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Volume 18 Number 6/7 2003

ISBN: 0-86176-871-X

ISSN 0268-6902

Managerial Auditing Journal Dispelling the Enron blues

www.emeraldinsight.com

ISSN 0268-6902

Managerial Auditing Journal Volume 18, Number 6/7, 2003

Dispelling the Enron blues

Contents

442 Access this journal online 443 Abstracts & keywords

538 Users’ perceptions of corporate social responsibility and accountabilty: evidence from an emerging economy Khalid Al-Khater and Kamal Naser

448 Enronitis – dispelling the disease Gerald Vinten

456 An exploratory study of adopting requirements for audit committees for non-US commercial bank registrants: an empirical analysis of foreign equity investment

549 The usefulness of the audit report in investment and financing decisions Antonio Dure´ndez Go´mez-Guillamo´n

560 Auditing in support of the integration of management systems: a case from the nuclear industry I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn

Louis Braiotta Jr

465 Developing a strategic internal audit-human resource management relationship: a model and survey

569 Current accounting investigations: effect on Big 5 market shares

MaryAnne M. Hyland and Daniel A. Verreault

478 Underreporting and premature sign-off in public accounting Mike Shapeero, Hian Chye Koh and Larry N. Killough

490 Internal auditors and the external audit: a transaction cost perspective Cameron Morrill and Janet Morrill

Christie L. Comunale and Thomas R. Sexton

577 The efficacy of liquidation and bankruptcy prediction models for assessing going concern Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere

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

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

599 Users’ perceptions of various aspects of Kuwaiti corporate reporting

517 Credibility and expectation gap in reporting on uncertainties

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini

Junaid M. Shaikh and Mohammad Talha

618 Book review 530 Improving corporate governance: the role of audit committee disclosures Zabihollah Rezaee, Kingsley O. Olibe and George Minmier

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Abstracts & keywords

Enronitis – dispelling the disease Gerald 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 adopting requirements for audit committees for non-US commercial bank registrants: an empirical analysis of foreign equity investment

Developing a strategic internal audit-human resource management relationship: a model and survey MaryAnne 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.

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

Managerial Auditing Journal 18/6/7 [2003] Abstracts & keywords # MCB UP Limited [ISSN 0268-6902]

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 nonUS 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.

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Abstracts & keywords Managerial Auditing Journal 18/6/7 [2003] 443-447

Underreporting and premature sign-off in public accounting Mike Shapeero, Hian Chye Koh and Larry 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 consequencesbased 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 external audit: a transaction cost perspective Cameron 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.

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The Mad Hatter’s corporate tea party Philomena 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 in reporting on uncertainties Junaid 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.

Abstracts & keywords Managerial Auditing Journal 18/6/7 [2003] 443-447

Improving corporate governance: the role of audit committee disclosures Zabihollah Rezaee, Kingsley O. Olibe and George 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 social responsibility and accountability: evidence from an emerging economy Khalid 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 in investment and financing decisions Antonio Dure´ndez Go´mez-Guillamo´n 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.

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Abstracts & keywords Managerial Auditing Journal 18/6/7 [2003] 443-447

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

The efficacy of liquidation and bankruptcy prediction models for assessing going concern

I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn

Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere

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 shares Christie 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 longterm 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.

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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 creditororiented 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.

Abstracts & keywords

Are auditors sensitive enough to fraud?

Managerial Auditing Journal 18/6/7 [2003] 443-447

Bilal Makkawi and Allen Schick Keywords Auditing, Fraud, Corporate governance, 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 aspects of Kuwaiti corporate reporting Kamal Naser, Rana Nuseibeh and Ahmad 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.

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Enronitis – dispelling the disease

Gerald Vinten European Business School, London

Keywords Corporate 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.

Managerial Auditing Journal 18/6/7 [2003] 448-455 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482597]

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Introduction

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.

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

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

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The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

Enron and aftermath

Gerald Vinten Enronitis – dispelling the disease Managerial Auditing Journal 18/6/7 [2003] 448-455

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 a seemingly 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 way corporations report their results. Exaggeration is out. Conservatism and cleaned-up financial statements are in.

Recommendations The factors here enunciated were first set out in bare outline in Vinten (2002), which also indicated some of the background to the debacle, and the immediate response. Apparently the article was the seventh most accessed article of all the myriad Emerald insight articles. The opportunity has been taken to revise and provide more extensive explanation to the original listing.

Protecting the public interest 1 State national audit offices across the world should follow the US General Accounting Office example of investigating matters of public interest, and issuing reports. This means moving beyond the narrow focus of the public sector viewed in splendid isolation. Such extension has occurred already in the explicit rather than implicit involvement in value-for-money studies in many jurisdictions. With the move of former state industries into the private sector, state audit has sometimes been retained. Hence the UK Competition Commission continues to ‘‘audit’’ the former nationalised industries to ensure they are operating in the public interest, with a focus on value-for-money which includes relations with the labour force and trades unions. 2 Legislation should specify clear and strict rights of access to relevant agencies for such information as they reasonably deem necessary, to avoid the need for them to initiate legal action on a case-by-case basis. The model of the UK Audit Commission should be adopted whereby it can act in an independent but quasi-judicial fashion to decide any challenges to such powers. This will avoid delaying tactics, and minimise cost. 3 Criminal penalties, large fines and strict liability will apply to all those implicated in the shredding or concealment of documentation. Organisations need to have policies relating to the retention and indeed archiving and disposal of

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Gerald Vinten Enronitis – dispelling the disease Managerial Auditing Journal 18/6/7 [2003] 448-455

documents in addition to those established by statute. Bank of Credit and Commerce International maintained a double set of documentation, one being fraudulent. The US federal Sarbanes-Oxley Act of 2002 contains stipulations on this. 4 Jurisdictions, the vast majority, which have not legislated to protect valid acts of whistleblowing should do so forthwith (Vinten, 1994a). The Sarbanes-Oxley Act has section 1107 retaliation against informers: 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 not currently present. The chartered secretary has the following responsibilities (Lai, 2002; Baker, 2002): . the maintenance of the statutory registers of the company; . attendance at board meetings, the formulation of agendas, taking minutes of the meeting, preparation of articles

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. .

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.

Gerald Vinten Enronitis – dispelling the disease Managerial Auditing Journal 18/6/7 [2003] 448-455

Similar developments are in train in other parts of the world. 9 Professional ethics need to be a major emphasis within the accounting and other relevant professions. They need to have bite in their enforcement, but equally important to be internalised in the hearts, minds and souls of all professionals. Those working within financial services, many of whom command ridiculously inflated salaries for what they do, are noted for treating professional ethics with some disdain, and seem to think that the unsuspecting public owe them an existence: unsuspecting because their relationship is often at second hand and indirect through the likes of pension funds. The public are simply the fodder for their high lifestyle and are to be treated with contempt.

Accounting and financial reporting 10 Principles-based ‘‘substance over form’’ should become the norm. However the proper role for a rules-based approach needs to be debated and determined. This is much more than a dry-as-dust philosophical debate. It is fundamental to the way accounting is formulated and executed. 11 The USA as a major player needs to move more in line with the rest of the world, with an expedited convergence taking place. This, indeed, has started to happen, with more openness to developments outside the USA, and the global need to be singing from the same hymn sheet. 12 Three levels of rigour of reporting need to be established as opposed to the present two: large, high risk and/or materiality entities; intermediate companies; small businesses. Previously there tended to be concessions only for the small company sector. One would not suggest the intermediate category have a lesser standard than at present, but rather that the top category have increasing demands placed on it. The notion of materiality is often left vague in accounting and auditing terms. It needs to be made more specific such that there is transparency (Vinten, 1994a). 13 With the complexities involved, as in derivatives and special purpose entities, the near incomprehensibility of accounts to many of the stakeholders, and accountancy itself trying to keep up with the realities of E-commerce and the knowledge environment, steps need to be taken to ensure adequate communication to users. Issues which impact on risk and value need to be made explicit. 14 Our more inclusive reporting model presupposes 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.

Auditing 15 ‘‘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 fac¸ade 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:

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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).

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17

18

19

20

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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. 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. A threats and risks based model should be adopted. Bazerman et al. (2002) indicate that 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. 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). 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. 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 for matters of concern. Internal control is a crucial concept. The US Federal Foreign and Corrupt Practices Act 1977 was said to have led to an increase in the employment of internal auditors in the late 1970s. The Act required a statement in the annual report and accounts as to how internal control had been safeguarded. Internal auditors are significant in this growing corporate governance framework. 21 The audit committee needs to play a significant role. In 1987, the Treadway Report (known as the Report of the National Commission of Fraudulent Financial Reporting), offered 11 recommendations to enhance the effectiveness of audit committees, which were to be the keystone of corporate financial governance. These remain a comprehensive and authoritative list: . They should have adequate resources and authority to discharge their responsibilities. . They should be informed, vigilant, and effective overseers of the company’s financial reporting process and its internal control system. . They should review management’s evaluation of the independence of the company’s public accountants. . They should oversee the quarterly as well as the annual reporting process. . The SEC should mandate the establishment of an audit committee composed solely of independent directors in all public companies. . The SEC should require committees to issue a report describing their responsibilities and activities during the year in the company’s annual report to shareholders. . A written charter for the committee should be developed. The full board should approve, review, and revise it as necessary. . Before the beginning of each year, audit committees should review management’s plans to engage the company’s independent public accountant to perform management advisory services. . Management should inform them of second opinions sought on significant accounting issues. . With top management, the committee should ensure that internal auditing involvement in the financial reporting process is appropriate and properly co-ordinated with the independent public accountant. . Annually, committees should review the programme that management establishes to monitor compliance with the company’s code of ethics.

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Most audit committee chairs commend the recommendations as having exerted a positive influence on corporate reporting and internal controls.

Corporate governance 22 Board members should be properly inducted, trained and developed. Originally there was a view that directors were born not made, reinforced by their being recruited via the old boys’ network, and it being assumed that they were all good chaps and entirely competent, or that the role was not that demanding. This was never satisfactory, and there are now professional certifications and even chartered status available via the Institute of Directors of the UK. Directors need both induction and mentoring. 23 The pros and cons of different types of corporate governance need to be explored and best practice disseminated. Thus the UK system has a balanced mixture of types of director, whereas in the US system the ‘‘independents’’ predominate. The UK ‘‘independents’’ may therefore be closer to the action. The European two tier board is also worth exploration over the prejudice of some in the UK that stick almost ideology to the Anglo-Saxon model. 24 There needs to be more company sponsored practical research on governance, rather than the black box it often is at present. Directors may have been reluctant to be exposed to research and hence greater scrutiny, but practice created in ignorance is hazardous, and the opportunity to benchmark and disseminate good practice is lost. 25 National research agendas need to be formulated, with central collection and dissemination of results. This has happened to a limited extent, but more is required. 26 Although the Turnbull Report emphasised risk, one needs to put risk in perspective. It is not simply a ‘‘policing’’ matter, but equally weighing up the risk of missing opportunities. Risk is endemic in business and presents opportunity as well as the possibility of sub-optimal performance or even disaster. There has been criticism that the whole series of corporate governance reports has led to a risk aversion mentality. 27 Business ethics is a crucial ingredient, and consideration should be given to appointing a chief ethics officer, an ombudsman, or the registrar function as in the John Lewis partnership. These need to have independence and a reporting relationship straight into the board and access to the chair of the board. 28 Equally crucial is what has been known as the ‘‘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.

Education 31 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.

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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 personal beliefs and values. . Level 2. Awareness of the wider social and environmental implications of area(s) of study. Ability to debate issues in relation to more general ethical perspectives. . Level 3. Awareness of personal responsibility and professional codes of conduct. Ability to incorporate a critical ethical dimension into a major piece of work. . Level M. Awareness of ethical dilemmas likely to arise in research and professional practice. An ability to formulate solutions in dialogue with peers, clients, mentors and others. 34 Business courses should place more emphasis on risk and fraud, rather than pretending that fraud never takes place. Some companies are established with fraud as their main intent, including the laundering of money. Others are the product of illegal funds, although in themselves operate as legitimate businesses. The remaining majority of businesses operate with varying degrees of noble intent, and if they survive long enough or are of sufficient size are highly likely to suffer fraud. Quality Assurance Agency for Higher Education (2000a) mentions risk but not fraud. An instructive story relates to the MBA examination at the City University Business School (now the Cass Business School) over a decade ago. A case study was set for the business strategy examination. Students had this in advance for any analysis they wished to conduct in advance. In the event the usual tools of business strategy were applied by the students. Only one got close to the truth of the situation and what was needed to improve the situation. Behind all the facts and figures was a gigantic fraud. The company produced a sucrose drink called ‘‘Tizer the Appetizer’’ in its promotional mode. It was bottled and sold off the back of lorrys which traversed townships. Initially the delivery staff, the sales people (in reality glorified lorry drivers), found that if they defrauded on the deliveries, no management action was taken. This then led to the foundation of an alternative bottling line which was purely for the benefit of the fraudsters. With this twin-track fraud, it was not surprising that the company was experiencing liquidity problems. It was eventually taken over for a song by Barr Brothers of Glasgow who stripped out the cancerous fraud in the process. Had the students been schooled with more fraud awareness, they may have come closer to offering the sort of solution that was

Gerald Vinten Enronitis – dispelling the disease

called for, and which all the lovely corporate strategy tools were otiose to save the company.

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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.

References Association 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’’, Managerial Auditing Journal, Vol. 8 No. 7, 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.

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An exploratory study of adopting requirements for audit committees for non-US commercial bank registrants: an empirical analysis of foreign equity investment Louis Braiotta, Jr School of Management, State University of New York, Binghamton, New York, USA

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

Abstract 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.

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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 The Emerald Research Register for this journal is available at http://www.emeraldinsight.com/researchregister

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). The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

Louis Braiotta, Jr An exploratory study of adopting requirements for audit committees for non-US commercial bank registrants: an empirical analysis of foreign equity investment Managerial Auditing Journal 18/6/7 [2003] 456-464

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 hypothesis development 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

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Louis Braiotta, Jr An exploratory study of adopting requirements for audit committees for non-US commercial bank registrants: an empirical analysis of foreign equity investment Managerial Auditing Journal 18/6/7 [2003] 456-464

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

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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 and description Sample selection During 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 commercial bank registrants without audit 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 commercial bank registrants without audit 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

Louis Braiotta, Jr An exploratory study of adopting requirements for audit committees for non-US commercial bank registrants: an empirical analysis of foreign equity investment Managerial Auditing Journal 18/6/7 [2003] 456-464

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 tests Tables 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 I Panel A: Distribution of means and standard deviations and comparison of US commercial banks with audit

Variablea 1996 BVA BVE MVE 1997 BVA BVE MVE

US commercial banks with audit committees (n = 31) Mean Std. dev.

Non-US commercial banks wihtout audit committees (n = 31) Mean Std. dev.

Between sample banks t-test Wilcoxon Z-value

4.122 3.025 3.327

0.989 0.909 0.969

4.081 2.599 2.949

0.909 1.260 1.130

0.172 1.504 1.426

0.38 1.72 1.34

4.196 3.101 3.540

0.988 0.917 0.966

4.141 2.611 3.057

0.925 1.188 1.161

0.225 1.786 1.799

0.39 1.99 1.80

Notes: Paired t-tests for means and Wilcoxon z-values were computed and no statistically significant differences were 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; and ADR = For panel B, the natural logarithm of the market value of American Depository Receipts at the end of fiscal years 1996 and 1997

Table II Panel B: Distribution of means and standard deviations and comparison of non-US commercial banks with and wihout audit commitees

Variablea

US commercial banks with audit committees (n = 31) Mean Std. dev.

Non-US commercial banks wihtout audit committees (n = 31) Mean Std. dev.

Between sample banks t-test Wilcoxon Z-value

1996 BVA BVE MVE ADR

4.830 3.703 3.639 3.700

0.841 0.423 1.241 0.784

4.081 2.599 2.949 3.089

0.909 1.260 1.130 0.917

2.67** 3.17*** 1.88 2.01**

2.91** 3.08** 2.89 1.48*

1997 BVA BVE MVE ADR

4.864 3.726 3.759 3.624

0.833 0.419 1.250 1.009

4.141 2.611 3.057 3.208

0.925 1.188 1.161 0.913

2.50** 3.38*** 1.87 1.32**

2.76** 3.30** 2.96 1.48

Notes: a see Table I; Model chi-square = 15.748, d.f. 3, p = 0.0013; *, ** Statistically significant at less than the 0.05, 0.01 level, based on two-sided tests [ 459 ]

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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 tests The following logistic regression model was used to estimate the likelihood of the presence of audit committees (oversight protection) with respect to non-US commercial bank registrants without audit committees (see panel A of Table III): AUDCOMMit ¼ B0 þ B1 logðBVAit Þ þB2 logðBVEit Þ þ B3 logðMVEit Þ þ Eit ;

V. Conclusions 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

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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.

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

Louis Braiotta, Jr An exploratory study of adopting requirements for audit committees for non-US commercial bank registrants: an empirical analysis of foreign equity investment Managerial Auditing Journal 18/6/7 [2003] 456-464

Table III Logistic regression results between the dichotomous dependent variable audit committees and the independent variables Term

Variable

Coefficients

t-statistics

Panel A: US commercial banks with audit committees and non-US commercial banks without audit committees AUDCOMMit ¼ B0 þ B1 logðBVAit Þ þ B2 logðBVEit Þ þ B3 logðMVEit Þ þ
it Model 2 = 9.324; df = 3; p = 0.0253 1996 (n = 31) B0 Intercept 1.932 1.75 B1 log (BVA) –2.450 4.31** B2 log (BVE) 1.108 1.63 B3 log (MVE) 1.582 2.15* Model 2 = 15.748; df = 3; p = 0.0013 1997 (n = 31) B0 Intercept 1.966 1.88 B1 log (BVA) –3.635 7.91** B2 log (BVE) 1.050 1.45 B3 log (MVE) 3.026 4.808* Panel B: Non-US commercial banks with audit committees (n = 15) and non-US commercial banks without audit committees (n = 31) AUDCOMMit ¼ B0 þ B1 logðBVAit Þ þ B2 logðBVEit Þ þ B3 logðMVEit Þ þ B4 logðADRit Þ þ
it Model 2 = 17.697; df = 4; p = 0.0014 1997 B0 Intercept –9.726 3.30* B1 log (BVA) 1.847 0.56 B2 log (BVE) 1.340 0.73 B3 log (MVE) 0.884 0.10 B4 log (ADR) –2.112 1.02 Model 2 = 22.270; df = 4; p = 0.0002 1996 B00 Intercept –10.837 4.68 B11 log (BVA) –1.891 0.21 B22 log (BVE) 3.761 1.54 B33 log (MVE) 3.347 0.55 B44 log (ADR) –1.861 1.62 Notes: *, ** Statistically significant at less than the 0.05, 0.01 level, based on two-sided tests 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.

Notes 1 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

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6

7

8

9

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every company specify that the outside auditor is ultimately accountable to the board of directors and the audit committee, as representatives of shareholders’’. 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). 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). 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). 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). 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.

