factors influencing

Factors influencing auditorindependence: Malaysian loan

officers’ perceptionsNur Barizah Abu Bakar, Abdul Rahim Abdul Rahman and

Hafiz Majdi Abdul RashidDepartment of Accounting, Faculty of Economics and Management Sciences,

International Islamic University Malaysia, Kuala Lumpur, Malaysia

Abstract

Purpose – Auditor independence is fundamental to public confidence in financial reporting and theauditing profession. The study aims to provide further understanding of the factors influencingauditor independence from the perspective of commercial loan officers. Loan officers formed thesample as they are relatively sophisticated financial statement users who would understand theimportance of audit report and the issues related to auditor independence.

Design/methodology/approach – The study examines the perceptions of commercial loan officersin Malaysian-owned commercial banks and a total of 86 officers responded to the self-administeredquestionnaire.

Findings – Results indicate that smaller audit firms, audit firms operating in a higher level ofcompetitive environments, audit firms serving a given client over a longer duration, larger size of auditfees, audit firms providing managerial advisory services, and, the non-existence of an audit committee,are perceived as having a higher risk of losing independence. Audit firm size appears to be the mostimportant factor that affects the auditor independence, followed by tenure, competition, auditcommittee, audit firms providing managerial advisory services and size of audit fee.

Originality/value – The paper provides important insights into the factors affecting auditorindependence and contributes towards better understanding on the ways to improve the confidence infinancial reporting and credibility of the auditing profession.

Keywords Auditors, Independent experts, Malaysia, Commercial banks

Paper type Research paper

IntroductionThe impairment or lack of auditor independence is a main cause of many corporatecollapses and corporate scandals across the world, including the US case of Enron.This important issue has been raised by the media. Media comments havedemonstrated that auditor independence is the main concern when talking aboutcorporate scandals. The paper supplies valuable input and feedback regarding auditorindependence so that these corporate scandals and collapses may be minimized orreduced.

The study aims to provide further understanding of the factors influencingauditor independence from the perspective of commercial loan officers in Malaysia.To achieve this objective, all the 12 Malaysian-owned[1] commercial banks areincluded. A sample of 86 commercial loan officers responded to the self-administeredquestionnaire. The findings of this study will provide better understanding on thefactors that influence auditor independence in Malaysia giving a better understandingof the factors that influenced the quality of auditing as perceived by the financial

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Managerial Auditing JournalVol. 20 No. 8, 2005pp. 804-822q Emerald Group Publishing Limited0268-6902DOI 10.1108/02686900510619665

statement users. It is vital that auditors maintain their independence and ensure thatthey provide a high quality of auditing, since the credibility of financial informationrelies heavily on their independence. Without auditors’ independence, the credibility offinancial information will be reduced, and this may be detrimental to the auditingprofession itself.

The main objective of this study is to examine the factors that influenced auditorindependence. Commercial loan officers of conventional banks are chosen as thesample because they can be regarded as relatively sophisticated financial statementusers who would understand the importance of the independent audit function (Knapp,1985). Bank loan officers also represent the lenders’ or creditors’ point of view, as one ofthe major users of financial statements.

Auditor independence: a review of the literatureSince the main objective of this study is to examine the factors that influenced auditorindependence, the literature on the basic meanings of auditor independence mainlyfrom standard auditing textbooks is first reviewed. The literature on empirical studiesmainly from academic journals is then reviewed with the main aim to identify andexamine the factors that have been found influential to either improve or impairauditor independence. The authors then synthesise the previous empirical findingsinto themes that later helps to develop research questions for the study.

Arens et al. (1999) defined “independence in auditing” as taking an unbiasedviewpoint in the performance of audit tests, the evaluations of the results and theissuance of audit reports. Independence includes the qualities of integrity, objectivityand impartiality. In discussing the foundation of the concept of auditor independence,Pany and Reckers (1983) emphasize that the concept is closely originated fromthe reason for the existence of auditing itself. According to them, the rationale for theexternal auditor’s work (i.e. independent audit) – indeed a primary justification forthe existence of the public accounting profession – arises from the need for reliablefinancial information

There are two types of auditor independence; actual and perceived independence.Independence in fact (or actual independence) can be defined as the auditor’s state ofmind, his or her ability to make objective and unbiased audit decisions (Dykxhoornand Sinning, 1982). It basically refers to the mental attitude of the auditor in terms ofprofessional objectivity (Gul and Tsui, 1992). On the other hand, independence inappearance (or perceived independence) refers to the public’s or others’ perceptionsof the auditor’s independence. This notion of independence (i.e. perceived auditindependence – PAI) is one of the cornerstones of auditing theory and the sine qua nonof auditing practice. Since independence in appearance relies on the perceptions ofusers of financial statements, thus, it is an empirical concept (Busse von Colbe andLutter, 1977; Dykxhoorn and Sinning, 1981).

Gunz and McCutcheon (1991) found that there is a relation between independenceand professional ethics especially on the issue of conflict of interest. Conflicts ofinterest might arise in many situations. Among others, conflict of interest between theduty of the client and to the public at large. Another perspective of conflict is in termsof the auditors’ duty to either the client or the public or both might conflict with theperceived self-interest of the auditor. In this situation, an auditor may be breachinghis/her responsibility to maintain clients’ confidentiality, for example, by passing

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relevant information between partners. This may be the result of auditors’ self-interest,whereby they did this among others, to avoid audit failure resulting in litigationagainst the auditor.

