Analysing the evolution of the audit quality


Auditing has experience evolution for few stages, from the traditional conformance role of auditing, enhance the credibility of the financial statement until provide value added services. Auditing is most likely to continue shifting in the future, however the main issue here is does the audit quality evolved accordingly with the shift of auditing? What is the impact of the audit firm size to the audit quality?

Audit quality is a key factor that can affects the credibility of financial statements. If the audit of the financial statements is seemed to be high quality, users will more rely and give high level of confidence on the information in the financial statements. Basically, audit quality is the probability that an error is detected and the material misstatements that cause the material uncertainties or going concern problems is reported. In other words, high audit quality means an absence of material misstatements in financial statements. High audit quality can bring all the professional auditing firms to success. According to the IFAC Report 2007, the audit quality service is the core of business strategy and is important to the public interest responsibilities of professional accountants. Encik Nik Mohd Hasyudeen Yusoff, President of  Malaysia Institute of Accountants (MIA) stated that audit quality is a commitment of audit firms in complying with auditing standards.

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Audit quality can be ranging from very low to very high audit quality. We can define in different way that audit as either meeting or not meeting minimum legal and professional requirements. Financial statement that complies with the standard is perceived as high audit quality and vice versa. Audit quality is inversely related to audit failures which mean that the higher the failure rate, the lower the quality of auditing. Generally, various definition of audit quality is connected to the independence and competence of auditors.

For a previous years, researchers have been proved that audit quality varies to the firms' size. As suggested by DeAngelo (1981), larger firms provide higher audit quality because large audit firms have less incentives to compromise their standards to make sure retention of clients compared to small audit firms. Audits by large firms are perceived to be higher expected quality than audits by small firms. Also, Palmrose (1988) discover that large auditors have lower litigation rates than small auditors. Besides, Dupoch and Simunic (1982) also found that audit quality is a function of the number of audit procedures performed by the auditor and large audit firms have more resources to conduct tests. In addition, Moore and Scott (1989) demonstrate that audit firm size and the extent of audit work undertaken are positively related.

However, as a result of the Enron's bankruptcy in 2001 and the collapse of Arthur Andersen in 2002, auditing have been criticized and the audit quality being performed by audit firms especially the large firms have been questioned. This criticism motivated regulatory changes in U.S by the Sarbanes-Oxley Act of 2002. Does audit firm size as a surrogate for audit quality? If audit firm size surrogate for audit quality, why mainly of the large audit firm involved in fraud since they have high audit quality? The audit quality issue regarding to the firm size will be discussed further.

Other variables that affect Audit Quality

There are other approaches to the study of audit quality including research on auditor tenure, non-audit fees, audit committees, industry specialization, office characteristics, cross-country differences in legal systems and auditor liability exposure. If the length of the auditor-client relationship affects the audit quality, auditor tenure will be examined. Audit quality decreases as auditor tenure increase which means that an auditor works in a same firm for a long period will affect the audit quality performed. There is an argument that auditors can become enslaved to clients in long tenure situations, however counter-argument stated that auditors have strong economic incentives enough to maintain their independence. Besides, the internal organisation system such as the rotation of engagement personnel are adequate to maintain the independence of auditors. According to Meyers et al. (2003), no evidence that long tenure will impairs audit quality and some evidence stated that there are higher quality as tenure increases.

Next, the researches on non-audit fees have been taken by the SEC's in 2000 to ban non-audit services for audit client and come out a new mandated US disclosures of fees paid to auditors. The most questionable of these studies is Frankel et al. (2002) who report evidence that companies which pay their auditors reasonably more non-audit fees have larger abnormal accruals and are more likely to meet forecasted earnings. With the large non-audit fees, auditors are treat clients more nicer. So, clients have greater opportunity to manage earnings to meet targets and this situation reflected lower audit quality. However, DeFond et al. (2002) find no evidence that auditor reporting decisions are affected by the level of non-audit fees. At this stage, the evidence is still debatable and inconclusive. However there is at least the possibility that high levels of non-audit fees may impair audit quality.

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Previous research has linked audit quality with the boards of directors and the audit committees. Past research showed that audit quality is higher when audit committees and board are more independent. Besides, error will be easily detected and abnormal accruals are small when boards are independent. There are many independent boards are less likely to hire auditors for non-audit services with evidence specify that there is a corporate governance since companies with more independent boards and also have auditors that are more likely to detect and report material misstatement. So, independent boards are able to control the scope of non-audit services which may have the potential to impair audit quality. The more independent boards are, the more audit quality will be performed.

