Auditing

ISBN: 0-86176-871-X ISSN 0268-6902

Managerial AuditingJournalDispelling the Enron blues

Volume 18 Number 6/7 2003

www.emeraldinsight.com

maj_cover_(i).qxd 8/22/03 10:23 AM Page 1

442 Access this journal online

443 Abstracts & keywords

448 Enronitis – dispelling the diseaseGerald Vinten

456 An exploratory study of adoptingrequirements for audit committees fornon-US commercial bank registrants:an empirical analysis of foreign equityinvestmentLouis Braiotta Jr

465 Developing a strategic internalaudit-human resource managementrelationship: a model and surveyMaryAnne M. Hyland andDaniel A. Verreault

478 Underreporting and premature sign-offin public accountingMike Shapeero, Hian Chye Koh andLarry N. Killough

490 Internal auditors and the externalaudit: a transaction cost perspectiveCameron Morrill and Janet Morrill

505 The Mad Hatter’s corporate tea partyPhilomena Leung and Barry J. Cooper

517 Credibility and expectation gap inreporting on uncertaintiesJunaid M. Shaikh and Mohammad Talha

530 Improving corporate governance: therole of audit committee disclosuresZabihollah Rezaee, Kingsley O. Olibeand George Minmier

538 Users’ perceptions of corporate socialresponsibility and accountabilty:evidence from an emerging economyKhalid Al-Khater and Kamal Naser

549 The usefulness of the audit report ininvestment and financing decisionsAntonio Durendez Gomez-Guillamon

560 Auditing in support of the integrationof management systems: a case fromthe nuclear industryI.A. Beckmerhagen, H.P. Berg,S.V. Karapetrovic and W.O. Willborn

569 Current accounting investigations:effect on Big 5 market sharesChristie L. Comunale andThomas R. Sexton

577 The efficacy of liquidation andbankruptcy prediction models forassessing going concernNirosh Kuruppu, Fawzi Laswad andPeter Oyelere

591 Are auditors sensitive enough tofraud?Bilal Makkawi and Allen Schick

599 Users’ perceptions of various aspectsof Kuwaiti corporate reportingKamal Naser, Rana Nuseibeh andAhmad Al-Hussaini

618 Book review

Managerial Auditing Journal

Volume 18, Number 6/7, 2003

Dispelling the Enron blues

ISSN 0268-6902

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Enronitis – dispelling the diseaseGerald Vinten

Keywords Corporate governance, Fraud,Internal control, Auditing, Boards of directors,Financial reporting

‘‘Enron’’ has become less the name for a

company than a shorthand for mammoth

abuse of financial reporting and corporate

governance of a variety so egregious as to be

almost unbelievable. Across the world there is

debate in conferences and regulatory bodies as

to whether ‘‘Enron’’ can happen in this or that

country. Few if any are so complacent as to

consider that they are immune from

Enronitus. While America bolts the stable door

after the event, or in the high likelihood that

there will be another Enron waiting in the

wings, other countries are taking preventive

measures. A multi-dimensional and

inter-professional approach is required to

combat Enronitus. Main headings are

protecting the public interest, accounting and

financial reporting, auditing, corporate

governance and education. Careful integration

of these factors is necessary if there is to be any

discernible impact on the problem. Complex

issues require complex solutions.

An exploratory study of adoptingrequirements for audit committees fornon-US commercial bank registrants:an empirical analysis of foreign equityinvestmentLouis Braiotta, Jr

Keywords Audit committees,Boards of directors, Corporate governance,United States of America

This study examines whether the presence of

audit committees for US commercial bank

registrants (SEC Form 10-K filers) significantly

affects the likelihood of adoption by certain

non-US commercial bank registrants (SEC

Form 20-F filers). Results of a logistic

regression analysis of 31 US commercial bank

registrants with audit committees and 31 non-

US commercial bank registrants without audit

committees suggest that demand for oversight

protection in the sample non-US commercial

banks is more likely to increase as the total

market capitalization (size) increases.

Additionally, this paper investigates whether

the presence of audit committees for non-US

commercial bank registrants (Form 20-F filers)

increases their transparency with a

concomitant effect on infusion of foreign

equity investment. Results of a logistic

regression analysis suggest that the presence

of audit committees does not significantly

affect the likelihood of an increase in the

banks’ American depository receipts.

Developing a strategic internalaudit-human resource managementrelationship: a model and surveyMaryAnne M. Hyland and Daniel A. Verreault

Keywords Internal auditing,Human resources management,Risk management

Presents a model for analyzing the potential

for value creation of the internal audit (IA)

function, the human resource management

(HRM) function, and the IA-HRM pairing. A

survey of 161 chief audit executives indicated

that virtually all IA functions are risk

managing in their audit approaches, while a

great majority of HRM clients are also

moderately or strongly strategic in their

outlook. Findings included that a productive

working relationship was strongest when a

risk managing IA function is paired with a

strategic HRM function. Also, the IA

planning process was found to be more

strategic in the presence of the same pairing.

Analysis of written examples of strategic

findings related to HRM supplied by the

respondents suggested that there may be a

significant gap between auditors’ knowledge

of strategic HRM practices as developed in

the literature and their self-reported

examples. Future research should use both

HRM and IA responses to reduce bias.

Additionally, there is a need for case studies

of the IA-HRM partnership.

[ 443 ]

Managerial Auditing Journal18/6/7 [2003]Abstracts & keywords

# MCB UP Limited[ISSN 0268-6902]

Abstracts&keywords

Underreporting and premature sign-offin public accountingMike Shapeero, Hian Chye Koh andLarry N. Killough

Keywords Ethics, Public sector accounting,Cognition, Auditing principles

This study uses the ethical decision-making

model to examine underreporting and

premature audit sign-off in public accounting.

Structural equation modelling results indicate

that accountants view premature sign-off

activities differently from underreporting

activities. For example, those accountants who

use a teleological moral evaluation process,

and who perceive a greater likelihood of

reward are more likely to underreport. That

these variables are not significantly related to

the likelihood of premature sign-off suggests

that accountants may use a consequences-

based approach when making decisions

having lesser ethical content (like

underreporting), but employ a different

decision process when faced with decisions

having greater ethical content (like whether to

prematurely sign-off). The results also suggest

that supervisors and managers are less likely

to underreport, and to prematurely sign-off,

than senior and staff-level accountants, and

that accountants with an internal locus of

control are less likely (than externals) to either

underreport or prematurely sign-off.

Internal auditors and the externalaudit: a transaction cost perspectiveCameron Morrill and Janet Morrill

Keywords Internal auditing, External auditing,Transaction costs, Surveys, Canada

Questions exist regarding the extent to which

internal auditors should participate in the

external audit, and wide variations are

observed in practice. Many professional bodies

increasingly advocate the view that increased

coordination between the internal and

external auditors, including increased use of

the internal auditor for the external audit,

provides more efficient and effective audit

coverage. However, others maintain that

internal auditors should not focus on areas

that are the subject of external audit interest.

This article attempts to shed light on this

debate by using insights from transaction cost

economics (TCE) to identify conditions under

which organizations encourage internal audit

participation in the external audit. An analysis

of survey data collected from directors of

Canadian internal audit departments indicate

that some (TCE) variables, particularly

transaction-specific investment, are

significantly associated with internal audit

participation in the external audit.

The Mad Hatter’s corporate tea partyPhilomena Leung and Barry J. Cooper

Keywords Corporate governance, Ethics,Standards, Accountancy

This paper aims to provide an insight into

the corporate greed and consequent

corporate collapses of companies such as

HIH, One.Tel and Harris Scarfe in Australia,

while concurrently, Enron, WorldCom and

other companies were attracting the

attention of the accounting profession, the

regulators and the general public in the USA.

It is argued that the rise in economic

rationalism and the related increased

materialism of both the public and company

directors and managers, fed the corporate

excesses that resulted in spectacular

corporate collapses, including one of the

world’s largest accounting firms. The

opportunistic behaviour of directors, and

managers and the lack of transparency and

integrity in corporations, was compounded

by the failure of the corporate watch-dogs,

such as auditors and regulators, to protect

the public interest. If the history of bad

corporate behaviour is not to be repeated, the

religion of materialism needs to be

recognised and addressed, to ensure any

corporate governance reforms proposed for

the future will be effective.

Credibility and expectation gap inreporting on uncertaintiesJunaid M. Shaikh and Mohammad Talha

Keywords Corporate governance, Reports,Financial reporting

This paper analyzes and reports on studies

that examine the extent to which

international auditing boards have

accomplished the goal of reducing the

expectation gap in reporting on

uncertainties. This is because there has been

a long-running controversy between the

auditing profession and the community of

financial statement users concerning the

responsibilities of the auditors to the users.

Enron and WorldCom scandals have

provoked the public to incite the government

and professional bodies to impose stringent

regulation in protecting their interests. It

also suggests the solutions to minimize the

gap and enhance the public’s perception

towards the profession.

[ 444 ]

Abstracts & keywords

Managerial Auditing Journal18/6/7 [2003] 443-447

Improving corporate governance: therole of audit committee disclosuresZabihollah Rezaee, Kingsley O. Olibe andGeorge Minmier

Keywords Corporate governance,Audit committees, Financial reporting,Auditing, Disclosure

An increasing number of earnings

restatements along with many allegations of

financial statement fraud committed by high

profile companies (e.g. Enron, WorldCom,

Global Crossing, Adelphia) has eroded the

public confidence in corporate governance,

the financial reporting process, and audit

functions. The Sarbanes-Oxley Act of 2002

was an attempt to regain confidence and trust

in corporate America and the accounting

profession. The Act addresses corporate

scandals and the perceived crisis in the

auditing profession. Some of its provisions

relate to the audit committee oversight

function over corporate governance,

financial reporting, internal control

structure, internal audit functions, and

external audit services. This study examines

three types of audit committee disclosures:

the annual report of the audit committee;

reporting of the audit committee charter in

the proxy statement at least once every three

years; and disclosure in the proxy statement

of whether the audit committee had fulfilled

its responsibilities as specified in the charter.

This study conducts a content analysis on

audit committee disclosures of Fortune 100

companies.

Users’ perceptions of corporate socialresponsibility and accountability:evidence from an emerging economyKhalid Al-Khater and Kamal Naser

Keywords Social responsibility, Annual reports,Qatar

This study sets out to investigate the

perception of different users of corporate

information about the notion of the

accountability process and the possibility of

widening the scope of the current corporate

annual report in Qatar to include social

responsibility information. To achieve this

objective, four user groups were invited to take

part in the study. The outcome of the analysis

revealed that most of those who took part in

the study would like to see corporate social

responsibility information disclosed, either in

a separate section, or as part of the board of

directors’ statement within the annual report.

To achieve accountability, the respondents

believe that a law that encourages the

disclosure of corporate social responsibility

information should be introduced, and

different parties within the society should

have the right to such information.

The usefulness of the audit report ininvestment and financing decisionsAntonio Durendez Gomez-Guillamon

Keywords Auditing, Reports,Investment appraisal, Influence

The usefulness of the auditor’s report is

sometimes called into question, the validity

of the information it contains for users when

making decisions therefore being criticized.

This survey is aimed, on the one hand, at

dealers and brokering companies, and, on the

other at banks to find out exactly how

important the audit report is in the

investment decisions that analysts make, as

well as in lending decisions made by credit

institutions. In this sense, the respondents

are asked about the source they consider

relevant when making decisions, that is to

say, the influence the auditor’s opinion

(clean, qualified, adverse or disclaimer) has

when investing in and financing companies.

The results show that users of audit reports

consider the information provided in the

auditor’s opinion as useful and important

when making decisions, both regarding their

decisions of investing in and financing

companies as well as the amount of the

investment or the loan to grant.

[ 445 ]



Auditing in support of the integration ofmanagement systems: a case from thenuclear industryI.A. Beckmerhagen, H.P. Berg,S.V. Karapetrovic and W.O. Willborn

Keywords Quality, Safety, Auditing,Nuclear energy industry, ISO 9000 series,Germany

Integration of function-specific management

systems in organizations is rapidly becoming a

topic of interest for managers and auditors

alike. This is mainly due to the proliferation of

management system standards that foster

compliance with the stated criteria for quality,

environmental, occupational health and safety,

social responsibility and other different

aspects of performance. While most of the

available literature on this topic focuses on the

integration of standards, there is

comparatively little information on how to

actually build an integrated system internally.

This paper hypothesizes that audits can

provide an excellent basis for these integration

efforts, discussing the prerequisites, strategies

and resources necessary for an effective audit

in support of integrated management systems.

The paper also describes how audits are used

to improve a combined quality and safety

management system in a German nuclear

facility.

Current accounting investigations:effect on Big 5 market sharesChristie L. Comunale and Thomas R. Sexton

Keywords Market share,Accounting standards, Accounting firms,Benchmarking, United States of America

Arthur Andersen’s conviction and its

decision not to audit public firms will

transform the Big 5 into the Big 4.

Meanwhile, other Big 4 firms face

investigations that threaten their future

market shares. The article compares the

observed post-scandal shifts in market share

with those estimated by a Markov model. It

then estimates the year-by-year and long-

term market shares that the Big 4 firms

would have achieved had they remained

untouched by these investigations. The study

finds that the absence of Arthur Andersen

alone would not have led to excessive market

share concentration. It demonstrates how the

post-scandal shifts reveal the impacts of the

investigations on the Big 4 firms and

provides market share benchmarks against

which the firms can evaluate the long-term

effects of the investigations. Finally, the

article concludes that a firm’s long-term gain

in market share depends on its ability to

retain audit clients.

The efficacy of liquidation andbankruptcy prediction models forassessing going concernNirosh Kuruppu, Fawzi Laswad and Peter Oyelere

Keywords Going concern value, Liquidation,Bankruptcy, Insolvency, Corporate finances

Recent research questions whether

bankruptcy is the best proxy for assessing

going concern since filing for bankruptcy is

not synonymous with the invalidity of the

going concern assumption. Furthermore, in

contrast to debtor-oriented countries such as

the USA, liquidation is the most likely

outcome of corporate insolvency in creditor-

oriented countries such as the UK, Germany,

Australia and New Zealand. This suggests

that bankruptcy prediction models have

limited use for assessing going concern in

creditor-oriented countries. This study

examines the efficacy of a corporate

liquidation model and a benchmark

bankruptcy prediction model for assessing

company liquidation. It finds that the former

is more accurate in predicting company

liquidations in comparison with the latter.

Most importantly, Type 1 errors for the

liquidation prediction model are

significantly lower than for the bankruptcy

prediction model, which indicates its greater

efficacy as an analytical tool for assessing

going concern. The results also suggest that

bankruptcy prediction models might not be

appropriate for assessing going concern in

countries where the insolvency code is

creditor-oriented.

[ 446 ]



Are auditors sensitive enough to fraud?Bilal Makkawi and Allen Schick

Keywords Auditing, Fraud, Corporategovernance, Auditors

This study investigates how auditors alter

their audit program decisions in response to

an increased likelihood of fraud risk. A total

of 48 auditors from one Big 5 CPA firm were

surveyed regarding the type of audit

procedures they would use in response to an

increased likelihood of material

misstatements caused by fraud. The auditors

were provided with a scenario that reflected

changes in economic and industry factors

that increase audit risk and typically require

a reevaluation of the audit program. They

were asked to make choices as to which tests

of balances and details and analytical

procedures to perform. The results of the

study are summarized and tabulated and

then explained in terms of the tradeoff

between effectiveness and efficiency and

corporate governance.

Users’ perceptions of various aspectsof Kuwaiti corporate reportingKamal Naser, Rana Nuseibeh andAhmad Al-Hussaini

Keywords Corporate finances,Corporate communications, Reports, Kuwait

In this study an attempt is made to provide

empirical evidence on the usefulness of

different aspects of the annual report to

various Kuwaiti user groups. To do so, eight

Kuwaiti user groups were surveyed through

a questionnaire. The groups were individual

investors; institutional investors, bank credit

officers, government officials, financial

analysts, academics, auditors and stock

market brokers. The analyses indicate that

the user groups surveyed in the study rely

mainly on information made directly

available by the company and do not consult

intermediary sources of corporate

information in order to make informative

decisions. The analyses also revealed that

credibility and timeliness are the most

important features of useful corporate

information and traditional financial

statements are the most important and

credible parts of corporate annual reports.

Non-financial information, however, proved

to be less credible and of less importance to

the Kuwaiti user groups.

[ 447 ]



Enronitis – dispelling the disease

Gerald VintenEuropean Business School, London

Introduction

Corporate governance is not a new issue. It

may be dated back to when incorporation

with limited liability became available in the

nineteenth century, with the need for

legislation and regulation. Recently debate

has focused on more specific concerns. These

revolve around the accountability of those in

control of companies to those with the

residual financial interest in corporate

success, normally the shareholders, but

when the company is approaching

insolvency, then also its creditors, as well as

widening discussion to consider

stakeholders. All in the workplace now

operate within such a framework, and this is

the context in which careers are developed

and enhanced internationally.

This focus seems to reflect seven

contemporary developments. First, there is

the economic analysis of corporate law. This

places priority on the efficiency of the

allocation of scarce economic resources

which will be achieved if companies are

accountable to those who take the profit or

bear the loss after all other claims on the

company have been met.

Second, the redistribution of tasks between

the public and the private sectors (through

privatisations, Public Finance Initiatives and

Public Private Partnerships and other

similar devices), and between public and

charitable sector of the economy demands

full public confidence in the manner in

which companies are run and securities

markets are organised. This has also led to

corporate governance concepts entering into

both the public and charitable spheres as all

sectors of the economy co-exist in fluid

interaction and mutual dependence.

Third, issues of public confidence can be

assessed in terms of levels of managerial

remuneration and the effectiveness with

which the boards of major companies carry

out the task of monitoring executive

management (with some such companies

unexpectedly collapsing in recent years).

Fourth, and of increasing future

importance, the shift in most countries from

pay-as-you-go pension schemes (often part of

the state welfare system) to a greater role for

funded pensions is increasing the flow of

funds onto the capital markets, as well as

increasing the risks to the pension holders as

there is a move away from final salary

pension schemes.

Fifth, the globalisation of the economy has

driven the largest companies to access

international capital markets. This has

produced greater risk exposures as one

enters into previously uncharted territory.

Six, abuse and fraud, sometimes on a global

scale, have led to greater awareness of

inadequacies of governance, and demand for

reform, and even entire models of operating

within a country are up for re-evaluation,

such as the role of the chaebol within Korea.

Finally, other conceptions of what

influences should be recognised within

governance systems provide for

accountability to representatives of the

employees or even to the state.

Enron and aftermath

Events in the USA often have global

consequences, and we are still living with the

impact of ‘‘September 11’’ (9/11 in American

parlance) as well as ‘‘Enron’’, both of which

have entered the global vocabulary as a type

of shorthand. Enron’s whistleblower vice

president Sherron Watkins was among

the three ‘‘Persons of the Year’’ 2003 for

Time magazine, and two other

whistleblowing women also shared this

honour: Cynthia Cooper, vice president for

The Emerald Research Register for this journal is available at

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The current issue and full text archive of this journal is available at

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[ 448 ]


# MCB UP Limited[ISSN 0268-6902][DOI 10.1108/02686900310482597]

KeywordsCorporate governance,

Fraud, Internal control,

Auditing, Boards of directors,

Financial reporting

Abstract‘‘Enron’’ has become less the

name for a company than a

shorthand for mammoth abuse of

financial reporting and corporate

governance of a variety so

egregious as to be almost

unbelievable. Across the world

there is debate in conferences and

regulatory bodies as to whether

‘‘Enron’’ can happen in this or that

country. Few if any are so

complacent as to consider that

they are immune from Enronitus.

While America bolts the stable

door after the event, or in the high

likelihood that there will be

another Enron waiting in the

wings, other countries are taking

preventive measures. A

multi-dimensional and

inter-professional approach is

required to combat Enronitus.

Main headings are protecting the

public interest, accounting and

financial reporting, auditing,

corporate governance and

education. Careful integration of

these factors is necessary if there

is to be any discernible impact on

the problem. Complex issues

require complex solutions.

internal audit at WorldCom, and Coleen

Rowley, special agent for the FBI, who

revealed the inadequacies of the FBI relating

to ‘‘September 11’’, thus linking our two bits

of shorthand. So two out of three of these

‘‘superwomen’’ were connected with

corporate governance infractions of a similar

ilk, with financial reporting having been

contravened.

Considerable soul-searching across the

world followed Enron, with endless debate as

to whether ‘‘Enron could happen here’’.

Sometimes the US situation was considered

sufficiently different from that of this or that

country as to indicate lower levels of risk.

However there was a general recognition that

mini-Enrons could well take place elsewhere,

and that complacency was not a suitable

response. The fact that The Netherlands is

currently reeling under its own ‘‘Enron’’ in

the shape of the retail chain Ahold reinforces

this. Founded in 1887 this company is very

much part of the Dutch landscape. It may be

considered the equivalent to Sainsbury’s in

the UK. Under the leadership of the now

dismissed chief executive Cees van der

Hoeven, Ahold expanded into the USA,

acquiring the Stop and Shop chain. In 2000,

Ahold purchased US Foodservice, which

markets catering supplies to restaurants,

schools and prisons. After £315 million worth

of inflated profits were discovered over the

past three years the chief executive and

finance director were sacked. The impact on

The Netherlands stock exchange was a 9 per

cent reduction in the value of equities. Since

the overstated profits emerged from the audit

of Foodservice, it has led to mutual

recriminations between the state of

European regulation versus that in the USA.

However Institute of Chartered Accountants

of England and Wales president, Peter

Wyman, has stated that the Ahold scandal

was not helpful to the European regulator’s

case, which appears inferior to that of

the USA.

The UK Accounting Foundation had only

just been established when Enron hit the

headlines, and had to divert most of its

attention and workload to Enron-related

issues. Since under the review of accounting

regulation and standard setting it was

subsequently abolished as a separate entity,

it means that during its short life it was

effectively an Enron organisation!

The situation was nicely summarised by

Harrington (2003) who calculated that an

otherwise $260 billion profit in the Fortune

500 companies was reduced to $69.6 billion in

2002 through accounting changes, mainly

relating to goodwill in mergers and

acquisitions. She reviews how accounting

made the year 2002 look a lot worse:We could blame this bleak state of affairs on

any number of scapegoats – the sluggish

economy, 2002’s sagging stock market, and aseemingly unending stream of scandals come

to mind. But there’s a simpler explanation:

accounting changes. Some of the new rules

have been in the works for years. Others were

accelerated by Enron fallout. Together they

reflect a paradigm shift in the waycorporations report their results.

Exaggeration is out. Conservatism and

cleaned-up financial statements are in.

Recommendations

The factors here enunciated were first set outin bare outline in Vinten (2002), which alsoindicated some of the background to thedebacle, and the immediate response.Apparently the article was the seventh mostaccessed article of all the myriad Emeraldinsight articles. The opportunity has beentaken to revise and provide more extensiveexplanation to the original listing.

Protecting the public interest1 State national audit offices across the

world should follow the US GeneralAccounting Office example ofinvestigating matters of public interest,and issuing reports. This means movingbeyond the narrow focus of the publicsector viewed in splendid isolation. Suchextension has occurred already in theexplicit rather than implicit involvementin value-for-money studies in manyjurisdictions. With the move of formerstate industries into the private sector,state audit has sometimes been retained.Hence the UK Competition Commissioncontinues to ‘‘audit’’ the formernationalised industries to ensure they areoperating in the public interest, with afocus on value-for-money which includesrelations with the labour force and tradesunions.

2 Legislation should specify clear and strictrights of access to relevant agencies forsuch information as they reasonably deemnecessary, to avoid the need for them toinitiate legal action on a case-by-casebasis. The model of the UK AuditCommission should be adopted whereby itcan act in an independent butquasi-judicial fashion to decide anychallenges to such powers. This will avoiddelaying tactics, and minimise cost.

3 Criminal penalties, large fines and strictliability will apply to all those implicatedin the shredding or concealment ofdocumentation. Organisations need tohave policies relating to the retention andindeed archiving and disposal of

[ 449 ]

Gerald VintenEnronitis – dispelling thedisease


documents in addition to thoseestablished by statute. Bank of Credit andCommerce International maintained adouble set of documentation, one beingfraudulent. The US federalSarbanes-Oxley Act of 2002 containsstipulations on this.

4 Jurisdictions, the vast majority, whichhave not legislated to protect valid acts ofwhistleblowing should do so forthwith(Vinten, 1994a). The Sarbanes-Oxley Acthas section 1107 retaliation againstinformers:

Whoever knowingly, with the intent to

retaliate, takes any action harmful to any

person, including interference with the

lawful employment or livelihood of any

person, for providing to a law enforcement

officer any truthful information relating

to the commission or possible commission

of any federal offense, shall be fined under

this title or imprisoned not more than ten

years, or both.

Previously whistleblowing protection

mainly applied to the public sector and

utility companies, but this section now

means that whistleblowing protection is

more universal across all sectors of the

economy, which is the situation in the

UK. Previously the trend was for

legislation to apply mainly to the public

sector, which was unhelpful when it came

to the sort of frauds and financial

irregularities with the capability to create

the most harm.

A more inclusive stakeholder model

should be adopted, rather than the

current minimalist model. All directors

are faced with real, or imagined, conflicts

of interest or competing demands for time

and resources, between shareholders and

stakeholders. This has always been the

case, but the contemporary emphasis on

stakeholders has brought this to a head.

Astute organisations and directors

maintain a suitable balance between the

various demands placed on them, and

there are systematic ways to do this.

Stakeholding is the viable and sustainable

way for companies to proceed. Practical

approaches to discriminating among the

claims of various stakeholders are

perfectly possible (Vinten, 2001).5 The UK model of the chartered secretary

should be extended world-wide where notcurrently present. The charteredsecretary has the followingresponsibilities (Lai, 2002; Baker, 2002):. the maintenance of the statutory

registers of the company;. attendance at board meetings, the

formulation of agendas, taking minutesof the meeting, preparation of articles

and notices to shareholders, and

ensuring that correct procedures are

followed both at board and general

meetings;. the custody of the company seal; and. the authentication and retention of

documents.

The company secretary, as an officer of

the company, must act in good faith in the

interests of the company and not act for

any collateral person. Conflicts of interest

are to be avoided as are making profits

from dealings for and on behalf of the

company. The secretary is a type of

corporate conscience to keep the act on

the straight and narrow in compliance

with legal and regulatory dictate.6 The law pertaining to fraud needs to be

consolidated and rationalised (Vinten,

1990). In the UK it is a curious amalgam of

various strands from different periods of

history, but there is no central fraud

statute as such. This can lead to legal

complications and the need to select the

correct statute under which to proceed, or

rely on the common law, as in the notion

of the tax cheat. There would be

considerable advantage in housing all the

stipulations under the one roof. The

allocation of police resources to fraud is

not always as great as its economic

consequences might demand.7 Pensions and employee savings plans

require more participant education and

safeguards. This is particularly the case

where employees are locked into schemes

in which material amounts are invested in

the employing company or a limited

range. Enron had 41 per cent of its direct

contribution scheme invested in its own

stock (compare Proctor and Gamble 92 per

cent, Anheuser-Busch 83 per cent, Abbott

Laboratories 82 per cent, Pfizer 82 per

cent, McDonald’s 74 per cent). It is

difficult for the consumer to be able to

reconcile their pension with their

contribution record, and since

occupational pensions tend to be largely

hidden and unnoticed until the person

retires, they present a high risk area. The

Maxwell Communications Corporation

pension scandal under Robert Maxwell is

a famous example of a pension fund being

raided to the huge detriment of its

members (Vinten, 1993).8 Regulation needs to be disconnected from

the accounting and auditing profession.

There is too much by way of vested

interests, plus the need to assuage public

perception after the whole array of recent

scandal. The Public Company Accounting

Oversight Board in the USA is an example

established under the Sarbanes-Oxley Act.

[ 450 ]



Similar developments are in train in otherparts of the world.

9 Professional ethics need to be a majoremphasis within the accounting and otherrelevant professions. They need to havebite in their enforcement, but equallyimportant to be internalised in the hearts,minds and souls of all professionals.Those working within financial services,many of whom command ridiculouslyinflated salaries for what they do, arenoted for treating professional ethics withsome disdain, and seem to think that theunsuspecting public owe them anexistence: unsuspecting because theirrelationship is often at second hand andindirect through the likes of pensionfunds. The public are simply the fodder fortheir high lifestyle and are to be treatedwith contempt.

Accounting and financial reporting10 Principles-based ‘‘substance over form’’

should become the norm. However theproper role for a rules-based approachneeds to be debated and determined. Thisis much more than a dry-as-dustphilosophical debate. It is fundamental tothe way accounting is formulated andexecuted.

11 The USA as a major player needs to movemore in line with the rest of the world,with an expedited convergence takingplace. This, indeed, has started to happen,with more openness to developmentsoutside the USA, and the global need to besinging from the same hymn sheet.

12 Three levels of rigour of reporting need tobe established as opposed to the presenttwo: large, high risk and/or materialityentities; intermediate companies; smallbusinesses. Previously there tended to beconcessions only for the small companysector. One would not suggest theintermediate category have a lesserstandard than at present, but rather thatthe top category have increasing demandsplaced on it. The notion of materiality isoften left vague in accounting andauditing terms. It needs to be made morespecific such that there is transparency(Vinten, 1994a).

13 With the complexities involved, as inderivatives and special purpose entities,the near incomprehensibility of accountsto many of the stakeholders, andaccountancy itself trying to keep up withthe realities of E-commerce and theknowledge environment, steps need to betaken to ensure adequate communicationto users. Issues which impact on risk andvalue need to be made explicit.

14 Our more inclusive reporting modelpresupposes more qualitative data,including that on which board and

company performance can be judged.

Indeed qualitative data is vital to interpret

the quantitative data, which rarely speaks

for itself and needs to be placed in context.

Auditing15 ‘‘True and fair’’ or ‘‘fairly present’’ should

mean not just conformity with accounting

principles, but convey adequately the

overall situation. This almost mystical

incantation needs to be taken out of the

realm of set-piece ritual and

individualised to each audit, such that the

reader has some idea of exactly what audit

work has been carried out, including what

has not been done. Readers of audit

reports quite often make unjustifiable

assumptions as to the nature of an audit. If

they were more aware of the truth behind

the audit facade they would be in a

position to pose more penetrating

questions, and uncover areas demanding

further attention.16 Auditors should adopt a stakeholder

orientation in addition to the current

shareholder one. By stereotype

accountants are not traditionally regarded

as avant-garde in their wish to recognise

wider notions of corporate or professional

liability, and the move to limited liability

partnerships is an example of

circumscribing liability. The 1990 House

of Lords decision in Caparo Industries v.

Dickman (1All ER HL 568) narrowed the

scope of professional third party liability.

In fact the decision has to be differentiated

on the facts of the case, and was concerned

with a restricted situation regarding the

external audit, and the audience for which

it was intended. Case law had arguably

opened the sluice gates too far, and the

audit was determined as being for the

shareholders, rather than the

stakeholders, although this term never

entered into the case.

It remains an unresolved question as to

whether the decision was retrograde, or in

the public interest, but it was not a

decision on corporate governance or the

wider responsibilities of businesses

across the entire scope of their dealings.

Despite the stereotype, accountants are, in

fact, increasingly talking the language of

stakeholding, and the only reason they are

likely to be doing this is because they find

it omnipresent in the business

community. A recent report by the

world’s oldest professional accounting

body indicates how this profession is

trying hard to meet the needs of the

stakeholder economy (Beattie, 1999). It

slips naturally into stakeholder language

as a natural recipient of accounting

information:

[ 451 ]



Stakeholders are aware that the fortunes

of a company can change rapidly and

dramatically and want to know about key

events when they happen. The current

reporting model, grounded in the entity

concept, periodicity, and strict recognition

criteria, appears to be partial and

problematic. A ‘‘business reporting

expectations gap’’ appears to exist (Beattie,

1999, p. 12).

It additionally showed the pace of change

when the major accounting firms of

KPMG, Pricewaterhouse Coopers and

Ernst & Young collaborate in November

1999 to launch the Copenhagen Charter to

present the business case for managing

stakeholder relationships. The Institute of

Social and Ethical Accountability (ISEA),

simultaneous with the Charter, provides

international standards to provide

organisations with a tool by which to

develop high quality systems and

procedures for stakeholder dialogue and

reporting.17 All the ramifications of audit

independence need to be assessed and

reported on, as does the detail of how the

external audit has been carried out and

the conclusions drawn. The onus should

be on the auditor to indicate how he/she

has upheld independence in terms of the

threats to it commonly encountered. Athreats and risks based model should be

adopted. Bazerman et al. (2002) indicatethat the problems residing in the external

audit reside less in deliberate corruption

and unethical practice but more in

unconscious bias. These are threefold:. ambiguity in the different possibilities

for interpretation;. the specific attachment to the company

which hires and can fire; and. the audit implicitly endorses or rejects

the accounting judgement of the client

firm.18 The rotation issue needs to be addressed

in a balanced fashion, with half-way

solutions, such as partial rotation of staff,

explored. Joint auditing may also be

considered (in Canada large banks require

two auditing firms).19 Opinion shopping for external auditors

needs to be discouraged (Lennox, 2003). At

present it is all too easy to manipulate the

situation to obtain the audit outcome

which a company desires. The ‘‘politics of

the external audit’’ tends to be a closed

book, but there is much that goes on in

secrecy which is unlikely to serve the

public interest.20 The role of internal auditing should be

highlighted, possibly made mandatory at

law, and its own independence

guaranteed, with protected external

reporting in the public interest formatters of concern. Internal control is acrucial concept. The US Federal Foreignand Corrupt Practices Act 1977 was said tohave led to an increase in the employmentof internal auditors in the late 1970s. The

Act required a statement in the annualreport and accounts as to how internalcontrol had been safeguarded. Internalauditors are significant in this growingcorporate governance framework.

21 The audit committee needs to play asignificant role. In 1987, the TreadwayReport (known as the Report of theNational Commission of FraudulentFinancial Reporting), offered 11recommendations to enhance theeffectiveness of audit committees, whichwere to be the keystone of corporatefinancial governance. These remain acomprehensive and authoritative list:. They should have adequate resources

and authority to discharge theirresponsibilities.

. They should be informed, vigilant, andeffective overseers of the company’sfinancial reporting process and itsinternal control system.

. They should review management’sevaluation of the independence of thecompany’s public accountants.

. They should oversee the quarterly as

well as the annual reporting process.. The SEC should mandate the

establishment of an audit committeecomposed solely of independentdirectors in all public companies.

. The SEC should require committees toissue a report describing theirresponsibilities and activities duringthe year in the company’s annualreport to shareholders.

. A written charter for the committeeshould be developed. The full boardshould approve, review, and revise itas necessary.

. Before the beginning of each year,audit committees should reviewmanagement’s plans to engage thecompany’s independent publicaccountant to perform managementadvisory services.

. Management should inform them ofsecond opinions sought on significantaccounting issues.

. With top management, the committeeshould ensure that internal auditinginvolvement in the financial reportingprocess is appropriate and properlyco-ordinated with the independentpublic accountant.

. Annually, committees should reviewthe programme that managementestablishes to monitor compliance withthe company’s code of ethics.

[ 452 ]



Most audit committee chairs commendthe recommendations as having exerted apositive influence on corporate reportingand internal controls.

Corporate governance22 Board members should be properly

inducted, trained and developed.Originally there was a view that directorswere born not made, reinforced by theirbeing recruited via the old boys’ network,and it being assumed that they were allgood chaps and entirely competent, or thatthe role was not that demanding. This wasnever satisfactory, and there are nowprofessional certifications and evenchartered status available via the Instituteof Directors of the UK. Directors need bothinduction and mentoring.

23 The pros and cons of different types ofcorporate governance need to be exploredand best practice disseminated. Thus theUK system has a balanced mixture oftypes of director, whereas in the USsystem the ‘‘independents’’ predominate.The UK ‘‘independents’’ may therefore becloser to the action. The European two tierboard is also worth exploration over theprejudice of some in the UK that stickalmost ideology to the Anglo-Saxon model.

24 There needs to be more companysponsored practical research ongovernance, rather than the black box itoften is at present. Directors may havebeen reluctant to be exposed to researchand hence greater scrutiny, but practicecreated in ignorance is hazardous, and theopportunity to benchmark anddisseminate good practice is lost.

25 National research agendas need to beformulated, with central collection anddissemination of results. This hashappened to a limited extent, but more isrequired.

26 Although the Turnbull Report emphasisedrisk, one needs to put risk in perspective.It is not simply a ‘‘policing’’ matter, butequally weighing up the risk of missingopportunities. Risk is endemic in businessand presents opportunity as well as thepossibility of sub-optimal performance oreven disaster. There has been criticismthat the whole series of corporategovernance reports has led to a riskaversion mentality.

27 Business ethics is a crucial ingredient,and consideration should be given toappointing a chief ethics officer, anombudsman, or the registrar function asin the John Lewis partnership. These needto have independence and a reportingrelationship straight into the board andaccess to the chair of the board.

28 Equally crucial is what has been known asthe ‘‘tone at the top’’. A board

sub-committee should consider this, or the

audit committee with widened remit take

this issue on board. It is often those at the

top who perpetrate the misdemeanours

with the potential to bring the corporation

to its knees.29 Institutional investors and organised

shareholder/stakeholder groups should

be permitted a voice in the boardroom.

This happens more in the USA than in

the UK.30 A diversity of non-executive directors,

outside the ‘‘old boys’’ network, and with

true independence should be recruited.

An organisation in the UK called ProNed

(Pro Non-Executive Directors) attempted

to widen the audience from which

directors were sought, as has the Institute

of Directors. They sometimes found they

were fighting an uphill battle.

Education31 Schools should include corporate

governance as part of their citizenship

education. The Commission of the

Speaker of the House of Commons on

Encouraging Citizenship provided a

definition of citizenship which,

incidentally, included whistleblowing

(Stonefrost, 1990):

The challenge to our society in the late

twentieth century is to create conditions

where all who wish can become actively

involved, can understand and participate,

can influence, persuade, campaign and

whistleblow, and in the making of

decisions can work together for the mutual

good.

This is certainly the nearest one came at

this time in the UK to any official

recognition of the value of whistleblowing

and, indeed the attribution of almost a

constitutional role for the activity.

Considerably more positive statements

had already been made in both the USA

and Australia. The Commission reported

on the workings of the honours system,

and even suggested that whistleblowers

might be included in the Honours List.

‘‘As to ‘whistleblowing’, we all regarded

this as an important part of citizenship.

We had no special problems with this

issue as an element of citizenship

although if there was too much

‘whistleblowing’ its effective value could

be drowned by the noise’’ (personal

communication, Maurice F. Stonefrost,

21 September 1990). Four years on,

Stonefrost (1994) indicated that there

had been little discussion of the report,

and its recommendations had remained

largely ignored.

[ 453 ]



32 Higher education should teach elements of

business ethics and corporate governance

as part of all courses. However, there are

problems of obtaining a clear statement of

need even within business studies and

accountancy. Quality Assurance Agency

for Higher Education (2000b) contains the

benchmarking statement for UK

bachelors degrees with honours for

general business and management. These

statements are for guidance and are not

meant to be straitjackets, although they

are sufficiently generalised that

institutions would be unwise to ignore

them, and they will be referred to in

subject reviews both internal and

external. ‘‘Business ethics, values and

norms’’ come under the heading of

‘‘contemporary and pervasive issues’’

under ‘‘relevant knowledge and

understanding’’. Corporate governance is

not mentioned which is extremely

surprising. However these statements are

due for revision in the middle of 2003 and

one hopes the opportunity will be taken to

consider what is needed in the post Enron

situation.33 Quality Assurance Agency for Higher

Education (2000a) contains the accounting

benchmarking statement. This does

mention accounting and society,

behavioural and sociological perspectives,

and alternative theories, but fails to

mention corporate governance or

professional ethics, which is surprising

almost to the extent of negligence. We are

told that accounting is practised in part

within a professional service context, and

that different universities will have

different relationships with the

requirements of the various professional

accountancy bodies in the UK. Given that

professional ethics is an integral part of

these professional bodies, it is simply

amazing that there is a failure to mention

this. The working parties which

formulated these would have had

available to them a whole series of

statements pertaining to the ethical

component. Thus SEEC (1996) contains an

ethical strand for each of the three levels

of a three year honours degree and for M

(Masters) level under the heading of

‘‘ethical understanding’’. This

concentration on ethics is all the more

remarkable when one realises that this is

a general statement across the entire

curriculum. It is far superior to the

statement for general business and

management and for accounting. The

requirements for ethical understanding

are:. Level 1. Awareness of ethical issues in

current area(s) of study. Ability to

discuss these in relation to personalbeliefs and values.

. Level 2. Awareness of the wider socialand environmental implications ofarea(s) of study. Ability to debateissues in relation to more generalethical perspectives.

. Level 3. Awareness of personalresponsibility and professional codesof conduct. Ability to incorporate acritical ethical dimension into a majorpiece of work.

. Level M. Awareness of ethicaldilemmas likely to arise in researchand professional practice. An ability toformulate solutions in dialogue withpeers, clients, mentors and others.

34 Business courses should place moreemphasis on risk and fraud, rather thanpretending that fraud never takes place.Some companies are established withfraud as their main intent, including thelaundering of money. Others are theproduct of illegal funds, although inthemselves operate as legitimatebusinesses. The remaining majority ofbusinesses operate with varying degreesof noble intent, and if they survive longenough or are of sufficient size are highlylikely to suffer fraud. Quality AssuranceAgency for Higher Education (2000a)mentions risk but not fraud. Aninstructive story relates to the MBAexamination at the City UniversityBusiness School (now the Cass BusinessSchool) over a decade ago. A case studywas set for the business strategyexamination. Students had this inadvance for any analysis they wished toconduct in advance. In the event the usualtools of business strategy were applied bythe students. Only one got close to thetruth of the situation and what wasneeded to improve the situation. Behindall the facts and figures was a giganticfraud. The company produced a sucrosedrink called ‘‘Tizer the Appetizer’’ in itspromotional mode. It was bottled and soldoff the back of lorrys which traversedtownships. Initially the delivery staff, thesales people (in reality glorified lorrydrivers), found that if they defrauded onthe deliveries, no management action wastaken. This then led to the foundation ofan alternative bottling line which waspurely for the benefit of the fraudsters.With this twin-track fraud, it was notsurprising that the company wasexperiencing liquidity problems. It waseventually taken over for a song by BarrBrothers of Glasgow who stripped out thecancerous fraud in the process. Had thestudents been schooled with more fraudawareness, they may have come closer tooffering the sort of solution that was

[ 454 ]



called for, and which all the lovelycorporate strategy tools were otiose tosave the company.

Epilogue

With the common issues impacting on the

economy, and the globalisation of business,

corporate governance, a term virtually

unknown 20 years ago, has now entered into

world currency. The contexts may differ. For

example, there is no parallel for the sokaiya

in Japan, specialists at disrupting AGMs, and

often related to the yakuza gangs, although

their influence has become reduced with the

criminalisation of paying protection money

to them, and the difficulty of them coping

with all the business with AGMs being held

on the same day. Despite the differing

contexts, the core issues sound familiar, and

this accounts for the world ambience of the

Cadbury Report.

Much of the need to encourage firm

corporate governance hangs on the supply of

suitable management, director, shareholder

and perchance stakeholder information. It is

recognised that corporations adopt a risky

strategy if they rely on the unpredictable

revelations of whistleblowers as a control

device, although it is a suitable control

device to encourage and reward internal

whistleblowing, and recognise this as a

natural part of any corporate governance

system.

A multi-faceted and global response is

required. This is complex when all the above

considerations need to be considered and in

place. There are so many variables involved

that weaknesses in any one link of the chain

may lead to breakage. Constant vigilance

from all concerned is vital.

This themed edition of the Managerial

Auditing Journal is one of many initiatives to

try to bring about improvement. Collected

within this double volume are contributions

from across the world on a range of

approaches and ideas which together may

minimise the risk of future Enrons and

hopefully provide some kind of antidote to

Enronitus, a pernicious inflammatory viral

infection which infects the very sinews and

tissues of an organisation with the potential

to be incurable, and bring about the fatality

of an organisation and all the resources,

human and material, within it.

ReferencesAssociation of Business Schools (1997), Guidelines

for the Master of Business Administration

Degree (MBA), ABS, London.

Baker, M. (2002), Company Secretary’s Checklists,

Tolley, Croydon.

Bazerman, M.H., Loewenstein, G. and Moore,

D.A. (2002), ‘‘Why good accountants do bad

audits’’, Harvard Business Review, Vol. 8

No. 11, pp. 97-102.

Beattie, V. (Ed.) (1999), Business Reporting: The

Inevitable Change?, Institute of Chartered

Accountants of Scotland, Edinburgh.

Harrington, A. (2003) ‘‘Honey, I shrunk the

profits’’, Fortune, European Edition, Vol. 147

No. 7, pp. 85-7.

Lai, J. (2002), Company Secretary’s Handbook

2002-2003, 12th ed., Tolley, Croydon.

Lennox, C. (2003), Opinion Shopping and the Role of

Audit Committees when Audit Firms are

Dismissed: The US Experience, Institute of

Chartered Accountants of Scotland, Edinburgh.

Quality Assurance Agency for Higher Education

(2000a), Accounting, QAA, Gloucester.

Quality Assurance Agency for Higher

Education (2000b), General and Business

Management, QAA, Gloucester.

SEEC (1996), Guidelines on Levels and Generic

Level Descriptor, South East England

Consortium for Credit Accumulation and

Transfer, London.

Stonefrost, M.F. (1990), Encouraging Citizenship.

Report of Commission on Citizenship, HMSO,

London.

Stonefrost, M.F. (1994), ‘‘Citizenship: in need of

care and attention’’, Public Money and

Management, October-December, pp. 258.

Vinten, G. (1990), ‘‘Ethics, law and computer’’,

Managerial Auditing Journal, Vol. 5 No. 4,

pp. 5-11.

Vinten, G. (1993), ‘‘The Maxwell interview’’,


pp. 22-4.

Vinten, G. (Ed.) (1994a), Whistleblowing

– Subversion or Corporate Citizenship?,

Sage Publishers, London, and St Martin’s

Press, New York, NY.

Vinten, G. (1994b), ‘‘Materiality and risk: the

babel of auditing?’’, Certified Accountant,

February, pp. 6.

Vinten, G. (2001), ‘‘Shareholder versus

stakeholder – is there a governance

dilemma?’’, Corporate Governance. An

International Review, Vol. 9 No. 1, pp. 36-47.

Vinten, G. (2002), ‘‘The corporate governance

lessons of Enron’’, Corporate Governance,

Vol. 2 No. 4, pp. 4-9.

[ 455 ]



An exploratory study of adopting requirements foraudit committees for non-US commercial bankregistrants: an empirical analysis of foreign equityinvestment

Louis Braiotta, JrSchool of Management, State University of New York, Binghamton,New York, USA

I. Introduction

This study empirically examines the relation

between market capitalization (demand for

oversight protection) of US commercial bank

registrants[1] (SEC Form 10-K filers) with

audit committees and market capitalization

of certain non-US commercial bank

registrants (SEC Form 20-F filers) without

audit committees[2]. In contrast to the legal

requirement for audit committees in the

USA, this paper argues that this inconsistent

requirement produces a high risk premium

for price protection to investors, i.e. non-US

commercial bank registrants are more likely

to establish audit committees because of the

movement toward globalization of capital

markets. Additionally, this paper

investigates whether the presence of audit

committees (oversight protection) for non-US

commercial bank registrants increases their

transparency with a concomitant effect on

infusion of foreign equity investment.

Although the benefits of audit committees in

the corporate governance context have been

recognized, the establishment of audit

committees to attract foreign equity

investment remains a controversial issue[3].

This study is important because investors

should be afforded equal oversight protection

with respect to a reliable financial reporting

process and an efficient global securities

marketplace. The lack of consistent

requirements for audit committees allows

cross-sectional examination of differences in

the aforementioned banks that are within the

same industry, similar in size, and test

period. Recent initiatives to develop

harmonized international accounting and

auditing standards reinforce the need to

achieve uniformity in requirements for audit

committees to ensure oversight protection to

investors. More recently, the International

Auditing Practices Committee (1998, p. 1)

recognized:. . . the auditor’s responsibility to

communicate matters of corporate

governance interest, arising from the audit of

financial statements, to those charged with

governance of an entity.

The committee (1998, p. 6) notes that:It is becoming an increasing practice to form

audit committees of the board to assist in the

governance responsibilities with respect to

financial reporting.

Similarly, the Public Oversight Board has

endorsed a corporate governance approach to

the audit process to enable boards of

directors and their audit committees to be

better informed about the quality of financial

reporting (Kirk, 1996)[4]. Indeed, boards of

directors through their independent audit

committees (non-executive directors) can

more effectively discharge their financial

and fiduciary responsibilities to

shareholders. Powell et al. (1992, p. 220) point

out:As the worldwide financial market expands

and more companies cross national borders to

become listed on major stock exchanges,

major markets will seek consistent reporting

requirements, and audit committee

requirements may tend to become more

consistent across individual markets[5].

To date, existing empirical research in an

agency theory context provides evidence

about the importance of creating audit

committees. Pincus et al. (1989) provide

empirical evidence that situations of high

agency costs were significant factors in the

creation of audit committees. They concluded

that the presence of audit committees:. . . enhance the quality of information flows

between principal and agent (Pincus et al.,

1989, p. 265).





[ 456 ]



KeywordsAudit committees,

Boards of directors,

Corporate governance,

United States of America

AbstractThis study examines whether the

presence of audit committees for

US commercial bank registrants

(SEC Form 10-K filers)

significantly affects the likelihood

of adoption by certain non-US

commercial bank registrants (SEC

Form 20-F filers). Results of a

logistic regression analysis of 31

US commercial bank registrants

with audit committees and 31

non-US commercial bank

registrants without audit

committees suggest that demand

for oversight protection in the

sample non-US commercial banks

is more likely to increase as the

total market capitalization (size)

increases. Additionally, this paper

investigates whether the presence

of audit committees for non-US

commercial bank registrants

(Form 20-F filers) increases their

transparency with a concomitant

effect on infusion of foreign equity

investment. Results of a logistic

regression analysis suggest that

the presence of audit committees

does not significantly affect the

likelihood of an increase in the

banks’ American depository

receipts.

Similarly, in the UK, Collier (1993, p. 428)

concluded:. . . the number of shareholders support the

contention that the incentive to form an audit

committee increases in line with the potential

agency cost of equity.

Although these two studies examined the

creation of audit committees within a

country, Braiotta (1998, p. 179) investigated

the market capitalization of the stock

exchange(s) with and without audit

committees in 25 countries and concluded

that:. . . the empirical evidence suggests that

oversight protection is more likely driven by

the effects of increases in total market

capitalization (size).

Because the current mandate for the

establishment of audit committees is

inconsistent among non-US commercial bank

registrants and consistent among US

commercial bank registrants, this study

examines the annual market capitalization

as the primary variable of interest to

estimate the likelihood of the presence of

audit committees in the sample non-US

commercial banks without audit committees.

Fiscal years 1996 and 1997 were selected

because of the gravity toward a global

securities marketplace (International

Federation of Accountants, 1995) along with

access to recent available data.

In addition to the aforementioned

empirical research, researchers (Mautz and

Neumann, 1970; 1977; Tricker, 1978; Birkett,

1986; Braiotta, 1986; Marrian, 1988; English,

1989; Spangler and Braiotta, 1990; Bull, 1991;

Knapp, 1991; Porter and Gendall, 1992;

Verschoor, 1993; Kalbers and Fogarty, 1993;

Braiotta, 1994) have examined the role,

responsibilities, and the primary

determinants of the audit committees’

effectiveness, such as independence and

active oversight of the financial reporting

process. Indeed, researchers have concluded

that vigilant audit committees help engender

a high degree of integrity in both the audit

processes and financial reporting

disclosures. While these studies support the

proposition that effective independent

oversight protection helps to ensure a

reliable financial reporting system and in

turn, an efficient international capital

marketplace, none has examined the issue of

whether the demand for oversight protection

is likely to differ between US commercial

bank registrants and non-US commercial

bank registrants. Additionally, none of the

above studies has examined the issue of

whether the demand for oversight protection

is likely to differ among non-US commercial

bank registrants with audit committees and

those registrants without audit committees.

During the first phase of this study, a

logistic regression analysis is used to

estimate the likelihood of the presence of

audit committees (oversight protection)

based on the observed differences in the book

values of total assets, total equity, and total

market value of equity between 31 US

commercial bank registrants and 31 non-US

commercial bank registrants that are similar

in size and within the same industry. In the

second phase, a logistic regression analysis is

used to test the hypothesis that the demand

for oversight protection based on market

capitalization is more likely to increase for

non-US commercial bank registrants without

audit committees compared to non-US

commercial banks with audit committees.

Additionally, a logistic regression model is

used to test the hypothesis that non-US

commercial bank registrants without audit

committees are less likely to have the same

level of American depository receipts than

non-US commercial bank registrants with

audit committees.

With respect to the first phase of the study,

results of a logistic regression analysis of the

aforementioned sampled banks suggest that

demand for oversight protection in the

non-US commercial banks is more likely to

increase as the total market capitalization

(size) increases. In the second phase, results

of logistic regression suggest that the

presence of audit committees does not

significantly affect the likelihood of an

increase in the banks’ American depository

receipts. This paper contributes to the extant

literature by estimating the requirements for

audit committees for non-US commercial

bank registrants and testing whether the

presence of audit committees significantly

effects the likelihood of attracting foreign

equity investments (American depository

receipts).

The remainder of this paper is organized as

follows: Section II provides the theory and

hypotheses development. Section III

describes the sample selection and Section IV

discusses the research design and empirical

results. Section V concludes the paper.

II. Theory and hypothesisdevelopment

Prior research has examined audit

committees drawing upon the concepts from

legal theory and agency theory in the context

of enhanced corporate governance. For

example, Sommer (1978), ABA (1994), ALI

(1994), Braiotta (1994) argue that

[ 457 ]

Louis Braiotta, JrAn exploratory study ofadopting requirements foraudit committees for non-UScommercial bank registrants:an empirical analysis offoreign equity investment


establishment of audit committees is in

response to the investing public’s increased

demand for corporate accountability through

effective oversight of both the audit processes

and financial reporting process. This stream

of legal research has recognized that boards

of directors through their audit committees

can effectively discharge their legal fiduciary

responsibilities to the stockholders. To the

extent that audit committees help boards

discharge their financial and fiduciary

responsibilities, shareholders and potential

investors are afforded a reliable financial

reporting system which, in turn, helps to

ensure an efficient global securities

marketplace. Thus, because boards and their

standing committees have a statutory duty of

care and loyalty in their fiduciary capacity

with the corporation (New York Business

Corporation Law, 1963), the investing public

is afforded oversight protection which helps

minimize a high risk premium for price

protection. Moreover, the fiduciary

responsibility of boards of directors in other

countries is definitively established (Fogarty,

1965). The universal acceptance of the

fiduciary principle and the board’s

stewardship accountability to shareholders

serves as a normative model of corporate

oversight protection for investors. Cook

(1993, p. 43) notes:These committees add considerable value to

the quality and credibility of our financial

reporting process. Their oversight of auditing

functions and of a company’s internal control

system helps to protect shareholder interests

by keeping business on the straight and

narrow.

Ceteris paribus, these arguments suggest that

national stock exchange(s) are more likely to

adopt audit committees to increase

transparency in their member firms as well

as help minimize litigation risk.

In the context of agency theory (Jensen

and Meckling, 1976) which is a descriptive

theory of agency costs (e.g. internal and

external audit costs) produced by the

inherent conflict of interests between

owners (principals) and management

(agents), researchers (Watts, 1977; Leftwich

et al., 1981) present evidence that the quality

of external reporting and related auditing

process can reduce agency costs. Pincus et

al. (1989, USA) and Collier (1993, UK)

investigated the voluntary formation of

audit committees using agency theory and

found evidence that suggests firms with

high agency costs will voluntarily form

audit committees to ensure the quality of

audit processes and financial reporting

disclosures. This second stream of research

suggests that as the number of stockholders

increases, the motivation to establish audit

committees increases because of the risk of

greater conflicts of interest between

principals and agents. Ceteris paribus, these

arguments suggest that the formation of

audit committees is responsive to the

investing public’s demand for oversight

protection. Hence, the aforementioned

discussion advances the following

hypotheses (stated in the alternative form):

H1. The demand for oversight protection

based on market capitalization (size) is

more likely to increase for non-US

commercial bank registrants without

audit committees compared to US

commercial bank registrants with

audit committees.

H2. The demand for oversight protection

based on market capitalization (size) is

more likely to increase for non-US

commercial bank registrants without

audit committees compared to non-US

commercial bank registrants with

audit committees.

H3. Non-US commercial bank registrants

without audit committees are less

likely to have the same level of ADR

activity than non-US commercial

banks with audit committees.

III. Sample selection anddescription

Sample selectionDuring the first phase of the sample selection

process, the sample consists of 31 US

commercial bank registrants with audit

committees (SIC code 6021) and 31 non-US


committees (SIC code 6029) matched by total

assets in US currency for fiscal years ended

31 December 1996 and 1997[6]. Banks

satisfying the three following criteria are

included in the sample:

1 The annual SEC Form 10-K reports and

SEC Form 20-F reports are available from

the CD-disclosure data base.

2 The market values of equity are available

from disclosure’s global sccess and

Datastream data bases.

3 The market values of the American

depository receipts are available from

Compustat’s annual bank tape and

Datastream data bases.

The final choice-based sample of 31 non-US


committees is based on the number of SEC

Form 20-F filings for the above test periods.

In the second phase, the sample consists of 46

non-US commercial bank registrants which

[ 458 ]



filed SEC Form 20-F in the aforementioned

sample period. Of the 46 banks, 15 (33 per

cent) represent non-US commercial bank

registrants with audit committees because of

the authoritative literature as shown in the

Appendix. Panel A in Table I and panel B in

Table II provide descriptive statistics for

both the univariate tests and multivariate

test of the hypotheses in the first and second

phases of the study.

IV. Empirical results

Univariate testsTables I and II provide summary descriptive

statistics for the independent variables used

to test the aforementioned hypotheses. Panel

A in Table I compares variables for US

commercial bank registrants with audit

committees and non-US commercial bank

registrants without audit committees[7],

while Panel B in Table II compares non-US

commercial bank registrants with and

without audit committees[8]. As reported in

panel A, the difference in mean market value

of equity is statistically insignificant over the

sample period (p=0.16). Similarly, the

Wilcoxon Z statistic (z=0.07) reveals no

significant difference at conventional levels

of significance. This result suggests that the

demand for oversight protection associated

with US commercial bank registrants with

audit committees is not significantly

Table IPanel A: Distribution of means and standard deviations and comparison of US commercial bankswith audit

US commercial banks withaudit committees (n = 31)

Non-US commercial banks wihtoutaudit committees (n = 31) Between sample banks

Variablea Mean Std. dev. Mean Std. dev. t-test Wilcoxon Z-value

1996BVA 4.122 0.989 4.081 0.909 0.172 0.38BVE 3.025 0.909 2.599 1.260 1.504 1.72MVE 3.327 0.969 2.949 1.130 1.426 1.341997BVA 4.196 0.988 4.141 0.925 0.225 0.39BVE 3.101 0.917 2.611 1.188 1.786 1.99MVE 3.540 0.966 3.057 1.161 1.799 1.80

Notes: Paired t-tests for means and Wilcoxon z-values were computed and no statistically significant differenceswere found; a All means and standard deviations are stated in log $ millions. Each variable is defined as follows:BVA=The natural logarithm of the book value of total assets at the end of fiscal years 1996 and 1997;BVE=The natural logarithm of the book value of common equity at the end of fiscal years 1996 and 1997;MVE=The natural logarithm of the market value of common equity at the end of fiscal year 1997 and 1997; andADR=For panel B, the natural logarithm of the market value of American Depository Receipts at the end of fiscalyears 1996 and 1997

Table IIPanel B: Distribution of means and standard deviations and comparison of non-US commercialbanks with and wihout audit commitees

US commercial banks withaudit committees (n = 31)

Non-US commercial banks wihtoutaudit committees (n = 31) Between sample banks

Variablea Mean Std. dev. Mean Std. dev. t-test Wilcoxon Z-value

1996BVA 4.830 0.841 4.081 0.909 2.67** 2.91**BVE 3.703 0.423 2.599 1.260 3.17*** 3.08**MVE 3.639 1.241 2.949 1.130 1.88 2.89ADR 3.700 0.784 3.089 0.917 2.01** 1.48*

1997BVA 4.864 0.833 4.141 0.925 2.50** 2.76**BVE 3.726 0.419 2.611 1.188 3.38*** 3.30**MVE 3.759 1.250 3.057 1.161 1.87 2.96ADR 3.624 1.009 3.208 0.913 1.32** 1.48

Notes: a see Table I; Model chi-square = 15.748, d.f. 3, p = 0.0013; *, ** Statistically significant at less thanthe 0.05, 0.01 level, based on two-sided tests

[ 459 ]



different for non-US commercial bank

registrants without audit committees. This

finding is consistent with the arguments

presented in the theory section and

consistent with H1.

As shown in Panel B, there is no significant

difference in the mean market value of equity

reported by the non-US commercial bank

registrants with and without audit

committees (p=0.07). The z-value reveals no

significant difference in these proportions.

However, the univariate tests reveal an

association between the independent

variable (ADR) and banks with and without

audit committees, indicating the need for

multivariate tests. As noted in panel A, the

insignificant differences in the MVE

variables suggest that the demand for equal

oversight protection is strengthened. This

finding is consistent with H2 on a univariate

basis.

Multivariate testsThe following logistic regression model was

used to estimate the likelihood of the

presence of audit committees (oversight

protection) with respect to non-US


committees (see panel A of Table III):

AUDCOMMit ¼ B0 þ B1logðBVAitÞ

þB2logðBVEitÞ þ B3logðMVEitÞ þ Eit; ð1Þ

where it = banks and years; AUDCOMMit =

0/1 dummy variable set to one if the bank has

an audit committee; log(BVAit) =natural

logarithm of the book value of total assets at

the end of fiscal years 1996 and 1997;

log(BVEit) =natural logarithm of the book

value of total equity at the end of fiscal years

1996 and 1997; log(MVEit) =natural logarithm

of the market value of common equity at the

end of fiscal years 1996 and 1997; and E= the

residual.

Panel A and panel B of Table III summarize

the logistic regression results for the sample

periods. In order to test H3, American

depository receipts (ADRs) are included in

the aforementioned logistic regression model

as an independent variable. This variable is

included to determine whether the presence

of audit committees could explain the

difference between non-US commercial bank

registrants with and without audit

committees and their related levels of ADRs.

This regression test provides insight on the

effect of audit committees on the banks’

ability to attract foreign equity investment.

As predicted, the coefficient for the MVE

variable (size) is positive and significant at

the level p=0.02. This variable indicates that

oversight protection is more likely to

increase as the total market capitalization

increases. This result is consistent with H1

on a univariate basis. While the coefficient of

the MVE variable in panel B is positive, it is

not significant (p=0.45) because of the small

sample size of 15 non-US commercial banks

with audit committees. This result is not

consistent with H2 on a univariate basis.

The sign of the ADR coefficient is negative

and insignificant (p-value= 0.20), suggesting

that the presence of audit committees has no

significant effect on the likelihood of higher

levels of ADRs. Thus, the results are not

consistent with H3. As noted above, this

finding is likely affected by noting the small

sample size of 15 non-US commercial banks

with audit committees and 31 non-US

commercial banks without audit

committees[9].

The other independent variables, BVA and

BVE are not significant at conventional

levels. This result is not surprising since

there is not a great deal of variation between

the non-US banks with and without audit

committees. This result suggests that the

argument for equal oversight protection is

strengthened.

V. Conclusions

This study empirically examines the

question of whether the demand for equal

oversight protection from the investing

public through the adoption of audit

committees for US commercial bank

registrants affects non-US commercial bank

registrants without audit committees. The

evidence suggests that there is no difference

in the mean demand for oversight protection

between the aforementioned banks. The

logistic regression results indicate that the

market value of equity (size) is a predictor of

oversight protection. The results of the

multivariate test also indicate that the

presence of audit committees is less likely to

attract foreign equity investment; however,

the mean differences in the ADRs between

the non-US banks with audit committees and

non-US banks without audit committees are

statistically significant on a univariate basis.

While results reported in this study

provide empirical evidence for the formation

of audit committees by certain non-US

commercial bank registrants, additional

research is necessary to determine the

likelihood of attracting foreign equity

investment through the formation of audit

committees. Given a changing global

securities marketplace and demands from

the investing public for increased corporate

governance and accountability, future

[ 460 ]



research is needed about the processes

associated with the formation of audit

committees and transparency in the

securities marketplace with a concomitant

effect on attracting foreign equity

investment.

Notes1 In 1991 the US Congress passed the Federal

Deposit Insurance Corporation Improvement

Act which requires insured depository

institutions (total assets of $150 million or

more) to establish independent audit

committees. In addition, both the New York

Stock Exchange (1983) and the National

Association of Securities Dealers (1987)

require their domestic listed companies to

maintain audit committees.

2 In this study, the presence of audit committees

is used as a proxy variable for oversight

protection.

3 To date, a number of stock exchanges(s) have

adopted audit committees to increase

transparency and corporate governance of

their member firms (see Appendix). Whether

this requirement for audit committees has led

to an increase in attracting foreign equity

investment is not well established. This study

addresses the claims of proponents that the

stock exchanges’ listing requirement for audit

committees significantly affects the likelihood

of receiving significantly higher percentages

of foreign equity investment than banks

without audit committees. For example, a

number of stock exchanges have recently

amended their listing requirements in order

to establish audit committees (e.g. Kuala

Lumpur Stock Exchange, 1995; Hong Kong

Stock Exchange, 1998; Stock Exchange of

Thailand, 1999).

4 The Blue Ribbon Committee on Improving the

Effectiveness of Corporate Audit Committees

(1999, p. 31) recommends that the listing rules

for both the New York Stock Exchange and the

National Association of Securities Dealers

require that ‘‘the audit committee charter for

Table IIILogistic regression results between the dichotomous dependent variable audit committees andthe independent variables

Term Variable Coefficients t-statistics

Panel A: US commercial banks with audit committees and non-US commercial banks without audit committeesAUDCOMMit ¼ B0 þ B1logðBVAitÞ þ B2logðBVEitÞ þ B3logðMVEitÞ þ �itModel �2 =9.324; df = 3; p=0.02531996 (n=31)

B0 Intercept 1.932 1.75B1 log (BVA) –2.450 4.31**B2 log (BVE) 1.108 1.63B3 log (MVE) 1.582 2.15*

Model �2 =15.748; df =3; p=0.00131997 (n=31)

B0 Intercept 1.966 1.88B1 log (BVA) –3.635 7.91**B2 log (BVE) 1.050 1.45B3 log (MVE) 3.026 4.808*

Panel B: Non-US commercial banks with audit committees (n =15) and non-US commercial banks without auditcommittees (n =31)AUDCOMMit ¼ B0 þ B1logðBVAitÞ þ B2logðBVEitÞ þ B3logðMVEitÞ þ B4logðADRitÞ þ �itModel �2 =17.697; df =4; p=0.00141997

B0 Intercept –9.726 3.30*B1 log (BVA) 1.847 0.56B2 log (BVE) 1.340 0.73B3 log (MVE) 0.884 0.10B4 log (ADR) –2.112 1.02

Model �2 =22.270; df =4; p=0.00021996

B00 Intercept –10.837 4.68B11 log (BVA) –1.891 0.21B22 log (BVE) 3.761 1.54B33 log (MVE) 3.347 0.55B44 log (ADR) –1.861 1.62

Notes: *, ** Statistically significant at less than the 0.05, 0.01 level, based on two-sided tests

[ 461 ]



every company specify that the outside

auditor is ultimately accountable to the board

of directors and the audit committee, as

representatives of shareholders’’.

