asanga jayasundara - cb004784 - fyp
TRANSCRIPT
Factors affecting External Audit Quality of organizations in
Asia
Asanga Chamara Jayasundara
BSB10183-3-Project
Submitted to the Business School in partial fulfillment for the degree of
Bachelor of Arts (Hons) in Business Management
Supervised By: Ms. Fathima Nazeefa Fawzer
Word Count: 2198
INDIVIDUAL ASSIGNMENT M A R K I N G S C H E M E (85%):BSB10183-3-Project 13/14 (Progress Report Not Included)
Student Name: Asanga Chamara Jayasundara CB Number: CB 004784Project Title: Factors affecting External Audit Quality of organizations in Asia
Supervisor: Ms. Fathima Nazeefa Fawzer Assessor: Dr. Hemamali Tennakoon
Criteria1st Marker (%)
Comments2nd Marker (%)
CommentsFinal Agreed Marks (%)
Introduction (10%)Comprehensive introduction withaim/objective/question/problemjustification, related to the literaturereview.
Resources Selection (20%)Appropriateinrespectof the aboveandcontemporary, has breadthanddepth.
Critical Analysis and Review (40%)Level o f a n a l y s i s a n d c r i t i c a l reviewof resources.
Conclusion (20%)Abilityto synthesizeand develop arguments/perspectives.
Presentation (10%)Accurate referencing, logicalstructure and languageproficiency.
TOTAL (%)
CB004784 Final Year Project
Abstract
The following research is an empirical study which critically evaluates the factors affecting
the external audit quality of organizations in Asia. The study also discusses the importance of
high quality audits, and different definitions which are based on the perceptions of different
stakeholders, in the first section of the literature review. It identifies that a universally
recognized definition is still yet to be developed, to fully understand the term ‘audit quality’,
and that the importance of audit quality has been developing throughout the history.
The study identifies Auditor independence, Mandatory auditor rotation, and Firm size as the
factors affecting external audit quality. The key findings regarding these factors are as
follows.
The research identifies auditor independence as the most influential factor for external audit
quality, and factors such as mandatory auditor rotation should be highly considered in order
to maintain an effective auditor independence level. Further, it identifies that mandatory
auditor rotation displays a positive relationship with external audit quality, and that the level
of influence changes according to business context characteristics, and present legal
structures of the country. Moreover, large firms are capable of producing high quality
external audits, thus small firms should enhance their quality standards and professional
standards to level their profession with larger firms.
Key Words: External Audit quality, Auditor independence, Mandatory auditor rotation,
Firm size
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Acknowledgement
The author would like to show his humble gratitude towards everyone who contributed their
support to the successful completion of the assignment. Firstly, the author would like to
extend his heartfelt gratitude and honour for Ms. Fathima Nazeefa Fawser for guiding and
leading towards the most accurate ways of getting the project done. Next the author thanks
Ms. Shurmara Fernando and Ms. Hemamali Tennakoon for their support and valuable
guidance. The author is grateful to Asia Pacific Institute and colleagues for their valuable
support of completing this project. Last but not least the author thanks his parents for
directing towards the success.
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Table of ContentsAbstract.............................................................................................................................................. iii
Acknowledgement............................................................................................................................ iv
List of Figure.......................................................................................................................................vi
List of Abbreviations.......................................................................................................................vii
01. Introduction.............................................................................................................................1
1.1 Background of the study...........................................................................................................1
1.2 Research scope...........................................................................................................................1
1.3 Research Question.....................................................................................................................1
1.4 Problem justification.................................................................................................................2
1.5 Research objectives....................................................................................................................2
02. Literature review.....................................................................................................................3
2.1 Audit Quality and its importance.............................................................................................4
2.2 The factors affecting on external audit quality..................................................................5
2.2.1 Auditor independence.........................................................................................................5
2.2.2 Mandatory Auditor rotation..................................................................................................6
2.2.3 Firm size..............................................................................................................................7
03. Conclusion....................................................................................................................................9
List of References.............................................................................................................................10
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List of Figure
Figure 1: Research Objectives..............................................................................................................2Figure 2: Literature review framework..................................................................................................3
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List of Abbreviations
ACCA - Association of Chartered Certified Accountants
AQ – Audit Quality
EAQ – External Audit Quality
IAASB - International Auditing and Assurance Standards Board
KPMG - Klynveld Peat Marwick Goerdele
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01. Introduction
1.1 Background of the study
Corporate failures and corporate problems that organizations had experienced in the recent
past have created a continuous debate globally on the importance of the role of auditor in
implementing quality audits (KPMG, 2013). The scale of the problem was strengthened by
the recent economic crisis situations, thus National regulatory systems were changing
continuously worldwide.
