Audit Regulatory Environment

Table of Contents
Contents
1.0 Introduction

Page
1

2.0 Findings
2.1 Problem faced by Auditors

2-3

2.2 Corporate Governance

2.2.1 Cadbury Committee

2.2.2 Sarbanes Oxley Act

2.3 Stakeholders Needs

2.4 Audit Committee

2.5 Positive & Negative Aspect of Audit Committees in enhancing the Role
of External Auditors
3.0 Conclusion

8-10
11

4.0 Recommendation

12-13

5.0 References

14-15

6.0 Appendices and Reflective Report

1.0 Introduction

Delraj Singh & Lim Chai Yan

The University of Greenwich

16

Audit Regulatory Environment

After the serious financial collapse scandals and ineffective corporate governance in
these high profile companies such as Enron, Tyco, Adelphia, Allied Irish Bank and
WorldCom have not only damage the auditors' reputation but they also widely cited as
reasons that the investors had lost confidence in making investment and widened the gap
between what the investors expect in the areas of corporate governance. Moreover,
stakeholders also aware that lack of independence among the monitors might result in any
financial scandals happen again.
Sori et al, (2009:317) stated that Various regulatory agencies and interest groups
had been actively promoting the idea of an effective audit committee in all public listed
companies, in the interest strengthen the corporate governance practices. The establishment
of audit committee is perceived to improve the financial aspects of corporate governance.
To avoid financial scandals problem, the government had required all the listed companies to
establish an audit committee. The audit committee is a measure to improve on the internal
control mechanism so it can directly impact on the company by helping to improve the
corporate governance practices in the company and to meet the stakeholders needs.
In addition, external auditor is required by law and the external auditor is hired by the
audit committee of the company. Moreover, the external auditor are required to render
independent opinions to shareholders and others regarding financial information presented by
the company. However, the external auditors will be facing some problem as a
communication problem, issues in judgement, natural clients business, difficult gathering
evidence, release new standards as well as some other unpredictable issues.
This report will highlight through the role of external auditors in our society today and
discuss the problems faced by the auditing profession. Next, this report will introduce
regarding to corporate governance and follow by the stakeholders needs. Specifically, the
report will discuss the role of audit committees in enhancing the role of external auditors in
meeting stakeholders needs. Lastly, this report will discuss other efforts currently being
undertaken to enhance the role of external auditors.

2.0 Findings
2.1 Problem faced by Auditing Profession

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Audit Regulatory Environment

In general, an auditor might need to perform their audit service in different type of
industry so one of the main role for an auditor is an auditor must be able to provide their
profession service according to the auditing standards for the different type of clients in
different situations. Furthermore, an auditor also must be having an objective mental attitude
as well as independent between themselves and the auditing company. By this, an auditor
only will be able to exercise their professional judgement based on the evidences and provide
assurance to the clients.
However, in reality the auditor will be facing different types of problem that will
affect them to exercise their professional judgement. The problems faced by the auditors are
such as:
Communication Problems
A good communication might come out a better outcome but a bad communication
between the auditors and audit committee will definitely give a bad outcome and it will
directly affect the quality of audit process.
Issues in Judgement
Normally an auditor will rely on the internal controls and then take a sample to
calculate the audit risk and if the risk is low and the internal control is good then the auditor
will do less audit work. By this, the auditor might provide a report which it will not show a
true and fair view because sometimes the fact shown that the internal control is good but the
reality it might not as good as what it shown. Furthermore, some external auditor will rely
more on the internal auditors work to enhanced the audit efficiency and reduce regulatory
cost (Brody, 2012). However, sometimes the external auditor might give a wrong judgement
to rely more on internal auditors work and come out with a report that is not true and fair.