Most of the literature on auditor independence suggests that the credibility offinancial statements depends on the perceived independence of the external auditor bythe users of the financial statements (Firth, 1980; Lavin, 1976; Dykxhoorn and Sinning,1982). For example, Firth (1980) argues that if the auditor is not seen to be independent,users will have less confidence in the financial statements, and the auditor’s opinionon the company’s financial statements will be of no value. Thus, the credibility ofauditors depends not only on facts but also, just as importantly, on the perceptionof independence. Both actual as well as perceived auditor independence are criticalelements in the maintenance of public confidence in the auditing profession (Pany andReckers, 1980). However, for this study, we will only focus on “independence inappearance”, since the actual independence of an auditor is unobservable.

The majority of empirical studies on the PAI focused upon identifying the factorswhich potentially influence independence, and assessing their impact upon perceivedindependence since independence in fact is unobservable. Some of these studies try tofind the relationship of these factors with PAI, whether they are significantly orinsignificantly related with PAI, and then whether they are positively or negativelyrelated with PAI (Pany and Reckers, 1980; Gul, 1989; Gul and Tsui, 1992). Anothergroup try to rank these factors according to their degree of influence on PAI(Shockley, 1981; Bartlett, 1993). Others do the combination of both approaches(Teoh and Lim, 1996).

Among the factors that affect PAI that have been studied are

(1) the effects of gifts (Pany and Reckers, 1980);

(2) the purchase discount arrangement (Pany and Reckers, 1980);

(3) the audit firm size (Shockley, 1981; Gul, 1989);

(4) the provision of management advisory services (MAS) by the audit firm(Shockley, 1981; Knapp, 1985; Gul, 1989; Bartlett, 1993; Teoh and Lim, 1996);

(5) the client’s financial condition (Knapp, 1985; Gul, 1989; Gul and Tsui, 1992);

(6) the nature of conflict issue (Knapp, 1985);

(7) the audit firm’s tenure (Shockley, 1981; Teoh and Lim, 1996);

(8) the degree of competition in the audit services market (Knapp, 1985; Gul, 1989);

(9) the size of the audit fees or relative client size (Gul and Tsui, 1992; Bartlett, 1993;Teoh and Lim, 1996; Pany and Reckers, 1980); and

(10) the audit committee (Gul, 1989; Teoh and Lim, 1996).

The second type of study on PAI focused on the differences in the positions of auditorindependence among various groups. Some studies focus on the differences of opinionsamong different groups of preparers and users (Lavin, 1976; Dykxhoorn and Sinning,1981; Jenkins and Krawczyk, 2001; Patel and Psaros, 2000). For example, Lavin (1976)studies the opinions of CPAs and two groups of users of financial statements, onauditor’s independence by presenting 12 auditor-client relationships. Three groupsinvolved in the study are AICPA members, bank loan officers and financial analysts.Their opinions are to be compared with the Securities Exchange Commission (SEC)

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rulings and AICPA positions on auditor independence. Using a mail survey, he foundthat the consensus of the CPAs and users agrees more with the AICPA than with theSEC, and that the authorities (i.e. SEC and AICPA) at times characterize relationshipsas not independent that the consensus considers as independent. On the whole, itappears that the SEC rulings on independence are more conservative than these usersfeel necessary in these situations.

Factors influencing auditor independenceThere are at least six factors that have been examined by previous studies onperceptions of auditor independence. The six factors are size of audit firm; level ofcompetition in the audit services market; tenure of audit firms serving the needs of agiven client; size of audit fees received by audit firms; provision of managerial advisoryservices by audit firms to the audit clients; and the existence of audit committee.

Size of audit firm. The majority of empirical studies that attempted to find therelationship between audit firm size and AI, found that there is a positive relationshipbetween them (DeAngelo, 1981b; Shockley and Holt, 1983; Nichols and Smith, 1983;Dopuch and Simunic, 1980; McKinley et al., 1985; Shockley, 1981; Gul, 1989). Basically,a positive relationship means that the larger the audit firm size, the greater theauditor’s independence. They prove that large firms are more resistant to clientpressures, thus maintaining higher audit independence. In fact, it has been argued thatlarge firms, due to their very size, may be more able and motivated to provide betteraudits. However, as pointed out by Goldman and Barlev (1974), one should notconclude that large CPA firms are immune to pressures from their clients. Competitionamong the offices of some large firms for clients may be as great as the competitionamong small, independent CPA firms. More to the point, the few court cases whichchallenge the assumption that CPA firms acted independently indicate that the use of alarge CPA firm is no guarantee of its ability to resist pressures from clients, ashappened with Arthur Andersen and Enron.

Level of competition in the audit services market. A number of empirical studies haveproven that the high level of competition in the audit firm has resulted in less auditorindependence (Knapp, 1985; Shockley, 1981). Gul (1989) found the opposite.

Tenure of an audit firm serving the needs of a given client. An audit firm’s tenure,which is the length of time it has been filling the audit needs of a given client, has beenmentioned as having an influence on the risk of losing an auditor’s independence. Mostwriters, who discuss the relationship between tenure and AI, support this view. A longassociation between a corporation and an accounting firm may lead to such closeidentificationof the accountingfirmwith the interests of its client’smanagement that trulyindependent action by the accounting firm becomes difficult (US Senate, 1976).Mautz andSharaf (1961) pointed out that in a many cases, the greatest threat to (the auditor’s)independence is a slow, gradual, almost casual erosion of “honest disinterestedness”.Complacency, lack of innovation, less rigorous audit procedures and a learned confidencein the client may arise after a long association. Some critics invoke the vested interestargument to support the assertion that auditors might compromise their independence togain continuing audit engagements, the prospect of raising audit fees if the client firmexpands, and opportunities of providing non-audit services later (Hoyle, 1978).