5 Powell et al. (1992) found in their

cross-cultural study of international

professionalism in the practice of internal

auditing by members of the Institute of

Internal Auditors wide adherence to the

Internal Auditing Standards promulgated by

the Institute. Additionally, the International

Task Force on Corporate Governance

concluded: ‘‘Given the development of the

global market, the inevitable expansion of

screen-based information and growth of

cross-border investment activity, corporate

behavior is coming under the scrutiny of an

increasingly large number of interested

parties. We can discern from our research that

the practice of other jurisdictions has clearly

brought about a natural process of

convergence’’. Examples include the

development of audit committees, first in the

USA and Canada and now common-place in

the UK, and being considered in Germany.

(International Task Force on Corporate

Governance, 1995, pp. 9-10).

6 In this study, the non-US commercial bank

registrants are the largest publicly traded

foreign banks in the USA. Total assets were

$3,851 billion ($4,353 billion) for 1996 (1997).

7 The data indicate a wide range of bank size

with BVA of $3.7 billion ($4.6 billion) at the

25th percentile compared to $61.1 billion ($72.3

billion) at the 75th percentile of the

distribution for 1996 (1997). The range

associated with BVE and MVE also reveals

substantial cross-sectional variation in bank

size (n=62: 31 with and 31 without audit

committees).

8 The data also indicate a wide range of bank

size with BVA of $4.1 billion ($4.8 billion) at

the 25th percentile compared to $125.9 billion

($147.0 billion) at the 75th percentile. The

range associated with the other independent

variables reveals substantial cross-sectional

variation in bank size (n=46: 15 with and 31

without audit committees).

9 To consider the possible significance of the

presence of audit committees and level of

ADRs in the sample banks, a sub-sample of 15

matched non-US commercial banks without

audit committees are compared to 15 non-US

commercial banks with audit committees. The

logistic regression model for the sub-sample

banks (n=30) is shown in panel B in Table III.

Logistic regression analysis (not reported)

indicates that the presence of audit

committees does not have a significant effect

on the likelihood of higher levels of ADRs. As

noted previously, the results are likely

affected by the relatively small sample size.

Additionally, the sample was sub-divided

based on more than the median market value

of equity. The logistic regression results (not

separately reported) indicate that the presence

of audit committees does not have a

significant effect on higher levels of ADRs.

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(The Appendix appears overleaf.)

The author wishes to thankthe conference participantsat the 1999 Asian-PacificInternational AccountingIssues Conference inMelbourne, Australia; the2000 AAA annual mid-yearInternational Sectionmeeting in Tampa, FL; andthe 2000 AAA annualNortheast meeting inBoston, MA for their usefulcomments on this paper.

[ 463 ]



Appendix

Table AISummary of requirements and/or recommendations for audit committees of companies listed onstock exchanges by country

Country Reference

Australia Working Group on Corporate Practices and Conduct (Borsch Committee), CorporatePractices and Conduct, 1990

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US Federal Sentencing Commission, Federal Sentencing Guidelines for Organizations,1991

[ 464 ]



Developing a strategic internal audit-human resourcemanagement relationship: a model and survey

MaryAnne M. HylandSchool of Business, Adelphi University, Garden City, New York, USADaniel A. VerreaultSchool of Business, Adelphi University, Garden City, New York, USA

Introduction

Achieving competitive advantage is an

increasingly important focus for firms today.

Although business strategy as a means of

competition is common conversation in the

executive suite, taking a strategic approach

can be especially beneficial for staff functions

within companies, as they often are required

to justify their need for resources and their

contribution to the company since they do

not directly report a profit or loss. Two such

staff areas are internal audit (IA) and human

resource management (HRM). The practices

and systems used within these areas may

have a profound, albeit indirect, effect on

company performance. In terms of HRM,

there is a growing recognition that human

capital and the impact of related HRM

practices are critical to an organization’s

success (e.g. Kling, 1995; Pfeffer, 1998;

Fitz-enz, 2000; Schmitt, 2002).

The present study cites prior evidence on

the competitive advantage of certain HRM

practices; proposes a model of how IA and

HRM functions might operate to achieve

maximum effectiveness; and examines the

relationship between IA and HRM functions

in a sample of organizations.

IA works with other functional units in the

organization by the very nature of the

profession. Internal auditors assess the risks,

internal controls, processes, practices, and

performance of functions such as marketing,

human resources, and production. IA is

under pressure to become more strategic in

an attempt to help organizations achieve

competitive advantage. The traditional

approach to internal auditing has been one of

policy and internal control compliance with

an emphasis on efficiency measures.

Although the traditional role remains a

critical part of IA today, organizations are

demanding that an audit also looks beyond

costs and compliance to the overall risk

profile of the audit subject. IA’s risk profile

model should include compliance,

operational, and strategic risks. Both upside

risk (opportunity for gain) and downside risk

(potential for loss) are relevant elements of

strategic risk. The risk management

paradigm, expressly including strategic risk,

increasingly permeates the audit planning

process of IA organizations (McNamee and

Selim, 1999; Tillinghast-Towers Perrin, 2001).

According to a survey by Tillinghast-Towers

Perrin (2001), 90 percent of IA functions

conduct risk-based audits at the business

unit level. However, in terms of

comprehensive risk assessments, less than

half consider strategic risk. Moreover, while

63 percent of respondents indicated that the

finance function had a formal risk

identification and assessment process, only

21 percent reported using the same rigorous

process related to the HRM function

(Tillinghast-Towers Perrin, 2001). However,

organizations consider human capital as

critical, with a recent survey of executives

ranking ‘‘people/intellectual capital’’ first (in

a tie with ‘‘reputation/rating’’) as the most

important out of 29 sources of risk going

forward (Tillinghast-Towers Perrin, 2001).

Progressive HRM functions are attempting

to demonstrate the link between HRM

practices and organizational performance.

However, we believe that the actual inroads

in practice lag the research findings. In the

past, HRM, known as ‘‘personnel

administration’’ was focused on

administrative tasks and lacked strategic

orientation. Today, an increasing number of

organizations now develop and use human

resource practices as a source of competitive

advantage. Theoretical developments, case

studies, and several key empirical studies

provide the underpinning for what is known





[ 465 ]



KeywordsInternal auditing,

Human resources management,

Risk management

AbstractPresents a model for analyzing the

potential for value creation of the

internal audit (IA) function, the

human resource management

(HRM) function, and the IA-HRM

pairing. A survey of 161 chief audit

executives indicated that virtually

all IA functions are risk managing

in their audit approaches, while a

great majority of HRM clients are

also moderately or strongly

strategic in their outlook. Findings

included that a productive working

relationship was strongest when a

risk managing IA function is paired

with a strategic HRM function.

Also, the IA planning process was

found to be more strategic in the

presence of the same pairing.

Analysis of written examples of

strategic findings related to HRM

supplied by the respondents

suggested that there may be a

significant gap between auditors’

knowledge of strategic HRM

practices as developed in the

literature and their self-reported

examples. Future research should

use both HRM and IA responses to

reduce bias. Additionally, there is

a need for case studies of the

IA-HRM partnership.

as ‘‘strategic human resource management’’

(SHRM). The purpose of this paper is to

explore the relationship between IA and

HRM and the potential for a value-adding

partnership between IA and HRM functions.

Risk managing and control focusedinternal auditing functions

IA faces challenges and opportunities on

three fronts. First, the IA profession is

responding to the paradigm shift from a

compliance and control-oriented model to a

risk managing model (McNamee and Selim,

1999). Second, IA functions must respond to

the demand from corporate boards for a

value-adding philosophy. Third, IA confronts

an array of internal clients whose service

needs vary. Excellence in client service

requires a rich understanding of client needs.

Driven by the risk managing paradigm,

corporate requirements, and client needs, IA

needs to develop and defend its own value

proposition.

Because of its expertise in risk

management and financial measurement, IA

can help clients develop their own value

proposition in the context of risk

management and can provide clients with

help in linking the client’s value proposition

to firm goals. Depending on client

characteristics and audit team

characteristics, IA may not be uniformly

successful across all clients (Verreault,

1984)[1]. In particular, in the HRM area, we

believe that IA must be aware of the research

that describes practices that may yield

competitive advantage and that use new

measurements to demonstrate value creation

in the HRM area (Verreault and Hyland,

forthcoming). Only with such knowledge can

IA provide HRM with value-added by being

either a synergistic partner to a strategic

HRM function or a motivator for positive

change with a non-strategic HRM function.

Strategic and non-strategic HRMfunctions

In the past, administrative activities

dominated HRM, consisting largely of

recordkeeping and maintenance activities.

Management considered personnel a

necessity, but one which added little value to

the organization in terms of productivity or

profitability. Most of the early research on

personnel focused on issues affecting

individuals, such as employee testing and

training (Ferris et al., 1999). The evolution

from personnel management to HRM was

more than simply a change in name. Rather,

it represented a conceptual change from

thinking of employees in an organization as

personnel (perhaps a cost to be minimized),

to resources that bring value to the

organization. However, it was not until

SHRM developed in the late 1980s and 1990s

that HRM began to gain credibility as a

source of competitive advantage.

SHRM stemmed from theoretical

arguments that an organization’s human

resources can be a source of sustainable

competitive advantage for the organization

(e.g. Wright and McMahan, 1992). Although

other resources, such as a new product

design, also can be sources of competitive

advantage, human resources are the more

sustainable competitive advantage because

they are somewhat difficult for other

organizations to imitate (Barney, 1991).

Staffing, training, compensation, and other

policies used by an organization may

differentiate the human resources at one

organization from those at another

organization. Indeed, groups of such

practices working together may be a source

of competitive advantage. Another

perspective on SHRM suggests that fit

between HRM practices and the strategic

goals of the company is vitally important

(Butler et al., 1991). All three approaches,

adopting certain HRM practices, grouping

synergistic HRM practices, and establishing

strategic fit between HRM practices and firm

strategy, assert that SHRM goes beyond

looking at the implications of traditional

individual HRM activities. There is general

agreement among scholars that SHRM

involves designing and implementing

internally consistent policies and practices

that enable an organization’s human

resources to contribute to the achievement of

business objectives (Huselid et al., 1997).

Research suggests that there is indeed a

relationship between a company’s human

resources and its performance. Using a US

sample, Huselid (1995) found that groups of

high performance work practices were

related to decreased turnover, increased

productivity, and enhanced corporate

financial performance. For example, use of

certain strategic HRM practices related to

more than a $7,000 profit increase per

employee net of the cost of the practices

(Huselid, 1995). Other studies also have found

support for the notion that progressive work

practices have more of an effect on the

bottom line when used as a group than when

adopted in isolation (e.g. Ichniowski et al.,

1997; Kling, 1995). Watson Wyatt Worldwide

(2002) examined human resource practices

over time to determine that such practices

are a leading indicator of corporate financial

[ 466 ]

MaryAnne M. Hyland andDaniel A. VerreaultDeveloping a strategicinternal audit-human resourcemanagement relationship:a model and survey


performance, rather than simply being

correlated with company performance.

Despite the evidence suggesting the

importance of HRM practices in achieving

competitive advantage, most organizations

are not measuring the financial impact of

these practices. One reason may be the

difficulty of doing so (Becker et al., 2001). As

acknowledged by a chief financial officer,

part of the reason for the failure to

adequately measure human resources

outcomes is the inability of traditional

accounting practices to make this link

readily apparent (Becker et al., 2001, p. 10).

The measurement issue creates a

tremendous opportunity for HRM and IA to

work together to determine the value-added

by various HRM practices. Several authors

have written books on metrics to guide

companies in measuring the cost and/or

effectiveness of HRM practices (e.g. Becker

et al., 2001; Cascio, 2000; Fitz-enz, 2000).

Although professional organizations have

endorsed such books, the question remains

as to whether organizations are taking

seriously the message of thinking

strategically and measuring the effectiveness

of HRM practices. Thus, we see an

opportunity for implementing strategic

practices that meet both the aspirations of

the risk managing IA function and the

strategically-oriented HRM organization.

Proposed frameworkWe set forth a framework for studying the

combined strategic impact of IA systems and

HRM systems (see Figure 1). The upper right

and lower left quadrants suggest a match in

the approaches of IA and HRM. We call these

combinations ‘‘value-creating’’ and

‘‘cost-minimizing’’, respectively.

Value-creating IA/HRM dyads are found

when a risk managing IA function is found in

the same organization as a strategic HRM

function. Cost-minimizing IA/HRM dyads

exist when a compliance-focused IA function

exists in the same organization as an

administratively-focused HRM function. The

remaining two possible combinations

indicate a lack of a complementary function.

The lower right hand quadrant depicts a risk

managing IA function paired with an

administrative HRM function; we call this a

‘‘motivating’’ combination. The upper right

hand quadrant depicts a compliance-focused

IA function paired with a strategic HRM

function; we call this a ‘‘limiting’’

combination. The terms ‘‘motivating’’ and

‘‘limiting’’ reflect our estimate of the likely

impact of IA on HRM (e.g. a risk managing IA

function may act as a motivator for an

administratively focused HRM function).

We discuss each quadrant in greater detail

below and suggest financial outcomes that

should be examined in future research. The

research questions that we will focus on

relate most closely to the relationship aspects

of the IA-HRM partnership. We acknowledge

that other aspects of the internal and

external organizational environment may

affect the relationships and financial

outcomes we propose; therefore the

statements we make should be considered

with these other factors (e.g. support from

upper management, approval of the board of

directors) taken into account.

Value-creating combinationWhen a risk managing IA function coexists

with a strategic HRM function, both of these

areas strive to assist the organization in

achieving competitive advantage. When the

HRM function uses high performance work

practices, such as incentive compensation

systems and extensive employee training

(Huselid, 1995), or other practices that fit

with the company’s overall business

strategy, risk managing internal auditors

look at the value of these practices (the

strategic upside), rather than focusing solely

on operational efficiency and/or policy

compliance. Through such an approach, IA

informs the human resources function by

providing a cost/benefit analysis of the

practices, and IA benefits by creating a

receptive client who is concerned with

strategic business risks. Assuming an

environment of top management support for

SHRM practices, and a productive working

relationship between IA and HRM, the result

of a partnership between a risk managing IA

and a strategic HRM function should be

enhanced financial performance.

Figure 1The proposed framework

[ 467 ]



Cost-minimizing combinationWhen a compliance-focused IA function

exists in the same organization as an

administratively-focused HRM function,

neither area is targeting competitive

advantage. Rather, both areas emphasize cost

control and compliance. In an administrative

HRM function, work practices that are

legally required are considered to be most

important; whereas ‘‘voluntary’’ practices

are considered to be extras that are the first

to be cut when budgets are depleted, without

measurement of the value these practices add

to the company. In a compliance-focused IA

function, emphasis is placed on following the

rules and procedures of the company. The

benefits from alternative policies and

procedures may easily be overlooked. We

propose that these combined practices will

not have a positive effect on the financial

performance of the company because neither

IA nor HRM is concerned with value-added

practices, but rather with operational

compliance.

Motivating combinationWhen a risk managing IA function exists in

the same organization as an

administratively-focused HRM function, IA

can serve as a motivator for HRM to think

more strategically by examining the

value-added from various human resource

practices and procedures. However, it may

take a while for the HRM function to adopt

the recommendations of IA and take the

initiative to implement strategic practices

and procedures. If HRM does take on such

initiatives, they will move towards the

value-creating combination. Until that time,

however, the company’s financial

performance will be lower than its potential

due to HRM’s lack of a strategic orientation.

We recognize that in times of organizational

stress both HRM and IA can take on a

punitive role which may undermine the

ability of IA to act as a motivator.

Limiting combinationWhen a compliance-focused IA function

exists in the same organization as a strategic

HRM function, the IA function does not add

strategic value to the human resources

function by examining the impact of various

human resources practices and procedures

on the company’s bottom line and the fit with

company strategy. The synergies created in

the value-added quadrant are not achieved,

and the limiting combination does not lend

itself to moving towards the value-creating

combination because HRM will not likely

influence the overall approach used by IA.

Therefore, we predict that the company’s

financial performance will be limited by the

lack of synergy between IA and HRM and the

fact that IA cannot assist human resources in

examining the strategic value of their

practices and procedures. HRM could still

operate strategically without the guidance of

a risk managing IA function; however, the

potential to reach maximal strategic

effectiveness would be limited because IA

could provide expertise in the area of

financial measurement of HR outcomes and

independent support of the strategic value of

HRM practices.

Research questions

We consider several research questions that

stem from the proposed framework that

relate to the performance of IA in relation to

HRM. The questions focus on the

relationship between IA and HRM from the

point of view of IA, as well as questions

related to the extent of strategic focus in

audit planning and reporting. Our first

question concerns the strength of the

relationship between HRM and IA. We

predict that the best relationships will exist

when the functions match to a high degree.

We predict that the working relationship will

be best for the value-creating combination

because of the focus of both functions on

important strategic concerns. We also predict

that the next best working relationship will

be for the cost-minimizing combination,

since both functions share a similar mindset.

We predict that the relationship will be worst

for the motivating and limiting quadrants

because of the lack of match.

RQ1a. The strength of the working

relationship between HRM and IA

will be strongest for the value

creating combination, followed by

the cost-minimizing combination.

An alternative way of examining the strength

of the relationship is to look not only at the

quadrant which depicts a combined measure,

but at the strategic extent of HRM and the

risk managing extent of IA considered

separately. Independent analysis allows us to

examine the discrete effects of HRM and IA,

rather than the results of the two paired

together in a quadrant. We predict that the

working relationship will be strongest when

HRM is strategic and IA is risk managing for

all of the reasons that are listed above.

RQ1b. A strategic approach to HRM and a

risk managing approach to IA, each

considered independently, will have

positive effects on the strength of

the working relationship between

IA and HRM.

[ 468 ]



Another question concerns the extent to

which the audit planning process reflects

strategic HRM concerns. We predict that the

value-creating combination will have the

highest scores, with the motivating quadrant

having the second highest scores, due to the

fact that for IA functions in this quadrant,

risk managing issues are important. Thus,

although the process should most highly

reflect strategic HRM concerns when the

HRM function is strategic, simply having a

risk managing IA function should influence

the strategic nature of the reports, even when

HRM is not strategic.

RQ2a. The strategic nature of the IA

planning process will be strongest

for the value-creating combination,

followed by the motivating

combination.

Again, an alternative way of examining this

issue is to look not only at the quadrant, but

at the strategic extent of HRM and the risk

managing extent of IA. We predict that the

extent to which the planning process reflects

strategic HRM concerns will be highest when

HRM is strategic and IA is risk managing.

RQ2b. A strategic approach to HRM and a

strategic approach to IA, each

considered independently, will

positively affect the strategic nature

of the IA planning process.

Another question concerns the extent to

which the actual audit reports reflect

strategic HRM concerns. We predict that the

value-creating combination will have the

highest scores, with the motivating quadrant

having the second highest scores, due to the

fact that for audit functions in both of these

quadrants, strategic issues are important.

RQ3a. The strategic nature of audit

reports will be strongest for the

value-creating combination,

followed by the motivating

combination.

We also propose examining the strategic

nature of audit reports as a function of the

strategic extent of HRM and IA. As with the

planning process, we predict that the extent

to which the reports reflect strategic HRM

topics will be positively affected by the

strategic extent of HRM and IA.

RQ3b. The more strategic HRM’s approach

and the more risk managing IA’s

approach, each variable considered

independently, the more that the

audit reports will reflect strategic

HRM concerns.

Methodology

To examine the perspectives of IA managers

regarding the proposed model, we designed a

survey that asked chief audit executives

(CAEs) about various aspects of the strategic

and compliance foci of their organizations

and their perceptions of the same variables

for the HRM function in their firms. The

sampling frame consisted of 1,200 CAEs who

were members of the Institute of Internal

Auditors and had subscribed to participate in

selected surveys of interest to the profession.

QuestionnaireThe survey questions, which used a

five-point Likert scale format, were

developed by the authors based on the

proposed model. The questions asked about

the extent of strategic and administrative

focus for HRM, and the extent of risk

managing and compliance focus for IA. For

IA functions, the questionnaire used the term

‘‘strategic’’ to direct the respondents towards

value-added practices geared to strategic risk

management as opposed to

operationally-focused risk management.

However, in this paper, we refer to the

strategic approach as the risk managing

approach. The questions about HRM were

more descriptive due to the fact that the

auditors were less likely to be as familiar

with the HRM function as with IA.

Additional questions asked about the

practices of both functions (e.g. the extent to

which the audit planning process reflects

strategic HRM concerns) and the

relationships between the two. General

questions about the organization also were

included in the survey. The survey was

posted on the Web site of the IIA Research

Foundation for a period of 47 days. This

organization frequently posts surveys on its

Web site, so the format was familiar to the

respondents. When members accessed the

Web site, they were able to click on a link to

complete the survey. There were 161

respondents, for a response rate of 13 percent.

The IIA Research Foundation reported that

this is slightly above the typical response

rate for surveys completed by this

organization.

Analysis and results

Plotting companies on the proposedframeworkThe first component of the analysis was the

plotting of the respondents’ approaches to

HRM and IA. Sunflower charts, in which

each petal represents a response, were used

[ 469 ]



to graph the responses (see Figure 2 and

Figure 3).

For Figure 2, the vertical axis shows the

responses to the question, ‘‘In your view, to

what extent does your firm’s HRM

organization implement programs and

practices focused on firm goals?’’. The

horizontal axis shows the responses to ‘‘In

your view, to what extent is your firm’s HRM

organization focused on the execution of

basic HRM activities (e.g. focused on

training, compensation, benefits, etc?).’’ Most

CAEs rated their firm’s HRM function high

on both strategic and administrative

orientations. The lower right quadrant shows

those CAEs who rated HRM low on strategic

orientation, but high on administrative

focus, which is the ‘‘traditional’’ or older

approach to HRM. None of the respondents

classified their HRM organizations as having

a high strategic focus and a low

administrative focus. This is not surprising,

given that a strategic approach does not

mean that organizations can ignore the need

to focus on administrative issues. Indeed, our

definition of a strategic approach is that it

focuses on the strategic risks and financial

impacts of both administrative and strategic

activities. In total, 11 CAEs (7 percent) rated

HRM low on both strategic and

administrative approaches. This finding was

surprising, given that not even the

traditional approach to HRM was a focus of

the function. This finding suggests that

perhaps the respondent was unfamiliar with

the HRM function or the respondent thought

that HRM was not performing adequately in

either of these areas.

For Figure 3, the vertical axis shows the

responses to the question, ‘‘In your view, to

what extent does your firm’s IA organization

have a strategic outlook?’’ The horizontal

axis shows the responses to ‘‘In your view, to

what extent is your firm’s IA organization

focused on compliance activities?’’ Although

most organizations rated their IA functions

high on both risk managing (strategic) and

compliance orientations, there was less of a

concentration of respondents in this upper

right quadrant for IA than there was for

HRM. The second most populated quadrant

was the upper left, which represented a high

risk managing orientation combined with a

low compliance orientation. There also were

a large number of organizations on the

border of these two quadrants, with a high

risk managing score, combined with a score

of three on compliance, which represented

some focus on this issue. Thus, IA’s

self-assessment placed IA functions in or

near the risk managing quadrant. There was

less focus on compliance in IA than there was

on administration in HRM. The lower right

quadrant, which shows those organizations

that rated themselves low on risk managing

IA and high on compliance-focused IA, was

sparsely populated. Only one organization

populated the lower left quadrant, combining

a low focus on both risk managing and

compliance orientations. Given our

conceptualization that organizations will

have, at a minimum, a compliance-based

Figure 2Chief audit executives’ perspectives of human resources

Figure 3Chief audit executives’ self-rating

[ 470 ]



focus, we were not surprised by the low

number of respondents in this quadrant.

The next aspect of the analysis was the

combined plotting of the HRM and the IA

functions. Because two questions were used

for each function (one asked about the extent

of the strategic approach and the other asked

about the extent of the compliance focus), the

following logic was used to classify each

organization:. Upper right quadrant (value-creating).

This match required an HRM score of four

or five, combined with an IA score of four

or five. The HRM and IA scores were

determined by looking at the responses to

the questions about the strategic extent of

each function. It was not necessary to

examine the compliance score, since a

strategic approach could be paired with a

high or low compliance focus.. Lower right quadrant (motivating). This

match required an HRM score of one or

two combined with an IA score of four or

five. This calculation required use of the

questions on the survey about the

strategic extent of each function, as well

as the questions about the compliance

focus of each function. An HRM score of

one or two required a high compliance

score (four or five) and a low strategic

score (one or two).. Upper left quadrant (limiting). This match

required an HRM score of four or five

combined with an IA score of one or two.

An IA score of one or two resulted when a

high compliance focus (four or five) was

combined with a low strategic focus (one

or two).. Lower left quadrant (cost-minimizing).

This match occurred when a low HRM

score (one or two) and a low IA score (one

or two) were plotted. See above for the

logic for computing the low scores.

Figure 4 shows the results of this analysis.

The logic listed above enables us to clearly

classify 75 of the organizations. The

remaining organizations fell on the

horizontal or vertical axis of the quadrants

and were therefore excluded. The most

populated quadrant was the value-creating

match in the upper right quadrant, which

contained 52 organizations. The second most

populated quadrant was the lower right,

which represents a motivating match of risk

managing IA and administratively-focused

HRM. A total of 19 organizations were in this

quadrant. Only one organization fell in the

upper left quadrant, which represents a

limiting match, and only three companies

were in the lower left quadrant, for a

cost-minimizing match. Thus, virtually all of

the CAEs categorized their IA organization

as taking a risk managing approach. There

are several possible reasons for this lack of

variability. First, there may be rating

inflation given that the audit executives

rated their own IA units and they may

perceive themselves as being more risk

managing or strategic than they actually are.

Second, there could be a response bias such

that only those audit executives who are the

most risk managing completed the survey,

while those who are less focused on risk

management opted not to participate. Third,

there may be a social desirability bias, such

that CAEs prefer to be recognized for their

risk managing philosophy than their

compliance-based work. We do see

variability in the HRM classifications. This

may be due to the fact that the data also came

from the audit executives, which reduces the

two concerns of rating inflation and response

bias listed above.

In order to include more companies, we

changed the classification system to plot the

companies that did not clearly fall into one of

the four proposed quadrants. These

companies had values of three on at least one

of the questions related to strategic

orientation or compliance/administrative

orientation. This resulted in the

categorization of an additional 71 companies,

for a total of 146; 15 companies still were not

plotted. Most of these were the companies

with a strategic score of one and a

compliance score of one for HRM. Given that

this combination does not fit our

conceptualization, they were omitted from

the analysis. Figure 5 shows that most of the

added companies were on the border of the

value-creating quadrant, with slightly more

companies high on risk managing IA than on

strategic HRM.

Quantitative analysis of the researchquestionsWe next examined the proposed research

questions concerning the relationships and

practices of the companies in relation to

their quadrants in the framework.

However, given that the ‘‘limiting’’ and

‘‘cost-minimizing’’ quadrants had such a

low number of responses, we were unable to

conduct our analysis using the four

quadrants. Therefore, we conducted our

analyses based on the differences in

strategic HRM vs administrative HRM by

splitting Figure 5 into three categories: one

group representing the ‘‘value-creating’’

quadrant, another group representing the

‘‘motivating’’ quadrant, and another group

representing the responses that fell

between these two quadrants (see the

[ 471 ]



circled areas on Figure 5). Thus we

eliminated quadrants one and two from the

analyses and included only those

respondents that clearly identified their IA

functions as risk managing. Although this

change prohibited us from testing our

research questions as proposed, we were

able to test for differences based on

the two quadrants and the borderline

area between them. We would expect

responses to the research questions for the

borderline area to fall between those for the

motivating quadrant and the value-creating

quadrant.

For RQ1a, we examined the extent to which

IA and HRM have a productive working

relationship by using ordinary least squares

(OLS) regression (see Table I). Given the

categorical nature of the quadrants and the

borderline region, we used dummy variables

to represent the value-creating quadrant and

the borderline region, with the motivating

quadrant serving as the omitted category.

There was a significant positive effect for the

value-creating quadrant (semipartial r=0.42,

p<0.01) indicating that being in the value-

creating quadrant (having a shared strategic

emphasis) had a more positive effect on the

working relationship than being in the

motivating quadrant. There was no

significant effect for the borderline region,

which suggests that the working relationship

was not significantly different from that of

respondents in the motivating quadrant. The

model explained 24 percent of the variance in

the CAEs’ perceived productivity in working

relationships between IA and HRM. Given

that we were unable to test the cost-

minimizing region, we found support for

RQ1a in so far as its prediction for the

value-creating quadrant. For RQ2a, we

examined the extent to which the IA

planning process reflects strategic HRM

concerns. Again, there was a significant

positive effect for the value-creating

quadrant (semipartial r=0.25, p<0.01) and

there was not a significant effect for the

borderline region. The model explained 7

percent of the variance in the audit planning

process reflecting strategic HRM concerns,

indicating support for the testable aspect of

this research question. The third research

question examined the extent to which audit

reports reflect strategic HRM concerns. This

model was not statistically significant and

there were no significant effects for the

value-creating quadrant or the borderline

region. Thus, RQ3a was not supported.

We also used OLS regression to examine

the influence of the strategic extent of human

resources and the strategic extent of IA on

the various outcomes (see Table II). We were

able to fully test the research questions

related to these variables because they were

not based on the quadrants proposed by our

model. We used the entire sample for these

analyses as we were not limited to the

responses that fell clearly within one of the

quadrants. For RQ1b, we predicted that the

strategic extent of HRM and the strategic

extent of IA both would have a positive effect

on the quality of the working relationship

between HRM and IA. We found a significant

positive effect for both the strategic extent of

HRM (semipartial r=0.40, p<0.01) and the

strategic extent of IA (semipartial r=0.18,

p<0.05), with the model explaining 23

percent of the variance, fully supporting the

research question. For RQ2b, we predicted

Figure 4Respondents falling clearly into one of the proposed quadrants

Figure 5Responses including those falling in the borderline region

[ 472 ]



that the strategic extent of HRM and the

strategic extent of IA would be positively

related to how much the audit planning

process reflects strategic HRM concerns. We

found full support for this question, as there

were significant positive main effects for the

strategic extent of both human resources

(semipartial r=0.18, p<0.05) and IA

(semipartial r=0.36, p<0.01), with the model

explaining 20 percent of the variance. For

RQ3b, we predicted that the strategic extent

of HRM and the strategic extent of IA would

be positively related to how much the audit

reports reflect strategic HRM concerns. This

was only partially supported, as there was a

significant positive main effect for the

strategic extent of IA (semipartial r=0.30,

p<0.01), but not for the strategic extent of

HRM. A total of 10 percent of the variance in

the audit reports was explained by this

model.

Thus, our findings indicate that there is a

significant positive relationship of the

strategic extent of HRM on first, the

perceived quality of the working relationship

between HRM and IA, and second, the audit

planning process reflecting strategic

concerns. We did not find a significant effect

for the audit reports reflecting strategic HRM

concerns. For the strategic extent of IA, we

found a significant positive effect for all three

dependent variables.

Analysis of qualitative responsesWe recognize that CAE’s definition of the

terms ‘‘strategic’’ and ‘‘risk managing’’ in

relation to HRM may differ from that

developed in the literature. Therefore, we

asked two questions that allowed us to probe

into the respondents’ definitions of these

terms by having them provide examples from

actual audits of the HRM function. First, we

asked for a specific example of an audit

finding included in the audit report for the

HRM function that recognizes a strategic

focus in HRM (e.g. the audit report notes that

HRM determined its training curriculum

based on corporate strategic objectives and

measured training outcomes in relation to

those objectives). Only 35 percent of the

respondents provided an example, with the

remainder leaving the space blank or saying

that they have not yet had a finding they

could share. The second question asked for a

specific example of an audit finding included

in the HRM audit report that reflects the

audit organization’s strategic focus (e.g. the

internal audit report makes a finding that

absenteeism rates exceed benchmarked

targets resulting in lower productivity and

delayed shipments). Only 22 percent of the

respondents provided an example in

response to this question. In light of the

auditors’ self-assessment as highly risk

managing, we find that both the 35 percent

and 22 percent success rate in citing a

specific example are low. We expected the

auditors to have a higher success rate in,

first, recognizing strategic HRM

achievements and, second, recommending

strategic improvement to the HRM process.

Some respondents may not have

Table IRegressions using modified quadrants

Productive working relationshipbetween HRM and IA

Audit planning process reflectsstrategic HRM concerns

Audit reports reflect strategicHRM concerns

Independent variable b(1) �(2) Part r (3) b(4) �(5) Part r (6) b(7) �(8) Part r (9)

Borderline region 0.28 (0.24) 0.14 0.10 0.42 (0.34) 0.16 0.12 0.30 (0.35) 0.12 0.09Value-creating quadrant 10.05 (0.22) 0.57** 0.42** 0.81 (0.31) 0.34* 0.25** 0.30 (0.32) 0.13 0.10Constant 30.16 (0.19) 20.58 (0.27) 20.74 (0.27)R2 0.24** 0.07* 0.01

Notes: n=160; * p<0.05; ** p<0.01

Table IIRegressions using the strategic extent of human resources and internal audit

Productive working relationshipbetween HRM and IA

Audit planning process reflectsstrategic HRM concerns

Audit reports reflect strategicHRM concerns

Independent variable b(1) �(2) Part r (3) b(4) �(5) Part r (6) b(7) �(8) Part r (9)

Strategic extent of human resources 0.39 (0.07) 0.41** 0.40** 0.21 (0.08) 0.19* 0.18* 0.06 (0.09) 0.05 0.05Strategic extent of internal audit 0.19 (0.08) 0.18* 0.18* 0.48 (0.09) 0.37** 0.36* 0.39 (0.10) 0.30* 0.30*Constant 1.66 (0.32) 0.33 (0.40) 1.05 (0.43)R2 0.23** 0.20** 0.10**

Notes: n=160; * p<0.05; ** p<0.01

[ 473 ]



distinguished between these two aspects of

the audit report, as was suggested by the 5.5

percent of the sample that cited the same

finding for both questions. For those cases we

did not include the second citation which

lowered the response rate for the second

question.

To quantify the responses, the authors

created a code sheet for each question, using

a three point rating scale with descriptive

anchors. The descriptive anchors for

strategic focus relied on the SHRM literature

and included various work practices,

cost-benefit analysis of practices, and clear

linkages of practices with firm strategy. A 3

indicated the most strategic response, a 2

indicated a somewhat strategic response, and

a 1 indicated a response that was not at all

strategic. After initially rating each of the

responses independently, the inter-rater

reliability for the two authors was 59 percent

for the first question and 54 percent for the

second question. We held a meeting to add

detail to the descriptive anchors on the code

sheet and to identify decision rules for how to

handle ambiguous responses and situations

(e.g. if a response addresses a hypothetical

situation, rather than an actual finding,

exclude it from the analysis). We then

re-rated each of the responses using the new

decision rules. The revised inter-rater

reliability for the first question was 93

percent and for the second question it was 90

percent, both being acceptable levels of

reliability (Carmines and Zeller, 1979).

For purposes of analysis using the

proposed model, we used only one author’s

ratings for each question. We chose the

ratings of the author who has more human

resources experience for the first question,

and the rating of the author who has more

audit experience for the second question. For

the first question (a specific example of an

audit finding included in the audit report for

the HRM function that recognizes a strategic

focus in HRM), we found that of the 30

respondents that clearly fell into one of the

four quadrants; 13 were in the value-creating

quadrant. Of these, only two received a

rating of ‘‘truly strategic’’ based on their

qualitative example; eight received a rating

of ‘‘somewhat strategic’’ and 11 received a

rating of ‘‘non-strategic’’. Although

respondents identified themselves as

strategic in general terms, their specific

work experience (as indicated by their

examples) often are not strategic. For

example, respondents who self-identified

themselves as being in the ‘‘value-creating’’

quadrant listed strategic examples such as

creating and implementing a code of ethics

and creating a mission statement for the

pension plan. Although both are important

audit findings, they relate to the basic

functioning of HRM, rather than the ability

of HRM to add value to the organization

through these practices. An example of a

response that was rated truly strategic

recounted an audit finding involving

payment strategies related to the sales

compensation plan to ensure that the

strategies stimulate the correct product mix

and align with corporate strategy.

For the second question (a specific example

of an audit finding included in the HRM audit

report function that reflects the audit

organization’s strategic focus), we found that

of the 20 responses that clearly fell into one of

the four quadrants in the proposed model, 13

had identified their organizations as being in

the ‘‘value-creating’’ quadrant. Of those, only

three received a rating of ‘‘truly strategic’’,

while eight were ‘‘somewhat strategic’’ and 11

were ‘‘non-strategic’’. Again, although

respondents identified themselves as

strategic, their actions as expressed through

audit findings often are not strategic.

Respondents who identified themselves as

being in the value-creating quadrant stated

underutilization of technology and the

update of policies after reorganization as

examples of the audit organization’s strategic

focus. Although these findings are important,

they do not clearly demonstrate the ability of

IA to add value to the organization through

SHRM practices and/or related measures. An

example of a response that was rated as truly

strategic stated an audit recommendation of

the need for formalized training by human

resources for overseas-based sales staff to

ensure consistency with corporate goals

communicated to sales staff domestically.

Discussion

The ability of IA groups to add value to the

functions they audit by managing risk is a

growing trend (Bou-Raad, 2000). Our study

proposed and examined a framework for how

IA and HRM can maximize the effectiveness

of their working relationship. This

framework is based on HRM acting

strategically, combined with IA taking a risk

managing approach. When both of these

approaches are used, the expected

effectiveness of a human resources audit is

highest. We call this a value-creating

combination. The other quadrants

(motivating, limiting, and cost-minimizing)

should strive towards the value-creating

quadrant in order to improve their

effectiveness.

[ 474 ]



The quadrants of the framework enable IA

and their HRM clients to conceptualize their

relationship, to understand the self and

peer-appraisal implications of their quadrant

location, and to plan on how to move toward

the value-creating quadrant. The framework

can serve as a guide for examining the effects

of the relationship between HRM and IA for

areas such as company financial

performance, the audit planning process and

reports, and the nature of the working

relationship between the two groups.

In our test of a sample of IA executives, we

found that most of the companies did indeed

characterize themselves as having a

value-creating combination of strategic

human resources paired with risk managing

IA. This was encouraging, given that little

has been written on the effects of the

strategic approaches of the relationship

between the two units. However,

examination of the examples provided by the

respondents showed that although

companies may self-report that they are

being strategic, their actions may not be

truly strategic. This finding has

methodological implications for studying

strategic issues. McNamee and Selim (1999,

p. 19) point out two weaknesses of the current

risk paradigm:One is that internal auditors focus too much

on measuring risk factors instead of the

underlying risk – different results can occur

when the nature of risk changes and the

internal auditor continues to use the same

factors. The second weakness in risk

assessment by internal auditors is that

planning is where the focus on risk usually

ends. Once the internal audit is planned (or

the group of audits for the annual plan are

chosen), the focus is switched to the system of

internal control. In current internal audit

practice, controls, not risks, are tested,

evaluated and reported to management.

We believe that familiarity with the current

risk profile of HRM developed primarily over

the past decade is not yet included in internal

auditors’ risk factors for HRM. Additionally,

the dearth of appropriate strategic examples

cited by respondents may be explained by the

shift to a control or compliance focus in audit

execution leaving few examples related to

strategic risk for citation.

Self-reported performance may encourage

a positive bias in the responses, as being

strategic is viewed as desirable in most

organizations and it is a popular topic in both

academic and practitioner literature. Indeed,

we were unable to test our research

questions as proposed because of a lack of

variability in the responses for the risk

managing nature of the IA function. On the

other hand, there was sufficient variability

in the audit executives’ ratings of the

strategic nature of the HRM function. One

way to surmount the self-report bias would

be to have someone from outside of IA rate

the extent to which the function is strategic

or risk managing (Van de Ven and Ferry,

1980). An HRM executive could rate the audit

function and the HRM score would be

averaged with the self-reported IA score.

Another possibility is to measure actions, in

lieu of or in addition to self-ratings. Although

respondents could overstate their actions, it

is less likely that they will be able to do so, as

is evident in the number of respondents who

were unable to cite any strategic finding in

our study.

Despite the lack of responses in the

limiting and cost-minimizing quadrants, we

were able to partially test the research

questions. As stated earlier, we analyzed the

value-creating quadrant, the motivating

quadrant, and the region between these

quadrants, which we identified as the

borderline area. We found support for the

testable aspect of RQ1a, as there was a

significant positive effect of the value-

creating quadrant on the strength of the

working relationship between IA and human

resources. We also found support for RQ1b,

which we were able to test completely, as it

examined the strategic extent of human

resources and IA on the working relationship

between the two functions. For the testable

portion of RQ2a, we found a positive

significant effect for the value-creating

quadrant on the extent to which the audit

planning process reflects strategic HRM

concerns in support of the research question.

Likewise, we found support for RQ2b, which

found significant effects suggesting that a

high strategic extent of human resources and

high strategic extent of IA is associated with

the audit planning process reflecting

strategic HRM concerns. We did not find

support for the testable portion of RQ3a, as

there was not a significant effect of the

value-creating quadrant on the audit reports

reflecting strategic HRM concerns. We also

found only partial support for RQ3b, as only

the strategic extent of IA was significantly

related to how much the audit reports

reflected strategic HRM concerns. Lack of

linkage between the strategic extent of HRM

and the audit reports’ reflecting strategic

HRM concerns may be due to the report being

the product of the audit organization; thus

the strategic extent of the HRM function may

not have a significant impact on the audit

report.

One of the implications of this research for

businesses is that creating relationships

where both HRM and IA are in the

[ 475 ]



value-creating quadrant should lead to an

improved opportunity to reap the financial

rewards of implementing SHRM practices.

However, this must be interpreted with

caution, as IA/HRM dyads self-reported as

value-creating often were not truly strategic

as measured by awareness of specific

strategic audit findings. For those companies

that meet the value-creating criteria, our

study serves as partial justification of their

approach. For those companies in the

cost-minimizing quadrant, this study should

serve as impetus for making a change in the

IA approach, and for encouraging change in

human resources. Although it is promising to

see support for the research questions, we

must keep in mind that even though there is

a relationship of the strategic nature of

human resources and IA with most of the

proposed outcomes, there may be an

overrepresentation of respondents in the

high end of the strategy spectrum. In

addition, the model and relationships

proposed in this study are exploratory in

nature; therefore, the findings reported are

just a first step in understanding the

potential for value creation from an IA and

HR partnership.

Future research on this topic should

further examine the implications of the

proposed framework. Although the logic

behind the four quadrants remains valid, an

alternative method for categorizing

companies into the quadrants should be

considered to reduce rating inflation due to

self-reports. The effects of being in each

quadrant on the performance of the human

resources function, as well as company

financial performance, should be evaluated.

Case studies of companies in each of the

quadrants also would provide a better

explanation of the practices employed by

companies following the various approaches.

It is important to note that for this study, all

measures were perceptions of IA executives.

Future studies also should get the

perspective of the human resources function

to mitigate bias (Van de Ven and Ferry, 1980).

Also, our survey drew on the perceptions of

CAEs. Future work would be enriched if

other audit participants’ views were sought,

such as audit team members. Multiple

internal viewpoints may mitigate any level of

analysis problem (Roberts et al., 1978).

Companies are beginning to realize the

importance of being strategic in the

management of their human resources. By

combining a strategic approach to human

resources with a risk managing approach to

IA, companies should be able to set

themselves apart from others and capitalize

on the value generated by progressive

management of people.

Note1 Verreault (1984) found that the strength of

relationship between IA and selected clients

was a decreasing function of the type of other

unit. He examined IA matched with

production, marketing, and R&D. The major

reasons for the differences included auditors’

level of familiarity with the paradigm used in

the other function and the limitation of the

accounting measures used by auditors. Kusel

and Oxner (1998) report on job characteristics

of internal auditing. Accounting is still the

dominant skill set just as it was in 1984. One

may expect the differences in paradigms to

still exist but to be mitigated by the move to

the risk assessment model. It is sensible to

expect variability across internal audit

engagements and therefore important to focus

on specific IA-client relationships. In the HRM

instance, we tentatively suggest that the

background of auditors on the audit team, the

relative newness of evidence regarding SHRM,

and the incomplete implementation of

rigorous risk models at the engagement level

are important factors to consider in the

analysis of IA-HRM performance. Verreault

and Hyland (forthcoming) cover in detail the

information necessary to inform IA about

current developments and the potential for

performance enhancement using SHRM

techniques.

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The authors gratefullyacknowledge the monetarysupport and data collectionassistance of the Institute ofInternal Auditors ResearchFoundation. They also thankDr Louis Primavera, Dean ofthe Derner Institute forPsychological Studies atAdelphi University, for hisstatistical assistance.

[ 477 ]



Underreporting and premature sign-off in publicaccounting

Mike ShapeeroCollege of Business, Bloomsburg University of Pennsylvania, Bloomsburg,Pennsylvania, USAHian Chye KohNanyang Business School, Nanyang Technological University, SingaporeLarry N. KilloughPamplin College of Business, Virginia Polytechnic Institute and State University,Blacksburg, Virginia, USA

Introduction

The underreporting of chargeable time and

premature audit sign-off activities can

adversely affect the ability of public

accounting firms to generate revenues,

complete professional quality work on a

timely basis, and accurately evaluate

employee performance. While prior studies

of these activities have generally lacked a

strong theoretical foundation, this study

examines underreporting and premature

sign-offs within the context of an ethical

decision-making model that integrates

elements of cognitive moral development,

moral evaluation, opportunity and

individual moderators.

Underreporting of chargeable timePublic accounting firms use reported

chargeable hours to bill clients, set time

budgets for assignments, and evaluate

employee performance. A firm’s ability to

successfully perform these functions depends

on the accuracy of the time sheets filled out

by accountants. However, the results of prior

studies suggest that a majority of

accountants have intentionally

underreported their chargeable hours, either

by not recording time worked or by shifting

chargeable hours to non-chargeable

categories.

In a survey of AICPA members, Rhode

(1977) found that 55 percent of the

respondents admitted performing audit work

without reporting all of their chargeable

time. Lightner et al. (1983) found that 67

percent of their respondents had

underreported a portion of their chargeable

hours during the preceding year. Cook and

Kelley (1988) reported a growing number of

auditors who either performed work on their

own time, or shifted chargeable hours to non-

chargeable categories on their time sheets.

There are several reasons why accountants

exceed time budgets; these include:. increased job complexity;. client-created problems;. accountant inefficiency; and. unrealistic time budgets.

In some cases, the additional time may be

billable – a decision typically made at the

partner level. However, underreporting

circumvents the partner’s authority as less

experienced accountants write-off a portion

of their chargeable hours. Beyond the

potential loss of revenue to the firm, client

retention decisions may also be affected as

underreporting makes it difficult to

determine which clients might be

undesirable due to repeated billing

write-downs.

Because time budgets are often based on

the number of hours reported on the previous

year’s work (Kelley and Seiler, 1982;

Pasewark and Strawser, 1994),

underreporting may result in unrealistically

low time budgets. In turn, time pressures

from these unrealistic budgets may lead to

continued underreporting, assignments not

completed on a timely basis, and shortages of

available personnel. Studies also indicate

that time budget pressures are significantly

related to the incidence of audit quality

reduction behaviors, including premature

audit sign-off and a failure to adequately

pursue questionable issues (Alderman and

Deitrick, 1982; Cook and Kelley, 1988; Kelley

and Margheim, 1990; Rhode, 1977).

Time pressures may also affect a firm’s

ability to retain qualified employees. Cook

and Kelley (1988) found lessened job

satisfaction, particularly at staff and senior

accountant levels, to be one of the most

frequently cited problems arising from time





[ 478 ]



KeywordsEthics, Public sector accounting,

Cognition, Auditing principles

AbstractThis study uses the ethical

decision-making model to examine

underreporting and premature

audit sign-off in public accounting.

Structural equation modelling

results indicate that accountants

view premature sign-off activities

differently from underreporting

activities. For example, those

accountants who use a

teleological moral evaluation

process, and who perceive a

greater likelihood of reward are

more likely to underreport. That

these variables are not

significantly related to the

likelihood of premature sign-off

suggests that accountants may

use a consequences-based

approach when making decisions

having lesser ethical content (like

underreporting), but employ a

different decision process when

faced with decisions having

greater ethical content (like

whether to prematurely sign-off).

The results also suggest that

supervisors and managers are less

likely to underreport, and to

prematurely sign-off, than senior

and staff-level accountants, and

that accountants with an internal

locus of control are less likely

(than externals) to either

underreport or prematurely

sign-off.

budget pressure – a finding which may

explain why underreporters, as a group, were

more likely to consider leaving their firms

(Lightner, 1981). Underreporting may also

affect a firm’s ability to accurately assess

employee performance. Studies indicate that

accountants in public practice believe that

the ability to meet time budgets is an

important factor in their performance

evaluations (Kelley and Seiler, 1982; Rhode,

1977). Lightner et al. (1983) found that

underreporters believed that their behavior

would lead to better performance

evaluations, supervisor recognition of

competency, and increased job security.

However, when employees fail to report all of

their chargeable hours, the firm’s ability to

accurately assess employee performance is

undermined.

Premature audit sign-offA premature audit sign-off occurs when an

auditor documents the completion of a

required procedure that is not covered by

other audit procedures, without performing

the work or noting the omission of the

procedure. Rhode (1977) found that almost 60

percent of the respondents had prematurely

signed-off on a required audit procedure

some time during their career. Because he

excluded first and second year auditors and

non-CPAs from his survey, it is possible that

Rhode may have understated the magnitude

of premature sign-off activities. In a follow-up

study (which included auditors with less

than two years of experience), Alderman and

Deitrick (1982) found the incidence of

premature sign-off to be more widespread

than that found by Rhode. In particular,

where Rhode found premature sign-off

activity at local and regional firms,

Alderman and Deitrick also found premature

sign-off activity present at the national firms.

Raghunathan’s (1991) survey of the Big Eight

Eight auditors found that 55 percent of the

respondents had prematurely signed-off at

least ‘‘very rarely’’.

Interestingly, Kaplan (1995) suggested that

the conventional methodology used in

premature sign-off studies may have actually

understated the incidence of premature sign-

off activities. To support this view, he cited

the results of Buchman and Tracy’s (1982)

study which examined the incidence of

premature sign-off activity using both

conventional and a randomized response

technique designed to overcome participants’

reluctance to answer sensitive questions in a

truthful manner. For six of seven audit

procedures, a higher incidence of premature

sign-off behavior was reported when the

randomized response technique was used.

Unlike underreporting (where the work is

performed), premature audit sign-offs

directly affect audit quality and violate

professional standards. Graham (1985)

concluded that audit failures were often due

to the omission of important audit

procedures rather than procedures not being

applied to a sufficient number of items. In

turn, these audit failures not only

significantly increase the litigation costs of

CPA firms but may also hinder their ability

to retain experienced personnel (Dalton et al.,

1994). Further, if experienced people do leave

the profession, and are replaced by

less-experienced personnel, the potential for

substandard work increases.

The ethical decision-making model

The ethical decision-making model used in

this study was developed by Ferrell et al.

(1989) and integrates elements of models

developed by Ferrell and Gresham (1985),

Hunt and Vitell (1986) and Kohlberg (1969)

into a comprehensive framework (see

Figure 1). It was selected because its

proposed relations are consistent with the

results of prior studies of underreporting and

premature sign-off activities.

Modifications to the decision modelBecause the data for this study were collected

using a mail-in questionnaire, it was

necessary to make two modifications to the

decision model. First, consistent with prior

research, it was assumed that respondents

perceive underreporting and premature

sign-off as unethical activities. Therefore,

subject awareness of these activities as

ethical issues was not included in the model.

Further, since the survey’s cover letter

promised confidentiality, respondents would

expect sensitive issues to be involved.

Second, although the model includes the

behavior and a post-behavior evaluation of

consequences, direct observation of

respondent behavior and subsequent

evaluation was not possible. Thus, the

respondents’ self-rated intent to underreport

chargeable time or prematurely sign-off

served as the dependent variable, and the

post-behavior evaluation was omitted. It is

noted that with this type of methodology,

intent often serves as a surrogate for

behavior. While it is possible that intentions

may differ from subsequent behavior:. . . the best predictor of a person’s behavior is

his intention to perform the behavior’’

(Fishbein and Ajzen, 1975, p. 381).

The modified model is given in Figure 2.

[ 479 ]

Mike Shapeero,Hian Chye Koh andLarry N. KilloughUnderreporting and prematuresign-off in public accounting


Cognitive moral developmentPrior studies indicate that an individual’s

level of cognitive moral development is

significantly related to their

underreporting and premature sign-off

activities. For example, Ponemon (1992a)

found staff auditors with lower levels of

cognitive moral development

underreported more frequently than

auditors with higher levels. Ponemon and

Gabhart (1993) noted that auditors with

higher levels of ethical reasoning were

more likely to view underreporting and

premature sign-off activities in a negative

light as compared to auditors with lower

levels of ethical reasoning.

Figure 1Integrated model of ethical decision making

Figure 2Modified integrated model of ethical decision making

[ 480 ]



Lampe and Finn (1992) found that managers

had higher levels of moral development than

staff accountants. Further, Ponemon and

Gabhart (1993) found that the level of moral

development of chartered accountants

employed by Canadian firms increased as

their job level increased. These findings,

when coupled with the results of studies that

indicate that managers and partners are less

likely than staff and senior accountants to

engage in underreporting and premature

sign-off activities, support the influence of

moral development[1]. Based on these

results, it is expected that level of cognitive

moral development is negatively related to

the intent to underreport chargeable time

and to the intent to prematurely sign-off on

audit procedures.

Moral evaluationsHunt and Vitell (1986) suggest that ethical

judgments result from a combination of

deontological and teleological evaluations.

These processes are fundamentally different –

a deontological evaluation focuses on the

inherent morality of behavior, whereas a

teleological evaluation is concerned with the

consequences of the behavior. Studies indicate

that these evaluations may be significant

during an accountant’s ethical decision-

making process. For example, consistent with

a deontological approach, Ponemon and

Gabhart (1993, p. 33) suggest that:. . . individuals with a high degree of integrity

tend to form his or her ethical judgment free

from the biases and pressures created both

within and outside the public accounting

firm . . .

While Swindle et al. (1987) found that

accountants tend to use a teleological process

when categorizing behaviors as acceptable or

unacceptable.

Consistent with the assumption that

respondents view underreporting and

premature sign-offs as ethical issues, it is

expected that the use of a deontological

evaluation process is negatively related to


and to the intent to prematurely sign-off. On

the other hand, studies indicate that

individuals who underreport and

prematurely sign-off do so with the

expectation that these activities will provide

them with certain benefits. Hence, it is

expected that the use of a teleological

evaluation process is positively related to the

intent to underreport and to the intent to

prematurely sign-off.

Job levelThe results of prior studies indicate that an

individual’s job level is significantly related

to his/her underreporting and premature

sign-off activities. Cook and Kelley (1988),

Lightner (1981) and Rhode (1977) all found the

incidence of underreporting to be highest

among staff and senior-staff accountants.

Cook and Kelley (1988) and Kelley and Seiler

(1982) reported that staff and senior-staff

auditors were more likely than managers and

partners to engage in acts of quality

reduction (including premature audit

sign-offs). Rhode (1977) concluded that staff

auditors were the most vulnerable to

premature sign-offs, while Raghunathan

(1991) found senior-staff accountants were the

most likely to prematurely sign-off on audit

procedures. From these results, it is expected

that experience in public accounting, as

measured by job level, is negatively related to


and to the intent to prematurely sign-off on

audit procedures.

Locus of controlLocus of control is:

. . . [a] generalized expectancy that rewards,

reinforcements, or outcomes in life are

controlled either by one’s own actions

(internality) or by other forces (externality)

(Spector, 1988, p. 335).

Individuals with an internal locus of control

are more likely to rely on their own

determination of what is right and wrong and

are more likely to accept responsibility for the

consequences of their behaviors. On the other

hand, individuals with an external locus of

control believe that results are attributable to

things beyond their control, and are less

likely to take personal responsibility for the

consequences (Trevino, 1986).

Because individuals with an internal locus

make their own determination of what is

right or wrong and because they believe that

their decisions result in consequences, it

would be expected that they would be less

likely to engage in unethical behaviors.

Therefore, an internal locus of control is

expected to be negatively related to the intent

to underreport chargeable time and to the

intent to prematurely sign-off.

OpportunitiesCPAs perceive numerous opportunities to

engage in unethical activities (Finn et al.,

1988). Lightner et al. (1983) found that over

80 percent of their respondents believed that

it was extremely or very possible to

successfully underreport their chargeable

time. Alderman and Deitrick (1982) reported

that more than 70 percent of their

respondents believed that premature

sign-offs resulted from inadequate

supervision and were more likely to occur in

[ 481 ]



areas where the risk of being caught was

small. Weaver and Ferrell (1977), Zey-Ferrell

and Ferrell (1982) and Zey-Ferrell et al. (1979)

all found the perceived opportunity to engage

in unethical behavior to be a significant

predictor of ethical decisions. Therefore, it is

expected that the belief that it is possible to

successfully underreport (prematurely

sign-off) is positively related to the intent to

underreport (prematurely sign-off).

RewardsAccountants believe that the ability to meet

time budgets is an important factor in

determining whether they advance within

their firm (Kelley and Seiler, 1982; Lightner

et al., 1983; Rhode, 1977). Therefore, it is not

surprising that time budget pressures appear

to influence underreporting and premature

sign-off behaviors. Lightner et al. (1983) found

underreporters to be more likely to doubt

their ability to meet time budgets, and to

believe that the expected rewards

(specifically, better performance evaluations,

supervisor recognition of competency and

increased feelings of job security)

outweighed the potential punishments.

Alderman and Deitrick (1982) reported that

staff auditors believed that they were at fault

when budgets were exceeded and responded

by prematurely signing-off in order to meet

the budget. Pany et al. (1989) found that their

subjects believed others were more likely to

prematurely sign-off to meet a time budget

when exceeding the budget would lead to a

negative performance evaluation. Based on

these findings, it is expected that an

individual’s expectation that underreporting

(premature sign-off) activities will lead to

rewards is positively related to their intent to

underreport chargeable time (prematurely

sign-off).

Operationalization of model elementsThe defining issues test (Rest, 1979) has been

used extensively in prior studies to measure

the level of moral development. Thoma and

Rest (1986) concluded that there is a moderate

link between moral judgment measured

using the defining issues test (DIT) and

behavior. The DIT contains hypothetical

moral dilemmas[2]. For each dilemma,

subjects first rate the importance of 12

statements which represent thinking that is

typical of one of the stages of moral

development, and then rank order the four

statements which they consider to be the

most significant in resolving the dilemma.

Points are assigned to the rank-ordered

statements and result in a P score measure of

moral development, which measures the

relative importance an individual assigns to

principled considerations.

Cohen et al. (1993) constructed a

multidimensional ethics scale consisting of

15 bipolar descriptions, and four

accounting-based scenarios. Their results

included extraction of both deontological and

teleological factors. As these results are

consistent with the moral evaluation element

in the Ferrell et al. (1989) model, their scale

and three of their four scenarios were

included in the questionnaire. Consistent

with the scoring used in Cohen et al. (1994),

the deontological and teleological variables

in this study are the sum of the response

scores for those scale items that comprise the

deontological and teleological moral

constructs.

Although locus of control research has

been dominated by the use of Rotter’s (1966)

scale, correlations between that measure and

other ‘‘work-related variables have been

rather modest’’ (Spector, 1988, p. 335). In

response, Spector developed a scale

specifically concerned with the work domain

which, according to the results of prior

studies, correlates significantly with

work-related variables and exhibits an

acceptable level of internal consistency

(Spector, 1988). Given that this study

examines ethical issues within a work

domain, Spector’s work locus of control was

included in the questionnaire.

To measure the perceived opportunity to

engage in underreporting and premature

sign-off behaviors, participants were asked to

indicate how possible it is to successfully

underreport chargeable time and to

prematurely sign-off. Responses were based

on a six-point Likert scale ranging from

‘‘extremely difficult’’ (1) to ‘‘extremely

possible’’ (6). Participants were also asked

whether underreporting or premature

sign-off activities would lead to rewards.

Responses were based on a six-point Likert

scale ranging from ‘‘extremely unlikely’’ (1)

to ‘‘extremely likely’’ (6).

The likelihood of engaging in unethical

behavior was measured with case scenarios

and a series of questions. In the

underreporting scenario, the number of

hours that had already been worked to

perform an audit procedure exceeded the

50-hour time budget. After reading the

scenario, participants were asked a series of

questions; in particular, they were asked to

estimate the likelihood that they would

underreport their chargeable time.

Responses were based on a seven-point

Likert scale ranging from ‘‘extremely

unlikely’’ (1) to underreport to ‘‘extremely

likely’’ (7) to underreport. After completing

[ 482 ]



the underreporting scenario, participants

read a second scenario. In this scenario, the

auditor was evaluating internal controls (an

area identified as susceptible to premature

sign-off activity by Alderman and Deitrick,

1982), and had already worked the budgeted

50 hours without completing the procedure.

After reading the scenario, participants were

asked to estimate the likelihood that they

would prematurely sign-off. A seven-point

Likert scale was used.

Research design and methodology

A 14-page questionnaire was administered to

accountants employed by six regional and

national public accounting firms located in

the eastern USA. Upon receiving a firm’s

agreement to participate in the study, the

questionnaires were mailed to a contact

partner who distributed them. After

completion, each participant returned the

questionnaire to the authors in a

pre-addressed, postage-paid envelope.

The questionnaire was divided into several

parts. The first asked questions related to

demographics and locus of control. This was

followed by the short version of the defining

issues test and the multidimensional scale

and vignettes. Each participant was then

asked to assess his/her ability to successfully

underreport, to successfully prematurely

sign-off, and whether either activity would

lead to personal rewards. Participants then

read the underreporting and premature

sign-off case scenarios and estimated the

likelihood that they would engage in these

activities.

When posing sensitive questions,

researchers are faced with two main

problems: that the subjects refuse to respond

or that they respond so as to conceal

unacceptable behaviors. By having the

questionnaires distributed in-house (rather

than mailing them directly to potential

participants), it was hoped that the subjects

would be more likely to respond. To reduce

the probability of biased responses, several

procedures were used. First, the cover letter

promised anonymity and directed each

participant to return their questionnaire

directly to the authors in a pre-addressed

envelope. Second, the DIT contains both anM

score and consistency check to identify

subjects who are faking responses or not

paying attention. Participants having either

an excessive M score or who were

inconsistent in their responses were dropped

from the sample.

Although it is not possible to determine

how non-respondents would have replied, the

results of prior research indicate that the

responses of non-respondents are similar to

those of late respondents (Armstrong and

Overton, 1977; Babbie, 1979; Oppenheim,

1966). Because the questionnaires were

mailed to the different offices at different

dates, a late respondent was defined as any

completed questionnaire received more than

four weeks after receipt of the first completed

questionnaire from that same office. While

there was no significant difference regarding

the likelihood of premature sign-off, late

respondents judged themselves significantly

less likely to underreport their chargeable

time than did the other respondents.

Statistical methodsStructural equation modelling (SEM) was

used to test the proposed causal models of


(Figure 3 and Figure 4 respectively). This

method of analysis is appropriate given the

causal relationships specified in the models

and the strong theoretical foundations.

Specifically, PROC CALIS in statistical

analysis software (SAS) was used to perform

path analyses of the underreporting and

premature sign-off models. In addition,

descriptive statistics were computed to

summarize the variables and understand the

sample data, and alpha correlation

coefficients were computed to assess the

internal reliability of the constructs (locus of

control, and the deontological and

teleological moral evaluation factors).

Results

In total, 82 usable questionnaires were

returned to the authors (due to a missing

response, the sample size for testing the

premature sign-off model was reduced to 81),

a 35 percent usable response rate. The results

reported in Table I support the use of the

measures included in the questionnaire. The

mean DIT P score of 45.35 is higher, but not

significantly different than those found in

prior studies (see Ponemon and Glazer, 1990;

Ponemon, 1992b; Ponemon and Gabhart,

1993)[3]. The mean locus of control score of

38.76 is comparable to the results of prior

studies as reported by Spector (1988). The

alpha coefficients for the deontological moral

evaluation (0.69), teleological moral

evaluation (0.89), and locus of control (0.88)

indicate acceptable levels of internal

reliability (Hair et al., 1998).

Table I indicates that respondents believe

it is ‘‘very possible’’ to successfully

underreport their chargeable time

(mean=5.18), although they think it is

[ 483 ]



‘‘somewhat unlikely’’ that underreporting

will lead to rewards (mean=3.12).

Respondents also believe it is only

‘‘somewhat possible’’ to successfully

prematurely sign-off (mean=3.65), and ‘‘very

unlikely’’ that this behavior will be rewarded

(mean=2.14). Finally, respondents indicate

that they are ‘‘somewhat unlikely’’ to

underreport their chargeable time

(mean=2.71), and ‘‘very unlikely’’ to

prematurely sign-off (mean=1.64).

Causal model of underreportingThe results of the causal model of

underreporting are summarized in Table II.

As indicated by the goodness-of-fit index of

0.9583, the model provides a good fit. Further,

the null hypothesis of no significant

difference between the model and the data

cannot be rejected (p=0.2442).

The results indicate significant paths

from deontological moral evaluation

(p= 0.0216), teleological moral evaluation

Figure 3Structural equation model – underreporting

Figure 4Structural equation model – premature sign-off

[ 484 ]



(p= 0.0228), job level (p= 0.0057), locus of

control (p= 0.0167) and likelihood of reward

from underreporting (p= 0.0002) to the

likelihood of underreporting. The

numerical signs are also consistent with the

hypothesized relations. That is,

accountants who use a deontological moral

evaluation process are less likely to

underreport, while those who use a

teleological moral evaluation process are

more likely to underreport. The results also

indicate that accountants who perceive a

greater likelihood of reward are more

likely to underreport, while supervisors

and managers (vis-a-vis staff and seniors)

and accountants having an internal

locus of control are less likely to

underreport. No statistically significant

paths are detected for cognitive moral

development (p= 0.3457) or for the

possibility of successful underreporting

(p= 0.4271).