References ABA (1994), Corporate Director’s Guidebook, American Bar Association, Chicago, IL. ALI (1994), Principles of Corporate Governance: Analysis and Recommendations, American Law Institute, Philadelphia, PA. Birkett, B.S. (1986), ‘‘The recent history of corporate audit committees’’, The Accounting Historians Journal, Vol. 13, Fall, pp. 109-24. Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999), Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, New York Stock Exchange, New York, NY and National Association of Securities Dealers, Washington, DC. Braiotta, L. (1986), ‘‘Audit committees: an international survey’’, The Corporate Board, May/June, pp. 18-23. Braiotta, L. (1994), The Audit Committee Handbook, John Wiley & Sons, New York, NY. Braiotta, L. (1998), ‘‘An exploratory study of adopting requirements for audit committees in international capital markets’’, Advances in International Accounting, Vol. 11, pp. 169-87. Bull, I. (1991), ‘‘Board of director acceptance of tramway responsibilities’’, Journal of Accountancy, Vol. 17, February, pp. 67-74. Collier, P. (1993), ‘‘Factors affecting the formation of audit committees in major UK listed companies’’, Accounting and Business Research, Vol. 23, pp. 421-30. Cook, J.M. (1993), ‘‘The CEO and the audit committee’’, Chief Executive, April, pp. 44-7. English, L. (1989), ‘‘Non-executive directors’’, Australian Accountant, Vol. 59, October, pp. 31-41. Fogarty, M.P. (1965), Company and Corporation – One Law, Geoffrey Chapman, London. International Auditing Practices Committee (1998), ‘‘Communications To Those Charged With Governance (Exposure Draft)’’, International Federation of Accountants, New York, NY. International Federation of Accountants (1995), Annual Report. International Task Force on Corporate Governance (1995), Who Holds the Reins?, International Capital Markets Group, London. Jensen, M.C. and Meckling, W.H. (1976), ‘‘Theory of the firm: managerial behavior, agency costs and ownership structure’’, Journal of Financial Economics, Vol. 3, pp. 305-60. Kalbers, L.P. and Fogarty, T. (1993), ‘‘Audit committee effectiveness; an empirical investigation of the contribution of power’’, Auditing: A Journal of Practice and Theory, Vol. 12, Spring, pp. 24-49.

Louis Braiotta, Jr An exploratory study of adopting requirements for audit committees for non-US commercial bank registrants: an empirical analysis of foreign equity investment Managerial Auditing Journal 18/6/7 [2003] 456-464

The author wishes to thank the conference participants at the 1999 Asian-Pacific International Accounting Issues Conference in Melbourne, Australia; the 2000 AAA annual mid-year International Section meeting in Tampa, FL; and the 2000 AAA annual Northeast meeting in Boston, MA for their useful comments on this paper.

Kirk, D.J. (1996), ‘‘How directors and auditors can improve corporate governance’’, Journal of Accountancy, Vol. 18, January, pp. 53-7. Knapp, M.C. (1991), ‘‘Factors that audit committee members use as surrogate for audit quality’’, Auditing: A Journal of Practice & Theory, Vol. 10, Spring, pp. 32-5. Leftwich, R.W., Watts, R.L. and Zimmerman, J.L. (1981), ‘‘Voluntary corporate disclosure: the case of interim reporting’’, Journal of Accounting Research, Vol. 19 (supp.), pp. 50-77. New York Business Corporation Law (1963), in McKinney’s Consolidated Laws of New York Annotated, sec. 717, Edward Thompson Company, Brooklyn, NY. Marrian, I.F.Y. (1988), Audit Committees, The Institute of Chartered Accountants of Scotland, Edinburgh. Mautz, R.K. and Neumann, F.L. (1970), Corporate Audit Committees, University of Illinois, Urbana, IL. Mautz, R.K. and Neumann, F.L. (1977), Corporate Audit Committees: Policies and Practices, Ernst & Ernst, New York, NY. National Association of Securities Dealers (1987), NASD Manual, Commerce Clearing House, Chicago, IL. New York Stock Exchange (1983), ‘‘Corporate responsibility: audit committee, sec. 303.00’’, New York Stock Exchange Listed Company Manual, NYSE, New York, NY. Pincus, K., Rusbarsky, M. and Wong, J. (1989), ‘‘Voluntary formation of corporate audit committees among NASDAQ firms’’, Journal of Accounting and Public Policy, Vol. 8, pp. 239-65.

Porter, B.A. and Gendall, P.J. (1992), ‘‘The potential contribution of audit committees to securing responsible corporate governance and reliable external financial reporting’’, Proceedings of the Fourth Asian-Pacific Conference on International Accounting Issues. Powell, N.C., Strickland, S. and Burnaby, P.A. (1992), ‘‘Internal auditing: the emergence of an international profession’’, Journal of International Accounting Auditing & Taxation, Vol. 1, pp. 209-28. Sommer, A.A. (1978), ‘‘The impact of the SEC on corporate governance’’, Law and Contemporary Problems, Vol. 41, pp. 115-16. Spangler, W.D. and Braiotta, L. (1990), ‘‘Leadership and corporate audit committee effectiveness’’, Group & Organization Studies, Vol. 15, June, pp. 134-57. Tricker, R.I. (1978), The Independent Director: A Study of the Non-Executive Director and the Audit Committee, Tolley, Croydon. Verschoor, C.C. (1993), ‘‘Benchmarking the audit committee’’, Journal of Accountancy, Vol. 17, September, pp. 59-64. Watts, R.L. (1977), ‘‘Corporate financial statements, a product of the market and political process’’, Australian Journal of Management, Vol. 2, pp. 53-75.

Further reading Vinten, G. (1993), ‘‘Audit committees and corporate control’’, Managerial Auditing Journal, Vol. 8, pp. 11-24. (The Appendix appears overleaf.)

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Appendix Table AI Summary of requirements and/or recommendations for audit committees of companies listed on stock exchanges by country Country

Reference

Australia

Working Group on Corporate Practices and Conduct (Borsch Committee), Corporate Practices and Conduct, 1990 The Bank Act; The Trust and Loan Companies Act, and the Insurance Company Act, 1992, Canadian Business Corporation Act 1975, Commission to Study the Public’s Expectations of Audits (MacDonald Commission) 1988, Canadian Securities Administrators Notice on Audit Committees 1990, Auditing and Related Service Guidelines, ‘‘Commission with Audit Committees,’’ 1991 1995 Vienot Report on Corporate Governance Hong Kong Society of CPAs and The Stock Exchange of Hong Kong, Amendments to Appendix 14 of its Listing Rules, May 1998 Confederation of Indian Industry, Desirable Corporate Governance in India, A Code, Recommendation No. 8, 1997 Israeli Companies Ordinance (New Version) 5743-1983, Section 96-15 Kuala Lumpur Stock Exchange 1995 and Companies Act 1995 1995 Peters Report on Corporate Governance Institute of Directors’ 1992 Draft Code of Practice for Boards of Directors Ministry of Commerce (for joint stock companies) Regulations 1994 Companies Act of 1989 Johananburg Stock Exchange Listed Companies Manual, 1989. King Committee Report on Corporate Governance, Code of Corporate Practices and Conduct, 1994 Stock Exchange of Thailand 1999 Recommendations of a Working Party Established by the Institute of Chartered Accountants of Scotland, Corporate Governance – Directors’ Responsibilities for Financial Statements, 1992. The committee on the Financial Aspects of Corporate Governance, The Code of Best Practice (Cadbury Committee) 1992. Statement of Auditing Standards 610 – ‘‘Reports to Directors of Management,’’ 1995 American Law Institute, Principles of Corporate Governance: Analysis and Recommendations, 1994 American Stock Exchange Guide, Vol. 2, Sec. 121, 1993 FDIC Improvement Act of 1991 (FDIC Improvement Act is contained in Title 1 of Public Law 102-242, December 19, 1991). Connecticut General Statutes, Sec. 33-318 (b) (1) and (b) (2) Statement on Auditing Standards No. 61 ‘‘Communication with Audit Committees,’’ 1988 COSO Report – ‘‘Internal Control – Integrated Framework’’ 1992 National Association of Securities Dealers, NASD Manual, Part III, Section (d) of Schedule D of the NASD bylaws, 1987 New York Stock Exchange Listed Company, 1993 Public Oversight Board, A Special Report by the Public Oversight Board of the SEC Practice Section, AICPA, 1993 Report of the National Commission on Fraudulent Financial Reporting (Treadway Commission) 1987 Statement on Internal Auditing Standards No. 7, ‘‘Communication with the Board of Directors’’ 1989 US Federal Sentencing Commission, Federal Sentencing Guidelines for Organizations, 1991

Canada

France Hong Kong India Israel Malaysia The Netherlands New Zealand Saudi Arabia Singapore South Africa Thailand UK

USA

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

MaryAnne M. Hyland School of Business, Adelphi University, Garden City, New York, USA Daniel A. Verreault School of Business, Adelphi University, Garden City, New York, USA

Keywords Internal auditing, Human resources management, Risk management

Abstract 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.

Managerial Auditing Journal 18/6/7 [2003] 465-477 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482614]

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

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Introduction

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MaryAnne M. Hyland and Daniel A. Verreault Developing a strategic internal audit-human resource management relationship: a model and survey

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.

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Risk managing and control focused internal 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 HRM functions 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,

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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

MaryAnne M. Hyland and Daniel A. Verreault Developing a strategic internal audit-human resource management relationship: a model and survey Managerial Auditing Journal 18/6/7 [2003] 465-477

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 framework We 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

Figure 1 The proposed framework

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 combination When 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.

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Cost-minimizing combination When 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 combination When 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 combination When 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

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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.

MaryAnne M. Hyland and Daniel A. Verreault Developing a strategic internal audit-human resource management relationship: a model and survey Managerial Auditing Journal 18/6/7 [2003] 465-477

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.

Questionnaire The 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 proposed framework The 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

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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

Figure 2 Chief audit executives’ perspectives of human resources

Figure 3 Chief audit executives’ self-rating

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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

MaryAnne M. Hyland and Daniel A. Verreault Developing a strategic internal audit-human resource management relationship: a model and survey Managerial Auditing Journal 18/6/7 [2003] 465-477

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 research questions We 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

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MaryAnne M. Hyland and Daniel A. Verreault Developing a strategic internal audit-human resource management relationship: a model and survey Managerial Auditing Journal 18/6/7 [2003] 465-477

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

Figure 4 Respondents falling clearly into one of the proposed quadrants

Figure 5 Responses including those falling in the borderline region

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(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 valuecreating 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 costminimizing 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

MaryAnne M. Hyland and Daniel A. Verreault Developing a strategic internal audit-human resource management relationship: a model and survey Managerial Auditing Journal 18/6/7 [2003] 465-477

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

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 responses We recognize that CAE’s definition of the terms ‘‘strategic’’ and ‘‘risk managing’’ in

Table I Regressions using modified quadrants Productive working relationship between HRM and IA b(1) (2) Part r (3)

Independent variable Borderline region Value-creating quadrant Constant R2

0.28 (0.24) 0.14 10.05 (0.22) 0.57** 30.16 (0.19) 0.24**

0.10 0.42**

Audit planning process reflects strategic HRM concerns b(4) (5) Part r (6) 0.42 (0.34) 0.81 (0.31) 20.58 (0.27) 0.07*

0.16 0.34*

0.12 0.25**

Audit reports reflect strategic HRM concerns b(7) (8) Part r (9) 0.30 (0.35) 0.30 (0.32) 20.74 (0.27) 0.01

0.12 0.13

0.09 0.10

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

Table II Regressions using the strategic extent of human resources and internal audit

Independent variable Strategic extent of human resources Strategic extent of internal audit Constant R2

Productive working relationship between HRM and IA b(1) (2) Part r (3) 0.39 (0.07) 0.19 (0.08) 1.66 (0.32) 0.23**

0.41** 0.18*

0.40** 0.18*

Audit planning process reflects strategic HRM concerns b(4) (5) Part r (6) 0.21 (0.08) 0.48 (0.09) 0.33 (0.40) 0.20**

0.19* 0.37**

0.18* 0.36*

Audit reports reflect strategic HRM concerns b(7) (8) Part r (9) 0.06 (0.09) 0.39 (0.10) 1.05 (0.43) 0.10**

0.05 0.30*

0.05 0.30*

Notes: n = 160; * p < 0.05; ** p < 0.01 [ 473 ]

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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.

MaryAnne M. Hyland and Daniel A. Verreault Developing a strategic internal audit-human resource management relationship: a model and survey Managerial Auditing Journal 18/6/7 [2003] 465-477

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 valuecreating 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

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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.

Note 1 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.

References Barney, J. (1991), ‘‘Firm resources and sustained competitive advantage’’, Journal of Management, Vol. 17 No. 1, pp. 99-120. Becker, B.E., Huselid, M.A. and Ulrich, D. (2001), The HR Scorecard: Linking People, Strategy, and Performance, Harvard Business School Press, Boston, MA. Bou-Raad, G. (2000), ‘‘Internal auditors and a value-added approach: the new business regime’’, Managerial Auditing Journal, Vol. 15 No. 4, pp. 182-6. Butler, J.E., Ferris, G.R. and Napier, N.K. (1991), Strategy and Human Resources Management, South-Western, Cincinnati, OH. Carmines, E.G. and Zeller, R.A. (1979), Reliability and Validity Assessment, Sage, Newbury Park, CA. Cascio, W.F. (2000), Costing Human Resources: The Financial Impact of Behavior in Organizations, South-Western, Cincinnati, OH. Ferris, G.R., Hochwarter, W.A., Buckley, M.R., Harrell-Cook, G. and Frink, D.D. (1999), ‘‘Human resources management: some new directions’’, Journal of Management, Vol. 25 No. 3, pp. 385-415. Fitz-enz, J. (2000), The ROI of Human Capital: Measuring the Economic Value of Employee Performance, AMACOM, New York, NY.

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The authors gratefully acknowledge the monetary support and data collection assistance of the Institute of Internal Auditors Research Foundation. They also thank Dr Louis Primavera, Dean of the Derner Institute for Psychological Studies at Adelphi University, for his statistical assistance.

Huselid, M. (1995), ‘‘The impact of human resource management practices on turnover, productivity, and corporate financial performance’’, Academy of Management Journal, Vol. 38 No. 3, pp. 635-72. Huselid, M., Jackson, S. and Schuler, R. (1997), ‘‘Technical and strategic human resource management effectiveness as determinants of firm performance’’, Academy of Management Journal, Vol. 40 No. 1, pp. 171-88. Ichniowski, C., Shaw, K. and Prennushi, G. (1997), ‘‘The effects of human resource management practices on productivity: a study of steel finishing lines’’, The American Economic Review, Vol. 87 No. 3, pp. 291-313. Kling, J. (1995), ‘‘High performance work systems and firm performance’’, Monthly Labor Review, Vol. 118 No. 5, pp. 29-36. Kusel, J. and Oxner, T. (1998), The Internal Auditor Job Market, The Institute of Internal Auditors, Altamonte Springs, FL. McNamee, D. and Selim, G. (1999), Risk Management: Changing the Internal Auditor’s Paradigm, The Institute of Internal Auditors Research Foundation, Altamonte Springs, FL. Pfeffer, J. (1998), ‘‘Seven practices of successful organizations’’, California Management Review, Vol. 40 No. 2, pp. 96-124. Roberts, K., Hulin, C. and Rousseau, D. (1978), Developing an Interdisciplinary Science of Organizations, Jossey-Bass, San Francisco, CA.

Schmitt, J.A. (2002), Making Mergers Work: The Strategic Importance of People, Society for Human Resource Management, Washington, DC. Tillinghast-Towers Perrin (2001), Enterprise Risk Management: Trends and Emerging Practices, The Institute of Internal Auditors Research Foundation, Altamonte Springs, FL. Van de Ven, A. and Ferry, D. (1980), Measuring and Assessing Organizations, Wiley, New York, NY. Verreault, D. (1984), ‘‘A contingency theory of interunit relations of the internal audit function’’, unpublished doctoral dissertation, Texas A&M University, College Station, TX. Verreault, D.A. and Hyland, M.M. (forthcoming), Internal Audit and Human Resource Management: Identifying and Managing Strategic Risk, The Institute of Internal Auditors Research Foundation, Altamonte Springs, FL. Watson Wyatt Worldwide (2002), Human Capital Index: Human Capital as a Lead Indicator of Shareholder Value, Watson Wyatt Worldwide, Reigate/Washington, DC. Wright, P.M. and McMahan, G.C. (1992), ‘‘Theoretical perspectives for strategic human resource management’’, Journal of Management, Vol. 18 No. 2, pp. 295-320.

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Underreporting and premature sign-off in public accounting

Mike Shapeero College of Business, Bloomsburg University of Pennsylvania, Bloomsburg, Pennsylvania, USA Hian Chye Koh Nanyang Business School, Nanyang Technological University, Singapore Larry N. Killough Pamplin College of Business, Virginia Polytechnic Institute and State University, Blacksburg, Virginia, USA Keywords Ethics, Public sector accounting, Cognition, Auditing principles

Abstract 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.

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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.

own time, or shifted chargeable hours to nonchargeable 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.

Public 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

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

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Underreporting of chargeable time

Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting Managerial Auditing Journal 18/6/7 [2003] 478-489

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.

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.

Premature audit sign-off

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.

A 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 signoff 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.

The ethical decision-making model

Modifications to the decision model Because 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.

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Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting

Figure 1 Integrated model of ethical decision making

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Cognitive moral development Prior 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 2 Modified integrated model of ethical decision making

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Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting Managerial Auditing Journal 18/6/7 [2003] 478-489

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 evaluations Hunt 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 decisionmaking 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 the intent to underreport chargeable time 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 level The 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 the intent to underreport chargeable time and to the intent to prematurely sign-off on audit procedures.

Locus of control Locus 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.

Opportunities CPAs 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

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Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting Managerial Auditing Journal 18/6/7 [2003] 478-489

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).

Rewards Accountants 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 elements The 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

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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

Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting Managerial Auditing Journal 18/6/7 [2003] 478-489

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 an M 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 methods Structural equation modelling (SEM) was used to test the proposed causal models of underreporting and premature sign-off (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

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Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting

Figure 3 Structural equation model – underreporting

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Figure 4 Structural equation model – premature sign-off

‘‘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).