IAASB (2014) has pointed out auditing as a major business, legal requirement under any
national laws and regulations and external audits should carry out in order to ensure the trust
and confidence of investors, government agencies and all financial information users. EAQ
and the factors that influence quality have been longstanding concerns of interest in
academic, professional and regulatory debates about auditing; hence better descriptions about
these factors will encourage audit firms to improve their professions, and other stakeholders
to challenge themselves on trying to increase the AQ in their particular environment.
1.2 Research scope
The scope of this research will be on identifying the term and the importance of EAQ and the
key factors affecting EAQ in Asian region.
1.3 Research Question
What are the key factors affecting the EAQ of organizations in Asia?
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1.4 Problem justification
According to Abdulganiyy (2013) major financial failures such as the Enron scandal and
WorldCom’s corporate governance failure has confirmed the importance of maintaining high
quality audits and global financial crisis of 2007-2008, enhanced this concern through
highlighting the importance of maintaining better EAQ levels to sustain the stability of
financial markets (ACCA, 2010). Similarly, many accounting and corporate scandals were
recorded recently in Asian countries, such as the 2012 Caterpillar Inc. accounting fraud
incident in China, 2011 Olympus accounting scandal in Japan and accounting irregularities of
Silver Bird Group in Malaysia (KPMG, 2013). These concerns have manipulated Asian
governments such as China to implement various regulatory changes to ensure the quality
external audits (Firth et al., 2010), thus the importance of identifying the different factors that
affect EAQ is identified as one of the major financial concerns in Asia.
1.5 Research objectives
Figure 1: Research Objectives
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Objective 01 Understand the term and the importance of external audit quality
Objective 02 Explore the key factors affecting on external audit quality
External Audit Qulity
Meaning and the importance of external
Audit Quality
Factors affecting on external Audit Quality
Auditor Independance
Mandatory Auditor rotation
Firm Size
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02. Literature review
Poor quality audits have caused for various corporate scandals worldwide, thus what AQ
means and what factors can affect it have been major research questions that were answered
by a number of researchers throughout the history. However, auditor independence,
mandatory auditor rotation and firm size have been highlighted as three major factors
affecting EAQ.
Figure 2: Literature review framework
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2.1 Audit Quality and its importance
Numerous researches and academic attempts were conducted on defining the term ‘Audit
quality’ in the past. According to IAASB (2013) none of these attempts has resulted in a
definition that has won the universal recognition and acceptance, hence AQ is a complex and
multi-faceted concept. However, these researches have provided various definitions and
theoretical assessments under different perspectives, thus all these attempts were conducted
regarding on answering the central question of what AQ really means.
AQ is directly related to the auditor’s professional approaches, hence various social, financial
and ethical concerns also relate to the concept. Regarding the auditor’s professional
approaches, AQ has been defined by DeAngelo (1981) as the market assessed joint
probability that the auditor will identify the financial misstatements in their client’s financial
statements and report them. Malihi et al., (2012) enhanced this point through analysing AQ as
a function of auditor's ability on detecting and reporting material misstatements and errors.
However, many professional argued that AQ cannot be analysed purely via its professional
perspectives, hence it also relates to various ethical perspectives too Vanasco (1996).
Despite of the above views on AQ, Moizer (1998) and Sutton (1993) have stated that the AQ
concept should be analysed through evaluating different perspectives of parties such as
financial statement preparers, auditors and users. However, the difference of these
perspectives will be depends on the level of assurance that audits provides on the probability
that financial statements do not contain any errors and material misstatements (Palmrose,
1988).
