Investigating the relationship between NAS and auditing independence

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The company law in the UK is very strict for the auditors due to the requirement: integrity and independence (Porter, 1996). In addition, the Enron Collapse brings a shock in the auditing profession industry, which is just like an alarm and warn the auditors in the future. Accordingly, most of the auditing regulators such as APB set the detailed standards for regulating the ethical activities of the auditors.

The one of the reasons for the Arthur Andersen (AA) bankruptcy is the high non-audit fees than audit fees (Chen and Chein, 2005). Equally, the Northen Rock's collapse has the same reason as the AA and the proportion of the NASF is extremely high (Walker and Pierce, 1988).

All of these scandals illustrate a problem that whether the provision amount of NAS will affect the auditor independence and if the high ratio of NASF (NASF/Total of AF) will impair the auditor independence. Fortunately, many researchers conducted a lot of studies in this area so as to provide a solid platform for easing this intension in auditing industry.

The purpose of this article is to investigate the relationship between NAS provided by the auditing firms and auditor independence and the tendency and the problem of NASF earned by the auditing firms. Based on these previous studies, this article will give some suggestions for future research and atone for the auditing mechanisms' demerits. Moreover, there are two reasons for reviewing the auditor independence and NAS. On the one hand, the space of this literature review is limited. On the other hand, the debate on the auditor independence and provision of NAS exerts a far-reaching influence on auditing quality and give the public much food for thought after these accounting scandals.

The mind-map of literature review was explained as followed:

2. What is Auditor Independence

Professional Accounting Association (PAA) and many government regulatory agencies in the worldwide have stressed that auditor independence is both an ethical and a professional issue, which is crucial for auditors regarding the rules set by AICPA and SEC as professional credo (Antle, 1984; Mednick, 1990; Hayes et al., 1999). Similarly, some studies explicit the contents of auditor independence through analyzing the Code of Ethics1issued by IFCA in the ISA200 (Glodman and Barlev, 1974; Millichamp, 1996; Wallman, 1996; Arens and loebbecke, 1997). Moreover, there is a convergent definition which is that independence is 'free of any influence' (Lee, 1972, p.68 and Bazerman et al., 1997, p.90) and 'free of any bias' (AICPA& ICAA, 1992). While, the auditing industry commonly use the definition of APB as followed:

"Independence is the freedom from situations and relationships which make if probable that a reasonable and a informed third party would conclude that objectivity either is impaired or could be impaired' (APB, 2004,p.6).

Mautz and Sharaf (1966) pointed the gap between auditor independence in fact and in appearance, which is relatively rigid dimension about auditor independence. They stated that auditor independence in fact is no useful when people who read the auditor report and do not believe independence's existence. Particularly, Fearnley et al. (1999) extents the Mautz and Sharaf's work by illustrating the interrelationship between independence in fact and appearance diagrammatically. The charts as follows:

Figure 1 Relationship between independence in fact and independence in appearance


Source: (Fearnley et al., 1999).

Additionally, they summarize the effects and safeguards of independence in fact by investigating the UK, Austria, New Zealand and other countries' studies (see Appendix 5). Otherwise, some scholars divide auditor independence into practitioner independence2 and professional independence3 (see appendix 6) (Flint, 1988; Dunn, 1996; Gray and Manson, 2000; Stevenson, 2002; Dopuch, 2003).

In practice, the wholly independent is hard to achieve during the process of auditing and difficult to maintain highly audit quality. Most of times, the public do not trust in the auditor's independent in appearance even though they are independent in fact (Fearnley, 2005; Hudib, 2006). Knapp (1985) and Arrunada (1999) highlight the auditor independence will be comprised by the threats (see Appendix 7) and concentrates on the safeguards related to these threats. Although they adopt the context-based research method to explore the independence threats in the UK and US, they fail to consider the other countries' situation. Yet, other researchers are aware of this point and begin to investigate some countries such as Hong Kong, Malaysia and Canada (Gul and Tsui, 1992; Teoh and Lim, 1996; Gorman and Ansong, 1998). According to the above outcome of researches, they have a common characteristic that is their research base on investigating the auditor-client relationship.

