Managerial Auditing Journal: Dispelling The Enron Blues

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Volume 18 Number 6/7 2003
ISBN: 0-86176-871-X
ISSN 0268-6902
Managerial Auditing
Journal
Dispelling the Enron blues
www.emeraldinsight.com
ISSN 0268-6902
Managerial Auditing Journal

Volume 18, Number 6/7, 2003
Dispelling the Enron blues
Contents
442 Access this journal online

443 Abstracts & keywords
538 Users perceptions of corporate social

responsibility and accountabilty:
evidence from an emerging economy
Khalid Al-Khater and Kamal Naser
448 Enronitis dispelling the disease

Gerald Vinten
456 An exploratory study of adopting

requirements for audit committees for
non-US commercial bank registrants:
an empirical analysis of foreign equity
investment
549 The usefulness of the audit report in

investment and financing decisions
Antonio Durendez Gomez-Guillamon
560 Auditing in support of the integration

of management systems: a case from
the nuclear industry
I.A. Beckmerhagen, H.P. Berg,
S.V. Karapetrovic and W.O. Willborn
Louis Braiotta Jr
465 Developing a strategic internal

audit-human resource management
relationship: a model and survey
569 Current accounting investigations:

effect on Big 5 market shares
MaryAnne M. Hyland and

Daniel A. Verreault
478 Underreporting and premature sign-off

in public accounting
Mike Shapeero, Hian Chye Koh and
Larry N. Killough
490 Internal auditors and the external

audit: a transaction cost perspective
Cameron Morrill and Janet Morrill
Christie L. Comunale and

Thomas R. Sexton
577 The efficacy of liquidation and

bankruptcy prediction models for
assessing going concern
Nirosh Kuruppu, Fawzi Laswad and
Peter Oyelere
591 Are auditors sensitive enough to

fraud?
Bilal Makkawi and Allen Schick
505 The Mad Hatters corporate tea party

Philomena Leung and Barry J. Cooper
599 Users perceptions of various aspects

of Kuwaiti corporate reporting
517 Credibility and expectation gap in

reporting on uncertainties
Kamal Naser, Rana Nuseibeh and

Ahmad Al-Hussaini
Junaid M. Shaikh and Mohammad Talha
618 Book review

530 Improving corporate governance: the
role of audit committee disclosures
Zabihollah Rezaee, Kingsley O. Olibe
and George Minmier
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Abstracts
&
keywords
Enronitis dispelling the disease

Gerald Vinten
Keywords Corporate governance, Fraud,
Internal control, Auditing, Boards of directors,
Financial reporting
Enron has become less the name for a
company than a shorthand for mammoth
abuse of financial reporting and corporate
governance of a variety so egregious as to be
almost unbelievable. Across the world there is
debate in conferences and regulatory bodies as
to whether Enron can happen in this or that
country. Few if any are so complacent as to
consider that they are immune from
Enronitus. While America bolts the stable door
after the event, or in the high likelihood that
there will be another Enron waiting in the
wings, other countries are taking preventive
measures. A multi-dimensional and
inter-professional approach is required to
combat Enronitus. Main headings are
protecting the public interest, accounting and
financial reporting, auditing, corporate
governance and education. Careful integration
of these factors is necessary if there is to be any
discernible impact on the problem. Complex
issues require complex solutions.
An exploratory study of adopting

requirements for audit committees for
non-US commercial bank registrants:
an empirical analysis of foreign equity
investment
Developing a strategic internal

audit-human resource management
relationship: a model and survey
MaryAnne M. Hyland and Daniel A. Verreault
Keywords Internal auditing,
Human resources management,
Risk management
Presents a model for analyzing the potential
for value creation of the internal audit (IA)
function, the human resource management
(HRM) function, and the IA-HRM pairing. A
survey of 161 chief audit executives indicated
that virtually all IA functions are risk
managing in their audit approaches, while a
great majority of HRM clients are also
moderately or strongly strategic in their
outlook. Findings included that a productive
working relationship was strongest when a
risk managing IA function is paired with a
strategic HRM function. Also, the IA
planning process was found to be more
strategic in the presence of the same pairing.
Analysis of written examples of strategic
findings related to HRM supplied by the
respondents suggested that there may be a
significant gap between auditors knowledge
of strategic HRM practices as developed in
the literature and their self-reported
examples. Future research should use both
HRM and IA responses to reduce bias.
Additionally, there is a need for case studies
of the IA-HRM partnership.
Louis Braiotta, Jr
Keywords Audit committees,
Boards of directors, Corporate governance,
United States of America

18/6/7 [2003]
Abstracts & keywords
# MCB UP Limited
[ISSN 0268-6902]
This study examines whether the presence of

audit committees for US commercial bank
registrants (SEC Form 10-K filers) significantly
affects the likelihood of adoption by certain
non-US commercial bank registrants (SEC
Form 20-F filers). Results of a logistic
regression analysis of 31 US commercial bank
registrants with audit committees and 31 nonUS commercial bank registrants without audit
committees suggest that demand for oversight
protection in the sample non-US commercial
banks is more likely to increase as the total
market capitalization (size) increases.
Additionally, this paper investigates whether
the presence of audit committees for non-US
commercial bank registrants (Form 20-F filers)
increases their transparency with a
concomitant effect on infusion of foreign
equity investment. Results of a logistic
regression analysis suggest that the presence
of audit committees does not significantly
affect the likelihood of an increase in the
banks American depository receipts.
[ 443 ]

18/6/7 [2003] 443-447
Underreporting and premature sign-off

in public accounting
Mike Shapeero, Hian Chye Koh and
Larry N. Killough
Keywords Ethics, Public sector accounting,
Cognition, Auditing principles
This study uses the ethical decision-making
model to examine underreporting and
premature audit sign-off in public accounting.
Structural equation modelling results indicate
that accountants view premature sign-off
activities differently from underreporting
activities. For example, those accountants who
use a teleological moral evaluation process,
and who perceive a greater likelihood of
reward are more likely to underreport. That
these variables are not significantly related to
the likelihood of premature sign-off suggests
that accountants may use a consequencesbased approach when making decisions
having lesser ethical content (like
underreporting), but employ a different
decision process when faced with decisions
having greater ethical content (like whether to
prematurely sign-off). The results also suggest
that supervisors and managers are less likely
to underreport, and to prematurely sign-off,
than senior and staff-level accountants, and
that accountants with an internal locus of
control are less likely (than externals) to either
underreport or prematurely sign-off.
Internal auditors and the external

audit: a transaction cost perspective
Cameron Morrill and Janet Morrill
Keywords Internal auditing, External auditing,
Transaction costs, Surveys, Canada
Questions exist regarding the extent to which
internal auditors should participate in the
external audit, and wide variations are
observed in practice. Many professional bodies
increasingly advocate the view that increased
coordination between the internal and
external auditors, including increased use of
the internal auditor for the external audit,
provides more efficient and effective audit
coverage. However, others maintain that
internal auditors should not focus on areas
that are the subject of external audit interest.
This article attempts to shed light on this
debate by using insights from transaction cost
economics (TCE) to identify conditions under
which organizations encourage internal audit
participation in the external audit. An analysis
of survey data collected from directors of
Canadian internal audit departments indicate
that some (TCE) variables, particularly
transaction-specific investment, are
significantly associated with internal audit
participation in the external audit.
[ 444 ]
The Mad Hatters corporate tea party