The US Congressional Subcommittee on Reports, Accounting and Management(the “Metcalf Committee” (1976)) considered that the above dangers are serious enough

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to recommend the mandatory rotation of auditors as a possible remedy. Rotationensures that the auditor remains independent since tenure will be limited and anyvested interest will no longer be relevant (Teoh and Lim, 1996). Nevertheless, thissuggestion has been opposed (Shockley, 1981; DeAngelo, 1981a).

In a study conducted by Shockley (1981), tenure was not found to have a significantimpact on perceptions of independence. Teoh and Lim (1996) also find the same andreport that there is a negative relationship between tenure and AI.

Size of audit fees received by audit firm (in relation to total percentage of auditrevenue). Normally, when talking about the relationship between size of audit fees andAI, large size of audit fees are associated with a higher risk of losing the auditor’sindependence. The Accountants International Study Group (1976) recommended thatauditors be restrained from accepting engagements for which the fees constitute 10 percent or more of the auditors’ total fee income. Additionally, both the IFAC’s (1996, p.8.7) Code of Ethics for Professional Accountants and the EFAA (1998) suggest thatclient size (measured from size of fees) could raise doubts as to independence, but donot state what constitutes an unacceptable proportion of total fees. However, the EFAA(1998, p. 4) clearly states that, “the (total) fee from one client should not exceed a certainpercentage of the total turnover of the audit firm”. In Malaysia, Noordin (1990)expresses his concern that a code of ethics should provide guidance to limitover-dependence on one client for revenue. The ICAEW has ruled that the size of auditfees of a major client should not exceed 15 per cent of total fees to avoid impairment ofauditor independence. This 15 per cent criterion has also been the level generally usedin Australia at which auditors have to consider their independent position and there iseven a suggestion that the 15 per cent is too low.

The Cohen Commission (AICPA, 1978) directed attention to the importance of size ofaudit fees as one of the crucial independence-related issues. Such attention hasprompted research into the inter-relationship between size of audit fees and otherindependence-related issues such as the provision of MAS, the size of the audit firmand competition. As a result, most empirical studies conducted on size of audit fees donot look at that factor per se; instead they inter-relate it with other factors. For example,Burton and Fairfield (1982) point out that there may be a close linkage between MASand size of audit fees. As the provision of MAS increases, the auditor is likely to bemore dependent on the client due to the size of the fees generated. It also seemsplausible that smaller audit firms will be more dependent on the client if the size ofaudit fees generated is a significant proportion of its overall revenue. Further, in ahighly competitive environment, the auditor is also perceived to be less independentdue to the increased likelihood of losing a client and the revenue the client generates.Thus, Shockley (1982) suggests that the adverse effects of MAS, the size of the auditfirm and competition on a third party’s PAI actually arise because of the linkage ofthese variables to audit fees.

Nevertheless, there is a study that proves otherwise. For example, Gul (1991)hypothesized and tested the notion that size of audit fees is a major determinant ofbankers’ PAI regardless of other variables, namelyMAS, competition and the audit firmsize. He showed that each independence-related variable affects bankers’ PAI in its ownright. He also found size of audit fees to be an important determinant of bankers’ PAI.

Another study related to the size of audit fees was by Pany and Reckers (1980).They advocated that the size of the client relative to the audit firm has a significant

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direct or modifying effect on the PAI. They define size in terms of the audit feemeasured as a percentage of office revenues. They found that it has no significanteffect on perceived independence. However, in their study of 1983, even thoughthe effect of client size do not show any significant results, they note that respondentsexpress less confidence in the auditor’s independence when a client was large (size isdefined in terms of the audit fee measured as a percentage of office revenues).

Management advisory services (MAS). Several empirical surveys were conductedin order to find how third parties, auditors and firms view this issue. The resultsare, however, similar to its debate, which is inconclusive (Goldman and Barlev,1974). McKinley et al. (1985) report that early research related to financialstatement users indicated that auditor independence is negatively affected whennon-audit services are performed for audit clients. They believe that thesecollateral services create a working relationship between the auditor and the clientthat is too close. Similarly, the studies by Shockley (1981), Pany and Reckers(1983, 1984) and Knapp (1985) all find that the provision of MAS negativelyaffected PAI. Reckers and Stagliano (1981) conclude that the loss of confidence inthe external auditor increased significantly if non-audit fees paid to the auditorexceeded 50 per cent of the audit fees.

Contrary to the above, some other studies found a positive relationship betweenMAS provision and PAI. They believe that MAS provision enhances the auditor’sknowledge of the client, thus increasing the auditor’s objectivity (Goldwasser, 1999;Wallman, 1996). According to Goldman and Barlev (1974) who support this view,the addition of management services increases the power and independence of theauditors. They argued that this occurs because most consulting-type services arenon-routine and because these services benefit the client firm directly. Consequently,the replacement of the consulting auditor may result in a loss of valuable advice to thefirm. The bargaining position, therefore, becomes stronger; s/he is better equipped toresist interference in the performance of auditing duties and is more likely to retainindependence.

Finally, there are studies that have shown that the provision of MAS has no effecton PAI. For example, McKinley et al. (1985) find that the provision of MAS did notsignificantly affect bank officers’ PAI, their perceptions of financial statementreliability or their loan decisions. Coreless and Parker (1987) find similar results.

The conflicting results suggest that the effect of MAS on perceptions of auditorindependence is complex (Gul, 1989; Shockley, 1982; Coreless and Parker, 1987) andother factors such as cultural differences of the subjects may also be a significant factorin the way MAS is viewed in the context of auditor independence.