3. Conflicts of Interest: The Case of Provision Non Audit Services

After a series of accounting scandals (the list of accounting scandals in Appendix 8), provision NAS becomes a controversial area. Enron Case sounded the alarm in the auditing industry and APB set the rules to regulate the auditing firms' provision NAS to their clients (APB, 2004). Most EU countries ban certain NAS (Lennox, 1999) and permitted as followed (Figure 2):

Taxation services will normally contain preparation of corporation tax, which is not a problem area; problem generates when the auditor gets involved in the executors personal tax affairs that would lead them to familiarity threat (Lassila et al., 2010). Thus, the auditor-client relationship will be close which involved the conflict-interest of directors. A full list of recommended treatment of NAS is included in the appendix 9). The prior researches (Selmrod and Blumenthal, 1996; Mills et al., 1998; Omer et al., 2006) show that there is an increase tendency of providing tax services to client and these client companies would like to retain the tax services by their previous auditors. Further, a lot of investigators question that whether provision NAS will impair the auditor independence (Simunic, 1984; Lafound et al., 2003; Krishnan et al., 2005; Francis, 2006; Schneider et al., 2006). The results are mixed. Some authors believe that provision NAS will impair the auditor independence (Firth, 1980; Parkash and Venable, 1993; Francis, 2006). Conversely, other scholars state that provision NAS will not comprise the auditor independence but benefit for the auditors (Simnett, 1994; Arrunada, 1999; Frankel et al., 2002). Based on the debate, it will generate two observations for unraveling the NAS' enigma.

3.1 Observation one: The arguments against the Provision of NAS

A lot of studies acknowledge that providing NAS threaten the auditor independence and show that offering NAS impair the auditor independence in the following ways (Deberg et al., 1991; Defond et al., 1992; Firth, 1997).

3.1.1The Economic Bonding

The economic bonds refer to the relationship between the auditor and the client, which will be increased by offering the NAS (DeAngelo, 1981). Then, numerous researchers find that this economic bonding will jeopardize the auditor independence (DeAngelo, 1981; Firth, 1997; Francis et al., 1999; Kinney et al., 2004). In order to save space, the literature review related economic bonds mainly can be classified into three parts (auditor-provided non-audit services, future economic interests and purchase audit services and NAS jointly). These three factors of economic bonds (the relationship and structure in the Figure 3) will be illustrated why the economic bonds impair the auditor independence and how the economic bonds impact on the auditor independence.

Figure 3 Relationships and Structure of Economic Bond (self-design) Provision of NAS and auditor independence

Many authors believe that the auditor get involved in providing NAS arise the problem of auditor independence (in real or in appearance) impairment (Mautz & Sharaf, 1961; Burton, 1980; Beck et al., 1988). Moreover, DeAnglo (1981) argues that provision the NAS will damage the auditor independence when the auditor provide the NAS with an additional rent paid by the client. In this case, the independence-impairing will be happened because the auditors have a willing to provide the lucrative report for those client-companies. In addition, DeAnglo (1981) find that there exists an interest-driven or interest-incentive to make the auditor infringe the independence and issue a biased report in order to assist the economic bonding and meet the needs of clients. This study reveals the potential reason for auditor violating the independence. Then Solomon et al. (1988) conclude that the provision of NAS strengthens the economic bond between the auditor and auditee thus the independence will be threatened.

Stockley (1981) put forward that the auditors who provide the NAS to their clients seem to be less independence than those do not provide. He proceeds to investigate the Big Eight partners (local firms, loan officers and financial analysis) in order to gain their perceptions of auditor independence related to providing NAS. The outcomes can be found that these partners believe that the auditor-provided NAS will harm the auditor independence. Along side this, a research based on the context of Malaysia conducted by Hai Yap and Gul (1984), they examine the situation of NAS provision in Malaysia through setting a hypothesis that the provision of NAS adversely impact on auditor independence. Consequently, Hai Yap and Gul (1984) test the hypothesis and verify the result that the auditors provide the NAS and the risk of auditor independence simultaneously.

Nevertheless, the problem area in the work of Hay Yap and Gul is the scope of study. They merely focus on the developing country. In Malaysia, the auditing industry do not developed as the same speed as those developed countries, thus the range of research maybe narrow which implies that they should also concern more about the developed countries.

