Role of corporate governance in enhancing audit quality

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Audit quality has been the main concern for the accounting world since the breakdown of Enron to corporate scandals that happened in Malaysia for example the Transmile Berhad, Megan Media Berhad, PKFZ Project and Kenmark Berhad (Azlan, 2010). There is no single available definition of audit quality that can be used as a acceptable standard against which actual performance can be valued. The audit opinion is subjective; different views are held as to the extent and nature of audit evidence required to support the opinion.

The information asymmetry between the management and shareholders has

resulted in agency problems (Fama, 1980). The external audit helps reduce the gap from the separation of ownership and control of an entity (Fama and Jensen, 1983). Any

manipulation of accounting information can be reduced through an audit (Jensen and

Meckling, 1976). Within the framework of corporate governance, the external auditors

have a considerable influence over the accountability of management and the integrity

of financial reports contained in corporate annual reports (Watts and Zimmerman, 1983;

Goodwin and Seow, 2000).

Auditors are a crucial part of the financial reporting value chain.If auditors underperform, investors will go elsewhere. The financial scandals prove to show that the auditors have fallen below the expected standards. The most common question asked whenever there has been a financial scandal is, whether the auditors carried out their duties and obligations properly (Reily, 2006). However, it is emphasized that by its nature, the inherent limitations of an audit make it impossible to eliminate the risk of audit failure. Hence, importance should be placed on the Corporate Governance (CG) framework to help the auditors to perform their duties and obligations.


The main purpose of this report is to analyse the significance influence of CG elements to the external auditors' quality within the Malaysia auditing context. Examples of CG elements would be balance of BOD, role of NEDs and the role of audit committee.


CG is a framework of managing, directing, and monitoring a corporation with the objective of creating shareholder value while protecting the interests of other stakeholder (such as creditors, employees, and customers). In 2007, the CG code in Malaysia has been revised. One of the main purposes is to strengthen the role of external auditor (EA) and its relationship with the audit committee (AC) of a company. Implementation of CG within an organization can enhance confidence in the quality, credibility and reliability of audited financial statement. CG enables auditors to carry out regular and rigorous inspection comply with appropriate standard of auditing. Hence, the auditors can provide a high level of assurance on the audited financial statement. Otherwise, the information contained in the report would be misleading.

Every corporation should be leaded by an effective board, which is ultimately drives the organization towards it's aim and objective. A clear seperation of responsibilies between the Chairman of the Board of Director (BOD) and the executive responsibility of Chief Executive Officer (CEO) should be established. No one individual should have unfettered authorities of decision making. In additions, there should be a balance of power between executive and non-executive directors and hence no individual can dominate the board's decision making.

In the case of Malaysia, there is a significant number of listed companies with substantial family shareholdings that elect family members to sit on the boards both as executive and non-executive directors (Haniffa and Cooke, 2002). Thus, they may use their position to achieve their financial and personal interest at the expense of minority shareholders. (Dr. Zulkarnain Bin Muhamad Sori and Dr Yusuf Karbhari). Sound governance by boards of directors is recognized to influence the way of financial reporting, which results an important impact on audit quality performed by external auditors (EA). Strong governance should reduce the likelihood of misstatements arising from fraud or errors.

Non-Executive directors (NEDs) play an important role in CG framework and help the EA in enhancing audit quality and increasing audit assurance. NEDs are directors who do not have an executive function in the company. Having NEDs on the BOD may provide a more objective and wider perspective view which will ease the external auditors in auditing the financial statement of the company. It will only helps external auditors to perform their duty effectively if the NEDs is independent in character and judgement.

One of the role and responsibility of the audit committee is to monitor the integrity of the financial statement of the company. The existence of an audit committee could improve the monitoring of corporate financial reporting and internal control. This could be done by bridging the communication gap between the external auditors and corporate management. An audit committee of independent NEDs provide the external auditor with an independent point of reference other than the executive directors of the company, in the event of a disagreement arising. By improving the quality of financial reporting and internal financial control, effectiveness of the external auditor's work improved as well. Independence of external auditors can be ensured if the audit committee involved in the selection of the external auditors.

According to Zulkarnain Muhamad Sori (2007), audit committees could observe the financial reporting process and provide recommendations in the selection of auditors, negotiation of fees and termination of external auditors, which would ultimately diminish management's power over the auditor. An audit committee is anticipated to ensure that a business organisation has sufficient internal controls, proper accounting policies, and independent external auditors that will prevent the incidence of fraud and promote high quality and timely financial statements. Furthermore, the existence of an audit committee was found to have an association with the tendency to switch from less credible to more credible auditors. These results indicate that the audit committee acts as a catalyst to enhance good financial reporting and support the role of auditors to produce quality output.