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Causal model of underreporting The 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

Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting Managerial Auditing Journal 18/6/7 [2003] 478-489

Table I Descriptive statistics and alpha coefficients Variable (abbreviation) Cognitive moral development (V1) Deontological moral evaluation (V2) Teleological moral evaluation (V3) Locus of control (V5) Possibility of successful underreporting (V6) Reward of underreporting (V7) Likelihood of underreporting (V8) Possibility of successful premature sign-off (V6) Reward of premature sign-off (V7) Likelihood of premature sign-off (V8)

Mean

Standard deviation

45.35 24.12 26.91 38.76 5.18 3.12 2.71 3.65 2.14 1.64

16.39 6.03 7.85 7.77 0.89 1.36 1.84 1.40 1.07 1.02

Job level (V4) Staff and senior supervisor and manager

Frequency

Percentage

56 26

68.29 31.71

Alpha coefficient

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

0.69 0.89 0.88

Notes: Responses are scored as follows: V6: The possibility of successfully underreporting or prematurely signing-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 scale ranging from extremely unlikely (1) to extremely likely (6); V8: The likelihood of respondents underreporting or prematurely signing-off is scored on a seven-point Likert scale ranging from extremely unlikely (1) to extremely likely (7)

Table II SEM results for underreporting Path (to-from) V1-V4 V2-V1 V3-V1 V8-V1 V8-V2 V8-V3 V8-V4 V8-V5 V8-V6 V8-V7

Coefficient

t-value

p-value*

–4.74 0.02 –0.01 0.01 –0.05 0.04 –0.91 –0.51 –0.03 0.45

–1.23 0.51 –0.11 0.40 –2.02 2.00 –2.53 –2.13 –0.18 3.54

0.1093 0.3038 0.4568 0.3457 0.0216# 0.0228# 0.0057# 0.0167# 0.4271 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) (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-off As 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

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Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting

Table III SEM results for premature sign-off

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V1-V4 V2-V1 V3-V1 V8-V1 V8-V2 V8-V3 V8-V4 V8-V5 V8-V6 V8-V7

Path (to-from)

Coefficient

t-value

p-value*

–4.68 0.01 –0.01 0.01 –0.01 0.01 –0.39 –0.53 0.01 0.06

–1.21 0.35 –0.17 0.42 –0.73 0.68 –1.74 –3.48 0.01 0.62

0.1127 0.3617 0.4327 0.3361 0.2318 0.2481 0.0412* 0.0002* 0.4958 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-fit index = 0.9598; Model 2 = 13.80 (p-value = 0.3137, df = 12) 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

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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.

Mike Shapeero, Hian Chye Koh and Larry N. Killough Underreporting and premature sign-off in public accounting Managerial Auditing Journal 18/6/7 [2003] 478-489

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.

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.

Notes Limitations There 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 underreporting and premature sign-off behaviors but not the consequences.

1 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 underreporting and premature sign-off activities, the inverse relation between job level and moral development suggests that level of moral development and likelihood of underreporting and premature sign-off 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.

Directions for future research The limitations highlighted above suggest possible directions for future research. For example, future research could examine

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Kaplan, S.E. (1995), ‘‘An examination of auditors’ reporting intentions upon discovery of procedures prematurely signed-off’’, Auditing: A Journal of Practice & Theory, Vol. 14 No. 2, pp. 90-104. Kelley, T. and Margheim, L. (1990), ‘‘The impact of time budget pressure, personality, and leadership variables on dysfunctional auditor behavior’’, Auditing: A Journal of Practice & Theory, Vol. 9 No. 2, pp. 21-42. Kelley, T. and Seiler, R.E. (1982), ‘‘Auditor stress and time budgets’’, The CPA Journal, Vol. 52 No. 12, pp. 24-34. Kohlberg, L. (1969), ‘‘Stage and sequence: the cognitive development approach to socialization’’, in Goslin, D.A. (Ed.), Handbook of Socialization Theory and Research, Rand McNally, Chicago, IL. Lampe, J.C. and Finn, D.W. (1992), ‘‘A model of auditors’ ethical decision processes’’, Auditing: A Journal of Practice & Theory, Vol. 11, Supplement, pp. 33-59. Lightner, S.M. (1981), ‘‘An examination of underreporting of hours by auditors in public accounting firms’’, The Ohio CPA Journal, Vol. 40 No. 3, pp. 97-100. Lightner, S.M., Leisenring, J.J. and Winters, A.J. (1983), ‘‘Underreporting chargeable time’’, Journal of Accountancy, Vol. 156 No. 1, pp. 52-7. Oppenheim, A.N. (1966), Questionnaire Design and Attitude Measurement, Basic Books, New York, NY. Pany, K., Pourciau, S. and Margheim, L. (1989), ‘‘Controlling audit staff underreporting of time and premature sign-offs: some preliminary findings’’, Advances in Accounting, Vol. 1, Supplement, pp. 181-94. Pasewark, W. and Strawser, J. (1994), ‘‘Subordinate participation in audit budgeting decisions: a comparison of decisions influenced by organizational factors to decisions conforming to the Vromm-Jago model’’, Decision Sciences, Vol. 25 No. 2, pp. 281-99. Ponemon, L.A. (1990), ‘‘Ethical judgments in accounting: a cognitive-developmental perspective’’, Critical Perspectives on Accounting, Vol. 1, pp. 191-215. Ponemon, L.A. (1992a), ‘‘Auditor underreporting of time and moral reasoning: an experimental lab study’’, Contemporary Accounting Research, Vol. 9 No. 1, pp. 171-89. Ponemon, L.A. (1992b), ‘‘Ethical reasoning and selection-socialization in accounting’’, Accounting, Organizations, and Society, Vol. 17 No. 3/4, pp. 239-58. Ponemon, L.A. and Gabhart, D.R.L. (1993), Ethical Reasoning in Accounting and Auditing, Research Monograph No. 21, CGA-Canada Research Foundation, Vancouver. Ponemon, L.A. and Glazer, A. (1990), ‘‘Accounting education and ethical development: the influence of liberal learning on students and alumni in accounting practice’’,

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Thoma, S.J. and Rest, J.R. (1986), ‘‘Moral judgment, behavior, decision making, and attitudes’’, in Rest, J.R. (Ed.), Moral Development: Advances in Research and Theory, Praeger Publishers, New York, NY. Trevino, L.K. (1986), ‘‘Ethical decision making in organizations: a person-situation interactionist model’’, Academy of Management Review, Vol. 11 No. 3, pp. 601-17. Weaver, K.M. and Ferrell, O.C. (1977), ‘‘The impact of corporate policy on reported ethical beliefs and behavior of marketing practitioners’’, in Greenberg, B. and Bellenger, D.N. (Eds), Contemporary Marketing Thought, American Marketing Association, Chicago, IL. Zey-Ferrell, M. and Ferrell, O.C. (1982), ‘‘Role-set configuration and opportunity as predictors of unethical behavior in organizations’’, Human Relations, Vol. 35 No. 7, pp. 587-604. Zey-Ferrell, M., Weaver, K.M. and Ferrell, O.C. (1979), ‘‘Predicting unethical behavior among marketing practitioners’’, Human Relations, Vol. 32 No. 7, pp. 557-69.

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Internal auditors and the external audit: a transaction cost perspective

Cameron Morrill Department of Accounting and Finance, I.H. Asper School of Business, University of Manitoba, Winnipeg, Manitoba, Canada Janet Morrill Department of Accounting and Finance, I.H. Asper School of Business, University of Manitoba, Winnipeg, Manitoba, Canada

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

Abstract 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.

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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 participation in the external 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.

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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.

Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective Managerial Auditing Journal 18/6/7 [2003] 490-504

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 participation in the external 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 on internal 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

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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

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uses transaction cost theory to identify these economic forces.

A transaction cost economics analysis 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

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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.

Uncertainty Williamson (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.

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Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective Managerial Auditing Journal 18/6/7 [2003] 490-504

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: H2. Internal auditors participate to a greater extent in external audits characterized by greater behavioral uncertainty.

Transaction-specific investment A 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

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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

Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective Managerial Auditing Journal 18/6/7 [2003] 490-504

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: H3. Internal auditors participate to a greater extent in external audits which require substantial audit-specific knowledge.

Methodology Data Survey 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.

Method Our 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 variables The 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 internal audit participation in the external 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.

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Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective

Figure 1 Model of internal audit participation in external audit

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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 uncertainty Respondents 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

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identified three areas of behavioral uncertainty, regarding: use of client personnel (LV2); quality of audit work (LV3); and efficiency of audit work (LV4).

Environmental uncertainty Respondents 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,

Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective

Table I Latent variables (LV) and their indicators (X)

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LV1: Participation X1 – Number of external audit activities in which your internal audit department work is used X2 – Percentage of external audit you estimate is performed by your internal audit department X3 – There is little internal audit involvement in external audit (1 = strongly agree; 7 = strongly disagree) Internal consistencyb = 0.89

Max

Loadinga

0

69

0.89

18.5

0

80

0.89

3.9

2.3

1

7

0.76

3.3

1.6

1

7

1

LV3: Quality of audit work X5 – Ability to detect errors X6 – Ability to detect internal control weaknesses Internal consistencyb = 0.89

4.0 3.6

1.5 1.5

1 1

7 7

0.85 0.93

LV4: Efficiency of work X7 – Use of most cost-effective auditing techniques X8 – Audit work performed as quickly as possible Internal consistencyb = 0.87

4.1 3.2

1.7 1.5

1 1

7 7

0.87 0.89

Environmental uncertainty LV5: Complexity of transactions X9 – Our firm enters into many unusual transactions (1 = strongly disagree; 7 = strongly agree) Internal consistencyb = 1.00

4.8

1.8

1

7

1

3.1

3.4

0

11

1

7.7

1.5

3.9

11

1

5.3 5.1 4.8 4.4 4.4 4.2 4.8 4.6

1.4 1.4 1.6 1.6 1.5 1.5 1.4 1.5

1 1 1 1 1 1 1 1

Latent variables (LV)/indicators (X)

Behavioural uncertainty How 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 personnel X4 – Efficient use of client personnel (excluding internal audit personnel) Internal consistencyb = 1.00

LV6: Geographical dispersion X10 – In how many provinces does your company have divisions, branches, etc.? Internal consistencyb = 1.00 LV7: Organization size X11 – Natural logarithm of number of employees Internal consistencyb = 1.00 LV8: Specific investment Specialized knowledge of this company and its industry is necessary on the part of the external auditor in order to perform the following activities (1=strongly disagree; 7 = strongly agree): X12 – Understanding the nature of our business X13 – Planning the audit X14 – Documenting and evaluating the internal control system X15 – Testing the internal control system X16 – Designing substantive tests X17 – Performing substantive tests X18 – Designing analytical review procedures X19 – Performing analytical review procedures Internal consistencyb = 0.95

Mean

Std dev.

17.6

16.5

15.8

Min

7 7 7 7 7 7 7 7

0.69 0.77 0.82 0.84 0.8 0.89 0.87 0.86

Notes a Loading is a measure of the correlation between the specific indicator and its latent variable. Loadings of 0.7 or better indicate an adequate level of individual indicator reliability; b The internal consistency measure is the one suggested by Fornell and Larcker (1981). Scores of 0.7 or better indicate an adequate level of latent variable internal consistency [ 497 ]

Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective

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

Managerial Auditing Journal 18/6/7 [2003] 490-504

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

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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 model Results 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

Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective Managerial Auditing Journal 18/6/7 [2003] 490-504

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 II Bivariate correlations between latent variables and indicators Indicators X1 X2 X3 X4 X5 X6 X7 X8 X9 X10 X11 X12 X13 X14 X15 X16 X17 X18 X19

LV1

LV2

LV3

0.89 0.90 0.75 –0.02 –0.06 –0.12 –0.18 –0.20 0.13 0.1 –0.23 0.06 0.18 0.18 0.27 0.27 0.37 0.30 0.37

–0.06 0.03 –0.04 1 0.17 0.28 0.27 0.18 0.02 0.04 0.14 0.10 0.06 0.15 0.12 0.12 0.07 0.13 0.10

–0.12 –0.07 –0.10 0.27 0.81 0.95 0.34 0.27 0.06 –0.12 0.1 0.11 0.09 0.06 0.07 0.08 0.01 –0.02 –0.01

Latent variables LV4 LV5 –0.20 –0.20 –0.16 0.25 0.24 0.35 0.87 0.89 –0.04 –0.08 0.04 –0.05 0.02 0.14 0.11 –0.06 –0.08 0.03 0.03

0.17 0.17 –0.05 0.02 –0.02 –0.07 –0.01 –0.05 1 0.07 0.1 0.37 0.38 0.25 0.20 0.30 0.29 0.28 0.21

LV6

LV7

LV8

0.11 0.08 0.07 0.04 –0.09 –0.12 –0.14 –0.00 0.07 1 0.26 –0.04 0.03 0.02 –0.00 0.10 0.07 0.15 0.12

–0.17 –0.24 –0.15 0.14 0.10 0.09 0.08 –0.00 0.1 0.26 1 –0.07 –0.08 –0.10 –0.12 –0.14 –0.16 –0.14 –0.15

0.30 0.37 0.17 0.12 –0.02 0.06 –0.04 0.07 0.32 0.09 –0.16 0.69 0.77 0.82 0.84 0.87 0.90 0.87 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 – geographical dispersion; LV7: Environmental uncertainty – organization size; LV8: Specific expertise; Correlations printed in italics are those between each latent variable and its indicators Table III Bivariate correlations of latent variables

LV1 LV2 LV3 LV4 LV5 LV6 LV7 LV8

LV1

LV2

LV3

LV4

LV5

LV6

LV7

LV8

0.85 –0.02 –0.11 –0.22 0.13 0.1 –0.23 0.34

1 0.27 0.25 0.02 0.04 0.14 0.12

0.88 0.35 –0.06 –0.12 0.1 0.04

0.88 –0.04 –0.08 0.04 0.02

1 0.07 0.1 0.32

1 0.26 0.09

1 –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 – geographical dispersion; LV7: Environmental uncertainty – organization size; LV8: Specific expertise; Diagonal elements (in italics) are the square roots of average variances extracted [ 499 ]

Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective Managerial Auditing Journal 18/6/7 [2003] 490-504

The structural model The 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 sector organizations TCE 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 survey The 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 internal audit participation in the external audit. In addition, we assume that internal

Figure 3 Results of partial least squares structural model estimation

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Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective Managerial Auditing Journal 18/6/7 [2003] 490-504

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 internal audit participation in the external 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

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Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective Managerial Auditing Journal 18/6/7 [2003] 490-504

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 internal audit participation in the external 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.

2

3

4

5

6

7

8

Notes 1 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

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in internal audit work, while this study is concerned with the reverse. 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). 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. 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. 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. Maletta (1993), however, found that the levels of inherent risk did not affect auditors’ decisions to employ internal auditors as assistants. 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’’. 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.

Cameron Morrill and Janet Morrill Internal auditors and the external audit: a transaction cost perspective Managerial Auditing Journal 18/6/7 [2003] 490-504

References Abdel-Khalik, R., Snowball, D. and Wragge, J. (1983), ‘‘The effects of certain internal audit variables on the planning of external audit programs’’, The Accounting Review, Vol. 58, April, pp. 215-27. AICPA (1997), Statements on Auditing Standards, American Institute of Certified Public Accountants, New York, NY. Anderson, R. (1984), The External Audit, Copp Clark Pitman, Toronto. Anderson, E. and Schmittlein, D. (1984), ‘‘Integration of the sales force: an empirical investigation’’, Rand Journal of Economics, Vol 15, pp. 385-95. Barclay, D., Higgins, C. and Thompson, R. (1995), ‘‘The partial least squares (PLS) approach to causal modelling: personal computer adoption and use as an illustration’’, Technology Studies, Vol. 2 No. 2, pp. 285-309. Barrett, M.J. and Brink, V.Z. (1980), Evaluating Internal/External Audit Services and Relationships, The Institute of Internal Auditors Inc., Altamonte Springs, FL. Brink, V.Z. and Witt, H. (1982), Modern Internal Auditing: Appraising Operations and Controls, 4th ed., John Wiley and Sons, New York, NY. Brody, R.G., Golen, S.P. and Reckers, P.M.J. (1999), ‘‘The effect of SAS 65 on the use of internal auditors’’, Internal Auditing, Vol. 14, January/February, pp. 28-36. Brown, P. (1983), ‘‘Independent auditor judgment in the evaluation of internal audit functions’’, Journal of Accounting Research, Vol. 21, Autumn, pp. 444-55. Burnaby, P. and Klein, L. (2000), ‘‘Internal auditors’ changing roles’’, Internal Auditing, Vol. 15, May/June, pp. 15-24. Carmines, E. and Zeller, R. (1979), Reliability and Validity Assessment, Sage University Paper Series on Quantitative Applications in the Social Sciences, No. 07-017, Sage Publications, Beverly Hills, CA. CICA (1989), The Independent Auditor’s Consideration of the Work of Internal Auditors: An Audit Technique Study, Canadian Institute of Chartered Accountants, Toronto. CICA (1997), CICA Handbook, Canadian Institute of Chartered Accountants, Toronto. Colbert, J.L. (1993), ‘‘Discovering opportunities for a new working relationship between internal and external auditors’’, The National Public Accountant, January, p. 40. Engle, T.J. (1999), ‘‘Managing external auditor relationships’’, The Internal Auditor, August, pp. 65-9. Felix, W.L. Jr, Gramling, A.A. and Maletta, M.J. (1998), Coordinating Total Audit Coverage: The Relationship between Internal and External Auditors, Institute of Internal Auditors Research Foundation, Altamonte Springs, FL.

Felix, W.L. Jr, Gramling, A.A. and Maletta, M.J. (2001), ‘‘The contribution of internal audit as a determinant of external audit fees and factors influencing this contribution’’, Journal of Accounting Research, Vol. 39 No. 3, pp. 513-34. Fornell, C. and Bookstein, F. (1982), ‘‘A comparative analysis of two structural equation models: LISREL and PLS applied to market data’’, in Fornell, C. (Ed.), A Second Generation of Multivariate Analysis: Volume 1. Methods, Praeger, New York, NY, pp. 289-324. Fornell, C. and Larcker, D. (1981), ‘‘Evaluating structural equation models with unobservable variables and measurement error’’, Journal of Marketing Research, Vol. 18, pp. 39-50. Gaston, S.J. (2000), Getting Value for Your Internal Audit Dollar, Canadian Institute of Chartered Accountants, Toronto. Globerman, S. and Schwindt, R. (1986), ‘‘The organization of vertically related transactions in the Canadian forest products industries’’, Journal of Economic Behavior and Organization, Vol. 7, pp. 199-212. Gramling, A. (1996), ‘‘External auditors’ reliance on internal auditors: the influence of client and partner preferences on audit managers’ reliance decisions’’, working paper, University of Illinois, Urbana-Champaign, IL. Gramling, A. (1999), ‘‘External auditors’ reliance on work performed by internal auditors: the influence of fee pressure on this reliance decision’’, Auditing: A Journal of Practice and Theory, Vol. 18, Supplement, pp. 117-35. Institute of Internal Auditors (1995), Standards for the Professional Practice of Internal Auditing, The Institute of Internal Auditors, Altamonte Springs, FL. John, G. and Weitz, B. (1988), ‘‘Forward integration into distribution: an empirical test of transaction cost analysis’’, Journal of Law, Economics and Organization, Vol. 4, Fall, pp. 337-55. Johnstone, K. (2000), ‘‘Client-acceptance decisions: simultaneous effects of client business risk, audit risk, auditor business risk, and risk adaptation’’, Auditing: A Journal of Practice and Theory, Vol. 19, Spring, pp. 1-27. Joskow, P. (1988), ‘‘Asset specificity and the structure of vertical relationships: empirical evidence’’, Journal of Law, Economics and Organization, Vol. 4, Spring, pp. 95-117. Krishnamoorthy, G. (2002), ‘‘A multistage approach to external auditor’s evaluation of the internal audit function’’, Auditing: A Journal of Practice and Theory, Vol. 21 No. 1, pp. 95-121. Leblebici, H. (1985), ‘‘Transactions and organizational forms: a re-analysis’’, Organizational Studies, Vol. 6, pp. 97-115. Levinthal, D. and Fichman, M. (1988), ‘‘Dynamics of interorganizational attachments:

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The authors acknowledge the assistance of the Institute of Internal Auditors and, in particular, the Ottawa, Canada chapter. This project has benefitted from the comments of Jean Be´dard, Peter Tiessen, Carman Xoung and workshop participants at Laval University and the University of Manitoba. The financial support of the Social Sciences and Humanities Research Council is gratefully acknowledged.