Philomena Leung and Barry J. Cooper
Keywords Corporate governance, Ethics,
Standards, Accountancy
This paper aims to provide an insight into
the corporate greed and consequent
corporate collapses of companies such as
HIH, One.Tel and Harris Scarfe in Australia,
while concurrently, Enron, WorldCom and
other companies were attracting the
attention of the accounting profession, the
regulators and the general public in the USA.
It is argued that the rise in economic
rationalism and the related increased
materialism of both the public and company
directors and managers, fed the corporate
excesses that resulted in spectacular
corporate collapses, including one of the
worlds largest accounting firms. The
opportunistic behaviour of directors, and
managers and the lack of transparency and
integrity in corporations, was compounded
by the failure of the corporate watch-dogs,
such as auditors and regulators, to protect
the public interest. If the history of bad
corporate behaviour is not to be repeated, the
religion of materialism needs to be
recognised and addressed, to ensure any
corporate governance reforms proposed for
the future will be effective.
Credibility and expectation gap in

reporting on uncertainties
Junaid M. Shaikh and Mohammad Talha
Keywords Corporate governance, Reports,
Financial reporting
This paper analyzes and reports on studies
that examine the extent to which
international auditing boards have
accomplished the goal of reducing the
expectation gap in reporting on
uncertainties. This is because there has been
a long-running controversy between the
auditing profession and the community of
financial statement users concerning the
responsibilities of the auditors to the users.
Enron and WorldCom scandals have
provoked the public to incite the government
and professional bodies to impose stringent
regulation in protecting their interests. It
also suggests the solutions to minimize the
gap and enhance the publics perception
towards the profession.

18/6/7 [2003] 443-447
Improving corporate governance: the

role of audit committee disclosures
Zabihollah Rezaee, Kingsley O. Olibe and
George Minmier
Keywords Corporate governance,
Audit committees, Financial reporting,
Auditing, Disclosure
An increasing number of earnings
restatements along with many allegations of
financial statement fraud committed by high
profile companies (e.g. Enron, WorldCom,
Global Crossing, Adelphia) has eroded the
public confidence in corporate governance,
the financial reporting process, and audit
functions. The Sarbanes-Oxley Act of 2002
was an attempt to regain confidence and trust
in corporate America and the accounting
profession. The Act addresses corporate
scandals and the perceived crisis in the
auditing profession. Some of its provisions
relate to the audit committee oversight
function over corporate governance,
financial reporting, internal control
structure, internal audit functions, and
external audit services. This study examines
three types of audit committee disclosures:
the annual report of the audit committee;
reporting of the audit committee charter in
the proxy statement at least once every three
years; and disclosure in the proxy statement
of whether the audit committee had fulfilled
its responsibilities as specified in the charter.
This study conducts a content analysis on
audit committee disclosures of Fortune 100
companies.
Users perceptions of corporate social

responsibility and accountability:
evidence from an emerging economy
Khalid Al-Khater and Kamal Naser
Keywords Social responsibility, Annual reports,
Qatar
This study sets out to investigate the
perception of different users of corporate
information about the notion of the
accountability process and the possibility of
widening the scope of the current corporate
annual report in Qatar to include social
responsibility information. To achieve this
objective, four user groups were invited to take
part in the study. The outcome of the analysis
revealed that most of those who took part in
the study would like to see corporate social
responsibility information disclosed, either in
a separate section, or as part of the board of
directors statement within the annual report.
To achieve accountability, the respondents
believe that a law that encourages the
disclosure of corporate social responsibility
information should be introduced, and
different parties within the society should
have the right to such information.
The usefulness of the audit report in

investment and financing decisions
Keywords Auditing, Reports,
Investment appraisal, Influence
The usefulness of the auditors report is
sometimes called into question, the validity
of the information it contains for users when
making decisions therefore being criticized.
This survey is aimed, on the one hand, at
dealers and brokering companies, and, on the
other at banks to find out exactly how
important the audit report is in the
investment decisions that analysts make, as
well as in lending decisions made by credit
institutions. In this sense, the respondents
are asked about the source they consider
relevant when making decisions, that is to
say, the influence the auditors opinion
(clean, qualified, adverse or disclaimer) has
when investing in and financing companies.
The results show that users of audit reports
consider the information provided in the
auditors opinion as useful and important
when making decisions, both regarding their
decisions of investing in and financing
companies as well as the amount of the
investment or the loan to grant.
[ 445 ]

18/6/7 [2003] 443-447
Auditing in support of the integration of

management systems: a case from the
nuclear industry
The efficacy of liquidation and

bankruptcy prediction models for
assessing going concern
I.A. Beckmerhagen, H.P. Berg,

S.V. Karapetrovic and W.O. Willborn
Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere
Keywords Quality, Safety, Auditing,

Nuclear energy industry, ISO 9000 series,
Germany
Integration of function-specific management
systems in organizations is rapidly becoming a
topic of interest for managers and auditors
alike. This is mainly due to the proliferation of
management system standards that foster
compliance with the stated criteria for quality,
environmental, occupational health and safety,
social responsibility and other different
aspects of performance. While most of the
available literature on this topic focuses on the
integration of standards, there is
comparatively little information on how to
actually build an integrated system internally.
This paper hypothesizes that audits can
provide an excellent basis for these integration
efforts, discussing the prerequisites, strategies
and resources necessary for an effective audit
in support of integrated management systems.
The paper also describes how audits are used
to improve a combined quality and safety
management system in a German nuclear
facility.
Current accounting investigations:

effect on Big 5 market shares
Christie L. Comunale and Thomas R. Sexton
Keywords Market share,
Accounting standards, Accounting firms,
Benchmarking, United States of America
Arthur Andersens conviction and its
decision not to audit public firms will
transform the Big 5 into the Big 4.
Meanwhile, other Big 4 firms face
investigations that threaten their future
market shares. The article compares the
observed post-scandal shifts in market share
with those estimated by a Markov model. It
then estimates the year-by-year and longterm market shares that the Big 4 firms
would have achieved had they remained
untouched by these investigations. The study
finds that the absence of Arthur Andersen
alone would not have led to excessive market
share concentration. It demonstrates how the
post-scandal shifts reveal the impacts of the
investigations on the Big 4 firms and
provides market share benchmarks against
which the firms can evaluate the long-term
effects of the investigations. Finally, the
article concludes that a firms long-term gain
in market share depends on its ability to
retain audit clients.
[ 446 ]
Keywords Going concern value, Liquidation,

Bankruptcy, Insolvency, Corporate finances
Recent research questions whether
bankruptcy is the best proxy for assessing
going concern since filing for bankruptcy is
not synonymous with the invalidity of the
going concern assumption. Furthermore, in
contrast to debtor-oriented countries such as
the USA, liquidation is the most likely
outcome of corporate insolvency in creditororiented countries such as the UK, Germany,
Australia and New Zealand. This suggests
that bankruptcy prediction models have
limited use for assessing going concern in
creditor-oriented countries. This study
examines the efficacy of a corporate
liquidation model and a benchmark
bankruptcy prediction model for assessing
company liquidation. It finds that the former
is more accurate in predicting company
liquidations in comparison with the latter.
Most importantly, Type 1 errors for the
liquidation prediction model are
significantly lower than for the bankruptcy
prediction model, which indicates its greater
efficacy as an analytical tool for assessing
going concern. The results also suggest that
bankruptcy prediction models might not be
appropriate for assessing going concern in
countries where the insolvency code is
creditor-oriented.
Are auditors sensitive enough to fraud?