Audit committees. There is much support to suggest a positive relationship betweenaudit committees and auditor independence. Basically, a positive relationship betweenaudit committees and AI means that the existence of an audit committee willenhance auditor’s independence. Teoh and Lim (1996) in their study find that theformation of audit committees has a strong positive impact on enhancing auditorindependence. Similarly, Patten and Nuckols (1970), Knapp (1985) and Lau and Ng(1994) find that the existence of an audit committee increases the likelihood of bankers’approving a loan, which is a reflection of an increased confidence in the auditor. Onthe contrary, Gul (1989) finds that audit committees did not significantly affect theperceptions of auditor independence.

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Malaysian accounting and auditing professionIn Malaysia, the authoritative body which regulates the accountancy profession is theMalaysian Institute of Accountants (MIA), which is established under the AccountantsAct 1967. The Institute is a member body of regional and international professionalbodies which play a significant role in the development and advancement of theaccountancy profession globally. With regards to qualification in becoming a CertifiedPublic Accountant, the only local body in Malaysia which conducts a professionalaccountancy examination which is recognised under the Accountants Act, 1967 isMalaysian Institute of Certified Public Accountants (MICPA). To date, the MICPA(formally known as MACPA) has trained more than 1,500 qualified accountants, someof whom are in senior positions in Government, public practice, commerce andindustry. The MICPA instituted its examination system in 1961. Its trainingprogrammes and schemes are best described as the only means of selecting the best orthe “creme de la creme” of accountants. MICPA, in its goals has broadened its scope ofservices so as to keep step with the challenges of the times, as well as itsresponsibilities in the advancement of the practice and the study of accountancy.

The body which develops and issues accounting and financial reporting standardsis the Malaysian Accounting Standards Board (MASB), which is established under theFinancial Reporting Act 1997 (the Act) as an independent authority. Basically, itadopts the International Accounting Standards (IAS).

With regards to size of audit firms in Malaysia, about 91.4 per cent of Malaysianaudit firms fall into the category of small firms with one to two partners. Whilemedium size audit firms with three to eight partners constitute 7.5 per cent of thepopulation of audit firms, the remaining figure of 1.1 per cent are of the large size auditfirms with more than nine partners.

Research methodologyThere are not many studies on perceptions of auditor independence outside theAnglo-American countries. In Malaysian, one of the few studies undertaken by Gul andTeoh (1984) investigate the effects of combined audit and management consultingservices by public accounting firms on a sample of the Malaysian public comprisingpublic accountants, bankers, managers and shareholders. They found that theexpansion by audit firms into non-audit services reduced their confidence in theauditor’s independence. It was also found that majority of respondents (except forshareholders) felt that it was not possible to separate the rendering of managementservices from participating in decision-making. Shareholders also believe that auditorscould still remain independent if the audit firms provide non-audit services, while thereare no definite conclusions for other categories of respondents. Gul and Teoh concludethat shareholders are less sophisticated users of financial statements vis-a-vis the othergroups.

Teoh and Lim (1996) investigate the effects of five selected variables on the PAI ofMalaysian public and nonpublic accountants. They employ a repeated measuresexperimental design. Results show a large audit fee received from a single client is themost important factor leading to the impairment of PAI, followed by the provision ofmanagement consultancy services. The non-rotation of audit firms is not a dominantfactor. The formation of audit committees is found to have a strong positive impact on

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enhancing auditor independence, while the positive impact of disclosure of non-auditfees is considerably less.

Lack of studies on factors influencing perceptions on auditor independenceprompted the need for such a study, especially in a non-Anglo-American environment.This study extends studies done by Gul and Teoh (1984) and Teoh and Lim (1996) inthe Malaysian context.

Research questionsThe following research questions have been developed, mainly based on thedevelopment of literature on auditor independence:

RQ1. To what extent is an audit report important for the loan officers to make theirlending decisions?

RQ2. Do the loan officers think that the six factors (i.e. audit firm size, competitionlevel, tenure, size of audit fees, MAS and audit committee) have any influenceon an auditor’s independence?

RQ3. What kinds of relationships (i.e. its direction) exist between the six factors(i.e. audit firm size, competition level, tenure, size of audit fees, MAS and auditcommittee) and the auditor’s independence?

RQ4. Which of the six factors (i.e. audit firm size, competition level, tenure, size ofaudit fees, MAS and audit committee) is the most important factor influencingauditor independence?

Data collectionThe subjects are bank loan officers who are chargedwith assessing the loans applied forby companies (regardless of the company size or the amount of the loan). They wereselected as the sample population of this study because they are regarded as relativelysophisticated financial statement users who would understand the importance of theindependent audit function (Knapp, 1985). They were also selected, because the loanofficers of banks make use of accounting information in business decision situations.Since they occupy strategic decision centres in the financial community, they are chosenas the third-party population to be studied. Bank loan officers also represent the lenders’or creditors’ point of view, which are among the major users of financial statements.

The commercial banks are the main players in the banking system and they operatewithin the ambit of the provisions of the BAFIA (Banking and Financial InsitutionsAct 1989) and under the direct supervision of Bank Negara Malaysia (1999) (theMalaysian Central Bank). Prior to 2001, there were 17 Malaysian-owned (conventional)commercial banks. However, due to the merger and consolidation programme amongdomestic banking institutions, currently there are only ten Malaysian-owned(conventional) commercial banks, all included in this study. (Dalila, 2000). In thisstudy, all the ten conventional commercial banks and two Islamic commercial banks inMalaysia are included. Both conventional as well as Islamic commercial banks areincluded since they have more or less the same characteristics, for example, in terms ofthe nature of their businesses and products and services offered. The only differenceis that Islamic banks operate based on the Syariah law, while conventional commercialbanks do not.