The appearance of audit committee independence would enhance auditor independence and make the management and auditors more honest in financial reporting (Lam, 1976). This is because independent directors have a greater incentive to avoid activities that would damage their reputation than nonindependent directors (Abbott and Parker, 2000; Abbott et al., 2003). They would try to avoid any potential reputational damage, such as financial misstatement, because non-executive directors might view audit committee service as reputational capital enhancement (Fama and Jensen, 1983; Abbot etal., 2003)

Kuala Lumpur Stock Exchange (KLSE) imposed restrictions on the number of directorships in order to enhance the level of corporate governance where directors are not allowed to hold more than 25 directorships in PLCs and more 15 directorships in non-PLCs. According to (Khoo, 2003), these numbers are still high which have the same view with Shivdasani (1993) and Song and Windram (2000) where both authors argue that multiple directorships may cause limitations of time and commitment for audit committee members. However, there are studies which show that multiple directorships may enhance the contribution of audit committee members towards discharging their duties effectively. Kiel and Nicholson (2003) find multiple directorship is positively associated market capitalization and performance of Australian listed companies. Multiple directorships enrich audit committee members with experience and knowledge of management of companies of different business background. For example, audit committees with multiple directorships demand a more extensive audit to protect their reputation capital (Boo and Sharma, 2008), hence, contributing to better reporting quality and audit quality.

The ruling in the Code of Corporate Governance (FCCG, 2001) requires companies to meet minimum characteristics with respect to financial literacy, frequency of meetings and independence of committee members. In order to comply with the ruling, companies would therefore have at least one MIA member in the committee who is deemed to have financial literacy. The absence of financial experts in the audit committee has led the company to have financial problems (McMullen and Raghunandan, 1996). They found firms with financial problems are unlikely to have audit committee members with financial expertise. The lack of knowledge in financial reporting and internal control among audit committee members are perceived by external auditors as the hindrance for effective interactions between external auditors and audit committees (Kalbers, 1992).

The literature has documented that planned audit hours increase as the efficiency of the internal control system decreases (Kaplan, 1985). This finding might indicate that efficient internal control would directly influence the reduction in audit hours and fees, especially in a large and complex business organisation. As a result, higher quality financial reports would be produced with a minimum of or no financial misstatement

Internal control systems and risk assessment are fundamental to overall financial reporting. When the systems are properly in place, the other reporting processed would be organised accordingly and hence it would help the EA to enhance the audit quality.

Structure of Audit Committee in Malaysia is where corporations merely comply in form by building up such committees without giving consideration to the spirit of the CG by ensuring, for example, the character and quality of the people within the committee (Azlan, 2010). In this respect, Mohamad et al. (2001) found that a large majority of companies listed on the KLSE tend to comply with all regulations imposed on them, such as the requirement to disclose audit committee reports, without concern for the quality of these reports. (Ismail, 2008) pointed out that audit committee independence did not guarantee effectiveness unless the committee was active. In addition, Kalbers and Forgarty (1993) supported this argument and indicated that audit committee effectiveness would only materialise if the members were committed to pursue their roles and duties. Existence of audit committee is more for cosmetic reason and does not really assist EA to perform their job effectively.

According to Malaysian Alliance of Corporate Directors (MACD) President Dato' Jaffar Indot, Malaysia CG framework is one of the best in the world, but the challenge lies in its implementation (Gomes, 2009). However, the main obstacles for Malaysia to good CG implementation is the limited supply of qualified independent directors (Gomes, 2009). The obligations and responsibilities are heavy, hence the qualified professionals are wary of accepting independent directorships (MSWG, 2009).


Auditors would be more able to resist management pressure when there is a law mandating compliance; thus, they would be able to highlight these legal requirements to the client. Due to a lack of voluntary effort among corporate participants, the force of the law could play a significant role in ensuring that financial reporting is in accordance with the stipulated standards. Malaysian society might be more autocratic because of tradition, culture and level of education, which contribute to the lower level of voluntary action. If non-compliance were to become an offence under the relevant law, it could lead to penalty and might become an incentive for auditors to comply with standards, fearing association with litigation.

Although Malaysian CG frameworks look good on paper, Malaysian corporates still score low in corporate governance ratings (OECD, 2009) To achieve a genuine CG overhaul, corporates need to subscribe to ethical behaviour and ethics need to be a key part of education. (Gomes, 2009)


Corporate participants in Malaysia see the issues relating to corporate governance as something that constrains them rather than something that encourages them to be more entrepreneurial and competitive. The issue of corporate governance should focus on long term shareholder value, how to generate this value, the benefits of a competitive strategy, employing good people, reacting to the market etc. These points should raise awareness of the need for good accounting standards, good financial reporting and the importance of auditor independence. CG practices is not a standard mode and thus cannot operates in any standard form but rather vary across nations and firms. This variety reflects distinct societal values, different ownership structures, business circumstances, and competitive conditions strength and enforceability of contracts.

Implementation of CG is highly dependable on the mindset of the corporate participants in order to embrace the true spirit of CG. It is true that morality and ethical conduct cannot be prescribed by black letter law. Tun Dr. Mahathir, former Prime Minister Malaysia posits that "there is too much greedy, profiteering and usurious practices are rampant. Business is about making profits but it should not be such that other would suffer"