18/6/7 [2003] 443-447
Bilal Makkawi and Allen Schick

Keywords Auditing, Fraud, Corporate
governance, Auditors
This study investigates how auditors alter
their audit program decisions in response to
an increased likelihood of fraud risk. A total
of 48 auditors from one Big 5 CPA firm were
surveyed regarding the type of audit
procedures they would use in response to an
increased likelihood of material
misstatements caused by fraud. The auditors
were provided with a scenario that reflected
changes in economic and industry factors
that increase audit risk and typically require
a reevaluation of the audit program. They
were asked to make choices as to which tests
of balances and details and analytical
procedures to perform. The results of the
study are summarized and tabulated and
then explained in terms of the tradeoff
between effectiveness and efficiency and
corporate governance.
Users perceptions of various aspects

of Kuwaiti corporate reporting
Kamal Naser, Rana Nuseibeh and
Ahmad Al-Hussaini
Keywords Corporate finances,
Corporate communications, Reports, Kuwait
In this study an attempt is made to provide
empirical evidence on the usefulness of
different aspects of the annual report to
various Kuwaiti user groups. To do so, eight
Kuwaiti user groups were surveyed through
a questionnaire. The groups were individual
investors; institutional investors, bank credit
officers, government officials, financial
analysts, academics, auditors and stock
market brokers. The analyses indicate that
the user groups surveyed in the study rely
mainly on information made directly
available by the company and do not consult
intermediary sources of corporate
information in order to make informative
decisions. The analyses also revealed that
credibility and timeliness are the most
important features of useful corporate
information and traditional financial
statements are the most important and
credible parts of corporate annual reports.
Non-financial information, however, proved
to be less credible and of less importance to
the Kuwaiti user groups.
[ 447 ]
Enronitis dispelling the disease
Gerald Vinten
European Business School, London
Keywords
Corporate governance,
Fraud, Internal control,
Auditing, Boards of directors,
Financial reporting
Abstract
Enron has become less the
name for a company than a
shorthand for mammoth abuse of
financial reporting and corporate
governance of a variety so
egregious as to be almost
unbelievable. Across the world
there is debate in conferences and
regulatory bodies as to whether
Enron can happen in this or that
country. Few if any are so
complacent as to consider that
they are immune from Enronitus.
While America bolts the stable
door after the event, or in the high
likelihood that there will be
another Enron waiting in the
wings, other countries are taking
preventive measures. A
multi-dimensional and
inter-professional approach is
required to combat Enronitus.
Main headings are protecting the
public interest, accounting and
financial reporting, auditing,
corporate governance and
education. Careful integration of
these factors is necessary if there
is to be any discernible impact on
the problem. Complex issues
require complex solutions.

18/6/7 [2003] 448-455
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482597]
[ 448 ]
Introduction
which the boards of major companies carry

out the task of monitoring executive
management (with some such companies
unexpectedly collapsing in recent years).
Fourth, and of increasing future
importance, the shift in most countries from
pay-as-you-go pension schemes (often part of
the state welfare system) to a greater role for
funded pensions is increasing the flow of
funds onto the capital markets, as well as
increasing the risks to the pension holders as
there is a move away from final salary
pension schemes.
Fifth, the globalisation of the economy has
driven the largest companies to access
international capital markets. This has
produced greater risk exposures as one
enters into previously uncharted territory.
Six, abuse and fraud, sometimes on a global
scale, have led to greater awareness of
inadequacies of governance, and demand for
reform, and even entire models of operating
within a country are up for re-evaluation,
such as the role of the chaebol within Korea.
Finally, other conceptions of what
influences should be recognised within
governance systems provide for
accountability to representatives of the
employees or even to the state.
Corporate governance is not a new issue. It

may be dated back to when incorporation
with limited liability became available in the
nineteenth century, with the need for
legislation and regulation. Recently debate
has focused on more specific concerns. These
revolve around the accountability of those in
control of companies to those with the
residual financial interest in corporate
success, normally the shareholders, but
when the company is approaching
insolvency, then also its creditors, as well as
widening discussion to consider
stakeholders. All in the workplace now
operate within such a framework, and this is
the context in which careers are developed
and enhanced internationally.
This focus seems to reflect seven
contemporary developments. First, there is
the economic analysis of corporate law. This
places priority on the efficiency of the
allocation of scarce economic resources
which will be achieved if companies are
accountable to those who take the profit or
bear the loss after all other claims on the
company have been met.
Second, the redistribution of tasks between
the public and the private sectors (through
privatisations, Public Finance Initiatives and
Public Private Partnerships and other
similar devices), and between public and
charitable sector of the economy demands
full public confidence in the manner in
which companies are run and securities
markets are organised. This has also led to
corporate governance concepts entering into
both the public and charitable spheres as all
sectors of the economy co-exist in fluid
interaction and mutual dependence.
Third, issues of public confidence can be
assessed in terms of levels of managerial
remuneration and the effectiveness with
Events in the USA often have global

consequences, and we are still living with the
impact of September 11 (9/11 in American
parlance) as well as Enron, both of which
have entered the global vocabulary as a type
of shorthand. Enrons whistleblower vice
president Sherron Watkins was among
the three Persons of the Year 2003 for
Time magazine, and two other
whistleblowing women also shared this
honour: Cynthia Cooper, vice president for
The Emerald Research Register for this journal is available at

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The current issue and full text archive of this journal is available at
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Enron and aftermath
Gerald Vinten
Enronitis dispelling the
disease
18/6/7 [2003] 448-455
internal audit at WorldCom, and Coleen