The Importance of EAQ has been emphasised Behn et al., (2008), through demonstrating the
capability of quality audits on increasing the reliability of financial information and support
the users such as investors to make accurate estimates and decisions. Ghosh and Moon (2004)
enhanced this idea through asserting the importance of maintaining a high quality level, thus
provide a significant confidence about the financial information to the public. Then again,
Duff (2004) argued that the importance of EAQ cannot be analysed only through the client’s
perspective thus it also affects the audit firm too. Poor quality audits will be result in strong
litigation actions against the auditor, reducing the auditor’s reputation and potential client
withdrawals due to their low trust of the auditor.
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As discussed above, the quality level of external audits acts a significant role in every
economic and business context, thus its importance has been strengthened throughout the
history. The author suggests that, different perceptions and opinions of all parties that are
related to audit procedures should be considered when defining and understanding the term
‘audit quality’.
2.2 The factors affecting on external audit quality
2.2.1 Auditor independence
The auditor independence is considered as the cornerstone of the auditing profession and it
has a direct impact on the quality level of external audits. High quality audits refer to the high
independence of the auditor through his ability to provide information regarding embedded
business failures of the company (Lennox, 1999). According to Jamal (2011) AQ is always
equated with independence and Mansouri (2009) enhanced this view through emphasizing
the positive relationship between EAQ and auditor independence. Therefore, it is possible to
understand the strong relationship between the auditor independence level and EAQ level,
hence maintaining a high auditor independence level is the most significant way of enhancing
the quality levels of audits.
Additionally, Raiborn et al., (2006) pointed out that independence should be maintained by
the auditor and it should be exercised both in fact and in appearance during the audit process.
Maintaining a high level of auditor independence is regarded as a key aspect of maintaining
high quality levels of audits, thus Elder et al., (2008) argued that the auditor independence in
appearance can be easily maintained through following certain regulations such as those
which were imposed by the national stock exchange commissions. However, this idea was
critically argued by Barret (2001) through evaluating the toughness of maintaining auditor
independence due to various reasons such as the unconscious bias of the auditor, regarding on
their excessive familiarity and long term attachment to the client.
As per Gavious (2007) lengthy auditor-client relationship will cause for the reduction of
auditor independence and decline in quality levels of audits, thus mandatory auditor rotation
could ensure the quality level of audits. Crabtree et al., (2006) enriched this through asserting
that the auditor rotation can lead auditors to be more independent and produce high quality
audits. On the other hand,
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Firth et al., (2012) has argued this through stating that the mandatory auditor rotation is
positively associated with the substantial improvement of auditor independence and audit
quality in Chinese firms.
Based on the above facts, the author asserts that the auditor independence should be
considered as the most influential factor on EAQ in every business continent worldwide.
Furthermore, the factors such as mandatory auditor rotation and auditor-client relationship
aspects should be considered in the process of ensuring the sufficient auditor independence
level to produce quality external audits.
2.2.2 Mandatory Auditor rotation
The Mandatory auditor rotation has been suggested as a means of reducing the threat of audit
failures, thus various arguments were also made regarding the negative aspects of this
approach. It is also a legal requirement for listed companies to do a mandatory audit partner
rotation over a specific short time period in many Asian countries such as Korea, Singapore,
Indonesia and Sri Lanka (Vanasco, 1996).
Mandatory auditor rotation provides much quality audits, since the auditing practice is
underlain with employing professional scepticism and the long term attachment to the client
will decrease the sharpness of the auditor’s judgment (Davis et al., 2009). Likewise, Dopuch
et al., (2011) and Raghunanthan et al., (1994) stated that the firms who are following shorter
auditor tenure, have an extended auditor-client relationship thus it was argued that an
extended auditor-client relationship will bring negative effects on audit quality due to lack of
auditor independence. However, these findings were critically argued by Geiger and
Raghunandan (2002) and Petty and Cuganesa (1996) through highlighting the significant
relationship between longer auditor tenure and higher audit quality level, therefore it was
recommended not to follow the mandatory audit partner rotation. Lu and Sivaramakrishnan,
(2009) also demonstrated that the quality of the audit will be limited through the mandatory
auditor rotation process, since the new auditors do not have a proper client specific
knowledge as a previous auditor, therefore this will hamper the effectiveness of the audit
process and will lead to various negative outcomes.