Conversely, at the same time (1984), Reckers and Pany continually seek the situation in the US (the developed country). Although the country is different, the result is the same. They observed the US company board of directors in a sample of 92 by sending the questionnaires. At last, they found that there are 69% people who believed that the auditor independence will be damaged when providing the NAS.

Many professionals hold the opinion that against providing the NAS. More interestingly, they examine the provision NAS will impair the auditor independence in agency cost and share price angels other than investigating the relationship between the provision NAS and the auditor independence directly. For example, Parkash and Venable (1993) explain that the companies have higher agency cost will hamper the auditor independence in appearance because those companies purchase relatively lower amount of NAS. To be more precisely, they use the cause-effect method to investigate whether the provision the NAS will infringe the auditor independence. Firstly, they observed the high agency cost of these companies so as to find the potential economic bond between the companies and incumbent auditors. Secondly, they found out the existing economic bond due to purchase the NAS. Finally, they verified that provision NAS will jeopardize the appearance of auditor independence which consistent with the viewpoint of Frecka et al. (1988) that the NAS purchased by the company as an incentive will induce the auditor to bear the audit risk and lead to comprise the auditor independence and the objective of the audit. Hence, they analyzed this issue through studying the agency cost dimension.

In share price angle, Firth (1997) adopts the method of investigating the share price of the company to illustrate how the auditor independence will be damaged by NAS provision. Firth (1997) concludes that the decreased share price of the company make the company access to the capital market difficult when the auditor is perceived to be lack of independence. The author researches the auditor impairment caused by the NAS provision by studying the share price and capital market. Then, Kasznik (1999) uses Firth's (1997) study as a basis for the argument that the share price in the financial report may reflects the level of purchasing the NAS. Actually, if the investors know the level of NAS provision, they would judge the degree both the economic independence and the impairment of independence. This may explain why the auditor's independence can be hampered. Equally, the following figure (Figure 5) will explain the idea of the Firth.

On the contrary, Fernley (2002) indicates that there is no relationship between the share prices and NAS provision. Additionally, Antle and Gordon (2006) make up for the deficiencies in the articles of Firth (1997) and Fernley (2002) and they propose a relatively neutral point of view. They find that the auditor independence will be diminished by the economic bond generated only by those abnormally lucrative NAS other than all of the NAS provision. Thereby, the prior researches' gap can be filled by Antle and Gordon's work. Future economic interest and auditor independence

According to Antle (1984), the auditor independence will be impaired due to the auditor obtain the future economic interest or income by mainly providing the NAS to the clients. Similarly, UK audit firms have been utilizing the statutory audit services as 'loss leader' because the profitable NAS provision is more worth securing for them (Mitchell et al., 1993). Most of times, the auditors will trade-off between the future income and the cost of violating independence and audit failures cost (DeAngelo, 1981; Simunic, 1984; Chuang and Kallapur, 2003) then auditors would reluctant to give up the opportunities of gaining high NAS fees (Matsumura et al., 1997). It is can be seen that the future economic interest for auditors mainly come from the payment of NAS provision, which may jeopardize auditor independence because the auditors fear of losing the NAS income (DeAngelo, 1981; Antle, 1984; Simunic, 1984; Magee and Tseng, 1990; Matsumura et al., 1997).

Most of audit firms now choose to provide the recurring NAS due to high NAS revenue (future economic interest), which could lead to independence-impairing (Parkash and Venalbe, 1993). In other words, the auditors enjoy the economic bond with the clients because their future interests rely on the clients. However, the amount of the recurring NAS provision will be determined by the higher or lower agency cost3 and various proxies (Firth, 1997). Moreover, the auditor independence impairment's level is different. When the auditor provide more recurring-NAS for those companies with lower agency cost, the independence is hard to maintain than those companies with higher agency cost purchase fewer recurring-NAS (Firth, 1997).