Rowley, special agent for the FBI, who
revealed the inadequacies of the FBI relating
to September 11, thus linking our two bits
of shorthand. So two out of three of these
superwomen were connected with
corporate governance infractions of a similar
ilk, with financial reporting having been
contravened.
Considerable soul-searching across the
world followed Enron, with endless debate as
to whether Enron could happen here.
Sometimes the US situation was considered
sufficiently different from that of this or that
country as to indicate lower levels of risk.
However there was a general recognition that
mini-Enrons could well take place elsewhere,
and that complacency was not a suitable
response. The fact that The Netherlands is
currently reeling under its own Enron in
the shape of the retail chain Ahold reinforces
this. Founded in 1887 this company is very
much part of the Dutch landscape. It may be
considered the equivalent to Sainsburys in
the UK. Under the leadership of the now
dismissed chief executive Cees van der
Hoeven, Ahold expanded into the USA,
acquiring the Stop and Shop chain. In 2000,
Ahold purchased US Foodservice, which
markets catering supplies to restaurants,
schools and prisons. After 315 million worth
of inflated profits were discovered over the
past three years the chief executive and
finance director were sacked. The impact on
The Netherlands stock exchange was a 9 per
cent reduction in the value of equities. Since
the overstated profits emerged from the audit
of Foodservice, it has led to mutual
recriminations between the state of
European regulation versus that in the USA.
However Institute of Chartered Accountants
of England and Wales president, Peter
Wyman, has stated that the Ahold scandal
was not helpful to the European regulators
case, which appears inferior to that of
the USA.
The UK Accounting Foundation had only
just been established when Enron hit the
headlines, and had to divert most of its
attention and workload to Enron-related
issues. Since under the review of accounting
regulation and standard setting it was
subsequently abolished as a separate entity,
it means that during its short life it was
effectively an Enron organisation!
The situation was nicely summarised by
Harrington (2003) who calculated that an
otherwise $260 billion profit in the Fortune
500 companies was reduced to $69.6 billion in
2002 through accounting changes, mainly
relating to goodwill in mergers and
acquisitions. She reviews how accounting

made the year 2002 look a lot worse:
We could blame this bleak state of affairs on
any number of scapegoats the sluggish
economy, 2002s sagging stock market, and a
seemingly unending stream of scandals come
to mind. But theres a simpler explanation:
accounting changes. Some of the new rules
have been in the works for years. Others were
accelerated by Enron fallout. Together they
reflect a paradigm shift in the way
corporations report their results.
Exaggeration is out. Conservatism and
cleaned-up financial statements are in.
Recommendations
The factors here enunciated were first set out
in bare outline in Vinten (2002), which also
indicated some of the background to the
debacle, and the immediate response.
Apparently the article was the seventh most
accessed article of all the myriad Emerald
insight articles. The opportunity has been
taken to revise and provide more extensive
explanation to the original listing.
Protecting the public interest

1 State national audit offices across the
world should follow the US General
Accounting Office example of
investigating matters of public interest,
and issuing reports. This means moving
beyond the narrow focus of the public
sector viewed in splendid isolation. Such
extension has occurred already in the
explicit rather than implicit involvement
in value-for-money studies in many
jurisdictions. With the move of former
state industries into the private sector,
state audit has sometimes been retained.
Hence the UK Competition Commission
continues to audit the former
nationalised industries to ensure they are
operating in the public interest, with a
focus on value-for-money which includes
relations with the labour force and trades
unions.
2 Legislation should specify clear and strict
rights of access to relevant agencies for
such information as they reasonably deem
necessary, to avoid the need for them to
initiate legal action on a case-by-case
basis. The model of the UK Audit
Commission should be adopted whereby it
can act in an independent but
quasi-judicial fashion to decide any
challenges to such powers. This will avoid
delaying tactics, and minimise cost.
3 Criminal penalties, large fines and strict
liability will apply to all those implicated
in the shredding or concealment of
documentation. Organisations need to
have policies relating to the retention and
indeed archiving and disposal of
[ 449 ]
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documents in addition to those

established by statute. Bank of Credit and
Commerce International maintained a
double set of documentation, one being
fraudulent. The US federal
Sarbanes-Oxley Act of 2002 contains
stipulations on this.
4 Jurisdictions, the vast majority, which
have not legislated to protect valid acts of
whistleblowing should do so forthwith
(Vinten, 1994a). The Sarbanes-Oxley Act
has section 1107 retaliation against
informers:
Whoever knowingly, with the intent to
retaliate, takes any action harmful to any
person, including interference with the
lawful employment or livelihood of any
person, for providing to a law enforcement
officer any truthful information relating
to the commission or possible commission
of any federal offense, shall be fined under
this title or imprisoned not more than ten
years, or both.
Previously whistleblowing protection

mainly applied to the public sector and
utility companies, but this section now
means that whistleblowing protection is
more universal across all sectors of the
economy, which is the situation in the
UK. Previously the trend was for
legislation to apply mainly to the public
sector, which was unhelpful when it came
to the sort of frauds and financial
irregularities with the capability to create
the most harm.
A more inclusive stakeholder model
should be adopted, rather than the
current minimalist model. All directors
are faced with real, or imagined, conflicts
of interest or competing demands for time
and resources, between shareholders and
stakeholders. This has always been the
case, but the contemporary emphasis on
stakeholders has brought this to a head.
Astute organisations and directors
maintain a suitable balance between the
various demands placed on them, and
there are systematic ways to do this.
Stakeholding is the viable and sustainable
way for companies to proceed. Practical
approaches to discriminating among the
claims of various stakeholders are
perfectly possible (Vinten, 2001).
5 The UK model of the chartered secretary
should be extended world-wide where not
currently present. The chartered
secretary has the following
responsibilities (Lai, 2002; Baker, 2002):
.
the maintenance of the statutory
registers of the company;
.
attendance at board meetings, the
formulation of agendas, taking minutes
of the meeting, preparation of articles
[ 450 ]
.
.
and notices to shareholders, and

ensuring that correct procedures are
followed both at board and general
meetings;
the custody of the company seal; and
the authentication and retention of
documents.
The company secretary, as an officer of

the company, must act in good faith in the
interests of the company and not act for
any collateral person. Conflicts of interest
are to be avoided as are making profits
from dealings for and on behalf of the
company. The secretary is a type of
corporate conscience to keep the act on
the straight and narrow in compliance
with legal and regulatory dictate.
6 The law pertaining to fraud needs to be
consolidated and rationalised (Vinten,
1990). In the UK it is a curious amalgam of
various strands from different periods of
history, but there is no central fraud
statute as such. This can lead to legal
complications and the need to select the
correct statute under which to proceed, or
rely on the common law, as in the notion
of the tax cheat. There would be
considerable advantage in housing all the
stipulations under the one roof. The
allocation of police resources to fraud is
not always as great as its economic
consequences might demand.
7 Pensions and employee savings plans
require more participant education and
safeguards. This is particularly the case
where employees are locked into schemes
in which material amounts are invested in
the employing company or a limited
range. Enron had 41 per cent of its direct
contribution scheme invested in its own
stock (compare Proctor and Gamble 92 per
cent, Anheuser-Busch 83 per cent, Abbott
Laboratories 82 per cent, Pfizer 82 per
cent, McDonalds 74 per cent). It is
difficult for the consumer to be able to
reconcile their pension with their
contribution record, and since
occupational pensions tend to be largely
hidden and unnoticed until the person
retires, they present a high risk area. The
Maxwell Communications Corporation
pension scandal under Robert Maxwell is
a famous example of a pension fund being
raided to the huge detriment of its
members (Vinten, 1993).
8 Regulation needs to be disconnected from
the accounting and auditing profession.
There is too much by way of vested
interests, plus the need to assuage public
perception after the whole array of recent
scandal. The Public Company Accounting
Oversight Board in the USA is an example
established under the Sarbanes-Oxley Act.
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Similar developments are in train in other

parts of the world.
9 Professional ethics need to be a major
emphasis within the accounting and other
relevant professions. They need to have
bite in their enforcement, but equally
important to be internalised in the hearts,
minds and souls of all professionals.
Those working within financial services,
many of whom command ridiculously
inflated salaries for what they do, are
noted for treating professional ethics with
some disdain, and seem to think that the
unsuspecting public owe them an
existence: unsuspecting because their
relationship is often at second hand and
indirect through the likes of pension
funds. The public are simply the fodder for
their high lifestyle and are to be treated
with contempt.
Accounting and financial reporting