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In short, the sample population of the study comprises the commercial loan officersof all local commercial banks, including both conventional as well as Islamiccommercial banks in Malaysia. Samples are chosen using stratified random sampling.Data were collected using the survey method. The questionnaire has been selfdeveloped by the researchers taking into consideration factors such as the level ofdifficulty of the questions and the length of time needed by the respondents inanswering it.

The questionnaire included six main elements with three main parts A, B and C.It was pilot tested to check reliability, understandability and language. It was pilottested on five academicians from the Department of Accounting, International IslamicUniversity Malaysia (IIUM) and five postgraduate students undertaking Master ofSciences in Accounting from the same department. After the necessary technical andother revisions and amendments had been made, the questionnaires were sent to thecontact persons.

Twenty sets of questionnaires were sent to each of the 12 banks. In total, 240questionnaires were sent out. Accompanying each set of questionnaires were lettersaddressed to the contact persons explaining the research and requesting them tocooperate in distributing as well as collecting back the questionnaires to and from theirrelevant officers. Self-addressed and post-paid envelopes were provided by theresearchers to facilitate the process.

Results and discussionsOf the 240 questionnaires, 116 were received, a response rate of 48.3 per cent. However,out of the 116 questionnaires returned, only 86 are usable, producing usable replies of35.8 per cent. These unusable replies are excluded from the analysis due to the failureof the respondents to complete certain parts of the questionnaires. Out of the 12 banks,one bank refused to participate at all in the study. The respondents were aheterogeneous group with an average age of 30.07 years (standard deviation 5.45,range from 22 to 48 years) and a mean experience in lending decisions of 52.26 months(equivalent to 4.355 years, standard deviation 42.92, range from 2 to 180 months).

The degree of importance of the audit reportThe first question in part A asked the respondents to give a score on how importantthey think an audit report is in making their lending decisions. There are two types ofaudit report, namely the financial statement audit report and the special purpose auditreport[2]. This question does not exclusively refer to only one of them, but rather refersto either or both. The level of importance is verbally anchored at the end points with“1” indicating unimportant and “9” very important. The respondents could choose anypoint on the scale. The range of 1-9 is chosen simply for comparable purposes withprior studies. The mean score for this question is 7.814 (standard deviation ¼ 1:2128Þ;the mode is 9 and the median is 8. The mean score, which is quite high, indicates thatthe respondents regarded an audit report as being “very important” in lendingdecisions. However, when comparing this result with Firth’s (1980), the present studyscore is slightly lower. Firth (1980) in asking the loan officers the importance of anaudit report in making lending decisions, obtained a mean score of 8.27. He concludedthat the loan officers regarded an audit report as being “very important” in makinglending decisions (Table I).

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The mode, which is 9, shows that the majority (41.9 per cent) of respondents thinkthat an audit report is very important in making their lending decisions. A highpercentage of respondents (30.2 per cent) chose scale 7, which can be translated as“important”, and 15.1 per cent chose scale 8. None of the respondents chose the firstthree scales on the continuum (i.e. 1, 2 and 3), while only one respondent chose scale 4.This shows that almost none of them think that the audit report is unimportant inmaking their lending decisions.

Bearing in mind that number 5 on the scale may signify a neutral position, and anynumber before that reflects the unimportance of an audit report in making lendingdecisions, while any number after five signifies its importance, it can be seen that96.5 per cent of responses mentioned that an audit report is important in making theirlending decisions, while only 1.2 per cent said that the audit report is not important.The remaining 2.3 per cent are in the neutral position.

Here, it is discovered that CLOs perceived that an audit report is “very important” inmaking their lending decisions, thus making it parallel to the findings of the previousstudy by Firth (1980). The implication of this finding is that it can be used to determinehow the respondents perceived auditor independence. This notion has been brought upby Firth (1980), and supported by Gul and Teoh (1984), whereby Firth mentioned thatthe importance placed on the audit report reflects how respondents view auditorindependence. In this case, since the respondents view the role of the audit report asvery important in making their lending decisions, it reflects that that they do notperceive that there is a lack of independence in the auditing profession in general.It shows that they have confidence (regardless of the degree of confidence) in thecredibility of the auditing profession.

Factors influencing auditor independenceThe second question in part A asked the respondents whether each of the six factorslisted has any influence on auditors’ independence. To answer, respondents just haveto circle either “yes” or “no”. It is found that 75.6 per cent of the respondents indicatethat the size of the audit firm does affect auditors’ independence, while 74.4 per cent ofthem mention that the level of competition in the audit services market influencesauditors’ independence. A relatively higher percentage of respondents mention that

(1) the tenure of an audit firm serving the needs of a given client;

(2) the provision of MAS by an audit firm to the audit client company; and

(3) the existence of an audit committee have some influence on auditors’independence, with 90.7, 86 and 87.2 per cent, respectively.

However, surprisingly, a high percentage of the respondents, i.e. 47.7 per cent indicatethat the size of audit fees received by the audit firm does not affect auditors’independence.

Mean Standard deviation Mode Median

7.814 1.2128 9 8

Scale: 1 – unimportant, 9 – very important

Table I.Level of importance of an

audit report in lendingdecisions

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There seems to be a balance between the number of respondents that indicate that thesize of audit fees has some influence on AI, and those who believe that size of audit feesdoes not have any influence on AI (Table II).

Nevertheless, for all the factors discussed, the mode is “Yes”, which shows that amajority of respondents think that there is some sort of relationship between all the sixfactors and auditor independence. However, at this point, the direction and the strengthof these relationships are not explored. Part B will try to explore the direction of theserelationships while part C will try to explore their strengths.

