auditing & assurance

Audit Regulatory Environment

Table of Contents

Contents Page

1.0 Introduction 1

2.0 Findings

2.1 Problem faced by Auditors

2.2 Corporate Governance

2.2.1 Cadbury Committee

2.2.2 Sarbanes – Oxley Act

2.3 Stakeholder’s Needs

2.4 Audit Committee

2.5 Positive & Negative Aspect of Audit Committees in enhancing the

Role of External Auditors

2-3

4

5

6

7

8-10

3.0 Conclusion 11

4.0 Recommendation 12-13

5.0 References 14-15

6.0 Appendices and Reflective Report 16

1.0 Introduction

Delraj Singh & Lim Chai Yan The University of Greenwich


After the serious financial collapse scandals and ineffective corporate governance in

these high profile companies such as Enron, Tyco, Adelphia, Allied Irish Bank and

WorldCom have not only damage the auditors' reputation but they also widely cited as

reasons that the investors had lost confidence in making investment and widened the gap

between what the investors expect in the areas of corporate governance. Moreover,

stakeholders also aware that lack of independence among the monitors might result in any

financial scandals happen again.

Sori et al, (2009:317) stated that “Various regulatory agencies and interest groups

had been actively promoting the idea of an effective audit committee in all public listed

companies, in the interest strengthen the corporate governance practices. The establishment

of audit committee is perceived to improve the financial aspects of corporate governance.”

To avoid financial scandals problem, the government had required all the listed companies to

establish an audit committee. The audit committee is a measure to improve on the internal

control mechanism so it can directly impact on the company by helping to improve the

corporate governance practices in the company and to meet the stakeholder’s needs.

In addition, external auditor is required by law and the external auditor is hired by the

audit committee of the company. Moreover, the external auditor are required to render

independent opinions to shareholders and others regarding financial information presented by

the company. However, the external auditors will be facing some problem as a

communication problem, issues in judgement, natural client’s business, difficult gathering

evidence, release new standards as well as some other unpredictable issues.

This report will highlight through the role of external auditors in our society today and

discuss the problems faced by the auditing profession. Next, this report will introduce

regarding to corporate governance and follow by the stakeholders’ needs. Specifically, the

report will discuss the role of audit committees in enhancing the role of external auditors in

meeting stakeholders’ needs. Lastly, this report will discuss other efforts currently being

undertaken to enhance the role of external auditors.

2.0 Findings

2.1 Problem faced by Auditing Profession



In general, an auditor might need to perform their audit service in different type of

industry so one of the main role for an auditor is an auditor must be able to provide their

profession service according to the auditing standards for the different type of clients in

different situations. Furthermore, an auditor also must be having an objective mental attitude

as well as independent between themselves and the auditing company. By this, an auditor

only will be able to exercise their professional judgement based on the evidences and provide

assurance to the clients.

However, in reality the auditor will be facing different types of problem that will

affect them to exercise their professional judgement. The problems faced by the auditors are

such as:

Communication Problems

A good communication might come out a better outcome but a bad communication

between the auditors and audit committee will definitely give a bad outcome and it will

directly affect the quality of audit process.

Issues in Judgement

Normally an auditor will rely on the internal controls and then take a sample to

calculate the audit risk and if the risk is low and the internal control is good then the auditor

will do less audit work. By this, the auditor might provide a report which it will not show a

true and fair view because sometimes the fact shown that the internal control is good but the

reality it might not as good as what it shown. Furthermore, some external auditor will rely

more on the internal auditor’s work to enhanced the audit efficiency and reduce regulatory

cost (Brody, 2012). However, sometimes the external auditor might give a wrong judgement

to rely more on internal auditor’s work and come out with a report that is not true and fair.

The Nature of Client’s Business

The external auditor’s needs to perform their audit service in different type of industry

due to the nature of the client’s business are different. However, many of the auditors might



only specialize in certain industries so the auditors might not be able to provide their

profession in the auditing service in those industries that they are not expert in.

Issues in Gathering Evidence

Even though by law the auditors have the right to gather any necessary information

for the auditing process but sometimes the auditor might fail to gather sufficient evidence for

the auditing purpose or they gather some evidence which are out of date. Moreover, some

auditors might be able to know the reason why they could not gather sufficient information

such as someone might keep two sets of book keeping and give the external auditor the

wrong set.

Release of New Standards

To be an auditor is not only need to be professional in auditing but they must be

professional in accounting as well. Therefore, the auditors will need to spend time and costs

to get use with the new standard, guidelines of auditing as well as accounting that had been

issued regularly.