10 Principles-based substance over form
should become the norm. However the
proper role for a rules-based approach
needs to be debated and determined. This
is much more than a dry-as-dust
philosophical debate. It is fundamental to
the way accounting is formulated and
executed.
11 The USA as a major player needs to move
more in line with the rest of the world,
with an expedited convergence taking
place. This, indeed, has started to happen,
with more openness to developments
outside the USA, and the global need to be
singing from the same hymn sheet.
12 Three levels of rigour of reporting need to
be established as opposed to the present
two: large, high risk and/or materiality
entities; intermediate companies; small
businesses. Previously there tended to be
concessions only for the small company
sector. One would not suggest the
intermediate category have a lesser
standard than at present, but rather that
the top category have increasing demands
placed on it. The notion of materiality is
often left vague in accounting and
auditing terms. It needs to be made more
specific such that there is transparency
(Vinten, 1994a).
13 With the complexities involved, as in
derivatives and special purpose entities,
the near incomprehensibility of accounts
to many of the stakeholders, and
accountancy itself trying to keep up with
the realities of E-commerce and the
knowledge environment, steps need to be
taken to ensure adequate communication
to users. Issues which impact on risk and
value need to be made explicit.
14 Our more inclusive reporting model
presupposes more qualitative data,
including that on which board and
company performance can be judged.

Indeed qualitative data is vital to interpret
the quantitative data, which rarely speaks
for itself and needs to be placed in context.
Auditing
15 True and fair or fairly present should
mean not just conformity with accounting
principles, but convey adequately the
overall situation. This almost mystical
incantation needs to be taken out of the
realm of set-piece ritual and
individualised to each audit, such that the
reader has some idea of exactly what audit
work has been carried out, including what
has not been done. Readers of audit
reports quite often make unjustifiable
assumptions as to the nature of an audit. If
they were more aware of the truth behind
the audit facade they would be in a
position to pose more penetrating
questions, and uncover areas demanding
further attention.
16 Auditors should adopt a stakeholder
orientation in addition to the current
shareholder one. By stereotype
accountants are not traditionally regarded
as avant-garde in their wish to recognise
wider notions of corporate or professional
liability, and the move to limited liability
partnerships is an example of
circumscribing liability. The 1990 House
of Lords decision in Caparo Industries v.
Dickman (1All ER HL 568) narrowed the
scope of professional third party liability.
In fact the decision has to be differentiated
on the facts of the case, and was concerned
with a restricted situation regarding the
external audit, and the audience for which
it was intended. Case law had arguably
opened the sluice gates too far, and the
audit was determined as being for the
shareholders, rather than the
stakeholders, although this term never
entered into the case.
It remains an unresolved question as to
whether the decision was retrograde, or in
the public interest, but it was not a
decision on corporate governance or the
wider responsibilities of businesses
across the entire scope of their dealings.
Despite the stereotype, accountants are, in
fact, increasingly talking the language of
stakeholding, and the only reason they are
likely to be doing this is because they find
it omnipresent in the business
community. A recent report by the
worlds oldest professional accounting
body indicates how this profession is
trying hard to meet the needs of the
stakeholder economy (Beattie, 1999). It
slips naturally into stakeholder language
as a natural recipient of accounting
information:
[ 451 ]
Stakeholders are aware that the fortunes

of a company can change rapidly and
dramatically and want to know about key
events when they happen. The current
reporting model, grounded in the entity
concept, periodicity, and strict recognition
criteria, appears to be partial and
problematic. A business reporting
expectations gap appears to exist (Beattie,
1999, p. 12).
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17
18
19
20
[ 452 ]
It additionally showed the pace of change

when the major accounting firms of
KPMG, Pricewaterhouse Coopers and
Ernst & Young collaborate in November
1999 to launch the Copenhagen Charter to
present the business case for managing
stakeholder relationships. The Institute of
Social and Ethical Accountability (ISEA),
simultaneous with the Charter, provides
international standards to provide
organisations with a tool by which to
develop high quality systems and
procedures for stakeholder dialogue and
reporting.
All the ramifications of audit
independence need to be assessed and
reported on, as does the detail of how the
external audit has been carried out and
the conclusions drawn. The onus should
be on the auditor to indicate how he/she
has upheld independence in terms of the
threats to it commonly encountered. A
threats and risks based model should be
adopted. Bazerman et al. (2002) indicate
that the problems residing in the external
audit reside less in deliberate corruption
and unethical practice but more in
unconscious bias. These are threefold:
.
ambiguity in the different possibilities
for interpretation;
.
the specific attachment to the company
which hires and can fire; and
.
the audit implicitly endorses or rejects
the accounting judgement of the client
firm.
The rotation issue needs to be addressed
in a balanced fashion, with half-way
solutions, such as partial rotation of staff,
explored. Joint auditing may also be
considered (in Canada large banks require
two auditing firms).
Opinion shopping for external auditors
needs to be discouraged (Lennox, 2003). At
present it is all too easy to manipulate the
situation to obtain the audit outcome
which a company desires. The politics of
the external audit tends to be a closed
book, but there is much that goes on in
secrecy which is unlikely to serve the
public interest.
The role of internal auditing should be
highlighted, possibly made mandatory at
law, and its own independence
guaranteed, with protected external
reporting in the public interest for