Evolution of audit quality

In the aftermath of the Enron bankruptcy in 2001 and the related collapse of Arthur Andersen in 2002, audit quality is a questionable issue. Turn the clock forward a few years, we are now reeling from the repercussions of a sub-prime crisis originating in the United States whereby assurance providers are being told they should have done their gatekeeper job well. The scandals shed light on the quality of audit work, which is hard to examine by other parties. Despite the effort of strengthening audit standards and oversight, Malaysia market is hit by scandals such as Transmile, Energro, Well Multi and Megan Media. The studies on Reduced Audit Quality Practices (RAQP) has indicated that quite a number of auditors tend to compromise audit effectiveness through improper execution of audit program.

Global developments on accounting standards to enhance audit quality

 Issues of audit quality has been the focus for a long time. The Enron scandal has led to the passage of Sarbanes-Oxley Act 2002 to enhance new standards for all public companies and public accounting firm in US besides outlines the rules on control of audit quality. Under the act, it has restricted public accounting firms to provide any non-auditing services and Public Company Accounting Oversight Board is established. The HIH insurance company scandal also leads to the issuance of Ramsay Report in Australia to give few recommendations on how to improve the independence of auditors. The recent development of audit control is International Federation of Accountant (IFAC) has required audit firms to comply with International Standards on Quality Control (ISQC 1) in year 2005 following the revised of ISA. There are establishment of audit oversight bodies in United States (PCAOB), United Kingdom (Financial Reporting Council), Australia (ASIC), and Singapore (ACRA through Public Accountants Oversight Committee).

IAASB (International Auditing and Assurance Standard Board)

It is a body that develops auditing and assurance standards and guidance through a shared standard-setting process involving the Public Interest Oversight Board, which oversees its activities, and the IAASB Consultative Advisory Group, which gives public interest input into the development of the standards and guidance. IAASB supports audit quality through International Standards on Auditing (ISAs) and International Standard on Quality Control (ISQC).  ISA provides benchmarks for performance of audits standards. IAASB has put efforts in develop and monitoring audit standards besides issue discussion papers on audit issues such as audit quality and gather different views from different stakeholders. For example, in March 2009, the IAASB has completed its Charity Project that improve the clarity and understandability of ISA standards and ISQC 1. Currently, IAASB is considering working on specific project on audit quality.

Development on accounting standards to enhance audit quality in Malaysia

As at 30 June 2008, there are 2,436 accountants holding public practice certificate and 1,348 firms are registered as audit firms. There are several legislative frameworks in Malaysia, such as Financial Reporting Standards, Companies Act, Accountants Act, and Bursa Malaysia Listing Requirements. The standards relating to auditing are MIA By-Laws, International Standards on Auditing adopted in Malaysia and practice guides issued by MIA.

In July 2006, Malaysian Institute of Accountant (MIA) has endorses ISQC 1 as part of the approved auditing standards in Malaysia and imposed that all registered practitioners such as accountants and auditors to comply with this standard by 30 June 2006. This is a way to benchmarking to international standards. ISQC 1 places focus on the control of the quality of audit work performed by the audit firms and compliance to the standard is perceived as high audit quality. Besides that, ISQC 1 ensures competence human capital and leadership as a right tone for high audit quality. However, there are limited practitioners of ISQC 1 due to lack of awareness and high cost of implementation.

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In October 2007, our Prime Minister announced that a Public Companies Accounting Oversight Board will be established under the Security Commission Malaysia during his speech on Budget 2008. This has lead to establishment of Audit Oversight Board in April 2010. AOB will provide for independent monitoring of audit practitioners and their services with the intention to enhance confidence and audit quality in public listed companies and public interest entities. AOB will cooperate with Bank Negara Malaysia, Company Commission of Malaysia, industry groups and auditors to implement robust oversight framework.

MIA Practice Review is a programme which applies to Malaysian members who hold a practicing certificate and is engaged in public practice services by assessing and developing their practices and offering practical support. The Malaysian Institute of Accountants' Annual Review for 2007 reports that 23% of total audit firms in Malaysia have undergone MIA's Practice Review and majority fail to meet the standards.