The Nature of Clients Business

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Audit Regulatory Environment

The external auditors needs to perform their audit service in different type of industry
due to the nature of the clients business are different. However, many of the auditors might
only specialize in certain industries so the auditors might not be able to provide their
profession in the auditing service in those industries that they are not expert in.
Issues in Gathering Evidence
Even though by law the auditors have the right to gather any necessary information
for the auditing process but sometimes the auditor might fail to gather sufficient evidence for
the auditing purpose or they gather some evidence which are out of date. Moreover, some
auditors might be able to know the reason why they could not gather sufficient information
such as someone might keep two sets of book keeping and give the external auditor the
wrong set.
Release of New Standards
To be an auditor is not only need to be professional in auditing but they must be
professional in accounting as well. Therefore, the auditors will need to spend time and costs
to get use with the new standard, guidelines of auditing as well as accounting that had been
issued regularly.
Unpredictable Issues
If a group of managers involved themselves in any fraud, then the audit committee
and external auditors might not be able to find out. Therefore, if anything goes wrong to the
clients company, the external auditors reputation might be damaged due to the audit report
provided by them did not show true and fair view and the company will not be able to be a
going concern anymore (Tremblay & Gendron, 2011).

2.2 Corporate Governance

Corporate governance is a system for companies to be directed and controlled. The
companys boards of directors are responsible for the governance of their companies. The
role of shareholders in governance is to appoint the auditors and the directors and this is to

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The University of Greenwich

Audit Regulatory Environment

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

prepare the companys strategic aims, reporting to shareholders on their stewardship and
supervising the management of the business and lastly providing leadership to put all these
into effect (Chahine & Filatotchev, 2011). However, there are weaknesses in corporate
governance such as it requires government oversight to avoid corruption in the company and
misleading financial statements problem which could mislead the investors, for instances
selling property from a parent company to a subsidiary to maximize parent company
revenues which is possible to present factually incorrect information that is difficult to detect
by establishing complex networks of subsidiaries and cross-shareholdings (Chahine &
Filatotchev, 2011:157). Therefore, after facing problems with corporate governance and many
companies had financial scandals in United Kingdom and United States, two new set of rules
was formed in these regions which are Cadbury Committee in United Kingdom and
Sarbanes-Oxley Act in United States. These two new standards are to help companies and
shareholders to protect their wealth.

2.2.1 Cadbury Committee

In year 1990 it was found there were many frailties in the United Kingdom
governance model and it required an urgent review. During that time, Institute of Chartered
Accountants in England and Wales, London Stock Exchange and Bank of England together
formed a committee to review the financial aspects of corporate governance. The report,
Corporate Governance is also known as the Cadbury Report. It is a tribute to Sir Adrian
Cadburys leadership that after extensive consultation the Cadbury Report was published on
December 1st, 1992.
The purpose of Cadbury Report is the Code of Best Practice which is designed to
achieve high standards of corporate behaviour. It is to set a benchmark and shareholders will
get information about how their company is governed so they could make decisions to
appoint directors (Percy, 1995). The Cadbury Report reviews the structure and
responsibility of boards of directors within a unitary framework. While the Code of Best
Practice is not legislated for in United Kingdom Law, it was made obligatory by the London
Stock Exchange for listed companies after June 1993 (Percy, 1995:25). In year 1995 another
report was published which is Greenbury Report and it is to focus on directors remuneration
issues. To stress on principles of good governance and to review and revise the Cadbury and
Greenbury Report another report was established in 1998 which is Hampel Report. Lastly, by

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combining Cadbury, Greenbury and Hampel Reports, the Combined Code on Corporate
Governance was established in year 2003 and these had formed three audit committees which
are necessary for good internal control.