matters of concern. Internal control is a
crucial concept. The US Federal Foreign
and Corrupt Practices Act 1977 was said to
have led to an increase in the employment
of internal auditors in the late 1970s. The
Act required a statement in the annual
report and accounts as to how internal
control had been safeguarded. Internal
auditors are significant in this growing
corporate governance framework.
21 The audit committee needs to play a
significant role. In 1987, the Treadway
Report (known as the Report of the
National Commission of Fraudulent
Financial Reporting), offered 11
recommendations to enhance the
effectiveness of audit committees, which
were to be the keystone of corporate
financial governance. These remain a
comprehensive and authoritative list:
.
They should have adequate resources
and authority to discharge their
responsibilities.
.
They should be informed, vigilant, and
effective overseers of the companys
financial reporting process and its
internal control system.
.
They should review managements
evaluation of the independence of the
companys public accountants.
.
They should oversee the quarterly as
well as the annual reporting process.
.
The SEC should mandate the
establishment of an audit committee
composed solely of independent
directors in all public companies.
.
The SEC should require committees to
issue a report describing their
responsibilities and activities during
the year in the companys annual
report to shareholders.
.
A written charter for the committee
should be developed. The full board
should approve, review, and revise it
as necessary.
.
Before the beginning of each year,
audit committees should review
managements plans to engage the
companys independent public
accountant to perform management
advisory services.
.
Management should inform them of
second opinions sought on significant
accounting issues.
.
With top management, the committee
should ensure that internal auditing
involvement in the financial reporting
process is appropriate and properly
co-ordinated with the independent
public accountant.
.
Annually, committees should review
the programme that management
establishes to monitor compliance with
the companys code of ethics.
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Most audit committee chairs commend

the recommendations as having exerted a
positive influence on corporate reporting
and internal controls.
Corporate governance
22 Board members should be properly
inducted, trained and developed.
Originally there was a view that directors
were born not made, reinforced by their
being recruited via the old boys network,
and it being assumed that they were all
good chaps and entirely competent, or that
the role was not that demanding. This was
never satisfactory, and there are now
professional certifications and even
chartered status available via the Institute
of Directors of the UK. Directors need both
induction and mentoring.
23 The pros and cons of different types of
corporate governance need to be explored
and best practice disseminated. Thus the
UK system has a balanced mixture of
types of director, whereas in the US
system the independents predominate.
The UK independents may therefore be
closer to the action. The European two tier
board is also worth exploration over the
prejudice of some in the UK that stick
almost ideology to the Anglo-Saxon model.
24 There needs to be more company
sponsored practical research on
governance, rather than the black box it
often is at present. Directors may have
been reluctant to be exposed to research
and hence greater scrutiny, but practice
created in ignorance is hazardous, and the
opportunity to benchmark and
disseminate good practice is lost.
25 National research agendas need to be
formulated, with central collection and
dissemination of results. This has
happened to a limited extent, but more is
required.
26 Although the Turnbull Report emphasised
risk, one needs to put risk in perspective.
It is not simply a policing matter, but
equally weighing up the risk of missing
opportunities. Risk is endemic in business
and presents opportunity as well as the
possibility of sub-optimal performance or
even disaster. There has been criticism
that the whole series of corporate
governance reports has led to a risk
aversion mentality.
27 Business ethics is a crucial ingredient,
and consideration should be given to
appointing a chief ethics officer, an
ombudsman, or the registrar function as
in the John Lewis partnership. These need
to have independence and a reporting
relationship straight into the board and
access to the chair of the board.
28 Equally crucial is what has been known as
the tone at the top. A board
sub-committee should consider this, or the

audit committee with widened remit take
this issue on board. It is often those at the
top who perpetrate the misdemeanours
with the potential to bring the corporation
to its knees.
29 Institutional investors and organised
shareholder/stakeholder groups should
be permitted a voice in the boardroom.
This happens more in the USA than in
the UK.
30 A diversity of non-executive directors,
outside the old boys network, and with
true independence should be recruited.
An organisation in the UK called ProNed
(Pro Non-Executive Directors) attempted
to widen the audience from which
directors were sought, as has the Institute
of Directors. They sometimes found they
were fighting an uphill battle.
Education
31 Schools should include corporate
governance as part of their citizenship
education. The Commission of the
Speaker of the House of Commons on
Encouraging Citizenship provided a
definition of citizenship which,
incidentally, included whistleblowing
(Stonefrost, 1990):
The challenge to our society in the late
twentieth century is to create conditions
where all who wish can become actively
involved, can understand and participate,
can influence, persuade, campaign and
whistleblow, and in the making of
decisions can work together for the mutual
good.
This is certainly the nearest one came at

this time in the UK to any official
recognition of the value of whistleblowing
and, indeed the attribution of almost a
constitutional role for the activity.
Considerably more positive statements
had already been made in both the USA
and Australia. The Commission reported
on the workings of the honours system,
and even suggested that whistleblowers
might be included in the Honours List.
As to whistleblowing, we all regarded
this as an important part of citizenship.
We had no special problems with this
issue as an element of citizenship
although if there was too much
whistleblowing its effective value could
be drowned by the noise (personal
communication, Maurice F. Stonefrost,
21 September 1990). Four years on,
Stonefrost (1994) indicated that there
had been little discussion of the report,
and its recommendations had remained
largely ignored.
[ 453 ]
Gerald Vinten
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18/6/7 [2003] 448-455
[ 454 ]
32 Higher education should teach elements of

business ethics and corporate governance
as part of all courses. However, there are
problems of obtaining a clear statement of
need even within business studies and
accountancy. Quality Assurance Agency
for Higher Education (2000b) contains the
benchmarking statement for UK
bachelors degrees with honours for
general business and management. These
statements are for guidance and are not
meant to be straitjackets, although they
are sufficiently generalised that
institutions would be unwise to ignore
them, and they will be referred to in
subject reviews both internal and
external. Business ethics, values and
norms come under the heading of
contemporary and pervasive issues
under relevant knowledge and
understanding. Corporate governance is
not mentioned which is extremely
surprising. However these statements are
due for revision in the middle of 2003 and
one hopes the opportunity will be taken to
consider what is needed in the post Enron
situation.
33 Quality Assurance Agency for Higher
Education (2000a) contains the accounting
benchmarking statement. This does
mention accounting and society,
behavioural and sociological perspectives,
and alternative theories, but fails to
mention corporate governance or
professional ethics, which is surprising
almost to the extent of negligence. We are
told that accounting is practised in part
within a professional service context, and
that different universities will have
different relationships with the
requirements of the various professional
accountancy bodies in the UK. Given that
professional ethics is an integral part of
these professional bodies, it is simply
amazing that there is a failure to mention
this. The working parties which
formulated these would have had
available to them a whole series of
statements pertaining to the ethical
component. Thus SEEC (1996) contains an
ethical strand for each of the three levels
of a three year honours degree and for M
(Masters) level under the heading of
ethical understanding. This
concentration on ethics is all the more
remarkable when one realises that this is
a general statement across the entire
curriculum. It is far superior to the
statement for general business and
management and for accounting. The
requirements for ethical understanding
are:
.
Level 1. Awareness of ethical issues in
current area(s) of study. Ability to
discuss these in relation to personal

