedback forms and cards) feedbacks. This work depicts the function of such a framework.

The implementation of the FHS was beyond the constraints of this research. Physicians and support staff (such as technicians and dietary) were not involved in the FHS design and verification interviews. Their inputs may have been useful in further refining the FHS.

The results from this paper contribute to the application of the ISO 10000 standards in health care, which still has not seen significant exploration. For example, establishment and implementation of a customer satisfaction promise based on ISO 10001:2007 isreported in Authors (2013) and (2014a). The handling of solicited feedback based on ISO 10004:2012 is discussed in Authors (2014b).

Using this paper as the baseline, it should be interesting to explore a pilot implementation by involving several ED and inpatients care units to further test the FHS’s usefulness and feasibility. The composition and usefulness of the decision procedure presented in this paper (Figure 3) can be further investigated when the FHS is actually implemented. The level of patient satisfaction with the FHS can be determined by conducting patient interviews or a survey, as suggested by ISO 10002:2004 (sub-clause 8.3). Such a survey can be designed by applying ISO 10004:2012 to further explore the integrated use of the two standards. The effectiveness of the FHS can be evaluated by implementing the ISO 19011:2012 auditing standard.

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Audit expectation gap: fraud detection and other factors

Abstract

Keywords

1. Introduction

2. The audit expectations gap

2.1. The legal account audit framework

2.2. Audit users

2.3. Proof of the expectation gap

3. Identifying the factors determining the expectation gap

3.1. Fraud detection

3.2. Auditor independence

3.3. The existence of erroneous expectations on auditing

3.4. The actual nature of the auditing process

3.5. The auditor’s responsibility with respect to the going concern principle.

4. The auditor as a fraud detector

4.1. Research work on fraud detection

4.2. International Standard on Auditing 240

5. Conclusions

References

Audit firm tenure and audit qualifications in Spain: a multinomial approach

Abstract

Keywords

1. Introduction

2. Review of the literature

3. Audit regulation in Spain

4. Methodology

4.1. Research design and hypothesis development

4.2. Sample and dataset

5. Results

5.1. Univariate analysis

5.2. Multivariate analysis

6. Additional results: controlling for accounting quality

7. Conclusions

References

An exploratory analysis of the board composition in Spanish innovative firms

Abstract

Keywords

1. Introduction

2. Literature review on the effects of board composition on innovation

2.1. Board size

2.2. Gender diversity

2.3. Typology of directors

2.4. CEO duality

3. Methodology

3.1. Data collection

3.2. Measurement of variables

4. Results

5. Discussion

6. Conclusions

References

New facets of quality. A multiple case study of green cosmetic manufacturers

Abstract

Keywords

1. Introduction

2. Cosmetic industry background

3. Trends in the cosmetic industry

4. Methodology

5. Results and discussion

5.1. Company characteristics

5.2. Orientation and Strategy

5.3. Quality and certifications

5.4. Research and sustainability

5.5. Innovation activities and outcomes

6. Conclusions

References

An ISO 10002:2004-based feedback-handling system for the emergency and inpatients care

Abstract

Keywords

1. Introduction

2. Feedback-handling: Significance and Frameworks

3. Methodology

4. Results

4.1. Study of the care continuum

4.2. Existing feedback-handling activities

4.3. Development of the FHS

5. Verification of the FHS

6. Discussion

7. Conclusions

References

EDITOR

4 . Results

4 .3. Development of the FHS

6 . Discussion

7 . Conclusions