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auditor-client relationships’’, Administrative Science Quarterly, Vol. 33, pp. 345-69. Lyons, B. (1995), ‘‘Specific investment, economies of scale, and the make-or-buy decision: a test of transaction cost theory’’, Journal of Economic Behavior and Organization, Vol. 26, May, pp. 431-43. Maletta, M. (1993), ‘‘An examination of auditors’ decisions to use internal auditors as assistants: the effect of inherent risk’’, Contemporary Accounting Research, Vol. 9, Spring, pp. 508-25. Mautz, R., Tiessen, P. and Colson, R. (1984), Internal Auditing: Directions and Opportunities, The Institute of Internal Auditors Research Foundation, Altamonte Springs, FL. Moore, W.G. and Hodgson, D. (1993), ‘‘The joint audit approach’’, The Internal Auditor, August, p. 14. Taylor, M.E., Peden, V.S. and Welch, J.K. (1997), ‘‘Internal auditor use: difference perceptions’’, Internal Auditing, Spring, pp. 35-9. Taylor, M.H. (2000), ‘‘The effects of industry specialization on auditors’ inherent risk assessments and confidence judgments’’, Contemporary Accounting Research, Vol. 17, Winter, pp. 693-712. Simunic, D. (1980), ‘‘The pricing of audit services: theory and evidence’’, Journal of Accounting Research, Vol. 18, pp. 161-90.

Walker, G. and Poppo, L. (1991), ‘‘Profit centres, single-source suppliers and transaction costs’’, Administrative Science Quarterly, Vol. 36, pp. 66-87. Widener, S.K. and Selto, F.H. (1999), ‘‘Management control systems and boundaries of the firm: why do firms outsource internal auditing activities?’’, Journal of Management Accounting Research, Vol. 11, pp. 45-73. Williamson, O. (1985), The Economic Institutions of Capitalism, Free Press, New York, NY. Williamson, O. (1991), ‘‘Strategizing, economizing and economic organization’’, Strategic Management Journal, Vol. 12, pp. 75-94. Williamson, O. and Ouchi, W. (1981), ‘‘The markets and hierarchies and visible hand perspectives’’, in Van de Ven, A. and Joyce, W. (Eds), Perspectives on Organizational Design and Behavior, Wiley, New York, NY, pp. 347-70. Wold, H. (1982), ‘‘Systems under indirect observation using PLS’’, in Fornell, E. (Ed.), A Second Generation of Multivariate Analysis: Volume 1. Methods, Praeger, New York, NY, pp. 325-47. Zaheer, A. and Venkatraman, N. (1994), ‘‘Determinants of electronic integration in the insurance industry: an empirical test’’, Management Science, Vol. 40, May, pp. 549-66.

The Mad Hatter’s corporate tea party

Philomena Leung RMIT University, Melbourne, Victoria, Australia Barry J. Cooper RMIT University, Melbourne, Victoria, Australia

Keywords Corporate governance, Ethics, Standards, Accountancy

Abstract 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.

Managerial Auditing Journal 18/6/7 [2003] 505-516 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482641]

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).

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 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

The reactions to the recent corporate collapses by governments and professional bodies have generally focused on regulations on corporate governance and on the

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. . . the tree of the American economy is rooted in the toxic soil of unbridled materialism.

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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 shareholderentrepreneurs 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 cooperative 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

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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

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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 shareholderentrepreneurs, 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

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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 and HIH 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

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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

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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 and auditors? 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

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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:

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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.

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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).

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What about directors and executives? 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

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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;

. .

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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.

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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 selfinterest 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.

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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.

References AAP (2002), ‘‘Finance director fronts HIH probe’’, News.com.au, 21 August, available at: www.news.com.au/common/story_page/ 0,4057,4943604%5E22802,00.html (accessed 11 September 2002). ABC Newsonline (2002), ‘‘Accountants hid One.Tel bonuses, inquiry told’’, available at: www.abc.net.au/news/business/2002/07/ item200207312161223_1.htm (accessed 9 September 2002). Australian Institute of Directors (2001), ‘‘AICD supports Ramsay Report on auditor independence’’, Media Release, 4 October, available at: www.companydirectors.

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com.au/po1sub/mrasrroai.html (accessed 12 September 2002). Australian Prudential Regulation Authority (2002), Superannuation Trends – March Quarter 2002, Canberra. Barry, P. (2002), ‘‘One.Tel’s cash SOS, then it all fell apart’’, Sydney Morning Herald, 31 July. Bartholomeusz, S. (2002), ‘‘The race to be ‘holier than thou’ will not guarantee good corporate governance’’, The Age, 6 August. BBC News (2001), Watchdog ‘‘Swoops’’ on One.Tel HQ, available at: www.news.bbc.uk/l/hi/ business/1365954.stm (accessed 4 September 2002). Bosch, H. (1995), Corporate Practices and Conduct, 3rd ed., Pitman Publishing, Melbourne. Bosch, H. (2001), Corporate Governance Discussion on National Radio, 22 October, available at: www.abc.net.au/rn/talks/perspective/ stories/s397255.htm (accessed 3 September 2002). Brown, B. (2001), ‘‘Untangling the HIH disaster’’, Asiamoney, London, 7 July. Business Roundtable (2002), available at: www.brtable.org/index.cfm (accessed 2 September 2002). CLERP 9 (2002), Proposals for Reform – Corporate Disclosure, The Commonwealth Treasury, Canberra. Conroy, S. (2002), ‘‘Improving corporate governance’’, ALP News Statements, 29 August, available at: www.alp.org.au/ media/0802/20001994.html (accessed 3 September 2002). Correy, S. (2001), ‘‘Independence and auditing: when companies collapse’’, Radio National, available at: www.abc.net.au/rn/talks/ bbing/stories/s297499.htm (accessed 9 September 2002). CPA Australia (2002), Ramsay Report Hits the Mark, Say CPAs, 4 October, available at: www.cpaonline.com.au/01_information_centre /16_media_releases/2001/1_16_0 (accessed 12 September 2002). Elias, D. (2001), ‘‘Why weren’t the HIH bells loud and clear’’, The West Australian, 1 September. Gaylord, B. (2001), ‘‘Wrong place, wrong time’’, New York Times, 29 June. Gettler, L. (2002), ‘‘Stop golden goodbyes, says taskforce’’, The Age, 11 December. Gittens, R. (2002), ‘‘Invasion of the money snatchers’’, The Age, 28 August. Gordon, J. (2002), ‘‘Firms to face tough accounting standards’’, The Age, 30 June. Gordon, J., Salmons, R. and FitzGerald, B. (2003), ‘‘Chief’s golden handshake sparks uproar’’, The Age, 9 January. Gray, J. (2000), ‘‘The golden parachute club’’, Canadian Business, June 12, pp. 31-4. Hewett, J. (2002), ‘‘The naughty noughties are making the greed-is-good ’80s look refined’’, Sydney Morning Herald, 5 June. Hughes, S. (2002), ‘‘One.Tel hearings close’’, The Courier Mail, 30 August.

Institute of Chartered Accountants in Australia (2002), Professor Ramsay’s Report on Auditor Independence Welcomed, available at: www.icaa.org.au/news/ index.cfm?menu=249&id=A104357278, 29 July (accessed 12 September 2002). Institutional Analysis (2002), Submission to the HIH Royal Commission, 12 August, Institutional Analysis Pty Ltd, Melbourne. Insurance Council of Australia (2002), HIH Royal Commission, available at: www.hihroyalcommission.ica.com.au/faq/ default.asp (accessed 6 September 2002). Jones, F. (1959) ‘‘The cotton spinning industry in the Oldham district from 1896-1914’’, MA thesis, University of Manchester, Manchester. Kehl, D. (2001), Current Issues – HIH Insurance Group, Economics, Commerce and Industrial Relations Group, Department of the Parliamentary Library, available at: www.aph.gov.au/library/intguide/econ/ hih_insurance.htm (accessed 3 September 2002). Kemp, S. (2001), ‘‘Select group should sort claims: ICA’’, The Age, 16 May. Knott, D. (2002b), ‘‘Corporate governance – principles, promotion and practice’’, Monash Governance Research Unit, Inaugural Lecture, Melbourne, 16 July. Mackay, H. (2002), ‘‘Boost the bottom line, pay the CEO less’’, The Age, 5 October. Marx, K. (1984), Capital, Vol. 3, Lawrence and Wishart (Eds), London. Mills, J. (2002), ‘‘Five dangers of materialism’’, Genetic, Social and General Psychology Monographs, Vol. 128 No. 1, Heldref Publications, Washington, DC. Myers, D.G. (2000), The American Paradox: Spiritual Hunger in an Age of Plenty, Yale University Press, New Haven, CT. Peacock, S. (2001), ‘‘Probe reveals the extent of Scarfe’s debts’’, The West Australian, 11 April. Ramsay, I. (2001), Independence of Australian Company Auditors, University of Melbourne, Melbourne, October. Scott, W. (2002), ‘‘Sorry, guys, but greed corrupts absolutely’’, Australian Financial Review, 1 August. Skeffington, R. (2002), ‘‘Behave . . . or what?’’, Business Review Weekly, Vol. 24 No. 35, available at: www.brw.com.au/stories/ 20020905/16114.asp (accessed 9 September 2002). Stephens, R. (2002), ‘‘Good policy, good politics – why don’t politicians push for better corporate governance’’, OnLine Opinion, 2 August, available at: www.onlineopinion. com.au (accessed 3 September 2002). Tabakoff, N. (2001), ‘‘Going broke: when is a CFO to blame?’’, CFO Magazine, available at: www.cfoweb.com.au/stories/2001 (accessed 9 September 2002). Toms, J.S. (1994), ‘‘Financial constraints on economic growth: profits, capital

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accumulation and the development of the Lancashire cotton spinning industry, 1885-1914’’, Accounting, Business and Financial History, pp. 363-83. Toms, J.S. (1998), ‘‘Growth, profits and technological choice: the case of the Lancashire cotton textile industry’’, Journal of Industrial History, pp. 35-55. Toms, J.S. (2002), ‘‘The rise and modern accounting and the fall of the public company: the Lancashire cotton mills 1870-1914’’, Accounting, Organizations and Society, Vol. 27 No. 1-2, January-March, pp. 61-84. Turner, L. (2002), ‘‘Just a few rotten apples? Better audit those books’’, Washington Post, 14 July. Tyson, R. (1968) ‘‘The cotton industry’’, in Aldcroft, D.H. (Ed.), The Development of British Industry and Foreign Competition 1875-1914, London. Walker, K. (2002), ‘‘HIH ignored warnings: inquiry’’, News.com.au, 27 August, available

at: www.news.com.au/common/story_page/ 0,4057,4982717%5E22802,00.html Wallis, J. (2002), ‘‘Amos and WorldCom’’, Sojourners Magazine, September/October, Vol. 31 No. 5, pp. 7-8. Wood, L. (2002), ‘‘Class action filed against Harris Scarfe directors’’, The Age, 31 July.

Further reading CCH (2001), Collapse Incorporated, CCH Australia, Sydney. Knott, D. (2002a), Protecting the Investor – the Regulator and Audit, Australian Shareholders Association, available at: www.asa.asn.au/;ArticlesMain/2002-07-01.asp (accessed 9 September 2002). Souter, G. (2001), ‘‘Facing big loss, HIH enters liquidation’’, Business Insurance, Vol. 35 No. 12, 19 March. Thomson, J. (2001), ‘‘The audit trail’’, Business Review Weekly, Vol. 23 No. 14, 12 April.

Credibility and expectation gap in reporting on uncertainties

Junaid M. Shaikh Faculty of Business and Law, Multimedia University, Melaka, Malaysia Mohammad Talha Faculty of Business and Law, Multimedia University, Melaka, Malaysia

Keywords Corporate governance, Reports, Financial reporting

Abstract 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.

Managerial Auditing Journal 18/6/7 [2003] 517-529 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482650]

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.

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 in books

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,

In 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

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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.

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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 interest In 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

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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

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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 in financial reporting from the perspective of Hong Kong bank loan officers Marian 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 development Ethics 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

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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 expectation gap The battle for credibility During 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

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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 of internal control In 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

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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’ and auditors’ materiality judgments The 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 average materiality levels A 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

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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.

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.

4. Proposed solutions to the problem

Dialogues with primary users of financial statements about standards for materiality in financial statements

Overall considerations Expectation 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 materiality among auditors The 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

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The 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 the most 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.

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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 audit report Once 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.

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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 of limiting liability language in engagement letters Engagement 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

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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 through unqualified opinion expressed by auditors To 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 to oversee audit regulation The 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.

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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 for standard setters According 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

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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.

Junaid M. Shaikh and Mohammad Talha Credibility and expectation gap in reporting on uncertainties

The effect of education on reducing the expectation gap concerning perceptions of messages conveyed by audit and review reports

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The 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;

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.

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.

.

.

.

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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

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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.

References AASB (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,

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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 reading Chapman, 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 AI Comparison of the auditors’ and the financial analysts’ average levels Index figures for auditors’ average levels (average of financial analysts = 100) Levels in the cases Overestimation Underestimation

Company 1: Company 2: Company 3: Company 4: Carlsberg Micro Matic B&O DDT 188 170

229 207

124 (15012) 66

94 102

Average 159 (157) 136

Source: Research in Accounting Conference Proceeding, Japan, 1998

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Improving corporate governance: the role of audit committee disclosures Zabihollah Rezaee Fogelman College of Business and Economics, The University of Memphis, Memphis, Tennessee, USA Kingsley O. Olibe Department of Accounting, Middle Tennessee State University, Murfreesboro, Tennessee, USA George Minmier Fogelman College of Business and Economics, The University of Memphis, Memphis, Tennessee, USA Keywords Corporate governance, Audit committees, Financial reporting, Auditing, Disclosure

Abstract 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 SarbanesOxley 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.

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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, The Emerald Research Register for this journal is available at http://www.emeraldinsight.com/researchregister

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 audit committee The report of the Public Oversight Board (POB) of the SEC Practice Section of the American Institute of Certified Public 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. The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

Zabihollah Rezaee, Kingsley O. Olibe and George Minmier Improving corporate governance: the role of audit committee disclosures Managerial Auditing Journal 18/6/7 [2003] 530-537

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 guidelines Corporate 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

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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

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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;

Zabihollah Rezaee, Kingsley O. Olibe and George Minmier Improving corporate governance: the role of audit committee disclosures Managerial Auditing Journal 18/6/7 [2003] 530-537

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 charters The 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).

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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,

Table I Audit committee charter analysis Characteristics Responsibilities/authorities Size 3-4 members Not specified Number of meetings 1-2 3-4 5+ Not specified Composition, qualifications, independence, financial literacy Notes: n = 93 [ 534 ]

Number

Percentage

93

100.0

84 9

90.3 9.7

5 52 2 34 92

5.4 55.9 2.25 36.6 98.9

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

Zabihollah Rezaee, Kingsley O. Olibe and George Minmier Improving corporate governance: the role of audit committee disclosures

external auditors regarding quality, transparency, and reliability of financial reports.

Managerial Auditing Journal 18/6/7 [2003] 530-537

The 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.

Audit committee reports

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 report Results 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 report The 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;

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Zabihollah Rezaee, Kingsley O. Olibe and George Minmier Improving corporate governance: the role of audit committee disclosures Managerial Auditing Journal 18/6/7 [2003] 530-537

Table II Title of the audit committee report Title Audit committee report Report of the audit committee Report of the audit and finance committee Audit and compliance committee report Audit committee report and related matters Board audit committee report Report of the audit committee of the board Audit and ethics committee report Audit and examination committee report Report of audit and legal committee Report of the audit and risk management committee Report of the audit committee on the financial statements Report of the board of directors audit committee

Number

Percentage

43 31 4 3 2 2 2 1 1 1 1 1 1

45.7 33.0 4.3 3.2 2.1 2.1 2.1 1.1 1.1 1.1 1.1 1.1 1.1

Notes: n = 94 .

. .

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

Table III Content of audit committee report A statement that the committee

Number

Percentage

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

91

96.8

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

92

97.9

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

92

97.9

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

94

100.0

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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.

Zabihollah Rezaee, Kingsley O. Olibe and George Minmier Improving corporate governance: the role of audit committee disclosures Managerial Auditing Journal 18/6/7 [2003] 530-537

Note 1 Sarbanes-Oxley Act of 2002. Public Company Accounting Reform and Investor Protection Act of 2002, available at: www/ whitehouse.gov/infocus/ corporateresponsibility/

References BRC (1999), Report and Recommendation of the Blue Ribbon Committee on Improving 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

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Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy Khalid Al-Khater College of Business Administration and Economics, University of Qatar, Qatar Kamal Naser Cardiff Business School, University of Wales, Cardiff, UK

Keywords Social responsibility, Annual reports, Qatar

Abstract 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.

Managerial Auditing Journal 18/6/7 [2003] 538-548 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482678]

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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 The Emerald Research Register for this journal is available at http://www.emeraldinsight.com/researchregister

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 in Qatar 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 The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy Managerial Auditing Journal 18/6/7 [2003] 538-548

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:

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Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy Managerial Auditing Journal 18/6/7 [2003] 538-548

. . . 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

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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

Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy Managerial Auditing Journal 18/6/7 [2003] 538-548

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, data collection and statistical techniques Research questions As 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? RQ2. What is the perception of different user groups in Qatar about the factor(s) that prevent(s) Qatari companies from disclosing corporate social responsibility information? RQ3. What is the perception of different user groups in Qatar about what motivate(s) Qatari companies to disclose corporate social responsibility information? RQ4. What is the perception of different 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 responsibility information? RQ7. What is the perception of different user groups in Qatar regarding the location of corporate social responsibility information? RQ8. What is the perception of different user groups in Qatar regarding the beneficiaries of corporate social responsibility disclosure?

Data collection To 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

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Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy Managerial Auditing Journal 18/6/7 [2003] 538-548

Table I Target groups and response rates Target groups

Distributed questionnaire

Received questionnaire

Response rate (%)

100 30 30 100 260

58 18 18 49 143

58 60 60 49 55

Accountants External auditors Academicians Bank officer Total

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 techniques To 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’ backgrounds The 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

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accounting, banking and finance and 41 per cent of the respondents had more than six years of work experience.

