The independence and effectiveness of the audit function

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The increasing issue of corporate scandal all over the world has changed lots of accounting dimension and standard to become more effective and efficient. The big question of what is auditor function has been widely discussed throughout the event of corporate scandal. The most effected party in the event of corporate collapse is institutional investors. Institutional investors are the parties who allocate fund into the corporation to be managed wisely by the management to get the high return and they are also the party who are been affected mostly when a corporation collapse. Therefore, most of institutional investors nowadays are concern on what are the management actually doing with their fund. To answer their query, institutional investors are concerned on the independence of the audit function. This paper is aimed to discuss the reasons institutional investors concerned about the independence and effectiveness of the audit function. The first section on this paper will discuss about the type of institutional investor, second section will describe about independence auditors and third section about the important of effectiveness of audit function to institutional investors.

Type of Institutional Investor

A primary function of investors is to allocate funds to company. Traditionally, investors are solely put their fund into potential company and wait for returns at the end of every financial period. Their returns are in term of dividend paid and increasing of price per share. Every annual grand meeting (AGM) investor will attend the AGM and analyze the company performance for the past year when company management will present the previous year financial performance to the shareholders aka investors.

Recently due to increasing of corporate scandal across the world like Enron, World Com, Layman Brothers, Parmalat and many more will increase the investor involvement in the company by not only allocate fund in the company to ongoing monitoring company performance and providing technical support and advice to company. With the increasing of the corporate scandal, now investors are more thorough in managing their funds, they are monitoring the company performance presently, not like traditionally they just look at the annual report been presented by management at the AGM. Their roles also providing the technical support to management for example investor also are sharing their expertise in the company to enhance the company capability and in returns will give the company profit and indirectly their market share price will be increase. The other roles of the institutional investors are to advice the company top management.

According to Porter (1992) and Bushee (1998, 2001), institutional investors can be classified into three types which is transient, dedicated, and quasi indexing. Transient institutions have high portfolio turnover and highly diversified portfolios, they are more short term focused investors whose interest in a firm’s stock is based on the likelihood of short term trading profits. Where dedicated institutions have large average investments in their stock holdings, and they have low turnover, consistent with a “relationship investing” role and a commitment to providing long term capital. The third type is quasi indexing institutions have low turn over, but they tend to have diversified holdings, consistent with a passive, buy and hold strategy of investing their funds in a broad set of firms.

According to Jensen and Meckling, 1976, the need for monitoring arises due to the classical agency problem. Agency problem commonly occurs between the principle and agent. In this context, principle we refer to institutional investor and agent refer to managers. Example of agency problem is conflict between investor and manager when manager may hold share less than the investor, then managers may make decisions that conflict the investor best interest of maximizing shareholder wealth. Agency losses occur when manager maximize their self interest at the expense of the principle (Jensen and Mecking, 1976). Therefore agency problem occurs when there is inequality between the work performed by the managers and the compensation packages received from the principle.

Independence Auditor

In order to avoid agency problem from occurs, institutional investors are seeking for independence auditor. In a simple word, independence auditor can be define as free from any interest and influence that create unacceptable risk of material bias to the reliability of information in the financial statement. Independence auditors can separate into “independence of mind” and “independence of appearance”. “Independence of mind” is state of mind that permits expression of a conclusion without being affected by any outside influences that compromise the professional judgment. Therefore can allow an auditor to act with full of integrity and exercise objectivity and professional skepticism. Hence, “Independence of appearance” is avoidance of facts and any circumstances that are significant that a reasonable and informed third party would be likely to conclude and weighting all specific fact that’s a firms or a member of audit team’s integrity, objectivity or professional skepticism has been compromised.

Therefore, institutional investors are seeking for independence auditor that can express an opinion on a fair view and reasonable assurance of all respect about the company present financial position, operation results and its cash flows conformity to general accepted auditing standard. This opinion communicated with the Auditor’s Report in the financial statement. The standard opinion from auditor contains of unqualified report that shows the auditor believes the financial statement present fairly the entity’s financial position and results in operation in conformity with accounting standard. In contrast, when auditor express qualified it is shows to notify financial statement readers about the concern of the auditor has about matters affecting the financial statement such as selection of accounting policy and many more.

The other roles of independence auditors beside oversight the company overall performance is to detect fraud. The independence auditor also has a responsibility to his profession to detect any misstatement during working on their audit work. During the audit, an auditor are responsible to assess the risk of material error and fraud and responsible to report any doubt from their evaluation of audit evidence to the institutional investors.

By having independence auditor it will increase the reliability of the information used by the institutional investor in making decisions. The reliable information will affect the value of the share price.

Effectiveness of audit function

To obtain the audit quality, the effective of audit function is crucially important. Therefore, an independence auditor should be competent enough in auditing. The professional qualification is required or compulsory for independent auditors are those people with the education and practice experience. When the financial statement being audited by the competent independence auditor, it will enhance the degree of institutional investor confident towards the information in the financial statement.

Audit rotation is one of mechanism to maintain the effectiveness of independence auditor. In the public listed company, it is required by law to rotate the external auditor every five years. This external auditor rotation only applies with the consent of shareholders. However there is several issue arises in external auditor rotation due to cost effective. Whereby when the new auditor take turn the audit work, they need to start from the scratch. This will impose to the high audit fee and long time taken to do the audit work.

To encounter the above issues, Price Water House Cooper has proposed a comprehensive review of the External Auditor Model (CREA). Where under this CREA, it’s would assess the ongoing effectiveness of the relationship between the external auditor and the company by focusing on the external auditor’s team independence and any impairment of effectiveness in conducting the audit. Therefore, by having the effective audit function, it will enhance the audit quality reports.


In conclusion, the reason why institutional investor concern about the effective and independence auditor is because to protect their own interest by reliance on professional judgment and true fairness view of external auditor and avoid from management misconduct and fraudulent conduct.


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