Unpredictable Issues

If a group of managers involved themselves in any fraud, then the audit committee

and external auditors might not be able to find out. Therefore, if anything goes wrong to the

client’s company, the external auditor’s reputation might be damaged due to the audit report

provided by them did not show true and fair view and the company will not be able to be a

going concern anymore (Tremblay & Gendron, 2011).

2.2 Corporate Governance

Corporate governance is a system for companies to be directed and controlled. The

company’s boards of directors are responsible for the governance of their companies. The



role of shareholders in governance is to appoint the auditors and the directors and this is to

ensure that an appropriate governance structure is effective. The boards responsibilities is to

prepare the company’s strategic aims, reporting to shareholders on their stewardship and

supervising the management of the business and lastly providing leadership to put all these

into effect (Chahine & Filatotchev, 2011). However, there are weaknesses in corporate

governance such as it requires government oversight to avoid corruption in the company and

misleading financial statements problem which could mislead the investors, for instances

“selling property from a parent company to a subsidiary to maximize parent company

revenues which is possible to present factually incorrect information that is difficult to detect

by establishing complex networks of subsidiaries and cross-shareholdings” (Chahine &

Filatotchev, 2011:157). Therefore, after facing problems with corporate governance and

many companies had financial scandals in United Kingdom and United States, two new set of

rules was formed in these regions which are Cadbury Committee in United Kingdom and

Sarbanes-Oxley Act in United States. These two new standards are to help companies and

shareholders to protect their wealth.

2.2.1 Cadbury Committee

In year 1990 it was found there were many frailties in the United Kingdom

governance model and it required an urgent review. During that time, Institute of Chartered

Accountants in England and Wales, London Stock Exchange and Bank of England together

formed a committee to review the financial aspects of corporate governance. The report,

Corporate Governance is also known as the Cadbury Report. It is a tribute to Sir Adrian

Cadbury’s leadership that after extensive consultation the Cadbury Report was published on

December 1st, 1992.

The purpose of Cadbury Report is the Code of Best Practice which is designed to

achieve high standards of corporate behaviour. It is to set a benchmark and shareholders will

get information about how their company is governed so they could make decisions to

appoint directors (Percy, 1995). “The Cadbury Report reviews the structure and

responsibility of boards of directors within a unitary framework. While the Code of Best

Practice is not legislated for in United Kingdom Law, it was made obligatory by the London

Stock Exchange for listed companies after June 1993” (Percy, 1995:25). In year 1995 another

report was published which is Greenbury Report and it is to focus on director’s remuneration

issues. To stress on principles of good governance and to review and revise the Cadbury and



Greenbury Report another report was established in 1998 which is Hampel Report. Lastly, by

combining Cadbury, Greenbury and Hampel Reports, the Combined Code on Corporate

Governance was established in year 2003 and these had formed three audit committees which

are necessary for good internal control.

2.2.2 Sarbanes -Oxley act

Holm and Zaman (2011:1) stated that “the global financial crisis, corporate failures

and scandals in many countries raise significant questions about the effectiveness of financial

reporting and auditing”. One of the financial scandals is the largest company Enron

Corporate, Enron misrepresent about their profitability by hiding the debts over $1 billion so

it would not show in the financial statements. Arthur Andersen was the auditing company for

Enron; the auditors didn’t do their professional responsibilities when auditing Enron. Due to

the report provided by auditors was not true and fair so the stakeholders were not able to

know the actual current financial issues in Enron. When Enron went into bankruptcy, the

stakeholders were question why the scandal did not spot out early. Moreover, there are not

only investors and creditors who had lost their investments because of Enron’s scandal but

more than ten thousand staff had lost their job as well as their income. Furthermore, the

stakeholders also lost their trust in United States companies and they also felt that the

corporate governance is not able to protect their interest or maximize their wealth.

The reaction from financial scandal crisis of Enron and other companies such as

WorldCom, Adelphia Communications, Duke Energy, Dynegy, Kmart and Tyco

International, United States sets out a legislation which is Sarbanes Oxley Act (SOX) to

enhance the standards which is effective form 30th July 2002 onwards. SOX will increase the

audit committees responsibilities and authority to address the financial reporting errors and

fraudulent practices among the companies (Zhang et al, 2007). By the SOX, a company's

financial statement will be more accurate and internal controls will be improved as well.

Therefore, the investors' wealth is protected and other stakeholders are able to get more

accurate and trustful financial information of an entity.