2.2.2 Sarbanes -Oxley act

Holm and Zaman (2011:1) stated that the global financial crisis, corporate failures
and scandals in many countries raise significant questions about the effectiveness of
financial reporting and auditing. One of the financial scandals is the largest company Enron
Corporate, Enron misrepresent about their profitability by hiding the debts over $1 billion so
it would not show in the financial statements. Arthur Andersen was the auditing company for
Enron; the auditors didnt do their professional responsibilities when auditing Enron. Due to
the report provided by auditors was not true and fair so the stakeholders were not able to
know the actual current financial issues in Enron. When Enron went into bankruptcy, the
stakeholders were question why the scandal did not spot out early. Moreover, there are not
only investors and creditors who had lost their investments because of Enrons scandal but
more than ten thousand staff had lost their job as well as their income. Furthermore, the
stakeholders also lost their trust in United States companies and they also felt that the
corporate governance is not able to protect their interest or maximize their wealth.
The reaction from financial scandal crisis of Enron and other companies such as
WorldCom, Adelphia Communications, Duke Energy, Dynegy, Kmart and Tyco International,
United States sets out a legislation which is Sarbanes Oxley Act (SOX) to enhance the
standards which is effective form 30th July 2002 onwards. SOX will increase the audit
committees responsibilities and authority to address the financial reporting errors and
fraudulent practices among the companies (Zhang et al, 2007). By the SOX, a company's
financial statement will be more accurate and internal controls will be improved as well.
Therefore, the investors' wealth is protected and other stakeholders are able to get more
accurate and trustful financial information of an entity.

2.3 Stakeholders Needs

The financial scandals happen such as Enron, WorldCom, Tyco and Adelphia had
shaken the trust and confident of stakeholders on external auditors, because a big audit firm
Arthur Anderson had failed to give an independent opinion on true and fair view on the
financial statements of Enron Company. That is why today to fulfilled stakeholders needs had

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The University of Greenwich

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become a vital task of auditors and enhancement must be done in the audit regulatory
environment. Auditors can do more to meet stakeholders needs; the roundtables had
concluded that by just reporting on historic financial statements is not good enough for
stakeholders but auditors should report on governance, risk, business model and other
important information which can broader the view of stakeholders. When a problem loomed,
stakeholders need red flags to be raised and most of all for greater communication of the
extensive work that goes into an audit to be made available outside the hallowed confines of
the boardroom (Welch, 2011:1). For instances, the case where one of the big four
accounting firms- Deloitte & Touche LLP was failed to detect the fraud of Taylor Bean which
was more than $ 7 billion. The shareholders of the Taylor Bean appointed Deloitte as an
auditor to audit the companys financial statements but at the end Deloitte was found to
ignore the red flags and let the chairman, Lee Farkas to orchestrate fraud in company. The
fraud of Taylor Bean was covered up by external auditors and provided a not true and fair
view of audit report to shareholders (Pearson, 2011). From the view of this example, the
stakeholders interest are being at a risk so the stakeholder needs auditors to be independent
and able to detect fraud on financial statements as well as not allowed bias to defeat
professional judgments.

2.4 Audit Committee

All Malaysian public listed companies are required to establish an audit committee
as measure to improve on internal control mechanism that can help improve the corporate
governance practices of firms (Sori et al, 2009:317). Under the Code in England as well as
Malaysia, all the listed companies should set up an audit committee to enhance the quality of
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corporate governance practices in entire entity, which the members of the audit committee are
consist at least three independent non-executive directors and financial experts or the
professional qualification of accountancy body such as MIA and ACCA holders and yet they
must be an independent in management.
The audit committees roles are to review and monitor the internal control procedures,
management systems, current accounting policies as well as internal audit function.
Moreover, an audit committee also need to review the companys financial information or
any announcements made by the company to the stakeholders.
In addition, one of the audit committees roles is to appoint, reappoint or replace the
external auditors and to ensure the external auditors is independent which he or she is not
providing any additional service apart from auditing. The audit committee also will review
the effectiveness and efficiency of the external auditors work and liaise with the external
auditors. Therefore, the audit committee is playing an essential role in enhancing the roles of
external auditor to meet the stakeholders needs (Millichamp & Taylor, 2008). However,
everything in this world is not prefect so the audit committee will also have positive and
negative aspects of how it can enhance the role of external auditors.