Causal model of premature sign-offAs reported in Table III, the goodness-of-fit

index of 0.9598 indicates that the causal

model of premature sign-off has a good fit.

Further, the null hypothesis of no significant

Table IISEM results for underreporting

Path (to-from) Coefficient t-value p-value*

V1-V4 –4.74 –1.23 0.1093V2-V1 0.02 0.51 0.3038V3-V1 –0.01 –0.11 0.4568V8-V1 0.01 0.40 0.3457V8-V2 –0.05 –2.02 0.0216#V8-V3 0.04 2.00 0.0228#V8-V4 –0.91 –2.53 0.0057#V8-V5 –0.51 –2.13 0.0167#V8-V6 –0.03 –0.18 0.4271V8-V7 0.45 3.54 0.0002#

Notes: * 1-tailed t-test; # Significant at a 0.05 significance level.; V1=Cognitive moral development;V2=Deontological moral evaluation; V3 = Teleological moral evaluation; V4 = Job level; V5 = Locus of control;V6=Possibility of successful underreporting; V7 =Reward of underreporting; V8= Likelihood of underreporting;Model goodness-of-fit index =0.9583; Model �2 =14.95 (p-value =0.2442, df = 12)

Table IDescriptive statistics and alpha coefficients

Variable (abbreviation)Mean

Standarddeviation Frequency Percentage

Alphacoefficient

Cognitive moral development (V1) 45.35 16.39Deontological moral evaluation (V2) 24.12 6.03Teleological moral evaluation (V3) 26.91 7.85Locus of control (V5) 38.76 7.77Possibility of successful underreporting (V6) 5.18 0.89Reward of underreporting (V7) 3.12 1.36Likelihood of underreporting (V8) 2.71 1.84Possibility of successful premature sign-off (V6) 3.65 1.40Reward of premature sign-off (V7) 2.14 1.07Likelihood of premature sign-off (V8) 1.64 1.02

Job level (V4) 56 68.29Staff and senior supervisor and manager 26 31.71

Deontological moral evaluation (V2) 0.69Teleological moral evaluation (V3) 0.89Locus of control (V4) 0.88

Notes: Responses are scored as follows: V6: The possibility of successfully underreporting or prematurelysigning-off is scored on a six-point Likert scale ranging from extremely difficult (1) to extremely possible (6); V7:The likelihood that underreporting or premature sign-off will lead to rewards is scored on a six-point Likert scaleranging from extremely unlikely (1) to extremely likely (6); V8: The likelihood of respondents underreporting orprematurely signing-off is scored on a seven-point Likert scale ranging from extremely unlikely (1) to extremelylikely (7)

[ 485 ]



difference between the model and the data

cannot be rejected (p=0.3137).

At a 0.05 level of significance, the results

indicate only two significant paths. As with

underreporting, supervisors and managers

are less likely to prematurely sign-off than are

staff and senior-level accountants (p=0.0412).

In addition, accountants having an internal

locus of control are less likely to prematurely

sign-off (p=0.0002). None of the other proposed

model paths is statistically significant.

Discussion and conclusion

The results suggest that accountants view

premature sign-off activities differently from

underreporting activities, and that what is

significant in the decision-making process

may be influenced by the ethical content of

the decision. For example, while almost 88

percent of respondents felt strongly (i.e. very

or extremely unlikely) that they would not

prematurely sign-off, only 61 percent felt that

way about underreporting. Further, while

reward expectation and a teleological

evaluation process were significantly related

to the likelihood of underreporting, neither

variable was significantly related to the

likelihood of premature sign-off. Finally,

respondents were more likely to believe that

underreporting activities would result in

rewards than would premature sign-off

activities.

These results suggest that while some

accountants may use a consequences-based

approach when making decisions having

lesser ethical content (like underreporting),

they employ a different decision process

when faced with decisions having greater

ethical content (like whether to prematurely

sign-off). If so, public accounting firms may

find that using a single approach to reduce

unethical behaviors will not be effective. For

example, an approach that focuses on

personal rewards (or negative rewards

through the use of organizational sanctions)

may reduce underreporting but not

premature sign-off activities. Instead,

appeals to the individual’s locus of control

(perhaps during staff training or through the

use of codes of conduct) may be more

effective in reducing the incidence of

premature sign-off.

Interestingly, opportunity appears to play

little part in whether respondents are likely

to underreport or prematurely sign-off. An

overwhelming majority of the respondents

(97 percent) indicated that it was at least

‘‘somewhat possible’’ to successfully

underreport while almost 75 percent felt this

way about their opportunity to prematurely

sign-off. This difference seems intuitive

given that underreporting is usually done in

private (when an accountant fills out his/her

time sheet), while premature sign-off occurs

in situations characterized by close

supervision (given the audit team structure

and lack of privacy at client locations) and

workpaper review.

The results also suggest that supervisors

and managers are less likely to underreport,

and to prematurely sign-off than senior and

staff-level accountants. A ‘‘survival of the

fittest’’ paradigm may explain the influence

of job level where those accountants whose

performance is weakest leave public

accounting (voluntarily or involuntarily)

before they advance within their firms.

There may be a maturation process where, as

employees gain experience, they become

more confident in their abilities and feel less

pressure to engage in unethical activities to

enhance perceptions of their performance.

Table IIISEM results for premature sign-off

Path (to-from) Coefficient t-value p-value*

V1-V4 –4.68 –1.21 0.1127V2-V1 0.01 0.35 0.3617V3-V1 –0.01 –0.17 0.4327V8-V1 0.01 0.42 0.3361V8-V2 –0.01 –0.73 0.2318V8-V3 0.01 0.68 0.2481V8-V4 –0.39 –1.74 0.0412*V8-V5 –0.53 –3.48 0.0002*V8-V6 0.01 0.01 0.4958V8-V7 0.06 0.62 0.2680

Notes: * 1-tailed t-test; * Significant at a 0.05 significance level.; V1=Cognitive moral development;V2=Deontological moral evaluation; V3 = Teleological moral evaluation; V4 = Job level; V5 = Locus of control;V6=Possibility of successful sign-off; V7 =Reward of sign-off; V8= Likelihood of sign-off; Model goodness-of-fitindex =0.9598; Model �2 =13.80 (p-value =0.3137, df = 12)

[ 486 ]



There may also be an investment aspect

where as individuals ‘‘build’’ their careers,

they are less willing to place their

‘‘investment’’ in danger by engaging in

unethical activities. Further, there may also

be a socialization effect where as accountants

advance in their firms, their personal

interests tend to be more closely tied to their

firm’s interest and they become less willing

to engage in activities which might damage

their firms.

Finally, the results of prior studies indicate

that individuals with an internal locus of

control are more likely (than externals) to

rely on their own determination of right and

wrong and to take responsibility for their

actions. The results of this study also suggest

that those with an internal locus of control

are less susceptible to outside influences and

are more likely to behave ethically.

LimitationsThere are several limitations that should be

considered when evaluating the results of

this study. First, the sample included

auditors from six regional and national

public accounting firms located in the

eastern USA. To the extent that this group is

unique, the findings may not be generalizable

to the general population of auditors and

public accounting firms. Second, the usual

limitations associated with self-reported

questionnaire apply (i.e. response and

non-response bias). The potential for

response bias was mitigated by the

anonymity of the respondents, promised

confidentiality of responses and direct return

of the completed questionnaires to the

authors. Still, the sensitive nature of the

questions may lead to response bias,

especially regarding premature sign-off.

There may also be a problem with

non-response bias regarding the

underreporting questions. Analysis indicates

that the likelihood of underreporting for late

respondents was significantly less than for

the on-time respondents (there was no

significant difference for the likelihood of

prematurely signing-off).

Third, the variables investigated in the

study are not meant to be complete or

exhaustive; there may be other variables that

influence underreporting and premature

sign-off which were not included. Finally, the

study looks only at the antecedents of


behaviors but not the consequences.

Directions for future researchThe limitations highlighted above suggest

possible directions for future research. For

example, future research could examine

ways to disguise the objective of the study or

desensitise the sensitive nature of the survey

questions in order to minimize the response

bias caused by the sensitive nature of ethics

research. Future studies could also examine

the ethical decision-making model in other

ethical decision situations typically found in

the practice of public accounting. The

aggregation of evidence over different

settings may be useful in generating an

understanding of the ethical decision-making

process of public accountants.

Finally, the results of prior studies suggest

that codes of conduct and organizational

sanctions may influence employee ethical

decisions (see, e.g. Lightner et al., 1983; Ford

and Richardson, 1994; Boo and Koh, 2001).

Future studies could include these additional

variables in the ethical decision model.

Notes1 Research results regarding the relation

between job and level of moral development

have been inconsistent. In contrast to the

findings of Lampe and Finn (1992), and

Ponemon and Gabhart (1993), Ponemon (1990)

found managers and partners had lower levels

of cognitive moral development than staff and

senior accountants. Similarly, Ponemon

(1992b) and Ponemon and Gabhart (1993) found

that the level of moral reasoning decreased as

CPAs’ job levels increased. Since the results of

prior studies indicate that managers and

partners are less likely to engage in


activities, the inverse relation between job

level and moral development suggests that

level of moral development and likelihood of


activities are inversely related. Part of this

inconsistency may be the result of differences

in how moral development was measured;

Ponemon (1990) used the Moral Judgment

Interview while the other studies used the

Defining Issues Test.

2 There are two versions of the DIT, a

six-vignette version and a shorter

three-vignette subset. Although not as

reliable, the short version correlates highly

(0.91 to 0.93) with the longer version and

possesses corresponding measurement

properties (Rest, 1986). Because of

considerations regarding questionnaire

length and response rates, the shorter version

of the DIT was used.

3 After removing partners from Ponemon’s

(1992b) sample, the mean DIT P score was 43.1.

The mean score for Canadian Chartered

Accountants in Ponemon and Gabhart (1993)

was 44.2.

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[ 487 ]



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[ 489 ]



Internal auditors and the external audit: a transactioncost perspective

Cameron MorrillDepartment of Accounting and Finance, I.H. Asper School of Business,University of Manitoba, Winnipeg, Manitoba, CanadaJanet MorrillDepartment of Accounting and Finance, I.H. Asper School of Business,University of Manitoba, Winnipeg, Manitoba, Canada

Introduction

While external and internal auditors occupy

distinct roles, many professional bodies

increasingly advocate that coordination of

the external and internal auditors can

provide total audit coverage more efficiently

and effectively (Brink and Witt, 1982; Engle,

1999; Felix et al., 1998; Moore and Hodgson,

1993; Institute of Internal Auditors, 1995). A

higher degree of coordination often will

include greater internal audit participation

in the external audit. For example, Engle

(1999) suggests that internal audit directors

should work aggressively with external

auditors to maximize their reliance on

internal auditors as one way to develop a

more effective strategy for collaboration.

However, the decision to encourage

internal auditors’ participation in the

external audit is not without controversy.

Gaston (2000, p. 37) asserts that the internal

audit is not a substitute for the external

audit, and that internal auditors should not:. . . unduly focus on those areas of financial

controls that are the subject of external audit

interest.

As well, relying on internal audit can reduce

the effectiveness of the external audit if the

internal audit department is of questionable

quality (Gramling, 1999).

Evidence of this debate is confirmed by the

wide variation in the observed extent of

internal audit participation in the external

audit. Burnaby and Klein (2000) report that

internal auditors are increasingly

contributing to the work performed for the

external audit, and a study by the Canadian

Institute of Chartered Accountants asserts

that external auditors seeking direct

assistance from internal auditors is common

practice in Canada (CICA, 1989). However,

empirical studies have also documented

significant inter-company differences in

activities performed by internal audit

departments, including activities such as

assisting the external auditor, detecting

errors, and monitoring controls (Mautz et al.,

1984; Felix et al., 1998; 2001).

The decision to have the internal auditors

participate in the external audit is similar to

the vertical integration or outsourcing

decision. As in the generic ‘‘make-or-buy’’

problem, audit services can be purchased

from outside the firm or provided from

within the firm (within, of course, some clear

limits). The optimal mix of internal and

external personnel in the external audit

depends upon the costs associated with each

of the available sources. This mix can (and,

based on the studies cited above, apparently

does) vary considerably from company to

company.

In this study, we use transaction cost

economics (TCE) (Williamson, 1985; 1991) to

help explain the variation in internal audit


According to TCE, different institutional or

organizational arrangements (e.g. internal vs

market-mediated, make vs buy) exist

principally for the purpose of facilitating

transactions, i.e. reducing the transaction

costs of conducting a particular activity. TCE

has been used as a framework for analyzing

many different transactions. To our

knowledge, our study is the first that uses it

to explain the participation of internal

auditors in the external audit[1]. This kind of

understanding could help companies and

their external auditors to identify

circumstances under which it would be

economically advantageous to involve the

internal audit department in the external

audit; and could have implications for

staffing and structuring an internal audit

department.





[ 490 ]



KeywordsInternal auditing,

External auditing,

Transaction costs, Surveys,

Canada

AbstractQuestions exist regarding the

extent to which internal auditors

should participate in the external

audit, and wide variations are

observed in practice. Many

professional bodies increasingly

advocate the view that increased

coordination between the internal

and external auditors, including

increased use of the internal

auditor for the external audit,

provides more efficient and

effective audit coverage. However,

others maintain that internal

auditors should not focus on areas

that are the subject of external

audit interest. This article

attempts to shed light on this

debate by using insights from

transaction cost economics (TCE)

to identify conditions under which

organizations encourage internal

audit participation in the external

audit. An analysis of survey data

collected from directors of

Canadian internal audit

departments indicate that some

(TCE) variables, particularly

transaction-specific investment,

are significantly associated with

internal audit participation in the

external audit.

We use partial least squares (PLS)

regression to analyze survey data collected

from directors of internal audit departments,

and external auditors, of Canadian

organizations. According to our findings, two

TCE variables are significantly associated

with the extent of internal audit


The paper is organized as follows. We first

review the research into external auditor

reliance on internal auditors. We then

outline the transaction cost model and derive

testable hypotheses related to the external

audit. We then present the results of a partial

least squares analysis of the internal audit

director survey data. Next, we present the

results of an analysis of survey responses of

the external auditors of these same

organizations. Finally, we discuss the results

and offer our conclusions.

External auditors’ reliance oninternal auditors

In recent years, professional accounting

bodies representing both internal and

external auditors have expressed interest in

increasing the level of coordination between

the internal and the external audit. The

purpose of such coordination is to ensure

adequate total audit coverage and minimize

duplication of efforts (Institute of Internal

Auditors Specific Standard 550; Institute of

Internal Auditors, 1995). This level of

coordination implies a less rigid separation

of responsibilities between the internal and

external auditor. Advocates argue that by

adopting a ‘‘joint audit approach’’ the

efficiency of both groups is improved without

sacrificing quality or independence (Moore

and Hodgson, 1993).

Significant opportunities exist for

reduction of duplicate audit efforts and

increased efficiencies by increasing internal

auditor participation in the external audit.

Internal auditing is an independent appraisal

function established with an organization to

examine and evaluate its activities as a

service to the organization. As such, the

internal auditor’s overall interests go far

beyond the system of internal accounting

control, but they do nevertheless include

those accounting controls of interest to the

external auditor. As well, the internal

auditor is interested, in terms of overall

company welfare, in the procurement of the

external auditing services in a manner that

provides good value for the fees charged

and minimizes interference with other

ongoing organizational activities (Brink and

Witt, 1982).

Both US SAS No. 65 (AICPA, 1997) and

Canadian Institute of Chartered Accountants

Handbook Section 5050 (CICA, 1997) allow the

external auditor to rely on evidence

generated from internal audit work when

they are satisfied with the competence and

objectivity of the internal auditors. Should

external auditors opt to rely on the work of

the internal auditors, there are three

potential areas of reliance:

1 understanding the control structure;

2 assessing control risk; and

3 performing substantive tests (Colbert,

1993).

While external auditors would never totally

eliminate their control evaluation and

testing procedures, significant overall

reductions, and complete substitutions in

some areas, are allowable (Engle, 1999).

Indeed, it has been common practice for the

external auditor to seek direct assistance

from internal auditors (Canadian Institute of

Chartered Accountants, 1989).

According to Felix et al. (1998), the trend

towards increased coordination between the

internal and external auditors, and

specifically increased participation by the

internal auditor in the external audit[2], is

the result of three major developments. First,

the Treadway Commission’s 1987 report put

pressure on organizations and external

auditors to involve the internal auditing

department in the external audit to a greater

extent. Second, pressure to reduce audit fees

has encouraged external auditors to explore

ways to use the work of internal auditors.

Third, many initiatives of the Institute of

Internal Auditors, such as the development

of professional internal auditing standards

and the growth of the professional

certification program, have served to

increase the stature of the internal auditing

profession.

Clearly, however, there are limits on the

extent to which the external audit can be

‘‘internalized’’ and too much internal audit

participation in the external audit can be

detrimental to the effectiveness of both the

external audit and the work of internal

auditors. Gaston (2000, p. 37) agrees that the

work of the external and internal auditors

should be coordinated to remove any

unnecessary duplication, but emphasizes

that the internal audit is not a substitute for

the external audit, and that internal auditors

should not:. . . unduly focus on those areas of financial

controls that are the subject of external audit

interest.

As well, Gramling (1999) noted that while

external auditors can rely on the work of

[ 491 ]

Cameron Morrill andJanet MorrillInternal auditors and theexternal audit: a transactioncost perspective


sufficiently competent and objective internal

auditors without impairing the quality of the

audit, some external auditors, particularly

under conditions of fee pressure, could rely

on internal audit departments of more

questionable quality, which would reduce the

effectiveness of the external audit.

Several research studies have focussed on

the external auditor’s reliance on the

internal audit function (e.g. Abdel-Khalik

et al., 1983; Brown, 1983; Maletta, 1993;

Gramling, 1996; Brody et al., 1999). Typically,

they have looked at the external auditor’s

evaluation of the competence, objectivity and

work performance of the internal auditor and

his or her subsequent decision regarding the

appropriate extent of reliance.

Krishnamoorthy (2002) notes that while the

results of these (for the most part,

experimental) studies differ regarding the

relative importance of these three factors, the

studies generally find that all three have an

important impact on external auditor

reliance on the internal audit.

These studies all consider the availability

of the internal audit department as

exogenous. That is, they assume that there is

an internal audit department that is

available to the external auditor. The focus is

exclusively on the external auditor’s decision

regarding the extent of his or her short-term

(i.e. for this particular audit) reliance on the

internal audit department.

In this study, the availability of internal

audit is endogenous, i.e. is determined by

conditions at work prior to the external

auditor’s reliance decision. We attempt to

identify those conditions under which an

acceptable internal audit department is

likely to be available to the external auditor.

In order for the external auditor to rely on

the internal audit department, a client must

previously decide to:. create an internal audit department;. structure it and staff it in such a way that

the external auditor is likely to deem it

acceptable; and. make the internal audit staff available to

perform work relevant to the external

audit.

Under what conditions is all of this likely to

occur? Transaction cost economists suggest

that efficiency considerations heavily

influence these outcomes. In other words,

economic forces reward efficient

organizational forms, including the

‘‘appropriate’’ structure of the internal audit

department and its relationship with the

external auditor, and punish inefficient

organizational forms[3]. The next section

uses transaction cost theory to identify these

economic forces.

A transaction cost economicsanalysis of the external audit

The transaction cost economics (TCE)

framework proceeds by: (1) making the

transaction the basic unit of analysis; (2)

expressly identifying alternative market and

internal modes of contracting; (3) identifying

the critical dimensions with respect to which

transactions differed; (4) tracing out the

transaction cost ramifications; and (5)

matching modes to transactions in a

discriminating way (Williamson and Ouchi,

1981, p. 349).

Within the TCE perspective, an organization

is any stable pattern of transactions between

individuals or aggregations of individuals.

Writers in the area have identified at least

three major organizational forms: markets,

hierarchies and hybrid arrangements (see

Leblebici, 1985, for a more complete

taxonomy of organizational forms). Which

form or mode of contracting is more efficient

(and, therefore, which prevails in a

competitive setting) depends upon the level

of transaction costs associated with that

form, where transaction costs are:. . . broadly defined as the costs of bargaining,

trading, searching, negotiating, policing, and

enforcing agreements – the sources of friction

that hinder efficient transactions within

different institutional modes of organizing

(Leblebici, 1985, p. 100)[4].

For example, a consumer could acquire fresh

produce (the transaction) in one of several

different organizational settings. In a market

setting, the consumer buys the produce from

a virtually anonymous vendor. In a

‘‘hierarchical’’ or internal setting, the

consumer grows the produce him or herself.

In a hybrid setting, the consumer always

buys the produce from the same supplier,

either under terms of a specific contract or

some informal, long-term commitment.

The organizational setting or form that

prevails is the one that best matches the

transaction in question, i.e. the one that

minimizes transaction costs. TCE identify

three dimensions for characterizing

transactions that give rise to transaction

costs:(1) uncertainty, (2) the frequency with which

transactions recur and (3) the degree to which

durable transaction-specific investments are

required to realize least-cost supply

(Williamson and Ouchi, 1981, p. 352).

Returning to the fresh produce example, the

market setting is sufficient if the consumer is

confident that he or she can easily judge the

[ 492 ]



quality of the produce on simple inspection.

Suppose, however, that the consumer

requires that the produce be pesticide- and

herbicide-free, and that this condition cannot

be verified by simple inspection (i.e. there is

uncertainty). In the market setting, the

consumer might then have to incur

potentially significant costs to test the

produce. Alternatively, the consumer might

be able to reduce these transaction costs by

identifying and dealing exclusively with a

vendor who can credibly guarantee that no

chemicals were used (a hybrid arrangement);

or the consumer could grow the produce him

or herself (an internal or hierarchical

arrangement).

Empirical research within the transaction

cost framework has been concentrated in the

area of vertical integration (e.g. Walker and

Poppo, 1991; Globerman and Schwindt, 1986;

Anderson and Schmittlein, 1984). In these

studies, some specific transaction is

considered (e.g. an auto manufacturer must

acquire carburetors). Alternative modes of

contracting are explicitly identified (make

in-house or purchase from an external

supplier) and choices among them explained

by reference to uncertainty and specific

investment variables. Among studies

concerned more directly with auditors and

their clients, Levinthal and Fichman (1988)

found that complexity and specific

investment variables were positively related

to the duration of auditor-client

relationships.

The next part of the paper deals with the

application of TCE variables (frequency of

recurrence, uncertainty and

transaction-specific investment) to the

external audit. Most organizations that

undergo external audits do so on a regular

(typically annual) basis. The frequency

dimension is therefore relatively constant for

almost all external audit transactions and is

not expected to be useful in explaining

variations in the level of internalization of

external audit activities. For this reason, the

next section of the paper discusses only

uncertainty and transaction-specific

investment as they apply to the external

audit and derives testable hypotheses.

UncertaintyWilliamson (1985) identifies two kinds of

uncertainty that have transaction cost

implications. The first is environmental

uncertainty, the inability to predict all

contingencies that might affect a particular

transaction. Because the human parties to

the transaction have limited cognitive

abilities, they can only deal with these

contingencies by writing contracts that are

incomplete in some important respects.

Market contracts are cumbersome in the face

of unforeseen contingencies as

opportunistically inclined agents can try to

interpret unspecified clauses of the

agreement to their advantage. TCE theorists

argue that an appropriate response to

increased environmental uncertainty is to

internalize the transaction, where stable,

long-term administration and

communication mechanisms can be

developed to enhance information flow

between the parties and resolve conflicts as

they arise.

Significant environmental uncertainty

exists in the context of external audits

characterized by high levels of complexity[5]

or risk, as either could impose unforeseen

costs onto the external auditor through

litigation or additional audit work.

Johnstone (2000) found that high levels of

audit risk expose partners to uncertainty as

auditors seem to be unwilling or unable to

adopt proactive strategies to manage risk

(such as increasing the audit fee) once the

decision to accept the engagement has been

made.

If TCE is correct, a complex and risky audit

is associated with high transaction costs in a

pure market-based contractual arrangement.

In such an audit, the external auditor might

be faced with difficult fee or contract

renegotiations with the client, or with

accepting lower profit and/or higher risk on

the engagement if certain contingencies

materialize. This is costly for both parties as

the external auditor requires compensation

for the elevated levels of external uncertainty

he or she must assume. In contrast, internal

auditors participating in the financial

statement audit, faced with these same

contingencies, can more easily adapt through

internal administration and communication

mechanisms. Thus the transaction costs

associated with a risky or complex financial

statement audit can be reduced by increasing

the internal audit participation. This

argument leads to the following hypothesis:

H1. Internal auditors participate to a

greater extent in external audits

characterized by greater

environmental uncertainty.

The other form of uncertainty discussed by

Williamson (1985) is behavioral uncertainty,

the level of difficulty involved in evaluating

performance and/or adherence to

contractual agreements. In transactions

characterized by a high level of behavioral

uncertainty, one or more opportunistically

inclined parties might be motivated to shirk

or consume excessive levels of perquisites.

[ 493 ]



Transaction cost theory suggests that

transactions characterized by high levels of

behavioral uncertainty are best internalized.

Within a hierarchical arrangement,

monitoring mechanisms and performance

histories can be developed that allow more

accurate measurement of performance. This

motivates parties to an agreement to perform

better and/or permits identification of

inefficient or opportunistic individuals.

In the context of an external audit, the

client may have difficulty in assessing the

efficiency with which the audit is performed

and/or the quality of the audit work. This

can be costly to the client if the audit work is

performed inefficiently or ineffectively.

Where possible, the client should prefer to

entrust to internal auditors those aspects of

the audit where performance is difficult to

measure, in order to take advantage of

monitoring mechanisms that are not

available within a market setting. This

argument leads to the following hypothesis:


greater extent in external audits

characterized by greater behavioral

uncertainty.

Transaction-specific investmentA transaction-specific investment is one that

is necessary to support a particular

transaction, but is not readily redeployable

or useful to any other transaction. Joskow

(1988) discusses four different types of

transaction-specific investment:

1 Site specificity. The buyer and seller are

located very close together, typically to

minimize inventory and transportation

costs. Once in place, the assets involved

are very difficult to move.

2 Physical asset specificity. One or both

parties to the transaction make

investments in equipment that has design

characteristics specific to the transaction

and little alternative use.

3 Human asset specificity.

Transaction-specific human capital that

often arises through a learning-by-doing

process.

4 Dedicated assets. General investments

made by a supplier that would not

otherwise be made but for the prospect of

selling a significant amount of product to

a particular customer.

Examples of transaction-specific investments

which have been studied within the TCE

literature include investment in equipment

dedicated to the manufacture of some specific

product and which has no alternative use

(e.g. Lyons, 1995); specialized

communications hardware and software in

the insurance industry (e.g. Zaheer and

Venkatraman, 1994); and specialized

knowledge required of sales personnel in

order to handle particular products (e.g. John

and Weitz, 1988).

Transaction-specific investment has

important transaction cost implications

because it creates a monopolist-monopsonist

relationship between the parties (or, at the

very least, a small numbers situation). The

party who has undertaken the investment is

the least-cost supplier of the good in question,

but the only interested consumer is the other

party to the transaction. Each party is

dependent upon the other and, therefore,

vulnerable to opportunistic action. TCE

posits that transactions characterized by

high levels of transaction-specific

investments are cumbersome in a market

setting. Agents are reluctant to undertake

transaction-specific investment if there is no

guaranteed long-term return to that

investment. A long-term relationship

between the parties, either through an

internal, hierarchical structure or some less

formal alliance, provides protection for both

parties.

Transaction-specific investment in the

form of human asset specificity is often a

significant feature of the external

auditor-client relationship. Some

considerable knowledge of the client’s

business is considered necessary to the

performance of the external audit,

particularly in the context of general

planning of the audit. This kind of knowledge

assists the auditor in identifying the nature

and source of audit evidence available,

identifying areas that need special

consideration, and subsequent

determination and evaluation of audit

procedures. Specific information required

includes:. industry data, including information on

the nature of the business and industry,

current business conditions and trends,

and the extent of government regulation;. client data concerning organization

structure, capital structure, nature of

products and services, major suppliers

and customers; and. financial data on sales and operating

results, budgeting, and the nature of

accounting records.

This knowledge is generally obtained by

reviewing prior years’ audit work, reading

internal client reports, meeting with client

personnel and reviewing industry

publications, research studies, periodicals

and financial statements of other enterprises

[ 494 ]



in the industry (Anderson, 1984; CICA, 1997,

section 5140).

The acquisition of this knowledge can

represent a substantial transaction-specific

investment on the part of the auditor. If the

client is in a very complex and dynamic

industry, considerable work is necessary to

form an adequate understanding of that

industry. If there are relatively few firms in

the industry, the industry-specific knowledge

necessary to the audit is less likely to be

readily transferable either to or from other

audit work (in that it is less likely that the

auditor will have other clients in the same

industry). TCE would predict that, in a case

like this, a client might be more likely to

involve internal auditors in the external

audit as they can more efficiently accumulate

and impart the required specific knowledge

to the external auditor, as compared to

having the external auditor acquire the

information independently. This is

consistent with the assertion by Engle (1999)

that:. . . internal auditors who are intimately

familiar with the organization under review

are in an ideal position to provide

information about the ‘‘business’’ behind the

financial statements.

This does not imply that the existence of an

internal audit department means that the

external auditor does not need to acquire

knowledge of the client’s business. Rather,

the external auditor can rely on the work of

the internal auditor, such as narratives and

descriptions of the internal control system

prepared by the internal auditor, to acquire

more efficiently the requisite knowledge of

the client.

This argument is not universally accepted

by auditing researchers. Taylor (2000), for

example, found that external auditors tended

to compensate for their relative lack of

industry-specific expertise by increasing

their inherent risk assessments. Engle (1999)

then suggests that it may be less appropriate

for external auditors to rely on the internal

auditor in areas where there is a high risk of

material financial statement

misstatements[6]. Taken together, this could

suggest that external auditors would use the

internal auditor less when the audit

engagement required high levels of specific

expertise.

The TCE specific investment hypothesis is

stated below:


greater extent in external audits which

require substantial audit-specific

knowledge.

Methodology

DataSurvey questionnaires were mailed to all

Canadian members of the Institute of

Internal Auditors who were designated

directors of their organization’s internal

audit department. Of 330 questionnaires sent

out, 153 (46 percent) were returned. After

excluding questionnaires from 18 federal and

provincial government ministries and five

blank questionnaires, 130 usable

questionnaires were available for this study.

This final sample included 32 public sector

and 98 non-public sector organizations.

MethodOur analysis is difficult for several reasons.

First, the TCE constructs are not directly

observable (i.e. they are latent constructs).

Therefore, it is necessary to use multiple

measures (or indicators) in an attempt to

capture adequately each construct. Second,

many of the indicators we use are ordinal in

nature. Finally, our sample size is limited to

130 cases. Partial least squares (PLS) analysis

is well suited to the estimation of this type of

model with data of this kind (Fornell and

Bookstein, 1982; Wold, 1982) and is used

here[7].

The PLS algorithm is designed to maximize

the predictive ability of the estimated model.

It simultaneously estimates each of the latent

variables as a linear function of the

designated indicators and the path

coefficients for the relationships specified

among the latent variables. Because of its

lenient assumptions concerning the nature

and distribution of the indicators, PLS

provides no statistical tests of the path

coefficients. However, bootstrapping can be

used to build distributions of model

parameters by repeatedly analyzing different

subsets of data. This process is used here to

determine the statistical significance of the

estimated path coefficients.

Measurement of the variablesThe first step in PLS analysis is to specify the

structural model (i.e. the expected

relationships among the latent variables) and

the latent-variable-to-indicators

relationships in the measurement model.

From the discussion and hypotheses above,

we identify eight latent variables related to


audit, behavioral uncertainty, external

uncertainty and specific investment. The

structural model is laid out in Figure 1 and

the latent-variable-to-indicators

relationships are described in Table I.

[ 495 ]



Participation (LV1)Three indicators are used to measure the

degree of internal audit department

participation in the external audit (hereafter,

simply participation). Internal audit

directors were asked to estimate in global

terms the proportion of external audit work

performed by the internal audit department.

It is interesting to note that the proportion of

external audit work performed by the

internal audit department varied widely,

from 0 percent to 80 percent.

Internal audit directors were also asked to

identify from a list of specific external audit

activities those in which their department

was involved (see Figure 2). We argue that

this operationalization of participation

captures elements of both the breadth and

depth of internal audit participation in the

external audit. Finally, internal audit

directors were asked their level of agreement

with the statement that there was little

internal audit involvement in the external

audit.

Behavioral uncertaintyRespondents were asked to evaluate how

difficult it was to measure the performance of

the external auditor with respect to several

dimensions of external audit work. Based on

a factor analysis of the survey results, we

identified three areas of behavioral

uncertainty, regarding: use of client

personnel (LV2); quality of audit work (LV3);

and efficiency of audit work (LV4).

Environmental uncertaintyRespondents were asked about

characteristics of their organizations that

potentially render the external audit more

complicated and unpredictable, thereby

entailing unforeseen additional audit work

or litigation risk. Specifically, we inquired

about the complexity of firm transactions

(LV5), the geographical dispersion of firm

activities (LV6) and the size of the

organization (LV7).

The size indicator was measured by the

number of organization employees, as

provided by the respondents. Sales and assets

are alternative measures of organizational

size and are both more frequently used in

empirical studies in accounting. These items

are not meaningful, however, for many

not-for-profit organizations, and were not

provided by many of our survey

respondents[8]. To maximize our sample size

for this analysis, then, we elected to use

number of employees over accounting

measures of size.

Similarly, we do not use receivables or

inventories as proxies for audit complexity,

Figure 1Model of internal audit participation in external audit

[ 496 ]



Table ILatent variables (LV) and their indicators (X)

Latent variables (LV)/indicators (X) Mean Std dev. Min Max Loadinga

LV1: ParticipationX1 – Number of external audit activities in which your internal

audit department work is used17.6 16.5 0 69 0.89

X2 – Percentage of external audit you estimate is performed byyour internal audit department

15.8 18.5 0 80 0.89

X3 – There is little internal audit involvement in external audit(1 = strongly agree; 7 = strongly disagree)

3.9 2.3 1 7 0.76

Internal consistencyb =0.89

Behavioural uncertaintyHow difficult is it to evaluate the performance of the external

auditor with respect to each of the following areas(1= not difficult; 7 = very difficult)?

LV2: Use of client personnelX4 – Efficient use of client personnel (excluding internal audit

personnel)3.3 1.6 1 7 1


LV3: Quality of audit workX5 – Ability to detect errors 4.0 1.5 1 7 0.85X6 – Ability to detect internal control weaknesses 3.6 1.5 1 7 0.93Internal consistencyb =0.89

LV4: Efficiency of workX7 – Use of most cost-effective auditing techniques 4.1 1.7 1 7 0.87X8 – Audit work performed as quickly as possible 3.2 1.5 1 7 0.89Internal consistencyb =0.87

Environmental uncertaintyLV5: Complexity of transactionsX9 – Our firm enters into many unusual transactions

(1= strongly disagree; 7 = strongly agree)4.8 1.8 1 7 1


LV6: Geographical dispersionX10 – In how many provinces does your company have

divisions, branches, etc.?3.1 3.4 0 11 1


LV7: Organization sizeX11 – Natural logarithm of number of employees 7.7 1.5 3.9 11 1Internal consistencyb =1.00

LV8: Specific investmentSpecialized knowledge of this company and its industry is

necessary on the part of the external auditor in order toperform the following activities (1=strongly disagree;7 = strongly agree):

X12 – Understanding the nature of our business 5.3 1.4 1 7 0.69X13 – Planning the audit 5.1 1.4 1 7 0.77X14 – Documenting and evaluating the internal control system 4.8 1.6 1 7 0.82X15 – Testing the internal control system 4.4 1.6 1 7 0.84X16 – Designing substantive tests 4.4 1.5 1 7 0.8X17 – Performing substantive tests 4.2 1.5 1 7 0.89X18 – Designing analytical review procedures 4.8 1.4 1 7 0.87X19 – Performing analytical review procedures 4.6 1.5 1 7 0.86Internal consistencyb =0.95

Notes a Loading is a measure of the correlation between the specific indicator and its latent variable. Loadings of0.7 or better indicate an adequate level of individual indicator reliability; b The internal consistency measure isthe one suggested by Fornell and Larcker (1981). Scores of 0.7 or better indicate an adequate level of latentvariable internal consistency

[ 497 ]



as Simunic (1980) did, as these items were not

reported for many of the organizations in our

sample.

Specific expertise (LV8)Respondents assessed the extent to which

specialized knowledge of the organization

was necessary to perform specific aspects of

the external audit.

Results

Although the measurement parameters and

path coefficients are estimated together by

the PLS algorithm, a PLS model is assessed in

two stages: first, the assessment of the

reliability and validity of the measurement

model and second, the assessment of the

structural model (i.e. the significance of the

path coefficients and percentage of variance

explained). The principle is to ensure that we

have reliable and valid measures of the latent

variables before attempting to draw

inferences regarding the relationships

among them.

The measurement modelResults in Table I indicate that all of the

latent variables exhibit acceptable levels of

internal consistency. The loading of each

indicator on its latent variable is

approximately 0.7 or higher, the rule of

thumb recommended by Carmines and Zeller

(1979). Additionally, the internal consistency

of each latent variable, using the measure

suggested by Fornell and Larcker (1981), is

Figure 2External audit activities in which internal audit work is useda

[ 498 ]



well above the suggested benchmark of 0.7.

Taken together, these results indicate

adequate internal consistency.

Discriminant validity is a measure of the

extent to which a given construct is different

from other constructs in the model. The

results in Tables II and III suggest that the

latent variables we use do have adequate

discriminant validity. Table II shows that the

correlations between each latent variable

and its indicators (printed in italics) are

higher than the correlations between those

indicators and any other latent variable.

Table III is the matrix of bivariate

correlations among the latent variables. The

diagonal elements are the square roots of the

average variances extracted (the average

variance shared between the latent variable

and its indicators). These diagonal elements

are greater than any of the off-diagonal

elements, indicating that each latent variable

is more closely associated with its indicators

than with any of the other latent variables

(Fornell and Larcker, 1981).

Table IIBivariate correlations between latent variables and indicators

Latent variables

Indicators LV1 LV2 LV3 LV4 LV5 LV6 LV7 LV8

X1 0.89 –0.06 –0.12 –0.20 0.17 0.11 –0.17 0.30

X2 0.90 0.03 –0.07 –0.20 0.17 0.08 –0.24 0.37

X3 0.75 –0.04 –0.10 –0.16 –0.05 0.07 –0.15 0.17

X4 –0.02 1 0.27 0.25 0.02 0.04 0.14 0.12

X5 –0.06 0.17 0.81 0.24 –0.02 –0.09 0.10 –0.02

X6 –0.12 0.28 0.95 0.35 –0.07 –0.12 0.09 0.06

X7 –0.18 0.27 0.34 0.87 –0.01 –0.14 0.08 –0.04

X8 –0.20 0.18 0.27 0.89 –0.05 –0.00 –0.00 0.07

X9 0.13 0.02 0.06 –0.04 1 0.07 0.1 0.32

X10 0.1 0.04 –0.12 –0.08 0.07 1 0.26 0.09

X11 –0.23 0.14 0.1 0.04 0.1 0.26 1 –0.16

X12 0.06 0.10 0.11 –0.05 0.37 –0.04 –0.07 0.69

X13 0.18 0.06 0.09 0.02 0.38 0.03 –0.08 0.77

X14 0.18 0.15 0.06 0.14 0.25 0.02 –0.10 0.82

X15 0.27 0.12 0.07 0.11 0.20 –0.00 –0.12 0.84

X16 0.27 0.12 0.08 –0.06 0.30 0.10 –0.14 0.87

X17 0.37 0.07 0.01 –0.08 0.29 0.07 –0.16 0.90

X18 0.30 0.13 –0.02 0.03 0.28 0.15 –0.14 0.87

X19 0.37 0.10 –0.01 0.03 0.21 0.12 –0.15 0.86

Notes LV1: Internal audit participation in external audit; LV2: Behavioral uncertainty – use of client personnel;LV3: Behavioral uncertainty – quality of audit work; LV4: Behavioral uncertainty – efficiency of audit work; LV5:Environmental uncertainty – complexity of transactions; LV6: Environmental uncertainty – geographicaldispersion; LV7: Environmental uncertainty – organization size; LV8: Specific expertise; Correlations printed initalics are those between each latent variable and its indicators

Table IIIBivariate correlations of latent variables

LV1 LV2 LV3 LV4 LV5 LV6 LV7 LV8

LV1 0.85LV2 –0.02 1LV3 –0.11 0.27 0.88LV4 –0.22 0.25 0.35 0.88LV5 0.13 0.02 –0.06 –0.04 1LV6 0.1 0.04 –0.12 –0.08 0.07 1LV7 –0.23 0.14 0.1 0.04 0.1 0.26 1LV8 0.34 0.12 0.04 0.02 0.32 0.09 –0.16 0.83

Notes LV1: Internal audit participation in external audit; LV2: Behavioral uncertainty – use of client personnel;LV3: Behavioral uncertainty – quality of audit work; LV4: Behavioral uncertainty – efficiency of audit work; LV5:Environmental uncertainty – complexity of transactions; LV6: Environmental uncertainty – geographicaldispersion; LV7: Environmental uncertainty – organization size; LV8: Specific expertise; Diagonal elements (initalics) are the square roots of average variances extracted

[ 499 ]



The structural modelThe results of the PLS estimation of the

model are presented in Figure 3. The model

explains 20.9 percent of the variability in the

participation construct.

The internal uncertainty coefficients are

not statistically significant and two of them

are negative, contrary to our prediction.

There is no support here for H1.

The results indicate some weak support for

H2 in that the geographical dispersion

coefficient is positive and statistically

significant (p<0.10). The complexity of

transactions coefficient is not statistically

significant. Contrary to H2, the size

coefficient is negative.

Finally, the specific expertise coefficient is

positive and statistically significant. This

constitutes strong support for H3.

Public sector vs private sectororganizationsTCE is based on the assumption that

competitive forces in the market place drive

firms to adopt technologies and

administrative structures that minimize

costs. To the extent that public sector

organizations are insulated from this sort of

competition, they might be able to adopt and

maintain inefficient systems of

administration. The presence of public sector

organizations in our sample might bias

against finding results that are consistent

with TCE predictions. To test whether this is

the case here, we dropped public sector

organizations from the sample and reran the

analysis. The results obtained were not

qualitatively different from those obtained

using the full sample.

External auditor surveyThe results reported above are founded upon

three maintained hypotheses. Specifically,

we assume that the internal audit director is

able to assess accurately: first, the TCE

dimensions (uncertainty,

transaction-specific investment) of the

external audit; and second, the extent of the


audit. In addition, we assume that internal

Figure 3Results of partial least squares structural model estimation

[ 500 ]



auditors in our sample who do participate in

the external audit meet the external auditor’s

requirements regarding competence and

objectivity, i.e. we assume that the variation

in internal audit participation is due

primarily to TCE factors, rather than the

external auditor’s refusal to rely upon the

internal audit department due to concerns

about internal audit quality or some personal

preference that might prevent reliance on the

internal auditor.

In order to test, at least partially, the

validity of these assumptions, we asked the

internal audit directors who responded to

our survey to send an additional, shorter,

survey to their organization’s external

auditor, which was returned directly to us

using an enclosed envelope. Of the 130 firms

that responded to the internal audit survey,

69 external auditors also responded.

We compared the external and internal

auditors’ assessments of the internal audit

participation for the 69 firms with both

internal and external auditor responses. The

external and internal auditors’ evaluations

were highly and significantly correlated

(Pearson’s r=0.78 for the proportion of audit

work performed by the internal audit

department; r=0.62 for number of external

audit activities in which internal audit work

is used), giving us some assurance as to the

validity of the internal auditors’

assessments.

In addition, we re-ran our PLS sample for

the 69 firms, using the external auditor

assessments as the dependent variable rather

than the internal audit directors’

evaluations. Specific expertise was still

significant and positively related to

participation, but geographical dispersion

(which was marginally significant in the

original analysis) was no longer significant.

Therefore, using the external audit responses

gives us similar results overall.

At least two features of our study provide

assurance that the internal auditors in our

sample were of acceptable quality to their

external auditors. First, all of the internal

auditors included in the survey were

members of the Institute of Internal Auditors

and possessed, therefore, some level of

professional qualifications. Second, our

survey results suggest that the external

auditors were, for the most part, impressed

with the quality of the internal audit

departments. The quality of the internal

audit departments was rated by 96 percent of

respondents as average or above. Similarly,

on a seven-point likert scale, 93 percent

agreed (score of four or above) that their

clients’ internal audit department possessed

sufficient independence, and 95 percent

agreed that the internal audit department

possessed sufficient competence.

Finally, the external auditors

overwhelmingly believed (98 percent giving a

score of four or above) that external auditors

should rely on internal audit whenever

possible. Taken together, these results

provide at least some assurance as to the

validity of our third maintained hypothesis,

that the internal auditors in our sample met

the external auditors’ standards for

competence and objectivity; and the external

auditors did not have strong reservations

about using the work of qualified internal

auditors.

Discussion and conclusions

Our results indicate that audit-related

specific expertise is strongly associated with


audit. This result is consistent with much of

the empirical research in TCE, where

Williamson (1991) has noted that, of the TCE

variables frequency, uncertainty and asset

specificity, the latter appears to contribute

most significantly to the choice of

governance structure. This result is also

consistent with those of studies more closely

related to auditing. Widener and Selto (1999)

found that asset specificity was significantly

associated with extent of outsourcing of

internal audit activities; and Levinthal and

Fichman (1988) found that specific

investment was associated with duration of

auditor-client relationships.

This result potentially gives some insight

into the controversy surrounding the

relationship between audit-specific expertise

and internal audit participation alluded to in

the development of H3. When an audit

requires substantial specific expertise,

external auditors in our sample tend to

increase reliance on internal audit.

Furthermore, our results suggest that

audit-specific expertise is a more important

determinant of internal audit participation

than measures of uncertainty or complexity.

This implies that a company whose audit

requires high levels of company-specific

expertise might achieve greater efficiencies

by promoting its internal auditors’

participation in the external audit. This

implies that a company in this situation

would be well advised to staff and structure

its internal audit department in such a way

that it would meet the external auditor’s

professional requirements.

Our study has some limitations. First, our

measures rely heavily on the internal audit

director’s impressions. To the extent that the

[ 501 ]



internal audit director has a good

understanding of the external audit and how

it is carried out within his or her

organization, this feature is an advantage of

our study over archival studies like

Levinthal and Fichman (1988). If this is not

the case, however, the internal auditor’s

evaluations may have questionable validity.

Using external auditor assessments of

internal audit participation in our analysis,

as described above, yielded results similar to

those obtained from analyses based solely on

internal auditor assessments. This provides

some assurance regarding the validity of

internal auditor perceptions of the external

audit.

This issue might be indirectly related to

the internal uncertainty results reported

here. We found a negative association

between internal uncertainty and internal

audit participation in the external audit,

when, according to H2, internal uncertainty

(the inability to measure auditor

performance) should be associated with

increased internal audit participation in the

external audit. A possible explanation for

this finding is that as internal audit

participation increases, internal auditors

work more closely with the external auditor

and are, therefore, better able to evaluate the

work of the external auditor. If this argument

is correct, it might well induce a negative

correlation between internal audit

participation and internal uncertainty.

A second limitation pertains to the

identification of alternative modes of

contracting that are available to

organizations and their external auditors.

Our dependent variable is the extent of


audit. Levinthal and Fichman (1988),

however, find evidence that complexity and

specific investment factors are also

positively related to the duration of

auditor-client relationships. This suggests

that extensive involvement in the external

audit by internal auditors is not the only

solution to the transaction cost problem.

Future research might extend our survey

approach to analyze the duration of the

auditor-client relationship and whether this

is a complement to, or a substitute for,

internal audit involvement in the external

audit.

Notes1 Widener and Selto (1999) use transaction cost

economics to explain firms’ decisions to

outsource internal auditing activities. Their

analysis identifies factors associated with the

participation of (typically) external auditors

in internal audit work, while this study is

concerned with the reverse.

2 Several empirical studies have examined the

extent of involvement of the internal audit

department in the external audit. For

examples, see Barett and Brink (1980); Mautz

et al. (1984); Taylor et al. (1997); and Felix et al.

(1998).

3 Transaction cost economics (TCE) might help

us to predict or explain the appropriate level

of internal audit participation in the external

audit, but it does not tell us how the client and

the external auditor arrive at this level. For

example, the client might inadvertently

structure the internal audit department

optimally according to TCE without any

knowledge or consideration of TCE factors.

Similarly, the client might not consider using

the internal audit in the external audit when

the internal audit department is created. TCE

predicts only that clients that have adopted

TCE-efficient structures will be rewarded with

lower costs, and therefore, have a competitive

advantage over other organizations. Other

things being equal, efficient transactional

forms will prevail, regardless of how they

come to exist.

4 TCE assumes that the cost of basic factors is

competitively priced and constant across

different governance structures. The choice of

governance structure affects only the

transaction costs.

5 Simunic (1980) suggests that audit complexity

is related to the size of the client, the diversity

of the client’s operations and auditing

problems associated with the client’s

receivables and inventories.

6 Maletta (1993), however, found that the levels

of inherent risk did not affect auditors’

decisions to employ internal auditors as

assistants.

7 Partial least squares (PLS) is particularly

useful in analyzing relatively small data sets.

The measurement and structural parameters

of a PLS model are estimated iteratively, using

ordinary least squares estimation. According

to the ‘‘rule of thumb’’ suggested by Barclay

et al. (1995), the minimum sample size

required for consistent estimates is ten times

the number of parameters estimated in the

largest regression model within the overall

causal model. In this study, the minimum

suggested sample size is 10� 7= 70, where

seven is the number of constructs leading to

the endogenous construct ‘‘participation’’.

8 We replicated our analysis using revenues and

total assets as alternative measures of size,

using only those cases that reported these

variables. The results were not qualitatively

different from those obtained using number of

employees as a measure of size, and so are not

reported here.

[ 502 ]



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The authors acknowledgethe assistance of theInstitute of InternalAuditors and, in particular,the Ottawa, Canadachapter. This project hasbenefitted from thecomments of Jean Bedard,Peter Tiessen,Carman Xoung andworkshop participants atLaval University and theUniversity of Manitoba. Thefinancial support of theSocial Sciences andHumanities ResearchCouncil is gratefullyacknowledged.

[ 504 ]



The Mad Hatter’s corporate tea party

Philomena LeungRMIT University, Melbourne, Victoria, AustraliaBarry J. CooperRMIT University, Melbourne, Victoria, Australia

Tea for two and me and you

There was a table set out under a tree in front

of the house, and the March Hare and the

Hatter were having tea at it: a Dormouse was

sitting between them, fast asleep, and the

other two were using it as a cushion, resting

their elbows on it, and talking over its head.

‘‘Very uncomfortable for the Dormouse,’’

thought Alice; ‘‘only, as it’s asleep, I suppose

it doesn’t mind.’’ The table was a large one,

but the three were all crowded together at one

corner of it: ‘‘No room! No room!’’ they cried

out when they saw Alice coming. ‘‘There’s

plenty of room!’’ said Alice indignantly, and

she sat down in a large arm-chair at one end

of the table (from Alice in Wonderland, by

Lewis Carroll).

The tea party of corporate greed has been

exposed with a vengeance in recent times,

with the CEOs and directors (the March

Hares and The Hatters) having their fill; the

regulators (the Dormouse) caught sleeping;

and the accountants and auditors (Alice),

joining the fray at the surreal tea party.

Excess in corporate life is not new, as the

party seems to come around every decade or

so until the bubble seems to expand another

size in absurdity and cost to the community,

before it finally implodes once again (Hewett,

2002). However, this time, an increasingly

angry public have seen their superannuation

and pension savings savagely mauled and

respect for corporate managers, regulators

and the accounting profession has arguably

sunk to an all time low. One of the big five

global accounting firms, Arthur Andersen,

has disappeared in the implosion, along with

the well known collapses of Enron,

WorldCom, Global Crossing and all the

others. In many parts of the developed world,

corporations reported to have been ‘‘cooking’’

their books have become constant news. In

America, the recent list includes Adelphia

Communications, the sixth largest cable

provider in the country, which inflated its

revenue with a $3 billion off-the-books

personal borrowing by the founding family;

Xerox, which was fined $10 million to settle

fraud charges by the SEC after it improperly

reported a $6.4 billion in revenue; while the

story with WorldCom continues to unfold

(Wallis, 2002). In Australia, the demise of

One.Tel, Harris Scarfe and HIH Insurance,

Australia’s largest corporate collapse, have

to some extent mirrored the American

experience, albeit on a smaller scale.

The greed and consequent loss of

confidence in the corporate sector is of

concern to many Australians. According to

the Australian Prudential Regulation

Authority (2002), 46 per cent of all

superannuation funds were invested in

equities or unit trusts, totalling A$245 billion

Accordingly, a large number of Australians

have an interest in the performance of

Australian companies, as their retirement

incomes depend on the strength of the share

market. Also, many Australians have a

further interest in the share market through

direct ownership of shares. These investors

have a right to know that a company is being

properly managed and have access to the

information they need to make their

investment decisions. Judging by the

constant press, they have not been impressed

with the feeding frenzy at the Mad Hatters

corporate tea party.

In discussing the current corporate

scandals, following Enron and WorldCom,

Wallis (2002) argues that:. . . the tree of the American economy is rooted

in the toxic soil of unbridled materialism.

The reactions to the recent corporate

collapses by governments and professional

bodies have generally focused on regulations

on corporate governance and on the





[ 505 ]



KeywordsCorporate governance, Ethics,

Standards, Accountancy

AbstractThis paper aims to provide an

insight into the corporate greed

and consequent corporate

collapses of companies such as

HIH, One.Tel and Harris Scarfe in

Australia, while concurrently,

Enron, WorldCom and other

companies were attracting the

attention of the accounting

profession, the regulators and the

general public in the USA. It is

argued that the rise in economic

rationalism and the related

increased materialism of both the

public and company directors and

managers, fed the corporate

excesses that resulted in

spectacular corporate collapses,

including one of the world’s

largest accounting firms. The

opportunistic behaviour of

directors, and managers and the

lack of transparency and integrity

in corporations, was compounded

by the failure of the corporate

watch-dogs, such as auditors and

regulators, to protect the public

interest. If the history of bad

corporate behaviour is not to be

repeated, the religion of

materialism needs to be

recognised and addressed, to

ensure any corporate governance

reforms proposed for the future

will be effective.

enforcement of professional codes. However,

as the following view indicates, there might

be other fundamental elements in the

corporate regime, which need to be examined

more closely. Wallis (2002) observes that the

entrepreneurial spirit and social innovation

fostered by a market economy has benefited

many, and should not be overly encumbered

by stifling regulations. But left to its own

devices and human weaknesses, the market

will too often disintegrate into greed and

corruption. Capitalism needs rules, or it

easily becomes destructive. A healthy

balancing relationship between ‘‘free

enterprise’’ and public accountability and

regulation is morally and practically

essential.

Following a brief analysis of the concept of

materialism, this paper discusses the three

corporate collapses in Australia, namely,

One.tel, Harris Scarfe and HIH. This

examination highlights some common

threads in the collapses, which include:. inappropriate management

compensation;. creative accounting;. failure of directors and managers to

exercise due diligence;. lack of adequate regulation; and. lack of independence in the audit

function.

Although it is generally acknowledged that

the key failure of such collapses lies in the

lack of effective corporate governance, the

analysis that follows offers a different view. It

is argued that the relationship of materialism

and corporate collapses has been largely

overlooked by the numerous corporate

governance recommendations, which merely

scratch the surface of the problems.

The new religion of materialism

As demonstrated by Toms (2002), the collapse

of a system of open corporate accountability

was due to the rise of a clique of shareholder-

entrepreneurs who instigated accounting

manipulation. Toms’ detailed analysis of the

Lancashire cotton mills from 1870-1914,

shows that social capital (namely, the capital

contributed by workers) demanded accurate

financial information, with the support of co-

operative governance. But systematic wealth

transfers in favour of cliques of promoters,

directors and institutions, narrow the social

base of share ownership, increasing the

power of the cliques and reducing proper

accountability. This cyclical effect can be

seen also in agency compensation, a

mechanism to minimise agency costs by

aligning individual agents’ interests with

that of the organisation’s. But as such a

mechanism becomes the tool for wealth

transfers, and prey to power and

materialism, agency compensation becomes

the rationale for creative accounting and

ultimately the demise of corporations. Also,

accounting and auditing rules develop

according to the accountability demanded by

collective capital, which is in turn the subject

of manipulations by managerial agents,

resulting in a failure to produce transparent

information.

Looking once again at history, Toms (2002)

claims that in many companies in the late

1890s, directors-owners consolidated their

control via the mechanism of extraordinary

general meetings. They put forward and

secured approval for the adoption of new

articles, allowing the plutocratic one share

one vote system, voting by proxy, minimum

shareholding qualifications for directors and

the removal of the obligation to forward

accounts to shareholders. Their rise to power

is consistent with Marx’s (1984) description of

a ‘‘new financial aristocracy’’. Capital

ownership centralised around cliques of

richer shareholders able to exclude residual

shareholders and to impose tightly controlled

nominee managers (Toms, 1998; Tyson, 1968).

Interlocking directorships and shareholdings

became commonplace – a feature of those

collapsed corporations.

Examples of creative accounting were

facilitated by the changes in governance and

monitoring structure that occurred as early

as the 1870s. Auditors were recruited from

the shareholder body of co-operative

companies. In cases of suspected frauds,

shareholder committees of investigation

were set up but small investors lost in most

cases (Toms, 1994). Such committees were

ineffective, and although they were able to

quantify losses ex post, fraudulent managers

left companies, or were dismissed, well ahead

of any possible prosecution. Combined with

the speculative nature of the market, this

placed considerable pressure on the audit

function despite the less-than-attractive audit

fees that were then the norm. It was also

noted by Jones (1959) that the controlling

cliques’ use of loan finance had reduced the

dependency on professional audit. He

observed that, when necessary, boards

simply over-rode the auditors’

recommendations and used the plutocratic

governance system to vote for increases in

salaries and also in remuneration for the

auditors, thereby compromising the

independence of the audit function. Toms

(2002) also noted that individual financial

status and capital maintenance reputation

were secured through accounting

[ 506 ]

Philomena Leung andBarry J. CooperThe Mad Hatter’s corporatetea party


manipulations and dividend announcements

and little reliance was placed on the

publication or auditing of financial

statements. In examining past history, Toms

(2002) has successfully provided a portrait of

how an open corporate accountability system

collapsed, with features of shareholder-

entrepreneurs, accounting manipulation and

the failure of reliance on the audit function.

Other authors have also highlighted the

significant pay-outs of under-performing

directors and managers (Gordon et al., 2003;

Gettler, 2002; Gray, 2000) – this also questions

the validity of the agency compensation

concept.

The recent corporate excesses have not,

therefore, happened in a vacuum. Gittens

(2002) argues that in the last decade or so, we

have entered a new age of materialism, as

researched by the leading American social

psychologist, David Myers (2000), in his

recent book on the American paradox of

spiritual hunger in an age of plenty. An

appreciation of the cultural shift makes sense

of a number of developments that have

occurred in Australia and the USA and, to a

varying extent, in many other developed

countries. Gittens (2002) observes that the

rise in economic rationalism in Australia

since the early 1980s has been the politicians’

reaction to the electorate’s increased

materialism and the higher material

standard of living that a more efficient

economy should deliver. The most senior

politician in Australia, Prime Minister John

Howard, when asked his opinion on the

current corporate governance debate, was

reported as saying that the debate was not as

important as the Commonwealth Games, or

as important as a number of other things that

are really important. This type of attitude by

the Prime Minister arguably exposes as

cheap rhetoric his claim to be the best mate

of the inspirational mum-and-dad

shareholders, superannuation holders and

self-funded retirees (Stephens, 2002).

The new religion of materialism could also

explain why Australian CEOs have been

awarding themselves unprecedented pay

rises and have become much more ruthless

in their attitudes to customers and

employees. Corporate boards often justify

astronomical salary and bonus payments by

the need to compete on the international

market and to reward CEOs for the impact

they have on the share price. However, with

the average wage for Australians with full

time jobs being $45,000 per year, it is not hard

to imagine the reaction of most wage earners

to the news that the CEO of Suncorp Metway

took home almost $30 million in salary,

shares and severance pay during his final

year at the company. When bank customers

feel they are being exploited by having to pay

higher fees for lower levels of service, their

outrage is understandably aggravated by

reports of record bank profits. The

perception of employee exploitation is

similarly heightened by revelations of

multi-million dollar salaries and perks for

senior executives, such as the remuneration

in excess of $7 million the CEO of the

Commonwealth Bank received in 2002,

including $4 million for reaching ten years in

his already well paid job. To many

Australians, the growing gap between our

highest and lowest paid employees is starting

to look like yet another factor in the

fragmentation of Australian society – and

that is as much about morality and culture as

about economics (Mackay, 2002).

This heightened materialism also provides

a context for the apparent declining ethical

standards among company directors and

auditors. David Knott, the Chairman of the

corporate regulator, the Australian

Securities Investment Commission (ASIC),

has lamented the outbreak of management

greed, the failure of boards to put a brake on

excessive and structurally unsound

remuneration practices, the focus on short

term pay-offs and the behaviour of analysts,

and at least some auditors, in foregoing their

ethics in return for record level fees and

commissions (Knott, 2002b). At the same

time, others have lamented the regulators

caught sleeping. The insurance industry

regulator, the Australian Prudential

Regulation Authority (APRA), has come in

for criticism in respect of the HIH Insurance

collapse, with politicians and leading

insurance executives claiming the regulator

was not adequately staffed to identify the

weaknesses in the HIH Insurance systems

(Kemp, 2001; Elias, 2001).

There is an old saying that power corrupts

and absolute power corrupts absolutely. The

same thing can be said about greed. Enough

was never enough in a system fed by stock

options, boardroom perks and consulting and

underwriting fees (Turner, 2002). The seeds

to the present crisis, particularly in the USA,

were sown in the technology stock boom in

the early 1990s, with the now bankrupt

e-commerce companies then hailed as the

way of the future. At the same time, the

telecommunications revolution, in a new

world of unregulated competition, required

billions of investment in fibre optic cables,

satellites and microwave towers. The

strategic decision by One.Tel to invest in its

own telecommunications system was a major

reason behind its eventual downfall. These

new technologies demanded financial

[ 507 ]



manipulation schemes to convert expenses

into capital expenditure, hide losses and

ensure that share prices held up and options

and unreal salaries and bonuses would

continue to be paid to the Mad Hatter and his

friends at the tea party. Even a first year

accounting student could work out that this

was financially unsustainable. The

accountants, investment banks and law

firms, who were the traditional gatekeepers

of market integrity, were just like Alice in

Wonderland at the Mad Hatter’s party. They

were caught up in the frenzy and wanted to

join the party. Their independence collapsed

under the threat of being left behind in the

new economy revolution. The belief in the

revolution was so pervasive, as well as the

belief that the old rules no longer applied,

that the gatekeepers became servants to the

new players rather than independent

guardians. The traditional brakes on the

system no longer worked (Scott, 2002).

One.Tel, Harris Scarfe andHIH Insurance

Three corporate collapses that have most

focussed on corporate governance issues

recently in Australia are One.Tel, Harris

Scarfe and HIH Insurance. The Australian

telecommunications company One.Tel was

placed in administration and subsequently

into liquidation in May, 2001 with estimated

debts of A$600 million. At the same time, the

Australian Securities and Investment

Commission (ASIC) announced it had

commenced a formal investigation into

One.Tel for potential breaches of the

Corporations Law. The potential breaches

according to an ASIC spokeswoman included

possible insolvent trading, possible insider

trading and market disclosure issues (BBC

News, 2001). The joint managing directors,

Jodee Rich and Brad Keeling, had received

bonuses of A$7 million each the previous

year, when One.Tel reported a A$291 million

loss. At one stage, when the company had

A$33 million in bills due, there was only

$500,000 in the bank and a management

report to the directors at the time did not

mention the liquidity crisis. Creative

accounting by One.Tel in capitalising

expenses had attracted the attention of ASIC

and its insistence that accounting practices

be changed led in August 2000 to the company

declaring $245 million of costs that would

otherwise be hidden (Barry, 2002).

After six months and a parade of

high-profile corporate executives, the public

hearings into the demise of the phone

company One.Tel were wound up on

29 August, 2002, as the liquidator retired to

consider whether grounds existed for legal

action against those involved (Hughes, 2002).

During the public hearings, the liquidator

questioned 18 witnesses including One.Tel

directors Lachlan Murdoch of News Limited

and James Packer of the Australian media

giant, Publishing and Broadcasting Limited.

Civil proceedings have been commenced

against a number of former directors of

One.Tel by the Australian Securities and

Investment Commission, seeking

declarations that they contravened their

responsibilities under the Act; orders that

they be banned from managing corporations

or acting as directors; and compensation of

up to A$75 million. In the interim,

appropriate orders have been obtained to

restrict dealing in assets and to monitor

travel (Knott, 2002b).

The retailer Harris Scarfe had been in

operation for 150 years before it was placed

into voluntary administration by the

directors on 2 April, 2001, after discovering

irregularities dating back six years. Four

days later, the ANZ bank placed the company

in receivership. In their report to creditors,

the administrators highlighted that the

systematic overstatement of profit had been

funded by increased debt, both to the bank

and the creditors (Peacock, 2001). After

investigations by the Australian Securities

and Investments Commission (ASIC) and

official examinations by the company’s

receivers and managers, ASIC alleged the

chief financial officer, Alan Hodgson, had

altered Harris Scarfe’s accounts to inflate the

company’s profits. In fact, Hodgson was

found to have played a leading role in

falsifying accounts and reports and had

created a false picture that Harris Scarfe was

in good financial health, permitting it to

trade when it was virtually insolvent. In

testimony given to the South Australian

Supreme Court, Hodgson told the court that

he had effectively authorised accounts to be

changed on cue, if a particular profit result

was required by the company’s managing

director or the chairman (Tabakoff, 2001).

Hodgson was jailed for six years.

The ANZ bank has filed a suit against

Harris Scarf’s auditors, Ernst and Young and

PricewaterhouseCoopers, seeking recovery

of at least A$70 million and alleging the

auditors had been negligent because they

failed to uncover the accounting

discrepancies and irregular entries in the

management accounts. Also, a shareholder

has brought a class action against the

directors, alleging that they engaged in false,

deceptive and misleading conduct over a

five-year period. The shareholder claims that

[ 508 ]



as a result of the deceptive statements,

investors paid more than the ‘‘true market

value’’ of the shares and eventually lost the

opportunity to sell their shares (Wood, 2002).