The main purpose(s) of corporate disclosure The 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

Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy Managerial Auditing Journal 18/6/7 [2003] 538-548

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 disclosing corporate social information by Qatari companies The 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 for companies’ social responsibility Drawing 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 II The importance that the target groups attach to the purpose(s) of corporate reporting in Qatar Purpose(s) Provides information to: Shareholders on the use of their funds and the legality of the uses Investors to assist them in making investment decisions Institutions to assist them to negotiate financial facilities Creditors with information that assists them in protecting their interest Tax authorities to be used as a basis to assess taxation Managers to manage their businesses Assist the society at large to judge a company’s actions and policies Employees to assess them to protect their interest

Mean scorea

Std. dev.

4.16 4.14 3.76 4.12 4.02 3.43 4.04 3.69

0.82 0.91 0.95 0.99 0.98 1.01 0.90 0.99

Kruskal-Wallis test Rank 2 1 2 6 3 5 8 4 7

11.27 6.84 4.90 2.62 2.73 0.313 1.050 4.24

Level of significance 0.010 0.077 0.179 0.453 0.435 0.950 0.780 0.230

Note: a Mean values – scoring: 1 = not important at all; 5 = very important [ 543 ]

Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy Managerial Auditing Journal 18/6/7 [2003] 538-548

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 accountability The 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 information Previous 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 III Reasons behind not disclosing corporate social information by Qatari companies

Reason Administrative difficulties and management does not appreciate its social responsibility The objectives of the company emphasize its economic rather than social performance Lack of legal requirements Lack of knowledge about this type of information prevents companies from disclosing it The public lacks enough knowledge of the importance of social responsibility information Not required by the IASs This type of information is sensitive to disclose The cost of disclosing this type of information outweighs its benefits Lack of demand for this type of information

Kruskal-Wallis test Level of Rank 2 significance

Mean scorea

Std. dev.

3.69

1.12

1

1.75

0.620

3.68 3.61 3.57

1.23 1.27 1.21

2 3 4

4.74 6.75 4.61

0.190 0.080 0.202

3.52 3.51 3.51 3.46 3.40

1.23 1.38 1.25 1.26 1.19

5 6 7 8 9

1.07 3.27 2.64 4.79 4.58

0.780 0.350 0.440 0.180 0.200

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

Table IV Respondents views of the motivation for company’s social responsibility Mean scorea Std dev.

View Large corporations have no social responsibility but to make profit to their shareholders Large companies should bear some sort of social responsibility to justify their existence within the society Large companies should be viewed as social organizations and their existence is justified as long as they satisfy the objectives of the society Strategic companies such as electricity should continue to be owned by the government to guarantee their social responsibility Decision makers within the organization appreciate the concept of social responsibility reporting and its importance to the organization Decision makers within the organization understand how to adopt social responsibility within the organization a

Note: Mean values – scoring: 1 = strongly disagree; 5 = strongly agree [ 544 ]

Kruskal-Wallis test Level of Rank 2 significance

2.77

1.56

6

2.08

0.550

3.75

1.26

1

0.71

0.860

3.63

1.08

2

8.14

0.043

3.30

1.39

5

0.47

0.920

3.56

1.28

3

9.69

0.021

3.41

1.22

4

1.61

0.650

Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy Managerial Auditing Journal 18/6/7 [2003] 538-548

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 corporate responsibility After 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 social responsibility information After 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 V User groups who have a right to corporate information Users Corporate management Customers Corporate employees Corporate creditors Shareholders Investors Government and its agencies Society at large

Kruskal-Wallis test Level of significance

Mean scorea

Std dev.

Rank

2

4.07 4.00 4.01 4.08 4.10 4.09 3.58 3.38

0.69 0.77 0.86 1.06 0.96 1.02 1.04 1.21

4 6 5 3 1 2 7 7

12.75 0.23 0.72 3.68 5.83 6.06 3.36 0.96

0.005 0.97 0.86 0.29 0.12 0.11 0.33 0.81

Note: a Mean values – scoring: 1 = strongly disagree; 5 = strongly agree [ 545 ]

Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy

Table VI Introduction of corporate social responsibility information

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By law To be encouraged by law By ethical considerations and social agreement

Approach

Mean scorea Std dev. 3.56 4.02 3.64

Kruskal-Wallis test Level of significance

Rank

2

3 1 2

0.82 0.76 1.77

1.26 0.81 1.12

0.84 0.86 0.62

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

Table VII Methods to be used to disclose corporate social responsibility information Method

Kruskal-Wallis test Level of significance

Mean scorea

Std dev

Rank

2

3.76 3.47 3.50 3.77 3.68 3.84

1.23 1.23 1.28 1.12 1.18 1.23

3 6 5 2 4 1

4.45 2.56 1.52 1.48 2.49 5.13

In descriptive manner Quantitative but not monetary (statistical) Monetary Descriptive and statistical Quantitative and monetary Descriptive, quantitative and monetary

0.21 0.46 0.67 0.68 0.47 0.16

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

Location of corporate social information The participants were provided with a number of possible locations to disclose corporate social responsibility information 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 corporate social responsibility information 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 social responsibility disclosure The 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 VIII Location of corporate social responsibility information Location In a separate section entitle ‘‘social responsibility’’ in the annual report Separate booklet attached to the annual report In the directors’ statement within the annual report In any section within the annual report

Mean scorea 4.05 3.58 3.72 3.23

Note: Mean values – scoring: 1 = strongly disagree; 5 = strongly agree [ 546 ]

Std dev Rank 1.03 1.16 1.23 1.45

1 3 2 4

2

Kruskal-Wallis test Level of significance

7.81 0.44 7.72 8.26

0.050 0.931 0.052 0.041

Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy

Table IX The importance of the following objectives of social responsibility to the organisation

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Serve society at large Serve customers Develop human resources (employees) Protect environment Emphasize the role of accounting as an effective information system Enforce investment environment

Benefit(s)

Mean scorea

Std dev Rank

2

Kruskal-Wallis test Level of significance

4.29 4.10 4.02 3.84 3.68

0.88 0.93 1.04 1.01 1.20

1 2 3 4 6

11.54 3.84 2.68 9.25 6.69

0.009 0.270 0.440 0.026 0.082

3.71

1.18

5

1.31

0.720

Note: Mean values – scoring: 1 = strongly disagree; 5 = strongly agree 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 corporate social responsibility information 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 corporate social responsibility information disclosed in both monetary and nonmonetary forms, either in a separate section or within the board of directors’ statement within the annual report. Finally, the respondents believed that disclosing corporate social responsibility information 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.

Notes 1 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

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Khalid Al-Khater and Kamal Naser Users’ perceptions of corporate social responsibility and accountability: evidence from an emerging economy

3

Managerial Auditing Journal 18/6/7 [2003] 538-548

4

5

6 7

8

9

government intends to privatize companies in the petrochemicals, cement chemical and steel sectors during this year. 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). Another group of the Arab countries, their economies mainly rely on tourism as do Tunisia and Morocco. 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. One US$ = QR3.65. 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. 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. The questionnaire was distributed to the target groups in the period between November-December 2002.

References ASC (1975), The Corporate Report, Accounting Standards Committee, London. Abu Baker, N. and Naser, K (2000), ‘‘Empirical evidence on corporate social disclosure (CSD) practices in Jordan’’, International Journal of Commerce and Management, Vol. 10 No. 3-4, pp. 18-34. Botosan, C.A. (1997), ‘‘Information level and cost of equity capital’’, The Accounting Review, Vol. 72 No. 3, pp. 323-49.

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Ghartey, J.B. (1987), Crisis Accountability and Development in the Third World – The Case of Africa, Avebury, Aldershot. Gray, R. (1992), ‘‘Accounting and environmentalism: an explanation of the challenge of gently accounting for accountability, transparency and sustainability’’, Accounting, Organizations and Society, Vol. 17, pp. 399-425. Gray, R., Owen, D. and Adams, C.A. (1987), Corporate Social Reporting: Accounting and Accountability, Prentice-Hall, London. Gray, R., Owen, D. and Adams, C.A. (1996), Accounting and Accountability: Changes and Challenges in Corporate Social and Environmental Reporting, Prentice Hall, London. Hove, M.R. (1986), ‘‘Accounting practices in developing countries: colonialism’s legacy of inappropriate technologies’’, The International Journal of Accounting Education and Research, Vol. 22, pp. 81-100. Huck, S.W. and Cormier, W.H. (1996), Reading Statistics and Research, Harper Collins College Publisher, New York, NY. Ijiri, Y. (1975), Theory of Accounting Measurement, American Accounting Association, Sarasota, FL. Ijiri, Y. (1983), ‘‘On the accountability-based conceptual framework of accounting’’, Journal of Accounting and Public Policy, Vol. 2 No. 2, pp. 75-81. Jensen, R.E. (1977), ‘‘Phantasmagoria accounting: tesearch and analysis of economic, social and environmental impact of corporate business’’, Studies in Accounting Research No. 14, American Accounting Association, Sarasota, FL. Naser, A. and Abu Baker, N. (1999), ‘‘Empirical evidence on corporate social responsibility reporting and accountability in developing countries: the case of Jordan’’, Advances in International Accounting, Vol. 12, pp. 193-226. Rosenfield, J.M. (1974), Stewardship in Objectives of Financial Statements, AICPA, New York, NY. Samuels, J.M. (1990), ‘‘Accounting for developing an analysis approach’’, Research in Third World Accounting, Vol. 1, pp. 67-86. Wallace, R.S.O. (1993), ‘‘Development of accounting standards for developing and newly industrialized countries’’, Research in Third World Accounting, Vol. 2, pp. 121-65. Williams, P. (1987), ‘‘The legitimate concern with fairness’’, Accounting, Organizations and Society, Vol. 12 No. 2, pp. 169-89.

The usefulness of the audit report in investment and financing decisions

Antonio Dure´ndez Go´mez-Guillamo´n Department of Accounting and Finance, Polytechnic University of Cartagena, Cartagena, Spain

Keywords Auditing, Reports, Investment appraisal, Influence

Abstract 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.

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.

# MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482687]

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).

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;

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 Martı´nez and Pucheta Martı´nez (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

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Previous research literature

Managerial Auditing Journal 18/6/7 [2003] 549-559

for this reason authors suggest the following questions:

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Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions Managerial Auditing Journal 18/6/7 [2003] 549-559

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), Sa´nchez Segura (1999), Go´mez 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 Brı´o Gonza´lez (1998) and Cabal Garcı´a (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 hypotheses It 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 mailsurvey 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.

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Subjects Credit institutions A 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 inspeccio´n del Banco de Espan˜a (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.

Analysts A sample design has been used to represent this community which has been obtained from the listing published by the Comisio´n 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.

Sample Once 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 collection Questionnaires 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.

Participants The 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 I Sampling errors

Sampling error value n (sample) p q n Confidence level

Credit institutions

Analysts

±7.615% 79 50 50 231 90.00%

±12.033% 33 50 50 104 90.00%

Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions

Table II Survey response Respondent groups

Population

Mailed

Failed

Responses

Response rate (%)

Managerial Auditing Journal 18/6/7 [2003] 549-559

Credit institutions Analysts Total

231 104 335

229 103 332

2 1 3

79 33 112

34.50 32.04 33.73

2 Analysts: in this case, the questionnaire was addressed to ‘‘the manager’’ of the company.

Construction of the questionnaire Preparation of the questions Once 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 questionnaire In 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 validation Once 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 employed The 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 analysis In 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’’,

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Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions

‘‘managing director’’, ‘‘internal auditor’’, ‘‘planning manager’’ and ‘‘operating control manager’’.

Managerial Auditing Journal 18/6/7 [2003] 549-559

Hypotheses tests Application of the Chi-square test for H01 In 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 Espan˜a (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

Table III Positions of respondents Position Financial director General manager Accountant Banker Analyst Other Sub-total Missing values Total [ 552 ]

Credit institutions

Respondent groups Analysts 5 7 2

47 28 75

4 11 29

Total 5 7 2 47 4 39 104 8 112

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’’, ‘‘nonfulfilment 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 H01 The 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 H02 The 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’’,

Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions Managerial Auditing Journal 18/6/7 [2003] 549-559

‘‘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 H02 The 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 analysis A 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 IV Chi-square test in the case of credit institutions Questions

n

Chi-square

Test Degrees of freedom

Mean

Significance

1. The presentation of the audit report is indispensable so that services are lent, to a company committed to audit, in the case of obtaining a: credit line short-term loan long-term loan bank discount bank guarantee

71 67 72 65 69

45.761 41.925 50.000 36.938 40.710

1 1 1 1 1

4.27 4.17 4.38 3.97 4.13

0.000*** 0.000*** 0.000*** 0.000*** 0.000***

2. The most relevant information when granting a loan is obtained from: the audit report Risk Information Centre private databases personal knowledge tax declarations financial statements having good references

57 64 51 63 47 61 51

24.018 56.250 8.647 51.571 11.255 42.639 10.373

1 1 1 1 1 1 1

3.68 4.18 3.42 4.15 3.47 3.97 3.44

0.000*** 0.000*** 0.003*** 0.000*** 0.001*** 0.000*** 0.001***

3. Express your agreement with the following statements: the opinion type influences on the decision of granting a loan the opinion type influences on the decision of thequantity to lend

65 64

46.538 7.563

1 1

4.03 3.36

0.000*** 0.006***

4. The type of qualifications with higher influence on the decision making process when granting a loan: going concern uncertainties non-fulfilment of accounting standards tax uncertainties assets valuation errors non-fulfilment of legal regulations scope limitations relationship with associated and group companies

75 50 50 64 58 54 53

71.053 15.680 32.000 45.563 36.483 32.667 28.698

1 1 1 1 1 1 1

4.69 3.47 3.67 3.90 3.81 3.73 3.69

0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 0.000*** 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 values in percentage correspond: (scale value/per cent expected value) = 0/50 per cent, 1/50 per cent; Mean values vary in a scale between 1 – total disagreement up to 5 – total agreement [ 553 ]

Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions Managerial Auditing Journal 18/6/7 [2003] 549-559

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 Espan˜a (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 Comisio´n 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 V Chi-square test in the case of dealers and brokering companies Questions

n

Chi-square

1. The most relevant information when investing is obtained from: technical analysis fundamental analysis -the audit report Risk Information Centre private databases personal knowledge tax declarations financial statements having good references

25 24 21 22 21 23 22 21 22

9.000 (1) 1.190 1.636 0.048 9.783 2.909 10.714 0.182

2. Express your agreement with the following statements: the opinion type influences on the decision of investing in a company the opinion type influences on the decision of the quantity to invest

25 23

11.560 3.522

3. The type of qualifications with higher influence on the decision-making process when investing: going concern uncertainties non-fulfilment of accounting standards tax uncertainties assets valuation errors non-fulfilment of legal regulations scope limitations relationship with associated and group companies

25 23 27 22 23 26 26

(1) 15.696 15.385 (1) 18.182 7.348 9.846

Test Degrees of freedom

Mean

Significance 0.003***

1 1 1 1 1 1 1

3.69 4.10 2.81 3.29 2.97 3.63 2.68 3.66 3.16

0.275 0.201 0.827 0.002*** 0.088* 0.001*** 0.670

1 1

3.81 3.41

0.001*** 0.061*

1

1 1 1 1 1

4.31 3.78 3.75 4.06 3.84 3.52 3.59

0.000*** 0.000*** 0.000*** 0.007*** 0.002***

Notes: * Significant at 10 per cent level; ** Significant at 5 per cent level; *** Significant at 1 per cent level; The obtained observations have been reclassified (old value/new value) = 1-2/0, 4-5/1; Tested values in percentage correspond: (scale value/ per cent expected value) = 0/50 per 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 out when taking the variable a constant value, in these cases ‘‘t-test’’ is applied [ 554 ]

Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions Managerial Auditing Journal 18/6/7 [2003] 549-559

Table VI Principal components factor analysis: rotated matrix loadings Questions

1

1. The most relevant information when investing or financing is obtained from: the audit report Risk Information Centre private databases personal knowledge tax declarations financial statements having good references

Factors 3

2

4

5

0.623 0.706 0.596 0.820 0.726 0.706 0.738

2. Express your agreement with the following statements: the opinion type influences on the decision of lending or investing in a company the opinion type influences on the decision of the quantity to invest or to lend

0.787 0.781

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

0.681 0.713 0.692 0.638 0.727 0.811

Notes: Extraction method: principal component factor analysis; Rotation method: varimax normalization with Kaiser; Only loadings having absolute value greater than 0.50 are shown 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 ‘‘nonfulfilment of accounting standards’’ ones.

Analysis by logistic regression test Once 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

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 VII Logistic regression on the decision-making process of investing or lending Independent variables: (qualifications) Tax uncertainties Relationship with associated or group companies Constant

B

ET

Wald

Degrees of freedom

Sig.

1.557 0.885 –5.642

0.795 0.536 2.921

3.833 2.728 3.731

1 1 1

0.050** 0.099* 0.053*

Notes: * Significant at 10 per cent level; ** Significant at 5 per cent level; Method of the regression: ‘‘first step enter’’; Only significant independent variables are shown; Model global fit (goodness of fit): –2 log verosimilitud = 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 ]

Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions

Table VIII Logistic regression on the quantity of investing or lending Independent variables: (qualifications)

B

ET

Wald

Degrees of freedom

Sig.

Managerial Auditing Journal 18/6/7 [2003] 549-559

Non-fulfillment of accounting standards Scope limitations

1.005 1.450

0.412 0.434

5.933 11.167

1 1

0.015** 0.001*

Notes: * Significant at 10 per cent level; ** Significant at 5 per cent level; Method of the regression: ‘‘first step enter’’; Only significant independent variables are shown; Model global fit (goodness of fit): –2 log verosimilitud = 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) .

.

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

[ 556 ]

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.

Notes 1 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 Garcı´a 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 Sa´nchez 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:
Np ¼
ðN
1Þ 1þp where the number questions outlined is N and the average of the correlation between items is
, taking values of between 0 and 1, so that the p higher the value the higher the internal consistency of the scale.

Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions Managerial Auditing Journal 18/6/7 [2003] 549-559

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 Sa´nchez et al. (1999) and Ato Garcı´a (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 Go´mez Aguilar and Ruiz Barbadillo (1999), Gonza´lez Bravo and Martı´n (1999), Villarroya Lequericaonandia (2000), Cabal Garcı´a (2001) and Cabal Garcı´a 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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Herrador Alcaide, T.C. (2000), ‘‘El informe de auditorı´a financiera de las cuentas anuales como conclusio´n y objetivo del trabajo del auditor: un estudio empı´rico para la Comunidad Auto´noma de Madrid’’, doctoral dissertation, Universidad Nacional de Educacio´n a Distancia, Madrid. Houghton, K.A. (1983), ‘‘Audit reports. Their impact on the loan decision process and outcome: an experiment’’, Accounting and Business Research, Winter, pp. 15-20. Johnson, D.A., Pany, K. and White, R. (1983), ‘‘Audit reports and the loan decision: actions and perceptions’’, Auditing: A Journal of Practice & Theory, Vol. 2 No. 2, Spring, pp. 38-51. Jones, F.L. (1996), ‘‘The information content of the auditor’s going concern evaluation’’, Journal of Accounting and Public Policy, Vol. 15, pp. 1-27. Lasalle, R.E. and Anandarajan, A. (1997), ‘‘Bank loan officers’ reactions to audit reports issued to entities with litigation and going concern uncertainties’’, Accounting Horizons, Vol. 11 No. 2, June, pp. 33-40. Libby, R. (1979), ‘‘The impact of uncertainty reporting on the loan decision’’, Journal of Accounting Research, Vol. 17, supplement, pp. 35-71. Loudder, M.L. et al. (1992), ‘‘The information content of audit qualifications’’, Auditing: A Journal of Practice & Theory, Vol. 11 No. 1, Spring, pp. 69-82. Mayper, A.G., Welker, R.B. and Wiggins, C.E. (1988), ‘‘Accounting and review services: perceptions of the message within the CPA’S report’’, Advances in Accounting, Vol. 6, pp. 219-32. Monterrey Mayoral, J., Pineda Gonza´lez, C. and Sa´nchez Segura, A. (2000), ‘‘La funcio´n de sen˜alizacio´n de las salvedades en el mercado de capitales espan˜ol: un ana´lisis empı´rico’’, paper presented at the IX ASEPUC Congress, May, Canarias. Nunnally, J.C. (1987), Teorı´a Psicome´trica, Trillas (Ed.) , Me´xico. Pany, K. and Johnson, D.A. (1984), ‘‘Forecasts auditor review and bank loan decisions’’, Journal of Accounting Research, Vol. 22 No. 2, Autumn, pp. 731-43. Peterson, R.A. (1994), ‘‘A meta-analysis of Cronbach’s coefficient alpha’’, Journal of Consumer Research, Vol. 21, September, pp. 381-91. Porter, B. (1993), ‘‘An empirical study of the audit expectation-performance gap’’, Accounting and Business Research, Vol. 24, Winter, pp. 49-68. Pringle, L.M., Crum, R.P. and Swetz, R.J. (1990), ‘‘Do SAS nº 59 format changes affect the outcome and the quality of investment decisions?’’, Accounting Horizons, September, pp. 68-75.

Antonio Dure´ndez Go´mez-Guillamo´n The usefulness of the audit report in investment and financing decisions Managerial Auditing Journal 18/6/7 [2003] 549-559

Rojas Tejada, A.J., Ferna´ndez Prados, J.S. and Pe´rez Mele´ndez, C. (1998), Investigar Mediante Encuestas: fundamentos teo´ricos y aspectos pra´cticos, Sı´ntesis Psicolo´gica, Madrid. Sa´nchez Segura, A. (1999), ‘‘El informe de auditorı´a: alcance, significado y evidencia empı´rica’’, Revista Espan˜ola de Financiacio´n y Contabilidad, Vol. 28 No. 2, October-December, pp. 1163-7. Sarabia Sa´nchez, F.J. et al. (1999), Metodologı´a para la investigacio´n en marketing y direccio´n de empresas, Madrid. Vico Martı´nez, A. and Pucheta Martı´nez, M.C. (2001), ‘‘Un estudio empı´rico acerca de la

relevancia del informe de auditorı´a entre los analistas de riesgos de las entidades de cre´dito’’, paper presented at the XI AECA Congress, September, Madrid. Villaroya Lequericaonandia, M.B. (2000), ‘‘Aportacio´n del informe de auditorı´a a la contabilidad’’, Actualidad Financiera, Vol. 5, May, pp. 3-18. Wilkerson, J.E. (1987), ‘‘Selecting experimental and comparison samples for use in studies of auditor reporting decisions’’, Journal of Accounting Research, Vol. 25, Spring, pp. 161-7.

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

I.A. Beckmerhagen Bundesamt fu¨r Strahlenschutz, Salzgitter, Germany H.P. Berg Bundesamt fu¨r Strahlenschutz, Salzgitter, Germany S.V. Karapetrovic Department of Mechanical Engineering, University of Alberta, Edmonton, Canada W.O. Willborn Faculty of Management, University of Manitoba, Winnipeg, Canada Keywords Quality, Safety, Auditing, Nuclear energy industry, ISO 9000 series, Germany

Abstract 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.

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Introduction

and some relevant experiences of a nuclear waste disposal facility in Germany.

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

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

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Systems approach

I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn Auditing in support of the integration of management systems: a case from the nuclear industry

Figure 1 IMS audit framework

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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.

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I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn Auditing in support of the integration of management systems: a case from the nuclear industry

Figure 2 Audit-related systems

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Audit as a supporting framework for 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

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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

I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn Auditing in support of the integration of management systems: a case from the nuclear industry Managerial Auditing Journal 18/6/7 [2003] 560-568

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 IMS audit 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

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I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn Auditing in support of the integration of management systems: a case from the nuclear industry Managerial Auditing Journal 18/6/7 [2003] 560-568

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:

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‘‘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 IMS audit 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.

I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn Auditing in support of the integration of management systems: a case from the nuclear industry Managerial Auditing Journal 18/6/7 [2003] 560-568

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 fu¨r 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 assurance measures 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,

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I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn Auditing in support of the integration of management systems: a case from the nuclear industry Managerial Auditing Journal 18/6/7 [2003] 560-568

.

.

.

.

.

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 for nuclear 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 fu¨r den Bau und Betrieb von Endlagerung fu¨r 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

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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

I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn Auditing in support of the integration of management systems: a case from the nuclear industry Managerial Auditing Journal 18/6/7 [2003] 560-568

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 3 Continuous improvement process using audits

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I.A. Beckmerhagen, H.P. Berg, S.V. Karapetrovic and W.O. Willborn Auditing in support of the integration of management systems: a case from the nuclear industry Managerial Auditing Journal 18/6/7 [2003] 560-568

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.

References Arter, D. (2000), ‘‘Beyond compliance’’, Quality Progress, Vol. 33 No. 6, pp. 57-61. Butterbrodt, D. et al. (1999), ‘‘Alles unter einem Dach’’, Qualitaet und Zuverlaessigkeit, Vol. 44 No. 7, pp. 866-72. Dilthey, U. and Bohlmann, H. (2000), ‘‘Zusammenarbeiten, aber wie?’’, Qualitaet und Zuverlaessigkeit, Vol. 45 No. 8, pp. 972-6.

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Funk, D. (2001), ‘‘Viel versprechendes Stiefkind’’, Qualitaet und Zuverlaessigkeit, Vol. 46 No. 6, pp. 758-62. Funk, D. and Mayer, M. (2001), ‘‘Integriertes Management – ein Modethema laesst Fragen offen’’, Qualitaet und Zuverlaessigkeit, Vol. 46 No. 9, pp. 1118-19. Geiger, W. (2000), ‘‘Begriffe’’, Qualitaet und Zuverlaessigkeit, Vol. 45 No. 10, pp. 12-24. International Atomic Energy Agency (1992), INES. The International Nuclear Event Scale User’s Manual, IAEA, Vienna. Janik, W. and Zimmermann, G. (1998), ‘‘Integrieren statt Parallelisieren’’, Qualitaet und Zuverlaessigkeit, Vol. 43 No. 3, pp. 277-9. Karapetrovic, S. and Willborn, W. (1998a), ‘‘Integration of quality and environmental management systems’’, TQM Magazine, Vol. 10 No. 3, pp. 204-13. Karapetrovic, S. and Willborn, W. (1998b), ‘‘Integrated audit of management systems’’, International Journal of Quality & Reliability Management, Vol. 15 No. 7, pp. 694-711. Karapetrovic, S. and Willborn, W. (2000a), ‘‘Quality assurance and effectiveness of audit systems’’, International Journal of Quality & Reliability Management, Vol. 17 No. 6, pp. 679-703. Karapetrovic, S. and Willborn, W. (2000b), ‘‘Generic audit of management systems: fundamentals’’, Managerial Auditing Journal, Vol. 15 No. 6, pp. 279-94. Karapetrovic, S. and Willborn, W. (2001a), ‘‘Audit and self-assessment in quality management: comparison and compatibility’’, Managerial Auditing Journal, Vol. 16 No. 6, pp. 366-77. Karapetrovic, S. and Willborn, W. (2001b), ‘‘Audit system: concepts and practices’’, Total Quality Management, Vol. 12 No. 1, pp. 13-28. Kerntechnischer Ausschuss (1996), General Requirements Regarding Quality Assurance, KTA-Gescha¨ftsstelle, Bundesamt fu¨r Strahlenschutz, Salzgitter. Sohrmann, R. and Pahl, M. (2000), ‘‘Besser durch Prozessbewertung, integriertes Bewertungsmodell zeigt betriebliche Verbesserungspotentiale auf’’, Qualitaet und Zuverlaessigkeit, Vol. 45 No. 3, pp. 280-4. Strese, V., Thiele, J. and Winzer, P. (2000), ‘‘Auditterror eindaemmen, Kombiaudits als Instrument zur kontinuierlichen Verbesserung integrierter Managementsysteme’’, Qualitaet und Zuverlaessigkeit, Vol. 45 No. 11, pp. 1439-42. Willborn, W. (1979), ‘‘Quality audits in support of small business’’, Quality Progress, Vol. 11 No. 4, pp. 34-6. Zechmeister, B. (2000), ‘‘Assessment innovativ’’, Qualitaet und Zuverlaessigkeit, Vol. 45 No. 4, pp. 404-10.

Current accounting investigations: effect on Big 5 market shares

Christie L. Comunale School of Professional Accountancy, Long Island University – C.W. Post Campus, Brookville, New York, USA Thomas R. Sexton Harriman School for Management and Policy, Stony Brook University, Stony Brook, New York, USA

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

Abstract 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.

Managerial Auditing Journal 18/6/7 [2003] 569-576 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482704]

Introduction

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.

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

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

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Data and methods

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

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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

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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 transition probabilities We 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 retention probabilities, attractiveness parameters, and estimated transition probabilities We next compute those values of the retention probabilities and attractiveness 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

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

observed values. See the Appendix for details.

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To 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.

Table I Observed transition probabilities

Modeling the absence of Arthur Andersen

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 probabilities We 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

AA EY DT PM PWC

AA (%)

EY (%)

DT (%)

PM (%)

PWC (%)

98.37 0.48 0.00 0.00 0.53

0.33 98.80 0.00 0.00 0.53

0.65 0.48 99.32 0.44 0.35

0.33 0.24 0.34 98.68 0.00

0.33 0.00 0.34 0.88 98.58

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 and attractiveness parameters From the matrix in Table I, we estimate the retention probabilities and attractiveness 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 probabilities We 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 Arthur Andersen Table 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

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Christie L. Comunale and Thomas R. Sexton Current accounting investigations: effect on Big 5 market shares Managerial Auditing Journal 18/6/7 [2003] 569-576

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

Observed retention probability Estimated retention probability Estimated attractiveness parameter Observed (and estimated long-term) market share

AA

EY

DT

PM

PWC

0.9837 0.9841 0.208 0.1689

0.9880 0.9890 0.194 0.2307

0.9932 0.9904 0.107 0.1634

0.9868 0.9863 0.120 0.1258

0.9858 0.9878 0.371 0.3113

Table III Estimated transition probabilities

AA EY DT PM PWC

AA (%)

EY (%)

DT (%)

PM (%)

PWC (%)

98.41 0.28 0.22 0.32 0.40

0.39 98.90 0.21 0.30 0.38

0.22 0.15 99.04 0.17 0.21

0.24 0.16 0.13 98.63 0.23

0.74 0.51 0.40 0.58 98.78

Table IV The estimated retention probabilities and the estimated attractiveness parameters of the remaining Big 4 accounting firms in the absence of AA

Estimated retention probability Estimated attractiveness parameter

EY

DT

PM

PWC

0.9890 0.244

0.9904 0.135

0.9863 0.152

0.9878 0.469

Table V Estimated transition probabilities

EY DT PM PWC

EY (%)

DT (%)

PM (%)

PWC (%)

98.90 0.27 0.40 0.56

0.20 99.04 0.22 0.31

0.22 0.17 98.63 0.35

0.69 0.52 0.76 98.78

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

Observed number of clients attracted Expected bumber of clients attracted
2 contribution [ 572 ]

EY

DT

PM

PWC

Total

22 17.8 0.97

22 9.9 14.87

14 11.1 0.77

15 34.2 10.78

73 73 27.39

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

Table VII Current market shares and estimated and observed post-scandal market shares in the first year without AA. Post-scandal increases in market share are shown in absolute and percentage terms

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Current market shares Estimated Market shares in first year without AA Post-scandal increase in market share Post-scandal % increase in market share Observed Market shares in first year without AA Post-scandal increase in market share Post-scandal % increase in market share

AA

EY

DT

PM

PWC

0.169

0.231

0.163

0.126

0.311

0.272 0.041 17.7

0.186 0.023 14.1

0.151 0.025 19.8

0.390 0.079 25.4

0.279 0.048 20.8

0.220 0.057 34.8

0.154 0.028 22.1

0.347 0.036 11.7

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

Current market shares Estimated market shares without AA Year 1 Year 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year 20 Long-term Long-term increase in market share Long-term % increase in market share 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

AA

EY

DT

PM

PWC

0.169

0.231

0.163

0.126

0.311

0.272 0.272 0.273 0.273 0.273 0.274 0.276 0.277 0.285 0.054 23.4

0.186 0.187 0.187 0.187 0.187 0.189 0.190 0.191 0.209 0.046 28.2

0.151 0.152 0.152 0.152 0.152 0.153 0.154 0.155 0.160 0.034 27.0

0.390 0.390 0.389 0.388 0.387 0.384 0.380 0.377 0.347 0.036 11.6

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

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

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

Managerial Auditing Journal 18/6/7 [2003] 569-576

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

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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: n X ðmarket shareÞ2j ; Gina coefficient ¼ 1  j¼1

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.

Note 1 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

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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.

Reference Comunale, 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.

Appendix We 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 ðpij Þ 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 ðj Þ of 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 matrix M 1 , where M 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:

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pij ¼

ri ; i¼j P ð1  ri ÞAj = k6¼i Ak ; i ¼ 6 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  Ai Þ 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 ( 5 X 5 X ðpij  p^ij Þ2 jj ¼ ^j ; j ¼ 1; . . . ; 5; minri ; Ai i¼1 j¼1

0  ri  1; i ¼ 1; . . . ; 5;

5 X

) Aj ¼ 1

j¼1

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.

The efficacy of liquidation and bankruptcy prediction models for assessing going concern

Nirosh Kuruppu Lincoln University, Canterbury, New Zealand Fawzi Laswad Massey University, Palmerston North, New Zealand Peter Oyelere Lincoln University, Canterbury, New Zealand

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

Abstract 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 debtororiented 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.

Managerial Auditing Journal 18/6/7 [2003] 577-590 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482713]

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 creditororiented. 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

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1. Introduction

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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 in auditing 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).

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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 statistical models for assessing going concern 3.1 Introduction The 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

Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere The efficacy of liquidation and bankruptcy prediction models for assessing going concern Managerial Auditing Journal 18/6/7 [2003] 577-590

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 I Evaluation required by auditing standards on going concern Country

Standard

Evaluation required

Audit period

USA

SAS 59 (SAS 34 was superseded by SAS 59)

Specifically form an opinion on the going concern assumption from the results of usual audit procedures

Not to exceed one year from the date of the financial statements being audited

UK

SAS 130

Plan and perform procedures specifically designed to identify going concern uncertainties (s21)

Not specifically defined or elaborated (s9), but likely to be the period that management has considered in assessing going concern s21[ii])

Australia

AUS 708

Auditor must obtain evidence that the going concern assumption is appropriate (s10) Must specifically assess going concern problems as part of the audit planning process (s17)

One year (s4)

New Zealand

AS 520

Obtain audit evidence that the going concern assumption is appropriate (s27) Plan and perform specific procedures to identify going concern uncertainties (s8a, 30)

One year (s25)

IAS (IFAC)

ISA 570

Auditor should consider the appropriateness of the going concern assumption when planning and performing audit procedures and in evaluating their results (s2, s11, s12, s17)

One year (s18, s19)

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the use of bankruptcy prediction models for assessing the validity of the going concern 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 findings The 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

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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 and hypotheses 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 assessing the validity of the going concern 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

Place

USA

USA

USA

USA

USA

Study

Altman and McGough (1974)

Altman (1983)

Levitan and Knoblett (1985)

Mutchler (1985)

Koh and Killough (1990)

Definition of company failure

35 failed; 35 non-failed companies

119 going concern qualified; 119 non-going concern modified companies

32 failed; 32 non-failed companies

40 failed companies

Model was able to predict the GC opinion 83 per cent of the time

Model and auditors have similar accuracy for non-failed companies (88.6 per cent and 88.86 per cent respectively) Model accuracy strongly outperforms auditors for failed companies (78.57 per cent to only 21.43 per cent by auditors)

MDA

Receipt of going concern qualification

Companies reported as ‘‘failed’’ MDA by the Wall Street Journal Index. No further details are provided

One year prior to bankruptcy, model 84 per cent accurate compared to auditors’ 66 per cent accuracy Three year model average is 67 per cent compared to auditors’ 33 per cent

MDA

MDA

Model accuracy 82 per cent compared to auditors 46 per cent accuracy Average bankruptcy model accuracy 86.2 per cent compared to auditors’ 48.1 per cent accuracy

Findings

Bankruptcy

Bankruptcy

MDA

Method

(continued)

Asserts that future research could provide auditors with more sophisticated and accurate models for assessing going concern problems

Urges more studies into the overall function of the audit opinion since the majority of these opinions could be predicted by publicly available information

Model accuracy is a better predictor of bankruptcy when compared to auditors’ opinion

Auditors should examine analytical methods which can assist in the going concern context

Bankruptcy prediction models can be useful to auditors

Conclusions

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33 bankrupt; 33 non-bankrupt Bankruptcy companies

Sample

Table II Studies applying bankruptcy prediction models for assessing going concern

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Canada 138 failed; 112 non-failed companies

Cormier et al. (1995) Annual stock return less than –50 per cent

Bankruptcy

Definition of company failure

Conclusions

Models developed in this study can be compared with current practice in accounting firms. From this exercise, better specified models can be developed

Suggests the model as a useful audit Model predicted 82.50 per cent of non-going concerns and 100 per cent tool of going concerns yielding an average success rate of 91.25 per cent. Auditors’ average success rate was 68.75 per cent, with a 40 per cent success rate for failed companies

Findings

Logit, MDA and Classification rates for failed companies using logit, MDA and RP Recursive partitioning (RP) respectively: 76.08 per cent, 81.88 per cent, 70.3 per cent Auditors’ accuracy was not compared in this study

Probit

Method

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40 failed; 40 non-failed companies

USA

Koh and Brown (1991)

Sample

Place

Study

Table II

Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere The efficacy of liquidation and bankruptcy prediction models for assessing going concern

Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere The efficacy of liquidation and bankruptcy prediction models for assessing going concern Managerial Auditing Journal 18/6/7 [2003] 577-590

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 prediction model in discriminating between liquidated and continuing 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 prediction model in discriminating between liquidated and continuing 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 variables The 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

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variable was coded as a binary variable, where 1 is defined as a failure and 0 is defined as a non-failure.