2.3 Stakeholders Needs

The financial scandals happen such as Enron, WorldCom, Tyco and Adelphia had

shaken the trust and confident of stakeholders on external auditors, because a big audit firm

Arthur Anderson had failed to give an independent opinion on true and fair view on the



financial statements of Enron Company. That is why today to fulfilled stakeholders needs had

become a vital task of auditors and enhancement must be done in the audit regulatory

environment. Auditors can do more to meet stakeholders’ needs; the roundtables had

concluded that by just reporting on historic financial statements is not good enough for

stakeholders but auditors should report on governance, risk, business model and other

important information which can broader the view of stakeholders. When a problem loomed,

stakeholders need red flags to be raised and “most of all for greater communication of the

extensive work that goes into an audit to be made available outside the hallowed confines of

the boardroom” (Welch, 2011:1). For instances, the case where one of the big four

accounting firms- Deloitte & Touche LLP was failed to detect the fraud of Taylor Bean

which was more than $ 7 billion. The shareholders of the Taylor Bean appointed Deloitte as

an auditor to audit the company’s financial statements but at the end Deloitte was found to

ignore the red flags and let the chairman, Lee Farkas to orchestrate fraud in company. The

fraud of Taylor Bean was covered up by external auditors and provided a not true and fair

view of audit report to shareholders (Pearson, 2011). From the view of this example, the

stakeholders interest are being at a risk so the stakeholder needs auditors to be independent

and able to detect fraud on financial statements as well as not allowed bias to defeat

professional judgments.

2.4 Audit Committee

“All Malaysian public listed companies are required to establish an audit committee

as measure to improve on internal control mechanism that can help improve the corporate

governance practices of firms” (Sori et al, 2009:317). Under the Code in England as well as



Malaysia, all the listed companies should set up an audit committee to enhance the quality of

corporate governance practices in entire entity, which the members of the audit committee are

consist at least three independent non-executive directors and financial experts or the

professional qualification of accountancy body such as MIA and ACCA holders and yet they

must be an independent in management.

The audit committee’s roles are to review and monitor the internal control procedures,

management systems, current accounting policies as well as internal audit function.

Moreover, an audit committee also need to review the company’s financial information or

any announcements made by the company to the stakeholders.

In addition, one of the audit committee’s roles is to appoint, reappoint or replace the

external auditors and to ensure the external auditors is independent which he or she is not

providing any additional service apart from auditing. The audit committee also will review

the effectiveness and efficiency of the external auditor’s work and liaise with the external

auditors. Therefore, the audit committee is playing an essential role in enhancing the roles of

external auditor to meet the stakeholders’ needs (Millichamp & Taylor, 2008). However,

everything in this world is not prefect so the audit committee will also have positive and

negative aspects of how it can enhance the role of external auditors.

2.5 Positive & Negative Aspect of Audit Committees in enhancing the Role

of External Auditors

Audit services had been dominated by the Big Four Auditing Companies which are

PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG. In the



United States, The Blue Ribbon Committee (BRC) reported in 1999 had made several

suggestions for the role of audit committees to enhance financial reporting. The suggestion

was that all audit committee members must be independent which actually is enforced in the

Sarbanes-Oxley Act (SOX), 2002. The first role of audit committee is to appoint external

auditors so if they are not independent then to expect external auditors to be independent is

far more difficult. For instances, a chairman of Financial Accounting Standards Board

(FASB), Dennis Beresford had been working for 10 years since 1987. His job scope was to

maintain independence and integrity of the board to avoid the pressure from outside interests.

He was the national director of accounting standards at Ernst & Young and later he joins the

faculty of University of Georgia (Tysiac, 2012).

Beasley et al. (2000:443) “find companies that commit financial fraud are associated

with weak and less independent audit committees”. A framework can be established which

will allow the non-executive director to work together with audit committee and this can

result in higher quality monitoring. This is because independent directors will be able to

question management whenever they consider it necessary and both independent director and

audit committee are concerned with their reputation capital. In order to avoid legal liability,

protect their reputation capital and take care of stakeholders’ interests, therefore the audit

committee will need to put a large degree of effort to fulfil their monitoring tasks. This will

result in a higher quality audits which will give a greater transparency in the financial

statement and it will reduce the agency costs such as external auditor fees (Carcello et al,

2002).