In March 2001, HIH Insurance was placed

in provisional liquidation with reported

losses of A$800 million, although more recent

estimates put the deficiency at between A$2.7

and A$4 billion, making it Australia’s largest

corporate collapse (Kehl, 2001). The HIH

group comprised several insurance

companies and was the biggest insurance

underwriter in Australia. Its collapse had a

widespread effect, as it was a major provider

of all types of insurance in Australia,

including much of the public risk cover. In

fact, HIH was known as a price cutter and

more willing underwriter than its

competitors in the insurance industry

(Brown, 2001) and an ex director,

Rodney Adler, had claimed that excessive

discounting was one of the contributing

factors in the failure of the company

(Gaylord, 2001). However, it was arguably the

hostile takeover of Adler’s company, FAI

Insurance, for A$300 million, without proper

due diligence investigations, that marked the

beginning of the end for HIH. The founder

and CEO of HIH, Ray Williams, has since

admitted that the price was too high (Brown,

2001). Also, HIH experienced major losses in

its operations in the USA and the UK, which

contributed to its eventual demise.

The Royal Commission into the affairs of

HIH Insurance was announced in June, 2001.

The terms of reference are wide ranging and

will enable the Royal Commission to fully

investigate the circumstances surrounding

HIH’s failure, the actions of Commonwealth

and State regulatory bodies and whether

changes should be made to the current legal

framework (Insurance Council of Australia,

2002). In summary, the terms of reference are

as follows.

1 The reasons for, and the circumstances

surrounding, the failure of HIH prior to

the appointment of the provisional

liquidators on 15 March 2001 and in

particular, whether, and if so the extent to

which, decisions or actions of HIH, or any

of its directors, officers, employees,

auditors, actuaries, advisers, agents, or

any other person, contributed to the

failure of HIH; or were involved in, or

contributed to, undesirable corporate

governance practices, including any

failure to make desirable disclosures

regarding the financial position of HIH.

2 Whether those decisions or actions might

have constituted a breach of any law of the

Commonwealth, a state or a territory.

3 The appropriateness of the manner in

which powers were exercised and

responsibilities and obligations were

discharged under Commonwealth, State

or Territory legislation.

4 The adequacy and appropriateness of

arrangements for the regulation and

prudential supervision of general

insurance at Commonwealth, state and

territory levels including Commonwealth

arrangements before and after the

Financial System Inquiry reforms and

different state and territory statutory

insurance and tax regimes.

As the above terms of reference indicate, the

Royal Commission into HIH Insurance was

set up with wide ranging powers of

investigation and its eventual

recommendations, expected by March 2003,

are likely to have a major impact on the

future corporate regulatory environment in

Australia. Also, civil proceedings have

already been successfully prosecuted against

three former officers of HIH in relation to a

specific breach of the Corporations Act,

involving improper use of company funds

and a breach of duty. The Australian

Securities and Investment Commission has

sought declarations, banning orders and

compensation, plus pecuniary penalties, and

an investigation into possible offences

connected with the collapse of HIH continues

(Knott, 2002b).

Where were the accountants andauditors?

So, just like Alice in Wonderland, did the

accountants and auditors elbow their way

into the Mad Hatter’s corporate tea party?

From the evidence presented so far, it

appears likely that is generally the case. The

liquidator’s inquiry into One.Tel was told

how multi-million bonuses paid to the

founders Jodee Rich and Brad Keeling, were

effectively hidden from public scrutiny by

questionable accounting practices. The

bonuses totalling A$14 million were incurred

in 1999, but a change in accounting policy

treated the bonuses as deferred expenditure

and treated them as set up costs associated

with One.Tel’s businesses across Europe and

Australia. This treatment, along with other

questionable accounting adjustments, had

the effect of converting a loss into a profit. It

was also claimed that the auditors had

supported the questionable accounting (ABC

Newsonline, 2002). However, when

questioned by Michael Slattery QC for the

liquidator, the One.Tel finance manager,

Steve Hodgson, agreed that the accounting

[ 509 ]



policy adopted was what he regarded as a bit

of a stretch (Hughes, 2002).

In the Harris Scarfe collapse, it appears

that the accountants were running two sets of

books, which was not picked up by the

auditors. Apart from the fraudulent

accounting by the chief financial officer,

Alan Hodgson, referred to earlier, there were

also, prima facie, independence problems

with the Harris Scarfe audit committee of the

board. The company had an audit committee

comprising three members, two of whom

were clearly internal (including Hodgson)

and one of which was possibly independent,

and they met only twice a year. An audit

committee is meant to be an independent

body to ensure efficient and effective

communication between external auditors

and senior management. So fundamentally, it

could not work (Correy, 2001). Also, as noted

earlier, the auditors are being sued by the

major creditor, the ANZ bank, alleging

negligence for not uncovering the

discrepancies over a number of years.

In the case of HIH Insurance, there were

also problems with the prima facie

independence of the audit committee of the

board. The chairman and another member of

the committee were both former senior

partners of Arthur Andersen, the auditors of

HIH. Also, the other two members of the

audit committee had business relationships

with the company (Correy, 2001) and the

finance director was a former Andersen

partner. Unlike Enron that hid liabilities to

boost its balance sheet, HIH attempted to pad

profits as major parts of its business eroded.

HIH did not set aside enough reserves to

cover future insurance claims and

overvalued some assets. Under questioning

at the HIH Royal Commission, the finance

director, Dominic Fodera, denied that

carrying out his acknowledged responsibility

to be prudent and conservative in assessing

policyholders’ claims required the use of a

safety margin in claims reserves. This was

despite the fact that the levels set by the

company had proved to be inadequate in the

past (AAP, 2002). Also, three different

actuaries and the United States regulator

warned that the company’s US operations in

1999 and 2000 were under-reserved by tens of

millions of dollars, but Fodera acknowledged

that the US branch and head office in

Australia chose instead to use their own

calculations of reserves. He also admitted

that when yet another actuary recommended

an increase in reserves, the board was never

informed of the fact (Walker, 2002).

So what does this all say about the

accountants and auditors? From the

investigations undertaken and reported so

far, it is apparent that the accountants in

One.Tel, Harris Scarfe and HIH Insurance,

all joined the March Hare and the Hatter at

the tea party of corporate greed. They were

supposed to be ethical professionals

providing quality financial control and

advice to management, but just like Alice,

they were determined to join the party. At

this point in time, it is not so clear-cut with

the auditors, although the evidence to date

points to them being in Wonderland. As

discussed earlier, the auditors were the

gatekeepers, but became servants to the new

players rather than independent guardians.

Therefore, it can be argued that some

significant common issues are apparent from

the brief overview of the above three cases.

These issues are:. the opportunistic behaviour of directors

and managers in pursuing self-interest

and undermining governance

mechanisms. Such behaviour was

demonstrated by failure of due diligence

in corporate affairs, interfering with

controls and audit independence

functions;. failure of transparency and integrity in

performance measurement and

management compensation, resulting in

the financial reporting functions being

undermined, as demonstrated by the

extensive practice of creative accounting;

and. the apparent failure of some of the

corporate watch-dogs such as some

auditors and government supervisory

bodies.

Good corporate governance

Before discussing the issues further, it is

worthwhile to reflect on what constitutes

good corporate governance. There are many

publications in the field of corporate

governance, but a useful and recent one is the

Principles of Corporate Governance, issued by

The Business Roundtable (2002), an

association of chief executive officers of

leading corporations in the USA. This

association claims that the USA has the best

corporate governance, financial reporting

and securities markets in the world, which

works because of the adoption of best

practices by public companies within a

framework of laws and regulations.

The Business Roundtable’s (2002)

Principles of Corporate Governance call on

companies to adopt a number of best

practices in corporate governance, that,

for example:

[ 510 ]



. require stockholder approval of stock

options and restricted stock plans in

which directors or executive officers

participate;. create and publish corporate governance

principles so that everyone, from

employees to potential investors,

understand the rules under which the

company is operating;. provide employees with a way to alert

management and the board to potential

misconduct, without fear of retribution;. require that only independent directors

may sit on the board committees that

oversee the three functions central to

effective governance – audit, corporate

governance and compensation; and. ensure that a substantial majority of the

board of directors comprises independent

directors, both in fact and appearance

(Business Roundtable, 2002).

An authoritative Australian publication on

corporate governance was issued by a group

of professional bodies in 1995, under the

chairmanship of former regulator, Henry

Bosch (Bosch, 1995). Most of the principles in

this pronouncement are similar to the

Business Roundtable, although the questions

surrounding executive options and

remuneration were not such big issues in

1995 as they are currently. What the above

reports and others such as the Cadbury

Report issued in the UK and the OECD

corporate governance guidelines

demonstrate, is that there is no simple

universal formula for good corporate

governance, as companies vary in complexity

and size and the nature of business and

community expectations are in a state of

constant change.

What is essential, however, is that all

involved in corporate governance, and

particularly boards of directors, should adopt

the practices best suited to the good

governance of their organizations in their

particular circumstances. Best practice in

Australia is arguably comparable to the best

anywhere in the world but, as Bosch (2001)

notes, there is far too little of it. Before

directors can satisfy themselves that they

understand what is really going on in the

companies for which they are responsible,

they must put in more time, pay more

rigorous attention to their duties and make

more use of the governance techniques that

have been developed.

Bad corporate governance

The above principles are indicators of good

corporate governance, but how do we know

bad corporate governance when we see it ? In

a submission to the HIH Royal Commission, a

corporate governance research and advisory

group, Institutional Analysis Pty Ltd,

provided an analysis of the bad corporate

governance practices at HIH Insurance

before its collapse, based on publicly

available empirical data from 2000/2001

company annual reports. Comparisons were

made of the corporate governance practices

at HIH with the corporate governance

practices at the top 100 companies on the

Australian Stock Exchange (‘‘the S&P/ASX

100 companies’’). Key findings included the

following (Institutional Analysis, 2002):. Among the S&P/ASX top 100 companies,

independent non-executive directors

comprised on average 45.3 per cent of the

board, whereas there were no independent

non-executive directors on the HIH board.

An ‘‘independent director’’ is not

financially or otherwise depending on the

company’s affiliated persons (e.g.

members of the board, auditor) and does

not represent consultants or other

businesses, which are, or have been,

contracted by the company. The published

2000-2001 HIH annual report shows that of

the four non-executive directors, Gardner

and Cohen were both former partners of

the auditors, Arthur Andersen, and Abbot

and Stitt were both involved in the

provision of legal services to the company.. The HIH board was dominated by

founders or relatives of founders, with

potential conflicts of interest and loyalties

to the company history and reputation.

These issues may have coloured their

judgment. HIH had two founders on the

board and also Adler, the son of the

founder of FAI, one of the core HIH

businesses.. In 54 per cent of S&P/ASX top 100

companies, the audit committee is

exclusively comprised of independent

non-executive directors. At HIH, there

was not a single independent director on

the audit committee.. In 72 per cent of the top 100 companies,

separate nomination and remuneration

committees were established, as per the

Investment and Financial Services

Association’s guidelines. HIH combined

the two committees.. At the top 100 companies, the average

percentage of CEO remuneration that was

‘‘ at risk’’ is 33 per cent. The higher the

proportion of a CEO’s remuneration at

risk, the more closely aligned are his or

her interests with those of shareholders.

At HIH, none of the remuneration of the

CEO was at risk.

[ 511 ]



As the above research indicates, corporate

governance practice at the company that

became the largest corporate collapse in

Australian history, was somewhat less than

world best practice.

The Ramsay Report

In October 2001, Professor Ian Ramsay

submitted his report, based on a study

commissioned by the Commonwealth

Government of Australia. Although it

provides a blueprint for reform of auditor

independence, the Commonwealth

Government is delaying implementation of

any of the recommendations until 2003.

The Ramsay recommendations include

(Ramsay, 2001):. the establishment of an Auditor

Independence Supervisory Board;. changes to the ASX listing rules requiring

listed companies to establish an audit

committee, with ASX input into its role

and composition;. requiring auditors to make an annual

declaration to the Board stating that they

have maintained their independence;. providing clarification on what

constitutes ‘‘independence’’;. requiring registered auditors to adhere to

the codes of ethics set down by

professional accounting bodies; and. closer regulation of the operations of

auditors, including the rotation of

partners and the increased disclosure of

fees and non-audit services.

The bodies that represent the interests of

accountants and directors have been

publicly supportive of these measures. The

Institute of Chartered Accountants in

Australia (2002) welcomed the Ramsay

recommendations as a significant step

towards improving the role and

effectiveness of audits in Australia, whilst

maintaining harmony with global

standards. CPA Australia (2002) was also

supportive, noting that the report enshrines

best practice audit principles, reinforces

the vital role of auditors and gives the

public highly visible assurance on matters

of auditor independence. The Australian

Institute of Directors (2001) also welcomed

the Ramsay report and its

recommendations. However, some

further reforms to augment Ramsay could

include an outright ban on non-audit

services being provided to audit clients, as

provided for in the US Sarbanes-Oxley Act

(Stephens, 2002).

What about directors andexecutives?

A serious attempt to change corporate

culture must venture into the boardroom

itself. Mooted reforms in this area, some of

which are in the US Sarbanes-Oxley Act,

include (Stephens, 2002):. simplifying the form of financial

statements for the average investor;. requiring public companies to disclose

rapidly, and in plain English, material

changes to their financial condition or

any other significant news;. prohibiting loans to directors and

corporate officers;. mandatory forfeiting of incentive

remuneration in the event of accounting

restatements;. making CEOs and chief financial officers

responsible for the accuracy of financial

statements;. requiring that stock options be expensed

in the accounts of a company;. subjecting officers, directors and auditors

to a greater risk of litigation; and. gaoling executives and directors who

deliberately mislead or who withhold

information, especially if in doing so they

benefit themselves at the expense of the

shareholders.

None of these reforms, however, would in

any way restrict the ability of directors to

make decisions. They merely strengthen the

hand of shareholders and regulators to hold

them responsible for these decisions. They

extend the principles of mutual obligation

beyond the welfare system and into corporate

governance.

Black-letter law versus principles

Bosch (2001) argues that there is little scope

for legal changes on corporate governance

and financial disclosure, in that detailed

black-letter law, or rules, are often only a

roadmap for the unscrupulous, as was

demonstrated in the Enron off-balance

sheet transactions. However, an underlying

theme to the numerous calls in the business

press for reform in Australia is that the

USA response to its corporate scandals will,

by virtue of the primacy of its capital

markets, become de facto standards that

Australia must adopt. Nevertheless, with

the notable exceptions of HIH Insurance

and One.Tel, Australia seems to have

weathered the demise of one of the longest

bull markets in history, without producing

the excesses that characterised previous

bubbles. The reforms introduced in

[ 512 ]



Australia in response to corporate

malfeasance in the 1980s, appear to have

held up under pressure. There were reforms

to corporate law, accounting standards and

stock exchange disclosure standards after

that debacle, which threatened Australia’s

access to foreign capital and markets. Also,

there were reforms to corporate culture and

notions of good governance

(Bartholomeusz, 2002).

The strength to the responses in Australia

in the 1980s, lies in their nature. Unlike the

US regime (including the raft of changes

made during 2002), Australia has tended to

favour ‘‘fuzzy’’ laws and rules – statements of

principle rather than black-letter law. In

combination with codes of best practice,

such an approach tends to encourage

companies and people to lift their gaze from

regulatory minimums to the principles

involved. It is arguably vital that Australia

maintains a principles-based approach to

regulation and self-regulation. As noted by

Bartholomeusz (2002), in making technical

compliance with the law less of an issue than

compliance with its spirit, the Australian

system has offered scope for good

governance and practice to evolve and

respond to the corporate environment and

community expectations.

Whilst the Australian government has not

yet committed itself to corporate governance

reforms pending the reporting of the Royal

Commission on HIH Insurance expected in

March 2003, the Labour party opposition

issued in late August 2002, a discussion

paper on ‘‘Improving corporate

governance’’. Issued by the Shadow Minister

for Finance, Small Business and Financial

Services, Senator Conroy (Conroy, 2002), the

paper lists a range of policy commitments,

which include:. doubling the penalties for serious

breaches of the Corporations Act;. introducing legislation to protect

corporate whistleblowers;. implementing the recommendations of the

Ramsay Report on independence of

company auditors and, in addition,

banning the provision of certain non-audit

services to audit clients;. requiring auditors to specifically report to

shareholders and to a company’s audit

committee on instances of aggressive

accounting;. requiring auditors to attend and answer

questions at annual general meetings;. requiring the full disclosure of

arrangements governing executive

remuneration and enforcing the

requirements for disclosure in the

Corporations Act;

. expensing share options;

. providing to all shareholders any

information provided to analysts during

an analyst briefing; and. improving analysts’ independence by

ensuring that they always act in the

interests of the users of the reports – not

in the interest of the analyst or the firm

which employs the analyst.

Further policy options are suggested in the

following areas:. auditor independence and the integrity of

financial statements;. executive remuneration;. corporate disclosures and information for

investors;. the composition of boards; and. analyst independence.

There are undoubtedly some useful points

raised in Labour’s discussion paper that will

improve corporate governance in the future.

However, a careful reading of the detail

leaves the impression that this paper, if

implemented, would lead Australia down the

path of black-letter law rather than

strengthen the principles-based approach

that has arguably served Australia well in

the past.

However, despite the optimism

of writers such as Bosch (2001) and

Bartholomeusz (2002), the stories of

excess and incompetence emerging from

the public enquiries into the collapses of

companies such as One.Tel and HIH

Insurance, and the corporate scandals

surrounding WorldCom and Enron in the

USA, have made investors nervous about

the standards of corporate governance in

Australia (Skeffington, 2002). That anxiety

has prompted the Australian Stock

Exchange (ASX) to set up a corporate

governance council, which includes

representatives of key business and

professional groups, to review governance

standards as part of ASX’s efforts

to ensure the Commonwealth government

does not force new legislation on

companies. The council plans to

recommend amendments to the ASX’s

listing rules and to the Corporations Act.

The council has also set corporate

governance requirements for companies to

include in their annual reports to

shareholders. It wants companies to release

quality information on share and options

schemes, audit committees, external

auditors, accounting standards and

‘‘shareholder empowerment’’. If companies

are not able to comply, they will be required

to explain why.

[ 513 ]



Shaping the winds of change

The Ramsay Report, the HIH Royal

Commission, investigations by ASIC and the

ongoing agitation and analysis in the

financial press, will all impact on the future

direction of audit regulation and corporate

disclosure and governance in Australia. In

particular, the recent release of the

discussion paper on the next phase in the

Commonwealth Government’s Corporate

Law Economic Reform Program (CLERP 9,

2002), addresses a number of key issues.

These include recommendations on

expanding the role of Australia’s Financial

Reporting Council; suggestions for

improving audit quality and accounting

standards; principles for continuous

disclosure; and recommendations to improve

shareholder participation and information

availability. The current government

strategy is to introduce into parliament in

2003 what Treasurer Peter Costello claims

will be corporate accountability laws

defining world’s best practice (Gordon, 2002).

However, will the long list of proposed

corporate reforms solve the problems of the

unbounded opportunistic behaviour of

directors and managers in pursuing self-

interest to the detriment of the long-term

well-being of the companies they run? Will

compliance on mandatory disclosure of

remuneration and non-audit services,

accounting requirements for options, and

making CEOs responsible for the accuracy of

the financial statements, prevent excessive

compensation schemes, lack of audit

independence, and creative accounting?

In commenting on the dangers of

materialism as discussed earlier, Mills (2002)

identified five central dangers, which result

in:

1 displacement of an ontology of

consciousness;

2 a simplistic and fallacious view of

causality;

3 the loss of free will;

4 renunciation of the self; and

5 questionable judgements concerning

social valuation practices.

It can be argued that these five dangers in

turn can be transformed into:

1 a failure to exercise due diligence;

2 a short-term mentality of the relationship

between creative accounting and

compensation;

3 compromised integrity and objectivity;

4 socialisation with powerful groups; and

5 rationalising creative accounting and

other opportunistic behaviour.

It is startling how close the above five

deductions reflect the current corporate

world, as observed in the recent corporate

collapses in the USA and Australia.

This paper has attempted to challenge

some of the current thinking on corporate

governance reforms. It is argued that

changes in the structure of the corporate

governance and compliance regime will not

necessarily change the risks associated with

the problems in the corporate environment.

Stewardship and agency principles have

existed over decades and accountants and

directors have been champions of the capital

market and its intellectual power, but history

shows that the religion of materialism needs

to be recognised, and addressed, if

meaningful change is to occur. As the capital

market has evolved alongside the rapid

growth of technology and globalisation, there

has arguably been an unhealthy shift in

attitudes in the corporate world that has also

existed in earlier times in the development of

modern corporations. Is the history of

corporate behaviour just repeating itself? It

is important to understand this phenomenon

if any proposed reforms are to be effective.

In concluding this paper, we return once

more to the tale of the Mad Hatter’s Tea Party

. . . this piece of rudeness from the (corporate)

March Hare and Mad Hatter was more than

Alice (the auditor) could bear: she got up in

great disgust, and walked off; the Dormouse

(the regulator) fell asleep instantly, and

neither of the others took the least notice of

her going, though she looked back once or

twice, half hoping that they would call after

her: the last time she saw them, they were

trying to put the Dormouse into the teapot!

‘‘At any rate I’ll never go there again!’’ said

Alice as she picked her way through the

wood. ‘‘It’s the stupidest tea-party I ever was

at in all my life!’’ Let us hope, at least for the

sake of the credibility of auditors and the

accounting profession, and the public that

have in the past placed their trust in them,

that history does not repeat itself.

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[ 516 ]



Credibility and expectation gap in reporting onuncertainties

Junaid M. ShaikhFaculty of Business and Law, Multimedia University, Melaka, MalaysiaMohammad TalhaFaculty of Business and Law, Multimedia University, Melaka, Malaysia

1. Introduction

One of the many issues that involve the

accounting profession and the community is

the expectation gap that exists in accounting

engagements. The expectation gap was

originally defined as the difference between

levels of expected performance as envisaged

by auditors and users of financial reports. It

is:. . . the gap between society’s expectations of

auditors and auditors’ performance, as

perceived by society.

The expectation gap has been attributed

to a number of different causes

(www.corpgov.net):. the probabilistic nature of auditing;. the ignorance, naivety, misunderstanding

and unreasonable expectations of

non-auditors about the audit function;. the evaluation of audit performance based

upon information or data not available to

the auditor at the time the audit was

completed;. the evolutionary development of audit

responsibilities, which creates time lags

in responding to changing expectations;. corporate crises which lead to new

expectations and accountability

requirements; or. the profession attempting to control the

direction and outcome of the expectation

gap debate to maintain the status quo.

While a consensus as to the causes of the

audit expectation gap has not been achieved,

its persistence has been acknowledged and

bears testimony to the profession’s inability

to remove the gap, despite attempts to do so

by educating the public and codifying

existing practices.

Following recent well-publicised failures

by large listed companies in Australia and

overseas, aspects of audit independence,

corporate governance and financial

reporting practices have again received wide

coverage by the media, and grabbed the

attention of regulatory bodies, stock

exchanges and the accounting profession.

2. Literature review

Companies should close credibility gap inbooksIn his findings, Murray (2002) has indicated

that some leading American corporations

have teamed up with unscrupulous

accountants to mislead shareholders about

how much money they make and also

mislead the Internal Revenue Service (IRS)

about how little money they make. The result

is a huge and growing gap – credibility gap –

which is between book income and taxable

income. If the efforts at accounting overhaul

now under way are to be successful, they will

need to close that yawning gap from both

ends.

For example, the case of WorldCom Inc.,

between 1996 and 2000, the company reported

$16 billion (e16.14 billion) in earnings to its

shareholders. But to the tax authorities, it

reported less than $1 billion of taxable

income. The truth undoubtedly lies

somewhere in between. Enron Corp. has a

similar story. To its shareholders, it reported

profits of $1.8 billion between 1996 and 2000.

But it told the IRS it lost $1 billion during the

same period, according to calculations by

Robert McIntyre of the labor-backed group,

Citizens for Tax Justice. Kmart Corp, to take

another name in the news, reported $1.6

billion in profits to its shareholders, but a

loss of $51 million to the IRS.

The games that allow companies to achieve

such anomalous results are often the

brainchildren of clever accountants and

investment bankers. One particularly





[ 517 ]



KeywordsCorporate governance, Reports,

Financial reporting

AbstractThis paper analyzes and reports on

studies that examine the extent to

which international auditing

boards have accomplished the

goal of reducing the expectation

gap in reporting on uncertainties.

This is because there has been a

long-running controversy between

the auditing profession and the

community of financial statement

users concerning the

responsibilities of the auditors to

the users. Enron and WorldCom

scandals have provoked the public

to incite the government and

professional bodies to impose

stringent regulation in protecting

their interests. It also suggests

the solutions to minimize the gap

and enhance the public’s

perception towards the

profession.

egregious tactic used by Enron was the now

infamous ‘‘MIPS’’ – a security invented by

Goldman Sachs that counted as debt on the

company’s tax return, but equity on its

public books. Regardless of whether MIPS

technically complied with the law, it was a

sham. Any honest accountant or tax lawyer

who works at one of the big accounting firms

would say that such tactics have become

increasingly common, and increasingly

outrageous. Indeed, fierce arguments have

occasionally broken out at those firms

between publicly minded tax experts who

still feel some obligation to abide by the spirit

of the tax laws, and profit-minded partners

eager to find clever new ways to exploit every

loophole in the law.

Lying to shareholders and lying to the IRS

are just opposite sides of the same coin.

Accounting is no longer a way to provide an

accurate and unified view of a company’s

finances. The fact that accountants have

become so ‘‘good at serving’’ both

shareholders and the IRS is the clearest

evidence of the corruption of their

profession.

As a solution, Murray emphasizes that

publicly traded companies should be

required to make tax returns public. That

kind of information may not be much use to

the average investor. But conscientious stock

analysts – surely there are some out there?

– could spend their time analyzing the gaps

between book and tax income, attempting to

find truth in between. Congress and the

Securities and Exchange Commission should

work to bring the two measures of income

into closer alignment.

Protecting the public interestIn the study, Walker (2002) found out the facts

regarding Enron’s failure still being gathered

to determine the underlying problems and

whether any civil and/or criminal laws have

been violated. At the same time, the Enron

situation raises a number of systemic issues

for congressional consideration to better

protect the public interest. It is fair to say

that other business failures or restatements

of financial statements have also sent signals

that all is not well with the current system of

financial reporting and auditing. As the

largest corporation failure in US history,

Enron, however, provides a loud alarm that

the current system may be broken and in

need of an overhaul.

The authors will focus on four overarching

areas – corporate governance, the

independent audit of financial statements,

oversight of the accounting profession, and

accounting and financial reporting issues

– where the Enron failure has already

demonstrated that serious, deeply rooted

problems may exist. It should be recognized

that these areas are the keystones to

protecting the public’s interest and are

interrelated. Failure in any of these areas

places a strain on the entire system.

The effectiveness of the system of

corporate governance, independent audits,

regulatory oversight and accounting and

financial reporting, which are the

underpinnings to the capital markets, to

protect the public interest has been called

into question by the failure of Enron. The

rapid failure and bankruptcy of Enron has

led to severe criticism of virtually all areas of

the financial reporting and auditing systems,

which are fundamental to maintaining

investor confidence in the capital markets.

This situation raises a number of system

issues for most professional considerations

to better protect the public interest. These

protections would include regulation and

oversight of the accounting profession, the

independent audit function, accounting and

financial reporting model and establishment

of professional body to govern the acts of the

accounting profession.

Auditors’ and investors’ perceptions of the‘‘expectation gap’’McEnroe and Martens (2002) have extended

the prior research by directly comparing

audit partners’ and investors’ perceptions of

auditors’ responsibilities involving various

dimensions of the attest function. This study

surveyed public accountants and individual

investors to obtain their perceptions of the

extent to which an expectation gap exists in

several dimensions of the attest function.

Investors were surveyed because they were

the main users of financial statements and

are the most appropriate subjects to employ

as representatives of the public and financial

statement users. Audit partners were

included as the group on the other side of the

expectation gap. The research was conducted

over a decade after the release of the

expectation gap SASs and also after the

issuance of SAS No. 82 (AICPA, 1996).

Throughout the research, McEnroe and

Martens (2002) found that an expectation gap

currently exists: investors have higher

expectations for various facets and/or

assurances of the audit than do auditors. The

findings served as evidence that the

accounting profession should engage in

appropriate measures to reduce this

expectation gap. The findings also indicated

that an expectation gap exists, investors had

higher expectations for various facets and/or

assurances of the audit than do auditors in

the following areas: disclosure, internal

[ 518 ]

Junaid M. Shaikh andMohammad TalhaCredibility and expectationgap in reporting onuncertainties


control, fraud, and illegal operations. It was

also discovered that investors expect

auditors to act as ‘‘public watchdogs’’

(www.isaca.org/standard/guide1.htm).

The expectations-performance gap infinancial reporting from the perspective ofHong Kong bank loan officersMarian et al. (2002) suggest that to close the

gap more completely, the audit profession

and financial community need to reexamine

the fundamental role of an audit in society

and make sure financial statement preparers,

users and auditors all are in agreement. It

was revealed that as long as users and

auditors continue to have different

understandings of the real meaning of

‘‘present fairly’’, according to the GAAP, the

gap will remain. The research was carried

out by comparing the audit report from 1948

to 1988. Except for minor editorial changes,

the standard audit report remained virtually

unchanged from 1948 to 1988. During this

period, there was concern that users might

not be correctly interpreting the auditors’

intended messages, and major revisions were

considered. However, these attempts to

revise the standard audit report failed to

attract widespread support. The evidence of

the research suggested that investors seek

very high levels of financial statement

assurance. Auditors should not only be

interested in, but also be aware of these

shareholder perceptions. The litigious

environment in which accountants operate

mandates that we, individually and as a

profession, monitor public opinion and

attitudes toward the level of services and

assurance provided. Marian et al. (2002)

stated that if investors expect, and courts

begin to uphold, a standard of absolute

assurance, audit liability inevitably will

increase substantially. Thus, it was

necessary from both societal and

professional perspectives that accountants

try to narrow the expectation

misunderstanding gap.

The research found out that the gap may be

narrowed partly through increased public

understanding of an audit, its nature and its

inherent limitations. Accountants should

devote substantial resources to explaining to

the public the auditor’s current role in the

financial reporting process and an audit’s

inevitable limitations. Increased educational

efforts with clients and audit committees at

shareholder meetings, in professional and

civic organizations and at every available

juncture should be used to communicate an

audit’s merits and limitations. A more direct

approach to increasing user awareness of the

audit function was also recommended in the

paper. In addition, the Securities and

Exchange Commission should be encouraged

to develop a similar unbiased report to be

presented with registrants’ filings and

financial statements. Besides, Marian et al.

(2002) suggested that a SEC communication

regarding the audit function and the

assurances provided may be more

convincing to financial statement users than

one emanating from auditors.

Theories of ethics and moral developmentEthics in general is defined as the systematic

study of behavior based on moral principles,

philosophical choices, and values of right and

wrong conduct. Similar to general ethics,

ethical behavior from a professional

standpoint also involves making choices

based on the consequences of alternative

actions. As stated in the following passage

from The Philosophy of Auditing by Mautz

and Sharaf (1961, p. 232):Ethical behavior in auditing or in any other

activity is no more than a special application

of the general notion of ethical conduct

devised by philosophers for men generally.

Ethical conduct in auditing draws its

justification and basic nature from the

general theory of ethics. Thus, we are well

advised to give some attention to the ideas

and reasoning of some of the great

philosophers on this subject.

Previous research on ethical issues in

accounting has generally avoided

philosophical discussions about ‘‘right and

wrong’’ or ‘‘good and bad’’ choices. Instead

the focus has been on the ethical or unethical

actions of accountants based on whether they

comply with rule-oriented codes of

professional conduct. Various theories of

ethics have been made known and used to

determine ethical dilemmas, but the two

existing theories applicable to CPAs are

utilitarianism and rule deontology:

1 Utilitarian principle. Utilitarianism is

based on the ‘‘greatest good’’ criterion.

According to this principle, when faced

with an ethical problem, the consequences

of the action are evaluated in terms of

what produces the greatest amount of

good for the greatest number of people.

The stress here is on the consequences of

the action rather than on the following of

rules.

2 Rule deontology. Rule deontology is a

deontological theory and is based on a

duty to a moral law. Thus, the

accountant’s actions rather than their

consequences become the focus of the

ethical reasoning process. According to

this principle, an accountant is morally

bound to act according to the

[ 519 ]



requirements of a rule of conduct of the

code without regard for the effects of that

action.

If utilitarianism is applied, each situation

involving confidential client information

would have to be evaluated to determine if it

would be morally right to reveal the

information (this does not relate to those

situations that are specifically excluded in

Rule 301). The confidentiality rule would be

followed only if that course of action

produced the greatest good to the greatest

number of people. If rule deontology is

applied, however, the Professional Code of

Conduct would be followed in all

circumstances involving client confidential

information (except as stated in the code),

despite the consequences.

The findings of studies indicate that CPAs

usually adhere to the code (rule deontology)

in resolving issues concerning

confidentiality. However, such decisions are

not always according to what they see as

‘‘good ethical behavior’’. The broad principles

of the code indicate that ethical conduct

means more than abiding by a letter of a rule.

It means accepting a responsibility to do

what is honorable or doing that which

promotes the greatest good to the greatest

number of people, even if it results in some

personal sacrifice. Somehow, the profession

needs to emphasize the ‘‘greatest good’’

criterion more strongly in applying the rules

of conduct.

3. Credibility gap and expectationgap

The battle for credibilityDuring the past two decades, there has been

an increasing expectation that business

exists to serve the needs of both shareholders

and society. Many people or the community

have a ‘‘stake’’ or interest, in a business, its

activities and impacts. If the interests of

these shareholders are not respected, then

action usually occurs which is often painful

to shareholders, officers and directors. In

fact, it is unlikely that businesses or the

profession can achieve their long-run

strategic objectives without the support of

key shareholders. As a result, management

and professional accountants, who serve the

often conflicting interests of shareholders

directly and the public indirectly, must be

aware of the public’s expectations for

business and other similar organizations.

More than just to serve intellectual curiosity,

this awareness must be combined with

traditional values and incorporated into a

framework for ethical decision-making and

action. Otherwise the credibility of the

organization, management, professional and

indeed, the professional will suffer.

There is no doubt that the public has been

surprised, dismayed and devastated by

periodic financial fiascos. The list of recent

classic examples includes Bre-X, Livent Inc.,

YBM Magnex International Inc., Enron, and

Worldcom. On a broader basis, continuing

financial malfeasance has led to a crisis of

confidence over corporate reporting and

governance. This lack of credibility has

spread from financial stewardship to

encompass the other spheres of corporate

activity and has become known as the

credibility gap. Audit committees and ethics

committees, both peopled by a majority of

outside directors, the widespread creation of

corporate codes of conduct, and the increase

of corporate reporting designed to promote

the integrity of the corporation all testify to

the importance being assigned to the crisis.

Besides that, professional bodies and the

Securities and Exchange Commission should

work together to bring the two measures of

income into closer alignment.

Expectation gap concerning evaluation ofinternal controlIn the last decades the focus on expectation

gap issues has determined many

fundamental inconsistency between

best-practice standards and the expectations

of the primary users of audit services. Maybe

the most important incongruity has been

between the view on internal control as

stated in the auditing standards and the

concept of internal control as understood by

company management.

In the USA, this was recognized in the

Treadway report on fraudulent financial

reporting, which acknowledged the necessity

for a common reference point on the content

of internal control. Since this need was

clearly affirmed in the late 1980s, the

Committee of Sponsoring Organizations of

the Treadway Commission decided to build

up an integrated framework on internal

control. The ensuing attempt to provide a

framework was published in the COSO

Report in 1992. Although the main coverage

of this report was a message regarding

internal controls intended for management

directors, it provides a framework which

unambiguously deals with the interests of all

parties involved (including auditors, board of

directors and regulating bodies). The

auditors took this into consideration by

updating the particular auditing standard on

internal control (the replacement of SAS 55

with SAS 78 ‘‘Consideration of the internal

[ 520 ]



control structure in a financial statement

audit’’ – The COSO Report (1992).

Overall, the findings of studies suggest that

the auditors have not made the needed effort

to close a realized expectation gap. One view

of these results can be linked to the need for

future regulation initiatives. An integrated

framework should include the auditor, that is,

the auditor has to make known the level of

internal control assessments in view of the

expectations from the primary users, i.e. that

they always perform such evaluations. The

conclusion is that a major divergence still

needs to be decided on. Another perception is

to steer clear of an exact duplication of the

described efforts to close the realized

expectation gaps as carried out by other

national (European) practices in the standard

setting efforts concerning internal control.

The expectation gap between users’ andauditors’ materiality judgmentsThe concept of materiality occupies a central

position in auditing. This is due to a demand

for efficiency and credibility on the auditor’s

report. Materiality thus ‘‘permeates’’ the kind

and range of all auditing procedures, the

selection of items, and the timing of the audit.

In auditing and accounting, materiality is

defined in different ways in different

guidelines and statutory provisions. It has,

for example, been included in frameworks in

the USA and other countries – though not

Denmark – with greater or lesser degrees of

‘‘precision’’. In Denmark, materiality is

defined in the Danish statement on auditing

standards, and has indirectly been included

in an auditing context in official audit report

regulations from 1996. In ISA No. 25 (Subject

matter 320) ‘‘audit materiality’’ the definition

of materiality is (with reference to IASC’s

‘‘Framework for the preparation and

presentation of financial statements’’, para.

30) as follows:Information is material if its omission or

misstatement could influence the economic

decision of use point rather than being a

primary qualitative characteristic which

information must have if it is to be useful.

Danish accounting legislation makes no

mention of materiality as an overall principle

in an accounting context, only in connection

with specific items. In Denmark, materiality

is often confused with the concept of

relevance, but the two terms should be

regarded separately, since they mean

different things. Materiality only makes

sense in connection with relevant

information, not irrelevant information.

While materiality is the same in

accounting as in auditing, it has a different

meaning for auditors’ tasks than for those of

users of financial statements. In both cases,

materiality must be ‘‘measured’’ in relation

to the ‘‘true and fair view’’ that the financial

statement must give. What is true and fair,

including what is material or immaterial, is

determined by the economic decisions which

users make on the basis of the financial

statements. If decisions are influenced by one

or more errors or omissions, they are

material, and if not, they are immaterial.

There are many different groups of users,

including the general public. The auditor

must take reasonable account of them all.

Most auditing firms use guidelines for

determining a starting point for their

assessment of the overall materiality in the

financial statement. The paradox of

materiality is that it is the auditor who

assesses what is material or immaterial for

users of financial statements. But does the

auditor really know what users regard as

material or immaterial?

Numerous studies and articles have dealt

with the concept of materiality. Many of

them express a lack of concensus between

participants in one group and between this

group and other groups of users, preparers

and auditors of financial statements. In the

study of Robinson and Fertuck (1985) the

participants were financial executives and

auditors. The participants in Woolsey’s

(1973a, b), Dyer’s (1975), Patillo’s (1976) and

Rosen’s (1982) studies were financial

executives, bankers, financial analysts,

academics and auditors. Of those, we have

got most inspiration from Dyer, Patillo and

Woolsey, whose studies come close to real life

situations, or have a great amount of external

validity. Cases in other studies, not

mentioned above, present not all relevant

information about the case companies (but

only few of them). These studies/cases

therefore run the risk of departing from the

financial statements users’ real life.

Differences between the two groups(auditor and financial analyst) and averagemateriality levelsA comparison of the groups reveals that,

overall, the auditors’ average materiality

levels for all four companies (Carlsberg,

Micro Matic, B&O, and DDT) are about 60

percent higher for overestimations than

those of the financial analysts, and 36 percent

for underestimations (refer to Appendix,

Table AI).

The differences appear especially in the

profit-companies, where the auditors average

levels for overestimation were 88 percent and

129 percent higher than the financial

analysts’ overestimation, and for

underestimation 70 percent and 107 percent

[ 521 ]



higher. In the losing concerns there was a

better correspondence between the groups.

This seems to confirm that the two groups –

in Denmark – have no knowledge of each

others’ materiality levels.

These results do not correspond to those of

Patillo (1976). In his findings the average

materiality levels for financial analysts was

4.9 percent of net income, and the auditors

were 4.8 percent. Patillo’s findings indicate a

high degree of agreement. The difference

between Patillo’s results and this study is

probably caused by national differences.

4. Proposed solutions to theproblem

Overall considerationsExpectation gaps are, amongst other things,

due to inadequate auditing standards and a

lack of acceptance of these standards,

together with unreasonable expectations of

auditors among users of financial statements

and the general public. These two elements

can be influenced via dialogues. The

procedures outlined below should be

implemented successively, and in the order

mentioned, over a period of several years.

The general idea is, as far as possible, to base

solutions on continuous dialogues between

the interested parties with the aim of

achieving as much consensus as possible.

Establishing standards for materialityamong auditorsThe survey’s conclusions appear to indicate

the need for standards, at least for auditors,

in order to ensure a degree of uniformity. In

order to establish common standards for

auditors, a Committee for Auditing

Standards should be appointed by the

Association of State Authorized Public

Accountants in Denmark (FSR) to draw up

common guidelines.

Every financial statement is unique and

individual in the sense that it sends its own

signals about a concrete firm. The form is (or

can be) the same for most firms, but

information that is very relevant and

material in one financial statement can be

relevant but immaterial in another, while in

a third both irrelevant and immaterial. The

information which the user of a financial

statement seeks about one firm can therefore

be very different from what is sought about

another firm.

As a result of this difference, the

materiality levels users employ can be

related to different items in different

financial statements, just as absolute items

are assigned different weights. Thus, even an

infinite number of rules for assessing

materiality would not be able to take account

of all situations.

These provisional guidelines should

therefore be made more concrete by

supplementing them with examples (from

surveys, for example) of how the frameworks

for materiality levels can be established in

different concrete situations and in different

concrete companies. These examples will not

be able to cover all situations, of course, but

they can help determine some normative

levels.

Dialogues with primary users of financialstatements about standards for materialityin financial statementsThe guidelines drawn up by auditors should

then be discussed in structured dialogues

with the primary user groups. A starting

point for this can be FSR’s Committee for

Auditing Standards in Denmark, with

representatives from the primary user

groups and public authorities. Such a

committee or panel should, of course, fully

inform all parties about its work, and hold

hearings, seminars, etc. with contributions

from different sides.

The aim of this is to include as many

informed views as possible. The task of the

committee will be, on the basis of the

provisional guidelines proposed by the

auditors, to draw up ‘‘the’’ standards that can

win themost support. In view of the results, in

order to achieve such a consensus, or even to

achieve acceptance, several of the groups will

probably have to ‘‘shift’’ their position first.

The dialogues should result in a description

of those guidelines on which agreement has

been reached in the form of a discussion paper

with examples, and later in the form of a

statement on auditing standards. This

approach will ensure that the criteria in the

statement on auditing standards conform to

the expectations/demands of the primary user

groups.

Disclosure of materiality levels in the‘‘engagement letter’’After a degree of consensus has been reached

between auditors and the primary user

groups, the auditor should be required to

disclose, and give reasons for, his materiality

levels in the engagement letter to the board.

In other words, the materiality levels can be

included as part of the agreement between

firm and auditor. This can be done in the

form of a statement on auditing standards.

Apart from the engagement letter, the

information can also be used in connection

with making an offer for the audit, of course.

[ 522 ]



In this way, the board will get factual

information about the precision of the

auditor’s work, and ‘‘unrealistic’’ expectations

among board members can be adjusted. The

dialogues this information can give rise to

will probably mean that the provisional

guidelines will have to be adjusted, and thus

be made permanent at a later date.

Disclosure of materiality levels in the auditreportOnce that the auditor’s materiality levels are

known to the board, and once, after dialogues

with primary user groups, there is a general

guideline setting out which criteria the

materiality levels should be based on, a

logical next step would be for the auditor to

also inform users of financial statements in

his report which specific materiality levels

he has used.

Since the firm discloses the principles on

which a concrete financial statement has been

drawn up, it only seems reasonable for the

auditor to disclose the principles his audit is

based on. As far as accounting principles are

concerned, the firm can, within the limits of

the law, choose those practices it regards as

being best suited to its needs. Users can then

base their views of the financial statement on

the published accounting practice. Similarly,

users can consider audit precision on the

basis of information about the audit,

including the materiality levels used, in the

auditor’s report.

The advantage for the auditor is that he

can no longer be held responsible for an

unknown error under his own materiality

level, since everybody now knows the level,

even though some may disagree with it.

There is still a risk of unknown material

errors (the audit risk) in the financial

statement, of course.

In the USA, Fisher (1990) has studied the

effect of whether or not auditors disclose

their materiality levels in an experimental

market setting. She concludes that

information on materiality levels is relevant

to share dealers, and that it results in a more

efficient market. The requirement of

information about materiality levels in the

auditor’s report can be incorporated into

audit report regulations and in auditing

standards on the auditor’s report, so that, to

start with, it is made voluntary by the

regulation first coming into effect after, say,

three years. This should rule out

misunderstandings, though there can still be

disagreement about the size of the

materiality level. The – not inconsiderable

– difference is, however, that the

disagreement is now ‘‘out in the open’’, which

means that it can be discussed and taken into

consideration, whether at the annual general

meeting or through interested parties’ direct

enquiries to the firm.

If the materiality levels are disclosed in the

auditor’s report, the importance of the

guidelines will probably be somewhat reduced

because they are general and the information

in the report is specific. And if users know the

actual levels, they can be assumed to be not

greatly interested in knowing how the auditor

has arrived at them.

One consequence of disclosing the

materiality levels in the auditor’s report, of

course, will be that there must be no doubt

that all known errors have been corrected. If

they have not been corrected, the user will

have doubts about whether the financial

statements actually contain known errors

near the materiality level. This uncertainty

can be eliminated by a legal requirement for

all known errors to be corrected, and, if

necessary, that the firm should positively

state that this has been done.

If this suggestion is not adopted, the

uncertainty must be eliminated in another

way. For example, by the auditor stating in

his report, after the disclosure of the

materiality level, that all known errors, apart

from petty errors, have been corrected.

The purpose of the above-mentioned

proposals is, of course, to help establish a

greater degree of consensus between

society’s expectations (including users of

financial statements) of auditors and its

opinion of auditors’ performance on the one

hand, and the concept of generally accepted

auditing standards, as laid down in the

current statement of auditing standards, on

the other. This can be achieved by attitudes

on both sides being influenced. For example,

the dialogues can result in the elimination of

unreasonable expectations of auditors,

including those that are too costly to fulfill.

The dialogues can also help reconcile

generally accepted auditing standards (and

thus auditors’ performance) with users’

expectations by means of guidelines in the

area. Or reduce, and perhaps eliminate, the

expectation gap, since, in principle,

expectation gaps should not result from

inadequate/out-of-date guidelines, but solely

from isolated cases of inadequate work from

individual auditors.

A study carried out in New Zealand by

Porter (1993) shows that 34 percent of the

reasons for the expectation gap between

auditors and society, including users of

financial statements, were due to

unreasonable expectations of the auditors, 50

percent to inadequate guidelines, and only 16

percent to inadequate work from the auditors.

[ 523 ]



According to these results, dialogues and

standards could help reduce a huge 84

percent of the expectation gap (in New

Zealand), which is quite remarkable. And

there is no reason to think that things are

different in the rest of the world.

The aim and goal of these proposals has

been to eliminate, or at least reduce, the

general – or abstract and often not

understandable – content of materiality, and

instead relate materiality assessments and

levels to something concrete in the financial

statement, to the benefit of both auditors and

users of financial statements.

Reducing the expectation gap by way oflimiting liability language in engagementlettersEngagement letters are tools that are used to

manage client’s expectations. One of its

fundamental benefits is that it clearly defines

the scope of the job and has the mutual

agreement of the accountants and the clients.

Engagement letters are able to close the

expectation gap concerning who is

responsible and who will pay in liability

settlements.

Camico Mutual Insurance Company,

recommends the use of limiting liability

language in engagement letters where the

risk-versus-reward scale is not appropriately

balanced. Limiting liability language is

recommended on jobs in which the risk is

high compared to the reward. For example,

Y2K consulting obviously was a situation

that needed the use of such language. The

types of engagements appear more often

today as accountants take up more

assignments involving high technology and

investment advising, in which the risks are

less predictable than in more traditional

services.

One Camico member recently evaluated a

client’s entire accounting system, in which

he would purchase, install, and test new

accounting software. He was worried about

the likelihood for liability problems if the

new system developed major glitches, so he

included the following limiting liability

language in the engagement letter:As we discussed, our essential fees in this

engagement are very small compared to the

amount of business that will be processed by

your new accounting system. Accordingly,

our liability to you in the event of any defects

in the system will be limited to the lesser of

our fees for this engagement, or the cost to

repair any defects in the accounting system

that we may have caused.

This language shows a number of key

characteristics of effective limiting liability

language. First, it is short and

unintimidating enough to not provoke a

client’s reservations about lengthy or

‘‘tricky’’ legalese. Second, it clearly states the

area of concern (in this case the new

accounting software system). Third, it

provides a detailed explanation of the

accountant’s liability if there are major

problems with the system. Finally, it

recognizes that problems could be caused by

the accounting firm. Such language is more

likely to be accepted in court than other form

of disclaimers that seek to avoid

responsibility in areas where the accountant

is actually negligent.

Despite its value, there are disadvantages

to the use of limiting liability language. It

does not limit liability to any third parties in

a lawsuit and it is not enforceable in every

court. In addition, some clients might be

offended, which may lead to loss of business.

However, Camico believes that, particularly

in high risk/lower reward jobs, the

advantages of limiting liability language far

offset the disadvantages.

Advantages can be seen during the

assessment stage, by encouraging the

accountant to assess risks versus rewards, an

essentially valuable exercise. Additionally,

discussions and negotiations with the client

contribute to an environment of open

communication from the start. The

communication process can also help

identify future clients that are totally

nonflexible in sharing liability risks. This

type of client one may be better off without.

Most notably, limiting liability language can

be an important reference point in settlement

negotiations.

As to whether such language will have any

grounds in court, this will vary from state to

state and court to court. Currently, such

decisions are being made on a case-by-case

basis. On the other hand, the simple act of

communicating with the prospective client

and coming to a mutual agreement that is

formally documented is a positive step

toward limiting liability. In short, a few

short, clearly written sentences that state the

risk, describe the appropriate liability, and

acknowledge responsibility for potential

negligence may significantly reduce

settlement fees.

Reduction of expectation gap throughunqualified opinion expressed by auditorsTo reduce the expectation gap, the auditors

have to exercise reasonable skill, care and

maintain their professional independence in

issuing unqualified opinion regarding true

and fair view of a client’s financial statement.

This is to ensure that the auditors do not

provide any misleading information that will

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provide a false perception to the public. An

auditor should not issue an unqualified

opinion unless the best judgment is that the

financial statements are free of misstatements

resulting from management fraud.

In the Malaysia context, MIA By-Law A-2

Integrity and Objectivity states that all

members of the accounting profession have to

be fair, intellectually honest and free of

conflicts of interest. In fact, the MIA By-Law

even specifically states that members shall be

fair in their approach to their professional

work and shall not allow any prejudice, bias

or influences of others to override their

objectivity. Thus, if the auditors are unable to

maintain their professional independence in

carrying out their audit work, an unqualified

opinion on the client’s financial position

should not be issued. Otherwise the audit

report will not be based on the true judgment

of the financial position of the client.

In the public practice, members may in the

course of their professional work, be exposed

to situations which involve the possibility of

pressures being exerted on them. These

pressures may impair their objectivity. Hence,

members shall identify and assess such

situations and ensure that they uphold the

principles of integrity and objectivity in their

professional work at all times. Members shall

neither accept nor offer gifts or entertainment

which might reasonably be believed to have a

significant and improper influence on their

professional judgment or those with whom

they deal, and shall avoid circumstances

which would bring their professional standing

or the institute into disrepute.

A member in public practice shall be, and

be seen to be, free in each professional

assignment he undertakes, of any interest

which might detract from objectivity. The

fact that this is self-evident in the exercise of

the reporting function must not obscure its

relevance in respect of other professional

work. Although a member not in public

practice may be unable to be, or be seen to be,

free of any interest which might conflict with

a proper approach to his professional work,

this does not diminish his duty of integrity

and objectivity in relation to that work. The

auditor should resign from performing that

audit task and may advise the client to hire

others who are competent to perform the

work (Audit Commission, www.cipfa.org).

If the client involved in any criminal

activities which might threatened the safety

of the public, MIA By-Law A-5:

Confidentiality states that the auditor has the

legal right or duty to disclose such fact in the

qualified opinion expressed in the audit

report to warn the public of such incidence.

Creating an independent agency tooversee audit regulationThe government could play an important role

in reducing the expectation gap by creating an

independent agency to oversee the audit

regulation. To investigate stakeholder

perceptions of the structure and function of

such an agency, three models were developed:

an Auditing Council; a Commission for Audit;

and a Securities and Exchange Commission

(SEC). Auditing Council would be a private

body analogous to the Financial Reporting

Council. Commission for Audit would be a

public sector body analogous to the Audit

Commission for local and health authorities

in England and Wales. A SEC would be a

public sector body with overall responsibility

for City regulation, including that of listed

company audit

An Auditing Council received the most

support, a Commission for Audit the least,

with a UK SEC provoking the strongest

reactions both for and against. Currently,

arguments in favor of increased regulation

were generally framed in terms of increased

openness that would ‘‘materially enhance the

credibility of audits’’; arguments against

expressed fears that it would be

‘‘cumbersome’’ and add a ‘‘further tier of

bureaucracy’’. Overall, there was a significant

degree of support to make the case for

establishing an independent regulatory body.

The structure of the independent body

should match the expectation gap’s main

components as revealed by the study:

independence, monitoring and discipline.

Such a body might be called a Listed

Companies Audit Board (LACB), structured

into three panels of responsibility: an auditor

independence panel; an audit quality panel;

and a disciplinary panel.

An auditor independence panel’s role

would be to set up to monitor independence

standards and guidelines, for example by

restricting non-audit services in whole or in

part, or by setting up procedures formally to

authorized provision of non-audit services. It

can be argued that providing audit services

should be remunerative in itself and not

conditional, or perceived as conditional, on

the auditor providing non-audit services.

The role of an audit quality panel would be

to set up and maintain a register of auditors

whom the panel recognized as capable of

undertaking listed company work, and to

monitor the quality of audit work done. A

possible consequence of such a licensing

procedure is that it might lead to increased

competition for listed company audits. These

are increasingly dominated by the Big Four

firms, partly because of the reputation effect.

[ 525 ]



External validation procedures might

allow other firms to join the register and

compete against the Big Four, especially for

the audit of middle or lower-ranking listed

companies, where the importance of global

reach is less significant. Failure to observe

standards of auditor independence and

quality, and ignoring guidelines, would

result in referral to a disciplinary panel.

Sanctions against a firm, a firm’s office or a

partner might include ‘‘naming and

shaming’’, fines, or removal from the register

of listed company auditors.

Going concern reporting developments forstandard settersAccording to Monroe and Woodliff (1994) they

have formally defined the expectations gap as

the difference between the beliefs of auditors

and the public about the duties and

responsibilities assumed by the auditor, and

the message conveyed by the audit report. One

key purpose of financial statements is to foster

the optimal allocation of investing capital

between competing uses by providing all

material, relevant information to the user

community. The purpose of the audit report is

to reveal the auditor’s success in verifying the

financial statement assertions. Thus, it is

dismaying to find differences between the

auditors’ definition of their responsibilities

and that of the user community. Accordingly,

the expectations gap has prompted many

questions about audit quality in general and,

in particular, the auditor’s ability to make

judgments in the presence of going concern

uncertainties.

This gap has led to the issuance of new

standards in many countries. For example, in

the USA, Statement of Auditing Standards

(SAS) No. 59 entitled ‘‘Auditors’

consideration of an entity’s ability to

continue as a going concern’’ (AICPA, 1989)

was issued to help reduce the expectations

gap. The Australian Auditing Standards

Board issued AUS 708, entitled ‘‘Going

concern’’ (AASB, 1996). The UK issued SAS

130 entitled ‘‘Going concern’’, to accomplish

similar objectives (APB 1996).

Financial statement users have stated that

the type of report issued is an important

element in their investing and credit-granting

decisions (AICPA, 1982). Therefore, inaccurate

reporting can result in suboptimal investment

and credit decisions. The resulting

misallocation of capital slows economic and

productivity growth. This situation arose

because, initially, auditors were not required

to search for indicators of going concern

problems. Financial statement users, on the

other hand, expected auditors to search for and

report on uncertainties that could threaten

that company’s ability to survive. The US

Auditing Standards Board’s (ASB)

deliberations led to the issuance of SAS No. 58,

which addressed all uncertainties, and SAS

No. 59, which had particular reference to going

concern uncertainties. A major purpose of

these standards was to enhance the auditors’

reporting responsibilities in order to remedy

the financial statement users’ complaints.

In the USA, the goal of Auditing Standard

Board (ASB) was to reduce the expectations

gap in audit reports on uncertainties. Most

studies indicate that investors do depend on

audit reports to highlight significant

uncertainties. Nevertheless, published

research indicates that many companies

receive clean reports prior to filing for

bankruptcy. Users have frequently asked the

question, ‘‘If an audit report cannot provide an

early warning signal of impending business

failure, what good is it?’’ (Carmichael and

Pany, 1993). From the financial statement’s

users’ perspective, the new form of going

concern report should sends a clear and

unambiguous signal to them. But from the

perspective of auditors, with the new standard,

they are more likely to modify reports for

distressed companies in accordance with users’

expectations (Carmichael and Pany, 1993).

The auditor should be required to evaluate

whether there is ‘‘substantial doubt’’ about

the client’s ability to continue as a going

concern in every audit. They are asked to

obey the following:. Detection. The auditor now has an

obligation to make an assessment at the

conclusion of the audit of the client’s

ability to continue as a going concern.. Time period. The focus of the auditor’s

assessment of the client’s ability to

continue as a going concern is now tied to

a ‘‘reasonable’’ time period of one year.. Evaluation. Previously, the decision to

modify the audit report hinged on

recoverability of the assets, and recognition

and classification of liabilities. Now going

concern status is a separate issue.. Reporting. The ‘‘subject to’’ qualification

should be supplanted by an explanatory

paragraph for all material uncertainties

including going concern uncertainties.

The major objectives of the new standards

were to improve communication to financial

statement users, and to ensure that auditors

made an affirmative effort to evaluate and

report on each client’s going concern status.

This will not only lead to addressing the issue

of auditor reputation and credibility, but it

also ensures useful, clear and unambiguous

financial statements to the user community.

[ 526 ]



The effect of education on reducing theexpectation gap concerning perceptions ofmessages conveyed by audit and reviewreportsThe audit expectation gap has been described

by Humphrey et al. (1992) as the gap between

the public’s perception of the role of the audit

and the auditor’s perception of that role. The

expectation gap still continues to persist, not

only with respect to naive users, but also

with respect to sophisticated users of general

purpose financial reports. Thus, efforts must

be doubled by the profession in its attempt to

narrow the expectation gap.

According to the Middleton Report, it

recognized that education is vital to help

contain the expectation gap. This view is

supported by Jenkins (1990) who indicated

that the profession needs a continuing,

imaginative program of explaining the

inherent limitations in accounting, reporting

and auditing to the users of accounts. Also,

Smithers (1992) stated that he believes that an

education process would have to form a

major part of any campaign aimed at closing

the expectation gap. Monroe and Woodliff

(1994) found that auditing students’ beliefs

about auditors’ responsibilities, the

reliability of audited financial information

and future prospects changed significantly

over the semester. They concluded that

education is an effective approach to address

the expectation gap. Ferguson et al. (2000)

found that Canadian co-operative students

had pre-scores on an expectation gap

instrument that are closer to practicing

auditors relative to the pre-scores of

Australian non-co-operative students, which

they attributed to experience.

There were significant differences between

auditors and students who had not completed

an auditing course, about auditors’

responsibilities, the reliability of audited

financial information and the decision

usefulness of audited or reviewed financial

statements. After completing their course, the

auditing students believed auditors assumed

less responsibility for soundness of internal

control, maintaining accounting records,

preventing fraud and detecting fraud;

management assumed more responsibility for

producing financial statements; the auditor/

reviewer was more independent; and the

auditor/reviewer exercised more judgment in

the selection of procedures, than they did at the

beginning of the course. These changes were in

the direction of auditors’ beliefs indicating a

significant reduction in expectation gap in

relation to auditor’s or reviewer’s

responsibilities.

After finishing the auditing course, students

believed to a greater extent that the auditor

agreed with the accounting policies and to a

lesser extent that the entity was free from

fraud. These changes were in the direction of

auditors’ beliefs indicating a significant

reduction in the expectation gap in relation to

the reliability of audited or reviewed financial

statements. However, the auditors still had a

significantly stronger belief that the audited

financial statements give a true and fair view

and believed a significantly higher level of

assurance was provided by the audit. All

groups believed that an audit provided a

higher level of assurance that there were no

material errors than a review.

After the auditing course, students believed

to a greater extent that reviewed financial

statements were useful for monitoring

performance and making decisions. These

changes were in the direction of auditors’

beliefs indicating a significant reduction in the

expectation gap in relation to the usefulness of

reviewed financial statements. However, the

students still believed that the unqualified

audit/review report meant that the entity was

well managed.

The results indicate that education may be

an effective way to reduce the expectation gap.

However, several differences in expectations

still existed. Also, it must be remembered that

it may not be practical to expect all parties to

the expectation gap to undertake the

equivalent of an undergraduate auditing

course. However, it emphasizes the

importance of the accounting bodies retaining

auditing as a prescribed subject for

accreditation purposes for undergraduate

tertiary degrees, to help ensure that members

of the accounting profession do not have

misconceptions about the audit function.

5. Conclusion

The collapse of Enron and WorldCom raise a

number of issues that have a direct bearing

on the expectation gap. Public debate of these

collapses has centered on issues of:. corporate governance and management

style, management neglect or misconduct

as is evident by recent ASIC enforcement

actions against executives and directors of

a number of collapsed companies;. mandatory audit committees, their role,

structure, composition and operation,

management representations to such

committees;. the independence of the auditor, the

provision of non-audit services, the

rotation of auditors, attendance of

auditors at AGMs and ex-auditors serving

on the boards of companies which are

audited by the same auditor;

[ 527 ]



. the need to reassess the effectiveness of

the audit process, including existing

auditing standards, as well as providing

them with the force of law;. the need to monitor the effectiveness of

legislation, regulations and regulatory

bodies particularly with regard to

specialised industries;. the need to review current accounting

standards, the standard setting process

and the adoption of international

accounting standards on a wholesale or

unconditional basis;. the need to reassess the financial

reporting framework, strengthening

continuous reporting requirements with

adequate sanctions for non-compliance;. the need to reassess the role and

responsibilities of the CEO and corporate

whistleblowing expectations including the

strengthening of current reporting

obligations of auditors to regulators; and. the need to assess the effectiveness of the

co-regulatory framework for the

profession and the ability of the

profession to maintain quality and

effectively sanction or discipline members

when required to do so.

In dealing with the above issues the

professional accounting bodies need to be

vigilant and proactive, working closely with

other professional bodies and regulators to

ensure that similar consequences are not

repeated in the future.

The movement to more democratic forms

of corporate governance by empowering

owners is important not only for creating

wealth; it cuts directly to our ability to

maintain a free society. It may be an

exaggeration but ‘‘Corporations determine

far more than any other institution the air we

breathe, the quality of the water we drink,

even where we live’’. However, they are not

accountable to anyone.

The Cadbury Report (Committee on the

Financial Aspects of Corporate Governance)

was published in December 1992 with a

further Financial Reporting Council study in

June 1995.

The former reported on the ‘‘propriety’’ of

corporate governance particularly public

quoted companies. It argued for:. . . clearly accepted division of

responsibilities at the head of a company,

which will ensure a balance of power and

authority, such that no individual has

unfettered powers of decision.

This reflects UK practice historically where

the chief executive’s and chairman’s position

are held by two people. The chairman chairs

the board and oversees external

communications: with large investors and

government, presenting the corporation’s

public face, etc. The CEO attends to executive

and operational aspects – coordinating the

work of other executive directors and

running the company internally.

This separation is a common UK model

whereas the USA model tends to position one

person in a combined role.

ReferencesAASB (1996), An Experimental Investigation of

Alternative Going Concern Reporting Formats:

Canadian Experience, Anandarajan, A, School

of Management, New Jersey Institute of

Technology, University Heights, Newark, NJ.

AICPA (1982), ‘‘Serving the public interest: a new

conceptual framework for auditor

independence’’, report prepared on behalf of

the AICPA in connection with the

presentation to the Independence Standards

Board of Serving the Public Interest, AICPA,

October 20.

AICPA (1989), Bankcruptcy Prediction Models and

Going Concern Audit Opinions Before and

After SAS, No. 59.

AICPA (1996), Auditing Procedures Study, Audit

Sampling, AICPA, New York, NY.

APB (1996), ‘‘The company applies APB Opinion

No. . . . that no warranty reserve was

necessary as of December 31, 1995 and 1996’’,

Leinenger Audit Report, 1995, 1996.

Carmichael, D.R. and Pany, S.G. (1993), ‘‘The

appearance standard for auditor

independence: what we know and should

know’’, in International Research Implications

for Academicians and Standard Setters on

Going Concern Reporting: Evidence from the

United States, Harvard University Press,

Cambridge, MA.

COSO Report (1982), December.

Dyer, J.L. (1975), ‘‘Toward the development of

objective materiality norms’’, The Arthur

Andersen Chronicle, October.

Ferguson, C.B., Richardson, G.D. and Wines, G.

(2000), ‘‘Audit education and training: the

effect of formal studies and work experience’’,

Accounting Horizon, June, Vol. 14 No. 2,

pp. 137-67.

Fisher, M.H. (1990), ‘‘The effects of reporting

auditor materiality levels publicly, privately,

or not at all in an experimental markets

setting’’, Auditing: A Journal of Practice &

Theory, Vol. 9, Supplement.

Grice, J.S. Sr (1989), Bankruptcy Prediction

Models and Going Concern Audit Opinions,

Before and After SAS, AICPA, New York, NY,

No. 59

Humphrey, C., Moizer, P. and Turley S. (1992),

‘‘The audit expectation gap – plus ca change,

plus c’est la meme chose?’’, Critical Perspectives

on Accounting, Vol. 3, May, pp. s137-61.

IASC (1995), Framework for the Preparation and

Presentation of Financial Statements, FSR,

Copenhagen.

Jenkins, W.P. (1990), ‘‘The goal of price stability’’,

Taking Aim: The Debate on Zero Inflation,

[ 528 ]



Policy Study No. 10, C.D. Howe Institute,

Toronto, pp. 19-24.

McEnroe, J.E. and Martens, S.C. (2002), Taxman,

March 9, pp. 236-51.

Marian, Y.J., Gladie, M.C. and Albert, Y.H. (2002),

Malayan Law Journal, Vol. 1.