Nowadays, the auditors become crazy for gaining the NASF. Hence, the Australian audit committee began to revise the proportion of NASF and make the NAS do not exceed 15% (NASF/Total revenue < 15%) (Sharma and Sidhu, 2001). Equally, the Toronto Audit Committee Office set the rules for regulating the revenue of NAS( provision (Mitchell et al., 2001). The reason for controlling the NAS provision found by Sharma and Sidhu (2001) is that the large amount of future income (NAS revenue) compromise independence thus influences the auditor's judgment easily. In one word, the future interest affects the auditor's judgment, which makes the auditors issue the biased clean report for those distressed companies (Firth, 2002) and going-concern report for bankruptcy companies (Sharma and Sidhu, 2001). In Sharma and Sidhu's (2002) study, they investigate the data of Australian bankrupt companies between 1989 and 1996. After observing the sample of 49 bankrupt companies, they found that the level of NAS payment (future interest) positively relates the possibility of issuing the biased going-concern opinion and negatively relates the auditor independence. Nevertheless, the problem of this study is the small sample size. Therefore, the external validity of these results is questioned. Provision of NAS and AS jointly and auditor independence

The audit firms view combining the audit services and NAS to the same clients as a valuable chance to grow (Hillison and Kennelley, 1988, p.33), which is helpful to gain a majority of market share for striving in the fierce competition among audit firms (Johnson and Lys, 1990). In contrast to the above argument, Canning and Gwilliam (1999) opine that the auditor independence comprised when they provide the audit and non-audit services to the same client. They investigate whether provision the audit services and NAS will impact on the perception of auditor independence in the commercial environment of Irish by using both mail questionnaires and semi-structured interviews. The 67% of respondents firmly oppose providing audit and NAS together due to the auditor-impairing. However, the limitation of this study may be the small and closed Irish audit market, which will influence the interviewees' answers (Canning and Gwilliam, 1999). In consistent with Canning and Gwilliam (1999), Fearnley (2002) conclude that joint provision will damage the auditor independence both in appearance and fact.

Consistent with the above authors, some investigators study the joint provision and auditor independence through analyzing the pricing strategies. Joint provisions associate with the 'lowballing' pricing, which means that the auditors decrease the audit fees in the whole audit process deliberately in order to earn the high NAS fees (DeAngelo, 1981 and Zimerman, 1986). The clients have an incentive to pay higher NASF for 'shopping opinion' (Magee and Tseng, 1990). Therefore, a lot of the scholars (DeAngelo, 1981a; Palmorose, 1986; Simon and Francis, 1988; Schartzberg, 1990) opine that the lowbaling will impair the auditor independence because the auditors will gain a rent from audit and NAS provision and the rent just likes the audit fees unpaid by the client.

3.2 Observation Two: The arguments in Favour of NAS provision

A lot researches point out that provision NAS will strengthen the auditor independence and bring benefits for the auditors and the clients (Simunic, 1984; Simon, 1985; Ferguson et al., 2000; Frankel et al., 2002). In the following, the reasons for why the NAS provision will not impair the auditor independence can be divided into two dimensions (due to the space is limited).

3.2.1 Knowledge Spillovers

The NAS provision enhances the auditor's knowledge of the client (Shockley, 1982). In addition, about the "knowledge spillover", some researchers have the different opinions, they believe that auditors' knowledge will be enhanced when they provide NAS, resulting in increased objectivity (knowledge spillover) and independence (Goldman and Barlev, 1974; Wallman, 1996). Specifically, the auditors will be familiar with the information of the clients and the process of the auditing (from auditor to auditee), which will produce the knowledge spillovers (Barkess and Simnett, 1994, p.101) from providing the audit and NAS jointly (Simunic, 1984; Simon, 1985; Turpen, 1990). Consistently, Simunic (1984) states that knowledge transfer occurs when the same auditors provide audit and NAS. They proceed to find that auditors can gain knowledge and accumulate their experience. The reason for it is that auditors utilize the knowledge of non audit work to apply in audit work when they audited both audit and NAS. Furthermore, Arrunada (1999) concludes that the dual function complements of the NAS improve audit function and add the value of the audit's firm reputation.