beliefs and values.
.
Level 2. Awareness of the wider social
and environmental implications of
area(s) of study. Ability to debate
issues in relation to more general
ethical perspectives.
.
Level 3. Awareness of personal
responsibility and professional codes
of conduct. Ability to incorporate a
critical ethical dimension into a major
piece of work.
.
Level M. Awareness of ethical
dilemmas likely to arise in research
and professional practice. An ability to
formulate solutions in dialogue with
peers, clients, mentors and others.
34 Business courses should place more
emphasis on risk and fraud, rather than
pretending that fraud never takes place.
Some companies are established with
fraud as their main intent, including the
laundering of money. Others are the
product of illegal funds, although in
themselves operate as legitimate
businesses. The remaining majority of
businesses operate with varying degrees
of noble intent, and if they survive long
enough or are of sufficient size are highly
likely to suffer fraud. Quality Assurance
Agency for Higher Education (2000a)
mentions risk but not fraud. An
instructive story relates to the MBA
examination at the City University
Business School (now the Cass Business
School) over a decade ago. A case study
was set for the business strategy
examination. Students had this in
advance for any analysis they wished to
conduct in advance. In the event the usual
tools of business strategy were applied by
the students. Only one got close to the
truth of the situation and what was
needed to improve the situation. Behind
all the facts and figures was a gigantic
fraud. The company produced a sucrose
drink called Tizer the Appetizer in its
promotional mode. It was bottled and sold
off the back of lorrys which traversed
townships. Initially the delivery staff, the
sales people (in reality glorified lorry
drivers), found that if they defrauded on
the deliveries, no management action was
taken. This then led to the foundation of
an alternative bottling line which was
purely for the benefit of the fraudsters.
With this twin-track fraud, it was not
surprising that the company was
experiencing liquidity problems. It was
eventually taken over for a song by Barr
Brothers of Glasgow who stripped out the
cancerous fraud in the process. Had the
students been schooled with more fraud
awareness, they may have come closer to
offering the sort of solution that was
Gerald Vinten
disease
called for, and which all the lovely

corporate strategy tools were otiose to
save the company.

18/6/7 [2003] 448-455
Epilogue
With the common issues impacting on the
economy, and the globalisation of business,
corporate governance, a term virtually
unknown 20 years ago, has now entered into
world currency. The contexts may differ. For
example, there is no parallel for the sokaiya
in Japan, specialists at disrupting AGMs, and
often related to the yakuza gangs, although
their influence has become reduced with the
criminalisation of paying protection money
to them, and the difficulty of them coping
with all the business with AGMs being held
on the same day. Despite the differing
contexts, the core issues sound familiar, and
this accounts for the world ambience of the
Cadbury Report.
Much of the need to encourage firm
corporate governance hangs on the supply of
suitable management, director, shareholder
and perchance stakeholder information. It is
recognised that corporations adopt a risky
strategy if they rely on the unpredictable
revelations of whistleblowers as a control
device, although it is a suitable control
device to encourage and reward internal
whistleblowing, and recognise this as a
natural part of any corporate governance
system.
A multi-faceted and global response is
required. This is complex when all the above
considerations need to be considered and in
place. There are so many variables involved
that weaknesses in any one link of the chain
may lead to breakage. Constant vigilance
from all concerned is vital.
This themed edition of the Managerial
Auditing Journal is one of many initiatives to
try to bring about improvement. Collected
within this double volume are contributions
from across the world on a range of
approaches and ideas which together may
minimise the risk of future Enrons and
hopefully provide some kind of antidote to
Enronitus, a pernicious inflammatory viral
infection which infects the very sinews and
tissues of an organisation with the potential
to be incurable, and bring about the fatality
of an organisation and all the resources,
human and material, within it.
References
Association of Business Schools (1997), Guidelines
for the Master of Business Administration
Degree (MBA), ABS, London.
Baker, M. (2002), Company Secretarys Checklists,
Tolley, Croydon.
Bazerman, M.H., Loewenstein, G. and Moore,
D.A. (2002), Why good accountants do bad
audits, Harvard Business Review, Vol. 8
No. 11, pp. 97-102.
Beattie, V. (Ed.) (1999), Business Reporting: The
Inevitable Change?, Institute of Chartered
Accountants of Scotland, Edinburgh.
Harrington, A. (2003) Honey, I shrunk the
profits, Fortune, European Edition, Vol. 147
No. 7, pp. 85-7.
Lai, J. (2002), Company Secretarys Handbook
2002-2003, 12th ed., Tolley, Croydon.
Lennox, C. (2003), Opinion Shopping and the Role of
Audit Committees when Audit Firms are
Dismissed: The US Experience, Institute of
Chartered Accountants of Scotland, Edinburgh.
Quality Assurance Agency for Higher Education
(2000a), Accounting, QAA, Gloucester.
Quality Assurance Agency for Higher
Education (2000b), General and Business
Management, QAA, Gloucester.
SEEC (1996), Guidelines on Levels and Generic
Level Descriptor, South East England
Consortium for Credit Accumulation and
Transfer, London.
Stonefrost, M.F. (1990), Encouraging Citizenship.
Report of Commission on Citizenship, HMSO,
London.
Stonefrost, M.F. (1994), Citizenship: in need of
care and attention, Public Money and
Management, October-December, pp. 258.
Vinten, G. (1990), Ethics, law and computer,
Managerial Auditing Journal, Vol. 5 No. 4,
pp. 5-11.
Vinten, G. (1993), The Maxwell interview,
pp. 22-4.
Vinten, G. (Ed.) (1994a), Whistleblowing
Subversion or Corporate Citizenship?,
Sage Publishers, London, and St Martins
Press, New York, NY.
Vinten, G. (1994b), Materiality and risk: the
babel of auditing?, Certified Accountant,
February, pp. 6.
Vinten, G. (2001), Shareholder versus
stakeholder is there a governance
dilemma?, Corporate Governance. An
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Vol. 2 No. 4, pp. 4-9.
[ 455 ]
An exploratory study of adopting requirements for

audit committees for non-US commercial bank
registrants: an empirical analysis of foreign equity
investment
Louis Braiotta, Jr
School of Management, State University of New York, Binghamton,
New York, USA
Keywords
Audit committees,
Boards of directors,
Abstract
This study examines whether the
presence of audit committees for
US commercial bank registrants
(SEC Form 10-K filers)
significantly affects the likelihood
of adoption by certain non-US
commercial bank registrants (SEC
Form 20-F filers). Results of a
logistic regression analysis of 31
US commercial bank registrants
with audit committees and 31
non-US commercial bank
registrants without audit
committees suggest that demand
for oversight protection in the
sample non-US commercial banks
is more likely to increase as the
total market capitalization (size)
increases. Additionally, this paper
investigates whether the presence
of audit committees for non-US
commercial bank registrants
(Form 20-F filers) increases their
transparency with a concomitant
effect on infusion of foreign equity
investment. Results of a logistic
regression analysis suggest that
the presence of audit committees
does not significantly affect the
likelihood of an increase in the
banks American depository
receipts.