CURRENT STATUS AND THE RELEVANCE OF THE TOPIC IN MALAYSIA OR ASIA (critical analysis of the issue, bring out the audit quality n firm size)

Corporate Scandal

In the industry, many people began aware of the audit quality after Enron's collapse. Generally, many people perceived that big firm especially Big 4 would provide excellent audit quality service. However, there is a suspicious about audit quality produced by Big 4 after Enron case. Enron's audit engagement partner is Arthur Andersen, one of the Big 4 which violated their duty as auditor.

In Malaysia, most of the audit services are provided by Big 4- KPMG, Deloitte, Ernst & Young, and PricewaterhouseCoopers. Mainly, the people believe that they would provide higher audit quality services. However, it became questionable when came to Transmile's scandal. The auditor of Transmile was Deloitte. Transmile case affected Deloitte's reputation especially from the aspect of  professional skepticism. Besides that, there are other cases related to Deloitte such as cases of Mesdaq-Listed NasionCom Holidings Bhd and Ocean Capital which are Deloitte's clients. Audit quality services offered by Deloitte had been questioned.

Another famous scandal case is Megan Media's case, which was audited by KPMG, one of the large audit firms in Malaysia. Provided with the example above, it viewed that audit firm's size would not affect the audit quality services provided. Because even Big 4 also not able to provide good audit quality services. Hence, there is a lots of arguments questioning the effect of audit firm's size on audit quality.

Previous researches viewed that audit quality has been affected by the audit firms' size. Most of the researchers gave opinion that Big 4 firms provide higher audit quality than non-Big 4 firms do. However, from the finding of Khurana and Raman (2004), it showed that there is no relationship between audit quality and audit firm's size in ASEAN.

The similar finding also found in the research of Takiah Mohd, Mohd. Mohid and Hashanah Ismail (2010). Using listed companies in Malaysia as sample, the researchers did a study on the companies' satisfaction on audit work performed by big 4 and non-Big 4 firms. Audit client satisfaction remained the same level within the audit firms' performance which means that regardless it is big 4 firms or Non-big 4 firms, it carried the same level of audit quality service that would satisfy their client. Their findings showed that audit quality is not affected by the size of audit firm but other attributes such as the audit independence.

Emerging Market in China

In contrast, Li, Song and Wong(2005)'s research showed that Big firms tend to provide higher quality services than small and medium firms. They made an assumption that there is high demand for higher level of audit quality results from the relationship between audit quality and audit firm size. Their study is motivated by the emerging market in China as in the year of 2001 to 2003, where audit market of public listed company in China emerged rapidly. In their opinion, Big firms will issued higher quality audit report than small firms do. This is because big firms tend to ignore client's pressure and provide more independent audit views.

Adoption of Audit and Accounting Standard

Generally, companies are always required to comply with accounting standard and auditors have fiduciary duties to provide reasonable assurance that the financial statement is free of material misstatement. Apart from this, auditors are gatekeepers or watchdogs to ensure the company comply with the accounting standard. The auditors should ask the company to make the adjustment if they found the financial statement did not adopted with accounting standard. Otherwise, they have to issue qualified audit report.

Research had been done by Tyrone M. Carlin, Nigel Finch and Khairil Faizal Khairi(2008), regarding the adoption of accounting standard by Singapore's public listed companies. They used the disclosure requirement for goodwill impairment testing to test the adoption of standards in the company. The results showed that most of audit firms failed to comply with accounting standard. They omitted the basic disclosure requirement of goodwill impairment testing. This indicates that regardless of the size of the audit firm, the auditors will not fully comply with the standards.

In Malaysia, for ensure local audit firms' operations were strengthened and could be benchmarked against the international requirements, Malaysian Institute of Accountant (MIA) has adopted the International Standards on Quality Control 1 (ISQC 1) to become approved standards of auditing in Malaysia since July 2006. Notwithstanding the adoption, it is not encouraging and very limited for small and medium audit firms to adopt it. As a result, small and medium do not fully comply with the standards.Without the adoption of standards by small and medium firms, it would affect the audit quality in small firms of Malaysia.Hence, a research carries out by (Aida Hazlin Ismail, Zuraidah Mohd-Sanusi, Yusarina Mat Isa, Syazliana Kasim, Kamaruzaman Muhamad and Nor'Azam Mastuki,2008)to evaluate the audit quality on small and medium firms in Klang Valley Area.

The reasons why the small and medium firms in Malaysia failed and difficult to comply with the standards are as the following:

(i)  Lack of employees

As we know, most of the small and medium firms lack of employees. With the shortage of human power, they unable to allocate their resources, for example the employees to check on the fulfillment of ISQC 1 especially during the peak period of audit time. Hence, they cannot meet the requirement of audit quality.