Mautz, R. and Sharaf, H. (1961), The Philosophy of

Auditing, American Accounting Association,

Sarasota, FL, ch. 9.

Monroe, G. and Woodliff, D. (1994), ‘‘The audit

expectation gap: messages communicated

through the unqualified audit report’’,

Perspectives on Contemporary Auditing,

pp. 47-56.

Murray, A. (2002), Enron Updates, August 20,

available at: www.trinity.edu/rjensen/

fraud082002.htm

Orrenstein, P. (1995), ‘‘Jenkins on the Jenkins

Report’’, CA Magazine, April, pp. 15-18.

Patillo, J.W. (1976), The Concept of Materiality in

Financial Reporting, Financial Executive

Research Foundation, New York, NY.

Porter, B. (1993), ‘‘An empirical study of the audit

expectation-performance gap’’, Accounting

and Business Research, Vol. 24 No. 93.

Robinson, C. and Fertuck, L. (1985), Materiality.

An Empirical Study of Actual Auditors

Decisions, Research Monograph No. 12, The

Canadian Certified General Accountants’

Research Foundation, Vancouver.

Rosen, L.S. (1982),An Empirical Study of Materiality

Judgements by Auditors, Bankers, and Analysts.

Research to Support Standard Setting in

Financial Accounting: A Canadian Perspective,

The Clarkson Gordon Foundation, Toronto.

Smithers (1992), ‘‘Legislative Session: 1st Session,

35th Parliament’’, Hansard, Vol. 3, May 12.

Walker, D. (2002), ‘‘Auditing the auditor’’, special

report on Enron, The Guardian, February 11.

Woolsey, S.M. (1973a), ‘‘Approach to solving the

materiality problem’’, Journal of

Accountancy, March.

Woolsey, S.M. (1973b), ‘‘Materiality survey’’,

Journal of Accountancy, September.

Further readingChapman, P. (2001), ‘‘Corporate governance and

the sons of Cadbury’’, Management

Accounting Journal, Vol. 1 No. 4.

Danish Accounting Standards (1994), FSR,

Copenhagen.

Danish Auditing Standards (1996), FSR,

Copenhagen (Danish edition only).

Elliott, R.K. (1981), ‘‘Audit materiality and myth’’,

D.R. Scott Memorial Lectures in Accountancy,

Vol. 11.

Elliott, R.K. (1983), ‘‘Unique audit methods: Peat

Marwick International’’, Auditing: A Journal

of Practice & Theory, Vol. 2 No. 2, Spring.

FASB (1975), Discussion Memorandum: An

Analysis of the Issues Related to Criteria for

Determining Materiality, 21 March.

Laing, D. and Weir, C.M. (1999), ‘‘Governance

structures, size and corporate performance in

UK firms’’,Management Decision,Vol. 37 No. 5,

pp. 457-64.

Glautier, M. and Underdown, B. (1997), Accounting

Theory and Practice, 6th ed., Pitman, London.

Godfrey, J., Hodgson, A. and Homes, S. (1997),

Accounting Theory, 3rd ed., John Wiley &

Sons, New York, NY.

Højskov, L. (n.d.), ‘‘Should errors in financial

statements be corrected?’’, unpublished

working paper.

ISA (1994), International Standards on Auditing

No. 320 and Glossary of Terms, International

Auditing Practices Committee (IAPC), issued

by the International Federation of

Accountants (IFAC), July, FSR, Copenhagen.

Leslie, D.A. (1985), Materiality, CICA, Toronto.

Public Sector Corporate Governance (2002),

‘‘Turnbull report’’, Credit Control, Vol. 23

No. 1, pp. 27-30.

Ricchiute, D. (1992), Auditing, South-Western

Thomson Learning, Mason, OH.

Schelluch, P. and Green, W. (1996), ‘‘The

expectation gap: the next step’’, Australian

Accounting Review, Vol. 6 No. 2.

Selley, D.C. (184), ‘‘The origins and development

of materiality as an audit concept’’, paper

presented at the Audit Symposium VII,

Touche Ross/University of Kansas

Symposium on Auditing Problems.

Vinten, G. (2002), ‘‘The corporate governance

lessons of Enron’’, Corporate Governance,

Vol. 2 No. 4, pp. 4-9.

Wilson, I. (2000), ‘‘The new rules: ‘ethics and

social responsibility’’’, Strategy and

Leadership, Vol. 28 No. 3, pp. 12-16.

Wolk, H. and Tearney, M. (1997), Accounting

Theory, 4th ed., Thomson, Mason, OH.

Appendix

Table AIComparison of the auditors’ and the financial analysts’ average levels

Index figures for auditors’ average levels(average of financial analysts =100)

Company 1:Carlsberg

Company 2:Micro Matic

Company 3:B&O

Company 4:DDT Average

Levels in the casesOverestimation 188 229 124 94 159Underestimation 170 207 (15012) 66 102 (157) 136

Source: Research in Accounting Conference Proceeding, Japan, 1998

[ 529 ]



Improving corporate governance: the role of auditcommittee disclosures

Zabihollah RezaeeFogelman College of Business and Economics, The University of Memphis,Memphis, Tennessee, USAKingsley O. OlibeDepartment of Accounting, Middle Tennessee State University, Murfreesboro,Tennessee, USAGeorge MinmierFogelman College of Business and Economics, The University of Memphis,Memphis, Tennessee, USA

Introduction

An increasing number of earnings

restatements by publicly traded companies

coupled with allegations of financial

statement fraud and lack of responsible

corporate governance of high-profile

companies (e.g. Enron, Global Crossing,

WorldCom, Adelphia) has sharpened the ever

increasing attention on corporate

governance in general and the audit

committee in particular. The audit

committee’s function has evolved over the

years and now with recommendations of the

Blue Ribbon Committee (BRC, 1999) and the

new rules of the Securities and Exchange

Commission (SEC, 1999) and organized stock

exchanges (e.g. New York Stock Exchange

(NYSE), American Stock Exchange (AMEX),

National Association of Securities Dealers

Automated Quotation NASDAQ), it is viewed

as an oversight function of corporate

governance, financial reporting process,

internal control structure, and audit

functions. The Sarbanes-Oxley Act of 2002,

also known as ‘‘Public Company Accounting

Reform and Investor Protection Act of 2002,’’

has expanded the formal responsibilities of

audit committees[1]. These expanded

responsibilities of audit committees should

be specified in both audit committee charters

and reports. Yet, until recently, there was not

a common view of what an audit committee

charter includes, what it should achieve, and

whether to include the report by the audit

committee in annual reports. The status of

the audit committee report has evolved from

nonexistence to voluntarily and now

mandatory for publicly traded companies

under the SEC jurisdiction in the USA.

The primary purposes of this paper are to,

first, discuss current initiative on corporate

governance and audit committees; second,

examine to what extend affected companies

are in compliance with audit committee

disclosure requirements; third, determine

best practices in audit committee reporting;

and fourth, make suggestions for

improvements in corporate governance in

general and the audit committee in

particular. The determination of best

practices in audit committee reporting

should assist organizations to establish

benchmarks in assessing the adequacy and

effectiveness of their audit committee

reporting. An effective audit committee

reporting can improve corporate governance

and accountability as President Bush urged

corporate America to regain the public

confidence in financial reports through

greater accountability.

Corporate governance and auditcommittee

The report of the Public Oversight Board

(POB) of the SEC Practice Section of the


Accountants (AICPA) (1993) states:Corporate governance in the United States is

not working the way it should . . . (It) is the

failure by too many boards of directors to

make the system work the way it should . . .more effective corporate governance depends

vitally on strengthening the role of the board

of directors.

Enron, Global Crossing, Adelphia, and

WorldCom debacles, caused by the alleged

commission of financial statement fraud,

have raised concerns regarding the lack of

vigilant oversight functions of their boards of

directors and audit committees in effectively

overseeing financial reporting process and

audit functions. Corporate governance in the

USA is coming under sharp criticism for its

lack of vigilant oversight functions.





[ 530 ]



KeywordsCorporate governance,

Audit committees,

Financial reporting, Auditing,

Disclosure

AbstractAn increasing number of earnings

restatements along with many

allegations of financial statement

fraud committed by high profile

companies (e.g. Enron, WorldCom,

Global Crossing, Adelphia) has

eroded the public confidence in

corporate governance, the

financial reporting process, and

audit functions. The Sarbanes-

Oxley Act of 2002 was an attempt

to regain confidence and trust in

corporate America and the

accounting profession. The Act

addresses corporate scandals and

the perceived crisis in the auditing

profession. Some of its provisions

relate to the audit committee

oversight function over corporate

governance, financial reporting,

internal control structure, internal

audit functions, and external audit

services. This study examines

three types of audit committee

disclosures: the annual report of

the audit committee; reporting of

the audit committee charter in the

proxy statement at least once

every three years; and disclosure

in the proxy statement of whether

the audit committee had fulfilled

its responsibilities as specified in

the charter. This study conducts a

content analysis on audit

committee disclosures of Fortune

100 companies.

President George W. Bush, in the recent State

of the Union address, mentioned the

seriousness of the corporate governance

problem by saying that:Through stricter accounting standards and

tougher disclosure requirement, Corporate

America must be made accountable to

employees and shareholders and held to the

highest standards of conduct (Bush, 2002).

The role of corporate governance is also

addressed by the Blue Ribbon Committee

(BRC, 1999, p. 20) as:Good governance promotes relationships of

accountability among the primary corporate

participants to enhance corporate

performance. It holds management

accountable to the board and the board

accountable to shareholders . . . A key element

of board oversight is working with

management to achieve corporate legal and

ethical compliance. Such oversight includes

ensuring that quality accounting policies,

internal controls, and independent and

objective outside auditors are in place to

deter fraud, anticipate financial risks, and

promote accurate, high quality, and timely

disclosure of financial and other material

information to the board, to the public

markets, and to the shareholders.

The Blue Ribbon Committee (BRC, 1999)

revealed the following three conclusions

regarding the oversight responsibility of

corporate governance including the audit

committee:

1 Quality financial reporting can only be

achieved through open and candid

communication and close working

relationships among the corporation’s

board of directors, audit committee,

management, internal auditors, and

external auditors.

2 Strengthening corporate governance

oversight in the financial reporting

process of publicly traded companies will

reduce instances of financial statement

fraud.

3 Integrity, quality, and transparency of

financial reports improve investors’

confidence in the capital market while

incidents of financial statement fraud

diminish such confidence.

Corporate governance guidelinesCorporate governance principles and

guidelines are established by several

organizations to provide best practices or

benchmarks against which to assess the

appropriateness of the corporate governance

system. For example, the Toronto Stock

Exchange (TSE) established a Committee on

Corporate Governance in 1993 to ensure

investors receive sufficient information to

assess the effectiveness of the company’s

corporate governance. The committee issued

a report, known as the Dey Report, entitled,

Where Were the Directors? Guidelines for

Improved Corporate Governance in Canada in

December 1994 (TSE, 1994). The Dey Report

proposed 14 guidelines for corporate

governance primarily aimed at the activities

of the board of directors.

TSE-listed companies should report on

their corporate governance system and on

whether their system is in compliance with

the 14 guidelines. These guidelines are

primarily aimed at the board of directors by:. specifying the responsibility of the board

of directors in the areas of strategic

planning, risk management, and internal

control;. suggesting that the board of directors

should be composed of a majority of

unrelated (independent) directors;. approving corporate objectives;. discussing orientation and training for

new board members, compensation

committees, and their functions;. functioning independently of

management; and. establishing the audit committee

composed solely of outside directors

which oversees audit functions and the

system of internal control.

The Business Roundtable, an association of

chief executive officers of leading

corporations that represents itself as an

‘‘authoritative voice’’ for American business,

has proposed six guiding principles of

corporate governance:

1 the board of directors should select a chief

executive officer (CEO) and oversee the

CEO and other top executive activities;

2 management is responsible for operating

the corporation in an effective and ethical

manner with the goal of creating

shareholder value;

3 management is responsible for preparing

financial statements, under the oversight

of the board of directors and its audit

committee, that fairly present the

financial condition and results of

operations of the corporation;

4 the board of directors and its audit

committee should engage an independent

accounting firm to perform financial

statement audits;

5 the independent accounting firm should

maintain its independence in fact and in

appearance, conduct the audit in

accordance with generally accepted

auditing standards (GAAS), inform the

board through the audit committee of any

concerns regarding the quality and

[ 531 ]

Zabihollah Rezaee,Kingsley O. Olibe andGeorge MinmierImproving corporategovernance: the role of auditcommittee disclosures


integrity of the financial reporting

process; and

6 corporations have responsibilities to deal

with their employees in a fair and

equitable manner (BRT, 2002).

The National Association of Corporate

Directors (NACD, 2002), an independent,

not-for-profit organization devoted to

improve corporate board performance, has

recently recommended to Congress a set of

core governance principles to be endorsed by

organized stock exchanges, and used by the

SEC as disclosure requirements in order to

improve corporate governance in the USA.

The core governance principles set forth by

NACD consist of ten governance principles

and related disclosure requirements for

publicly traded companies in the USA. These

ten governance practices and principles set

forth the following expectations for boards of

directors. The board of directors should:

1 comprise a substantial majority of

‘‘independent’’ directors;

2 require establishment of key committees

(e.g. audit, compensation, nominating) to

be composed of independent directors;

3 ensure that each key committee has a

board-approved written charter detailing

its functions and responsibilities;

4 formally designate an independent

director as chairman or lead director;

5 regularly and formally evaluate the

performance of the CEO;

6 review the adequacy of their companies’

compliance and reporting systems at least

annually;

7 adopt a policy of holding periodic sessions

of independent directors;

8 require their audit committee to meet

independently with both the internal and

independent auditors;

9 be constructively engaged with

management in corporate strategy; and

10 provide new directors with a ‘‘director

orientation’’ program to familiarize them

with their companies’ business, industry

trends, recommended governance

practices, and then ensure ‘‘continuing

education’’ for directors (NACD, 2002).

Currently, under the pressure from the SEC

and organized stock exchanges in the USA,

interested parties are considering how to

improve corporate governance in general

and the effectiveness of the audit committee

in particular.

Audit committees

Recent high profile business failures and

corporate misconducts (e.g. Enron, Global

Crossing, WorldCom, Adelphia) have

galvanized more interest in and discussion

on the proper oversight of audit committees.

The success of audit committees in fulfilling

their oversight responsibility depends on

their working relationships with other

participants of corporate governance,

including the board of directors,

management, external auditors, internal

auditors, legal counsel, professional advisors,

regulators, and standard-setting bodies. The

new audit committee rules of the NYSE and

NASD, which govern companies listed on

both the AMEX and NASDAQ, set forth

requirements for independent directors,

charter, structure, membership, and

compliance. The emerging interest in

corporate governance underscores the

importance of audit committees as a crucial

element of corporate governance

mechanisms. Arthur Levitt, former

chairman of the SEC, rightfully stated that:Effective oversight of the financial reporting

process depends, to a very large extent, on

strong audit committees; qualified,

committed, independent, and tough-minded

audit committees represent the most reliable

guardians of the public interest – this time for

bold action (Levitt, 1999).

Rezaee (2002) states that the evolution of

audit committees shows many companies

voluntarily created audit committees in the

mid-twentieth century to provide more

effective communication between the board

of directors and external auditors. Current

audit committees are expected to oversee

corporate governance, financial reporting,

internal control structure, internal audit

functions, and external audit services. The

SEC rules on audit committees significantly

affect the structure, composition, functions,

and responsibilities of audit committees.

DeZoort and Salterio (2001) discuss audit

committee composition, functions,

responsibilities, and resources as well as the

effects of corporate governance experience

and audit knowledge on audit committee

members’ judgments. To effectively fulfill its

oversight function, the audit committee

should be independent, competent,

financially literate, adequately resourced

and properly compensated.

The Sarbanes-Oxley Act of 2002 enacted six

requirements for audit committees;

1 the audit committee should be composed

entirely of independent members of the

board of directors;

2 the audit committee should be directly

responsible for the appointment,

compensation, and oversight of the work

of external auditors;

[ 532 ]



3 the audit committee should have

authority to engage advisors;

4 the audit committee should be properly

funded to effectively carry out its duties;

5 auditors must report to the audit

committee all ‘‘critical accounting policies

and practices’’ used by the client; and

6 the SEC should issue rules to require

public companies disclose whether at

least one member of their audit committee

is a ‘‘financial expert.’’

The BRC (1999) recommended and the SEC

requires that an audit committee report be

included annually in the proxy statement.

The report should state whether the audit

committee has:. reviewed and discussed the audited

financial statements with management;. discussed with the external auditors those

matters required to be communicated to

the audit committee in accordance with

generally accepted auditing standards

(GAAS);. received from the external auditors a

letter revealing matters that, in the

auditors’ judgment, may reasonably be

thought to bear on the auditors’

independence from the company and

discussed with them their independence;

and. recommended to the board of directors

that the company’s audited financial

statements be included in the annual

report on the form 10-K or form 10-KSB

based on discussions with management

and external auditors.

The inclusion of the audit committee report

in the proxy statements presents challenges

for audit committees on the one hand; it

should improve the trust and confidence in

the financial reporting process. On the other

hand, it raises some concerns that audit

committee members are not thoroughly

involved in the preparation of financial

statements and, thus, this requirement

increases audit committee’s liability. This

increased oversight function and associated

liability may ultimately result in either

higher compensation for audit committee

members or fewer qualified directors willing

to serve on audit committees. This study

attempts to determine the best practices and

guidelines on audit committee disclosures.

Methods and procedures

In the presence of mandatory requirements

for the inclusion of a report by the audit

committee in the company’s proxy statement,

all publicly traded companies have prepared

such reports. This study performs a content

analysis on audit committee reports of

Fortune 100 companies in the USA to

determine the information content of these

reports and the extent to which these reports

conform to the requirements of the SEC,

NSDQ, and NYSE. The final sample consists

of only 94 companies because audit

committee reports and charters of several

companies were not publicly available.

Reports on audit committees were submitted

to a content analysis to identify the title and

format of such reports. These proxy

statements were examined to determine:. the presence of the audit committee report

in the proxy statement;. the title of such report (e.g. report on audit

committee); and. the content of the report.

This study also examines the audit

committee charters in determining

characteristics, structure and functions of

audit committees.

Results

The currently mandatory audit committee

disclosures are, first, the annual report of the

audit committee; second, reporting of the

audit committee charter in the proxy

statement at least once every three years; and

third, disclosure in the proxy statement of

whether the audit committee had fulfilled its

responsibilities as specified in the charter.

These enhanced mandatory audit committee

disclosures are expected to:. encourage more vigilant audit committee

oversight function;. improve corporate governance;. foster the public confidence in the

financial reporting process; and. promote audit efficacy.

Results are presented in two categories of

audit committee charters and audit

committee reports.

Audit committee chartersThe SEC requires that publicly traded

companies adopt formal written charters for

their audit committee describing their

responsibilities, composition, qualifications,

and functions. The charter should be

approved by the board of directors and

disclosed at least triennially in the annual

report to shareholders or proxy statement.

Publicly traded companies listed on

organized stock exchanges (NYSE, AMEX,

NASDAQ) are required to include the audit

committee charter in their proxy statement

at least once every three years (SEC, 1999).

[ 533 ]



The audit committee charter states the

committee’s responsibilities, size,

composition, authority, meetings, diligence,

financial literacy, and independence.

Results presented in Table I indicate that

all of the analyzed charters specify the

responsibilities and authority of the audit

committee. Although, audit committee

charters vary in describing responsibilities

and authorities of the audit committee, the

general recurring responsibilities are:. recommendation to the board of directors

for nominating and/or retaining the

independent auditors;. reviewing the audited financial

statements and discussing them with

management and the independent

auditors;. issuing a report (e.g. audit committee

report) to be included in the company’s

proxy statement;. overseeing internal audit activities; and. reviewing the relationship with the

independent auditors and their audit

activities.

Table I shows that more than 90 per cent of

the analyzed charters specify that the size of

their audit committee is three to four

members. All three stock exchanges (NYSE,

AMEX, NASDAQ) in the USA require that

the audit committee contain at least three

members.

Results in Table I also reveal that about 60

per cent of audit committee charters studied

specify three to four meetings of the audit

committee per year while more than 5 per cent

indicate one to two meetings, about 3 per cent

point out more than five meetings annually

and more than 35 per cent do not specify the

number of meetings of the audit committee.

The BRC recommends that the audit

committee meet at least four times per year.

Table I provides information on the audit

committee composition, qualifications,

independence, and the requirement of

financial literacy. Almost all of the analyzed

charters provide adequate information

regarding the composition, qualifications,

independence, and financial literacy of audit

committee members. Organized stock

exchanges in the USA require that, with a

few limited exceptions, all audit committee

members be independent. For example, an

exception is permitted for one

non-independent audit committee member

which is suitably justified. The SEC,

however, requires that any such exceptions

and related justifiable reasons be fully

disclosed in the charter. The Sarbanes-Oxley

Act of 2002 defines independent as not

receiving, other than for service on the

board, any consulting, advisory, or other

compensatory fee from the company, and not

being an affiliated person of the company, or

any subsidiary thereof.

The BRC requires that at least one member

of the audit committee must have accounting

or financial management skills and members

of the audit committee be financially literate.

Financial literacy is defined as the ability to

read and understand fundamental financial

statements including balance sheet, income

statement and the statement of cash flow. The

issue is whether one ‘‘financial expert’’ is

sufficient on an audit committee to

understand the nature and impacts of

complex business transactions such as

derivative financial instruments, related

party transactions, special purpose entities.

Table I shows that almost all analyzed

charters specify composition, qualifications,

independence and financial expertise of their

committee members. The requirement of

only one ‘‘financially literate’’ audit

committee member may not be adequate to

fulfill effectively the financial oversight

function of the audit committee. The more

effective approach is the audit committee

work diligently with management and

auditors to identify the most complex

business activities, assess their relative

risks, determine their accounting treatments

and obtain complete understanding of their

impacts on fair presentation of financial

performance and conditions. The audit

committee should obtain independent advice

on these business activities and related

transactions, associated risks and proper

accounting treatments. The audit committee

should inform the board of directors about

these transactions, their risks, accounting

treatments, and ensure that they are

adequately communicated to investors. Audit

committee members should be sufficiently

knowledgeable to ask tough questions of

management as well as internal auditors and

Table IAudit committee charter analysis

Characteristics Number Percentage

Responsibilities/authorities 93 100.0Size

3-4 members 84 90.3Not specified 9 9.7

Number of meetings1-2 5 5.43-4 52 55.95+ 2 2.25Not specified 34 36.6

Composition, qualifications,independence, financial literacy

92 98.9

Notes: n = 93

[ 534 ]



external auditors regarding quality,

transparency, and reliability of financial

reports.

Audit committee reportsThe usefulness and value relevance of the

mandatory reporting by the audit committee

has been challenged. Critics (McMullen, 1996)

argue that such a mandatory reporting

requirement by the audit committee will

increase the audit committee’s liability

which will eventually result in either higher

compensation for audit committee members

or fewer qualified directors willing to serve

on audit committees. Furthermore, the

financial reporting oversight function of the

audit committee has its limits in the sense

that:. management is primarily responsible for

fair presentation of financial statements

in conforming with GAAP;. auditors are responsible for providing

reasonable assurance regarding fair

presentation of financial statements in

conformity with GAAP; and. the audit committee is not adequately

resourced and competently staffed to

shoulder the onerous legal responsibility

of reliability of financial statements.

Proponents (the BRC, SEC, NYSE, NASD) of

the mandatory audit committee reporting

argue that such reports will improve

integrity, quality, reliability, and

transparency of financial reports because the

report indicates that financial statements are

useful and reliable; the audit was thorough;

and the auditor’s have no flagrant conflicts of

interest. This should reduce the information

risks that may be associated with published

audited financial statements. The usefulness

of the audit committee report depends on its

format and content.

1. Title of audit committee reportResults presented in Table II indicate that

corporations use a variety of titles for the

audit committee report. The most frequently

used titles are ‘‘Audit committee report’’

(about 46 per cent) and ‘‘Report of the audit

committee’’ (33 per cent). Other titles are

‘‘Report of the audit and finance committee’’;

‘‘Audit and compliance committee report’’;

‘‘Audit committee report and related

matters’’; and ‘‘Report of the audit committee

of the board’’. The majority of corporations

(more than 85 per cent) differentiated the

audit committee report from reports

published by other committees of the board

of directors (e.g. compensation, ethics,

compliance, finance). This study suggests

that the title of ‘‘Audit committee report’’ be

used to improve consistency, comparability,

and uniformity in the audit committee

reporting process.

2. Content of audit committee reportThe SEC requires that a report by the audit

committee be included annually in the proxy

statement of publicly traded companies. The

report on audit committee should state

whether the audit committee has:. reviewed and discussed the audited

financial statements with management;. discussed with the external auditors those

matters required to be communicated to

the audit committee in accordance with

GAAS;. received from the external auditors a letter

revealing matters that, in the auditors’

judgment, may reasonably be thought to

bear on the auditors’ independence from

the company and discussed with them

their independence; and. recommended to the board of directors

that the company’s audited financial

statements be included in the annual

report on the form 10-K or form 10-KSB

based on discussions with management

and external auditors.

Results presented in Table III indicate that

almost all analyzed audit committee reports

address the aforementioned items in the

audit committee report. The results also

show that the focus has been on audit

committee roles and structure rather than

the process of fulfilling oversight functions.

Many of these reports contain a disclaimer

that the audit committee does not guarantee

the financial statements adhere to GAAP and

based their recommendations solely on the

word of management and auditors. This

suggests that the audit committee charter has

been driven by regulatory bodies with

self-denial and window-dressing that do not

deal with the underlying fundamentals. The

audit committee report should provide

information regarding the audit committee’s

oversight functions of the financial reporting

process and audit activities. The audit

committee should ask the auditors if

management’s assertions are in conformity

with GAAP assuming that GAAP is

unambiguous and GAAP compliance makes

those assertions accurate, objective, and

transparent. The existing GAAP is very

flexible and there is no clear cut criteria to

question management judgments of selecting

the appropriate accounting methods.

The reports of the audit committees are

expected to lend more credibility to audit

financial statements by affirming that:. financial statements present fairly in

conformity with GAAP;

[ 535 ]



. financial statement fairly reflect the

company’s financial conditions and

performance;. the financial audit was thorough; and. there were no conflicts of interest that

could possibly impair the auditors’

independence.

Results show that:. the majority of the studied audit

committee reports contain a disclaimer

phrase, indicating that their committee

was not responsible for fair presentation

of financial statements;. their recommendations are primarily

based on management assertions and

auditors findings; and. limitations of their oversight function.

Conclusion

The audit committee is empowered to

function, on behalf of the board of directors,

by assuming an important oversight role in

the corporate governance intended to protect

investors and ensure corporate

accountability. The audit committee has

oversight responsibility over corporate

governance, the financial reporting process,

internal control structure, internal audit

functions, and external audit activities.

Recommendations of the BRC and new rules

of the SEC, NYSE and NASD require that

publicly traded companies in the USA:. adopt formal written charters for their

audit committees describing their

responsibilities, composition, structure,

and qualifications;. the adopted audit committee charter be

reviewed, revised, and included in the

proxy statement at least once every three

years; and. companies include a report of the audit

committee in their proxy statement

annually.

Results of this study indicate that all

companies examined have adopted

audit committee charters that are published

at least once every three years. All studied

companies currently include a report of the

audit committee in their annual report or

proxy statement. The majority of audit

committee composition, structure,

meetings, and qualification are in

compliance with the requirements of the SEC

and organized stock exchanges. The report of

audit committee is intended to ensure that

financial statements are legitimate, the audit

was thorough, and the auditors have no

flagrant conflicts of interest that may

jeopardize their objectivity, integrity, and

independence. It is expected that more

effective audit committee disclosures in

conformity with the provisions of the

Sarbanes-Oxley Act of 2002 (e.g. charter,

report) improve the trust and confidence in

corporate governance, the financial

reporting process, and audit functions.

Table IIIContent of audit committee report

A statement that the committee Number Percentage

a. Reviewed and discussed with management the company’saudited financial statements

91 96.8

b. Discussed with independent auditors audit issues, findingsand matters related to audited financial statements

92 97.9

c. Received and reviewed the written disclosures and theletter from the auditors regarding their independence

92 97.9

d. Recommended to the board of directors that thecompany’s audited financial statements be included in theannual report on Form 10-K or KSB

94 100.0

Table IITitle of the audit committee report

Title Number Percentage

Audit committee report 43 45.7Report of the audit committee 31 33.0Report of the audit and finance committee 4 4.3Audit and compliance committee report 3 3.2Audit committee report and related matters 2 2.1Board audit committee report 2 2.1Report of the audit committee of the board 2 2.1Audit and ethics committee report 1 1.1Audit and examination committee report 1 1.1Report of audit and legal committee 1 1.1Report of the audit and risk management committee 1 1.1Report of the audit committee on the financial statements 1 1.1Report of the board of directors audit committee 1 1.1

Notes: n = 94

[ 536 ]



Note1 Sarbanes-Oxley Act of 2002. Public Company

Accounting Reform and Investor Protection

Act of 2002, available at: www/

whitehouse.gov/infocus/

corporateresponsibility/

ReferencesBRC (1999), Report and Recommendation of the


Effectiveness of Corporate Audit Committees.,

Blue Ribbon Committee, New York Stock

Exchange and National Association of

Securities Dealers, New York, NY.

Bush, G.W. (2002), The President’s State of the

Union Address, 29 January, available at:

www.whitehouse.gov/news/releases/2002/

01/20020129-11.html

BRT (2002), ‘‘Principles of corporate governance’’,

Business Roundtable, May, available at:

www.brtable.org/pdf/704.pdf

DeZoort, F.T. and Salterio, S. (2001), ‘‘The effects

of corporate governance experience and audit

knowledge on audit committee members’

judgments’’, Auditing: A Journal of Practice

and Theory, Vol. 20, September, pp. 31-47.

Levitt, A. (1999), ‘‘Chairman, securities and

exchange commission’’, The Numbers Game,

29 September, available at: www.sec.gov/

news/speech/speecharchive/1998/

spch220.txt

McMullen, D.A. (1996), ‘‘Audit committee

performance: an investing of the

consequences associated with audit

committees’’, Auditing: A Journal of Practice

and Theory, Spring, pp. 87-103.

NACD (2002), The NACD Board’s

Recommendations for Governance Reform,

April, National Association of Corporate

Directors, Washington, DC, available at:

www.nacdonline.org

Public Oversight Board (POB) of the SEC Practice

Section, AICPA (1993), A Special Report on

Issues Confronting the Accounting Profession.

Rezaee, Z. (2002), Financial Statement Fraud:

Prevention and Detection, John Wiley & Sons,

New York, NY.

SEC (1999), Final Rule: Audit Committee

Disclosure. Release No. 34-42266, Securities

and Exchange Commission, Washington, DC.

TSE (1994), Where Were the Directors? Guidelines

for Improved Corporate Governance in

Canada (The Dey Report), December, Toronto

Stock Exchange, Toronto, available at:

http://www.tsers.com/cgi_bin/

uni_framset.cgi?content=/new/dey.html

[ 537 ]



Users’ perceptions of corporate social responsibilityand accountability: evidence from an emergingeconomy

Khalid Al-KhaterCollege of Business Administration and Economics, University of Qatar, QatarKamal NaserCardiff Business School, University of Wales, Cardiff, UK

Introduction

Although corporate social responsibility

formed a major financial reporting issue in

the developed countries in the last decade, it

is still a minor issue in the developing

countries. A number of developing countries,

however, have paid a little attention to

corporate social reporting (see, for example

Abu Baker and Naser, 2000). In this study, an

attempt is made to explore the perception of

the various users of corporate information in

Qatar about corporate social responsibility

and the accountability concept[1].

Since the middle of the 1990s, Qatar took

several steps towards introducing democracy

and liberating the economy. This can be

clearly seen through the lifting of restrictions

on the media and abolishment of the

Ministry of Media and Information. This

coincided with the introduction of the

privatization programme and the creation of

the national stock market[2]. The authorities

are further debating the possibility of

establishing a national association of

accountants with the responsibility of

issuing accounting standards. Given that

Qatar is an Islamic and conservative society,

corporate social responsibility disclosure

would form an important ingredient in the

accountability concept that represents an

Islamic society. More importantly, a review

of the annual reports of the Qatari

commercial banks for the last five years

indicated that all these banks devote part of

their income to support projects that

emphasize the banks’ role in society[3].

Hence, a study that investigates various

users’ opinions of different aspects of

corporate social responsibility reporting

from an emerging economy like Qatar will

add a new dimension to the literature. So far,

one study that addresses this issue was

undertaken in an Arab country – Jordan – by

Naser and Abu Baker (1999). The economies

of Arab countries, however, can be classified

into those in which revenues are coming

directly from oil such as Saudi Arabia and

Qatar and those that benefit indirectly from

oil revenues, such as Jordan and Sudan,

since a significant proportion of their labour

force is working in the oil producing

countries[4]. Thus, providing empirical

evidence on corporate social responsibility

and accountability from Qatar will add to the

literature.

The remainder of the paper proceeds as

follows. The following section summarizes

the financial reporting environment in

Qatar. Previous studies on corporate social

responsibility reporting are reviewed in

section three. Study questions, data

collection and statistical tests employed in

this study are discussed in section four.

While the findings are offered in section 5,

the conclusion is presented in the final

section.

Financial reporting environment inQatar

In the last three decades and mainly due to

vast oil revenues, the Gulf Cooperation

Council (GCC) countries have witnessed

tremendous economic development. The

economic development coincided with an

increase in the number of companies

operating in the GCC region. Consequently,

national stock exchanges have been

established and now all GCC countries hosts

stock exchanges. The increase in the number

of publicly owned companies and the

creation of stock exchanges, however, was

not matched by development in the

accounting and auditing systems within

these countries. Hence, a gap exists between





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KeywordsSocial responsibility,

Annual reports, Qatar

AbstractThis study sets out to investigate

the perception of different users of

corporate information about the

notion of the accountability

process and the possibility of

widening the scope of the current

corporate annual report in Qatar to

include social responsibility

information. To achieve this

objective, four user groups were

invited to take part in the study.

The outcome of the analysis

revealed that most of those who

took part in the study would like to

see corporate social responsibility

information disclosed, either in a

separate section, or as part of the

board of directors’ statement

within the annual report. To

achieve accountability, the

respondents believe that a law

that encourages the disclosure of

corporate social responsibility

information should be introduced,

and different parties within the

society should have the right to

such information.

the degree of economic development and the

development of the accounting and auditing

systems within the GCC countries. The main

problem that faces the GCC countries in

general, and Qatar in particular, is the lack of

specific accounting standards that govern the

activities of companies, whether national or

international, operating within the

country[5]. The international audit firms that

have offices in different parts of the country

influence accounting and auditing systems in

Qatar. Although GCC countries, such as

Bahrain, Kuwait, UAE and Oman, adopt the

International Accounting Standards (IASs),

while Saudi Arabia attempted to develop

their own accounting standards, until now

Qatar neither developed its own standards

nor adopted the IASs. However, most large

companies operating in Qatar are affected by

their external international auditors and

apply the IASs.

In fact, the accounting and auditing

systems in Qatar are still in a primitive

stage. Until 1974, the accounting and auditing

practice was no more than mere judgment by

practicing accountants and auditors without

any official guidelines. In 1974, however, the

Qatari authorities issued Law Number 7 that

regulated the work of the external auditor.

This was followed by the publication of Law

Number 11, the Companies Acts, in 1981 that

organized the work of companies operating

in Qatar. The two laws were then adjusted by

the publication of Law Number 9 in 1998.

Cumulatively, the Acts asked management of

publicly owned companies to publish the

traditional financial statements, together

with the basis upon which these statements

were prepared, on a regular basis after

presenting them to qualified external

auditors.

In May 2002, the 1981 Company Acts that

regulate the work of commercial companies

replaced Law Number 11. The newly issued

Companies Acts became effective 60 days

after their publication in the official

newspaper on 25 May 2002. The first chapter

of the Acts covers general rules that contain,

among other things, the definition of a

publicly owned company, a name that

reflects its purpose rather than a personal

name, specific date for its creation, a starting

capital of not less than QR10 million[6] . The

second chapter of the Acts indicates that the

publicly owned company should be created

after obtaining the permission of the

Minister of Economics and Commerce, and

with a minimum of five investors. With the

exception of cases identified by Law Number

(13) 2000, all shareholders must be Qatari

nationals. Article (119) of Companies Acts

(2002) requests all publicly owned companies

to provide shareholders at the end of every

financial year with an audited balance sheet,

profit and loss accounts, cash flow statement

and explanations in comparison with the

previous financial year together with details

of the company’s activities and future plans

for the coming year. The company’s board of

directors should make the information

publicly available within not more than three

months after the end of the company’s

financial year to be presented to the general

meeting that should convene within not more

than four months after the end of the

financial year.

The fourth chapter of Companies Acts 2002

addresses the work of the external auditor.

According to Article (141) of the Acts, the

general assembly of the publicly owned

company should appoint one or more

external auditors for one year for a specified

fee. The company has the right to reappoint

the same auditor as long as the appointment

does not exceed five years continuously. The

Article indicates that the board of directors is

delegated with the authority to appoint the

external auditor and the founders of the

publicly owned company can appoint an

external auditor until the first meeting of the

company’s general assembly. The remainder

of chapter four of the Companies Acts 2002

identifies the activities and the

responsibilities of the external auditor.

Previous studies

The Corporate Report (ASC, 1975) and other

researchers such as Samuels (1990), Hove

(1986), Wallace (1993) and Abu Baker and

Naser (2000) have referred to different

statements, reports and other items of

corporate social responsibility disclosure. In

this respect, Gray et al. (1987, p. 4) defined

corporate social responsibility as:. . . responsibilities of actions which do not

have purely financial implications and which

are demanded of an organization under some

(implicit and explicit) identifiable contract.

Hence, corporate social disclosure implies

that corporate disclosure should not be

restricted to information that emphasizes

corporate performance, liquidity and

financial position. Corporate reporting

should be widened to accommodate social

and economic aspects of the company. In a

conservative Islamic society like Qatar,

information relating to Zakat calculation and

its sources and uses is expected to form an

important part of the corporate report[7].

Naser and Abu Baker (1999), viewed

corporate social responsibility disclosure as:

[ 539 ]

Khalid Al-Khater andKamal NaserUsers’ perceptions ofcorporate social responsibilityand accountability: evidencefrom an emerging economy


. . . important and relevant information input

to the understanding, debate and, hence,

solutions of social and economic development

problems relating, for example, to

income/wealth distribution, unemployment,

safety/security at work and level of training,

balance of payments, regional imbalances,

environmental pollution, energy usage and

natural resources consumption, and

consumer/product related problems.

Corporate social responsibility reporting is

important to various users of corporate

information such as employees, consumers,

local communities, and government and its

agencies, pressure groups and society at

large. Making social responsibility

information available to the users assists

them in making more informed decisions

about a company of concern. For example,

religious groups that form pressure groups

and account for a significant proportion of

many Islamic countries, in general, and

Qatar in particular, may invest their money

in companies that pay Zakat and donate

money to charitable organizations. Qataris

also deal with banks that do not pay or

receive interests on loans. Social

responsibility information assists the

religious groups in making judgment about

corporate social involvement. Furthermore,

the corporation reflects its image by

disclosing the degree of its involvement in

social and ethical responsibility issues.

Samuels (1990), who contended that corporate

social responsibility disclosure is relevant to

the developing countries’ social and

economic development problems, also

highlighted this reality. Similarly, Wallace

(1993) reveals that companies operating in a

certain country are expected to be socially

responsible. Such responsibility emphasizes

the objectives and desires of the society.

Since this issue is not fully addressed by the

International Accounting Standards (IASs),

Wallace (1993) argues that the IASs are

perceived to be deficient in identifying to

what extent a company contributes to the

social and economic development of a

country. As a consequence, Wallace (1993)

believes that attention should be paid to the

social and governmental interest in the IASs.

By the same token, Ghartey (1987)

demonstrates that the aim of corporate social

responsibility is to disclose information that

assures the public that their rights, whether

individually or as groups, are protected and

gives them the chance to complain if they feel

otherwise.

Drawing on the work of Naser and Abu

Baker (1999), an increase in corporate social

responsibility disclosure in an emerging

economy like Qatar should be coupled with a

clear accountability framework that

guarantees the structure of such disclosure.

Rosenfield (1974) defines the objective of the

accountability process as:. . . to report on the control and use of

resources by those accountable for their

control and use to those whom they are

accountable.

In the same fashion, Ijiri (1975) defined

accountability as the relationship between

two parties, the accountor and the accountee,

where the latter is accountable to the former

for his/her activities and the consequences.

Naser and Abu Baker (1999) referred to

three basic elements of the accountability

concept. First, the accountee has an

obligation to provide the accountor with

detailed information. Second, the

responsibilities of those who are held

accountable for their action and the

consequences must be spelled out clearly.

Third, stating accounts of actions and related

consequences will be used by the accountor

as a yardstick to assess the accountee. This is

expected to have implications for his/her

decision.

Naser and Abu Baker believe that the

accountability process can form a useful

basis for corporate reporting, if it observes

the following.. The accountability process should not be

restricted to economic issues. It should be

viewed as a social and economic concept.

The needs of the shareholders and

creditors should not be seen as being more

important than those of other users of

corporate information. The public needs

should be observed in the accountability

process. Hence, the company is expected

to disclose information that benefits

various users and the society at large.. The accountability process should be

viewed as a mechanism that lays down the

ethical foundations for accounting and

assures the fairness and public interest

within this framework. Williams (1987)

affirmed that fairness is a feature that

must be observed in the accountability

process.. The accountability process should

emphasize the notion of the right to know,

or the right to information (Ijiri, 1983;

Gray, 1992). Hence, the accountability

process ensures this right.. The accountability process is consistent

with the democratic movement led by the

Prince of Qatar and his government who

encourage freedom of speech and access to

information.. In an emerging economy like Qatar, with

the most influential television satellite

broadcasting not only to Qatari but also to

[ 540 ]



Arabs all over the world, the

accountability process guarantees free

access and the flow of information

relevant to debate problems that might

influence social and economic

development in Qatar[8].

It is evident from the above discussion that

accountability is relevant to the Qatari

society and it is expected to lend legitimacy

and justification to corporate social

responsibility disclosure in an emerging

economy like Qatar. In this context, Jensen

(1977) makes the point that variation in the

impact of business on economic,

environment and society makes it difficult to

prescribe a standard solution within and

between countries. He believes that radical

solutions to emerging businesses’ problems

can be dealt with by making businesses

accountable to their actions. This reality is

more needed in emerging economies, since

regulations offer little protection to

investors. As such, assurances to investors

and other users of corporate information a

greater level of accountability should be

introduced.

Research questions, datacollection and statisticaltechniques

Research questionsAs mentioned earlier, the main purpose of

this study is to poll the opinion of different

users in Qatar of corporate information

regarding different aspects of corporate

social responsibility. In particular, the study

sets out to provide answers to the following

research questions (RQ):

RQ1. What is the perception of different

user groups in Qatar regarding the

main purpose(s) of corporate

reporting?


user groups in Qatar about the

factor(s) that prevent(s) Qatari

companies from disclosing corporate

social responsibility information?


user groups in Qatar about what

motivate(s) Qatari companies to

disclose corporate social

responsibility information?


user groups in Qatar about who has

the right to corporate social

responsibility information in Qatar?

RQ5. How do various users view the

current level of corporate social

responsibility information

disclosure by Qatari companies?

RQ6. What approach(s) should be adopted

to disclose corporate social




location of corporate social




beneficiaries of corporate social

responsibility disclosure?

Data collectionTo provide answers to the above-mentioned

research questions, a questionnaire was

designed and distributed to the following

user groups in Qatar: accountants, external

auditors, academicians and bank officers.

The choice of these groups was based on the

grounds that they represent the interests of

different sections of the Qatari society. These

groups are also expected to be familiar with

different aspects of corporate reporting. In

addition, similar groups were targeted in

previous studies (Naser and Abu Baker,

1999).

The questionnaire was separated into two

parts. The first part sought general

information on the respondents’ background

profile and the second part of the

questionnaire was related to the respondents’

opinion about different aspects of corporate

social responsibility disclosure and the

accountability concept. The respondents

were requested to indicate their opinion on a

five-point Likert scale in terms of ‘‘strongly

agree’’ to ‘‘strongly disagree’’ or ‘‘very

important’’ to ‘‘not important at all’’. The

questionnaire covered four pages.

An early draft of the questionnaire was

piloted on lecturers at the Business

Administration and Economics College of

Qatar University. Based on the feedback from

these respondents, several modifications

were made to the wording of some questions,

and some less important questions were

deleted to reduce the length of the

questionnaire.

The questionnaire was translated into

Arabic and delivered by hand to the target

groups. Table I shows the number of

questionnaires that were distributed, the

number returned (the response rate) for each

group, and the overall response rate[9].

Two pre-analysis tests were undertaken to

generalize the results of the questionnaire

(non-response bias analysis) and to measure

its internal consistency (Cronbach’s Alpha).

In the non-response bias test, early

[ 541 ]



respondents were compared with late

respondents (as a surrogate of those who

have not responded to the questionnaire).

After conducting the Mann-Whitney U test,

no significant difference was reported

between the two groups. The Cronbach’s

Alpha test, however, was used to assess the

relationship between different parts of the

questionnaire. The Cronbach’s Alpha ranges

between zero and one; where zero indicates

no correlation exists between various parts

of the questionnaire and one refers to perfect

correlation between them. Huck and Cormier

(1996) indicated that 0.70 is an acceptable

level of significance for Alpha. Botosan

(1997), however, indicated that 0.80 or more is

preferable. In all cases, the value of

Cronbach’s Alpha for all user groups for the

answers of all questions in the study was 0.83.

Statistical techniquesTo conduct data analyses, descriptive

statistics that include frequencies and

measures of tendency were adopted. Since

the sample is taken from a number of user

groups, the Kruskal-Wallis test was

undertaken. The test is used to identify

whether the average perception of the

investigated variables used in the survey is

identical for all target groups.

Findings

Respondents’ backgroundsThe questionnaire sought information about

the user groups’ ages, levels of education,

specialization in their last academic degree,

place of education and years of experience.

The vast majority of the respondents (66 per

cent) were less than 30 years old. The average

age of the whole sample was around 35 years.

A total of 79 per cent of the participants

indicated that they hold a bachelor degree or

a higher degree and the same percentage of

the respondents revealed that they had

completed their education at Qatari or Arab

universities. A total of 5 per cent of the

respondents had completed their last degree

in America and 8 per cent at British

universities. More than 84 per cent of those

who took part in the survey had degrees in

accounting, banking and finance and 41 per

cent of the respondents had more than six

years of work experience.

The main purpose(s) of corporatedisclosureThe respondents were given a list of possible

purposes of corporate disclosure and asked to

identify the importance that they attach to

each of them. A summary of the participants’

responses is presented in Table II.

It is evident from the table that the

respondents attached the highest importance

to the proposal that the main purpose of

corporate reporting is to provide information

to shareholders, investors and creditors. This

is reflected by the reported mean score and

supported by the standard deviation. The

result of the Kruskal-Wallis test represented

by the �2 and its significance, and reported in

Table II, points to significant differences in

the respondents’ opinions about the

importance that they assign to the

information provided to shareholders and

investors. Viewing the frequencies

associated with these two purposes revealed

that the vast majority of the participants

either strongly agreed or agreed with the two

purposes. Hence, the difference reported by

the �2 is mainly between those who agreed

and strongly agreed. The outcome of the

analysis is consistent with Naser and Abu

Baker (1999), who conducted their study in

the Jordan environment. It seems to be that

both Jordanian and Qatari users of corporate

information emphasized in their answers the

importance of the objective of corporate

reporting in assisting investors and creditors

in making informative decisions about a

company of concern.

The respondents, however, attached the

lowest importance to the proposal that

corporate report provides information to

assist corporate management and employees

in making decisions. Although the two

proposals were ranked at the bottom of the

list, the mean scores were 3.43 and 3.69

respectively. This implies that the

respondents attached a certain degree of

importance to these proposals.

The result of the analysis may be explained

on the grounds that most business

Table ITarget groups and response rates

Target groups Distributed questionnaire Received questionnaire Response rate (%)

Accountants 100 58 58External auditors 30 18 60Academicians 30 18 60Bank officer 100 49 49Total 260 143 55

[ 542 ]



management in Qatar mainly comes from the

majority shareholders. Hence, referring to

shareholders and investors as important

users of corporate reporting implies

indirectly that such information is going to

be used by management. The result also

indicates that various users of corporate

reports attach a certain degree of importance

to the annual report since it provides

information to society to enable it to judge its

policies and its impact on society. Given that

Qatar is a small country with a limited

number of companies and a sizable number

of investors, ordinary users of corporate

reports are expected to monitor corporate

policies and their impact on society.

Possible reasons behind not disclosingcorporate social information by QataricompaniesThe respondents were given a list of reasons

that might prevent Qatari companies from

disclosing corporate social responsibility

information. The reasons are mainly derived

from previous studies (see for example Naser

and Abu Baker 1999). The analysis of the

participants’ answers is listed in Table III.

The respondents agreed that almost all

listed reasons prevent Qatari companies

from disclosing corporate social

responsibility information. The respondents,

however, believed that Qatari companies are

not currently reporting such information due

to administrative difficulties and

management does not appreciate its social

responsibility. They also indicated that the

objectives of the company emphasize its

economic rather than social performance.

They also believed that lack of legal

requirements provides companies with little

incentive to disclose corporate social

responsibility information. The result is

partially consistent with the Naser and Abu

Baker (1999), who found that corporate social

responsibility disclosure is not widely used

by Jordanian companies since this sort of

disclosure is not requested by law.

Although the reported standard deviations

in Table III signal possible variations in the

surveyed opinions, the Kruskal-Wallis test

reported in the same table demonstrates that

no significant differences exist. Hence, the

respondents believed that all the listed

factors may prevent Qatari companies from

disclosing social responsibility information.

The result is expected to assist policy makers

in Qatar in formulating future national

accounting standards.

Respondents’ views of the motivation forcompanies’ social responsibilityDrawing on Naser and Abu Baker (1999), the

respondents were asked to express their

opinion about issues that motivate the

disclosure of social responsibility

information. A summary of the participants’

answers is given in Table IV.

What attracts one’s attention in Table IV is

that the respondents agreed with almost all

the proposals given in the questionnaire,

except the proposal that large corporations

have no social responsibility but to make

profit for their shareholders. The highest

level of agreement among the respondents

was around the proposals that large

companies should bear some sort of social

responsibility to justify their existence

within the society and large companies

should be viewed as social organizations and

their existence is justified as long as they

satisfy the objectives of the society. The

result supports the findings of Naser and Abu

Baker (1999). The respondents, however,

were less enthusiastic about the idea of

attaching strategic companies to the public

sector to insure their social responsibility.

This implies that the respondents trust the

social role of the private sector in Qatar.

The Kruskal-Wallis test, on other hand,

revealed significant disagreement among the

Table IIThe importance that the target groups attach to the purpose(s) of corporate reporting in Qatar

Mean Kruskal-Wallis test Level ofPurpose(s) scorea Std. dev. Rank �2 significance

Provides information to:Shareholders on the use of their funds and the legality of the uses 4.16 0.82 1 11.27 0.010Investors to assist them in making investment decisions 4.14 0.91 2 6.84 0.077Institutions to assist them to negotiate financial facilities 3.76 0.95 6 4.90 0.179Creditors with information that assists them in protecting their interest 4.12 0.99 3 2.62 0.453Tax authorities to be used as a basis to assess taxation 4.02 0.98 5 2.73 0.435Managers to manage their businesses 3.43 1.01 8 0.313 0.950Assist the society at large to judge a company’s actions and policies 4.04 0.90 4 1.050 0.780Employees to assess them to protect their interest 3.69 0.99 7 4.24 0.230

Note: a Mean values – scoring: 1 = not important at all; 5 = very important

[ 543 ]



participants on two of the possible factors

that motivate the disclosure of social

responsibility information. The respondents’

opinions were mixed on whether strategic

companies should continue to be run by the

public sector to guarantee social

responsibility and whether decision makers

within the organization appreciate the

concept of social responsibility and its

importance to the organization. As in other

countries in the region, the Qataris seem to

be divided between those who support and

those who are against privatization and its

role in society. This reality is clearly

reflected in the participants’ answers. The

fact that the social responsibility issue is

relatively new to the Arab countries, in

general, and Qatar in particular, is also

reflected in the respondents’ opinions.

Variations in the participants’ as well as

management’s knowledge of the issue of

corporate responsibility disclosure are

further reflected in the respondents’

opinions.

Social responsibility and accountabilityThe previous discussion suggests that

various users of corporate information in

Qatar support the idea of disclosing

corporate social responsibility information.

Also in the previous sections, a broad

accountability mechanism was proposed as a

basis for corporate reporting. In the

subsections that follow, two issues are

introduced to test the notions of corporate

social responsibility and accountability.

The right to corporate informationPrevious results demonstrate that various

users of corporate information in Qatar seem

to support more disclosure of corporate

social information to ensure the corporate

role within the society. Hence, the

participants were given a list of possible user

Table IIIReasons behind not disclosing corporate social information by Qatari companies

Kruskal-Wallis testMean Level of

Reason scorea Std. dev. Rank �2 significance

Administrative difficulties and management does not appreciate its social responsibility 3.69 1.12 1 1.75 0.620The objectives of the company emphasize its economic rather than social

performance 3.68 1.23 2 4.74 0.190Lack of legal requirements 3.61 1.27 3 6.75 0.080Lack of knowledge about this type of information prevents companies from disclosing it 3.57 1.21 4 4.61 0.202The public lacks enough knowledge of the importance of social responsibility

information 3.52 1.23 5 1.07 0.780Not required by the IASs 3.51 1.38 6 3.27 0.350This type of information is sensitive to disclose 3.51 1.25 7 2.64 0.440The cost of disclosing this type of information outweighs its benefits 3.46 1.26 8 4.79 0.180Lack of demand for this type of information 3.40 1.19 9 4.58 0.200

Note: a Mean values – scoring: 1 = strongly disagree; 5 = strongly agree

Table IVRespondents views of the motivation for company’s social responsibility

Kruskal-Wallis testMean Level of

View scorea Std dev. Rank �2 significance

Large corporations have no social responsibility but to make profit to their shareholders 2.77 1.56 6 2.08 0.550Large companies should bear some sort of social responsibility to justify their existence

within the society 3.75 1.26 1 0.71 0.860Large companies should be viewed as social organizations and their existence is

justified as long as they satisfy the objectives of the society 3.63 1.08 2 8.14 0.043Strategic companies such as electricity should continue to be owned by the government

to guarantee their social responsibility 3.30 1.39 5 0.47 0.920Decision makers within the organization appreciate the concept of social responsibility

reporting and its importance to the organization 3.56 1.28 3 9.69 0.021Decision makers within the organization understand how to adopt social responsibility

within the organization 3.41 1.22 4 1.61 0.650


[ 544 ]



groups and invited to indicate their level of

agreement about whether each of these

groups should have the right to information

about the actions for which Qatari

shareholding companies could be held

responsible. Table V reveals that the

respondents either strongly agreed, or agreed

that the traditional users of corporate

information (shareholders, investors,

creditors, management, employees and

customers) have the right to the information.

Less support, however, was given, by the

respondents, to the right of the government

and society to corporate information. This

result is partially consistent with Naser and

Abu Baker (1999). This might be due to the

fact that, unlike Jordan, national companies

in Qatar do not pay tax. Hence, the

government and its agencies have less

incentive to use corporate information than

they do in Jordan. Yet, the government and

its agencies need corporate to provide

statistics on the state of the economy.

The Kruskal-Wallis test points to no

significant disagreement among the

respondents about who has the right to

information except for management. The

difference, however, was mainly between

those who agreed and strongly agreed to

management’s right to corporate information.

Methods of establishing corporateresponsibilityAfter establishing various users’ opinions of

the role of Qatari companies within the

society and the importance of corporate

social responsibility disclosure to different

sectors within the economy, it was important

to elicit the respondents’ opinions about how

to introduce corporate social responsibility

reporting. The respondents were given three

different approaches to introduce corporate

social disclosure and were asked to indicate

the degree of the agreement with them. The

outcome of their answers is provided in

Table VI.

It is obvious from the table that the

respondents support the more liberal

approach to introducing corporate social

responsibility reporting in Qatar. The

strongest support was given to the proposal

that corporate social responsibility

disclosure should be encouraged, rather than

enforced by law. The respondents also show a

certain degree of agreement with the

suggestion that ethical and social agreement

should underline corporate social

responsibility reporting in Qatar.

The respondents demonstrated a high

degree of consistency about how to introduce

corporate social responsibility information

as reflected by the Kruskal-Wallis Test. No

significant differences in the respondents’

opinion were reported by the test. The result

may reflect the nature of the Qatari society,

which is moving towards democracy.

Methods used to disclose corporate socialresponsibility informationAfter the respondents have shown a certain

degree of support for corporate social

reporting and indicated that its introduction

can be encouraged by law, it was then

important to ask them to express the extent

of their agreement with different methods

that can be used to disclose corporate social

responsibility information. Analysis of their

answers is provided in Table VII.

It can be noticed from Table VII that the

respondents granted support to all methods

proposed to introduce corporate social

responsibility information. The respondents,

however, gave the strongest support to a

combination of methods that include

information of descriptive, quantitative and of

monetary nature. The Kruskal-Wallis test

appears in Table VII points to no significant

difference in the respondents’ opinion about

any of the listed methods. Hence, the Qatari

users of corporate information seem to favor

the disclosure of corporate social information

in both financial and non-financial forms.

Table VUser groups who have a right to corporate information

Kruskal-Wallis testUsers Mean scorea Std dev. Rank �2 Level of significance

Corporate management 4.07 0.69 4 12.75 0.005Customers 4.00 0.77 6 0.23 0.97Corporate employees 4.01 0.86 5 0.72 0.86Corporate creditors 4.08 1.06 3 3.68 0.29Shareholders 4.10 0.96 1 5.83 0.12Investors 4.09 1.02 2 6.06 0.11Government and its agencies 3.58 1.04 7 3.36 0.33Society at large 3.38 1.21 7 0.96 0.81


[ 545 ]



Location of corporate social informationThe participants were provided with a

number of possible locations to disclose


and asked to express the level of agreement

with each of the locations. Analysis of their

responses is presented in Table VIII.

It is evident from the table that disclosing


in a separate section entitled social

responsibility within the annual report is the

most popular location among the

respondents. A sizable number of the

participants favored the board of directors’

statement within the annual report as a

venue for corporate social responsibility

information. The respondents, however, did

not seem to favor the disclosure to be in any

other sections in the annual report and

wanted it to be disclosed either in a separate

section or within the board of directors’

statement. This result is in total agreement

with Naser and Abu Baker (1999).

The Kruskal-Wallis test, however, reported

in Table VIII, shows significant differences in

the respondents’ opinions on whether social

responsibility information should appear in

a separate section called social

responsibility, or in the board of directors’

statement. In the former, the differences were

between those who strongly agreed and those

who agreed. In the latter, the differences

were between participants who agreed and

those who somehow agreed. Thus, in both

cases, the differences are not serious at all.

Potential benefits of corporate socialresponsibility disclosureThe questionnaire contained a section about

the potential benefits of corporate social

responsibility disclosure by the Qatari

companies. The respondents were given a list

of potential benefits that can be obtained

from disclosing social responsibility

information and asked to express the level of

agreement with each of these benefits.

Analysis of their answers is given in Table IX.

Table VIIntroduction of corporate social responsibility information

Kruskal-Wallis testApproach Mean scorea Std dev. Rank �2 Level of significance

By law 3.56 1.26 3 0.82 0.84To be encouraged by law 4.02 0.81 1 0.76 0.86By ethical considerations and social agreement 3.64 1.12 2 1.77 0.62


Table VIIMethods to be used to disclose corporate social responsibility information

Kruskal-Wallis testMethod Mean scorea Std dev Rank �2 Level of significance

In descriptive manner 3.76 1.23 3 4.45 0.21Quantitative but not monetary (statistical) 3.47 1.23 6 2.56 0.46Monetary 3.50 1.28 5 1.52 0.67Descriptive and statistical 3.77 1.12 2 1.48 0.68Quantitative and monetary 3.68 1.18 4 2.49 0.47Descriptive, quantitative and monetary 3.84 1.23 1 5.13 0.16


Table VIIILocation of corporate social responsibility information

Kruskal-Wallis testLocation Mean scorea Std dev Rank �2 Level of significance

In a separate section entitle ‘‘socialresponsibility’’ in the annual report 4.05 1.03 1 7.81 0.050

Separate booklet attached to the annual report 3.58 1.16 3 0.44 0.931In the directors’ statement within the annual report 3.72 1.23 2 7.72 0.052In any section within the annual report 3.23 1.45 4 8.26 0.041

Note: Mean values – scoring: 1 = strongly disagree; 5 = strongly agree

[ 546 ]



Table IX indicates that society at large is the

main beneficiary of corporate social

responsibility information. The respondents

gave little support to the proposal that wider

disclosure of corporate social responsibility

information in the annual report would

protect the environment in Qatar. This result

is justified on the grounds that the services

sector, that includes financial institutions,

currently accounts for a high proportion of

the Qatari economy. Hence, the environment

and pollution are not issues of concern to

various users of corporate reports in Qatar.

The Krusakl-Wallis test points to

significant differences in the respondents’

opinions about whether the disclosure of


in the annual report would benefit the society

at large or it would protect the environment.

Differences on whether the information

benefits society at large were mainly between

those who agreed and strongly disagreed.

The background of the respondents may have

contributed to the significant differences in

their opinion about whether the information

assists in protecting the environment. While

participants from the services industry can

see little impact of corporate social

responsibility information on the

environment, participants representing the

manufacturing, oil and gas industries see a

major impact of corporate social

responsibility disclosure on the

environment.

Conclusion

In this study, an attempt was made to

investigate the perceptions of various user

groups of Qataris corporate reports about

different aspects of corporate social

responsibility disclosure and accountability.

Four user groups took part in the survey,

namely, accountants, external auditors, bank

officers and university lecturers. The initial

response of the participants was in favor of

corporate social responsibility disclosure,

either in a separate section in the annual

report, or within the board of directors’

statement.

To emphasize the accountability concept,

the participants believed that the disclosure

of corporate social responsibility

information should be encouraged by law

rather than enforced by the authorities. This

result emphasizes the government’s

participative style of leadership that

encourages public freedom and ensures

openness and transparency.

Although the participants emphasized the

typical objectives of corporate reporting in

providing information to shareholders,

creditors and management, they disagreed

with the proposal that corporation do not

have social responsibility and their objective

should only be restricted to making profit.

They strongly supported the suggestion that

corporations bear some sort of social

responsibility to justify their existence

within the society. They also supported the

view that corporate existence is justified, as

long as it satisfies the society’s objectives.

The participants would like to see


disclosed in both monetary and non-

monetary forms, either in a separate section

or within the board of directors’ statement

within the annual report. Finally, the

respondents believed that disclosing


in the annual report of the Qatari companies

would serve society at large as well as

customers and contribute to the development

of corporate human resources and protect the

environment.

Notes1 Qatar is a member of the Gulf Cooperation

Council (GCC). It is one of the oil and natural

gas exporting countries. Qatar borders the

Persian Gulf and Saudi Arabia.

2 According to Al-Watan daily newspaper,

Wednesday 15 January 2003, No. 2691, p. 8, the

Table IXThe importance of the following objectives of social responsibility to the organisation

Benefit(s) Mean scorea Std dev Rank �2

Kruskal-Wallis testLevel of significance

Serve society at large 4.29 0.88 1 11.54 0.009Serve customers 4.10 0.93 2 3.84 0.270Develop human resources (employees) 4.02 1.04 3 2.68 0.440Protect environment 3.84 1.01 4 9.25 0.026Emphasize the role of accounting as an effectiveinformation system

3.68 1.20 6 6.69 0.082

Enforce investment environment 3.71 1.18 5 1.31 0.720

Note: Mean values – scoring: 1 = strongly disagree; 5 = strongly agree

[ 547 ]



government intends to privatize companies in

the petrochemicals, cement chemical and steel

sectors during this year.

3 A section in the 1999 annual report of Qatar

National Bank entitled ‘‘Social

responsibilities’’ states that the success of the

bank is connected with the bank’s interaction

with the community environment in which

the bank operates. For example, Qatar

National Bank spent in the years 1998 and 1999

QR1.1 million and QR11.2 million respectively

on social responsibilities activities. This

includes ‘‘conferences, exhibitions and

sporting events, both large and small, held

throughout Qatar as part of its continued

commitment to assist the development of the

community for the benefit of the citizens’’

(Annual report, 1999, p. 21).

4 Another group of the Arab countries, their

economies mainly rely on tourism as do

Tunisia and Morocco.

5 The development of the accounting and

auditing systems varies from one GCC

country to another. While Qatar has no

specific accounting or auditing standards that

govern companies’ activities, in 1991 Saudi

Arabia established the Saudi Association of

the Certified Public Accountants that was

given the responsibility of issuing accounting

standards.

6 One US$=QR3.65.

7 Zakat is one of the basic pillars of Islam. The

main purpose of Zakat is to achieve social

justice by collecting money from the rich and

distribute it to the needy.

8 Qatar is currently hosting the most influential

setline channel that broadcasts around the

clock in Arabic all over the world. The

channel enjoys complete freedom without any

interference from the Qatari authorities.

9 The questionnaire was distributed to the

target groups in the period between

November-December 2002.

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Challenges in Corporate Social and

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Statistics and Research, Harper Collins

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countries: the case of Jordan’’, Advances in

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Objectives of Financial Statements, AICPA,

New York, NY.

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[ 548 ]



The usefulness of the audit report in investment andfinancing decisions

Antonio Durendez Gomez-GuillamonDepartment of Accounting and Finance, Polytechnic University of Cartagena,Cartagena, Spain

Introduction

The present study approaches the problem of

whether the auditor’s report is useful or not

and, following a line of experimental studies

initiated in the USA at the beginning of the

1970s, interviews two communities of users

interested in the professional opinion issued

by the financial auditor on company

financial statements, bankers and analysts.

In this sense, this study fits in with those

carried out in relation to the so-called

‘‘expectation gap’’[1] that occurs when there

is a difference between what the customers

expect from the auditor’s work and what they

in fact receive from the report. So, the fact

that the auditor incorporates ‘‘value added’’

to the accounting information provided by

the firms is called into question. In order to

verify the usefulness of the audit report, this

study refers to two communities of users

that, by means of a questionnaire, are asked

about the importance given to the auditor’s

opinion when taking financial and

investment decisions in companies. The

results of our investigation show enough

evidence to sustain that the audit report is

indeed useful for those interviewed when

making decisions, proving to be so by the fact

that it affects the investment and financing

decisions carried out by dealers, brokering

firms, and credit institutions respectively.