2.5 Positive & Negative Aspect of Audit Committees in enhancing the Role
of External Auditors
Audit services had been dominated by the Big Four Auditing Companies which are
PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG. In the
United States, The Blue Ribbon Committee (BRC) reported in 1999 had made several

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suggestions for the role of audit committees to enhance financial reporting. The suggestion
was that all audit committee members must be independent which actually is enforced in the
Sarbanes-Oxley Act (SOX), 2002. The first role of audit committee is to appoint external
auditors so if they are not independent then to expect external auditors to be independent is
far more difficult. For instances, a chairman of Financial Accounting Standards Board
(FASB), Dennis Beresford had been working for 10 years since 1987. His job scope was to
maintain independence and integrity of the board to avoid the pressure from outside interests.
He was the national director of accounting standards at Ernst & Young and later he joins the
faculty of University of Georgia (Tysiac, 2012).
Beasley et al. (2000:443) find companies that commit financial fraud are associated
with weak and less independent audit committees. A framework can be established which
will allow the non-executive director to work together with audit committee and this can
result in higher quality monitoring. This is because independent directors will be able to
question management whenever they consider it necessary and both independent director and
audit committee are concerned with their reputation capital. In order to avoid legal liability,
protect their reputation capital and take care of stakeholders interests, therefore the audit
committee will need to put a large degree of effort to fulfil their monitoring tasks. This will
result in a higher quality audits which will give a greater transparency in the financial
statement and it will reduce the agency costs such as external auditor fees (Carcello et al,
2002).

Tsui et al. (2001) who had investigated CEO duality and audit pricing of Hong Kong
companies and found that more audit effort and higher audit fees results when the CEO is the
board chairperson. The board is only independent when Chief Executive Officer (CEO) and
chairperson of the board is not the same person. The chairperson duty in the company is to
monitor and perform an evaluation on the CEO and executive directors but the CEO is
responsible for the day to day activities in running the company and setting up corporate
strategy. When the CEO is the chairperson itself, it actually reduces the effectiveness of the

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board and even audit committee because it leads to weak internal control system in the
company which increases the chances of having a poor accounting system. Therefore, the
external auditors appointed by audit committee can no longer rely on internal control systems
and need to increase the collection of substantive evidence in order to perform a good
evaluation on the companys accounting system. This will require more work and which will
lead to higher demand of audit fees and more time consumed. Not only that, CEO duality
gives impact to the auditors assessment of a companys audit risk.
However, audit fees had become an issue nowadays but before its an issue CEO
duality should be banned because it also jeopardizing the duty of CEO to monitor the quality
of accounting information. However, some companies the CEO and chairman are different
person but it also will face some issue such as the dishonesty of auditors got banned over
fiddling expenses (Bliss et al, 2011). For instances, PricewaterhouseCoopers audit manager
Lee Douglass was excluded from ICAEW (Institute of Chartered Accountants in England and
Wales) because he failed to follow the PwCs expenses policy and he dishonestly claimed
3,858.94 in 15 expenses. He further claimed that only 3 expenses were over claimed but no
specific reason was explained for the claimed. Therefore, it was found guilty and he was
ordered to pay cost of 2,915 so he was fired by PwC and excluded from ICAEW as an
auditor (Lovell, 2012).
As mentioned before one of the audit committees roles are to review and monitor the
internal control procedures, management systems, current accounting policies as well as
internal audit function. Haron (2004:1148) stated that internal auditors can assist external
auditors to understand the internal control system that has been set up before any
compliance or substantive work is being carried out. Moreover, the internal auditors work
can help the external auditor in determine the nature, time consume and extent of their audit
work, and the company also will save cost due to the increase in reliance on internal auditors
work then reducing the external audit fee.
Haron (2004:1148) also mentioned that external auditors will usually evaluate the
internal control system of the company to ensure that it is capable of preventing and
detecting material mis-statements from occurring". Apart from the CEO duality issue, the
external auditor will also not rely on the internal auditor work if the external auditor found
that the inherent risk (influence by internal audit) and control risk (internal control
procedures) is high. By this, they will not rely on the internal auditors work but if the
inherent risk is low then they might choose to rely on the internal auditors work. Therefore,
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The University of Greenwich