Part B of the questionnaire asked subjects to indicate whether they are stronglyagree (“1”), agree (“2”), slightly agree (“3”), neutral (“4”), slightly disagree (“5”), disagree(“6”) or strongly disagree (“7”) with the statements given. Each statement provideseither a positive or negative relationship between the factors and auditor independence.The 7-point Likert-scale was provided based on past studies and thus for comparablepurposes. Table III shows the frequency of occurrence and percentages for the level ofagreement for each of the factors and their relationships with auditor independence.

Table IV above shows the mode (or most common response) for each questionregarding the respondents’ level of agreement with the statements given. The mode orthe majority of the respondents “agree” that:

(1) the larger the size of an audit firm;

(2) the shorter the duration an audit firm serves an audit client;

(3) the smaller the amount of audit fees paid by the audit client company to theaudit firm (in relation to the total percentage of audit revenue); and

(4) the existence of an audit committee in the audit client company – the greaterthe auditor independence will be.

The majority also “slightly agrees” that

(1) the higher the level of competition among audit firms; and

(2) the provision of MAS by the audit firm to the audit client company; the more itwill impair auditor independence.

For the firm size and audit committee factor, the mode tend to agree with the positiverelationship between the factors and AI, while for competition level, tenure, size ofaudit fees and MAS, the mode tend to agree with the negative relationship betweenthose factors and AI.

Results also show that the majority neither takes the position of “strongly agree”nor “strongly disagree”. They seem to prefer choosing a more moderate position bychoosing a mere agree (or disagree), or, slightly agree (or disagree).

Firm size Competition Tenure Fees MASAudit

committeeFrequency Per cent No. Per cent No. Per cent No. Per cent No. Per cent No. Per cent

Yes 65 75.6 64 74.4 78 90.7 45 52.3 74 86 75 87.2No 21 24.4 22 25.6 8 9.3 41 47.7 12 14 11 12.8Total 86 100 86 100 86 100 86 100 86 100 86 100

Table II.Frequency andpercentage indicating“Yes” and “No” regardingfactors which influenceauditors’ independence

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If we compare the mode between the two contradicting statements for each factor, wewill find that if the mode is to agree (or slightly agree) with one direction of therelationship, the mode of the opposite direction will be to disagree (or slightly disagree).This remains true for all of the six factors except for the size of audit fees where onedirection is to agree and another is neutral. Perhaps this reversal of answers happensbecause most respondents think that the first six questions and the last six

Factors R/ship

1Stronglyagree

2

Agree

3Slightlyagree

4

Neutral

5Slightlydisagree

6

Disagree

7Stronglydisagree

Size ofaudit firm

þve FrequencyPer cent

33.5

2630.2

1820.9

1214.0

1011.6

1214.0

55.8

2ve Frequency 0 4 7 20 22 29 4Per cent 0 4.7 8.1 23.3 25.6 33.7 4.7

Level ofcompetition


00

1315.1

1011.6

1719.8

1820.9

2427.9

44.7

2ve Frequency 6 18 20 12 12 14 4Per cent 7.0 20.9 23.3 14.0 14.0 16.3 4.7

Tenure ofservices


00

78.1

910.5

2124.4

2023.3

2326.7

67.0


Size ofaudit fees


00

44.7

89.3

2529.1

2023.3

2326.7

67.0


MAS þve Frequency 2 10 12 18 24 19 1Per cent 2.3 11.6 14.0 20.9 27.9 22.1 1.2


Auditcommittee


78.1

3743.0

2023.3

910.5

78.1

67.0

00


Table III.Frequency and

percentage of occurrenceof responses for each

question

Factors Relationship Agree/disagree mode

Firm size Positive 2 (agree)Negative 6 (disagree)

Level of competition Positive 6 (disagree)Negative 3 (slightly agree)

Tenure of service Positive 6 (disagree)Negative 2 (agree)

Size of audit fees Positive 4 (neutral)Negative 2 (agree)

MAS Positive 5 (slightly disagree)Negative 3 (slightly agree)

Audit committee Positive 2 (agree)Negative 5 (disagree)

Table IV.Mode for each factor

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questions are dependant on each other (please bear in mind that out of the 12 questionsstatements given, the last six questions are stated in just the reverse manner of the firstsix). Thus, they tend to answer the questions in a mirror image to each other (Table V).

The statement that has been “agreed” most by the respondents according to rankingis that:

(1) “the existence of an audit committee in the audit client company may enhancethe auditor’s independence”. This is then followed by the statement;

(2) “the longer the duration an audit firm serves an audit client, the more likelihoodthat auditors’ independence will be impaired”;

(3) “auditor’s independence will be weakened if the audit firm provides MAS to theaudit client company”;

(4) “the larger the size of audit fees paid by the audit client company to the auditfirm (in relation to the total percentage of audit revenue), the more likelihoodthat it will weaken the auditor’s independence”;

(5) “the larger the size of an audit firm, the greater the auditor’s independence”; and

(6) “the higher the level of competition among audit firms, the more likelihood thatthe auditor’s independence will be weakened”.

On the other hand, the statement that has been “disagreed” with most by therespondents, according to ranking, is:

(1) “the smaller the size of an audit firm, the greater the auditor’s independence”.This is then followed by the statement;

(2) “the smaller the amount of audit fees paid by the audit client company to theaudit firm (in relation to the total percentage of audit revenue), the morelikelihood that it will weaken the auditor’s independence”;

(3) “the shorter the duration an audit firm serves an audit client, the morelikelihood that auditor’s independence will be weakened”;

(4) “the existence of an audit committee in the audit client company may notenhance an auditor’s independence”;

FactorsRelationship withauditor independence Mean

Rank (according todegree of agreement)

Size of audit firm Positive 3.65 5Negative 4.90 12

Level of competition Positive 4.49 8Negative 3.74 6

Tenure of service Positive 4.71 10Negative 3.31 2

Size of audit fees Positive 4.79 11Negative 3.62 4

MAS Positive 4.31 7Negative 3.52 3

Audit committee Positive 2.88 1Negative 4.56 9

Table V.Mean score of the level ofagreement for each factorand its rank

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(5) “the lower the level of competition among audit firms, the more likelihood thatauditor’s independence will be weakened”; and

(6) “the auditor’s independence will not be weakened if the audit firm providesMAS to the audit client company”.