Previous research literature

As Libby (1979) indicates ‘‘financial

statement information plays a major role in

the credit evaluation phase of the

commercial loan decision . . . ’’ in that sense

bank officers as well as analysts attempt to

ensure accuracy of the financial information

by requiring the audit of that information;

for this reason authors suggest the following

questions:Do lenders, investors, and other audiences

react differently to a company if its financial

statements carry a qualified opinion? (Estes

and Reimer, 1977);

Does the form of auditor association

significantly influence the banker’s decisions

regarding the acceptance of company loan

applications? (Johnson et al., 1983);

Do banks lend less money when a firm’s

accounts have been qualified? (Firth, 1979).

Along this line of investigation, that shows

mixed results, the existing empiric studies

were previously carried out by means of two

different methodologies:

1 Laboratory experiments, that is to say,

extensive and detailed studies without

random samples or individuals, but based

on the participants’ convenience or easy

access or on the investigator’s subjective

selection criteria, which implies certain

conditions that allow the scientist to

directly control all or nearly all the

important factors that may affect the

results of the experiment (Dillon et al.,

1997). In this way, and following this

methodology, authors like Firth (1979,

1980), Gul (1987), Pringle et al. (1990),

Geiger (1992), Anandarajan and Jaenicke

(1995), Lasalle and Anandarajan (1997),

Bamber and Stratton (1997), Vico Martınez

and Pucheta Martınez (2001), have verified

the usefulness or relevance of the

information that the auditor provides in

the case of loan decisions to companies or

investment decisions on the part of

analysts. However, other investigations,

such as those by Estes and Reimer (1977),

Libby (1979), Houghton (1983) and Pany

and Johnson (1984), suggest that the





[ 549 ]



KeywordsAuditing, Reports,

Investment appraisal, Influence

AbstractThe usefulness of the auditor’s

report is sometimes called into

question, the validity of the

information it contains for users

when making decisions therefore

being criticized. This survey is

aimed, on the one hand, at dealers

and brokering companies, and, on

the other at banks to find out

exactly how important the audit

report is in the investment

decisions that analysts make, as

well as in lending decisions made

by credit institutions. In this

sense, the respondents are asked

about the source they consider

relevant when making decisions,

that is to say, the influence the

auditor’s opinion (clean, qualified,

adverse or disclaimer) has when

investing in and financing

companies. The results show that

users of audit reports consider the

information provided in the

auditor’s opinion as useful and

important when making decisions,

both regarding their decisions of

investing in and financing

companies as well as the amount

of the investment or the loan to

grant.

information supplied by the audit report

has no effect on the bankers’ decisions.

2 The studies carried out regarding the

‘‘capital market’’, which try to give

relevance to the information contained in

the auditor’s report, for investors,

through its impact on share prices. In this

sense, the investigations carried out by

Firth (1978), Ball et al. (1979), Banks and

Kinney (1982), Chow and Rice (1982),

Dopuch et al. (1987), Wilkerson (1987),

Fields and Wilkins (1991), Loudder et al.

(1992), Chen and Church (1996), Jones

(1996), Sanchez Segura (1999), Gomez

Aguilar et al. (1999) and Monterrey et al.

(2000), suggest a certain degree of

usefulness; whilst the studies carried out

by Baskin (1972), Alderman (1979), Elliot

(1982), Dodd et al. (1984), Ameen et al.

(1994), Del Brıo Gonzalez (1998) and Cabal

Garcıa (2000, 2001a, b) come to the opposite

conclusion, in such a way that the

relevance of the information contained is

considered little or null.

Unlike the methodologies used to date, the

main contribution of the present study is the

use of the ‘‘survey’’, that allows the obtaining

of results which can be extrapolated to the

whole of the communities being interviewed,

since a considerable number of replies were

obtained.

Methodology

Objectives and hypothesesIt is our purpose to discover the perceptions

that audit report users have about the

qualitative variable that is being measured:

the ‘‘usefulness’’ of the auditing service. In

particular, we are specifically looking for

information regarding credit institution risk

by department directors and analysts

belonging to dealers and brokering

companies. With this aim in mind, a mail-

survey has been prepared containing a series

of questions for both groups in each of their

fields of performance.

The test hypotheses can be stated as

follows:

H01. Credit institutions perceive that the

information given by the auditor’s

opinion is ‘‘not useful’’ when making

their financing decisions.

H02. Analysts perceive that the

information given by the auditor’s

opinion is ‘‘not useful’’ when making

their investment decisions.

SubjectsCredit institutionsA sample design has been obtained that

includes all the credit banks, savings banks

and land banks registered with the Spanish

Central Bank, through the Registro Oficial de

entidades sujetas al control e inspeccion del

Banco de Espana (Official Registry of Entities

Subject to the Spanish Central Bank’s

Control and Inspection) that amounts to a

total of 231 entities: 88 credit banks, 48

savings banks and 95 land banks.

AnalystsA sample design has been used to represent

this community which has been obtained

from the listing published by the Comision

Nacional del Mercado de Valores (CNMV –

Spanish Stock Exchange Commission) by the

Registro Oficial de sociedades y agencias de

valores (Official Register of Spanish Dealers

and Brokering Companies) that comprises

104 entities.

SampleOnce the study population and the

corresponding sample designs were defined,

a random selection of individuals was

carried out. Sampling errors are shown in

Table I.

Data collectionQuestionnaires were sent out from

12-16 April 2000. began on 12 April 2000. Then

it was sent again by fax between 9-14 May

2000. The deadline for the reception of

surveys was established for 14 June. Two

different methods have been used to collect

the necessary information for the study, ‘‘by

post’’ and ‘‘by fax’’. The results, which turned

out to be very satisfactory[2], are shown in

the Table II.

ParticipantsThe people interviewed in each group are the

following:

1 Credit institutions: the credit entities

questionnaire was sent to head offices,

addressed to the ‘‘risk department’’ in

charge of loan concessions to companies.

Table ISampling errors

Credit institutions Analysts

Sampling error valuen (sample)pqnConfidence level

±7.615%795050

23190.00%

±12.033%335050

10490.00%

[ 550 ]

Antonio DurendezGomez-GuillamonThe usefulness of the auditreport in investment andfinancing decisions


2 Analysts: in this case, the questionnaire

was addressed to ‘‘the manager’’ of the

company.

Construction of the questionnairePreparation of the questionsOnce the ‘‘target-variable’’ to be measured

had been defined between the groups

interviewed, the questions were then

prepared in order to get the necessary

information; for this, data that had already

been successfully used in other similar

investigations[3] was used as reference, as

well as counting, at all times, on the

collaboration of auditors who were in

practice and teaching. The questions were

edited in ‘‘closed-ended format’’, to make

them easier to answer. The answers to the

questions were given by means of a Likert[4]

scale going from 1 ‘‘in total disagreement’’ to

5 ‘‘in total agreement’’.

Reliability of the questionnaireIn order to verify the reliability of the

questionnaire as being internally consistent

when measuring the qualitative variable of

the ‘‘usefulness of the report’’ for the

financing and investment decisions, we have

applied the pattern of internal consistency

known as Cronbach’s alpha method[5]. This

way, once the ‘‘reliability analysis’’ has been

applied, the following results have been

obtained:. For questions on ‘‘lending decisions’’

taken by credit entities, an alpha value

equivalent to 0.8488 has been obtained.. For questions that measure the relevance

of the auditing report on ‘‘investment

decisions’’, a value of 0.7977 has been

estimated.

From the reliability values obtained, it is

possible to conclude that the questionnaire

has an overall internal consistency[6] that is

acceptable.

Data analysis

Data recording and validationOnce the information had been processed,

with the purpose of avoiding human errors, a

statistical control of ranges was first carried

out for each variable with the aim of

detecting layers that have been corrected.

Also, and by means of random sampling, a

sample from each one of the groups in the

study was verified, the errors being

statistically non-significant. In the case of

‘‘missing values’’, that is to say, those

questions left unanswered by the

respondents, either deliberately or through

ignorance, they have been considered

statistically non-significant because of their

low number and influence on the results

obtained.

Techniques employedThe analysis of the data begins with an

exploratory study after which we proceed to

test the hypotheses outlined, by means of the

statistical techniques that accounting

specialists have used in the accounting

literature, besides using other more

advanced techniques in order to obtain and

interpret relevant conclusions in a better

way. The hypotheses have been tested with

the non-parametric ‘‘Chi-square test’’, as well

as corroborating the results with the

parametric ‘‘t-test’’[7]. A ‘‘factor analysis’’[8]

has also been made with the purpose of

condensing the information into those

factors that best define each one of the

variables being studied. The application of a

‘‘logistic regression test’’ also helps to clarify

the relationship between the variables

observed at aggregate level.

Descriptive analysisIn total, 79 questionnaires from credit

entities and 33 from analysts are obtained. In

the case of the credit institutions, the number

of questionnaires received has been 19 from

banks, 26 from savings banks and 34 from

land banks; as for analysts, the number of

surveys received was 14 from dealers and 17

from brokering companies.

Table III shows the position held by those

answering the survey, classified by study

groups and under six possibilities: financial

director, manager, accountant, banker,

analysts and others. Out of a total of 112

surveys received, 104 have been classified,

while eight have been counted as missing

values. Inside the option of ‘‘other

employments’’, 39 people have been included

with other positions such as: ‘‘tax manager’’,

Table IISurvey response

Respondent groups Population Mailed Failed Responses Response rate (%)

Credit institutions 231 229 2 79 34.50Analysts 104 103 1 33 32.04Total 335 332 3 112 33.73

[ 551 ]



‘‘managing director’’, ‘‘internal auditor’’,

‘‘planning manager’’ and ‘‘operating control

manager’’.

Hypotheses testsApplication of the Chi-square test for H01In order to assess null hypotheses, H01 and

H02, the ‘‘Chi-square test’’ has been used for

those questions outlined for each group

taking part in each of the two hypotheses.

The following results regarding the group of

banks come from Table IV:

1 As for the first question, it can be

observed that the credit entities strongly

agree, statistically significantly, with the

fact that they consider the presentation of

the audit report as something essential so

that audited companies can obtain a

‘‘credit line’’, a ‘‘short-term and long-term

loan’’, a ‘‘bank discount’’ and a ‘‘bank

guarantee’’.

2 When credit entities are asked about

which is the most relevant information

when granting a loan to companies, they

are most in agreement with the fact that it

comes from the Central de Riesgos del

Banco de Espana (CIRBE – Risk

Information Centre of the Spanish Central

Bank[9]), followed by ‘‘personal

knowledge’’, ‘‘financial statements’’ and

‘‘audit report’’. Nevertheless, they also

express their agreement on the

importance of the information coming

from ‘‘good references’’, ‘‘tax returns’’ and

‘‘private databases’’.

3 Credit institutions also highly agree with

the fact that the type of opinion given by

the auditor (clean, qualified, adverse or

disclaimer) influences their lending

decisions. In this sense, they agree,

although to a lesser extent, with the fact

that the type of opinion given by the

auditor influences the lending amount.

Geiger (1992) and Anandarajan and

Jaenicke (1995) reach the same conclusion

showing that, in the USA, the audit report

affects financing decisions. However,

Libby (1979) concluded by pointing out

that ‘‘subject to’’ qualifications have no

significant impact on the bankers’

judgments.

4 Last of all, they are requested to point out

the ‘‘type of qualifications’’ with most

influence on financing decisions, mostly

agreeing that they are those that come

from ‘‘going concern uncertainties’’,

followed by ‘‘asset valuation errors’’, ‘‘non-

fulfilment of legal regulations’’, ‘‘scope

limitations’’, ‘‘relationships with group

and associated companies’’, ‘‘tax

uncertainties’’ and ‘‘non-fulfilment of

accounting standards’’. Firth (1980)

reaches the same conclusion, in the UK,

when contrasting that ‘‘going concern

qualifications’’ as well as ‘‘valuation of

assets qualifications’’ are the most

relevant when granting a loan to

companies.

With the results obtained, the null

hypothesis (H01) is ‘‘rejected’’ and, therefore,

it is assumed that bankers perceive the

information given by the auditor’s opinion as

decisive when making their lending

decisions.

Application of the t-test H01The parametric ‘‘t-test’’ has been carried out

to check if the means are significantly

different or not from the normal distribution

in order to corroborate the statistical results

obtained with the non-parametric test (the

tested value is 3); the results are exactly the

same as those obtained with the

non-parametric ‘‘Chi-square test’’.

Application of the Chi-square test H02The following conclusions have been

obtained from Table V:. In the case of dealers and brokering

companies, the most important

information for carrying out an

investment is obtained by a ‘‘fundamental

analysis’’, followed by a ‘‘technical

analysis’’, ‘‘financial statements’’ and

‘‘personal knowledge’’.. Dealers and brokering companies agree

on the fact that the type of opinion issued

by the auditor does indeed influence their

investment decisions, as well as the

amount to be invested in companies.. This group is also in agreement about the

fact that those qualifications that most

affect their investment decisions are, in

this order: ‘‘going concern uncertainties’’,

those referred to ‘‘assets valuation’’,

‘‘non-fulfilment of legal regulations’’,

‘‘non-fulfilment of accounting standards’’,

Table IIIPositions of respondents

Respondent groupsPosition Credit institutions Analysts Total

Financial director 5 5General manager 7 7Accountant 2 2Banker 47 47Analyst 4 4Other 28 11 39Sub-total 75 29 104Missing values 8Total 112

[ 552 ]



‘‘tax uncertainties’’, ‘‘relationships with

associated and group companies’’ and

‘‘scope limitations’’.

With the results of this test, it is possible to

conclude by rejecting the null hypothesis

(H02) and, therefore, assume that dealers and

brokering companies perceive that the

information given by the auditor’s opinion is

indeed relevant for making their investment

decisions.

Application of the t-test H02The parametric ‘‘t-test’’ has been carried out

in order to confirm the statistical results

obtained with the non-parametric test (the

tested value is 3). When the parametric test is

applied, we get the same results as in the

‘‘Chi-square test’’, with the exception of the

expression that indicates the most significant

information when carrying out an

investment is obtained from ‘‘tax returns’’,

since the ‘‘t-test’’ shows the differences are

statistically non-significant whilst the

non-parametric test indicates the opposite.

Factor analysisA factor analysis has been applied, at

aggregate level, with the purpose of obtaining

underlying factors that are smaller in

number and greater in importance than each

one of the variables analysed. The 16

variables are reduced to five main factors

that explain 64.787 per cent of the total

variance. Sampling adequacy of the analysis

is appropriate, as the KMO[10] measure

indicates, when taking a value of 0.737.

Three main factors have been obtained

with the following characteristics:

1 The first factor refers to the question on

what type of information is considered as

most important when financing or

investing in a certain company, and is

defined as being that which comes from

those sources of information of

Table IVChi-square test in the case of credit institutions

TestQuestions n Chi-square Degrees of freedom Mean Significance

1. The presentation of the audit report is indispensable sothat services are lent, to a company committed to audit,in the case of obtaining a:credit line 71 45.761 1 4.27 0.000***short-term loan 67 41.925 1 4.17 0.000***long-term loan 72 50.000 1 4.38 0.000***bank discount 65 36.938 1 3.97 0.000***bank guarantee 69 40.710 1 4.13 0.000***

2. The most relevant information when granting a loan is obtainedfrom:the audit report 57 24.018 1 3.68 0.000***Risk Information Centre 64 56.250 1 4.18 0.000***private databases 51 8.647 1 3.42 0.003***personal knowledge 63 51.571 1 4.15 0.000***tax declarations 47 11.255 1 3.47 0.001***financial statements 61 42.639 1 3.97 0.000***having good references 51 10.373 1 3.44 0.001***

3. Express your agreement with the following statements:the opinion type influences on the decision of granting a loan 65 46.538 1 4.03 0.000***the opinion type influences on the decision of thequantity to lend 64 7.563 1 3.36 0.006***

4. The type of qualifications with higher influence on thedecision making process when granting a loan:going concern uncertainties 75 71.053 1 4.69 0.000***non-fulfilment of accounting standards 50 15.680 1 3.47 0.000***tax uncertainties 50 32.000 1 3.67 0.000***assets valuation errors 64 45.563 1 3.90 0.000***non-fulfilment of legal regulations 58 36.483 1 3.81 0.000***scope limitations 54 32.667 1 3.73 0.000***relationship with associated and group companies 53 28.698 1 3.69 0.000***

Notes: ***Significant at 1 per cent level; The obtained observations have been reclassified (old value/new value) = 1-2/0, 4-5/1; Tested valuesin percentage correspond: (scale value/per cent expected value) = 0/50 per cent, 1/50 per cent; Mean values vary in a scale between 1 – totaldisagreement up to 5 – total agreement

[ 553 ]



compulsory elaboration for the companies

and, therefore, that which the social

agents grant an official or institutional

validity. As we can see in Table VI, they

are: the ‘‘audit report’’, the information

obtained from the Central de Riesgos del

Banco de Espana (CIRBE – Risk

Information Centre of the Spanish Central

Bank), ‘‘tax declarations’’, which are

presented to the Inland Revenue, and

‘‘financial statements’’ that, just like the

‘‘audit report’’, are of compulsory

presentation to the Registro Mercantil

(RM – Companies Registration Office)

and/or at the Comision Nacional del

Mercado de Valores (CNMV – the Spanish

Stock Exchange Commission).

2 The third factor, which also refers to the

question about what type of information is

considered as most significant when

financing or investing in a certain

company, is defined as being that which

comes from unofficial or private sources of

information and, therefore, is not granted

an official or institutional validity. In this

case, the information is obtained from

‘‘private databases’’, ‘‘personal knowledge’’

and from the fact of having ‘‘good

references’’ on the entity being financed or

the one being invested in.

3 A second factor, the same as the fourth,

refers to the question about the most

relevant type of qualifications auditors

include in their reports when providing a

‘‘subject to’’ opinion for financing or

investing. In this sense, a second factor

can be observed that includes

‘‘non-fulfilments of legal regulations or

accounting standards’’ as well as ‘‘assets

valuation errors’’ and ‘‘tax uncertainties’’;

as opposed to the fifth factor that would

include other qualifications arising from

‘‘scope limitations’’ and problems in the

‘‘relationships with associated and group

companies’’. This grouping finds its sense,

on the one hand, in the most important

qualifications and, therefore, which those

interviewed know and interpret in a

better way, and the rest of qualifications

of lesser generalization, in the case of big

companies and, as various authors[11]

point out, for companies trading on the

stock exchange, where ‘‘uncertainties’’

and ‘‘non-fulfilments’’ are the most

recurrent qualifications, and, therefore,

are more widespread and have a greater

impact.

Table VChi-square test in the case of dealers and brokering companies

TestQuestions n Chi-square Degrees of freedom Mean Significance

1. The most relevant information when investing is obtained from:technical analysis 25 9.000 1 3.69 0.003***fundamental analysis 24 (1) 4.10-the audit report 21 1.190 1 2.81 0.275Risk Information Centre 22 1.636 1 3.29 0.201private databases 21 0.048 1 2.97 0.827personal knowledge 23 9.783 1 3.63 0.002***tax declarations 22 2.909 1 2.68 0.088*financial statements 21 10.714 1 3.66 0.001***having good references 22 0.182 1 3.16 0.670

2. Express your agreement with the following statements:the opinion type influences on the decision of investing in a company 25 11.560 1 3.81 0.001***the opinion type influences on the decision of the quantity to invest 23 3.522 1 3.41 0.061*

3. The type of qualifications with higher influence on thedecision-making process when investing:going concern uncertainties 25 (1) 4.31non-fulfilment of accounting standards 23 15.696 1 3.78 0.000***tax uncertainties 27 15.385 1 3.75 0.000***assets valuation errors 22 (1) 4.06non-fulfilment of legal regulations 23 18.182 1 3.84 0.000***scope limitations 26 7.348 1 3.52 0.007***relationship with associated and group companies 26 9.846 1 3.59 0.002***

Notes: *Significant at 10 per cent level; **Significant at 5 per cent level; ***Significant at 1 per cent level; The obtained observations havebeen reclassified (old value/new value) = 1-2/0, 4-5/1; Tested values in percentage correspond: (scale value/ per cent expected value) = 0/50per cent, 1/50 per cent; Mean values vary in a scale between 1 – total disagreement up to 5 – total agreement; (1) Test cannot be carried outwhen taking the variable a constant value, in these cases ‘‘t-test’’ is applied

[ 554 ]



Analysis by logistic regression testOnce the usefulness of the auditor’s

professional opinion has been verified, both

in financing and investing decisions and the

amount that the respondents are willing to

invest or to lend, a logistic regression test has

been applied to check the type of

qualification that has the greatest influence

on making decisions at aggregate level.

In this sense, the first logistic regression

test[12] takes the influence of the auditor’s

type of opinion on the decision to invest in or

finance a company as a dependent variable.

This way, as can be seen in Table VII, ‘‘tax

uncertainty’’ is a type of qualification that is

taken more into account in the

decision-making process than that derived

from ‘‘relationships with associated and

group companies’’.

The second logistic regression test takes the

influence the auditor’s type of opinion has on

the quantity to invest in or finance a company

as a dependent variable, in the case of credit

institutions and analysts. So, as we can see in

Table VIII, ‘‘scope limitations’’ qualifications

are taken more into account than ‘‘non-

fulfilment of accounting standards’’ ones.

Limitations. Due to the scarce ‘‘sample design’’ of

analysts, and in spite of having obtained

some high rates of response, the

‘‘sampling error’’ is high.

Table VIPrincipal components factor analysis: rotated matrix loadings

FactorsQuestions 1 2 3 4 5

1. The most relevant information when investing or financingisobtained from:the audit report 0.623Risk Information Centre 0.706private databases 0.596personal knowledge 0.820tax declarations 0.726financial statements 0.706having good references 0.738

2. Express your agreement with the following statements:the opinion type influences on the decision of lending orinvesting in a company

0.787

the opinion type influences on the decision of the quantityto invest or to lend

0.781

3. The type of qualifications with higher influence on thedecision making process when investing or lending:non-fulfilment of accounting standards 0.681tax uncertainties 0.713assets valuation errors 0.692non-fulfilment of legal regulations 0.638scope limitations 0.727relationship with associated and group companies 0.811

Notes: Extraction method: principal component factor analysis; Rotation method: varimax normalization withKaiser; Only loadings having absolute value greater than 0.50 are shown

Table VIILogistic regression on the decision-making process of investing or lending

Independent variables: (qualifications) B ET Wald Degrees of freedom Sig.

Tax uncertainties 1.557 0.795 3.833 1 0.050**Relationship with associated or group companies 0.885 0.536 2.728 1 0.099*Constant –5.642 2.921 3.731 1 0.053*

Notes: *Significant at 10 per cent level; **Significant at 5 per cent level; Method of the regression: ‘‘first stepenter’’; Only significant independent variables are shown; Model global fit (goodness of fit): –2 logverosimilitud =41.445; R2 of Cox and Snell = 0.172; R2 of Nagelkerke =0.357; Chi-square =7.165; df = 8;Significance=0.519 (Hosmer and Lemeshow)

[ 555 ]



. As it is characteristic in every ‘‘survey’’,

the questions used to measure the

variables being studied bear a certain

degree of subjectivity, which has been

limited by using questions successfully

used in previous studies.. The questions have not always been

answered by the people for whom the

survey was intended and, therefore, the

results cannot always be considered as

valid.

Conclusions

With the results obtained, we can conclude

by rejecting the null hypotheses that assume

the ‘‘lack of usefulness’’ of the audit report in

‘‘lending decisions’’ made by banks, and in

‘‘investment decisions’’, carried out by

dealers and brokering companies.

Credit banks, savings banks and land

banks strongly agree on the fact that the type

of opinion (clean, qualified, adverse or

disclaimer) issued by the auditor in the

report influences their lending decisions. In

the same way, they agree, although to a lesser

extent, with the fact that the type of opinion

also has its influence on the amount of the

loan to be granted. In that sense analysts also

indicate that the auditor’s type of opinion

does have its influence on taking the decision

to invest or not in a company, as well as on

the amount to be invested.

Both groups distinguish, when making

their investment and lending decisions,

between the sources of information with

legal or public content and others that are of

a private origin. From the aggregate analysis

it can be seen that greater importance is

given to ‘‘tax uncertainties’’ qualifications

than the ‘‘relationships with associated or

group companies’’ ones, when making a

financing or investing decision. At the same

time, they consider ‘‘scope limitations’’ more

relevant than ‘‘non-fulfilment of accounting

standards’’ when deciding on the investment

or loan amount.

Through this study, we have come to the

conclusion that both credit institutions and

dealers and brokering companies consider

the information contained in the auditor’s

report as being relevant and useful for their

investment and lending decisions, in such a

way that it can affect their attitude when

financing or investing in a company, as well

as when they choose the amount to be loaned

and invested.

Notes1 Porter (1993) defines the ‘‘expectations gap’’ as

the gap between society’s expectations of

auditors and auditors’ performance, as

perceived by society. It is seen to comprise two

components: reasonableness gap (i.e. the gap

between what society expects the auditors to

achieve and what the auditors can reasonably

be expected to accomplish); and performance

gap (i.e. the gap between what society can

reasonably expect auditors to accomplish and

what auditors are perceived to achieve).

2 As Dillon et al. indicate (1997), in the case of

‘‘cold’’ surveys, that is to say those surveys

which are sent out to people who have not

previously committed themselves to

participating, the response rate is not expected

to be any higher than 10-20 per cent. In similar

studies, such as those carried out by Garcıa

Benau et al. (1993) and Carro Arana (2000), a

response rate of 15.25 per cent and 23.43 per cent

are obtained respectively, whilst Herrador

Alcaide’s study (2000) reflects a response rate of

31.23 per cent, meaning that a satisfactory

success rate has been obtained in the answers.

3 As Rojas Tejada et al. (1998) show, the fact that

questions already successfully used in other

surveys are being used now, makes the results

more reliable and communicated in a better

way.

4 As Sarabia Sanchez et al. (1999) point out, the

use of the Likert scale has the advantage of

being a scale that are easy to understand and

to make as well as having a high degree of

validity and reliability.

5 The formula that defines the alpha coefficient is:

� ¼ N�pp

1 þ �ppðN � 1Þ

where the number questions outlined is N and

the average of the correlation between items is

�pp, taking values of between 0 and 1, so that the

higher the value the higher the internal

consistency of the scale.

Table VIIILogistic regression on the quantity of investing or lending

Independent variables: (qualifications) B ET Wald Degrees of freedom Sig.

Non-fulfillment of accounting standards 1.005 0.412 5.933 1 0.015**Scope limitations 1.450 0.434 11.167 1 0.001*

Notes: *Significant at 10 per cent level; **Significant at 5 per cent level; Method of the regression: ‘‘first stepenter’’; Only significant independent variables are shown; Model global fit (goodness of fit): –2 logverosimilitud =78.269; R2 of Cox and Snell = 0.293; R2 of Nagelkerke =0.408; Chi-square =5.027; df = 7;Significance=0.657 (Hosmer and Lemeshow)

[ 556 ]



6 As Sarabia et al. (1999) point out, considering

the recommendations of Nunnally (1987) and

Peterson (1994), an alpha value similar to 0.7 is

usually considered as the minimum level for

preliminary investigation, 0.8 for basic

investigation and 0.9 for applied investigation.

Nevertheless, another author, Camacho

Rosales (2000), indicates that an alpha level of

0.67 implies a moderately high coefficient of

reliability.

7 Mayper et al. (1988), apart from

non-parametric tests such as the

‘‘Mann-Whitney test’’ use other parametric

ones such as ‘‘T2 of Hotelling’’ and the ‘‘t-test’’.

Bailey et al. (1983) use the ‘‘ANOVA’’ test for

interval-reason scales in the case of ordinal

variables. Nevertheless, and because most

variables are of an ordinal nature,

non-parametric tests should be applied in

preference as numerous authors point out. See

Dillon et al. (1997), Sarabia Sanchez et al. (1999)

and Ato Garcıa (1991).

8 Hair et al. (1999) indicate, when summarizing

data with the ‘‘factor analysis’’ technique,

some underlying dimensions are obtained

that, when interpreted and understood,

describe information with a much more

reduced number of concepts than the original

individual variables.

9 The Risk Information Centre is the office that

provides on the creditworthiness of potential

clients of Spanish credit banks.

10 The Kaiser-Meyer-Olkin measure is used to

check sampling adequacy.

11 See the studies carried out by Gomez Aguilar

and Ruiz Barbadillo (1999), Gonzalez Bravo

and Martın (1999), Villarroya

Lequericaonandia (2000), Cabal Garcıa (2001)

and Cabal Garcıa and Robles Lorenzana (2001).

12 The use of this technique means that the

dependent variables analysed have been

reclassified, so both the decision of financing

or investing and the amount to finance or to be

invested, since their original values vary in a

scale of 1 ‘‘entirely in disagreement’’ up to 5

‘‘entirely in agreement’’. Therefore, when the

original response takes a value of 1 or 2 it is

reclassified in a binary value 0; when it takes

the values of 4 and 5 it is reclassified in the

binary value 1, the original value of 3 being

considered as a missing value.

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[ 559 ]



Auditing in support of the integration of managementsystems: a case from the nuclear industry

I.A. BeckmerhagenBundesamt fur Strahlenschutz, Salzgitter, GermanyH.P. BergBundesamt fur Strahlenschutz, Salzgitter, GermanyS.V. KarapetrovicDepartment of Mechanical Engineering, University of Alberta, Edmonton, CanadaW.O. WillbornFaculty of Management, University of Manitoba, Winnipeg, Canada

Introduction

Integrating management systems, such as

those for quality and safety, should enhance

managerial and operational effectiveness.

Whether or not this goal can or has been

achieved is still a lingering question. A

well-proven method to assess the

effectiveness of any management system is

auditing. Audits are designed to determine

adequate compliance with applicable

standards and guidelines. Moreover, they can

and should be instrumental in identifying

problem areas and potential improvements,

along with corrective and preventive actions.

Much has been written in recent times

about management system integration and

auditing. Yet the interrelationship of an

integrated management system (IMS) with

auditing remains largely unexplored. This

paper will focus on the audit as a support

structure for system integration. The system

concept will be applied, as it is extremely

useful for the modeling and development of

both the individual function-specific

management systems and the IMS

(Karapetrovic and Willborn, 1998a). In

particular, the systems framework for the

audit will be used to support an integrated

system for quality and safety management

applied in the nuclear industry.

How can an audit assist in integrating a

quality and safety management system?

What are the requirements for an effective

audit in the various phases of integrating

these management systems? Once the

integrated system is established, how can

audits assist management to further

strengthen and improve both the IMS and the

audit? What technical resources for these

special types of audits, for example standards

and software, are available? This paper

presents general answers to these questions

and some relevant experiences of a nuclear

waste disposal facility in Germany.

Systems approach

A system consists of interrelated elements,

such as processes, that use various resources

to achieve set goals. A quality management

system (QMS), for instance, with all its

individual parts (processes and resources),

should attain a goal of customer satisfaction

with products and services. In other words, it

is a system for the management of quality

(Geiger, 2000; Arter, 2000). This definition of a

system also applies to an audit. For example,

Figure 1 illustrates a generic audit system

framework, adapted from Karapetrovic and

Willborn (2001b), that can be applied to the

auditing of either a function-specific or a

cross-functional (i.e. integrated) management

system (MS). Recently, it was recognized that

specialized management systems and

corresponding standards have many

essential features in common (Karapetrovic

and Willborn, 2000a). Various forms of

integrating these individual systems into an

overriding entity have been presented,

discussed, and also implemented (for

example, see Janik and Zimmerman, 1998;

Butterbrodt et al., 1999; Dilthey and

Bohlmann, 2000; Funk, 2001; Funk and

Mayer, 2001). For instance, an overriding

generic management system (GMS) may be

designed to contain the fundamentals of any

function-specific management system, for

example the ones for quality, environmental

and safety management (Karapetrovic and

Willborn, 1998a). The GMS addresses mainly

top management, executive responsibilities

and activities. Subordinated and

technically-specialized MSS, called

‘‘sub-systems’’, remain largely separated and

cover quality, safety, corporate





[ 560 ]



KeywordsQuality, Safety, Auditing,

Nuclear energy industry,

ISO 9000 series, Germany

AbstractIntegration of function-specific

management systems in

organizations is rapidly becoming

a topic of interest for managers

and auditors alike. This is mainly

due to the proliferation of

management system standards

that foster compliance with the

stated criteria for quality,

environmental, occupational

health and safety, social

responsibility and other different

aspects of performance. While

most of the available literature on

this topic focuses on the

integration of standards, there is

comparatively little information on

how to actually build an integrated

system internally. This paper

hypothesizes that audits can

provide an excellent basis for

these integration efforts,

discussing the prerequisites,

strategies and resources

necessary for an effective audit in

support of integrated management

systems. The paper also describes

how audits are used to improve a

combined quality and safety

management system in a German

nuclear facility.

accountability and other important

functional areas. In this ‘‘system of

sub-systems’’, audits can also be arranged as

a specialized and partly independent

supporting sub-system (Karapetrovic and

Willborn, 2000a, b). Figure 2 illustrates the

main elements of a GMS, from the

determination and review of stakeholder

requirements to the evaluation of GMS

effectiveness and continuous improvement.

Embedded within each GMS element is the

corresponding element of an audit

sub-system.

As was mentioned above, these integrated

systems should help managers at all levels of

responsibilities to gain a clearer view and

understanding of managerial tasks at a time

of increasing complexity and risks. This is

also true for auditors. In a ‘‘systematic’’,

well-designed and performed audit, all

participants must know the goal of the audit.

The specific goal then determines the

approach to be taken and the resources to be

deployed. Much has been written about an

effective audit of specialized management

systems. For the fairly new audit task,

namely to achieve an integrated management

system, many questions are still

unanswered. Although the development of

the first integrated audit standard for quality

and environmental management systems

(ISO 19011) started some seven years ago, the

standard is not yet published (at the time of

writing this paper). This quagmire continues

in spite of much effort of the ISO Joint Work

Group on auditing and pressures from the

various interested parties. A brief history

and analysis of the causes of problems related

to the integrated audit of management

systems can be found in Karapetrovic and

Willborn (1998b). Nevertheless, the applied

systems approach can help all people

concerned and involved to utilize human and

technical audit resources in effectively

facilitating the integration of management

systems.

Figure 1IMS audit framework

[ 561 ]

I.A. Beckmerhagen,H.P. Berg,S.V. Karapetrovicand W.O. WillbornAuditing in support of theintegration of managementsystems: a case from thenuclear industry


Audit as a supporting frameworkfor system integration

Audits are conducted in different forms and

using different approaches. These range from

a simple gap analysis or self-assessment to a

comprehensive and technically involved

audit project (Karapetrovic and Willborn,

2001a). Even the standards that describe the

major features of an audit vary in some

details. The systems view of an audit helps us

to focus on essentials of audits, especially

when a new kind of audit is to be introduced,

as it is in the case of an IMS.

Audits that have been conducted in a

function-specific management system (MS),

such as the ones for quality management, are

relatively unique regarding their goals,

approaches, resource requirements,

outcomes, and follow-up. This is not to say

Figure 2Audit-related systems

[ 562 ]



that such audits cannot be converted in order

to assist in the integration of

function-specific MS. As a prerequisite,

audits and the audit team themselves must be

integrated sufficiently in order to participate

effectively in a broader system integration

project. In fact, joint and combined audits,

even if only conducted in a single specialized

system, demonstrate practical cooperative

integration of audit procedures and

operations. For example, Strese et al. (2000)

state that:. . . with the aid of combined audits, a motor

manufacturer has introduced and is

continuously improving a process-oriented,

integrated management system in its factory.

Zechmeister (2000) provides a further

example of such successful audit support:. . . within the framework of reorganizing its

quality system, a manufacturer of electrical

products integrated its management systems

and developed and introduced a new method

of assessment.

Within a specialized MS, both internal and

external audits are often closely planned and

conducted. Moreover, auditors and auditees,

as well as other participants and

stakeholders, share responsibilities for a

useful audit outcome. Integrating audits for

the purpose of assisting in integrating

function-specific MSS is not an entirely new

phenomenon. The novelty is, however, that

auditors with specialized experience and

competence must learn to conduct a new kind

of an audit, namely an audit that assists

management to integrate function-specific

management systems.

One can envision that if an IMS consists of

an overriding GMS and specialized

sub-systems, then integrated audit teams

would be assisting mainly at the generic

system level (Karapetrovic and Willborn,

2000a, b). During prior joint audits across

function-specific management systems,

auditors should have become familiar with

commonalities of such different systems that

will serve as building blocks for the

developed IMS. The experience gained from

joint audits and from the preparation of a

GMS can be also useful for future separate

conventional audits of the modified and

integrated sub-systems. For the success of

this auditing strategy, certain essential

requirements must be met.

Requirements for an effective IMSaudit

Any audit is, by its very nature, a blend of

basic and unique requirements concerning

the initiation, planning, conduct, and

follow-up of an audit project. Auditors

themselves, and to a certain extent the

auditees and executive management as the

audit client, have to be properly motivated

and prepared for this new kind of audit. At

this time, not many truly integrated

management systems exist worldwide.

Consequently, experience for auditing such

systems is still fairly sporadic. Not

surprisingly, a respective standard for such

audits does not exist, although it would be

very timely and useful.

Theoretically, an audit can generate

important findings, insights, and

recommendations when integration is

considered, initiated, planned, established,

maintained, and improved. Most crucial for

management are the early phases of IMS

audit development, as many uncertainties,

risks and barriers exist. The situation where

an IMS is to be established from the ground

up is certainly not the rule. In such a case,

audits would most likely be delayed and

introduced once the management system is

finally established. However, a quality

management system (QMS) usually already

exists in companies, possibly along with

other management systems. To assist and

guide the management in developing this

new system, specialized management

consultants and professional auditors may be

involved in the effort. Possibilities for

gaining important benefits through system

integration commonly exist in this case,

albeit these are not readily recognized.

Auditors can help by identifying such

benefits. In the example described later in

this paper, audits were used to assist in the

integration of a quality and a safety

management system in the nuclear industry.

Audit resources and auditor competence

existing from audits of specialized

management systems need to be extended

and partly modified in the case of IMS audits.

When management considers integrating the

existing management systems, much new

knowledge and expertise is required.

Auditors, among other experts and

consultants, can effectively participate due to

their intimate knowledge of the company’s

operational strengths and weaknesses,

however only in one specialized area, or

through joint audits. Auditors normally have

a close working relationship and

communication links with managers. What

is furthermore required is that auditors

acquire additional knowledge about system

integration from the early development

phases onward.

As has been pointed out, auditors of the

different function-specific MS should

cooperate in establishing joint audits as a

[ 563 ]



preliminary form of IMS audits. As an IMS

does not exist at this stage, QMS auditors

might join a team of those in the safety area

and vice versa. As a next step, a joint audit

team might be able to prepare and to conduct

an audit for the development of an IMS. In

this situation, auditors might initially act

more like consultants and system developers

than independent auditors, while at the same

time assessing (and not strictly auditing) the

performance of the system (Willborn, 1979).

For further explanation of the differences

between assessments and audits, the

interested reader may refer to Karapetrovic

and Willborn (2001a).

Helping the improvement efforts

Once a recognized standard for an IMS comes

into existence, auditors will be able to

determine with more authority if a proper

integration has been achieved or not.

Registration of the system after a successful

audit will then also become feasible.

Auditors, especially those who have

participated in the integration of audits and

management systems already, will be best

prepared to continue in their task.

Integration, in whatever form or degree

achieved, will probably never end in the life

of a company. New specialized MS will

continue to emerge, for example the ones for

knowledge management, complaints

handling, financial planning, corporate

social responsibility, and these may not

immediately fit into an existing integrated

system.

The audit tasks will change somewhat once

an IMS is established to the satisfaction of

management and auditors alike. While

auditing during the development phase

involves much consulting, motivating,

learning, and improvising, it shifts now to a

more traditional and solid ground. In a

predominately stable environment,

compliance audits tend to be the rule and

self-assessments become feasible. Yet the

tasks for auditors, although changing,

remain as important as before. The ultimate

goal for audits must never be simply

maintaining effectively what has been

achieved. In today’s volatile and uncertain

business environment, auditors must assist

management to identify necessary

improvements of the IMS in all its parts. This

assistance must be especially focused on

possible weaknesses and redundancies, as

these might otherwise remain undetected. Of

course, a declared and understood positive

audit approach would emphasize searching

for feasible and necessary improvements:

‘‘Integrated evaluation model indicates

potential operating improvements’’

(Sohrmann and Pahl, 2000). Auditors must

follow-up findings for improvement and for

problem-related corrective and preventive

action. The necessity of such a procedure can

be seen from the example provided at the end

of this paper.

Auditors themselves, now being organized

as an integrative part of the comprehensive

MS, again must set an example and

demonstrate effectiveness and improvements

in ongoing auditing. This is now true more

than ever before, because protective barriers

of former specialized MS might still exist

after integration. With the changed audit

goal and focus, some new audit methods need

to be adapted. For instance, if self-assessment

is to be facilitated, training and suitable

checklists are required. Often, resources for

auditing are curtailed, once an MS runs

fairly smoothly. The opposite should be the

case in a newly integrated MS. In other

words, adequate audit resources need to be

deployed.

Neceessary resources for an IMSaudit

It is largely up to auditors themselves to gain

and maintain adequate human and technical

resources for their tasks. Relying solely on

pressure to obtain sufficient funds from

senior management obviously does not

suffice, even once auditors have achieved

recognition by their clients. The following

technical resources are required for

continued effective auditing of an IMS.

During the IMS development phase:

1 A standard or official guideline for

integrating management systems (does

not yet exist).

2 Publications or other results of internal

research that can be used for retraining

auditors and managers.

3 Training opportunities, for example

participation in relevant congresses and

seminars.

4 System documentation structure that

allows for auditing by different external

bodies and according to different criteria.

5 Assistance by competent management

consultants and technical experts before

and during audits during this phase of

integration.

6 Understanding and acceptance of certain

risks during this system development

phase by all participants and the company

in general.

7 Special checklists and evaluation criteria.

[ 564 ]



8 Adequate audit follow-up meetings with

management and auditees for feedback

about the audit, its results and further

improvements.

9 Appropriate cooperation and a helpful

attitude of audit team members, audit

participants, and managers.

10 Audit by external auditors along with

required experts to determine final

satisfactory establishment of the IMS.

After the completion of system integration:

1 Continued assistance to audit

management and individual auditors to

reorient audits to both compliance and

improvements; and to further improve the

integrated audit sub-system.

2 Adoption of innovative computer-based

auditing methods and software along with

adequate research and technical assistance.

3 Retraining if necessary.

4 Facilitation of new forms of auditing, such

as self-assessment.

5 Cooperation of external and internal

auditors to identify system improvements.

6 Fostering continuous improvement of the

integrated system as the main audit

objective.

7 Obtaining the system registration (if

feasible) and acknowledgement of

continued audit effectiveness.

Theory and practice of management systems

and their integration need to be closely

interrelated and integrated in order to be of

real value. This is especially necessary in the

case of an industry with high risks, such as

the nuclear industry. The following example

from a German nuclear facility explains how

effective auditing was applied in support of

an integrated quality and safety management

system.

Nuclear waste disposal in Germany

Since 1983, the ‘‘Safety criteria for the

disposal of radioactive waste in a mine’’ have

been used as a guideline for planning,

constructing and operating radioactive waste

repositories in Germany. Apart from

containing the basic framework and

elements of a system necessary to achieve the

desired objective of nuclear waste disposal,

these criteria require that all appropriate

laws, regulations and guidelines, including

for example mining regulations and

radiation protection guidelines are complied

with. Moreover, the criteria demand that the

safety of a waste repository be demonstrated

by a site-specific safety assessment.

The Bundesamt fur Strahlenschutz

(Federal Office for Radiation Protection: BfS)

is the responsible body for the disposal of

radioactive waste in Germany, and as such, it

ensures that the requirements resulting from

these different regulations are systematically

fulfilled. In order to address all safety aspects

of a waste repository, an effective quality

assurance system is needed. This system

must cover the whole life cycle of the

repository, including its design,

manufacture, construction, and operation.

Consequently, it must also address

geological, occupational health and safety,

and environmental requirements, as well as

a set of specific guidelines for the protection

from nuclear radiation. Therefore, an

integrated management system (IMS), which

encompasses quality, safety and other

function-specific management systems, is

required. In BfS, such a system has been

developed under the overarching quality

assurance framework.

The quality management system (QMS) of

BfS for the organizational unit dealing with

the final repository for radioactive waste

came into force in 1987. Therefore, the

operations performed in this unit of BfS have

been ‘‘quality assured’’ since then. Since this

system is cross-functional by nature, as it

addresses not only quality, but also safety,

environmental and other criteria, we will

refer to it as the quality-integrated

management system (Q-IMS), in order to

distinguish it from management systems

covering quality assurance requirements

only. The BfS Q-IMS was developed as a

process-oriented system, as required by the

Safety Standard of the German Nuclear

Standards Commission KTA 1401

(Kerntechnischer Ausschuss, 1996): ‘‘General

requirements regarding quality assurance’’. It

is described in the BfS quality manual, which

comprises all generic quality and safety

assurance requirements and is consequently

relevant to all repository projects. The

manual is divided into two parts: a general

framework based on the requirements of

relevant standards and regulations, and a set

of procedures, which illustrate how specific

mining/geological, occupational health and

safety, environmental and radiation

protection specifications are addressed. Some

specific quality assurancemeasures described

in this manual include:. Complete or random inspection of

purchasing data, planning results and

products for compliance with quality

requirements.. Procedures for the documentation of

scientific work during site investigations.. Guarantees of the existence of adequate

flows and feedback of information,

[ 565 ]



including cooperation between the

different parties involved.. Decisions in the event of significant

changes of planning of the design,

construction and operation of the nuclear

waste repository.. Ensuring that special conditions and

additional requirements resulting from the

licensing procedures are taken into

account.. Ensuring the existence and

implementation of appropriate

documentation.. Determination of requirements regarding

contractor quality assurance.. Surveillance of the contractor quality

assurance system by means of external

audits.

An independent surveillance team monitors

the implementation of the quality assurance

program in BfS and evaluates the Q-IMS at

appropriate intervals on the basis of an audit

plan. Records of these evaluations are kept

containing any nonconformities found.

Resolution of unacceptable nonconformities

is accomplished either in a separate

follow-up audit or during the next scheduled

audit. In the following section, a description

of an integrated management system, which

was developed for a nuclear waste repository

under the auspices of BfS, is given.

Example of IMS development fornuclear waste disposal

After the unification of the Federal Republic

of Germany (FRG) and the German

Democratic Republic (GDR), BfS took over a

repository for radioactive waste in

Morsleben which had already been in

operation in the GDR. As it was necessary to

adapt FRG nuclear laws, rules and

regulations, such as the Mining Law,

Radiation Protection Ordinance, Atomic

Energy Act, Safety Standards of the Nuclear

Standards Commission, and a variety of

other German Standards, the existing quality

system for the Morsleben repository had to

be somehow adapted. While one possibility

was to create a new quality manual for the

Morsleben repository, another one was to

derive it from the existing procedures.

The operation of the Morsleben repository

was subcontracted to Deutsche Gesellschaft

fur den Bau und Betrieb von Endlagerung fur

Abfallstoffee mbH (German Company for the

Construction and Operation of Repositories

of Waste: DBE), which is the main contractor

of BfS. DBE performed a system audit of the

repository in 1990 on behalf of BfS. After the

evaluation of the audit results, a decision was

made to create an independent quality

manual for this repository. The manual

would be based on valid existing procedures

and would completely integrate the new

requirements. The way in which this was

accomplished is explained next.

The structure of the quality manual for the

Morsleben repository was based on the

requirements of the mining law, the existing

permanent operation license and the

requirements of the ISO 9001 standard. All

existing requirements of applicable laws,

rules and regulations, as well as the separate

operational requirements, were listed in a

tabular form. By having this table of

contents, it was not only possible to assign

the requirements to the corresponding

chapters of the manual, but also to illustrate

a clear framework of operation to the

differing regulatory bodies which conduct

separate external audits (e.g.

mining/geological and nuclear). In the

following step, the existing procedures were

applied to fulfil the requirements that had

been assigned to the specific chapters in the

manual. In that manner, an auditor, for

example, could clearly see which

requirement had to be fulfilled in which

manner by what procedure. This approach

was proven to be very advantageous when an

expert of the FRG Mining Authority audited

the repository in 1995, as one could see right

away how the different quality, safety,

environmental and other requirements were

fulfilled. Following the new standard DIN

ISO 10013, this table was later replaced by a

subchapter format. Each chapter had a

subchapter in which the relevant procedures

(i.e. references) were listed. Therefore, the

procedures were grouped into two categories:

the ones related to the applicable standards

(e.g. ISO 9001) and the ones related to the

operation of the repository. The appendix of

the quality manual contained a list of the

relevant operating instructions.

The operational personnel of the

Morsleben repository, the respective

personnel from the DBE headquarters and

an external advisor were the human

resources necessary for the writing of the

new manual and the completion of the

procedures. The new Q-IMS has been

audited internally by DBE and externally

by BfS. Some possibilities for improvement

were shown in the beginning, but fewer and

fewer were found later on. As the

operational personnel had been involved in

writing of the chapters of the manual and of

the specific procedures, there were no

difficulties in the implementation of Q-IMS

documentation. This active participation

by the operational personnel created a very

[ 566 ]



positive effect, since any mistakes or

inaccurate formulations in the description

of work processes were quickly found and

corrected. Additional training helped the

personnel obtain confidence with the ‘‘West

German’’ laws and regulations. It is

important to note here that some of the

former GDR standards had to be used not as

guidelines but as more restrictive laws.

Therefore, it is easy to understand that the

use of the FRG rules and regulations, which

seemed to have more operational freedom,

periodically led to irritations on the part of

the ‘‘East German’’ personnel. But as audits

were performed very frequently during the

introduction phase, undesirable

developments were prevented.

On the basis of the audit results, quality

management reviews were performed

annually (Figure 3). Improvements in the

Q-IMS documentation and in the system itself

represented the output of these reviews. In

addition to the reviews, the quality

surveillance team (QST) performs annual

training. During the training, improvements

in the manual are explained and the

personnel are encouraged to understand and

implement them. Apart from the internal

DBE audits, there are also external BfS

audits to evaluate the overall effectiveness of

the Q-IMS. Therefore, a combination of

audits, reviews and training helps to

continuously improve the effectiveness and

efficiency of the Q-IMS.

It is also worth noting that original plans

for the Morsleben Q-IMS included the

integration of ISO 14001 environmental

management system requirements into the

Figure 3Continuous improvement process using audits

[ 567 ]



quality manual. This would have been done

in the same manner as occupational health

and safety requirements. However, the

disposal of radioactive waste at the

Morsleben site was stopped in 1998. In 2001,

the final decision for the decommissioning of

the repository was made.

Conclusions

The world is about to witness the first-ever

audit standard that spans over two

disciplines and functions in an organization,

namely quality and environmental auditing.

It is expected that the ISO 19011 guideline will

be finally available in the fall of 2002.

Although it is certainly a step in the right

direction of harmonizing function-specific

audits, this new guideline unfortunately does

not address the auditing of integrated

management systems, or for that matter the

integration of auditing systems in an

organization. The former issue is of

particular importance, since an

ever-increasing number of companies are

looking into the establishment of integrated

management systems (IMS).

This paper discussed some of the main

concepts and the necessary conditions for

setting up an audit system that would

support the development and

implementation of IMS in organizations.

Following an illustration of the systems

approach to IMS auditing, the manner in

which an audit can support the integration of

function-specific management systems was

analyzed. Subsequently, some of the

requirements and resources necessary to

conduct an effective IMS audit were

presented, and the ability of audits to act as a

basis for continuous improvement of such an

integrated system was addressed. Finally, a

case study from the nuclear industry was

used to demonstrate the importance of an

adequately planned audit in simultaneously

meeting the requirements of quality and

safety management systems.

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[ 568 ]



Current accounting investigations: effect on Big 5market shares

Christie L. ComunaleSchool of Professional Accountancy, Long Island University – C.W. Post Campus,Brookville, New York, USAThomas R. SextonHarriman School for Management and Policy, Stony Brook University,Stony Brook, New York, USA

Introduction

The imminent demise of Arthur Andersen is

evidenced by its loss of many major audit

clients, including Merck, Qwest

Communications, Worldcom, Halliburton,

Freddie Mac, Wyeth, and Peregrine Systems.

Arthur Andersen’s recent announcement

that it would soon cease audit operations for

publicly traded firms formalizes the

transition from the Big 5 to the Big 4.

Meanwhile, other Big 4 firms are also facing

investigations into major accounting

irregularities. These developments raise

questions about the future market shares of

the remaining Big 4 accounting firms. From

the regulatory point of view, will any firm

emerge from this turbulent era to dominate

the audit industry? From the industry point

of view, what will be the short- and long-term

effects of the current accounting scandals on

the market shares of the Big 4 firms?

Extensive shifts in audit market shares

among the Big 5 firms would affect not only

the Big 5 firms, but also clients, regulators,

and corporate stakeholders. For accounting

firms, market share is a major issue, as it

determines their revenue and therefore their

profitability. For clients, excessive market

concentration could result in higher audit

fees. For regulators and corporate

stakeholders, increased market

concentration, and the concurrent lower

competition among accounting firms, would

raise concerns about reduced audit quality.

In this paper, we compare the observed

post-scandal shifts in US market share

resulting from the decline of Arthur

Andersen with those estimated by a Markov

model. The differences between the observed

and the estimated post-scandal market shares

allow us to assess the immediate impacts of

the investigations involving the Big 4 firms

on their market shares. Then we estimate the

year-by-year and long-term market shares

that the Big 4 firms would have achieved had

they all remained untouched by these

investigations. These estimates serve as

future reference points for the Big 4 firms.

For example, if a firm’s market share in a

future year is higher (lower) than its

estimated market share for that year, then

we can deduce that the firm fared better

(worse) than expected in the current turmoil.

Data and methods

We define the audit market share of a Big 5

accounting firm to be the number of

Standard & Poor’s (S&P) 500 client firms

audited by the given accounting firm divided

by the total number of S&P 500 client firms

audited by all Big 5 accounting firms. This

definition does not reflect the asset value of

the client firms, which would provide an

alternative definition of audit market share.

Because the S&P 500 serves as the US

component of the S&P global index family,

our results are most applicable to the US

audit market. While we restrict our analysis

to client firms listed on the S&P 500, we could

expand the model to include all auditors that

the client might retain.

We collect data from Standard & Poor’s

Research Insight for the years 1995-1999,

providing us with 2,000 observations (500

firms� 4 opportunities to change auditors).

We construct a Markov model that depicts

the transitions of a client firm among the set

of Big 5 accounting firms during this period.

Markov models are useful in depicting the

probabilistic evolution of a system over time

among a set of states, as we show in Figure 1.

In this application, the system is one of the

S&P 500 client firms and each Big 5

accounting firm is a state. In any year, one of





[ 569 ]



KeywordsMarket share,

Accounting standards,

Accounting, Benchmarking,

United States of America

AbstractArthur Andersen’s conviction and

its decision not to audit public

firms will transform the Big 5 into

the Big 4. Meanwhile, other Big 4

firms face investigations that

threaten their future market

shares. The article compares the

observed post-scandal shifts in

market share with those

estimated by a Markov model. It

then estimates the year-by-year

and long-term market shares that

the Big 4 firms would have

achieved had they remained

untouched by these

investigations. The study finds

that the absence of Arthur

Andersen alone would not have led

to excessive market share

concentration. It demonstrates

how the post-scandal shifts reveal

the impacts of the investigations

on the Big 4 firms and provides

market share benchmarks against

which the firms can evaluate the

long-term effects of the

investigations. Finally, the article

concludes that a firm’s long-term

gain in market share depends on

its ability to retain audit clients.

the Big 5 accounting firms will audit the

client firm, meaning that, in any year, the

system will reside in exactly one state. Each

year, the client firm decides whether to

remain with its current auditor or transition

to another member of the Big 5, movements

that the model captures using transition

probabilities.

There are two basic kinds of transitions:

those in which the client firm remains with

the same auditor, and those in which the

client firm switches to a new auditor. The

first kind of transition reflects the auditor

firms’ abilities to retain client firms. We

refer to the probability that a client firm

remains with a given Big 5 accounting firm

from one year to the next as the retention

probability of the Big 5 accounting firm. The

second kind of transition reflects the auditor

firms’ abilities to attract client firms from

other Big 5 firms. We refer to the ability of a

given Big 5 firm to attract client firms as its

attractiveness parameter, a number between

zero and one with larger values indicating

greater ability to attract. We estimate the

retention probabilities and attractiveness

parameters of each of the Big 5 firms using

the methodology described below.

The transition probabilities are important

because they allow us to calculate the state

probabilities, defined as the probability that

any given Big 5 accounting firm will audit

the client firm in any given future year. Over

many years, the state probability that a given

Big 5 accounting firm will audit the client

firm approaches a limiting value, which we

call the steady-state probability. The model

also calculates this long-term, or steady-state,

probability. We may interpret these

steady-state probabilities as the long-term

market shares for the Big 5 accounting firms.

Computing observed transitionprobabilitiesWe compute the observed transition

probabilities as relative frequencies. The

observed transition probability from one

Big 5 accounting firm to another (possibly

the same) is the ratio of the number of

observed transitions from the first firm to the

second, divided by the total number of

transitions from the first firm to any Big 5

firm, including itself[1].

Computing estimated retentionprobabilities, attractiveness parameters,and estimated transition probabilitiesWe next compute those values of the


parameters that minimize the sum of the

squared differences between the observed

and estimated transition probabilities. We

use equation (1) in the Appendix for the

estimated transition probabilities. This

optimization is constrained to ensure that

the estimated transition probabilities

produce long-term market shares equal to the

Figure 1Diagram of the Markov model showing the possible transitions of an E&Y client firm among theBig 5 accounting firms

[ 570 ]

Christie L. Comunale andThomas R. SextonCurrent accountinginvestigations: effect on Big 5market shares


observed values. See the Appendix for

details.

Modeling the absence of Arthur AndersenTo model the absence of any one of the Big 5

accounting firms, we assume that the

retention probabilities of the other four

accounting firms will remain the same and

we rescale the remaining attractiveness

parameters. We then compute the new

matrix of transition probabilities for a

Markov model that contains only the

remaining Big 4 firms (see equation (1) in the

Appendix).

We compute the market shares for the

remaining Big 4 firms in the first year without

Arthur Andersen in two ways. First, we

assume that client firms currently audited by

Arthur Andersen will move to other Big 4

firms in proportion to their attractiveness

parameters. This reflects the situation that

would have prevailed had the other Big 4 firms

not undergone investigations. We refer to these

as the estimated post-scandal market shares.

We then use the estimated post-scandal market

shares and the new transition matrix to

compute the year-by-year and long-term

market shares for comparison with market

shares that preceded the Enron crisis. We do

this for each year using matrix multiplication

to multiply the market shares in the previous

year by the estimated transition matrix in the

absence of Arthur Andersen.

Second, we compute the observed

post-scandal market shares based on the

actual transitions of S&P 500 client firms

from Arthur Andersen to another member of

the Big 4 since the onset of the Enron debacle.

These market shares incorporate the effects

of the investigations into the Big 4 firms. We

refer to these as the observed post-scandal

market shares.

Results

We use the following notation to denote the

Big 5 accounting firms: AA=Arthur

Andersen; EY=Ernst & Young; DT=Deloitte

& Touche; PM=KPMG Peat Marwick; and

PWC=PriceWaterhouseCoopers.

Observed transition probabilitiesWe show the observed matrix of transition

probabilities in Table I. For example, during

the five-year period 1995-1999, 98.8 per cent of

EY’s audit clients chose to remain with EY.

We show this percentage in the cell labeled

‘‘EY’’ for both the row and column. During

the same five-year period, 0.48 per cent of

EY’s audit clients switched to DT. We show

this percentage in the cell labeled ‘‘EY’’ for

the row and ‘‘DT’’ for the column. We derive

these percentages as follows. During this

period, EY’s clients made 418 decisions about

whether to remain with EY or switch to

another accounting firm. The clients decided

to remain with EY in 413 of these instances

(98.8 per cent), and to switch to DT in two of

these instances (0.48 per cent).

Estimated retention probabilities andattractiveness parametersFrom the matrix in Table I, we estimate the


parameters using the least squares

optimization procedure described in the

Appendix. We show the estimated retention

probabilities and attractiveness parameters,

the observed retention probabilities, and the

(observed and estimated) long-term audit

market shares in Table II. For example, the

estimated retention probability for EY is 98.9

per cent, which is very close to its observed

value of 98.8 per cent. The estimated

attractiveness parameter for EY is 0.194. The

attractiveness parameters reveal that EY has

greater ability to attract clients from

competitors than does either PM or DT, but

less ability than does either AA or PWC. Table

II also shows that EY has captured 23.07 per

cent of the S&P 500 firms, which equals the

market share estimated by the model because

of the constraints in the optimization step.

Estimated transition probabilitiesWe show the estimated transition

probabilities in Table III. We compute these

values using equation (1) in the Appendix by

substituting the estimated retention

probabilities and attractiveness parameters.

We observe that the estimated transition

probabilities in Table III are very close to the

observed values in Table I.

Estimates in the absence of ArthurAndersenTable IV shows the retention probabilities and

the rescaled attractiveness parameters in the

absence of AA, and Table V shows the

resulting matrix of transition probabilities. In

this matrix, the estimated retention

probabilities are on the main diagonal and

Table IObserved transition probabilities

AA(%)

EY(%)

DT(%)

PM(%)

PWC(%)

AA 98.37 0.33 0.65 0.33 0.33EY 0.48 98.80 0.48 0.24 0.00DT 0.00 0.00 99.32 0.34 0.34PM 0.00 0.00 0.44 98.68 0.88PWC 0.53 0.53 0.35 0.00 98.58

[ 571 ]



transition probabilities computed using

equation (1) in the Appendix are in all other

cells.

Table VI shows how the 73 S&P 500 clients

that have left AA since the Enron affair have

distributed themselves among the remaining

Big 4 firms. The table also shows the expected

number of AA clients that would have retained

each of the Big 4 firms, based on the

attractiveness parameters of the firms. A �2

test reveals that the observed and expected

numbers differ significantly (�2 =27.39, df=3,

p-value<0.000005). This indicates that DT

attracted significantly more of AA’s S&P 500

clients than expected during the wave of recent

scandals, while PWC attracted significantly

fewer than expected. We see that EY and PM

have attracted roughly as many such firms as

predicted by their attractiveness parameters.

Table VII shows the current market shares

and the estimated and observed post-scandal

market shares in the first year without AA. By

assumption, the attractiveness parameter of a

remaining Big 4 accounting firm determines

its estimated post-scandal market share

increase had it been unaffected by its own

accounting difficulties. For example, PWC had

the largest attractiveness parameter and thus

would have received the largest post-scandal

increase in market share.

Table VIII shows current market shares,

estimated year-by-year market shares (for

Table IIThe observed and estimated retention probabilities, the estimated attractiveness parameters,and the observed (and estimated long-term) market shares of the Big 5 accounting firms

AA EY DT PM PWC

Observed retention probability 0.9837 0.9880 0.9932 0.9868 0.9858Estimated retention probability 0.9841 0.9890 0.9904 0.9863 0.9878Estimated attractiveness parameter 0.208 0.194 0.107 0.120 0.371Observed (and estimated long-term) market share 0.1689 0.2307 0.1634 0.1258 0.3113

Table IIIEstimated transition probabilities

AA(%)

EY(%)

DT(%)

PM(%)

PWC(%)

AA 98.41 0.39 0.22 0.24 0.74EY 0.28 98.90 0.15 0.16 0.51DT 0.22 0.21 99.04 0.13 0.40PM 0.32 0.30 0.17 98.63 0.58PWC 0.40 0.38 0.21 0.23 98.78

Table IVThe estimated retention probabilities and the estimated attractiveness parameters of theremaining Big 4 accounting firms in the absence of AA

EY DT PM PWC

Estimated retention probability 0.9890 0.9904 0.9863 0.9878Estimated attractiveness parameter 0.244 0.135 0.152 0.469

Table VEstimated transition probabilities

EY(%)

DT(%)

PM(%)

PWC(%)

EY 98.90 0.20 0.22 0.69DT 0.27 99.04 0.17 0.52PM 0.40 0.22 98.63 0.76PWC 0.56 0.31 0.35 98.78

Table VIThe observed and expected distributions among the remaining Big 4 firms of the 73 S&P 500clients that have left AA since the Enron affair. A �2 test reveals that the observed andexpected numbers differ significantly

EY DT PM PWC Total

Observed number of clients attracted 22 22 14 15 73Expected bumber of clients attracted 17.8 9.9 11.1 34.2 73�2 contribution 0.97 14.87 0.77 10.78 27.39

[ 572 ]



selected years), and estimated long-term

market shares following the demise of AA.

The values in Table VIII represent the

market shares that the remaining Big 4 firms

would have attained had all four been

unaffected by their own accounting

investigations. Therefore, these estimates

serve as future reference points for the Big 4

firms. For example, if a firm’s market share

in a future year is higher (lower) than its

estimated market share for that year, then

the firm can deduce that it fared better

(worse) than expected in the current turmoil.

We observe that the increases in long-term

market share among the remaining Big 4

accounting firms would have ranged from 3.4

per cent to 5.4 per cent, a relatively uniform

set of increases. Thus, we would not have

anticipated excessive long-term market share

concentration in any one of the remaining

Big 4 accounting firms.

Figure 2 shows what the market share

evolution of the Big 4 accounting firms would

have been over several decades in the

absence of AA. Following the post-scandal

increase, the market share of a firm drifts

slowly toward its long-term value. We

consider these drifts to be of no practical

importance for three of the remaining Big 4

accounting firms. Only PWC experiences a

drop in market share of 0.044 following its

post-scandal increase of 0.079.

We observe in Figure 3 that the increase in

the long-term market share of a remaining

Big 4 accounting firm is loosely associated

with the firm’s estimated retention

probability. This is consistent with the

commonly held view that a business

maintains its market share more readily by

retaining its existing customers rather than

attracting customers from its competitors.