More importantly, the clients will get the benefit from the knowledge spillover because they do not need to find their own consultants for doing consultancy work that will save cost for them (Simunic, 1984 and Beck et al., 1988). Additionally, the clients who purchase both audit and NAS from the same audit firm normally would be charged less than those clients buy the audit and NAS from different audit firms, which mean that clients could enjoy the benefits from the knowledge spillover and cost-saving effect (Palmrose, 1986). Similarly, Antle et al. (2006) investigate the audit and NAS fees data from UK between 1994 and 2000 and find the knowledge spillover (economic scales) generated from NAS provision to auditing. Then, they state that the NAS provision also do not influence the auditor independence. From a cost point of view, providing NAS will reduce overall cost increases the technical quality of auditing, enhance competition, which ultimately increase the auditor independence not undermine it (Arrunada, 1999; Goldman and Barlev, 1974; Wallman, 1996).

However, Davis et al. (1993) conduct a study for challenging the theory of Simunic (1984) that there exists an effect of cost saving for clients. Davis et al. (1993) assume that knowledge spillover may arise the cost saving and the client become profitable, which will impair the auditor independence. At last, this assume is rejected because there is an evidence showing that joint provision not only do not cause the cost saving but do not damage the auditor independence as well.

3.2.2 Production Efficiencies

The Council of the ICAEW (1987,p.5) state that provisions the NAS will help the auditors to carry out their audit work effectively due to the knowledge spillover and believe that a ban on provision NAS may be 'counter-productive'. Moreover, the auditors have an overall understanding with the situation of the clients and offer some useful suggestions for them, therefore the client are willing to retain their auditors because they will gain the production efficiencies' benefit (Beck et al., 1988 and Beattie et al., 1996). Dopuch and King (1991, p.61) conclude that the auditors provide the NAS to their clients may generate the efficiencies of the production in most of times.

3.2.3 Audit Quality

In a distinct perspective, provision NAS do not necessarily damage the auditor independence but reinforce the audit quality (Arrunada, 2008). Moreover, using one-third of the UK listed companies as sample, Lennox (1999) examines the relationship between the NAS provision and the audit quality when the NASF are disclosed, which has a result that audit quality do not reduced by NAS provision.

Specifically, Firth (2002) consisted with Lennox (1999) argues that the NAS provision will improve the efficiency of the distressed companies' problem discovery which in turn enhance the whole audit process and audit quality. Two years later, Kinney et al. conduct a study to examine whether the NAS provision would impair the audit quality through analyzing 500 companies in the US during 1995-2000. After observing this issue on these companies, Kinney et al. (2004) opine that there is a probability that NAS provision may strengthen the audit quality due to the auditor obtains more available information or the knowledge spillover benefit. Therefore, some studies (Krishnan, 2003, Balsam et al., 2003) also test the influence of the NAS provision on the audit quality by measuring the proxies (ERC and discretionary accruals) and conclude that the NAS provision is unlikely to violate the audit quality despite of the increased NASF (Lim and Tan, 2006).

4. Fees War: The Case of Economic Dependence

4.1. Fee dependence and Auditor independence

Most of the times, fee dependence associates with the audit and NAS fees payment (Mautz and Sharaf, 1961). Facing this issue, the third parties often question that whether the auditor will maintain the auditor independence when they received the audit and NAS fees from their heavy buyers (Mautz and Sharaf, 1961; Firth, 1981; DeAngelo, 1981a). Most of the outsiders answer that the large amount of fees paid by the directors of the business may bring the risk of the independence-imparing because the auditors reluctant to lose the fees (Mautz and Sharaf, 1961) and in turn hard to maintain independence (Firth, 1980).

In order to find out the potential reason why the fee dependence arises, DeAngelo(1981a) gives the answer that there is an incentive for auditors to earn fees due to the DeAngelo's economic model, which in turn the independence will be threatened. Along side with the DeAngelo (1981a), Wines (1994) states that the auditors will try their bests to keep the clients due to the close economic dependence on the auditee. Therefore, the complete auditor independence does not exist when there fee dependence existed (Francis, 2006). Base on the above analysis, the relationship between auditor independence and fee independence can be summarized in the Figure 7.

4.2. Compare the tendency of Audit and NAS fees in typical countries

China Situation

In China, the audit committee do not require the companies disclosure the fees of audit and NAS in the annual report, which is the gray area for auditing. Therefore, it is difficult to find the overall tendency of the fees. In the following, take the bank and mobile industry for analyzing the tendency.