Tsui et al. (2001) “who had investigated CEO duality and audit pricing of Hong Kong

companies and found that more audit effort and higher audit fees results when the CEO is the

board chairperson”. The board is only independent when Chief Executive Officer (CEO) and

chairperson of the board is not the same person. The chairperson duty in the company is to

monitor and perform an evaluation on the CEO and executive directors but the CEO is

responsible for the day to day activities in running the company and setting up corporate



strategy. When the CEO is the chairperson itself, it actually reduces the effectiveness of the

board and even audit committee because it leads to weak internal control system in the

company which increases the chances of having a poor accounting system. Therefore, the

external auditors appointed by audit committee can no longer rely on internal control systems

and need to increase the collection of substantive evidence in order to perform a good

evaluation on the company’s accounting system. This will require more work and which will

lead to higher demand of audit fees and more time consumed. Not only that, CEO duality

gives impact to the auditors’ assessment of a company’s audit risk.

However, audit fees had become an issue nowadays but before it’s an issue CEO

duality should be banned because it also jeopardizing the duty of CEO to monitor the quality

of accounting information. However, some companies the CEO and chairman are different

person but it also will face some issue such as the dishonesty of auditors got banned over

fiddling expenses (Bliss et al, 2011). For instances, PricewaterhouseCoopers audit manager

Lee Douglass was excluded from ICAEW (Institute of Chartered Accountants in England and

Wales) because he failed to follow the PwC’s expenses policy and he dishonestly claimed

£3,858.94 in 15 expenses. He further claimed that only 3 expenses were over claimed but no

specific reason was explained for the claimed. Therefore, it was found guilty and he was

ordered to pay cost of £2,915 so he was fired by PwC and excluded from ICAEW as an

auditor (Lovell, 2012).

As mentioned before one of the audit committee’s roles are to review and monitor the

internal control procedures, management systems, current accounting policies as well as

internal audit function. Haron (2004:1148) stated that “internal auditors can assist external

auditors to understand the internal control system that has been set up before any compliance

or substantive work is being carried out”. Moreover, the internal auditor’s work can help the

external auditor in determine the nature, time consume and extent of their audit work, and the

company also will save cost due to the increase in reliance on internal auditor’s work then

reducing the external audit fee.

Haron (2004:1148) also mentioned that “external auditors will usually evaluate the

internal control system of the company to ensure that it is capable of preventing and

detecting material mis-statements from occurring". Apart from the CEO duality issue, the

external auditor will also not rely on the internal auditor’ work if the external auditor found

that the inherent risk (influence by internal audit) and control risk (internal control

procedures) is high. By this, they will not rely on the internal auditor’s work but if the



inherent risk is low then they might choose to rely on the internal auditor’s work. Therefore,

it is important for the audit committee to ensure that good internal control and high quality of

internal audit’s work which it means that the company’s financial statement had been

prepared in an accurate and transparency way. By this, the external auditor might decide to

rely on the internal auditor’s work if the inherent risk and control risk is low.

In addition, sometimes it is risky for the external auditors to rely on the internal

auditors work even the inherent risk and control risk is low because when a group of people

intentionally commits a fraud by keeping two sets of book keeping and give the external

auditor the wrong set and the audit committee lost their independence, then how low is the

inherent risk is also useless. For example, Yasu (2012:1) stated that “Olympus Corp., the

Japanese camera maker that hid $1.7 billion in losses, faulted five internal auditors for the

fraud and said KPMG Azsa LLC and Ernst & Young ShinNihon LLC weren’t responsible”.

By this, the stakeholders interest are being at a risk and stakeholder needs auditors to detect

fraud on financial statements not only that but not to allowed bias to defeat professional

judgements. Therefore, it is important for the external auditor to judge whether they should

base on the inherent risk and control risk and then rely on the internal auditor’s work or not.

So that, the external auditor can avoid giving any wrong assurance to the client regarding the

financial statements whether they are true and fair according to the standards.

3.0 Conclusion

In a nut shell, the role of audit committees had always been in approach to enhance

the role of external auditors in meeting stakeholders’ needs and to practice good corporate

governance in companies. There are however, certain problems faced by auditors when they

are carrying out their duty such as communication problems, issues in judgement, nature of



client’s business, issues in gathering evidence, release of new standards and unpredictable

issues.

Furthermore, there is corporate governance to direct and control companies but due to

financial scandals corporate governance is consider failed to direct the company well.

Therefore, two new set of standards were formed to protect the stakeholders’ needs which are

the Cadbury Committee and Sarbanes-Oxley Act. These two standards have the same

objective to protect the interest of shareholders and to prevent from any financial scandals

happening in the company.

