Asanga Jayasundara - CB004784 - FYP

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


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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List of References

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Chandler, A.D. (1990) Scale and Scope, Harvard University Press, Cambridge MA

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Asanga Jayasundara - CB004784 - FYP

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