Bank Industry

For investigate the fees tendency in this industry, taking the pillar company as the sample may find the tendency easily.

The following Figure 8 shows the tendency of the bank.

Source: (Lin and Chan, 2000).

It is clear to see that the audit fees were increased from 2006 to 2007. By contrast, the non audit fees were decreased, which implies that the change of the fees follow the international tendency after the Enron bankruptcy.

Telecom Industry (The table is the audit and NAS fees of China mobile )

This Figure 9 shows a downward tendency on the audit and NAS fees. By contrast, the audit and NAS fees in China have a relatively lower level than other developed countries.

For China, the committee of the auditing should control the audit and NAS fees' level and improve the fees' transparency.

Australia Situation

Audit fees ratios (Figure 10) are shown in the following.

Source: (Li, 2006).

The decreased audit fee ratio between 1982 and1995 occurred when auditors adding costs through increasing the inflation and salaries, which lead to the ratio of audit fees go down. On the contrary, the NASF increases which reveal that the audit and NAS fees relate with the situation of the economic.

Canada Situation

The NAS fees portion in Canada are shown in the Figure 11.

Source: (Samer, et al., 2008).

The NAS fees ratio decreased from 2003 to 2007 in a high speed, which maybe a response of the accounting scandals in the world wide.

United States

For the local accounting firms in United States, their sources of income are explained in the Figure 12.

Source: (Chen, et al., 2008).

Prior to the Enron debacle, the income of the NAS of the New York's local audit firms goes up during 1998-2000 while the NAS revenue has a decreased trend after the Enron collapse because some profitable NAS will not allowed to offer to the clients (APB, 2004).

4.3. The Case of Economic Dependence

The economic dependence can be found both in developed countries and in developing countries as well and investigate the fees payment becomes the hot issue in the auditing industry.

DeBerg et al. (1991) imply that economic dependence relates with the provision of NAS. In consistent with DeBerg et al. (1991), Ezzamel et al., (1996) investigate the relationship between audit service and NAS by using a sample of 314 UK listed companies during 1992-1993. The result shows that the NASF make up vast amount (87%) of total fees that pose a threat on the auditor-independence. However, the problem of the study is the short observing period so the result could be subject to the short-period bias which may be lack of persuasive in a sense.

After this, the study conducted by Craswell (2002) measures the relationship between the fee dependence and auditor independence by using the disclosure fees data from 1989 mergers in Australia, which could not find any evidence that the fee dependence in the national level or the local market level impairs the auditor independence. Comparing with prior researches (DeBerg et al., 1991; Ezzamel et al., 1996), Craswell (2002) has an opposite conclusion that is fee dependence (economic dependence) do not threat the independence because the audit firms adopt the system (the reviews of partner and peer) so as to protect the personal auditor-independence.

Two years later, Hay et al. choose the top 200 firms in New Zealand during 1996-1998 in order to examine the influence of economic dependence on the objective of the auditors by comparing the speed of audit and NAS fees' growth. The results imply that the NAS fees' growth (42.95%) is quicker than the audit fee (6.96%), which means that the audit firms' incomes mainly depend on the NAS payments (NAS fees dependence) and fee dependence have the negative influence on the auditor independence (Hay, et al., 2004).

Similarly, the accounting firms' fees portion in 2006 also consisted with the conclusion of Hay et al. (2004). The following Figure 13 shows the data of the fees.

From the above table, it is can be seen that the fees created from NAS are higher than those from audit services, which indicates that the NASF take up the vast majority of the total revenue of the auditing firms and the audit firms rely on the NASF.

Furthermore, economic dependence requires improving the transparency of the fees disclosure. In early study, Firth (1980) argues that the gross of the audit firm's revenue will be controlled between 10% and 15%. Moreover, Glezen and Millar (1985) state that ASR no. 250 in the USA requires the listed companies to disclose the amount of the NAS purchased from the auditing firms. In recent study, Peasnell et al. (2007) suggest that the UK should disclose the NAS completely, separating the audit and NAS and ban certain those NAS that impair the independence. However, in the USA, the SOX add the tax services to prohibit and the Danish becomes more extreme because it bans all of the NAS (Canning and Gwilliam, 1999).