Comparing these results with prior studies, certain results seem to be parallel withthem. For example, in prior studies, there are no supporters for

(1) the positive relationship between size of audit fees and AI; and

(2) the negative relationship between firm size and AI. Quite in line with that, inthis study, it is found that these two statements obtain the lowest and secondlowest mean regarding the degree of agreement by the respondents. In otherwords, these two statements are being disagreed with most by the respondentscompared to other relationships for other factors. Also, in prior studies, thereare no supporters for

(3) the negative relationship between the existence of an audit committee and AI.

Quite parallel, in this study, the positive relationship between audit committee and AIseems to have the highest level of agreement. These three circumstances show someconsistencies between this study’s results with those done previously.

Level of importance of the factors influencing auditor independenceAccording to ranking, the most important factors that influence auditor independence,are

(1) the size of the audit firm;

(2) the tenure of an audit firm;

(3) the level of competition among audit firms;

(4) the existence of an audit committee;

(5) the provision of MAS; and

(6) size of audit fees.

Comparing the rank with the mode, it can be seen that they are almost similar, exceptfor the last three factors, where all the modes are 6.

Comparing part C results with the findings in part A: question 2, there are a few casesthat show some parallel answers. In part A: question 2, the size of audit fees is found asthe factor with the highest percentage of responses that mentioned it has “no influence”on AI. In parallel to that, in this part (i.e. part C), the respondents’ views regarding thatparticular factor are reflected here in part C when they rank the size of audit fees as theleast important factor whichmay affect AI. The same goes for the “tenure” factor. In partA: question 2, the tenure factor has the highest percentage of responses that agree that ithas some influence on AI. Almost similarly, in part C, the tenure factor is found to be thesecond most important factor that may influence AI (Table VI).

One study which involved factors ranking is Shockley (1981). Shockley reports thecompetition variable was ranked as most important, followed by the size and MASfactors. Thus, the results of this study seem inconsistent with Shockley’s, except for theMAS factor which is ranked last after the other two factors.

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The tenure factor, which is ranked as the second most important factor affecting AI,has a significant implication. It implies that any policy action taken to reduce theaverage tenure of auditors (e.g. mandatory rotation of audit firms) may have a strong(positive) effect on PAI.

The factor size of audit fees is ranked as the least important. One possibleexplanation is that the loan officers themselves do not have that information available.Usually they only assess the financial statements of the loan applicants. It is rare thatthe loan officers will ask the auditor of the loan applicants to hand over their financialstatement, where this information may be available. Normally, only the audit firmsthemselves know the size of audit fees, as a percentage of their total revenue, whichthey receive from their clients.

ConclusionsThe high level of importance attached by the commercial loan officers to an auditreport in making their lending decisions can be attributed to their views on theauditor’s independence in Malaysia. It cannot be denied that it is only when auditorsappear to be highly independent, that an audit report will be seen as useful and, in turn,will be seen as highly important in decision-making. An audit report will not be seen asvery important in making any decisions, be it lending or investment decisions, if thereis no integrity, objectivity and independence on the part of those preparing it, and mostimportantly, of those who are given the right to provide an opinion regarding it is trueand fair representations, which are the auditors. Thus, there is an important link orrelationship among the auditor’s independence, the usefulness of the audit report andthe importance attached to the audit report.

Generally, regarding the factors of

(1) The size of an audit firm.

(2) The existence of an audit committee, the commercial loan officers perceived thattheir relationship with auditor independence is of a positive kind. Commercialloan officers generally perceived that the larger the size of an audit firm, themore likely it is that it may enhance the auditor’s independence. The existenceof an audit committee in an audit client company is also believed to increase theexternal auditor’s independence. For the other four factors, namely:

(3) The level of competition among audit firms.

(4) An audit firm’s tenure of service.

(5) The size of audit fees.

Factors Mean score Rank Mode

Firm size 2.97 1 1Competition 3.36 3 3Tenure 2.99 2 2Fees 4.08 6 6MAS 3.94 5 6Audit 3.65 4 6

Table VI.Mean and rank of factors

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(6) The provision of MAS, a negative relationship between them and auditorindependence seems to gain more support from the commercial loan officers.

The commercial loan officers seem to believe that an auditor’s independence ismore easilyimpaired in four situations. Among the situations are when there is a higher level ofcompetition among audit firms as compared to when the competition level is lower.Secondly, when there is a longer duration of service provided by the auditor for a givenclient as compared towhen the auditor serves a given client over a shorter durationof time.Thirdly, when there is a larger size of audit fees provided by the audit client to the auditoras compared to when the auditor receives a smaller size of audit fees. Finally, when thereare MAS provided by the auditor to its audit client as compared to when there is noprovision ofMAS by the auditor to its audit client. In all these four situations, commercialloan officers believe that the auditor’s independence will easily be weakened.

The ranking of factors, according to their importance in influencing the auditor’sindependence, are:

(1) audit firm size;

(2) tenure of an audit firm serving the needs of a given client;

(3) level of competition among audit firms;

(4) existence of an audit committee;

(5) provision of MAS; and finally

(6) size of audit fees.

The main limitation of the study is that it only considers each factor per se. It ignoresany interaction effects which may exist between any two factors. For example, in a fewof the prior studies, they find the interaction effects between

(1) firm size and fees;

(2) competition and tenure;

(3) fees and MAS; and

(4) fees and competition.