(ii)  Lack of awareness among audit staff about ISQC 1

ISQC 1 is a newly implementation standard in Malaysia in the year 2006. Thus, the employees especially who worked in small and medium firms might not realize the existence of this standard of audit quality controls. Without realizing the existence of the standards, the audit firms might ignore and not apply the standard to review their audit quality. As a result, MIA has the responsible to create the awareness about the standards among the audit firms, regardless the firms size, from small to medium and big firms.  

(iii)  Complexity in ISQC 1

The employees found that ISQC 1 is too complex to be understood and not user-friendly. This might caused by lack of training and exposure to ISQC 1 provided to the employees. Employees should have basic knowledge about the standard. Thus, training to adopt the standards is needed for the employees so that they would understand well what exactly needed to meet the requirement of higher level of audit quality.

Nevertheless, supporting given by few of the respondents of the study to implement and adopt the standard in small and medium firms. They suggest that the adoption could assist the auditors to increase the level of audit quality as well as audit quality control. It could benefit small and medium firms as well as the audit industry in Malaysia, that it helps to strengthen the small and medium firms' professionalism and increase their credibility.

Takiah Mohd, Mohd. Mohid and Hashanah Ismail did a research regarding the relationship between audit client satisfaction and audit quality attributes. From their research, they evaluate the audit firm and audit team separately, because they constitute two different dimensions of audit quality. Regarding audit quality, the finding suggested that auditors gain good evaluation from clients as a result of the firm reputation rather than the recognition of the work of audit team. When considering the selection of external auditors, clients give more emphasis on audit-form factor, which is the reputation established among audit firms

In Malaysia, very little evidence exists of law suits involving external auditors. The auditing profession is highly regulated in Malaysia. For example, audit fees charged to clients are determined based on formula prescribed by MIA, which is based on total revenue, total assets and total expenses. Consequently, auditors are less motivated to apply their expertise, in example to improve audit quality, in order to gain higher audit fees. (Mohd-Mohid & Takiah 2004)

When a litigation risk is non-existence, auditors are not motivated to improve the effectiveness of audit. Hence, there is no incentive for Big 4 to provide better quality audit, consequently there is no difference in the quality of audit between the Big 4 and non-big 4.


(c. clarity of opinion points & d. proper citation and referencing)

In our opinion, there is no definite answer for whether audit firm size will affect the audit quality. As mentioned above, corporate scandals also happened in corporations that audited by the big firms such as Enron, Sime Darby and etc.  However, sometimes, the audit quality of small audit firms might be lower than big audit firms because of certain reasons such as lack of employees and non-adoption of standards. Through our research, we found out that audit quality affected by several criteria such as auditor tenure, non-audit fees, audit committees, industry specialization, office characteristics, cross-country differences in legal systems and auditor liability exposure.

Nevertheless, we could not deny that audit firm size is one of the factors which would affect the client satisfaction and client's perception toward the audit quality. Clients would normally believe and satisfy on the audit work which is done by big firm than small firm do. Client would emphasize and evaluate the audit quality through the firm's reputation . Therefore, relatively, audit firm size has smaller impact on the audit quality from client's perspective.

Audit quality can be improved in several ways. Compulsory training such as adoption of standard by each of the audit firms regardless of the size.  Training could help audit staff to be aware of ISQC 1 and get basic knowledge about the relevant standards as well as improve audit quality in their respective firms.

Another way is educate the accounting undergraduate on the importance of audit quality control and introduce them to ISQC 1. They also should be educated on the importance of the independence and objectivity and how to distinguish between independence and objectivity. By educating accounting students, when they work in the future, they will know the basic core competency required as an auditor and thus increase audit quality.

Besides that, The standard setting bodies and other relevant bodies should also continuously developing high quality standards. Accounting standard should be defined in simple and understandable words to avoid ambiguities and complexity. Compliance with accounting standards and MIA by-Law can also also enhance the audit quality. For example, the audit firms should follow the MIA by-law which state that a person should be rotated after serving for a same firm for five years.

In conclusion, the most important attribute that contribute to the audit quality is the fundamental human values. This is because the audit services is conducted by people. Leadership by example and talent development should be emphasised. The top management should set the tone at the top to ensure the firms are pursuing the culture of of complying with the related standards. In order to enhance the audit quality, the quality of the people in the profession should be improved.