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5.2 Statistical modelling approach

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Multiple 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 accuracy and hypotheses testing The 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 crossvalidation, 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 Zscore model is used with adjusted coefficients (Eidleman, 1995).

Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere The efficacy of liquidation and bankruptcy prediction models for assessing going concern Managerial Auditing Journal 18/6/7 [2003] 577-590

6. Data analysis and results 6.1 The model The 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’s Q 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 III Discriminant function summary statistics Step

Entered variable

1 2 3 4 5 6 7 8 9 10 11 12

Total sales/total tangible assets Quick assets/total assets Current assets/current liabilities Total sales/average total assets Net income/average total assets Total liabilities/total assets Net income/shareholders funds Working capital/total sales Sales/average accounts receivable Sales/average working capital Net income/total liabilities Shareholders funds/total assets Constant

Function

Eigenvalue

1

0.421(a)

Test of function(s) 1

Wilks’ lambda 0.704

Unstandardised canonical discriminant function coefficients 3.298 –3.920 0.163 –2.671 5.030 3.654 –0.119 0.023 0.005 –0.002 –0.425 1.727 –2.786 Eigenvalues Per cent of variance 100.0 Wilks’ lambda Chi-square 38.685

Wilks’ lambda ()

Tolerance at step 12

Sig.

0.952 0.903 0.875 0.847 0.801 0.775 0.760 0.746 0.732 0.722 0.713 0.704

0.051 0.673 0.566 0.051 0.232 0.167 0.829 0.936 0.970 0.968 0.263 0.196

0.017 0.003 0.002 0.001 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Cumulative per cent

Canonical correlation

100.0

0.545

df

Sig. 0.000

12

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Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere The efficacy of liquidation and bankruptcy prediction models for assessing going concern Managerial Auditing Journal 18/6/7 [2003] 577-590

Table IV Lachenbruch cross-validation results Predicted group membership 0.00 1.00

Status

Original Count Per cent

Cross-validated Count Per cent

Tests of predictive accuracy Proportional chance criterion Press’s Q statistic

Total

0.00 1.00 0.00 1.00

19 7 38.0 8.2

31 78 62.0 91.8

50 85 100.0 100.0

0.00 1.00 0.00 1.00

18 7 36.0 8.2

32 78 64.0 91.8

50 85 100.0 100.0

0.5338 25.785

Notes: Type 1 error: 8.2 per cent Type 2 error: 64 per cent; 71.9 per cent of original grouped cases correctly classified. 71.1 per cent of cross-validated grouped cases correctly classified Due to differences in debtor- and creditororiented 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

6.2 Altman’s Z-score model Altman’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 tests The 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.

Table V Altman’s Z-score model accuracy Actual membership Non-failed Failed

Predicted membership Failed Non-failed 23 35

27 50

Note: Type 1 error: 59 per cent Type 2 error: 46 per cent [ 586 ]

Total

Per cent accuracy

50 85

54 41

Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere The efficacy of liquidation and bankruptcy prediction models for assessing going concern Managerial Auditing Journal 18/6/7 [2003] 577-590

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 assessing the validity of the going concern 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 creditororiented, 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

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frameworks, which have not been addressed in prior accounting and auditing research.

Notes 1 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.

References Afifi, A. and Clark, V. (1984), Computer Aided Multivariate Analysis, Wadsworth, Belmont, CA. Alderson, M. and Betker, B. (1996), ‘‘Liquidation costs and accounting data’’, Financial Management, Vol. 25 No. 2, pp. 25-36. Alderson, M. and Betker, B. (1999), ‘‘Assessing post-bankruptcy performance: an analysis of reorganised firms’ cash flows’’, Financial Management, Vol. 28 No. 2, pp. 68-82. Allen, D. and Chung, J. (1998), ‘‘A review of choice of model and statistical techniques in corporate distress prediction studies’’, Accounting Research Journal, Vol. 11 No. 1, pp. 245-69. Altman, E. (1983), Corporate Distress: A Complete Guide to Predicting, Avoiding and Dealing with Bankruptcy, 3rd ed., John Wiley & Sons, New York, NY. Altman, E. (1968), ‘‘Financial ratios, discriminant analysis and the prediction of corporate bankruptcy’’, Journal of Finance, Vol. 23 No. 4, pp. 589-609. Altman, E. and McGough, T. (1974), ‘‘Evaluation of a company as a going concern’’, Journal of Accountancy, December, pp. 50-7. Anderson, J., Jennings, M., Kaplan, S. and Reckers, P. (1995), ‘‘The effect of using diagnostic decision aids for analytical procedures on judges’ liability judgements’’, Journal of Accounting and Public Policy, Vol. 14 No. 1, pp. 33-41. Asare, S. (1990), ‘‘The auditor’s going-concern decision: a review and implications for future research’’, Journal of Accounting Literature, Vol. 9, pp. 39-64. Barnes, P. and Huan, H. (1993), ‘‘The auditor’s going concern decision: some UK evidence concerning independence and competence’’, Journal of Business Finance & Accounting, Vol. 20 No. 2, pp. 213-28.

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Beaver, W. (1966), ‘‘Financial ratios as predictors of failure’’, Journal of Accounting Research, Vol. 4, pp. 71-127. Bertoneche, M. and Knight, R. (2001), Financial Performance, Butterworth-Heinemann, Oxford. Blocher, E. and Loebbecke, J. (1993), ‘‘Research in analytical procedures: implications for establishing and implementing auditing standards’’, in Guy, D. and Winters, A. (Eds), The Expectations Gap Standards, AICPA, Jersey City, NJ, pp. 177-226. Boritz, J. and Kralitz, E. (1987), ‘‘Reporting on condition: auditing the going-concern assumption’’, CA Magazine, March, pp. 67-70. Carcello, J. and Palmrose, Z. (1994), ‘‘Auditor litigation and modified reporting on bankrupt clients’’, Journal of Accounting Research, Vol. 32, pp. 1-38. Casterella, J., Lewis, B. and Walker, P. (2000), ‘‘Modelling the audit opinions issued to bankrupt companies: a two-stage empirical analysis’’, Decision Sciences, Vol. 31 No. 2, pp. 507-30. Chatterjee, S., Dhillon, U. and Ramirez, G. (1996), ‘‘Resolution of financial distress: debt restructurings via chapter 11, prepackaged bankruptcies, and workouts’’, Financial Management, Vol. 25 No. 1, pp. 5-18. Chen, K. and Church, B. (1992), ‘‘Default on debt obligations and the issuance of going-concern options’’, Auditing: A Journal of Practice & Theory, Vol. 11 No. 2, pp. 30-49. Collins, R. and Green, R. (1982), ‘‘Statistical methods for bankruptcy forecasting’’, Journal of Economics and Business, Vol. 34, pp. 349-54. Constable, J. and Woodliff, D. (1994), ‘‘Predicting corporate failure using publicly available information’’, Australian Accounting Review, Vol. 4 No. 1, pp. 13-27. Cormier, D., Magnan, M. and Morard, B. (1995), ‘‘The auditor’s consideration of the going concern assumption: a diagnostic model’’, Journal of Accounting, Auditing & Finance, Vol. 10 No. 2, pp. 201-21. Dunn, K., Tan, C. and Venuti, E. (2002), ‘‘Audit firm characteristics and Type 2 errors in the going concern opinion’’, Asia-Pacific Journal of Accounting & Economics, Vol. 9, pp. 39-69. Eidleman, G. (1995), ‘‘Z scores – a guide to failure prediction’’, CPA Journal, February, pp. 52-3. Finkelstein, M. and Levin, B. (1990), Statistics for Lawyers, Springer-Verlag, New York, NY. Foster, B., Ward, T. and Woodroof, J. (1998), ‘‘An analysis of the usefulness of debt defaults and going concern opinions in bankruptcy risk assessment’’, Journal of Accounting, Auditing & Finance, Vol. 13 No. 3, pp. 351-67. Franks, J., Nyborg, K. and Torous, W. (1996), ‘‘A comparison of US, UK, and German insolvency codes’’, Financial Management, Vol. 25 No. 3, pp. 86-101. Geiger, M., Raghunandan, K. and Rama, D. (1998), ‘‘Costs associated with going concern modified audit opinions: an analysis of

Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere The efficacy of liquidation and bankruptcy prediction models for assessing going concern Managerial Auditing Journal 18/6/7 [2003] 577-590

auditor changes, subsequent opinions, and client failures’’, Advances in Accounting, Vol. 16, pp. 117-39. George, D. and Mallery, P. (2001), SPSS for Windows: Step by Step, 3rd ed., Allyn & Bacon, Needham Heights, MA. Gilbert, L., Menon, K. and Schwartz, K. (1990), ‘‘Predicting bankruptcy for firms in financial distress’’, Journal of Business Finance & Accounting, Vol. 17 No. 1, pp. 161-71. Grant, T., Wheeler, S. and Ciccotello, C. (1998), ‘‘Predicting financial distress: audit classification in a litigious environment’’, Advances in Accounting, Vol. 16, pp. 163-93. Guy, D. and Carmichael, D. (2000), Practitioner’s Guide to GAAS 2000, 1st ed., John Wiley & Sons, New York, NY. Hair, J., Anderson, R., Tatham, R. and Black, W. (1995), Multivariate Data Analysis, 4rd ed., Prentice Hall, Englewood Cliffs, NJ. Holmen, J. (1988), ‘‘Using financial ratios to predict bankruptcy: an evaluation of classic models using recent evidence’’, ABER, Vol. 19 No. 1, pp. 52-63. International Federation of Accountants (2000), Going Concern, International Standards on Auditing No. 570, available: www.ifac.org/ members (accessed 23 August 2002). Izan, H. (1984), ‘‘Corporate distress in Australia’’, Journal of Banking and Finance, Vol. 8, pp. 303-20. Johnson, V. and Khurana, I. (1993), ‘‘Companies in trouble: what are the auditor’s responsibilities?’’, Journal of Commercial Lending, Vol. 76 No. 4, pp. 52-7. Jones, F. (1987), ‘‘Current techniques in bankruptcy prediction’’, Journal of Accounting Literature, Vol. 1, pp. 131-64. Kaiser, K. (1996), ‘‘European bankruptcy laws: implications for corporations facing financial distress’’, Financial Management, Vol. 25 No. 3, pp. 67-85. Kennedy, D. and Shaw, W. (1991), ‘‘Evaluating financial distress resolution using prior audit opinions’’, Contemporary Accounting Research, Vol. 8 No. 1, pp. 97-114. Ketz, J., Doogar, R. and Jensen, D. (1990), A Cross-industry Analysis of Financial Ratios, Quorum Books, Westport, CT. Koh, C. (1991), ‘‘Model predictions and auditor assessments of going concern status’’, Accounting and Business Research, Vol. 21 No. 84, pp. 331-8. Koh, C. and Brown, R. (1991), ‘‘Probit predictions of going and non-going concerns’’, Managerial Auditing Journal, Vol. 6 No. 3, pp. 18-23. Koh, C. and Killough, L. (1990), ‘‘The use of discriminant analysis in the assessment of the going concern status of an audit client’’, Journal of Business Finance & Accounting, Vol. 17 No. 2, pp. 179-92. Koh, C. and Oliga, J. (1990), ‘‘More on AUP17 and going concern prediction models’’, Australian Accountant, October, pp. 67-72.

Lau, A. (1987), ‘‘A five-state financial distress prediction model’’, Journal of Accounting Research, Spring, pp. 127-38. Levitan, A. and Knoblett, J. (1985), ‘‘Indicators of exceptions to the going concern assumption’’, Auditing: A Journal of Practice & Theory, Vol. 5 No. 1, pp. 26-39. Loftus, J. and Miller, M. (2000), ‘‘International developments on reporting going concern uncertainties and financial vulnerability’’, Advances in International Accounting, Vol. 13, pp. 23-57. Louwers, T., Messina, F. and Richard, M. (1999), ‘‘The auditor’s going concern disclosure as a self-fulfilling prophecy: a discrete time survival analysis’’, Decision Sciences, Vol. 30 No. 3, pp. 808-24. Lowe, D., Reckers, P. and Whitecotton, S. (2002), ‘‘The effects of decision aid use and reliability on jurors’ evaluations of auditor liability’’, Accounting Review, Vol. 77 No. 1, pp. 185-202. Morris, R. (1997), Early Warning Indicators of Corporate Failure: A Critical Review of Previous Research and Further Empirical Evidence, Aldershot, Ashgate. Mutchler, J. (1985), ‘‘A multivariate analysis of the auditor’s going concern opinion decision’’, Journal of Accounting Research, Vol. 23 No. 2, pp. 668-82. Nasir, M., John, R., Bennett, S., Russell, D. and Patel, A. (2000), ‘‘Predicting corporate bankruptcy using artificial neural networks’’, Journal of Applied Accounting Research, Vol. 5 No. 3, pp. 30-52. Schultz, S. (1995), ‘‘Financial reporting for firms in chapter 11 reorganisation’’, National Public Accountant, Vol. 40 No. 1, pp. 24-8. Taffler, R. (1982), ‘‘Forecasting company failure in the UK using discriminant analysis and financial ratio data’’, Journal of the Royal Statistical Society, Vol. 145 No. 3, pp. 342-58. Wallace, W. (1983), ‘‘The acceptability of regression analysis as evidence in a courtroom: implications for auditors’’, Auditing: A Journal of Practice & Theory, Vol. 2 No. 2, pp. 66-90. Woelfel, C. (1994), Financial Statement Analysis: The Investor’s Self-study Guide to Interpreting and Analyzing Financial Statements, revised ed., Probus, Chicago, IL. Zhang, M. and Harrold, S. (1997), ‘‘Going, going . . . gone? Is a GCQ a self-fulfilling prophecy?’’, Australian Accountant, August, available at: www.cpaonline.com.au/Archive/9708/ pg_aa9708_goinggone.htm (accessed 23 August 2002).

Further reading American Institute of Certified Public Accountants (1988), Analytical Procedures, Statement on Auditing Standards No. 56, AICPA, New York, NY. American Institute of Certified Public Accountants. (1978), Commission on Auditors’

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Responsibilities: Report Conclusions and Recommendations, AICPA, New York, NY. American Institute of Certified Public 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.

Auditing Practices Board (1994), The Going Concern Basis in Financial Statements, tatements of Auditing Standards 130, APB, London. Betker, B. (1996), ‘‘The administrative costs of debt restructurings: some recent evidence’’, Financial Management, Vol. 26 No. 4, pp. 56-68. Institute of Chartered Accountants of New Zealand (1998), Analytical Procedures, Auditing Standard No. 504, ICANZ, Wellington. Institute of Chartered Accountants of New Zealand (1998), Going Concern, Auditing Standard No. 520, ICANZ, Wellington.

Are auditors sensitive enough to fraud?

Bilal Makkawi Morgan State University, Baltimore, Maryland, USA Allen Schick Morgan State University, Baltimore, Maryland, USA

Keywords Auditing, Fraud, Corporate governance, Auditors

Abstract 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.

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

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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 Managerial Auditing Journal 18/6/7 [2003] 591-598 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482722]

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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 financial reporting 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

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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:

Bilal Makkawi and Allen Schick Are auditors sensitive enough to fraud? Managerial Auditing Journal 18/6/7 [2003] 591-598

1 All auditors increased the performance of certain procedures. 2 Some auditors chose not to reduce any procedures. 3 A consensus existed on which 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 I Analytical review procedures No. 1 2 3 4 5 6 7 8 9 10 11

Procedures The relationship of purchases to usage reports and production costs was compared for both years for consistency. Any unusual deviation was examined Investigation of unusual fluctuations (more than 10 per cent annually) Consideration of the reasonableness of the cost of sales by multiplying units sold by average cost per product line Comparisons of inventory turnover and number of days’ sales in ending inventory Comparisons of microprocessor inventory by type Comparisons of inventory shrinkages Comparisons of scrap and stock out report Analysis of purchase commitments for motherboard parts (i.e. hard drive, floppy, and microprocessors on computer base) Analysis of production performance report Analysis of rework reports Inspection of large purchases near year-end

Increase

Decrease

26 2 16 4

6

1

7 8

8 6 12 2 [ 593 ]

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Table II Changes to tests of balances and details procedures No. 1 2 3

4 5 6

7 8 9 10

11 12

Procedures Observed client’s team measure, weigh, and count inventory Performed test counts and mathematical computations to confirm client’s counting For a sample of purchase orders: a Tested for mathematical accuracy b Agreed details to receiving documents Confirmations were sent for inventory on consignment 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 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 Reviewed and tested procedures for slow moving items Traced inventory totals from trial balance to subsidiary ledgers and verified agreement of details by product to general ledger total Reviewed largest purchase returns Obtained purchase transactions listing and traced monthly totals to general ledger: a Tested mathematical accuracy b Investigated large and unusual amounts Reviewed terms governing passage of title and freight terms, to ensure that only valid purchases have been booked Compared carrying cost to market values

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

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Increase

Decrease 2

13 8

6 26

2

11 4

8

5 28

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

Bilal Makkawi and Allen Schick Are auditors sensitive enough to fraud? Managerial Auditing Journal 18/6/7 [2003] 591-598

more of a balance between effectiveness and efficiency.

References Abdolmohammadi, 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 experiment This 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 Corporation Your 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 industry American Microchip Corporation, a mediumsized 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 SRAMs (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

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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,

Table AI

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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

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

Table AII

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accounting principles might result in over valuation of assets such as inventory or miss classification of liabilities.

Additional information American 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 writedown 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.

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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 yearend. 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

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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 to the best of your knowledge Do 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 __________________

Users’ perceptions of various aspects of Kuwaiti corporate reporting

Kamal Naser Cardiff Business School, University of Wales, Cardiff, UK Rana Nuseibeh Cardiff Business School, University of Wales, UK Ahmad Al-Hussaini Public Authority for Applied Education and Training, Kuwait

Keywords Corporate finances, Corporate communications, Reports, Kuwait

Abstract 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.

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

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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 in Kuwait Managerial Auditing Journal 18/6/7 [2003] 599-617 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900310482731]

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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.

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 report

Previous studies and study questions User groups’ primary sources of information In 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?

Sterling (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, importance and timeliness of different parts of the annual report Understandability For 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. RQ4. What are the perceptions of the various user groups regarding the understandability of information contained in the annual report?

Credibility Characteristics of useful corporate information Textbooks 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

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Another 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

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting Managerial Auditing Journal 18/6/7 [2003] 599-617

attach to different sections of the annual report. RQ5. What are the perceptions of the various user groups regarding the credibility of different parts of the annual report?