It is suggested that further studies could be undertaken by adding subjects such asaccountants andfinancial analysts. Comparisons couldbemadeamong these three groupswhich represents preparers (i.e. accountants) and users (i.e. CLO and financial analysts).

Notes

1. It is important to note that the term “Malaysian-owned” is different from “local”. “Local”bank does not necessarily mean that it is owned by Malaysians.

2. “Special purpose audit report” basically provides the auditor’s opinion on statements otherthan the normal financial statements.

References

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American Institute of Certified Public Accountants, Commission on Auditors’ Responsibilities(1978), Report, Conclusions and Recommendations, AICPA, New York, NY.

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Arens, A.A., Loebbecke, J.K., Iskandar, T.M., Susela, S.D., Isa, S. and Boh, M. (Eds) (1999),Auditing in Malaysia: An Integrated Approach, Prentice-Hall, Selangor.

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Dopuch, N. and Simunic, D. (1980), “The nature of competition in the auditing profession”, inBuckley, J.W. and Weston, J.F. (Eds), Regulation and the Accounting Profession, LifetimeLearning, New York, NY, pp. 77-94.

Dykxhoorn, H.J. and Sinning, K.E. (1981), “Wirtschaftsprufer perception of auditorindependence”, The Accounting Review, Vol. LVI No. 1, pp. 97-107.

Dykxhoorn, H.J. and Sinning, K.E. (1982), “Perceptions of auditor independence: its perceivedeffect on loan and investment decisions of German financial statement users”, Accounting,Organizations and Society, Vol. 7 No. 4, pp. 337-47.

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Goldwasser, D.L. (1999), “The task awaiting the ISB”, Accounting Today, Vol. 7, pp. 52-4, 7-20June.

Gul, F. (1989), “Bankers’ perceptions of factors affecting auditor independence”, Accounting,Auditing & Accountability Journal, Vol. 2 No. 3, pp. 40-51.

Gul, F.A. (1991), “Size of audit fees and perceptions of auditors’ ability to resist managementpressure in audit conflict situations”, Abacus, pp. 162-72, September.

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Gul, F. and Tsui, J.S.L. (1992), “An empirical analysis of Hong Kong bankers’ perceptions ofauditor ability to resist management pressure in an audit conflict situation”, Journalof International Accounting, Auditing and Taxation, Vol. 1 No. 2, pp. 177-90.

Gunz, S. and McCutcheon, J. (1991), “Some unresolved ethical issues in auditing”, Journal ofBusiness Ethics, Vol. 10, pp. 777-85.

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Hoyle, J. (1978), “Mandatory auditor rotation: the arguments and an alternative”, The Journalof Accountancy, pp. 69-78, May.

International Federation of Accountants (1996), IFAC Handbook, International Federation ofAccountants, New York, NY.

Jenkins, J.G. and Krawczyk, K. (2001), “The influence of nonaudit services on perceptionsof auditor independence”, Journal of Applied Business Research, Vol. 17 No. 3, pp. 73-8.

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Pany, K. and Reckers, P.M.J. (1983), “Auditor independence and non-audit services: Directorviews and their policy implications”, Journal of Accounting and Public Policy, pp. 43-62,Spring.

Pany, K. and Reckers, P.M.J. (1984), “Non-audit services and auditor independence: A continuingconcern”, Auditing: A Journal of Practice and Theory, pp. 89-97, Spring.

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Further reading

American Institute of Certified Public Accountants (1991), AICPA Professional Standards 1 & 2,AICPA, New York, NY.

Guan, C.K. (1995), Financial Institutions in Malaysia, 2nd ed., Institut Bank-Bank Malaysia,Kuala Lumpur, Trans. Yin, T.S..

Lowe, D.J. and Pany, K. (1996), “An examination of the effects of type of engagement, materialityand structure on CPA consulting engagements with audit client”, Accounting Horizon,Vol. 10 No. 4, pp. 32-51.

Malaysian Institute of Accountants (1990), “A case for the establishment of audit committees”, (amemorandum submitted to the Registrar of Companies, the Capital Issues Committee, andthe Kuala Lumpur Stock Exchange; reproduced in summary form in) National Accountant(Malaysia) October.

Messier, W.F. and Boh, M. (2002), Auditing and Assurance Services in Malaysia, 2nd ed.,McGraw-Hill, Selangor.

Pang, J. (1996), Understanding Banking Services and Facilities, 2nd ed., Federal Publications,Selangor.

Pany, K. and Reckers, P.M.J. (1988), “Auditor performance of MAS: a study of its effects ondecisions and perceptions”, Accounting Horizons, June, pp. 31-8.

Peng, L.T. (1998), The Business of Banking in Malaysia, Pelanduk Publications, Selangor.

Pirok, K.R. (1994), Commercial Loan Analysis, Probus Publishing, Chicago, IL.

Raja Tun Arshad, R.T.U. (2002), “Auditor independence”, The Edge, 11 November, pp. 12-13.

SPSSw Base 10.0 (1999), Application Guide, SPSS Inc., Chicago, IL.

Schulte, A.A. (1966), “Management services: a challenge to audit independence?”,The AccountingReview, pp. 721-8, October.

The Basics: SPSS 10.0 for Windows (1999), SPSS Inc., Chicago, IL.

Wilcox, E.B. (1952) in Robert, L.K. Jr (Ed.), CPA Handbook, Chapter 13, The American Instituteof Accountants, New York, NY, p. 8.

Zikmund, W.G. (2000), Business Research Methods, 6th ed., Dryden Press, Oklahoma, OK.

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factors influencing

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