Audit Regulatory Environment

it is important for the audit committee to ensure that good internal control and high quality of
internal audits work which it means that the companys financial statement had been
prepared in an accurate and transparency way. By this, the external auditor might decide to
rely on the internal auditors work if the inherent risk and control risk is low.
In addition, sometimes it is risky for the external auditors to rely on the internal
auditors work even the inherent risk and control risk is low because when a group of people
intentionally commits a fraud by keeping two sets of book keeping and give the external
auditor the wrong set and the audit committee lost their independence, then how low is the
inherent risk is also useless. For example, Yasu (2012:1) stated that Olympus Corp., the
Japanese camera maker that hid $1.7 billion in losses, faulted five internal auditors for the
fraud and said KPMG Azsa LLC and Ernst & Young ShinNihon LLC werent responsible. By
this, the stakeholders interest are being at a risk and stakeholder needs auditors to detect fraud
on financial statements not only that but not to allowed bias to defeat professional
judgements. Therefore, it is important for the external auditor to judge whether they should
base on the inherent risk and control risk and then rely on the internal auditors work or not.
So that, the external auditor can avoid giving any wrong assurance to the client regarding the
financial statements whether they are true and fair according to the standards.

3.0 Conclusion
In a nut shell, the role of audit committees had always been in approach to enhance
the role of external auditors in meeting stakeholders needs and to practice good corporate
governance in companies. There are however, certain problems faced by auditors when they
are carrying out their duty such as communication problems, issues in judgement, nature of
clients business, issues in gathering evidence, release of new standards and unpredictable
issues.
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The University of Greenwich

Audit Regulatory Environment

Furthermore, there is corporate governance to direct and control companies but due to
financial scandals corporate governance is consider failed to direct the company well.
Therefore, two new set of standards were formed to protect the stakeholders needs which are
the Cadbury Committee and Sarbanes-Oxley Act. These two standards have the same
objective to protect the interest of shareholders and to prevent from any financial scandals
happening in the company.
Stakeholders needs are to have true and fair view on the financial statements so that
they feel protected. Therefore, the shareholders establish an audit committee to enhance the
efficiency among the entire company and protect their interests. The audit committees duty
is to appoint external auditors and monitor their task whether they are performing well or not
and examine the internal control procedures, management systems, current accounting
policies as well as internal audit function. Moreover, an audit committee also need to review
the companys financial information or any announcements made by the company to the
stakeholders.
Lastly, there are other efforts undertaken to enhance the role of external auditors to
meet the stakeholders needs. However, these efforts are faced with positive and negative
aspect for audit committee such as framework to allow independent directors to work
together with external auditors, issue of CEO duality, issue of audit fees, and the reliance of
external auditors on internal auditors work and the risk they might face. Therefore, some
necessary efforts always are important to apply in an organisation to enhance the audit
committees work as well as external auditors work so the stakeholders needs will be able to
achieve.

4.0 Recommendation
After doing research on this report, we found that the audit committee and the
external auditors are playing a vital duty to meet the stakeholders need. However, there are
still few areas that can be improved to solve the problems in audit committee, internal and
external auditors and employers in the company. Therefore, the following are those efforts
that could be help to solve the problems such as: Enhancement on Regulations

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The government should released new regulations or enhances the degree of the
regulations more often instead waiting for issues to occur only then start to solve the
problems. For example, in Malaysia CEO duality should be totally banned because this will
cause lot problems such as reduces the effectiveness of the board and audit committee,
weaken the internal control system and increases the chances of having poor accounting
system. Therefore, prevention is better than cure.
Investigate before Hire
The financial scandals had made the stakeholders lost their confidence in the external
auditors. Therefore, to avoid those scandals from happening again, the audit committee
should investigate the external auditors profile before hire them. By doing this, the audit
committee will be able to know the way they do their audit work and the ethic value in
external auditors.
Penalties and Punishments
The government should increase the penalty and punishments to those people that are
trying to involve themselves by committing any fraud or error. The penalty or punishment for
those people can be such as entire life they cannot work as what their qualification are now,
sentenced to prison for five years or above, each of the people will bear the same amount of
the loss for the company or will be charged any both at once. Moreover, the government must
be strict and dont give any chance to whomever tries to cheat or commit fraud, only then
they will be afraid of it and do as what their duty require them to do.