Importance The 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. RQ6. What are the perceptions of various user groups regarding the importance of different parts of the annual report?

Timeliness The 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. RQ7. What are the perceptions of the various Kuwaiti user groups regarding the timeliness of the corporate annual report?

The importance of different item disclosures requested by the IASs In 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. RQ8. What are the perceptions of various user groups regarding the importance of various disclosure items required by IASs?

The importance of different items of voluntary disclosures In 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. RQ9. What are the perceptions of the various user groups regarding the 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

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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 groups User 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 corporate information Various 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 I Subject groups and response rates Subject groups Institutional investors Individual investors Bank loan officers Government officials Financial analysts Academics Auditors Stock market brokers Total and over all response rate [ 602 ]

Distributed questionnaire

Received questionnaire

Response rate (%)

50 50 50 50 50 50 50 50 400

41 42 36 39 36 38 39 35 306

82 84 72 78 76 78 70 77 77

306 306 306 306 306 306 306 306

4.90 4.27 4.80 3.63 3.36 4.31 4.95 4.33 0.39

4.85 4.47 4.80 3.80 3.78 4.40 4.61 3.84 0.47

4.63 3.86 4.88 3.55 3.50 4.11 4.86 3.56 0.47

4.87 3.95 4.44 3.44 3.59 4.36 4.72 3.64 0.46

4.75 4.20 4.47 3.50 3.61 4.44 4.72 4.19 0.45

4.89 4.08 4.08 3.63 3.55 3.95 4.42 3.55 0.53

4.95 4.49 4.36 3.31 3.54 4.51 4.87 4.03 0.50

4.69 4.31 4.69 4.17 4.00 4.37 4.83 4.83 0.33

4.82 4.21 4.57 3.63 3.61 4.31 4.75 3.99

0.38 0.68 0.62 0.87 0.82 0.72 0.49 1.07 0.38

1 5 3 7 8 4 2 6

Rank

0.002 0.00 0.00 0.00 0.06 0.001 0.00 0.00

KWSL

Notes: KWSL: Kruskall-Wallis significance level; Mean values – scoring: 1 = not important at all; 5 = very important; 1. Individual investors; 2. Institutional investors; 3. Bank credit officers 4; Government officials; 5. Financial analysts; 6. Academics; 7. Auditor; 8. Stock market brokers

Annual report Interim report Specialist’s advice Friend’s advice Newspapers and magazines Special publications Direct information from the company Market rumours Kendall’s coefficient of concordance W

Whole sample Mean SD

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User groups Frequency 1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35)

Table II User groups’ attitudes towards various sources of information

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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

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting Managerial Auditing Journal 18/6/7 [2003] 599-617

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 corporate information To 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 report The 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 ]

[ 606 ]

306 306 306 306 306 306 306

4.76 4.37 4.44 4.61 4.83 4.12 3.95 0.42

4.98 4.57 4.57 4.43 4.79 4.50 4.64 0.55

4.58 4.53 4.58 4.75 4.89 4.67 4.28 0.51

4.79 4.59 4.59 4.87 4.95 4.67 4.59 0.51

4.81 4.69 4.72 4.89 4.97 4.72 4.58 0.57

Notes: KWSL: Kruskall-Wallis significance level; Mean values – scoring: 1 = not important at all; 5 = very important

Timeliness Availability of specific information Understandability Neutrality Credibility Easy access to sources of information Independent verification Kendall’s coefficient of concordance W

5.00 4.53 4.68 4.71 4.97 4.63 4.34 0.65

4.98 4.72 4.72 4.95 4.97 4.87 4.79 0.59

4.91 4.89 4.97 4.83 4.89 4.89 4.77 0.45

4.85 4.60 4.65 4.75 4.91 4.62 4.49

0.24 0.34 0.38 0.38 0.31 0.36 0.52 0.53

Whole sample Mean SD

2 6 4 3 1 5 7

Rank

Managerial Auditing Journal 18/6/7 [2003] 599-617

User groups Frequency 1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35)

Table III Users’ ratings of the importance of a set of criteria of corporate information quality

0.625 0.421 0.506 0.486 0.821 0.325 0.499

KWSL

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting

4.35 4.20 4.24 3.98 3.87 4.20 4.07 0.50

306 306 306 306 306 306 306

4.15 0.52

4.23 4.26 3.83 4.34

4.32

4.41

4.51 0.54

4.22 4.30 3.95 4.41

4.33

4.64

4.62 0.55

4.21 4.46 4.06 4.48

4.27

4.44

3.97 0.51

3.97 3.93 3.56 4.18

4.25

4.40

4.08 0.52

4.22 4.12 3.85 4.28

4.26

4.38

4.32 0.53

4.14 4.28 3.92 4.36

4.34

4.51

4.02 0.52

4.07 4.14 4.08 4.34

4.26

4.39

4.27

4.21 4.17 3.90 4.33

4.27

4.43

0.89 0.53

0.89 0.86 0.97 0.80

0.85

0.82

3

5 6 7 2

3

1

User groups Whole sample 1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35) Mean SD Rank

Notes: KWSL: Kruskall-Wallis significance level; Mean values – scoring: 1 = not useful at all; 5 = very useful

Provide primary information to investors to help them in making informed investment decisions Provide information to help investors to monitor their investment Help investors to predict expected income and earnings per share To help investors in assessing liquidity of the company Help investors to predict future dividends of the company Help investors to evaluate company’s performance over time Help investors to make comparison between a company’s performance with other companies’ performance Kendall’s coefficient of concordance W

Freq.

Managerial Auditing Journal 18/6/7 [2003] 599-617

Usefulness criterion

Table IV Groups’ views about usefulness of information contained in the annual financial statement

0.025*

0.905 0.10 0.96 0.152

0.374

0.236

KWSL

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting

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Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting Managerial Auditing Journal 18/6/7 [2003] 599-617

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, importance and timeliness of different parts of the annual report Understandability The 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

[ 608 ]

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].

Credibility The 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

2.88* 4.07 4.07 3.66 0.15 4.3 4.5 4.6 4.8 4.5 4.6 3.9 0.16 4.73 3.04 1.76 1.16 1.01 0.61

306 306 306 306

306 306 306 306 306 606 306

306 306 306 306 306

3.51 3.61 3.21 3.56 0.15

4.74 2.94 1.65 1.04 1.00 0.67

4.3 4.2 4.4 4.6 4.6 4.4 3.8 0.21

2.52 4.38 4.33 4.10 0.20

3.52 3.81 3.41 3.63 0.28

2 n = (42)

4.75 2.82 1.71 1.03 0.98 0.63

3.9 4.3 4.7 4.9 4.6 4.8 4.6 0.38

2.61 4.17 4.11 4.03 0.36

3.61 3.72 3.54 3.67 0.25

4.75 2.82 1.72 1.15 0.67 0.64

3.6 4.2 4.7 5.0 4.7 4.9 4.1 0.51

2.64 3.59 3.56 3.56 0.47

3.64 3.72 3.45 3.79 0.23

User groups 3 n = (36) 4 n = (39)

4.74 2.75 1.75 1.12 1.00 0.63

4.0 4.2 4.5 4.7 4.6 4.6 4.4 0.23

2.89 3.97 3.97 3.89 0.22

3.89 4.17 3.22 4.17 0.30

5 n = (36)

4.74 2.52 1.62 1.00 0.96 0.65

4.1 4.5 4.9 5.0 4.7 4.9 4.3 0.50

2.24 3.45 3.39 3.18 0.45

3.89 3.95 3.25 4.03 0.34

6 n = (38)

4.73 3.02 1.70 1.10 1.00 0.63

4.1 4.4 4.9 4.9 4.8 4.9 4.6 0.44

2.69 4.18 4.10 3.95 0.42

3.69 3.62 3.44 3.51 0.26

7 n = (39)

4.74 2.68 1.68 1.06 0.98 0.65

4.0 4.2 4.3 4.9 4.9 4.9 3.2 0.50

3.11 3.91 3.80 2.94 0.45

4.11 4.14 3.31 4.14 0.27

8 n = (35)

4.74 2.83 1.70 1.08 0.95 0.63

4.1 4.3 4.6 4.8 4.7 4.7 4.1 0.28

2.69 3.96 3.93 3.67 0.27

3.73 3.84 3.35 3.81 0.28

0.34 0.92 0.46 0.44 0.30

0.7 0.6 0.5 0.5 0.6 0.5 1.1

0.80 0.68 0.71 1.02

0.81 0.49 1.07 0.60

Whole sample Mean SD

Notes: Scoring a1 = very easy to understand; 5 = very difficult to understand; b1 = not credible at all; 5 = very credible; c1 = not Important at all; 5 = very important; d1 = strongly disagree; 5 = strongly agree

Understandability Directors’ report Financial statements Auditor’s report Notes to financial statements Kendall’s coefficient of concordance W (Mean valuesa) Credibility Directors’ report Financial statements Auditor’s report Notes to financial statements Kendall’s coefficient of concordance W (Mean valuesb) Importance Board of directors’ report Auditor’s report Balance sheet Income statement Retained earnings statement Cash flow statement Note to the accounts Kendall’s coefficient of concordance W (Mean valuesc) Timeliness Less than 30 days From 30 to less than 60 days From 60 to less than 90 days From 90 to less than 120 days 120 days or more Kendall’s coefficient of concordance W (Mean valuesd)

1 n = (41)

Managerial Auditing Journal 18/6/7 [2003] 599-617

Freq.

Table V Users’ ratings of the degree of credibility of different parts of the annual report

0.923 0.377 0.793 0.798 0.968

6 5 4 1 2 2 6

4 1 2 3

3 1 4 2

Rank

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting

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Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting Managerial Auditing Journal 18/6/7 [2003] 599-617

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.

Importance The 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

[ 610 ]

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

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting Managerial Auditing Journal 18/6/7 [2003] 599-617

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.

Timeliness Viewing 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 items required by accounting standards A 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 ]

[ 612 ] 4.32 4.49 4.59 4.56 4.62 4.71 4.71 4.74 4.64 4.71 4.69 4.79 4.90 4.87 4.77 4.92 4.92 4.77 4.72 4.74 4.70 4.97 4.70 4.67 0.28

306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306

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

Two years’ statistical figures Classification of assets and liabilities to current/non-current Classification of assets in sequence – current followed by fixed assets Accounting standards used Major components of assets Disclosure of total current assets Major components of current assets Major components of fixed assets Net value of depreciable assets Classification of liabilities in a specific sequence Disclosure of current liabilities value Disclosure of components of long-term liabilities in a specific sequence Classification of shareholders’ equity section in a specific sequence Gross sales Other sources or revenue Cost of sales Gross profit Administrative expenses Selling expenses General expenses Research and development expenses Net profit/loss Nature of company’s activities Summary of accounting policies Kendall’s coefficient of concordance W 4.86 4.31 4.31 4.50 4.19 4.31 4.19 4.33 4.90 4.38 4.17 0.37

4.62

3.90 4.36 4.33 4.19 4.14 4.29 4.31 4.29 4.19

4.26 4.21 4.31

5.00 4.83 4.44 5.00 4.42 4.50 4.39 4.53 5.00 4.69 4.53 0.33

4.83

4.53 4.64 4.67 4.72 4.72 4.61 4.75 4.75 4.78

4.64 4.56 4.64

4.92 4.90 4.74 4.92 4.67 4.69 4.67 4.51 4.95 4.59 4.46 0.21

4.77

4.67 4.69 4.74 4.74 4.74 4.59 4.67 4.62 4.62

4.59 4.69 4.72

4.86 4.75 4.78 4.81 4.67 4.75 4.64 4.58 4.89 4.56 4.53 0.23

4.67

4.50 4.41 4.58 4.53 4.47 4.47 4.47 4.50 4.47

4.53 4.50 4.50

4.95 4.71 4.61 4.71 4.58 4.55 4.58 4.66 4.92 4.24 4.29 0.49

4.68

4.34 4.66 4.66 4.66 4.66 4.47 4.84 4.66 4.66

3.66 4.55 4.82

4.87 4.77 4.92 4.92 4.77 4.72 4.74 4.70 4.97 4.70 4.67 0.16

4.90

4.56 4.62 4.71 4.71 4.74 4.64 4.71 4.69 4.79

4.41 4.49 4.59

4.60 4.43 4.34 4.74 4.31 4.31 4.34 4.26 4.94 4.60 4.49 0.27

4.86

4.49 4.51 4.51 4.49 4.43 4.37 4.37 4.40 4.40

4.46 4.40 4.40

4.87 4.64 4.59 4.79 4.49 4.57 4.52 4.50 4.94 4.50 4.43 0.29

4.78

4.39 4.55 4.59 4.57 4.55 4.45 4.57 4.56 4.58

4.35 4.47 4.56

0.34 0.51 0.54 0.50 0.60 0.55 0.62 0.65 0.24 0.61 0.67

0.45

0.80 0.60 0.51 0.56 0.63 0.61 0.50 0.54 0.56

0.75 0.56 0.55

User groups Whole sample 1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35) Mean SD

Managerial Auditing Journal 18/6/7 [2003] 599-617

Freq.

Table VI Groups’ views about usefulness of information contained in the annual financial statement

2 5 6 3 19 9 16 17 1 17 22

4

23 13 6 9 13 21 9 12 8

24 20 13

Rank

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting Managerial Auditing Journal 18/6/7 [2003] 599-617

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. 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 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 voluntary disclosure items A 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. To assess the degree of agreement within individual target groups and the whole sample, the Kendal’s coefficient of concordance W was executed and reported in 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.

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[ 614 ] 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306 306

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

Donations to charitable organisations Recruitment policy among university graduates Details of plant and equipment Pension plan Human resources development Factor(s) that influenced firm’s activities Factor(s) expected to affect future activities Promotion and advertisement expenses Directors’ remuneration Amount paid as directors’ remuneration Percentage of Kuwaitis employed by the firm Information on future expansion in assets Percentage of salaries/total salaries paid to Kuwaitis Percentage of revenue generated from foreign sources Information on different sources of revenue Information on investment in shares List of directors’ names List of top management names Stock value Information on stock contents Details of dividends policy Names of majority shareholders Value of investment in bonds Value of raw materials produced locally Information on long-term liabilities Auditors’ fees Information on various products produced by the firm Information on cash surplus Information on ageing debtors Earnings per share Statistics for more than one year Kendall’s coefficient of concordance W

3.73 3.71 4.12 3.80 3.59 4.46 4.37 4.15 3.98 3.88 3.49 4.61 3.27 4.68 4.54 4.90 4.44 4.49 4.41 4.32 4.66 4.63 4.54 4.63 4.51 4.05 4.46 4.39 4.41 4.80 4.66 0.25

3.57 3.71 4.12 3.80 3.59 4.46 4.37 4.15 3.98 3.88 3.49 4.61 3.27 4.68 4.54 4.90 4.44 4.49 4.41 4.32 4.66 4.63 4.54 4.63 4.51 4.05 4.46 4.39 4.41 4.80 4.66 0.27

4.39 3.71 4.12 3.80 3.59 4.46 4.37 4.15 3.98 3.88 3.49 4.61 3.27 4.68 4.54 4.90 4.44 4.49 4.41 4.32 4.66 4.63 4.54 4.63 4.51 4.05 4.46 4.39 4.41 4.80 4.66 0.42

3.38 3.38 4.26 3.36 3.92 4.90 4.70 4.79 4.36 4.36 3.21 4.15 3.18 4.82 4.82 5.00 4.38 4.38 4.92 4.92 4.69 4.23 4.95 4.77 4.82 4.31 4.62 4.72 4.74 4.85 4.74 0.55

4.58 4.53 4.72 4.53 4.69 4.86 4.81 4.78 4.56 4.53 4.61 4.75 4.61 4.83 4.83 4.78 4.47 4.50 4.83 4.67 4.83 4.47 4.81 4.64 4.81 4.72 4.75 4.64 4.72 4.78 4.72 0.09

4.26 3.37 4.63 3.97 3.74 4.95 4.95 4.44 4.37 4.42 3.29 4.00 3.42 4.92 4.92 4.92 3.53 3.53 4.92 4.66 4.92 3.74 4.89 4.66 4.71 4.37 4.78 4.68 4.50 5.00 4.92 0.52

3.87 3.79 4.05 3.72 4.03 4.28 4.33 4.51 4.08 4.10 3.54 3.92 3.46 4.69 4.72 4.79 3.95 4.02 4.79 4.77 4.41 3.90 4.64 4.49 4.54 3.92 4.54 4.44 4.46 4.82 4.59 0.35

3.06 3.17 4.63 3.77 4.57 4.94 4.91 4.54 4.46 4.46 3.20 4.71 3.31 4.74 4.83 4.91 4.71 4.74 4.77 4.63 4.89 4.69 4.89 4.74 4.74 4.46 4.71 4.69 4.74 4.94 4.89 0.52

3.73 3.62 4.40 3.75 4.12 4.68 4.66 4.52 4.19 4.15 3.47 4.36 3.42 4.70 4.71 4.83 4.27 4.35 4.74 4.62 4.69 4.32 4.75 4.63 4.66 4.23 4.64 4.59 4.58 4.85 4.70 0.10

0.91 3.62 4.40 3.75 4.12 4.68 4.66 4.52 4.19 4.15 3.47 4.36 3.42 4.70 4.71 4.83 4.27 4.35 4.74 4.62 4.69 4.32 4.75 4.63 4.66 4.23 4.64 4.59 4.58 4.85 4.70

User groups Whole sample 1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35) Mean SD

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Freq.

Table VII Groups’ views about usefulness of voluntary information contained in the annual report

29 30 19 28 27 10 11 18 25 26 31 20 32 7 6 2 23 21 5 15 9 22 4 14 11 24 13 16 17 1 7

Rank

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting

Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting Managerial Auditing Journal 18/6/7 [2003] 599-617

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.

Notes 1 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.

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Kamal Naser, Rana Nuseibeh and Ahmad Al-Hussaini Users’ perceptions of various aspects of Kuwaiti corporate reporting Managerial Auditing Journal 18/6/7 [2003] 599-617

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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Further reading Abu-Baker N. and Naser, K. (2000), ‘‘Empirical evidence on corporate social disclosure (CSD), practices in Jordan’’, International Journal of Commerce and Management, Vol. 10 No. 3-4, pp. 18-34. Benjamin, J.J. and Stanga, K.G. (1977), ‘‘Differences in disclosure needs of major users of financial statements’’, Accounting and Business Research, Vol. 7 No. 26, pp. 187-92. McNally, G.M., Eng, L.H. and Hasseldine, C.R. (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 evidence on corporate social responsibility reporting and accountability in developing countries: the case of Jordan’’, Advances in International Accounting, Vol. 12, pp. 193-226. 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.

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Book review

Opinion Shopping and the Role of Audit Committees when Audit Firms are Dismissed: the US Experience Clive Lennox Institute of Chartered Accountants of Scotland 2003 78 pp. ISBN 1 871250 93 5 £15 Review 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

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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 Vinten Editor, Managerial Auditing Journal