5. Conclusion

The auditor plays an important role in the auditing industry. The auditors should represent the complete independence when they carried on the audit work. Specifically, the auditors provide an unbiased report for investors and shareholders, which will improve the audit quality. In fact, the auditors always are tempted by the high NASF then issue the more favourable opinion even for the distressed companies. Therefore, the auditor could not economically independent of their client. Although provision of the NAS will impair the auditor independence, there also has some positive effects such as knowledge spillover, audit quality improvement and production efficiency. Obviously, prohibit all types of the NAS may be inappropriate for maintain the independence. The suggestion of Peasnell et al. (2007) is that it is not necessary to ban all of the NAS and they state that disclosing the NASF will enhance the auditor independence. These suggestions are meaningful and can be referenced by the audit committee in the further.


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Appendix 1: Context of Auditing

In Latin meaning, the word "audire" represented hearer or listener. (Hayes, et al., 1999, page 2). Then they argued that the audit activities also are found in ancient China, Greek and Rome. In fact, China experiences a long history of audit development. The shadow of audit can be found out in different dynasties (see Appendix 2). It shows the development of audit in various periods in ancient China. In the world wide, audit went through two stages---ancient auditing and modern auditing.

The date back to ancient Egyptian and Roman and Greek civilisations, the ancient audit was implemented only when the proprietor suspected a fraud had occurred. Independent auditors were appointed to hear verbal explanations from people who responsible for managing the accounting records. Compared with the ancient auditing, the modern auditing is more complex and the auditors will check the accounts for possible fraud by a client, which is far more than cash verification. For modern audit, detecting the possible fraud and errors are merely an incidental aim, its main objective being to give a "true and fair view" on the audit report for the business activities and report on the financial position of these activities.

Additionally, the international and professional bodies of auditing give new life to audit so as to understand audit in a clear way. For audit, its basic definition is "an official examination of the accounts (or accounting systems) of an entity by an auditor". (ACCA paper F8 UK, 2007, page 12).

The Auditing Practices Board (APB) also defines an audit as:

"An audit of financial statements is an exercise whose objective is to enable auditors to express an opinion whether the financial statements give a true and fair view (or equivalent) of the entity's affairs at the period end and of its profit of loss (or income and expenditure) for the period then ended and have been properly prepared in accordance with the applicable reporting framework (for example relevant legislation and applicable accounting standards)or, where statutory of other specific requirements prescribe the term 'present fairly'.'' (Millichamp, 1996, page 6).

Apart from the professional definition for audit, in a business point of view, it also defined audit as "a systematic examination of the activities and status of an entity, based primarily on investigation and analysis of its systems, controls, and records." (Millichamp,1996).

In addition, Auditing & Assurance Standard 'Basic Principles Governing an Audit' issued by the Institute of Chartered Accountants in Ireland (ICAI) points out "An audit is the independent examination of financial information of any entity, whether profit oriented or not and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon." (Kumar and Sharma, 2005).

Similarly, the American Accounting Associations Committee (AAAC) in 1973 states that audit is "a systematic process of objectively gathering and evaluating evidence relating to assertions about economic actions and events in which the individual or organization making the assertions has been engaged, to ascertain the degree of correspondence between those assertions and established criteria, and communicating the results to users of the reports in which the assertions are made." (Poter, et al, 2003).

According to the explanation of audit in dictionary, it says that audit is a process used to test whether the existing standards of care are being satisfied, which illustrates the audit in detail. The process of audit as follows:

( 12/11/2008).

This graph reflects the function of audit in side. This cycle may control the activities of companies effectively and makes them to provide their true financial statements.

The objective of an audit defined by the first International Standard on Auditing (ISA) 200 Objective and general principles governing an audit of financial statements:

'…to enable the auditor to express an opinion whether the financial statements are prepared in all material respects, in accordance with an applicable financial reporting framework.' (ACCA paper F8 UK, 2007, page 12).

Of course, the auditor must provide an audit report which included the true and fair opinion for not only large but also small and medium sized company's financial statements. Normally, Hayes, et al. (1999) argued that the auditor has certain tolerable errors in the audit process, which means the auditor have a chance to make mistakes because they may not ensure their opinions are accurate. This rule may be reasonable for auditors.