Conclusions

Based on observed post-scandal shifts in

market shares immediately following the

demise of AA, DT appears to have weathered

the current scandals better than expected

while PWC has been hurt more than

Table VIICurrent market shares and estimated and observed post-scandal market shares in the first yearwithout AA. Post-scandal increases in market share are shown in absolute and percentageterms

AA EY DT PM PWC

Current market shares 0.169 0.231 0.163 0.126 0.311Estimated

Market shares in first year without AA 0.272 0.186 0.151 0.390Post-scandal increase in market share 0.041 0.023 0.025 0.079Post-scandal % increase in market share 17.7 14.1 19.8 25.4

ObservedMarket shares in first year without AA 0.279 0.220 0.154 0.347Post-scandal increase in market share 0.048 0.057 0.028 0.036Post-scandal % increase in market share 20.8 34.8 22.1 11.7

Table VIIICurrent market shares and estimated year-by-year (for selected years) and long-term marketshares following the demise of AA. Long-term increases in market share are shown in absoluteand percentage terms

AA EY DT PM PWC

Current market shares 0.169 0.231 0.163 0.126 0.311Estimated market shares without AA

Year 1 0.272 0.186 0.151 0.390Year 2 0.272 0.187 0.152 0.390Year 3 0.273 0.187 0.152 0.389Year 4 0.273 0.187 0.152 0.388Year 5 0.273 0.187 0.152 0.387Year 10 0.274 0.189 0.153 0.384Year 15 0.276 0.190 0.154 0.380Year 20 0.277 0.191 0.155 0.377Long-term 0.285 0.209 0.160 0.347

Long-term increase in market share 0.054 0.046 0.034 0.036Long-term % increase in market share 23.4 28.2 27.0 11.6

[ 573 ]



Figure 2Evolution of market shares of the Big 5 accounting firms in the absence of AA in 2003 andbeyond, using estimated post-scandal market shares and assuming that the other fouraccounting firms remained unaffected by their own accounting investigations

Figure 3Long-term increases in market share versus estimated retention probability for the remainingBig 4 accounting firms

[ 574 ]



expected. The observed market share effects

on EY and PM are nearly equal to those

expected by the model.

Based on our model, in the absence of AA,

PWC would have experienced the greatest

post-scandal gain in market share because of

its high attractiveness parameter. However,

EY would have eventually benefited from the

greatest long-term gain because of its high

retention probability. However, as Figure 2

shows, because market shares drift slowly

following their post-scandal increases, it

would have taken until the year 2058 before

EY’s market share gain would have equaled

that of PWC.

Our model illustrates that long-term gains

in market share depend on the ability of the

accounting firm to retain its audit clients.

The observed retention probabilities of the

Big 5 accounting firms are uniformly high,

ranging from 98.37 per cent to 99.32 per cent.

On the other hand, the attractiveness

parameters of these firms vary considerably,

from 0.107 to 0.371 (before the absence of AA).

This suggests that S&P 500 firms tend to

remain with their accounting firm for long

periods but, when they switch, certain of the

Big 5 accounting firms are considerably more

attractive than others. The variation in

attractiveness parameters leads to variation

in post-scandal market share increases, but

long-term market shares depend more on

retention probabilities than on

attractiveness. In other words, when a large

number of S&P 500 firms are seeking new

auditors, the more attractive Big 5

accounting firms will experience the largest

post-scandal market share increases.

However, over time, the Big 5 accounting

firms with greater ability to retain their

audit clients are more likely to achieve the

larger long-term market share gains. We note

that, while retention rates have been very

high in the past, the current environment

may cause client firms to become less

reluctant to switch auditors, resulting in

lower retention probabilities in the future.

Certain regulatory policies such as

mandatory auditor rotation would greatly

increase the frequency with which client

firms change auditors. Comunale and Sexton

(2002) extend the current Markov model to

assess the effects of mandatory auditor

rotation and retention on market share. They

find that under mandatory auditor rotation,

the long-term market share of any given

accounting firm would depend most heavily

on its ability to attract new clients. As a

result, accounting firms would be likely to

shift resources to expand their marketing

efforts possibly endangering audit quality.

Finally, the absence of AA alone will not

lead to excessive market share concentration

within the remaining Big 4 accounting firms

among the S&P 500 firms. Analysts often use

the Gini coefficient to measure market share

concentration in an industry. We compute

the Gini coefficient using the following

formula:

Gina coefficient ¼ 1�Xnj¼1

ðmarket shareÞ2j ;

where n is the number of firms in the

industry. Complete market concentration

occurs, as a limiting case, when one firm has

a 100 per cent market share and all the other

firms have 0 per cent market shares. In this

situation, the Gini coefficient equals 0. In the

absence of market concentration, all n firms

have equal market share and the Gini

coefficient attains its largest value 1� ð1=nÞ.The Gini coefficient for the Big 5

accounting firms (among the S&P 500 firms)

before the accounting scandals equals 0.779,

which is 97.4 per cent of its maximum value

1� ð1=5Þ ¼ 0:8. This suggests that there was

very little market concentration among the

Big 5 firms. In the first year without AA, the

Gini coefficient for the observed market

shares is 0.730, which is 97.3 per cent of its

maximum value 1� ð1=4Þ ¼ 0:75. Thus, we see

that the observed post-scandal shifts in

market shares have resulted in essentially

the same market share concentration as that

which existed before the scandals.

In the first year without AA, if all the other

Big 4 firms had remained untouched by the

scandals, the Gini coefficient would have

been 0.717, which is 95.5 per cent of its

maximum value 1� ð1=4Þ ¼ 0:75. Thus, the

model indicates that a slight increase in

market concentration would have occurred

in the first year without AA had the other Big

4 firms remained untouched. However, in the

long-term, the model indicates that the Gini

coefficient would have equaled 0.729, which

is 97.2 per cent of its maximum value

1� ð1=4Þ ¼ 0:75, and which is almost identical

to the current percentage. Thus, market

share concentration would have returned

eventually to its current level.

Note1 Before July 1, 1998, when Price Waterhouse

(PW) merged with Coopers & Lybrand (CL),

we treated the two separate firms as if they

were one. Specifically, if a client remained

with either PW or with CL, or switched

between PW and CL, we counted that as an

occurrence of client retention for PWC. If a

client firm switched auditors from one of the

other four accounting firms to either PW or

CL, we counted that as an occurrence of client

[ 575 ]



attraction for PWC. During the pre-merger

period, two client firms left CL for PWC and

one firm left PWC for CL, resulting in a net

change of only one client firm transition.

ReferenceComunale, C.L. and Sexton, T.R. (2002), ‘‘The

impact of mandatory auditor rotation and

retention on the market shares of the Big 5

accounting firms’’, paper presented at the

2002 American Accounting Association

Annual and Northeast Regional Meetings.

AppendixWe construct a Markov model that depicts

the movements of a client firm among the set

of Big 5 accounting firms. We have five states

in our model, one for each of the Big 5

accounting firms. While we restrict our

analysis to client firms listed on the S&P 500,

the model is equally applicable to any client

firm if we expand the state space to include

all auditors that the client might retain. In

any given year, the client firm retains one of

the accounting firms for audit purposes.

Suppose the selected accounting firm is

represented by state i. In the next year, the

client may remain with accounting firm i,

with probability pii, or may switch to

accounting firm j, with probability pij.

Consistent with standard Markov model

axioms, we assume that these probabilities

are the same for all client firms and that they

remain constant over time.

Let P ¼ ðpijÞ denote the 5� 5 matrix of

transition probabilities. Clearly, our model is

ergodic, meaning that the client firm can

move from any accounting firm to any other

in a finite number of transitions. Thus, we

know that there exists a 1� 5 vector � ¼ ð�jÞof steady-state probabilities that are

independent of the initial state of the client

firm. The steady-state probability �j is the

asymptotic probability that the client firm

will retain accounting firm j in any year.

Therefore, we can interpret the steady-state

probability �j as the long-term market share

of accounting firm j. We compute the

steady-state vector � as the first row of the

matrixM�1, whereM is the matrix P � I with

the first column replaced by all 1s, and where

the matrix I is the 5� 5 identity matrix.

We model the transition probabilities

as follows:

pij ¼ri; i ¼ jð1� riÞAj=

Pk 6¼i Ak; i 6¼ j

�ð1Þ

where we define the parameters ri and Ai as

the retention probability and the

attractiveness parameter of accounting firm

i, respectively. The retention probability of

accounting firm i is the likelihood that a

client firm will remain with accounting firm

i in the next year given that it retained

accounting firm i in the current year. The

attractiveness parameter of accounting firm i

is a measure of its ability to recruit a client

firm from another accounting firm given that

the client firm has decided to change

accounting firms.

We restrict the attractiveness parameters

to sum to 1 so that the denominator of pij for

i 6¼ j represents the sum of the attractiveness

parameters of all accounting firms except i.

Thus, the ratio Aj=ð1�AiÞ represents the

probability that a client firm leaving

accounting firm i will move to accounting

firm j. Then, for i 6¼ j, pij equals this

conditional probability multiplied by the

probability 1� ri that the client firm leaves

accounting firm i.

We estimate the retention and

attractiveness parameters by determining

the values of ri and Ai that minimize the sum

of the squared differences between the

observed transition probabilities and the

estimated transition probabilities computed

using (1). We perform this minimization

subject to the constraints that the estimated

transition probabilities produced market

shares equal to the observed market shares.

In addition, we require that the retention

probabilities lie between zero and one, and

that the attractiveness parameters sum to

one. Thus, we use the Solver add-in in

Microsoft Excel to solve

minri ; Ai

X5i¼1

X5j¼1

ðpij � ppijÞ2 j�j ¼ ��j ; j ¼ 1; . . . ; 5;

(

0 � ri � 1; i ¼ 1; . . . ; 5;X5j¼1

Aj ¼ 1

)

The resulting retention probabilities and

attractiveness parameters thus produce an

estimated transition matrix that is as close as

possible to the observed transition matrix

while producing identical market shares for

all five accounting firms.

[ 576 ]



The efficacy of liquidation and bankruptcy predictionmodels for assessing going concern

Nirosh KuruppuLincoln University, Canterbury, New ZealandFawzi LaswadMassey University, Palmerston North, New ZealandPeter OyelereLincoln University, Canterbury, New Zealand

1. Introduction

The purpose of this article is to examine the

efficacy of statistical corporate liquidation

prediction models for assessing client going

concern status. Previous research shows that

statistical bankruptcy prediction models

consistently outperform auditors’ going

concern judgement in discriminating

between bankrupt and non-bankrupt

companies (Levitan and Knoblett, 1985;

Cormier et al., 1995; Grant et al., 1998).

However, research also questions whether

corporate bankruptcy is the best proxy for

the assessment of going concern since filing

for bankruptcy is not synonymous with the

invalidity of the going concern assumption

(Shultz, 1995; Casterella et al., 2000).

Indeed, in countries such as the USA where

the insolvency laws are debtor-oriented,

corporate bankruptcy procedures encourage

companies in financial difficulty to continue

as going concerns (Franks et al., 1996).

Therefore it is possible for companies that

file for bankruptcy to reorganise and emerge

from bankruptcy, or to merge with another

entity as a going concern (Shultz, 1995). This

is in contrast to the insolvency procedures in

creditor-oriented countries such as the UK,

Germany, Australia and New Zealand where

liquidation is the most common outcome of

corporate insolvency (Kaiser, 1996; Franks

et al., 1996). The costs of corporate liquidation

also exceed the cost of bankruptcy to

shareholders and to other stakeholders

(Alderson and Betker, 1996; 1999). Moreover,

companies in debtor-oriented countries may

also choose to file for bankruptcy for

strategic reasons other than financial

distress, such as to avoid an unprofitable

contract (Kennedy and Shaw, 1991;

Chatterjee et al., 1996; Franks et al., 1996).

These arguments suggest that a bankruptcy

prediction model might not be the best proxy

for assessing going concern, especially in

creditor-oriented countries.

This study examines the efficacy of a

statistical model to predict company

liquidation, which is a better proxy for

assessing the validity of the going concern

assumption than bankruptcy prediction

models used in previous research. Given the

differences in debtor- and creditor-oriented

insolvency frameworks, the results can assist

auditors in choosing appropriate business

failure prediction models as an analytical

technique for assessing going concern.

The study develops a liquidation

prediction model from a sample of 135 New

Zealand Stock Exchange listed companies

and analyses its classification accuracy in

terms of Type 1 and Type 2 errors, and

compares it to a benchmark bankruptcy

prediction model which has been used to

benchmark the performance of newly

developed corporate failure models. The

results indicate that the Type 1 errors for the

liquidation prediction model are

significantly lower than for the bankruptcy

prediction model. Given the high costs

associated with misclassifying failing

companies, it suggests that the liquidation

prediction model can be used as a valuable

audit tool for assessing going concern. The

high accuracy of the liquidation prediction

model also raises the implications of using

bankruptcy prediction models in countries

where the insolvency framework is creditor-

oriented.

The remainder of the article is structured

as follows. Section 2 examines the

importance of the going concern concept in

auditing and the requirements of the current

auditing standards on going concern.

Section 3 examines the usefulness of

corporate distress models as an analytical

procedure for assessing going concern, and





[ 577 ]



KeywordsGoing concern value, Liquidation,Bankruptcy, Insolvency,Corporate finances

AbstractRecent research questions

whether bankruptcy is the best

proxy for assessing going concern

since filing for bankruptcy is not

synonymous with the invalidity of

the going concern assumption.

Furthermore, in contrast to debtor-

oriented countries such as the

USA, liquidation is the most likely

outcome of corporate insolvency in

creditor-oriented countries such as

the UK, Germany, Australia and

New Zealand. This suggests that

bankruptcy prediction models have

limited use for assessing going

concern in creditor-oriented

countries. This study examines the

efficacy of a corporate liquidation

model and a benchmark

bankruptcy prediction model for

assessing company liquidation. It

finds that the former is more

accurate in predicting company

liquidations in comparison with the

latter. Most importantly, Type 1

errors for the liquidation prediction

model are significantly lower than

for the bankruptcy prediction

model, which indicates its greater

efficacy as an analytical tool for

assessing going concern. The

results also suggest that

bankruptcy prediction models

might not be appropriate for

assessing going concern in

countries where the insolvency

code is creditor-oriented.

discusses prior research in the area. Section

4 describes the research objective and

hypotheses, followed by a description of the

research design in Section 5. The data

analysis and results are presented in

Section 6, while Section 7 concludes the paper

with the main findings and opportunities for

further research.

2. The going concern concept inauditing

The going concern assumption has been

recognised as one of the main concepts

underlying financial reporting, which

justifies accounting practices such as period

reporting, accrual accounting and asset

valuation (Boritz and Kralitz, 1987; Barnes

and Huan, 1993; International Federation of

Accountants, 2000). The going concern

concept assumes that the reporting entity

will continue in operation for the foreseeable

future, and that it will be able to realise

assets and discharge financial obligations in

the normal course of operations. If the going

concern assumption were to become invalid,

both the period reporting and accrual

concepts will also lose their relevance since

defining assets as future economic benefits

then becomes erroneous (Boritz and Kralitz,

1987). The traditional valuation of assets also

loses its relevance since the realisation of

assets at their reported value in the balance

sheet becomes uncertain (Boritz and Kralitz,

1987). Furthermore, the classification of

assets and liabilities into current and

non-current categories in the balance sheet

would also become meaningless.

Even though the going concern assumption

is a fundamental concept in financial

reporting, there has been little professional

guidance on assessing going concern prior to

the issuance of SAS 34 in the USA in 1981

(Johnson and Khurana, 1993; Guy and

Carmichael, 2000). The development of SAS

34 was motivated by the dissatisfaction with

auditors over the many company failures

that occurred soon after the issuance of an

unqualified audit report (Guy and

Carmichael, 2000). The aim of this auditing

standard was to bridge the publics’

expectation gap that auditors should be held

responsible for disclosing going concern

uncertainties (Guy and Carmichael, 2000).

Other countries have since then followed suit

to issue their own auditing standards on

going concern such as SAS 130 in the UK,

AUS 708 in Australia and AS 520 in New

Zealand (Cormier et al., 1995; Loftus and

Miller, 2000).

The early auditing standards on going

concern, including SAS 34, only required a

passive approach to assessing going concern

(Asare, 1990). For instance, it was only when

matters indicating going concern issues were

detected during the course of an audit that

the auditor was required to search for more

evidence supporting or refuting the going

concern assumption. Subsequent revisions of

auditing standards on going concern have

increased in scope to minimise the

‘‘expectations gap’’ between the financial

statement users and auditors (Geiger et al.,

1998). Current auditing standards on going

concern now require the auditor to actively

seek out circumstances that may negate the

validity of the going concern assumption.

Table I summarises the main requirements

of auditing standards on going concern in the

USA, the UK, Australia, New Zealand and

international auditing standards.

Table I shows that auditors are required to

perform procedures designed specifically to

identify going concern uncertainties.

Furthermore, since the use of analytical

procedures is mandatory in all the countries

referred to above, for example SAS 56, AUS

512 and AS 504, auditing standards are

already in place to accommodate statistical

models as an integral part of the review

process.

3. The relevance of statisticalmodels for assessing going concern

3.1 IntroductionThe link between going concern and

bankruptcy is recognised in the accounting

and auditing literature (Blocher and

Loebbecke, 1993; Koh and Brown, 1991; Loftus

and Miller, 2000). Due to the perceived

expectations gap between auditors and

financial statement users who place greater

responsibility on the auditor for disclosing

going concern uncertainties, statistical

corporate failure models are seen as a tool

that could assist auditors in making more

accurate going concern judgements (Levitan

and Knoblett, 1985; Asare, 1990; Louwers

et al., 1999). The potential usefulness of

statistical models for assessing going concern

has been recognised in the expectations gap

literature since the late 1970s, when the

Cohen commission’s report (1978) on auditor

responsibilities first suggested their use as a

means toward reducing the expectations gap

(Altman, 1983; Levitan and Knoblett, 1985;

Asare, 1990). More recently, the AICPA (1993)

in the USA has also recognised the public’s

demand for an early warning system of

[ 578 ]

Nirosh Kuruppu, Fawzi Laswadand Peter OyelereThe efficacy of liquidation andbankruptcy prediction modelsfor assessing going concern


corporate failure (Loftus and Miller, 2000;

Dunn et al., 2002).

Previous research shows objective

statistical models to outperform auditors in

assessing company failure (Cormier et al.,

1995; Grant et al., 1998). One of the best known

corporate failure models is Altman’s ZETA

bankruptcy prediction model which is used

by over 80 commercial clients (Loftus and

Miller, 2000). Such models can help auditors

in forming more accurate assessments of

clients’ going concern status, and thereby

help reduce the costs associated with

inappropriate audit opinions such as

litigation from shareholders, loss of clients

and the loss of professional reputation (Koh,

1991; Carcello and Palmrose, 1994, Grant et al.,

1998).

Koh and Brown (1991) assert that an

accurate corporate distress model can help

the auditor identify high-risk companies in

the planning stages of the audit. This helps

the auditor in planning specific audit

procedures aimed at assessing the

appropriateness of the going concern

assumption (Koh and Brown, 1991).

Statistical models developed from probit and

logit analyses, which are types of conditional

probability model, also provide an objective

assessment of the probability of the client

failing. A high probability of failure alerts

the auditor to the need to apply a more

rigorous audit assessment than he or she

might have in the absence of this

information.

In the final stages of the audit, a corporate

distress model can be used to verify that the

overall audit opinion in relation to going

concern is appropriate for the client’s

financial statements (Chen and Church,

1992). In the event that an adverse or

qualified opinion is rendered, an objective

statistical model can more readily help the

auditor in justifying the decision to

interested parties (Koh and Oliga, 1990; Chen

and Church, 1992).

Furthermore, statistical evidence is

accepted as evidence in court (Finkelstein

and Levin, 1990; Anderson et al., 1995; Lowe

et al., 2002). This allows an objective model to

be used as a defence in court cases claiming

audit failure (Wallace, 1983; Anderson et al.,

1995; Lowe et al., 2002). A model that can

assist auditors in minimising the risk of

client misclassification can lessen the risks

of litigation, which might subsequently filter

down to clients in the form of lower audit

fees. In the USA, for example, approximately

9 percent of auditor revenues are spent on

defending lawsuits (Grant et al., 1998).

Due to the usefulness of statistical

corporate failure models described above,

auditing standards such as in Australia

already recognise statistical models. The

Australian standard on Analytical

Procedures (AUS 512) with reference to AUS

708 on going concern draws the auditors’

attention to financial models developed from

probit and discriminant analysis for

assessing going concern. The Proceedings of

the Expectations Gap Roundtable in the

United States (1993) has also called for

continued research into the effectiveness of

analytical procedures, and it has identified

Table IEvaluation required by auditing standards on going concern

Country Standard Evaluation required Audit period

USA SAS 59 (SAS 34was superseded bySAS 59)

Specifically form an opinion on the going concernassumption from the results of usual auditprocedures

Not to exceed one year from the date of thefinancial statements being audited

UK SAS 130 Plan and perform procedures specificallydesigned to identify going concern uncertainties(s21)

Not specifically defined or elaborated (s9), butlikely to be the period that management hasconsidered in assessing going concern s21[ii])

Australia AUS 708 Auditor must obtain evidence that the goingconcern assumption is appropriate (s10)Must specifically assess going concern problemsas part of the audit planning process (s17)

One year (s4)

New Zealand AS 520 Obtain audit evidence that the going concernassumption is appropriate (s27)Plan and perform specific procedures to identifygoing concern uncertainties (s8a, 30)

One year (s25)

IAS (IFAC) ISA 570 Auditor should consider the appropriateness ofthe going concern assumption when planning andperforming audit procedures and in evaluatingtheir results (s2, s11, s12, s17)

One year (s18, s19)

[ 579 ]



the use of bankruptcy prediction models for


assumption (Blocher and Loebbecke, 1993).

The ability of corporate failure models to

provide objective evidence for making a

going concern judgement is also recognised

by accounting practitioners (Constable and

Woodliff, 1994).

3.2 Review of empirical findingsThe pioneering work of Beaver (1966) and

Altman (1968) developed the first bankruptcy

prediction models using univariate and

multivariate approaches respectively, from

US company data. Following these early

studies, other researchers have applied

similar methodologies for development of

corporate failure models in other countries,

such as Taffler (1982) for the UK and Izan

(1984) for Australia.

Although a large number of bankruptcy

studies have been conducted, only a limited

number of studies have examined the

usefulness of corporate failure models for

assessing going concern. The seminal work

by Altman and McGough (1974) first

suggested the usefulness of bankruptcy

prediction models for assessing company

going concern status. Altman and McGough

(1974) found that their model was 82 percent

successful in predicting bankruptcy filings

when compared with auditors’ going concern

assessment of 46 percent accuracy. These

results were re-affirmed in a later study by

Altman (1983) where the models’ average

success in predicting bankruptcy was 86

percent compared to auditors’ 48 percent.

Table II provides a summary of empirical

studies. Most of the studies that followed the

early work of Altman and McGough (1974)

are similar in design, except that they were

applied to different samples and sample

periods, and examined bankrupt companies.

These include Levitan and Knoblett (1985),

Mutchler (1985), Koh and Killough (1990), Koh

and Brown (1991) and Cormier et al. (1995)

who developed bankruptcy prediction models

to predict company failure[1]. These studies

examined the usefulness of bankruptcy

prediction models for assessing going

concern by comparing the accuracy of the

developed models to auditors’ going concern

qualifications issued prior to bankruptcy.

The developed models were found to be more

accurate when compared with auditors’ prior

audit opinions.

The findings of the empirical studies

summarised in Table II indicate that

statistical models could assist auditors in

forming more accurate going concern

judgements. This would assist the accounting

profession in reducing the public’s

expectations gap of the profession, and in

increasing the public’s confidence in the

audit function.

However, even though prior research has

found bankruptcy prediction models to be

useful for assessing going concern, recent

research suggests that bankruptcy prediction

models might not be the best proxy for

assessing going concern, especially in

creditor-oriented countries, where

liquidation is the likely outcome of corporate

insolvency (Kaiser, 1996; Franks et al., 1996).

Furthermore, recent research also argues

that a bankrupt company can be regarded as

a going concern until the resolution of

bankruptcy, and that company bankruptcy is

less costly compared to company liquidation

(Shultz, 1995; Alderson and Betker, 1996;

Franks et al., 1996; Casterella et al., 2000).

Indeed, Alderson and Betker (1996) show that

the loss of going concern value forms the

largest component of liquidation cost at 32

percent of corporate value. Furthermore,

more than 50 percent of companies that

re-emerge from bankruptcy generate a return

that exceeds the return available on

benchmark portfolios, indicating that

corporate bankruptcy is not as costly as

liquidation to shareholders and to other

stakeholders (Alderson and Betker, 1996;

1999).

These findings suggests that inappropriate

audit opinions issued to liquidated

companies are more costly than

inappropriate opinions issued to companies

which emerge from bankruptcy as going

concerns. This distinction between bankrupt

and liquidated companies suggests that

company liquidation is a better proxy for

assessing client’s going concern status in

statistical business continuity models.

4. Research objective andhypotheses

The objective of this study, therefore, is to

examine the efficacy of a business continuity

model to predict company liquidation. It is

argued that liquidation is the better proxy for


assumption than bankruptcy prediction

models used in previous research. To achieve

this objective, three hypotheses are tested.

H1. A liquidation prediction model

outperforms a benchmark bankruptcy

prediction model in discriminating

between liquidated and continuing

companies.

This hypothesis examines whether a

liquidation prediction model is a better

predictor of company liquidation than a

[ 580 ]



Table

IIStudiesapplyingbankruptcypredictionmodels

forass

ess

inggoingconcern

Study

Place

Sam

ple

Definitionof

compa

nyfailu

reMetho

dFind

ings

Con

clus

ions

Altman

andMcG

ough

(1974)

USA

33ba

nkrupt;33no

n-ba

nkrupt

compa

nies

Ban

krup

tcy

MDA

Mod

elac

curacy

82pe

rce

nt

compa

redto

auditors

46pe

rce

nt

accu

racy

Ban

krup

tcypred

iction

mod

elsca

nbe

useful

toau

ditors

Altman

(1983)

USA

40faile

dco

mpa

nies

Ban

krup

tcy

MDA

Ave

rage

bank

ruptcy

mod

elac

curacy

86.2

perce

ntco

mpa

redto

auditors’

48.1

perce

ntac

curacy

Aud

itorssh

ould

exam

inean

alytical

metho

dswhich

canas

sist

inthe

goingco

ncernco

ntex

t

Levitanan

dKno

blett

(1985)

USA

32faile

d;32no

n-faile

d

compa

nies

Ban

krup

tcy

MDA

One

year

priorto

bank

ruptcy

,mod

el

84pe

rce

ntac

curate

compa

redto

auditors’66pe

rce

ntac

curacy

Threeye

armod

elav

erag

eis

67pe

r

cent

compa

redto

auditors’33pe

r

cent

Mod

elac

curacy

isabe

tter

pred

ictor

ofba

nkruptcy

whe

nco

mpa

redto

auditors’op

inion

Mutch

ler(1985)

USA

119go

ingco

ncernqu

alified

;

119no

n-go

ingco

ncern

mod

ified

compa

nies

Rec

eipt

ofgo

ingco

ncern

qualifica

tion

MDA

Mod

elwas

able

topred

icttheGC

opinion83pe

rce

ntof

thetime

Urges

morestud

iesinto

theov

erall

func

tion

oftheau

ditop

inionsinc

e

themajorityof

thes

eop

inions

could

bepred

ictedby

publicly

available

inform

ation

Koh

andKillou

gh

(1990)

USA

35faile

d;35no

n-faile

d

compa

nies

Com

panies

repo

rted

as‘‘failed’’

bytheWallStree

tJourna

lInde

x.

Nofurthe

rde

tails

areprov

ided

MDA

Mod

elan

dau

ditors

have

simila

r

accu

racy

forno

n-faile

dco

mpa

nies

(88.6

perce

ntan

d88.86pe

rce

nt

resp

ective

ly)

Mod

elac

curacy

strong

ly

outperform

sau

ditors

forfaile

d

compa

nies

(78.57pe

rce

ntto

only

21.43pe

rce

ntby

auditors)

Ass

erts

that

future

rese

arch

could

prov

ideau

ditors

withmore

soph

istica

tedan

dac

curate

mod

els

foras

sess

inggo

ingco

ncern

prob

lems

(con

tinu

ed)

[ 581 ]



Table

II

Study

Place

Sam

ple

Definitionof

compa

nyfailu

reMetho

dFind

ings

Con

clus

ions

Koh

andBrown(1991)

USA

40faile

d;40no

n-faile

d

compa

nies

Ban

krup

tcy

Probit

Mod

elpred

icted82.50pe

rce

ntof

non-go

ingco

ncerns

and100pe

rce

nt

ofgo

ingco

ncerns

yielding

an

averag

esu

cces

srate

of91.25pe

r

cent.Aud

itors’

averag

esu

cces

srate

was

68.75pe

rce

nt,witha40pe

r

cent

succ

essrate

forfaile

d

compa

nies

Sug

geststhemod

elas

aus

eful

audit

tool

Cormieret

al.(1995)

Can

ada

138faile

d;112no

n-faile

d

compa

nies

Ann

ualstoc

kreturn

less

than

–50pe

rce

nt

Logit,

MDAan

d

Rec

ursive

partitioning

(RP)

Class

ifica

tion

ratesforfaile

d

compa

nies

usinglogit,

MDAan

dRP

resp

ective

ly:76.08pe

rce

nt,81.88

perce

nt,70.3

perce

nt

Aud

itors’

accu

racy

was

not

compa

redin

this

stud

y

Mod

elsde

velope

din

this

stud

yca

n

beco

mpa

redwithcu

rren

tprac

tice

in

acco

unting

firms.

From

this

exercise

,

better

spec

ified

mod

elsca

nbe

deve

lope

d

[ 582 ]



benchmark bankruptcy prediction model.

Altman’s Z-score bankruptcy prediction

model is used for the comparison since it is

frequently used to benchmark the

performance of newly developed bankruptcy

prediction models (Holmen, 1988; Eidleman,

1995, Dunn et al., 2002). Furthermore, it is a

tried and tested model that has been used in a

number of different countries across various

industry settings, and it has been even found

to outperform country specific corporate

failure models (Holmen, 1988; Eidleman,

1995).

H2. Type 1 errors are lower for the

liquidation prediction model compared

to the benchmark bankruptcy



companies.

A Type 1 error is misclassifying a failed

company as non-failed. Prior research

indicates that Type 1 errors are costliest to

auditors, where it would lead to the possible

loss of audit fee, professional reputation and

litigation from shareholders (Koh, 1991;

Carcello and Palmrose, 1994; Geiger et al.,

1998). This indicates that for a corporate

failure model to be an effective analytical

technique for assessing going concern, it has

to be highly accurate in predicting failing

companies. This hypothesis identifies the

errors of misclassifying a failed company as a

non-failed company for the developed

liquidation prediction model and the

benchmark bankruptcy prediction model.

H3. Type 2 errors are lower for the

liquidation prediction model compared

to the benchmark bankruptcy



companies.

A Type 2 error is misclassifying a healthy

company as failed, and the costs of Type 2

errors include the loss of professional

reputation, loss of audit fee, and the client

company’s actual demise due to the

inappropriate audit opinion (Geiger et al.,

1998; Louwers et al., 1999). This hypothesis

assesses the difference in accuracy between

the liquidation prediction model and the

benchmark bankruptcy prediction model in

misclassifying non-failed companies. The

next section describes the research design

followed to test the above hypotheses.

5. Research design

5.1 Sample selection and variablesThe first stage in testing the developed

hypotheses requires the development of a

liquidation prediction model for New

Zealand companies. Most prior studies on

bankruptcy prediction were able to use

online databases such as Compact Disclosure

and NAARS to obtain the required data for

model development. New Zealand has no

such online database of failed company

financial data which makes the data

collection more difficult.

However, a large number of listed

companies failed in the years following the

stock market crash of 1987 which enables the

researcher to obtain a sufficiently large

number of failed companies. Therefore, to

enable the development of a liquidation

prediction model for New Zealand, listed

companies that were liquidated and struck

off from the Companies Register from

1987-1993 were identified from the Companies

Office database. This process identified 85

liquidated companies. A further group of 50

continuing companies that delisted during

the same period were also selected to

represent companies which are going

concerns, but which are not in sound

financial health (Zhang and Harrold, 1997;

Nasir et al., 2000). Since auditors are more

likely to issue a going concern qualification

to companies in financial stress, a model that

can discriminate between failed and other

stressed companies is argued to be especially

useful (Foster et al., 1998). Companies in the

financial and property sectors were excluded

from the sample due to significant industry

differences (Grant et al., 1998). This resulted

in a total sample size of 135 companies, which

is a significantly large sample relative to the

number of companies listed on the New

Zealand Stock Exchange.

The financial statement data for the

identified sample were then manually

obtained from the various archives of New

Zealand universities and national libraries.

For each company, 174 individual pieces of

data were entered, which resulted in over

23,000 entries.

The financial statement data collated from

the sample companies were used to derive 63

explanatory variables for the prediction

model. This includes variables found to be

useful in prior studies and additional

variables not used in prior corporate failure

studies. The new variables were identified as

potentially useful variables for corporate

failure prediction by examining the

literature on financial statement analysis

(Ketz et al., 1990; Woelfel, 1994; Bertoneche

and Knight, 2001). These new variables

include ratios calculated from total tangible

assets, interest coverage, working capital

turnover, asset turnover ratios and the audit

report lag, among others. The dependent

[ 583 ]



variable was coded as a binary variable,

where 1 is defined as a failure and 0 is defined

as a non-failure.

5.2 Statistical modelling approachMultiple discriminant analysis (MDA) is

used to develop the liquidation prediction

model since it is proven to be robust in

bankruptcy prediction and there is no

significant difference in accuracy between

MDA models and logit/probit analyses

(Collins and Green, 1982; Cormier et al., 1995;

Allen and Chung, 1998). Furthermore,

preliminary data analysis using both these

methods on the New Zealand sample

identified the MDA model as having greater

accuracy in predicting company liquidation

when compared with a logit model developed

from the same data.

Prior studies using multiple discriminant

analysis (MDA) have often used a sample

matching approach, for example, by

matching failed and non-failed companies by

industry. However, this approach is not

necessary since discriminant analysis

optimally classifies between the two given

sample groups. Lau (1987) and Gilbert et al.

(1990) have used this approach. Furthermore,

due to the relatively small New Zealand

sample size compared to overseas studies it is

difficult to obtain a sufficiently large number

of failed companies if sample matching is

used.

Prior studies have also used equal group

sizes when analysing the discriminant

function that maximally discriminates

between the two groups. However,

discriminant analysis does not require equal

group sizes since prior probabilities can be

computed from the individual samples by

weighing (George and Mallery, 2001). Hence,

in this study, prior probabilities of group

membership are calculated from the failed

and non-failed sample sizes.

The discriminant function that maximally

discriminates between the sample groups can

be derived from either stepwise or

simultaneous estimation (Hair et al., 1995;

George and Mallery, 2001). The stepwise

procedure is often used in preference to

simultaneous estimation because in practice,

the stepwise discriminant procedure

performs better than when all the variables

are simultaneously entered into the

discriminant function (George and Mallery,

2001). This was confirmed during

preliminary analysis on the New Zealand

sample using both simultaneous and

stepwise methods. Consequently, the

liquidation model in this study is derived by

the Wilks’ lambda (�) stepwise method. This

procedure uses the 63 variables for the 135

companies in an iterative process to retain

the most significant variables in a

discriminant function that maximally

discriminates between the two sample

groups by minimising the Wilks’ � at each

step of variable entry.

5.3 Model validation, predictive accuracyand hypotheses testingThe developed model can be validated by one

of two main methods, namely by using a

holdout sample or the Lachenbruch

procedure (Jones, 1987; Hair et al., 1995). The

former method entails applying the

developed model to a new sample of

companies not used to derive the model. The

Lachenbruch procedure develops a model

from n – 1 observations, and applies it to the

observation not used in developing the

model. This is repeated until all the firms in

the sample are used to assess the model’s

accuracy. Most importantly, the

Lachenbruch method provides an unbiased

estimate of the misclassification rate (Afifi

and Clark, 1984; Jones, 1987; Hair et al., 1995).

Since the entire sample can be used for cross-

validation, this method is particularly useful

in the corporate failure setting due to the

generally small[2] sample sizes available.

Therefore, due to the suitability of the

Lachenbruch method in this context, given

the relatively small sample size that can be

used in New Zealand, it is used to

cross-validate the discriminant function.

Following on from model validation is the

important question of classification accuracy

(Hair et al., 1995). Although model validation

by the Lachenbruch method provides an

unbiased estimate of the misclassification

rate, it does not indicate how significant the

classification accuracy is compared to

chance. If the classification accuracy is

greater than what can be expected by chance,

it indicates that the developed model is useful

(Hair et al., 1995). Therefore, the significance

of the developed model’s classification

accuracy is examined by the proportional

chance criterion and Press’s Q statistic,

which are tests of the model’s accuracy

against what can be expected from a chance

model (Hair et al., 1995).

Finally, the hypotheses are tested by

comparing the developed models’ accuracy

from the Lachenbruch cross-validation

method to Altman’s Z-score bankruptcy

prediction model that is also applied to the

sample of companies used to develop the New

Zealand model. Owing to the lack of market

value information, Altman’s modified Z-

score model is used with adjusted coefficients

(Eidleman, 1995).

[ 584 ]



6. Data analysis and results

6.1 The modelThe summary discriminant analysis results

are shown in Table III. The discriminant

analysis on the sample of New Zealand

companies using the 63 independent

variables with the stepwise methodology

results in a 12 variable discriminant

function. These 12 variables coincidently

form the optimum discriminant function that

maximally discriminates between the failed

and non-failed company groups. Out of the 12

variables found to be significant (p<0.05),

only three are common to prior studies.

These are the current assets/current

liabilities, total sales/average total assets and

total liabilities/total assets ratios. The

remaining eight ratios have not been found

to be significant in previous bankruptcy

prediction research and are therefore unique

to this study.

The tolerances for the model at the final

step of variable entry are all above 0.001

indicating that the variables in the

discriminant function are not highly

dependent or correlated with other variables

in the function. The canonical correlation is

54.5 percent and 100 percent of the variance is

explained by the discriminant function. A

high Chi-square value which is statistically

significant at p<0.05 indicates that the

discriminant function classifies well.

Table IV shows the results of the Lachenbruch

cross-validation procedure. Lachenbruch

cross-validation involves developing a

discriminant function from all companies in

the sample except for one that used to validate

the function. This procedure is repeated until

all the companies in the sample have been

used as a held-out company. The Lachenbruch

classification results show that 36 percent of

non-failed companies and 92 percent of failed

companies are correctly identified. This is a

robust performance given that the function

correctly classified 38 percent and 92 percent

respectively for the original cases. The model

has a Type 1 error of only 8 percent and a Type

2 error of 64 percent. The very high accuracy

for predicting failed companies and lesser

accuracy for non-failed companies is

consistent with prior research (Mutchler,

1985; Koh and Killough, 1990; Morris, 1997).

Since Type 1 errors are argued to be the most

costly to auditors, the model’s Type 1 error

rate of only 8 percent shows its usefulness as

an analytical technique for assessing going

concern.

The tests of predictive accuracy further

show that the model’s classification accuracy

significantly exceeds what a chance model

would expect. Specifically, the model has an

overall cross-validated accuracy of 71.1

percent, when the proportional chance

criterion only expects 53.4 percent accuracy.

The Press’sQ statistic also exceeds the critical

chi-square value of 6.63 at one degree of

freedom, which indicates that the model’s

predictions is significantly better

than chance.

Table IIIDiscriminant function summary statistics

Step Entered variableUnstandardised canonical

discriminant function coefficients Wilks’ lambda (�) Tolerance at step 12 Sig.

1 Total sales/total tangible assets 3.298 0.952 0.051 0.0172 Quick assets/total assets –3.920 0.903 0.673 0.0033 Current assets/current liabilities 0.163 0.875 0.566 0.0024 Total sales/average total assets –2.671 0.847 0.051 0.0015 Net income/average total assets 5.030 0.801 0.232 0.0006 Total liabilities/total assets 3.654 0.775 0.167 0.0007 Net income/shareholders funds –0.119 0.760 0.829 0.0008 Working capital/total sales 0.023 0.746 0.936 0.0009 Sales/average accounts receivable 0.005 0.732 0.970 0.00010 Sales/average working capital –0.002 0.722 0.968 0.00011 Net income/total liabilities –0.425 0.713 0.263 0.00012 Shareholders funds/total assets 1.727 0.704 0.196 0.000

Constant –2.786

Function EigenvalueEigenvalues

Per cent of varianceCumulative per

cent Canonical correlation

1 0.421(a) 100.0 100.0 0.545

Test offunction(s) Wilks’ lambda

Wilks’ lambdaChi-square df Sig.

1 0.704 38.685 12 0.000

[ 585 ]



6.2 Altman’s Z-score modelAltman’s model was applied to the same

sample of companies used to develop the

liquidation prediction model and comprises

of five ratios, namely:

1 working capital/total assets;

2 retained earnings/total assets;

3 EBIT/total assets;

4 book value of equity/book value of debt;

and

5 sales/total assets.

The results of Altman’s Z-score model are

shown below in Table V. Altman’s model

correctly classifies company failures 41

percent of the time and correctly classifies

non-failed companies 54 percent of the time.

This results in a Type 1 error rate of 59

percent and a Type 2 error rate of 46 percent.

6.3 Hypotheses testsThe results support H1 that a liquidation

prediction model outperforms a bankruptcy

prediction model in discriminating between

liquidated and continuing companies. The

developed company failure model for New

Zealand companies was 92 percent successful

in predicting company failures compared to

Altman’s Z-score model accuracy of 41

percent.

Due to differences in debtor- and creditor-

oriented insolvency frameworks in various

countries, this finding has significant

implications on the choice of corporate

failure model that is more appropriate for

assessing going concern. Essentially, a

non-going concern in a debtor-oriented

insolvency framework has the opportunity to

reorganise and continue operations when the

same company would have been more likely

to be liquidated in a creditor-oriented

insolvency framework.

For debtor-oriented countries such as the

USA where much of the previous corporate

failure research has taken place, bankruptcy

prediction models might still be of value

since the US bankruptcy code is designed to

keep companies as going concerns (Franks

et al., 1996). A liquidation prediction model

would not be suitable in this context since

bankrupt companies can emerge from

bankruptcy as a going concern. However, for

countries where the insolvency procedures

are creditor-oriented, such as in the UK,

Germany, Australia and New Zealand,

liquidation is the more likely outcome of

insolvency (Kaiser, 1996; Franks et al., 1996).

In the latter mentioned countries, creditors

can obtain control of the company and have

the legal right to recover their debt even

Table IVLachenbruch cross-validation results

Predicted group membershipStatus 0.00 1.00 Total

OriginalCount 0.00 19 31 50

1.00 7 78 85Per cent 0.00 38.0 62.0 100.0

1.00 8.2 91.8 100.0Cross-validatedCount 0.00 18 32 50

1.00 7 78 85Per cent 0.00 36.0 64.0 100.0

1.00 8.2 91.8 100.0

Tests of predictive accuracyProportional chance criterion 0.5338Press’s Q statistic 25.785

Notes: Type 1 error: 8.2 per cent Type 2 error: 64 per cent; 71.9 per cent of original grouped cases correctlyclassified. 71.1 per cent of cross-validated grouped cases correctly classified

Table VAltman’s Z-score model accuracy

Predicted membershipActual membership Failed Non-failed Total Per cent accuracy

Non-failed 23 27 50 54Failed 35 50 85 41

Note: Type 1 error: 59 per cent Type 2 error: 46 per cent

[ 586 ]



though it results in the debtor companies’

liquidation (Kaiser, 1996; Franks et al., 1996).

This suggests that liquidation prediction

models are better proxies for assessing going

concern in countries where the insolvency

laws are creditor-oriented.

H2, that Type 1 errors are lower for the

liquidation prediction model compared to the

bankruptcy prediction model, is also

supported. It shows that the liquidation

prediction model correctly classified a failing

company 92 percent of the time compared to

Altman’s bankruptcy prediction model’s

accuracy of 41 percent. This results in a Type

1 error rate for the liquidation prediction

model of only 8 percent compared to Altman’s

Type 1 error rate of 59 percent. Given that

Type 1 errors are most expensive to auditors

(Koh, 1991; Carcello and Palmrose, 1994;

Geiger et al., 1998), it shows that the

liquidation prediction model is a better

analytical tool for the auditor for assessing

going concern.

H3 is rejected since the developed model

has a higher Type 2 error rate of 64 percent

compared to Altman’s Type 2 error rate of 46

percent. Prior bankruptcy research also

shows that corporate failure models

generally have high Type 2 errors compared

to Type 1 errors (Koh and Killough, 1990,

Morris, 1997). The liquidation prediction

model correctly classified non-failed

companies 36 percent of the time compared to

Altman’s 54 percent accuracy. This indicates

that Altman’s model is better at predicting

non-failures compared to the developed

liquidation prediction model.

The above findings substantiate the

liquidation prediction model’s accuracy over

Altman’s benchmark bankruptcy prediction

model in classifying between liquidated and

continuing companies. The liquidation

prediction model is more accurate in

predicting company liquidation with an

accuracy of 92 percent. Given the high costs

associated with misclassifying failing

companies, this suggests that the developed

model can be used as a valuable analytical

tool to assist auditors in forming the going

concern judgment.

Furthermore, the findings of this study

also raise the issue of the appropriateness of

using bankruptcy prediction models in

countries where the insolvency code is

essentially creditor oriented. In countries

such as the UK, Australia and New Zealand, a

liquidation prediction model is likely to be

more appropriate because the majority of

insolvent companies are liquidated, and not

given the opportunity of remaining as a

going concern as encouraged by the US

Chapter 11 insolvency procedures.

7. Summary and conclusions

This study developed and tested the

efficiency of a liquidation prediction model

against Altman’s benchmark bankruptcy

prediction model based on the premise that

company liquidation is a better proxy for


assumption than corporate bankruptcy. The

developed corporate liquidation model was

found to outperform Altman’s bankruptcy

prediction model in predicting company

liquidation. This finding is significant given

that Altman’s model is a proven model and

has been used to benchmark the performance

of newly developed corporate failure models

(Holmen, 1988; Eidleman, 1995). The Type 1

error of only 8 percent for the New Zealand

model is very important given the large costs

associated with not qualifying a failing

company (Koh, 1991). Furthermore, the going

concern status of a company is more likely to

be called into question for companies in

financial distress rather than for healthy

companies (Foster et al., 1998). Hence, the

New Zealand model’s accuracy of 92 percent

in classifying failed companies is especially

significant given that the model was

developed from failed and stressed

companies rather than failed and healthy

companies as used in prior studies.

Consistent with prior research, Type 2 errors

remain relatively high compared to Type 1

errors (Mutchler 1985; Koh and Killough,

1990; Morris, 1997).

This research therefore shows that a

company liquidation model can be used as a

valuable audit tool in assessing going

concern due to its very high accuracy with

low Type 1 errors. Given the argument that

company liquidation is a more appropriate

proxy for a company’s non-going concern

status, this finding is especially important.

As a result, future research should be

directed at assessing the efficiency of

corporate liquidation prediction models as

an analytical tool for auditors. This line of

research is useful given that bankruptcy

prediction models developed in countries

where the insolvency law is debtor-oriented

may not be appropriate for countries where

the insolvency laws are essentially creditor-

oriented, such as in the UK, Australia and

New Zealand.

Furthermore, previous research has made

inferences between auditor accuracy and

statistical models’ accuracy based on prior

audit opinions. Future research should more

actively seek to address how useful are

statistical corporate failure models for

auditors in the actual decision-making

environment and in different insolvency

[ 587 ]



frameworks, which have not been addressed

in prior accounting and auditing research.

Notes1 The most common definition of company

failure used in prior accounting research is

filing for bankruptcy. Other definitions of

corporate failure in accounting research

include large losses disproportionate to assets,

stock exchange delisting, companies in the

process of liquidation or receivership, an

arrangement with creditors, failure to pay

annual listing fees, negative stock returns and

the receipt of a going concern qualification

(Taffler, 1982; Mutchler, 1985; Cormier et al.,

1995; Zhang and Harrold, 1997; Nasir et al.,

2000).

2 For example, Grant et al. (1998) developed

their model using 17 bankrupt companies and

validated it by using 15 companies. Lau (1987)

also used a very small sample size of 15

companies.

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Further readingAmerican Institute of Certified Public

Accountants (1988), Analytical Procedures,

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Accountants. (1978), Commission on Auditors’

[ 589 ]



Responsibilities: Report Conclusions and

Recommendations, AICPA, New York, NY.


Accountants (1988), The Auditor’s

Consideration of an Entity’s Ability to

Continue as a Going Concern, Statement on

Auditing Standards No. 59, AICPA,

New York, NY.

Australian Accounting Research Foundation

(1999), Analytical Procedures, ASB Auditing

Standard AUS 512, Prentice Hall, Sydney.

Australian Accounting Research Foundation

(1999), Going Concern, ASB Auditing

Standard AUS 708, Prentice Hall, Sydney.

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Concern Basis in Financial Statements,

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London.

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debt restructurings: some recent evidence’’,

Financial Management, Vol. 26 No. 4, pp. 56-68.

Institute of Chartered Accountants of New

Zealand (1998), Analytical Procedures,

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Wellington.

Institute of Chartered Accountants of New

Zealand (1998), Going Concern, Auditing

Standard No. 520, ICANZ, Wellington.

[ 590 ]



Are auditors sensitive enough to fraud?

Bilal MakkawiMorgan State University, Baltimore, Maryland, USAAllen SchickMorgan State University, Baltimore, Maryland, USA

Auditors are caught on the horns of a

dilemma. On one horn they are asked to do

everything possible to prevent material

financial statement fraud. On the other horn

hangs the reality that auditing is a

competitive business, subject to the same

demands for profitability and the return on

capital as other businesses. These economic

demands create a conflict for auditors by

constraining their ability to detect fraud.

What then do auditors do when faced with

the increased possibility of fraudulent

financial reporting? That is the issue

examined in this article, the impetus for

which was the issuance of Statement on

Auditing Standards No. 82 (SAS No. 82),

‘‘Consideration of fraud in a financial

statement audit’’ (AICPA, 1997). This

statement describes fraud and its

characteristics, indicates conditions under

which fraud is more likely to occur, and

requires the auditor to make an assessment

of the risk of material misstatement due to

fraud. The issue of how independent auditors

respond to an increased likelihood of

financial statement fraud is important for

two reasons. First, fraud induced material

misstatements can have a substantial

negative financial impact on users of

financial information and the capital market

system as a whole. Evidence of this impact is

indicated by the current confidence crisis of

investors over the credibility of financial

reporting. Second, it reinforces the role of

auditors in society to provide reasonable

assurance about the reliability and

dependability of financial information. The

role of an audit and auditors is to reduce the

information risk associated with financial

statements.

Fraudulent financial reporting

Material misstatements, whether caused by

fraud (intentional) or error (unintentional),

can have a substantial negative impact on

shareholders’ wealth as illustrated by the

accounting problems associated with

companies like Enron and Rite Aid. These

companies had reported rapidly growing

revenues and earnings, with a corresponding

increase in stock prices. Unfortunately, this

picture of growth was inaccurate. Instead,

these companies were found to have applied

generally accepted accounting principles

inappropriately, resulting in a massive

overstatement of income. For example,

Enron recorded unrealized trading gains on

long-term futures contracts for which there

were no market prices upon which to base

valuations. Essentially, Enron made up the

prices and recognized fictitious gains. These

fictitious gains accounted for more than half

of their $1.41 billion reported pretax income

for the year 2000 (Thomas, 2002). In the case of

Rite Aid, senior management engaged in a

host of accounting trickery to manufacture

imaginary sales and other revenues and

pump up earnings. One such trick was not to

write down assets acquired as part of an

overly ambitious expansion of their drug

store chain that did not work out. Another

accounting trick used to increase income was

to inflate the dollar value of damaged and

outdated goods in order to receive a larger

credit from vendors than appropriate. The

result of all the accumulated accounting

fraud was a $1.6 billion restatement of net

income for the late 1990s, one of the largest

corporate earnings restatement ever

(Barrett, 1999; Kilman, 2002).

When the magnitude of these accounting

irregularities and the length of time over

which they occurred became known, the

companies’ stock prices dropped

significantly. What made matters even

worse, and what could have significant

implications for the accounting profession, is

that their independent auditors either

attested to, in the case of Enron, or failed to

recognize and/or call attention to, in the case





[ 591 ]



KeywordsAuditing, Fraud,

Corporate governance, Auditors

AbstractThis study investigates how

auditors alter their audit program

decisions in response to an

increased likelihood of fraud risk.

A total of 48 auditors from one Big

5 CPA firm were surveyed

regarding the type of audit

procedures they would use in

response to an increased

likelihood of material

misstatements caused by fraud.

The auditors were provided with a

scenario that reflected changes in

economic and industry factors

that increase audit risk and

typically require a reevaluation of

the audit program. They were

asked to make choices as to

which tests of balances and

details and analytical procedures

to perform. The results of the

study are summarized and

tabulated and then explained in

terms of the tradeoff between

effectiveness and efficiency and

corporate governance.

of Rite Aid, the erroneous accounting

numbers and the associated inaccurate

financial picture of these companies. In

short, the financial statements of both these

companies were materially misstated.

Of interest in this paper is the way auditors

respond to the increased likelihood of

material misstatements caused by fraud.

Since fraudulent financial reporting is

mainly committed by management, fraud

undermines the integrity of management and

its representations. According to SAS No. 82,

there are two types of fraud. The first is

fraudulent financial reporting. In general

terms, fraudulent financial reporting occurs

when, for example, firms intentionally take

actions to overstate assets and revenues and

understate liabilities and expenses. The

second type of fraud relates to

misappropriation of assets, which is a nice

way of saying that assets are being stolen

from the company.

Pressures for fraudulent financialreporting

One important factor that might induce

companies to commit fraud is the increased

institutional stock ownership of many

companies. Institutional competition for

investors’ monies and the increasing number

of financial publications reporting

short-term returns have made short-term

performance a priority for financial

institutions. In turn, this emphasis on

short-term performance has increased the

pressure on companies to meet investors’

expectations concerning revenue and

earnings growth. Further, this pressure is

exacerbated when there also is substantial

insider stock ownership or executive

compensation tied to stock market

performance. Failure to meet these

expectations can result in a substantial

decline in a company’s stock price (e.g.

Lucent Technology, Intel, and Apple

Computer). As a result, companies that

cannot meet these expectations through

legitimate business operations instead may

seek to do so through fraudulent financial

reporting.

Conduct of the study

To satisfy our curiosity, we surveyed 48

auditors from one of the ‘‘Big Five’’ CPA

firms regarding their choice of auditing

procedures in response to an increased

likelihood of fraudulent financial reporting.

Following the recommendation of

Abdolmohammadi (1999) that the minimum

staff level required to perform various

orientation tasks leading to the audit plan is

the rank of senior, we included only senior

auditors in the study. Contact partners from

two offices of the firm assisted us in

collecting data from practicing auditors in

their offices. The data were responses to a

case study (see Appendix) distributed to 70

senior auditors attending a continuing

professional education seminar. Auditors

were asked to complete the task, explained

below, in their own time. In total, 48

responses were returned to the contact

partners for a response rate of 69 percent. On

average, the subjects had 3.2 years of

experience with 1.16 standard deviations

(range: 1.8-7.0 years).

The case study used described a medium

size manufacturing company in the

semiconductor industry, along with a

summary of the company’s past financial

performance, an outlook for the company’s

future, and the future of the industry and the

economy. The case study indicated that there

had been a boom in the semiconductor

industry for the past five years, but that now

a slowdown was occurring. The slowdown

also was accompanied by a dramatic

decrease in the company’s stock price and

earnings.

In order to enhance the auditors’

understanding of the study, they were told

that SAS No. 82 (AICPA, 1997) requires the

auditors to assess the risk of material

misstatement due to fraud, including fraud

relating to financial reporting and

misapplication of accounting principles. The

auditors then were given a list of the

analytical review procedures and tests of

balances and details performed last year. The

auditors’ task was to indicate the changes, if

any, in this year’s analytical review

procedures and tests of balances and details

as applied to an audit of the inventory and

production cycle. The inventory and

production cycle was selected as the context

for the auditors’ task, since asset

overstatements often involve inventory

overstatements. After reviewing the above

information, the subjects were asked to

indicate which two analytical review

procedures and which two tests of balances

and details procedures they would increase

and/or decrease, if any, compared to last

year. They also were given the opportunity to

choose their own procedures.

Results

The results of the study indicate the

following four points:

[ 592 ]

Bilal Makkawi andAllen SchickAre auditors sensitive enoughto fraud?


1 All auditors increased the performance of

certain procedures.

2 Some auditors chose not to reduce any

procedures.

3 A consensus existed onwhich procedures to

increase both for the analytical review

procedures and tests of balances and

details.

4 There was less agreement on which

procedures to reduce for those auditors

who chose to reduce some procedures.

This was the case for both the analytical

review procedures and tests of balances

and details.

Table I presents the number of auditors and

their planned increase and decrease of the

analytical review procedures. The table

shows a clear preference for two analytical

review procedures: first, the further

investigation of unusual fluctuations, and

second, comparison of inventory turnover

and number of days’ sales in ending

inventory. Table II presents the number of

auditors and their planned increase and

decrease of the tests of balances and details

procedures. The auditors seemed to agree

that more work should be placed first, in

testing for slow moving items, and second,

comparing carrying cost to market values.

Conversely, auditors exhibit less of a

consensus regarding the performance of a

specific procedure.

Discussion

These results indicate that auditors

emphasize effectiveness over efficiency with

respect to the performance of audit

procedures. The greater consensus among

auditors on the additional procedures to

perform is indicative of an effort to ‘‘cover all

the bases’’ in attempting to increase the

effectiveness of an audit and reduce the

potential for material misstatement. Since

the accounting profession almost

unanimously agrees on the importance of

reducing audit risk, our auditor subjects

almost seemed programmed to do more, not

less. Indeed, the results are reasonable, since

auditors are taught to be risk averse and,

consequently, trained more to reduce audit

risk than to conduct an efficient audit.

Nevertheless, in a world of cost and price

pressures, a lack of clarity about what are

redundant procedures becomes an important

issue for the profitability of the auditing

firm. When auditors are taught that the way

to reduce audit risk is by doing more work, it

should come as no surprise that our auditors

disagree on what procedures to eliminate in

auditing the inventory and production cycle.

No consensus exists on the relevant

significance and value of each auditing

procedure in the evaluation of audit risk and

the risk of material misstatement caused

by fraud.

Audit fees, however, are no longer

determined by the amount of work auditors

do. In the past if auditors did more work, they

got paid more. Today the fixed fee

environment limits the amount of work that

auditors are inclined to do by limiting the

fees clients are willing to pay. Thus, auditors

no longer can sustain profitability by doing

more work. Instead, the fixed fee

environment requires auditors to ‘‘audit

smarter’’.

‘‘Auditing smarter’’ means that auditors

have to achieve a greater balance between

effectiveness and efficiency. Movement

towards this balance can be fostered in two

ways. First, auditors should have a greater

awareness of the context in which the audit

takes place. Recent evidence (Beasley, 1996;

Table IAnalytical review procedures

No. Procedures Increase Decrease

1 The relationship of purchases to usage reports and production costs wascompared for both years for consistency. Any unusual deviation was examined

2 Investigation of unusual fluctuations (more than 10 per cent annually) 263 Consideration of the reasonableness of the cost of sales by multiplying units sold

by average cost per product line 24 Comparisons of inventory turnover and number of days’ sales in ending inventory 165 Comparisons of microprocessor inventory by type 4 76 Comparisons of inventory shrinkages 87 Comparisons of scrap and stock out report8 Analysis of purchase commitments for motherboard parts (i.e. hard drive, floppy,

and microprocessors on computer base) 6 89 Analysis of production performance report 610 Analysis of rework reports 1211 Inspection of large purchases near year-end 1 2

[ 593 ]



Beasley et al., 2000) not only has indicated

that financial statement fraud is

concentrated in selective industries, but also

that the nature of financial fraud differs by

industry. For example, revenue

overstatements were found to be prevalent in

the technology industry, whereas asset

overstatements occurred more in the

financial services industry. This suggests the

need to consider the industry, when

identifying the high potential areas for

fraudulent financial reporting.

In addition, corporate governance

mechanisms have been linked to financial

statement fraud (Beasley, 1996; Beasley et al.,

2000). Specifically, fraudulent financial

reporting occurred more for companies with

fewer audit committees, fewer audit

committees composed entirely of outside

directors, fewer audit committee meetings,

fewer board of directors with a majority of

outside members and where internal audit

functions were not performed. Hence,

understanding the corporate governance

structure is becoming imperative.

The second way to move towards a better

effectiveness-efficiency balance is to develop

in auditors a greater understanding of the

relationship of audit procedures to the

different audit objectives and the greater

likelihood of certain kinds of accounting

fraud in specific industries. This

understanding can be achieved by issuing

more explicit auditing standards that specify

the types of audit procedures best suited to

detect fraudulent financial reporting in these

industries. Additional training should be

directed towards making auditors pay more

attention to a company’s industry and its

corporate governance structure. When

training is coupled with a more explicit

delineation of audit procedures to use in

assessing the possibility of fraudulent

financial reporting, managing the

effectiveness-efficiency tradeoff is enhanced.

Finally, it is difficult to argue against the

premise that top management is responsible

for the occurrence of financial reporting

fraud. This suggests that auditors need to be

more skeptical of management

representations and more aggressive in

assessing their integrity. Questions about

such topics as performance pressures,

compensation, personal or financial

hardships, lifestyle and the degree of

managerial domination by a strong

personality should be asked of management.

Greater skepticism and a better assessment

of management integrity can lead to a more

effective and efficient audit.

Auditors are caught on the horns of a

dilemma. They need to be sensitive to the

conditions under which fraudulent financial

reporting may flourish and be effective in

recognizing the occurrence of those

conditions. At the same time they also need

to be attuned to the financial constraints

under which they operate. The proposed

suggestions may aid auditors in striking

Table IIChanges to tests of balances and details procedures

No. Procedures Increase Decrease

1 Observed client’s team measure, weigh, and count inventory2 Performed test counts and mathematical computations to confirm client’s counting 23 For a sample of purchase orders:

a Tested for mathematical accuracyb Agreed details to receiving documents

4 Confirmations were sent for inventory on consignment 135 Inventory tags were observed and tested to determine that all tags used for the

physical count and only those tags are included in physical inventory summaries 86 Selected a representative sample of receiving documents for a few days before

and subsequent to year-end, and performed cutoff tests to ensure thattransactions were recorded properly, including accounts, amounts, and period 6 2

7 Reviewed and tested procedures for slow moving items 268 Traced inventory totals from trial balance to subsidiary ledgers and verified

agreement of details by product to general ledger total 119 Reviewed largest purchase returns10 Obtained purchase transactions listing and traced monthly totals to general

ledger:a Tested mathematical accuracyb Investigated large and unusual amounts

4 8

11 Reviewed terms governing passage of title and freight terms, to ensure that onlyvalid purchases have been booked 5

12 Compared carrying cost to market values 28

[ 594 ]



more of a balance between effectiveness and

efficiency.

ReferencesAbdolmohammadi, M.J. (1999), ‘‘A comprehensive

taxonomy of audit task structure,

professional rank, and decision aids for

behavioral research’’, Behavioral Research in

Accounting, Vol. 11, pp. 51-92.

AICPA (1997), Statement on Auditing Standards

No. 82: Consideration of Fraud in a Financial

Statement Audit, American Institute of

Certified Public Accountants, New York, NY.

Barrett, A. (1999), ‘‘Rite Aid hasn’t treated its real

ills’’, Business Week, 1 November, p. 46.

Beasley, M.S. (1996), ‘‘An empirical

investigation of the relation between board of

director composition and financial statement

fraud’’, The Accounting Review, October,

pp. 443-65.

Beasley, M.S., Carcello, J.V., Hermanson, D.R.

and Lapides, P.D. (2000), ‘‘Fraudulent

financial reporting: consideration of industry

traits and corporate governance

mechanisms’’, Accounting Horizons,

December, pp. 441-55.

Kilman, S. (2002), ‘‘Rite Aid ex-officials charged in

accounting – fraud probe’’, The Wall Street

Journal, 24 June, p. A2.

Thomas, C.W. (2002), ‘‘The rise and fall of Enron’’,

Journal of Accountancy, April, pp. 41-52.

Appendix

Case used in the experimentThis exercise investigates audit-planning

decisions in the production/inventory cycle.

The questionnaire relates to your assessment

of audit risk at both the financial statement

level and account/cycle level. It also deals

with your planned audit program with

respect to the nature, timing, and extent of

audit procedures. There are no right or

wrong answers to the questions and there is

no time limit.

Please work independently and answer all

the questions to the best of your ability given

the information provided to you. In order to

maintain confidentiality of your responses,

only summary results will be released. After

completing the questionnaire, return the

instrument in the enclosed envelope to your

firm’s human resource director.

American Microchip CorporationYour firm has been the auditor of American

Microchip Corporation for the past five

years. American Microchip Corporation

received an unqualified opinion last year. It

is 15 July 19x2, you are the senior auditor on

the job, and this is your first year. You are to

recommend/prepare the client’s 19x2

detailed audit plan for the inventory/

production cycle as part of the overall audit

program. This includes assessing the risk of

material misstatements at the financial

statement level as well as at the cycle level

and determining the nature, timing, and

extent of audit procedures for the inventory/

production cycle.

History of client and industryAmerican Microchip Corporation, a medium-

sized calendar-year corporation,

manufactures and markets semiconductor

components, microprocessors, board-level

and system-level products used in the

computer, telecommunications, and office

automation industries. The major products

(more than 50 percent of total production) are

high speed microprocessors targeted for

business use and the 4 and 16Mb D-RAMs

(dynamic random access memory), and S-

RAMs (static random access memory).

The semiconductor industry is cyclical and

is affected by changes in economic

conditions. The moderate growth in the

economy for the past five years along with

continual technological innovation and a

boom in personal computers provided a

steadily increasing and profitable

environment for the semiconductor industry

(a 25 percent average annual increase in

earnings).

The boom in personal computers in the

past five years has created strong demand for

microprocessors, D-RAMs, and S-RAMs. To

meet this demand, manufacturers of

semiconductors expanded capacity

aggressively. Currently, it appears that

supply is catching up and might be exceeding

demand in the next year. The book to bill

ratio (the ratio of dollar value of orders

placed to orders delivered, a measure of

strength of demand) has fallen below one for

the first time in five years suggesting that

supply has finally caught up with demand.

Initially, the excess demand created strong

support for memory chip prices and for a

profitable semiconductor industry. As the

imbalance in demand shifts, memory chip

prices are expected to fall rapidly.

This potential imbalance has taken its toll

on the semiconductor industry. Stock prices

have dropped dramatically reflecting the

downward pressure on the price of memory

chips. In addition, the economy seems to be

slowing down with an estimated increase in

gross domestic product of about 2 percent as

compared to about 3 percent for the past five

years. The slow-down in economic activity

affects the demand for durable goods such as

computers, which in turn affects the demand

[ 595 ]



for memory chips, thus putting more price

pressure on memory chips and decreasing

overall profitability of the industry.

Professional standards require the

auditor to evaluate the risk of material

misstatements at the financial statement

level (the risk that is inherent to the

financial statements as a whole) and

the audit risk at the cycle level as part

of the initial planning of the audit program.