Increase the frequency of Meeting

Generally, the audit committee will be having a meeting in every three months but
this might not be the best option to avoid the problem from occurring because they might be
vigilant of the issue but then problems already occur before the meeting. Therefore, the audit
committee should increase the frequency of meeting such as once in a month. Moreover, the
audit committee and auditors should be strict and straight forward when discussion the issues
arising in the company during the meeting, because if they are too friendly then it might
make them close friends and lose their independence. Furthermore, the shareholders should
involve themselves in the meeting so they will be able to know what is happening in the

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current period instead of knowing the outcome of financial information after the entire
financial year.
Training
Some auditors might only specialize in certain industries so the external auditor will
be facing a problem in their auditing service in those industries that they are not expert in.
Therefore, the government should provide classes or training for auditors in those industries
that they are not familiar with. Moreover, the training regarding to the standards also should
be provided to the auditors whenever any new standard had been released. By this, the
auditor will be able to understand the standards and regulations.
Standardized the Audit Fees
The common issue occurred among the external auditors is to reduce the audit work
and the quality due to the low audit fees. The audit fees paid by the clients normally will be
based on how much the external auditors rely on the internal auditors work (Brody, 2012).
Therefore, the government should standardized the audit fees based on the auditors
qualification then the external auditors will not feel that they doing more work and received
less fees.

5.0 References
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consideration of industry traits and corporate governance mechanisms, Accounting
Horizons, 14(4): pp. 441-454
Bliss, M., Gul, F. & Majid, A. (2011) Do political connections affect the role of independent
audit committees and CEO Duality? Some evidence from Malaysian audit pricing,
Journal of Contemporary Accounting & Economics, 7(2): pp. 82-98

Delraj Singh & Lim Chai Yan

The University of Greenwich

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Brody, R. (2012) External auditors willingness to rely on the work of internal auditors: The
influence of work style and barriers to cooperation, Advances in Accounting,
incorporating Advances in International Accounting, 48(1): pp. 1-11
Carcello, J., Hermanson, D., Neal, T. & Riley Jr, R. (2002) Board characteristics and audit
fees, Contemporary Accounting Research, 19(3): pp. 365-384
Chahine, S. & Filatotchev, I. (2011) The effects of corporate governance and audit and nonaudit fees on IPO Value, The British Accounting Review, 43(1): pp. 155-172
Haron, H., Chambers, A., Ramsi, R. & Ismail, I. (2004) The reliance of external auditors on
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Holm, C. & Zaman, M. (2012) Regulating audit quality: Restoring trust and legitimacy,
Accounting Forum, 36(1): pp. 51-61
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http://www.accountingweb.co.uk/article/pwc-auditor-banned-over-fiddlingexpenses/527174 (Accessed: 22 June 2012)
Millichamp, A. & Taylor, J. (2008) Auditing. London: South Western Educational Publishing
Pearson, S. (2011), Deloitte Sued for $ 7.6 Billion in Taylor Bean Collapse. Available at:
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Percy, J. (1995) The Cadbury Report and Corporate Governance in the U.K., The CPA
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Sori, Z., Ramadili, S. & Karbhari, Y. (2009) Audit Committee and Auditor Independence:
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Perspectives on Accounting, 22(1): pp. 259-272
Tsui, J., Jaggi, B. & Gul, F. (2001) CEO domination, growth opportunities, and their impact
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The University of Greenwich

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Tysiac, K. (2012), Leaders who left a mark on the profession. Available at:
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June 2012)
Welch,

I.

(2011),

How

to

Get

Greater

Value

from

Audit?

Available

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Yasu, M. (2012), Olympus Clears KPMG in Fraud, Faults Internal Auditors. Available at:
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The University of Greenwich