Stakeholders’ needs are to have true and fair view on the financial statements so that

they feel protected. Therefore, the shareholders establish an audit committee to enhance the

efficiency among the entire company and protect their interests. The audit committee’s duty

is to appoint external auditors and monitor their task whether they are performing well or not

and examine the internal control procedures, management systems, current accounting

policies as well as internal audit function. Moreover, an audit committee also need to review

the company’s financial information or any announcements made by the company to the

stakeholders.

Lastly, there are other efforts undertaken to enhance the role of external auditors to

meet the stakeholders’ needs. However, these efforts are faced with positive and negative

aspect for audit committee such as framework to allow independent directors to work

together with external auditors, issue of CEO duality, issue of audit fees, and the reliance of

external auditors on internal auditors work and the risk they might face. Therefore, some

necessary efforts always are important to apply in an organisation to enhance the audit

committees work as well as external auditors work so the stakeholders’ needs will be able to

achieve.

4.0 Recommendation

After doing research on this report, we found that the audit committee and the

external auditors are playing a vital duty to meet the stakeholders’ need. However, there are

still few areas that can be improved to solve the problems in audit committee, internal and



external auditors and employers in the company. Therefore, the following are those efforts

that could be help to solve the problems such as:-

Enhancement on Regulations

The government should released new regulations or enhances the degree of the

regulations more often instead waiting for issues to occur only then start to solve the

problems. For example, in Malaysia CEO duality should be totally banned because this will

cause lot problems such as reduces the effectiveness of the board and audit committee,

weaken the internal control system and increases the chances of having poor accounting

system. Therefore, prevention is better than cure.

Investigate before Hire

The financial scandals had made the stakeholders lost their confidence in the external

auditors. Therefore, to avoid those scandals from happening again, the audit committee

should investigate the external auditor’s profile before hire them. By doing this, the audit

committee will be able to know the way they do their audit work and the ethic value in

external auditors.

Penalties and Punishments

The government should increase the penalty and punishments to those people that are

trying to involve themselves by committing any fraud or error. The penalty or punishment for

those people can be such as entire life they cannot work as what their qualification are now,

sentenced to prison for five years or above, each of the people will bear the same amount of

the loss for the company or will be charged any both at once. Moreover, the government must

be strict and don’t give any chance to whomever tries to cheat or commit fraud, only then

they will be afraid of it and do as what their duty require them to do.

Increase the frequency of Meeting

Generally, the audit committee will be having a meeting in every three months but

this might not be the best option to avoid the problem from occurring because they might be

vigilant of the issue but then problems already occur before the meeting. Therefore, the audit



committee should increase the frequency of meeting such as once in a month. Moreover, the

audit committee and auditors should be strict and straight forward when discussion the issues

arising in the company during the meeting, because if they are too friendly then it might

make them close friends and lose their independence. Furthermore, the shareholders should

involve themselves in the meeting so they will be able to know what is happening in the

current period instead of knowing the outcome of financial information after the entire

financial year.

Training

Some auditors might only specialize in certain industries so the external auditor will

be facing a problem in their auditing service in those industries that they are not expert in.

Therefore, the government should provide classes or training for auditors in those industries

that they are not familiar with. Moreover, the training regarding to the standards also should

be provided to the auditors whenever any new standard had been released. By this, the

auditor will be able to understand the standards and regulations.

Standardized the Audit Fees

The common issue occurred among the external auditors is to reduce the audit work

and the quality due to the low audit fees. The audit fees paid by the clients normally will be

based on how much the external auditors rely on the internal auditor’s work (Brody, 2012).

Therefore, the government should standardized the audit fees based on the auditors’

qualification then the external auditors will not feel that they doing more work and received

less fees.

5.0 References

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reporting consideration of industry traits and corporate governance mechanisms”,

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Bliss, M., Gul, F. & Majid, A. (2011) “Do political connections affect the role of independent

audit committees and CEO Duality? Some evidence from Malaysian audit pricing”,

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Brody, R. (2012) “External auditors’ willingness to rely on the work of internal auditors: The

influence of work style and barriers to cooperation”, Advances in Accounting,

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Carcello, J., Hermanson, D., Neal, T. & Riley Jr, R. (2002) “Board characteristics and audit

fees”, Contemporary Accounting Research, 19(3): pp. 365-384

Chahine, S. & Filatotchev, I. (2011) “The effects of corporate governance and audit and non-

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