In evaluating risk, the auditor considers,

first, general risk factors relating to

the engagement as a whole such as industry

risk, second, overall materiality

and financial factors, and third, control

risk.

More recent auditing pronouncements

require the auditor to assess the risk of

material misstatements due to fraud. One

type of fraud relates to financial reporting,

such as the intentional misapplication of

accounting principles. The misapplication of

Table AI

[ 596 ]



accounting principles might result in over

valuation of assets such as inventory or miss

classification of liabilities.

Additional informationAmerican Microchip’s earnings for the past

three quarters have fallen below analysts’

forecasts. The primary cause has been the

drop in market value of inventory and the

consequent need for an unexpected inventory

write-down. This write-down has been

triggered by the speed by which faster and

more efficient microprocessors are being

introduced, rendering the old

microprocessors technologically obsolete.

This year American Microchip

overstocked on many D-RAMs, S-RAMs and

other purchased parts hoping for a recovery

of the personal computer market. The

recovery never materialized and a write-

down of overstocked parts was required.

The following analytical review

procedures were performed last year.

Discrepancies and unusual variations from

the prior year were discussed with

management and resolved to the auditor’s

satisfaction. The majority of the procedures

consisted of comparisons of financial

information with the prior year’s financial

information, and with comparable industry

financial information and ratios. Specific

procedures performed included:

1 The relationship of purchases to usage

reports and production costs was compared

for both years for consistency. Any

unusual deviation was examined.

2 Investigation of unusual fluctuations

(more than 10 percent annually) for

a. Cost of sales by product.

b. Gross margins by product.

c. Cost of sales for month prior to and

month following the year-end.

d. Purchase returns as a percentage of

purchases.

e. Cost of sales percentage breakdown

(labor vs material).

f. Variances in production reports

(standard cost and standard freight).

g. Comparison of ending inventory of

finished goods to sales budgets.

h. Comparison of the ending balance of

raw material to budgeted production.

i. Ratio of write down to total inventory.

3 Consideration of the reasonableness of the

cost of sales by multiplying units sold by

average cost per product line.

4 Comparisons of inventory turnover and

number of days’ sales in ending inventory.

5 Comparisons of microprocessor inventory

by type.

6 Comparisons of inventory shrinkages.

7 Comparisons of scrap and stock out report.

Table AII

[ 597 ]



8 Analysis of purchase commitments for

motherboard parts.

9 Analysis of production performance

report.

10 Analysis of rework reports.

11 Inspection of large purchases near year-

end.

The majority of tests of balances and details

performed last year consisted of inspection of

assets, vouching, re-performance and

observation. Specific procedures performed

included:

1 Observed client’s team measure, weigh,

and count inventory.

2 Performed test counts and mathematical

computations to confirm client’s counting.

3 For a sample of purchase orders:

a. Tested for mathematical accuracy.

b. Agreed details to receiving documents.

c. Agreed purchase price to authorized

purchase order.

d. Traced to supplier payable account.

4 Confirmations were sent for inventory on

consignment.

5 Inventory tags were observed and tested to

determine that all tags used for the

physical count and only those tags are

included in physical inventory summaries.

6 Selected a representative sample of

receiving documents for a few days before

and subsequent to year-end, and performed

cutoff tests to ensure that transactions

were recorded properly, including

accounts, amounts, and period.

7 Reviewed and tested procedures for slow

moving items.

8 Traced inventory totals from trial balance

to subsidiary ledgers and verified

agreement of details by product to general

ledger total.

9 Reviewed largest purchase returns.

10 Obtained purchase transactions listing

and traced monthly totals to general

ledger:

a) Tested mathematical accuracy.

b) Investigated large and unusual

amounts.

11 Compared carrying cost to market values.

12 Reviewed terms governing passage of title

and freight terms, to ensure that only

valid purchases have been booked.

Please answer the following questions tothe best of your knowledgeDo you expect to change the type of analytical

review procedures performed this year as

compared to last year?

Yes No

If yes, list the two procedures that you will

decrease the most, if any.

1 __________________ 2 ___________________

List the two procedures you will increase

the most, if any.

1 __________________ 2 ___________________

Do you expect to change the type of tests of

balances and details performed this year as

compared to last year?

Yes No

If yes, list the two procedures that you will

decrease the most, if any.

1 __________________ 2 ___________________

List the two procedures you will increase

the most, if any.

1 __________________ 2 __________________

[ 598 ]



Users’ perceptions of various aspects of Kuwaiticorporate reporting

Kamal NaserCardiff Business School, University of Wales, Cardiff, UKRana NuseibehCardiff Business School, University of Wales, UKAhmad Al-HussainiPublic Authority for Applied Education and Training, Kuwait

Introduction

The perception of various user groups of

corporate annual reports has been

investigated in a number of studies (see for

example, Lee and Tweedie, 1975a, b; 1976;

1981; Briggs, 1975; Epstein, 1975; Chang and

Most, 1977, 1985; Chenhall and Juchau, 1977;

Wilton and Tabb, 1978; Winfield, 1978;

Anderson, 1981; Arnold and Moizer, 1984;

Day, 1986; Gniewosz, 1990; Wallace, 1988;

Epstein and Pava, 1993; Streuly, 1994;

Anderson and Epstein, 1995; Bence et al.,

1995; Bartlett and Chandler, 1997). The vast

majority of these studies, however, have

covered developed economies. Little

reference has been made in the literature to

the developing countries in general and to

the Gulf Co-operation Council (GCC)

countries, in particular. Although the GCC

countries are classified as emerging

economies, huge returns from oil revenues

make them major economies.

The main purpose of this study is to

explore the perception of various user groups

of financial information about corporate

annual reporting in Kuwait. Although the

Kuwaiti economy is classified as an emerging

one, the country hosts a developed banking

sector and one of the oldest stock exchanges

in the region. More importantly, the Kuwaiti

companies adopt the International

Accounting Standards (IASs). Hence,

exploring the opinion of Kuwaiti user groups

about the various aspects of corporate annual

reports will undoubtedly add a new

dimension to the literature.

Financial reporting system inKuwait

Kuwait is one of the major oil exporting

countries in the world. As in other GCC

countries, oil revenues account for more than

95 per cent of the Kuwaiti exports. Kuwait

hosts the oldest and most developed stock

exchange in the Arab Gulf region. According

to the Investors Guide of the Kuwaiti Stock

Exchange (2000), 86 companies listed on the

exchange with market capitalisation

exceeding US$4 billion. Kuwait also hosts one

of the most developed banking sectors in the

region that accounts for more than 30 per

cent of the stock market’s capitalisation.

The requirements of corporate reporting in

Kuwait are influenced by the International

Accounting Standards (IASs) and the listing

requirements of the Kuwaiti Stock Exchange

(KSE). In April 1990, the Ministry of Trade

and Industry issued directive No. 18,

requesting all companies operating in

Kuwait to comply with the international

accounting standards (IASs) effective

1 January 1991. The ministerial order

indicated that the implementation of the

International Accounting Standards should

not contradict national regulations. This

order overrode a previous ministerial

decision and referred to the accounting

principles that ought to be used when

preparing final financial statements, No. 4 for

the year 1987. In the same order, the Ministry

of Trade and Industry asked for the

formation of a permanent technical

committee that would be given the

responsibility of identifying international

accounting standards to be adopted by the

Kuwaiti companies. The technical committee

was also assigned the responsibility of

looking at the national accounting standards

that cannot be replaced by the IASs and

recommend their adoption.

In addition to the IASs, companies listed on

the Kuwaiti Stock Exchange (KSE) should

comply with its requirements. The KSE has

managed to establish regulations for Kuwaiti

shareholding companies listed on the





[ 599 ]



KeywordsCorporate finances,

Corporate communications,

Reports, Kuwait

AbstractIn this study an attempt is made to

provide empirical evidence on the

usefulness of different aspects of

the annual report to various

Kuwaiti user groups. To do so,

eight Kuwaiti user groups were

surveyed through a questionnaire.

The groups were individual

investors; institutional investors,

bank credit officers, government

officials, financial analysts,

academics, auditors and stock

market brokers. The analyses

indicate that the user groups

surveyed in the study rely mainly

on information made directly

available by the company and do

not consult intermediary sources

of corporate information in order

to make informative decisions.

The analyses also revealed that

credibility and timeliness are the

most important features of useful

corporate information and

traditional financial statements

are the most important and

credible parts of corporate annual

reports. Non-financial information,

however, proved to be less

credible and of less importance to

the Kuwaiti user groups.

market, and to follow up on their financial

positions periodically by binding them to

submit annual or bi-annual financial

statements. Since the beginning of 1998,

companies have been required to submit

financial statements every three months, as

is the case in international stock markets.

Previous studies and studyquestions

User groups’ primary sources ofinformationIn general, corporate information user

groups refer to different sources of

information to assist them in making

informative decisions about a company.

Previous studies pointed to a number of

possible sources of corporate information.

The annual report, however, is documented

in a significant number of studies as the most

important source of corporate information

frequently used by various users in many

countries (see for example Arnold and

Moizer, 1984; Abu-Nassar and Rutherford,

1996; Bence et al., 1995; Briggs, 1975; Chang

and Most, 1985; Day, 1986; Mautz, 1968; Moizer

and Arnold, 1984; Streuly, 1994). In addition

to the annual report, financial press reports,

newspapers and magazines were reported

among the important sources of information

to the users of corporate information in a

number of studies (Anderson and Epstein,

1995; Bartlett and Chandler, 1997; Chang and

Most, 1977; Lee and Tweedie, 1975a, b;

Winfield, 1978). Other studies referred to

stockbrokers’ advice as an important source

of information to the users (Anderson, 1981;

Anderson and Epstein, 1995; Chang and Most,

1977; Chenhall and Juchau, 1977; Epstein and

Pava, 1993; Winfield, 1978). A further source

of corporate information that appeared in the

Bence et al. (1995) study is paying the

company a visit or holding interviews with

company officials.

It was, therefore, important to investigate

the most important sources of information

used by various Kuwaiti user groups by

asking the following research question (RQ).

RQ1. What are the sources of corporate

information used by the various

Kuwaiti user groups?

Characteristics of useful corporateinformationTextbooks in accounting associate the

usefulness of corporate information with

characteristics such as timeliness,

availability of specific information,

understandability, neutrality, credibility,

easy access to sources of information, and

independent verification. Consequently, the

study seeks the various users’ rating of

elements that form criteria for useful

corporate information.

RQ2. What are the perceptions of various

user groups of the characteristics of

useful corporate information?

The usefulness of the annual reportSterling (1972) indicated that the objective of

financial reporting is to provide useful

information to the users. Zairi and Letza

(1994) concluded that the purpose of the

annual report is to convey information,

which is useful to those who have an active

interest in the organisations, mainly

shareholders. Various Kuwaiti user groups

were asked to indicate how the annual report

could be useful.

RQ3. What are the perceptions of the

various user groups of how the

annual report can be useful?

Understandability, credibility, importanceand timeliness of different parts of theannual reportUnderstandabilityFor corporate information to be useful, it

should be presented in an understandable

manner. This reality was emphasised by

Buzby (1974), who demonstrated that the

annual report could be adequate and

readable if the information contained in it is

presented in an understandable manner and

grouped and organised appropriately.

Similarly, Wolk et al. (1992) contended that

even if users of annual reports are assumed

to be knowledgeable, the information itself

could have different degrees of

comprehensibility. Hence, the quality of

understandability is a characteristic

influenced by both users and preparers of

annual reports. Thus, the notion of

understandability is of great concern to users

of annual financial statements. It was,

therefore, important to investigate to what

extent different Kuwaiti users of the annual

report understand the information contained

in annual financial reports.


various user groups regarding the

understandability of information

contained in the annual report?

CredibilityAnother important characteristic of useful

corporate information used in accounting

textbooks is credibility. Credibility is viewed

as an important characteristic of corporate

information sources. Hence, the following

research question was put to the various

users of corporate information in Kuwait to

express the degree of credibility that they

[ 600 ]

Kamal Naser, Rana Nuseibehand Ahmad Al-HussainiUsers’ perceptions of variousaspects of Kuwaiti corporatereporting


attach to different sections of the annual

report.



credibility of different parts of the

annual report?

ImportanceThe annual report contains various sections

that provide user groups with information to

facilitate their decisions. To ensure that the

corporate message is communicated to

various users of corporate information, the

company makes every effort to ensure a

correct selection of information (Neimark,

1992). Generally speaking, information

contained in the annual report can be divided

into two main parts. The first part comprises

the chairman’s and directors’ reports. The

second part contains the main financial

statements, which include the balance sheet,

profit and loss account, cash flow statement,

auditor’s report, and notes to the financial

statements. The income statement and the

balance sheet are generally viewed as the

most important sections of the corporate

annual report. They are also the most

commonly used by investors in the

investment decision-making process (Epstein

and Anderson, 1994; Berry and Waring, 1995).

At present, the importance of the cash flow

statement is increasing, while the profit and

loss account is being regarded as less

significant (Epstein and Pava, 1994). On the

other hand, the importance of the

non-financial statement is derived from the

information that is included. This

information is mainly non-quantitative, and

normally includes a review of the year’s

operations, important projects, news of

recent developments, and progress of the

company within the prevalent economic,

social and political environments (Lee and

Tweedie, 1981). This information, contained

in the two main parts of the annual report, is

important to investors in their investment

decisions. It is, therefore, important to ask

the various groups of investors about their

perception of the importance of different

sections of the annual report.


user groups regarding the

importance of different parts of the

annual report?

TimelinessThe usefulness of information disclosed by a

company is measured, among other things,

by its relevance. Outdated information is

irrelevant and could lead to incorrect

decisions. For the corporate information to

be relevant, it must be available to

decision-makers before it loses its capacity to

influence their decisions. Barton (1982) and

Solomons (1989) indicated that timeliness of

information is one of the main aspects of

relevance. In this respect, Davies and

Whittered (1980) concluded that timeliness is

a necessary condition to be satisfied, if

financial statements are to be useful. It is,

therefore, important to ask the various

groups of investors about their perceptions

regarding the timeliness of annual financial

information.


various Kuwaiti user groups

regarding the timeliness of the

corporate annual report?

The importance of different itemdisclosures requested by the IASsIn 1991, Kuwait adopted the IASs. It was,

therefore, important to identify the

importance that the Kuwaiti user groups

attach to a number of information items

requested by the standards.


user groups regarding the

importance of various disclosure

items required by IASs?

The importance of different items ofvoluntary disclosuresIn addition to the information requested by

the IASs, the annual reports published by the

Kuwaiti companies contain voluntary

disclosure items. While some of the items

form important information to the users,

others tend to be less important. It was,

therefore, important to ask the respondents

to rate the importance of a list of possible

voluntary disclosed items.



importance of disclosure items

voluntarily disclosed by Kuwaiti

companies?

Study instrument

To provide empirical evidence on the above

discussed research questions, data were

collected by a survey questionnaire in the

period between March and May 2000. Unlike

previous studies where a limited number of

user groups were surveyed, eight user groups

were targeted in this study: institutional

investors, individual investors, financial

analysts, bank loan officers, government

officials, auditors and stock market brokers.

The choice of the target groups was

influenced by the literature. In addition, the

target groups are expected to use the annual

report on a regular basis and hence to

[ 601 ]



exercise a certain degree of knowledge and

experience to complete the questionnaire.

The target groups were asked to indicate

their opinion on a five-point scale in terms of

strongly agree to strongly disagree or very

important or not important at all.

An early draft of the questionnaire was

piloted by a number of Kuwaiti and Arab

research students at the Cardiff Business

School. Based on the feedback from these

students, it was evident that some of the

students were not familiar with some issues

contained in the questionnaire. Proper

explanations of the issues they raised were

given in the questionnaire.

The questionnaire was administered to the

target groups. Details of the number of

questionnaires that were distributed, the

number of returned questionnaires, the

response rate for each group and the overall

response rate are presented in Table I.

To generalise the results of the

questionnaire and measure its internal

consistency, a non-response bias analysis

and Cronbach’s Alpha test were conducted.

Early responses were compared with late

responses to identify possible non-response

bias[1]. After conducting the Mann-Whitney

U test, minor but insignificant difference

were reported between the two groups.

Internal consistency among various sections

of the questionnaire was tested by measuring

Cronbach’s Alpha[2]. The result of the test

showed that Alpha ranged between 0.82 and

0.85. While there is no acceptable level of

significance of Alpha in the literature, Huck

and Cormier (1996) indicated that 0.70 is an

acceptable level. Botosan (1997), however,

indicated that 0.80 or more is preferable.

Findings

Profile of user groupsUser groups who took part in the survey were

asked to give information about their age,

level of education, latest academic degree

obtained, place from which the latest

academic degrees obtained, specialisation

and years of experience. The average age of

the respondents was 34 years and 84 per cent

of them indicated that they hold a bachelor

degree or more. While 62 per cent of the

participants showed that they completed the

latest academic degree in Kuwait and other

Arab countries, 35 per cent revealed that they

got their degrees in the USA and the UK.

Around 85 per cent of the participants

indicated that they completed a degree in

business related areas. The vast majority of

the respondents (70 per cent) showed that

they have more than six years of working

experience.

Importance of various sources of corporateinformationVarious user groups who took part in the

study were asked to indicate the importance

that they attach to different sources of

corporate information and the results are

reported in Table II. At the whole sample

level, the table demonstrated that the

respondents ranked the annual report as the

first source of information, followed by

information directly obtained from the

company and specialist advice. As for the

individual user groups, however, five out of

the eight user groups (institutional investors,

government officials, financial analysts,

academics and auditors) who took part in the

survey indicated that the annual report is the

most important source of corporate

information. Individual investors and stock

market brokers indicated that information

directly obtained from the company is their

most important source of corporate

information. In addition to the annual report

and direct information from the company,

the participants indicated that they seek

specialists’ advice when making investment

decisions about a company. Further, the

respondents revealed that special

publications and interim reports are used

as major sources of information about

the company.

Table ISubject groups and response rates

Subject groups Distributed questionnaire Received questionnaire Response rate (%)

Institutional investors 50 41 82Individual investors 50 42 84Bank loan officers 50 36 72Government officials 50 39 78Financial analysts 50 36 76Academics 50 38 78Auditors 50 39 70Stock market brokers 50 35 77Total and over all response rate 400 306 77

[ 602 ]



Table

IIUse

rgroups’

attitudestowardsva

riousso

urcesofinform

ation

Use

rgrou

psWho

lesa

mple

Freq

uenc

y1n=(41)

2n=(42)

3n=(36)

4n=(39)

5n=(36)

6n=(38)

7n=(39)

8n=(35)

Mea

nSD

Ran

kKWSL

Ann

ualrepo

rt306

4.90

4.85

4.63

4.87

4.75

4.89

4.95

4.69

4.82

0.38

10.002

Interim

repo

rt306

4.27

4.47

3.86

3.95

4.20

4.08

4.49

4.31

4.21

0.68

50.00

Spe

cialist’sad

vice

306

4.80

4.80

4.88

4.44

4.47

4.08

4.36

4.69

4.57

0.62

30.00

Friend

’sad

vice

306

3.63

3.80

3.55

3.44

3.50

3.63

3.31

4.17

3.63

0.87

70.00

New

spap

ersan

dmag

azines

306

3.36

3.78

3.50

3.59

3.61

3.55

3.54

4.00

3.61

0.82

80.06

Spe

cial

publications

306

4.31

4.40

4.11

4.36

4.44

3.95

4.51

4.37

4.31

0.72

40.001

Direc

tinform

ationfrom

theco

mpa

ny306

4.95

4.61

4.86

4.72

4.72

4.42

4.87

4.83

4.75

0.49

20.00

Marke

trumou

rs306

4.33

3.84

3.56

3.64

4.19

3.55

4.03

4.83

3.99

1.07

60.00

Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.39

0.47

0.47

0.46

0.45

0.53

0.50

0.33

0.38

Notes

:KWSL:

Krusk

all-W

allis

sign

ifica

nce

leve

l;Mea

nva

lues

–sc

oring:

1=no

tim

portan

tat

all;

5=ve

ryim

portan

t;1.Individu

alinve

stors;

2.Institutiona

linve

stors;

3.Ban

kcred

itoffic

ers4;

Gov

ernm

entoffic

ials;5.Fina

ncialan

alysts;6.Aca

demics;

7.Aud

itor;8.Stock

marke

tbrok

ers

[ 603 ]



The findings regarding the importance of the

annual reports for individual investors in

Kuwait are somewhat surprising. Several

studies conducted in this area have found the

annual report to be the single most important

source of information for individual

investors. Hence the rating of the annual

report is in contrast with the findings of

Abu-Nassar and Rutherford (1996) on the

perceptions of individual investors in

Jordan. Similarly, a study by Epstein and

Pava (1993) on the perceptions of US

individual investors found the annual

corporate report to be the most important

source of information for users. Other

studies, such as those conducted by

Anderson (1981) on Australian individual

investors, and Bartlett and Chandler (1997)

on UK investors, reached similar

conclusions.

However, what attracts one’s attention

about the results regarding the perceptions of

individual investors in Kuwait is that

newspapers and magazines, friends’ advice

as well as market rumours are not used as a

main source of information by Kuwaiti

individual investors. These three sources of

information, however, have generally been

found to be least important to various user

groups, as supported by the works of

Abu-Nassar and Rutherford (1996) on Jordan,

and Andersen (1981) on Australia. Given that

the vast majority of the respondents have

relatively more than six years of experience

and hold academic degrees in the business

related areas, it is unlikely to see them

seeking friends’ advice or following market

rumours. The fact that newspapers and

magazines are not used as primary sources of

corporate information is explained on the

grounds that such magazines are not in

existence in Kuwait. Newspapers and

magazines might contain a section that

covers business and economics news without

any intensive analysis. The information that

they address is of little benefit to the user

groups.

Unlike individual investors, institutional

investors chose the annual report as their

main source of information about a company.

One possible explanation for this difference

may relate to the fact that individual

investors may find it difficult to absorb and

understand all the information contained in

the annual report. They also indicated their

heavy reliance on specialists’ advice when

making investment decisions about a

particular company. As was the case with

individual investors, institutional investors

perceived direct contact with the company as

an important source of information[3].

An interesting point to note is that

although institutional investors and stock

market brokers ranked market rumours

among the important sources of corporate

information, this source of information was

ranked among the less important sources of

corporate information across the target

groups. Given that institutional investors

and stock market brokers recruit

professional staff to make investment

decisions, this result is surprising. This

strange result can be explained on the

grounds that the work of the institutional

investors and stock market brokers is

conducted in the stock exchange. They are

very likely to be influenced by any rumour.

Needless to say that the collapse of the

Kuwaiti stock exchange in 1982 was mainly a

reaction to rumours[4].

Be that as it may, the bank managers who

took part in the survey rely on a combination

of specialists’ advice, direct contact with the

company and the published annual report

when making decisions to deal with a

particular company. Specialist publications

also form another important source of

information for bank managers. On the other

hand, the table revealed that sources such

newspapers and magazines, friends’ advice,

interim report and market rumours are of

little use to bank mangers. Government

representatives, however, showed that they

rely on the annual report and direct contact

with the company as main sources of

corporate information. It is also evident from

Table II that government representatives

seek specialists’ advice and special

publications as main sources of corporate

information. Unlike the other users of

corporate information, government

representatives seem to rely on the interim

report and market rumours as main sources

of information.

The academics’ main sources of corporate

information are the published annual report

and direct information obtained from the

company. The academics also indicated that

they use the interim report and seek

specialists’ advice when making decisions

about a particular company. An interesting

point to note about Table II is that the

academics do not seem to rate highly

specialised publications as a main source of

corporate information. Since academics are

expected to use corporate information for

academic research purposes, one would have

expected different results. This, however, can

be explained on the ground that in Arab

countries in general, Kuwait not an

exception, a limited number of specialised

journals and magazines publish information

related to companies. Business and economic

[ 604 ]



news are restricted to small sections in the

national newspapers. This section lacks

depth and analysis. Hence, it is not

surprising to see this source of information

of little use to the academics.

Since the groups that took part in the

survey are of different size, and users’

perceptions were measured on an ordinal

scale, a non-parametric test is found to be

most appropriate for such data to investigate

the homogeneity or lack thereof, among the

target user groups in the utilisation of

various sources of corporate information

(Huck and Cormier, 1996; Siegel and

Castellan, 1998; Silver, 1997). Hence, the

Kruskal-Wallis H test was used to test

possible differences between all groups.

The results of the analysis pointed to

significant disagreements between all pairs

of groups on the importance that they attach

to various sources of corporate information.

The highest degree of agreement attained

concerned friends’ advice, which cannot be

used as a credible source of corporate

information. The results of the analysis also

revealed a high degree of agreement that the

annual report, specialist advice, special

papers and magazines and direct information

from the company are useful sources of

corporate information. The highest degree of

disagreement among pairs of target groups

was associated with the interim report and

stock market rumours. It is worth

mentioning that, on the whole, difference in

the importance that the respondents attach to

different sources of corporate information

seem to exist on all possible sources.

The outcome of the analysis pointed to the

fact that different users of different sources of

corporate information attach different

importance to such sources. The importance

that a group of users attach might change

from time to time and from one decision to

another.

Characteristics of useful corporateinformationTo investigate how different users of

corporate information perceive the

importance of various sets of criteria that

form useful corporate information, a list of

the characteristics of corporate information

was included in the questionnaire and the

respondents were asked to rate them on a

Likert-type scale. The scale ranges from 1

‘‘not important at all’’ to 5 ‘‘very important’’.

The results of the analysis are given in

Table III.

The table shows that the Kuwaiti user

groups rated all listed features of useful

corporate information as being highly

important. Credibility and timeliness were

viewed by almost all groups as the most

important features of useful corporate

information. The result is consistent with the

findings of Abu-Nassar and Rutherford (1996)

on Jordan, who also found timeliness to be

one of the most important criteria to affect

users’ perceptions regarding the quality of

financial information.

The Kruskal-Wallis H test of differences

between all groups, presented in Table III,

showed consensus on all the characteristics

of useful corporate information. Although

the Kendall’s coefficient of concordance W

showed a high degree of agreement within

individual user groups and the sample as a

whole on the importance that they attach to

the characteristics of good quality corporate

reporting, the highest degree of agreement

reported between the academics followed by

auditors. Individual investors, followed by

stock market brokers, however, achieved the

lowest degree of agreement. The results are

not surprising. Academics are expected to

support the characteristics of corporate

information, since they form the basis for

useful information. They are listed in all

accounting textbooks. Auditors are expected

to be familiar with the features of useful

corporate information since their main task

is to ensure that the company’s annual

reports reflect a true and fair view of the

company. Individual investors and stock

market brokers, on the other hand, usually

rely on different sources of information.

Given that one of the main source of

corporate information used by individual

investors and stock market brokers are stock

market rumours, as reported in the previous

section, the characteristics of useful

corporate information are of little relevance

to them.

The usefulness of the annual reportThe respondents were asked to give their

level of agreement with seven statements

that may reflect the areas where the annual

report can be useful to the user groups. The

outcome of their answers is presented in

Table IV. It is obvious from the table that the

respondents either strongly agreed or agreed

with all listed statements with the exception

of the proposal that information contained in

the corporate report could ‘‘help investors to

predict dividends of the company’’. The table

also indicated that information contained in

the annual report is useful in making

informed investment decisions and assessing

the users in evaluating the company’s

performance. The Kuwaiti user groups also

revealed that the annual report is useful in

monitoring their investment and in

comparing a company’s performance with

[ 605 ]



Table

III

Use

rs’ratingsoftheim

portanceofase

tofcriteriaofcorporate

inform

ationquality

Use

rgrou

psWho

lesa

mple

Freq

uenc

y1n=(41)

2n=(42)

3n=(36)

4n=(39)

5n=(36)

6n=(38)

7n=(39)

8n=(35)

Mea

nSD

Ran

kKWSL

Timelines

s306

4.76

4.98

4.58

4.79

4.81

5.00

4.98

4.91

4.85

0.24

20.625

Ava

ilabilityof

spec

ificinform

ation

306

4.37

4.57

4.53

4.59

4.69

4.53

4.72

4.89

4.60

0.34

60.421

Und

erstan

dability

306

4.44

4.57

4.58

4.59

4.72

4.68

4.72

4.97

4.65

0.38

40.506

Neu

trality

306

4.61

4.43

4.75

4.87

4.89

4.71

4.95

4.83

4.75

0.38

30.486

Credibility

306

4.83

4.79

4.89

4.95

4.97

4.97

4.97

4.89

4.91

0.31

10.821

Eas

yac

cess

toso

urce

sof

inform

ation

306

4.12

4.50

4.67

4.67

4.72

4.63

4.87

4.89

4.62

0.36

50.325

Inde

pend

entve

rific

ation

306

3.95

4.64

4.28

4.59

4.58

4.34

4.79

4.77

4.49

0.52

70.499

Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.42

0.55

0.51

0.51

0.57

0.65

0.59

0.45

0.53

Notes

:KWSL:

Krusk

all-W

allis

sign

ifica

nceleve

l;Mea

nva

lues

–sc

oring:

1=no

tim

portan

tat

all;5=ve

ryim

portan

t

[ 606 ]



Table

IVGroups’

viewsaboutuse

fulness

ofinform

ationcontainedin

theannualfinancialstatement

Use

rgrou

psWho

lesa

mple

Use

fulnes

scriterion

Freq

.1n=(41)

2n=(42)

3n=(36)

4n=(39)

5n=(36)

6n=(38)

7n=(39)

8n=(35)

Mea

nSD

Ran

kKWSL

Provide

prim

aryinform

ationto

inve

storsto

help

them

inmak

inginform

edinve

stmen

tde

cision

s306

4.35

4.41

4.64

4.44

4.40

4.38

4.51

4.39

4.43

0.82

10.236

Provide

inform

ationto

help

inve

storsto

mon

itor

their

inve

stmen

t306

4.20

4.32

4.33

4.27

4.25

4.26

4.34

4.26

4.27

0.85

30.374

Helpinve

storsto

pred

ictex

pected

inco

mean

dea

rnings

per

share

306

4.24

4.23

4.22

4.21

3.97

4.22

4.14

4.07

4.21

0.89

50.905

Tohe

lpinve

storsin

asse

ssingliq

uidity

oftheco

mpa

ny306

3.98

4.26

4.30

4.46

3.93

4.12

4.28

4.14

4.17

0.86

60.10

Helpinve

storsto

pred

ictfuture

divide

ndsof

theco

mpa

ny306

3.87

3.83

3.95

4.06

3.56

3.85

3.92

4.08

3.90

0.97

70.96

Helpinve

storsto

evalua

teco

mpa

ny’s

performan

ceov

ertime

306

4.20

4.34

4.41

4.48

4.18

4.28

4.36

4.34

4.33

0.80

20.152

Helpinve

storsto

mak

eco

mpa

riso

nbe

twee

naco

mpa

ny’s

performan

cewithothe

rco

mpa

nies

’pe

rforman

ce306

4.07

4.15

4.51

4.62

3.97

4.08

4.32

4.02

4.27

0.89

30.025*

Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.50

0.52

0.54

0.55

0.51

0.52

0.53

0.52

0.53

Notes

:KWSL:

Krusk

all-W

allis

sign

ifica

nceleve

l;Mea

nva

lues

–sc

oring:

1=no

tus

eful

atall;5=ve

ryus

eful

[ 607 ]



others. The results are in line with previous

ones obtained by Anderson (1981), Arnold

and Moizer (1984), Chenhall and Juchau

(1977), Chang and Most (1985), Lee and

Tweedie (1975a, b; 1981), Streuly (1994) and

Winfield (1978).

The indifference that the respondents

showed to the usefulness of the corporate

report in predicting future dividends could

be due to the fact that data contained in the

annual report are mainly of historic nature.

In addition, the annual reports published by

the Kuwaiti companies have little forecasted

data that would enable the users to predict

corporate dividend policy. On the other hand,

the Kruskall-Wallis test pointed to significant

differences in the respondents’ opinions on

whether the annual report can help in

making comparison between companies’

performances. This might imply that Kuwaiti

users tend to invest in specific companies

due to the limitation in the companies’

number, and hence they are unlikely to use

the annual report to compare companies’

performance. Yet, the Kendall’s coefficient of

concordance W test within individual user

groups and within the sample as a whole

pointed to a certain degree of agreement

about all listed statements.

Understandability, credibility, importanceand timeliness of different parts of theannual reportUnderstandabilityThe user groups’ level of understandability of

different parts of the annual report is

reported in Table V. The table revealed that

all participants agreed that financial

statements and notes to the accounts are

relatively difficult to understand. This was

evident across the user groups and within the

sample as a whole. The participants,

however, believe that the auditor’s report is

the easiest part to understand in the annual

report. The result is not surprising and is

consistent with Abu-Nassar and Rutherford

(1996), who found the auditor report easy to

understand and the statement of accounting

policies relatively difficult to understand in a

similar environment. The auditor’s report is

standard, and given that the participants

have an average six years or more of

experience in the business related areas, it is

very likely to find the participants familiar

with it. Financial statements and notes to the

accounts, however, contain technical issues

that require a certain level of knowledge and

experience.

On the other hand, descriptive statistics for

the whole sample demonstrated that it is easy

to understand the directors’ report. The

outcome of the analysis is predictable. The

directors’ report contains descriptive and

simple statistical information that the user

can understand. In all cases, the general

result points to the fact that participants

from various user groups do not seem to have

major difficulties in understanding different

sections of the annual report. This might be

due to the fact that most of the participants

have either completed academic degrees or

experience in business related areas. The

results, however, may not reflect reality. In

this context, Parker (1982) stated that

although users might give the impression

that they understand corporate information,

it is difficult to identify the users’ actual level

of knowledge.

The Kendall’s coefficient of concordance W

test reported that the highest degree of

agreement was achieved by the academics,

followed by the financial analysts. The lowest

degree of agreement was reported among

individual investors and government

officials. The result might be justified on the

grounds that academics and financial

analysts have the required qualifications and

expertise to understand the contents of the

annual report. Needless to say that most of

the academics who took part in the survey

hold high academic degrees in business

studies. Financial analysts are expected to

have high degree of experience to enable

them to perform their jobs. Individual

investors, however, are coming from

different backgrounds and very likely to have

different investment experience. Hence,

inconsistency in their answers is predictable.

As for the government representatives, they

are expected to have different backgrounds.

For example, while those representing the

finance ministry are expected to have

intensive knowledge in finance, the

participants from the Department of Zakat

are expected to have intensive knowledge in

accounting. This reality might have

contributed to variations in their answers[5].

CredibilityThe respondents were asked to rank the

degree of credibility that they attach to

various sections of the annual report and the

results of their answers are given in Table V.

The table indicated that all user groups view

financial statements as the most credible part

of the annual report followed by the auditor’s

report. The directors’ report, however,

received the lowest ranking. It is worth

noting that the notes to the accounts are

associated with the highest standard

deviation. This implies variations in the

participants’ opinion about the extent of

credibility that they attach to the notes to the

accounts. What attracts attention is that the

credibility attached to different sections of

[ 608 ]



Table

VUse

rs’ratingsofthedegreeofcredibilityofdifferentpartsoftheannualreport Use

rgrou

psWho

lesa

mple

Freq

.1n=(41)

2n=(42)

3n=(36)

4n=(39)

5n=(36)

6n=(38)

7n=(39)

8n=(35)

Mea

nSD

Ran

k

Und

erstan

dability

Direc

tors’repo

rt3.51

3.52

3.61

3.64

3.89

3.89

3.69

4.11

3.73

0.81

3Fina

ncialstatem

ents

3.61

3.81

3.72

3.72

4.17

3.95

3.62

4.14

3.84

0.49

1Aud

itor’s

repo

rt3.21

3.41

3.54

3.45

3.22

3.25

3.44

3.31

3.35

1.07

4Notes

tofin

ancial

statem

ents

3.56

3.63

3.67

3.79

4.17

4.03

3.51

4.14

3.81

0.60

2Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.15

0.28

0.25

0.23

0.30

0.34

0.26

0.27

0.28

(Mea

nva

lues

a)

Credibility

Direc

tors’repo

rt306

2.88*

2.52

2.61

2.64

2.89

2.24

2.69

3.11

2.69

0.80

4Fina

ncialstatem

ents

306

4.07

4.38

4.17

3.59

3.97

3.45

4.18

3.91

3.96

0.68

1Aud

itor’s

repo

rt306

4.07

4.33

4.11

3.56

3.97

3.39

4.10

3.80

3.93

0.71

2Notes

tofin

ancial

statem

ents

306

3.66

4.10

4.03

3.56

3.89

3.18

3.95

2.94

3.67

1.02

3Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.15

0.20

0.36

0.47

0.22

0.45

0.42

0.45

0.27

(Mea

nva

lues

b)

Impo

rtan

ceBoa

rdof

directors’

repo

rt306

4.3

4.3

3.9

3.6

4.0

4.1

4.1

4.0

4.1

0.7

6Aud

itor’s

repo

rt306

4.5

4.2

4.3

4.2

4.2

4.5

4.4

4.2

4.3

0.6

5Balan

cesh

eet

306

4.6

4.4

4.7

4.7

4.5

4.9

4.9

4.3

4.6

0.5

4Inco

mestatem

ent

306

4.8

4.6

4.9

5.0

4.7

5.0

4.9

4.9

4.8

0.5

1Retaine

dea

rnings

statem

ent

306

4.5

4.6

4.6

4.7

4.6

4.7

4.8

4.9

4.7

0.6

2Cas

hflo

wstatem

ent

606

4.6

4.4

4.8

4.9

4.6

4.9

4.9

4.9

4.7

0.5

2Noteto

theac

coun

ts306

3.9

3.8

4.6

4.1

4.4

4.3

4.6

3.2

4.1

1.1

6Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.16

0.21

0.38

0.51

0.23

0.50

0.44

0.50

0.28

(Mea

nva

lues

c)

Timelines

sLe

ssthan

30da

ys306

4.73

4.74

4.75

4.75

4.74

4.74

4.73

4.74

4.74

0.34

0.923

From

30to

less

than

60da

ys306

3.04

2.94

2.82

2.82

2.75

2.52

3.02

2.68

2.83

0.92

0.377

From

60to

less

than

90da

ys306

1.76

1.65

1.71

1.72

1.75

1.62

1.70

1.68

1.70

0.46

0.793

From

90to

less

than

120da

ys306

1.16

1.04

1.03

1.15

1.12

1.00

1.10

1.06

1.08

0.44

0.798

120da

ysor

more

306

1.01

1.00

0.98

0.67

1.00

0.96

1.00

0.98

0.95

0.30

0.968

Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.61

0.67

0.63

0.64

0.63

0.65

0.63

0.65

0.63

(Mea

nva

lues

d)

Notes

:Sco

ring

a1=ve

ryea

syto

unde

rstand

;5=ve

rydifficultto

unde

rstand

;b1=no

tcred

ible

atall;5=ve

rycred

ible;c1=no

tIm

portan

tat

all;5=ve

ryim

portan

t;d1=strong

lydisa

gree

;5=strong

lyag

ree

[ 609 ]



the annual report by the academics was the

lowest among the target groups. The analysis

also revealed that stock market brokers

attach a low degree of credibility to the notes

to the accounts.

The results of the analysis can be explained

on the grounds that academics as well as

other user groups are mainly concerned with

the financial statements. They, therefore, pay

little attention to what the board of directors

says in its report. Yet, the average degree of

credibility the academics attach to the

financial statements may reflect their

understanding of the way in which these

statements are prepared. Academics are

aware of different methods used to arrive at

the reported profit and the ability of

company’s management to manipulate their

figures. They, therefore, provided a cautious

rating to these statements. The low rating

that the academics attached to the auditor’s

report, in comparison with other user

groups, can be explained on the grounds that

the auditor’s work in Kuwait is a routine one,

since national companies do not pay taxes.

Hence, the auditors’ work is mainly an

administrative one[6].

The low rating of credibility that stock

market brokers attach to the notes to the

accounts might be due to the fact that this

section of the annual report is of little

importance to them. The main concern of

stock market brokers is the profitability and

liquidity of the company. They focus on a

number of financial ratios to enable them to

give the right advice to their clients.

Given that respondents from all target

groups rated credibility as the most

important feature of corporate information,

the above results reflect respondents’

concern about the level of credibility of the

current information reported in the annual

report of Kuwaiti companies. Given that

various users of the corporate reports can

obtain information directly from the

company, this result is not surprising. It is,

therefore, possible that the user groups give

more credibility to such information.

The Kendall’s coefficient of concordance W

test revealed that the highest degree of

agreement was achieved by government

officials, followed by the academics and stock

market brokers. The lowest degree of

agreement was reported among individual

and institutional investors.

ImportanceThe respondents were asked to indicate the

degree of importance that they attach to each

section of the annual report. The results of

the analysis are summarised in Table V. It

can be noticed from the table that all

individual target groups either strongly

agreed that the income statement, cash flow

statement and statement of retained earnings

are the most important sections of the annual

report. The respondents, however, attached

less importance to the balance sheet. In

addition, the table revealed that all

individual target groups either strongly

agreed or agreed that the auditor’s report

forms an important part of the annual report.

Although most target groups agreed with the

proposal that the board of directors’ report

and notes to the accounts are important, they

showed less enthusiasm than that associated

with other sections of the annual report. The

highly reported standard deviations in some

cases imply a certain degree of differences in

the target groups’ opinion.

The outcome of the analysis is predictable,

since a company’s profitability and liquidity

are the main concern for all user groups. In a

small country like Kuwait with a limited

number of shares, investors tend to invest in

companies with a profitable track record.

The statement of retained earnings reflects a

company’s profitability and assists the users

in estimating their return on investment.

The cash flow statement assists the users in

predicting the liquidity position of the

company.

To assess the degree of agreement within

the individual target groups and the whole

sample, the Kendal’s coefficient of

concordance W was executed and reported in

Table V. The table shows that a certain

degree of agreement has been achieved

within all individual target groups and

within the sample. The highest degree of

agreement was achieved by financial

analysts, followed by stock market brokers

and academics. However, the lowest degree of

agreement obtained was by individual and

institutional investors. The results can be

explained on the grounds that financial

analysts, stock market brokers and

academics are expected to have a high degree

of knowledge of the annual report. All of

them use the annual report for various

reasons. Hence, it is difficult to see a high

degree of disagreement among these users on

the importance of various sections of the

report. On the other hand, the low level of

agreement reported within individual and

institutional investors and government

representatives can be explained on the

grounds that these users are likely to use

specific parts of the annual report, mainly

the income statement and the statement of

retained earnings. Hence, a certain degree of

agreement is expected on the importance of

these sections of the annual report.

Disagreement is likely to occur when rating

the importance of other sections of the

[ 610 ]



annual report. As for the whole sample, the

participants either strongly agreed or agreed

that all listed sections in the questionnaire

are important to their decisions about a

company.

The findings are partially in line with

previous studies undertaken in developed

and developing countries (Australia,

New Zealand, UK, and Jordan) cited earlier

in that the income statement and the balance

sheet are the most important sections of a

corporate annual report. The main difference

between the results of the current study and

a similar study undertaken in Jordan is that

the respondents attach less importance to the

auditor’s report. The fact that Kuwaiti

companies do not pay corporate tax like their

Jordanian counterparts might explain the

result. In this case, the auditor’s report is

routine work and Kuwaiti investors would

have little information of relevance to them.

The result also contradicts Wallace (1988),

who reported evidence on the significance of

auditor’s report in developing countries. He

found that the auditor’s report achieved the

highest ranking for importance across the

surveyed user groups. The result of the

current study, however, is not comparable

with Wallace’s study, since in this study the

annual report is compared with other

sections of the annual report rather than

with individual disclosure items as in

Wallace’s study.

TimelinessViewing a sample of annual reports

published by Kuwaiti companies showed

variations in the publication date of the

annual report and the end of the corporate

financial year. In some cases, it reached three

and four months. The relevancy or otherwise

of corporate information is dependant on the

speed of its publication. The longer the

period between the end of the accounting

period and the date of the publication of the

annual report, the less relevant the

information. Hence, the respondents were

asked to express the degree of agreement

with the suitable period of time that it takes

to publish the annual report to make it more

relevant. The outcome of their answers is

summarised in Table V. The table

demonstrates that almost all respondents

within individual groups or the sample as a

whole either strongly agreed or agreed that

the annual report should be published within

less than 30 days of the end of the accounting

period. The respondents, however, either

strongly disagreed or disagreed with any

longer period of time.

The Kruskall-Wallis test showed no

significant difference in the respondents’

opinions. Similarly, the Kendal’s coefficient

of concordance W test within individual

groups or within the sample as a whole

pointed to a certain degree of consensus

among the respondents.

Rating the importance of disclosure itemsrequired by accounting standardsA list of items required by the International

Accounting Standards that are expected to

appear in the annual report of any Kuwaiti

company formed a part of the questionnaire.

The respondents were then invited to express

the degree of importance they attach to each

of these items using a Likert-type scale,

where one referred to ‘‘not important’’ and

five to ‘‘very important’’. The results are

summarised in Table VI. What attracts one’s

attention in the table is the fact that the

respondents at the individual level as well as

the whole sample level rated all disclosure

items that appeared in the questionnaire as

either very important or important. The

results achieved by each of the target groups

were consistent in most cases. Bank credit

managers and financial analysts showed that

almost all listed items of disclosure are very

important. The results are predictable, since

the International Accounting Standards

emphasised them due to their importance to

the users.

Another important point to note from

Table VI is that items such as net profit/loss,

gross profit, gross sales and classification of

shareholders’ equity were viewed by almost

all respondent groups and the whole sample

as the most important disclosure items.

Although the resulted standard deviations on

both individual target group level and the

whole sample level were relatively low, they

reflected a certain degree of disagreement

among the participants. The disagreement

was mainly concentrated on whether the

disclosure items were very important or

important.

While the result is similar to that achieved

by Stanga and Tiller (1983), who found net

income to be the most important item of

disclosure to creditors, it is not consistent

with the result obtained by Firth (1978),

Ibrahim and Kim (1994) and Wallace (1988),

who found that those who took part in their

studies attach low rating to income. On the

other hand, the cost of sales rating in this

study is similar to that reported by Chandra

(1974), Firth (1978; 1979), Ibrahim and Kim

(1994) and Stanga and Tiller (1983). Yet, the

cost of sales was not among the most

important disclosure items in Wallace’s

(1988) study.

Disclosure items, such as two-year

statistical figures, accounting standards

used, summary of accounting policies and

[ 611 ]



Table

VI

Groups’

viewsaboutuse

fulness

ofinform

ationcontainedin

theannualfinancialstatement Use

rgrou

psWho

lesa

mple

Freq

.1n=(41)

2n=(42)

3n=(36)

4n=(39)

5n=(36)

6n=(38)

7n=(39)

8n=(35)

Mea

nSD

Ran

k

Twoye

ars’

statistica

lfig

ures

306

4.32

4.26

4.64

4.59

4.53

3.66

4.41

4.46

4.35

0.75

24

Class

ifica

tion

ofas

sets

andlia

bilitiesto

curren

t/no

n-cu

rren

t306

4.49

4.21

4.56

4.69

4.50

4.55

4.49

4.40

4.47

0.56

20

Class

ifica

tion

ofas

sets

inse

quen

ce–cu

rren

tfollo

wed

byfix

edas

sets

306

4.59

4.31

4.64

4.72

4.50

4.82

4.59

4.40

4.56

0.55

13

Acc

ountingstan

dardsus

ed306

4.56

3.90

4.53

4.67

4.50

4.34

4.56

4.49

4.39

0.80

23

Major

compo

nentsof

asse

ts306

4.62

4.36

4.64

4.69

4.41

4.66

4.62

4.51

4.55

0.60

13

Disclos

ureof

totalcu

rren

tas

sets

306

4.71

4.33

4.67

4.74

4.58

4.66

4.71

4.51

4.59

0.51

6Major

compo

nentsof

curren

tas

sets

306

4.71

4.19

4.72

4.74

4.53

4.66

4.71

4.49

4.57

0.56

9Major

compo

nentsof

fixed

asse

ts306

4.74

4.14

4.72

4.74

4.47

4.66

4.74

4.43

4.55

0.63

13

Net

valueof

deprec

iableas

sets

306

4.64

4.29

4.61

4.59

4.47

4.47

4.64

4.37

4.45

0.61

21

Class

ifica

tion

oflia

bilitiesin

asp

ecificse

quen

ce306

4.71

4.31

4.75

4.67

4.47

4.84

4.71

4.37

4.57

0.50

9Disclos

ureof

curren

tlia

bilitiesva

lue

306

4.69

4.29

4.75

4.62

4.50

4.66

4.69

4.40

4.56

0.54

12

Disclos

ureof

compo

nentsof

long

-term

liabilitiesin

asp

ecific

sequ

ence

306

4.79

4.19

4.78

4.62

4.47

4.66

4.79

4.40

4.58

0.56

8

Class

ifica

tion

ofsh

areh

olde

rs’eq

uity

sectionin

asp

ecific

sequ

ence

306

4.90

4.62

4.83

4.77

4.67

4.68

4.90

4.86

4.78

0.45

4

Gross

sales

306

4.87

4.86

5.00

4.92

4.86

4.95

4.87

4.60

4.87

0.34

2Other

source

sor

reve

nue

306

4.77

4.31

4.83

4.90

4.75

4.71

4.77

4.43

4.64

0.51

5Cos

tof

sales

306

4.92

4.31

4.44

4.74

4.78

4.61

4.92

4.34

4.59

0.54

6Gross

profit

306

4.92

4.50

5.00

4.92

4.81

4.71

4.92

4.74

4.79

0.50

3Adm

inistrativeex

pens

es306

4.77

4.19

4.42

4.67

4.67

4.58

4.77

4.31

4.49

0.60

19

Sellin

gex

pens

es306

4.72

4.31

4.50

4.69

4.75

4.55

4.72

4.31

4.57

0.55

9Gen

eral

expe

nses

306

4.74

4.19

4.39

4.67

4.64

4.58

4.74

4.34

4.52

0.62

16

Res

earchan

dde

velopm

entex

pens

es306

4.70

4.33

4.53

4.51

4.58

4.66

4.70

4.26

4.50

0.65

17

Net

profit/loss

306

4.97

4.90

5.00

4.95

4.89

4.92

4.97

4.94

4.94

0.24

1Natureof

compa

ny’s

activities

306

4.70

4.38

4.69

4.59

4.56

4.24

4.70

4.60

4.50

0.61

17

Sum

maryof

acco

unting

polic

ies

306

4.67

4.17

4.53

4.46

4.53

4.29

4.67

4.49

4.43

0.67

22

Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.28

0.37

0.33

0.21

0.23

0.49

0.16

0.27

0.29

Notes

:Mea

nva

lues

–sc

oring:

1=no

tim

portan

tat

all;5=ve

ryim

portan

t

[ 612 ]



net value of depreciable assets, were ranked

at the bottom of the list. The above results

imply that the users of Kuwaiti corporate

information are mainly concerned with

profit. They pay less attention to additional

details related to accounting standards and

detailed accounting policies.


the individual target groups and the whole



Table VI. Table VI demonstrated a certain

degree of agreement within the target groups

and the whole sample. The table revealed

that the highest degree of agreement was

registered by the academics, followed by

institutional investors, as reflected by W

scores. The lowest degree of agreement,

however, was associated with the auditors

and financial analysts. Yet, the resulted level

of significance P implied reasonable levels of

agreement within the target groups and the

sample as a whole.

Rating the importance of voluntarydisclosure itemsA list of expected items of voluntary

disclosure that might appear in the annual

report was given to participants to indicate

the degree of importance that they attach to

each of these items. The results are

summarised in Table VII. It is evident from

Table VII that respondents from all target

groups, or within the sample as a whole,

attach a certain degree of importance to all

listed voluntary disclosure items. However,

the table points to variations between the

target groups. For example, while

government representatives and bank credit

managers ranked almost all listed items of

voluntary disclosure as being very

important, such consistency was not evident

in the cases of institutional investors and the

academics. This result reflects differences in

the target groups’ needs and, therefore, the

importance of each of the voluntary

disclosure items.

On the other hand, all respondents, with

the exception of government representatives,

viewed the disclosure of earnings per share

as the most important one, followed by

information on investment in shares.

Disclosure items such as the percentages of

salaries/total salaries paid to Kuwaitis and

the percentage of Kuwaitis/total employees

employed by a firm were ranked at the

bottom of the list. The respondents also put

voluntary disclosure items such as

recruitment policy among university

graduates and donation to charitable

organisations at the bottom of the list. As was

the case with rating mandatory disclosure

items, the main concern of the respondents

was the firm’s profitability and liquidity. The

respondents showed little interest in the

recruitment policy and firm’s involvement in

society. The results are predictable in a small

and rich society like Kuwait, where the

government plays a major role in creating job

opportunities to university graduates.

Needless to say, the public sector absorbs

most of the graduates. In addition, charitable

organisations receive massive support from

the government. In this respect, it is

important to mention that the companies’

law in Kuwait requires all publicly owned

companies to devote 5 per cent of their net

profit to the benefit of the scientific institute

led by the Emir. On the other hand, since

Kuwait has a limited number of companies,

different users of the annual reports are

expected to focus on the profitability and

solvency of the firm concerned.


individual target groups and the whole



Table VI. The table showed a certain degree

of agreement within individual target

groups. Although a significant level of

agreement reported within the whole sample

as reflected by P, the level of agreement W

was relatively low. On other hand, the

highest level of agreement was registered by

financial analysts, followed by stock market

brokers and the academics, as mirrored by

the resulted W. Yet, the lowest level of

agreement was associated with government

officials, followed by individual and

institutional investors.

Conclusion

The main purpose of this study is to provide

empirical evidence on the usefulness of the

various aspects of corporate information to

Kuwait users. Consequently, eight user

groups were surveyed: individual and

institutional investors, bank credit officers,

government officials, financial analysts,

academics, auditors and stock market

brokers. The analyses revealed that external

users of corporate information in Kuwait

prefer to extract information directly from

the company, whether through the published

annual and interim report, or through direct

contact with the company itself. This reflects

both the nature of Kuwaiti business and

Kuwaiti social environment, where

companies are mainly limited to a small

population. This is expected to develop a

close relationship between companies

and investors.

[ 613 ]



Table

VII

Groups’

viewsaboutuse

fulness

ofvo

luntary

inform

ationcontainedin

theannualreport

Use

rgrou

psWho

lesa

mple

Freq

.1n=(41)

2n=(42)

3n=(36)

4n=(39)

5n=(36)

6n=(38)

7n=(39)

8n=(35)

Mea

nSD

Ran

k

Don

ations

toch

aritab

leorga

nisa

tion

s306

3.73

3.57

4.39

3.38

4.58

4.26

3.87

3.06

3.73

0.91

29

Rec

ruitmen

tpo

licyam

ongun

iversity

grad

uates

306

3.71

3.71

3.71

3.38

4.53

3.37

3.79

3.17

3.62

3.62

30

Details

ofplan

tan

deq

uipm

ent

306

4.12

4.12

4.12

4.26

4.72

4.63

4.05

4.63

4.40

4.40

19

Pen

sion

plan

306

3.80

3.80

3.80

3.36

4.53

3.97

3.72

3.77

3.75

3.75

28

Hum

anreso

urce

sde

velopm

ent

306

3.59

3.59

3.59

3.92

4.69

3.74

4.03

4.57

4.12

4.12

27

Factor(s)that

influ

ence

dfirm’s

activities

306

4.46

4.46

4.46

4.90

4.86

4.95

4.28

4.94

4.68

4.68

10

Factor(s)ex

pected

toaffect

future

activities

306

4.37

4.37

4.37

4.70

4.81

4.95

4.33

4.91

4.66

4.66

11

Promotionan

dad

vertisem

entex

pens

es306

4.15

4.15

4.15

4.79

4.78

4.44

4.51

4.54

4.52

4.52

18

Direc

tors’remun

eration

306

3.98

3.98

3.98

4.36

4.56

4.37

4.08

4.46

4.19

4.19

25

Amou

ntpa

idas

directors’

remun

eration

306

3.88

3.88

3.88

4.36

4.53

4.42

4.10

4.46

4.15

4.15

26

Perce

ntag

eof

Kuw

aitisem

ploy

edby

thefirm

306

3.49

3.49

3.49

3.21

4.61

3.29

3.54

3.20

3.47

3.47

31

Inform

ationon

future

expa

nsionin

asse

ts306

4.61

4.61

4.61

4.15

4.75

4.00

3.92

4.71

4.36

4.36

20

Perce

ntag

eof

salaries

/totalsa

laries

paid

toKuw

aitis

306

3.27

3.27

3.27

3.18

4.61

3.42

3.46

3.31

3.42

3.42

32

Perce

ntag

eof

reve

nuege

neratedfrom

foreignso

urce

s306

4.68

4.68

4.68

4.82

4.83

4.92

4.69

4.74

4.70

4.70

7Inform

ationon

differen

tso

urce

sof

reve

nue

306

4.54

4.54

4.54

4.82

4.83

4.92

4.72

4.83

4.71

4.71

6Inform

ationon

inve

stmen

tin

shares

306

4.90

4.90

4.90

5.00

4.78

4.92

4.79

4.91

4.83

4.83

2List

ofdirectors’

names

306

4.44

4.44

4.44

4.38

4.47

3.53

3.95

4.71

4.27

4.27

23

List

oftopman

agem

entna

mes

306

4.49

4.49

4.49

4.38

4.50

3.53

4.02

4.74

4.35

4.35

21

Stock

value

306

4.41

4.41

4.41

4.92

4.83

4.92

4.79

4.77

4.74

4.74

5Inform

ationon

stoc

kco

nten

ts306

4.32

4.32

4.32

4.92

4.67

4.66

4.77

4.63

4.62

4.62

15

Details

ofdivide

ndspo

licy

306

4.66

4.66

4.66

4.69

4.83

4.92

4.41

4.89

4.69

4.69

9Nam

esof

majoritysh

areh

olde

rs306

4.63

4.63

4.63

4.23

4.47

3.74

3.90

4.69

4.32

4.32

22

Value

ofinve

stmen

tin

bond

s306

4.54

4.54

4.54

4.95

4.81

4.89

4.64

4.89

4.75

4.75

4Value

ofraw

materials

prod

uced

loca

lly306

4.63

4.63

4.63

4.77

4.64

4.66

4.49

4.74

4.63

4.63

14

Inform

ationon

long

-term

liabilities

306

4.51

4.51

4.51

4.82

4.81

4.71

4.54

4.74

4.66

4.66

11

Aud

itors’

fees

306

4.05

4.05

4.05

4.31

4.72

4.37

3.92

4.46

4.23

4.23

24

Inform

ationon

variou

sprod

ucts

prod

uced

bythefirm

306

4.46

4.46

4.46

4.62

4.75

4.78

4.54

4.71

4.64

4.64

13

Inform

ationon

cash

surplus

306

4.39

4.39

4.39

4.72

4.64

4.68

4.44

4.69

4.59

4.59

16

Inform

ationon

ageing

debtors

306

4.41

4.41

4.41

4.74

4.72

4.50

4.46

4.74

4.58

4.58

17

Earning

spe

rsh

are

306

4.80

4.80

4.80

4.85

4.78

5.00

4.82

4.94

4.85

4.85

1Statisticsformorethan

oneye

ar306

4.66

4.66

4.66

4.74

4.72

4.92

4.59

4.89

4.70

4.70

7Ken

dall’sco

effic

ient

ofco

ncorda

nceW

0.25

0.27

0.42

0.55

0.09

0.52

0.35

0.52

0.10

Notes

:Mea

nva

lues

–sc

oring:

1=strong

lydisa

gree

;5=strong

lyag

ree

[ 614 ]



The user groups considered credibility and

timeliness as the most important features of

useful corporate information. The users,

however, attached less importance to

independent verification and the availability

of specific information as contributing

features to the usefulness of corporate

information. This might emphasise the

previous result in that Kuwaiti users can

enjoy the privilege of directly contacting the

company to request specific information.

Independent verification is, however,

connected with the auditor’s report. The

analysis showed that the Kuwaiti users

attach little importance to the auditor’s

report, since it is only a matter of routine and

also corporate income tax is not paid in

Kuwait[7].

In the main, there was general consensus

within the target groups that all of the main

sections of the annual report published by

Kuwaiti companies are not difficult to

understand. This implies that most user

groups who participated in this study have a

certain degree of knowledge about corporate

accounting and finance. The results also

imply that annual reports published by

Kuwaiti companies ensure a certain degree

of quality, since most of them are audited by

either the big firms, or by local firms

affiliated to them.

As far as the issue of credibility and

importance of different parts of the corporate

annual report are concerned, the respondents

made it clear that they had full confidence in

all sections contained in the annual report.

They believe financial statements to be the

most credible and important part of the

report. This result might reflect the Arab

culture in general, and the GCC countries in

particular, where the focus is on the main

issues without the need to examine minor

details. Financial statements are regarded

sufficient in formulating their decisions

about a company. To emphasise the

relevance of the annual report, the

respondents asked for a speedier publication

within a period of no more than 30 days.

The analyses also revealed that the

corporate annual report is useful in making

informed decisions about a company and

assists in evaluating corporate performance.

The analysis, however, indicates that current

information published by Kuwaiti companies

is insufficient to estimate corporate dividend

policy.

Overall, the respondents attached a high

degree of importance to all disclosure items

expected to be reported in the annual report

under the IASs, with more emphasis placed

on performance items. They also viewed the

list of voluntary disclosure items presented

in the questionnaire as being important. A

high degree of importance, however, was

attached to disclosure items such as earnings

per share and investments in shares and

bonds. Nevertheless, a low rating was

attached to disclosure items such as the

recruitment policies among Kuwaiti

graduates, pension plans and charitable

donations. These issues are unlikely to be of

any concern to a rich country like Kuwait.

The public sector still forms the biggest

employer of graduates. The government also

takes care of its pensioners and donates large

sums to charities. Hence, these issues are of

least concern to the users of the corporate

annual report.

In sum, the perception of user groups to

different aspects of the annual corporate

report, from an emerging economy like

Kuwait, seems to be generally similar to that

of the users in the developed economies. Both

agree that the annual report is the main

source of information, specific criteria ought

to be met to make the corporate report useful

to the users and the information disclosed in

the annual report is not difficult to

understand. Unlike user groups in the

developed economies, the Kuwaiti user

groups obtain information directly from the

company and place little importance on the

auditor’s report.

Notes1 Late responses were used as a surrogate of

those who have not responded to the

questionnaire.

2 The Cronbach’s Alpha ranges between zero

and one, where zero means no correlation

exits between various parts of the

questionnaire and one refers to perfect

correlation between different parts of the

questionnaire.

3 Given that Kuwait is a small country,

companies’ management establish close

relationships with investors. It is, therefore,

difficult for individual investors to request

information directly from the companies.

4 In August 1982, the Kuwaiti Stock Exchange

was struck by the Al-Manakh crisis. The

crises happened in an unorganised Kuwait

stock exchange as a result of speculations and

the absence of an effective control authority.

5 Zakat is the third basic pillar of the Islamic

faith, which is built on five main pillars. Zakat

in the Arabic language means increment,

growth, and/or purification of the soul and

wealth. It is a levy on wise and rational

Muslim adults whose wealth exceeds specific

minimum value.

6 Auditors work in a country like Kuwait,

where income tax is not paid, is to emphasise

accountability by assuring investors

and lenders.

[ 615 ]



7 The fact that almost all firms in Kuwait are

affiliated to large international firms ensures

accountability and makes fraud only a remote

possibility.

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[ 616 ]



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evidence on corporate social disclosure

(CSD), practices in Jordan’’, International

Journal of Commerce andManagement, Vol. 10

No. 3-4, pp. 18-34.

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‘‘Differences in disclosure needs of major

users of financial statements’’, Accounting

and Business Research, Vol. 7 No. 26,

pp. 187-92.

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(1982), ‘‘Corporate financial reporting in New

Zealand: an analysis of user preferences,

corporate characteristics and disclosure

practice for discretionary information’’,

Accounting and Business Research, Vol. 13

No. 49, pp. 11-20.

Naser, K. and Abu-Baker, N. (1999), ‘‘Empirical


reporting and accountability in developing

countries: the case of Jordan’’, Advances in


Naser, K. and Idris, F. (1997), ‘‘Users opinions of a

useful annual report produced by Islamic

banks’’, Accounting Commerce and Finance:

The Islamic Perceptive Journal, December,

Vol. 1 No. 2, pp. 1-42.

[ 617 ]



Book review

Opinion Shopping and the Role ofAudit Committees when Audit Firmsare Dismissed: the US Experience

Clive LennoxInstitute of Chartered Accountants ofScotland200378 pp.ISBN 1 871250 93 5£15Review DOI 10.1108/02686900310482740

This is a compact, timely and valuable

publication on a topic of high significance in

the post Enron situation. It lets a few ‘‘cats

out of bags’’ that were always suspected and

often secretly acknowledged. Now there is

proof, and it makes for disturbing reading.

With the highly diversified share portfolios

held by US investors, there is little incentive

to monitor senior management (p. 2). So

there goes one control. US auditors are

permitted to disclose ‘‘emphases of matter’’ if

deemed appropriate for the interests of

shareholders, but they rarely do so in fact

only in 0.43 per cent of the sub-sample of 2,405

unqualified but modified audit opinions out

of the 19,273 sample of company-year

observations between 1996 and 1998 (pp. 3 and

28). The Americans stand accused of being

overly legalistic and rule-based in their

approach to accounting, and this is

confirmed by when they have the

opportunity to break out, they rarely take it.

So there goes another potential control.

The overall findings are deeply disturbing

and indicate senior management

manipulation reigns supreme. First,

companies do successfully engage in opinion

shopping, swapping auditors to suit their

narrow self-interest. Second, audit committee

meetings are held at a low level of activity,

and only an estimate of 85 per cent engage in

auditor dismissal decisions. Third,

companies often dismiss auditors despite

audit committee disapproval. Fourth comes

higher audit committee member turnover

when audit committees disapprove. Rather

than hang around to raise Cain and Abel,

they simply clear off, thus reinforcing the

undesirable tendency. For those innocent

investors who believe they are being well

served, the uncomfortable message is that

mandated corporate governance initiatives

may not reduce the incidence of accounting

scandals since they do not address the

temptations of senior management, well

portrayed in agency theory. Perhaps granny

was right to invest her money under the

mattress, and had a canny intuition not to

trust companies and the financial markets.

So folk, in lieu of stricter regulation,

enforcement, comprehensive treatment of

the issue, audit professionalism, and

seriousness of intent of audit committee

members, expect senior management to get

away with what they have traditionally got

away with, and await the Messianic arrival

of the next Enron-imaged anti-Christ. Unless

issues relate to going concern, you can bet on

the auditors to keep their mouths shut. There

is no impetus on either audit firms or audit

committee members to whistleblow on behalf

of investors, who are patently not well served

in the USA. May those in other jurisdictions

examine their situations and their

consciences. Thanks go to the Scottish

Institute for sponsoring such a pertinent

publication.

Professor Gerald VintenEditor, Managerial Auditing Journal

[ 618 ]

Managerial Auditing Journal18/6/7 [2003] 618

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