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Catanach and Walker (1999) argued that the mandatory auditor rotation is as a way of
improving EAQ and minimizing the negative effects of poor auditor independence level. This
significant relationship was proved by Hamilton et al., (2005), whereas they identified the
significant support of new mandatory audit partners for big 5 Australian firms to achieve a
greater earning conservation in 2002.
However, Chi et al., (2009) argued these views through their analysis of Taiwan firms,
whereas they have emphasised that the mandatory audit rotation does not help to improve the
EAQ. These different views prove how the impact of mandatory auditor rotation would differ
from different country to country and business context to context.
Considering the above arguments on implementing the mandatory auditor rotation concept, it
is evident that the mandatory auditor rotation displays a more positive relationship with the
quality level. Moreover the author states that the legal notions and implementation
procedures should be changed and supplemented in order to minimize mandatory auditor
rotation’s negative influence on EAQ and different individual business context
characteristics, financial information users’ perspectives and present legal structures should
be critically evaluated too.
2.2.3 Firm size
Numerous researches have been done in order to identify the relationship between the size of
the audit firm and the quality of their audits. Cheng (2009) pointed out that it is important to
analyse the quality of external audits regarding the size of different audit firms. However,
Behn et al., (2008) argued that it is unfair to distinguish firms as large and small, since they
are following the same professional standards and qualifications. Likewise, DeAngelo (1981)
stated that small firms and regulators argued that the quality of audits should not be judged on
the basis of the size of the firm.
According to Reisch (2000) the bigger firms are capable of undertaking stronger tests,
advanced technical approaches, since they have a better and larger scale of resources than
smaller firms. Furthermore, large audit firms could produce much quality audits than smaller
firms, thus they have higher forecast accuracy (Behn et al., 2008). Large firms tend to have
the benefit of not having the pressure of losing a client like smaller firm thus they are not
scared to be objective (DeAngelo, 1981).
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However, various arguments were also made against these views, regarding the small firm’s
capability of producing quality external audits than larger firms. As per McLennan and Park,
(2004), smaller firms are much capable of implementing a personalized service approach than
large firms. Additionally, larger firms tend to have minimum abnormal accruals as well
(Michael, 2007).
On the other hand, considering firm size as a factor influence on EAQ has been critically
argued by some academics and researchers. Chandler (1991) stated that external audits been
produced by individual auditors than the firm, therefore it is hard to identify a direct
relationship between audit firm size and EAQ. Auditors professions are focused on producing
quality audits through using their individual opinions thus the influence of their firm size will
be less (Naslmoaswe et al., 2013). Lee et al., (2007) enriched these views through identifying
that larger firms do not have a quality advantage of producing quality audits than smaller
firms. However, the research by Bakar et al., (2005) on Malaysian Firms, Hua et al., (2010)
about Chinese firms and many other researchers have proven the significant relationship
between firm size and AQ in Asia.
The above study explained that large firms are capable of providing high quality audits, due
to the amount of resources they have, thus this differentiation between small and large firms
should be minimized through enhancing the quality standards and approaches in smaller
firms.
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03. Conclusion
In conclusion, the importance of maintaining a high quality level in external audits has been
identified as a central concern in Asian economies, as well as in the overall global business
context.
It was derived through literature that the term AQ has not been explained through a
universally accepted definition yet, and the importance quality audits have increased
throughout corporate history. Furthermore, it was identified that Auditor independence,
mandatory auditor rotation and audit firm size, are major factors that affecting the EAQ.
Multiple empirical evidences in the literature review demonstrated that auditor independence
is the most influential factor in EAQ, and the effect of auditor rotation, and firm size were
argued through both supportive and contradictory perspectives, thus indicating they are still
influential on quality levels of external audits.
In order to minimize the negative effects of factors identified, it was recommended to
consider different perceptions of all related parties to external audits, evaluate the business
context characteristics, supplement legal and implementation procedures, enhance the quality
standards and professional approaches of both large and small firms.
The potential limitation of the study is, it is based purely on literature review where the
accuracy of the result is hindered.
Finally, the findings of the above research will direct future studies to produce quality and
acceptable definitions for audit quality, and create a thoughtful platform about ‘Audit
Quality’, and identify approaches to minimize the negative influence of the factors affecting
it.
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