18/6/7 [2003] 456-464
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482605]
[ 456 ]
I. Introduction
This study empirically examines the relation
between market capitalization (demand for
oversight protection) of US commercial bank
registrants[1] (SEC Form 10-K filers) with
audit committees and market capitalization
of certain non-US commercial bank
registrants (SEC Form 20-F filers) without
audit committees[2]. In contrast to the legal
requirement for audit committees in the
USA, this paper argues that this inconsistent
requirement produces a high risk premium
for price protection to investors, i.e. non-US
commercial bank registrants are more likely
to establish audit committees because of the
movement toward globalization of capital
markets. Additionally, this paper
investigates whether the presence of audit
committees (oversight protection) for non-US
commercial bank registrants increases their
transparency with a concomitant effect on
infusion of foreign equity investment.
Although the benefits of audit committees in
the corporate governance context have been
recognized, the establishment of audit
committees to attract foreign equity
investment remains a controversial issue[3].
This study is important because investors
should be afforded equal oversight protection
with respect to a reliable financial reporting
process and an efficient global securities
marketplace. The lack of consistent
requirements for audit committees allows
cross-sectional examination of differences in
the aforementioned banks that are within the
same industry, similar in size, and test
period. Recent initiatives to develop
harmonized international accounting and
auditing standards reinforce the need to
achieve uniformity in requirements for audit
committees to ensure oversight protection to
investors. More recently, the International
Auditing Practices Committee (1998, p. 1)

recognized:
. . . the auditors responsibility to
communicate matters of corporate
governance interest, arising from the audit of
financial statements, to those charged with
governance of an entity.
The committee (1998, p. 6) notes that:

It is becoming an increasing practice to form
audit committees of the board to assist in the
governance responsibilities with respect to
financial reporting.
Similarly, the Public Oversight Board has

endorsed a corporate governance approach to
the audit process to enable boards of
directors and their audit committees to be
better informed about the quality of financial
reporting (Kirk, 1996)[4]. Indeed, boards of
directors through their independent audit
committees (non-executive directors) can
more effectively discharge their financial
and fiduciary responsibilities to
shareholders. Powell et al. (1992, p. 220) point
out:
As the worldwide financial market expands
and more companies cross national borders to
become listed on major stock exchanges,
major markets will seek consistent reporting
requirements, and audit committee
requirements may tend to become more
consistent across individual markets[5].
To date, existing empirical research in an

agency theory context provides evidence
about the importance of creating audit
committees. Pincus et al. (1989) provide
empirical evidence that situations of high
agency costs were significant factors in the
creation of audit committees. They concluded
that the presence of audit committees:
. . . enhance the quality of information flows
between principal and agent (Pincus et al.,
1989, p. 265).
Louis Braiotta, Jr
An exploratory study of
adopting requirements for
audit committees for non-US
commercial bank registrants:
an empirical analysis of
foreign equity investment
18/6/7 [2003] 456-464
Similarly, in the UK, Collier (1993, p. 428)

concluded:
. . . the number of shareholders support the
contention that the incentive to form an audit
committee increases in line with the potential
agency cost of equity.
Although these two studies examined the

creation of audit committees within a
country, Braiotta (1998, p. 179) investigated
the market capitalization of the stock
exchange(s) with and without audit
committees in 25 countries and concluded
that:
. . . the empirical evidence suggests that
oversight protection is more likely driven by
the effects of increases in total market
capitalization (size).
Because the current mandate for the

establishment of audit committees is
inconsistent among non-US commercial bank
registrants and consistent among US
commercial bank registrants, this study
examines the annual market capitalization
as the primary variable of interest to
estimate the likelihood of the presence of
audit committees in the sample non-US
commercial banks without audit committees.
Fiscal years 1996 and 1997 were selected
because of the gravity toward a global
securities marketplace (International
Federation of Accountants, 1995) along with
access to recent available data.
In addition to the aforementioned
empirical research, researchers (Mautz and
Neumann, 1970; 1977; Tricker, 1978; Birkett,
1986; Braiotta, 1986; Marrian, 1988; English,
1989; Spangler and Braiotta, 1990; Bull, 1991;
Knapp, 1991; Porter and Gendall, 1992;
Verschoor, 1993; Kalbers and Fogarty, 1993;
Braiotta, 1994) have examined the role,
responsibilities, and the primary
determinants of the audit committees
effectiveness, such as independence and
active oversight of the financial reporting
process. Indeed, researchers have concluded
that vigilant audit committees help engender
a high degree of integrity in both the audit
processes and financial reporting
disclosures. While these studies support the
proposition that effective independent
oversight protection helps to ensure a
reliable financial reporting system and in
turn, an efficient international capital
marketplace, none has examined the issue of
whether the demand for oversight protection
is likely to differ between US commercial
bank registrants and non-US commercial
bank registrants. Additionally, none of the
above studies has examined the issue of
whether the demand for oversight protection
is likely to differ among non-US commercial
bank registrants with audit committees and

those registrants without audit committees.
During the first phase of this study, a
logistic regression analysis is used to
estimate the likelihood of the presence of
audit committees (oversight protection)
based on the observed differences in the book
values of total assets, total equity, and total
market value of equity between 31 US
commercial bank registrants and 31 non-US
commercial bank registrants that are similar
in size and within the same industry. In the
second phase, a logistic regression analysis is
used to test the hypothesis that the demand
for oversight protection based on market
capitalization is more likely to increase for
non-US commercial bank registrants without
audit committees compared to non-US
commercial banks with audit committees.
Additionally, a logistic regression model is
used to test the hypothesis that non-US
commercial bank registrants without audit
committees are less likely to have the same
level of American depository receipts than
non-US commercial bank registrants with
audit committees.
With respect to the first phase of the study,
results of a logistic regression analysis of the
aforementioned sampled banks suggest that
demand for oversight protection in the
non-US commercial banks is more likely to
increase as the total market capitalization
(size) increases. In the second phase, results
of logistic regression suggest that the
presence of audit committees does not
significantly affect the likelihood of an
increase in the banks American depository
receipts. This paper contributes to the extant
literature by estimating the requirements for
audit committees for non-US commercial
bank registrants and testing whether the
presence of audit committees significantly
effects the likelihood of attracting foreign
equity investments (American depository
receipts).
The remainder of this paper is organized as
follows: Section II provides the theory and
hypotheses development. Section III
describes the sample selection and Section IV
discusses the research design and empirical
results. Section V concludes the paper.
II. Theory and hypothesis

development
Prior research has examined audit
committees drawing upon the concepts from
legal theory and agency theory in the context
of enhanced corporate governance. For
example, Sommer (1978), ABA (1994), ALI
(1994), Braiotta (1994) argue that
[ 457 ]
Louis Braiotta, Jr
18/6/7 [2003] 456-464
establishment of audit committees is in

response to the investing publics increased
demand for corporate accountability through
effective oversight of both the audit processes
and financial reporting process. This stream
of legal research has recognized that boards
of directors through their audit committees
can effectively discharge their legal fiduciary
responsibilities to the stockholders. To the
extent that audit committees help boards
discharge their financial and fiduciary
responsibilities, shareholders and potential
investors are afforded a reliable financial
reporting system which, in turn, helps to
ensure an efficient global securities
marketplace. Thus, because boards and their
standing committees have a statutory duty of
care and loyalty in their fiduciary capacity
with the corporation (New York Business
Corporation Law, 1963), the investing public
is afforded oversight protection which helps
minimize a high risk premium for price
protection. Moreover, the fiduciary
responsibility of boards of directors in other
countries is definitively established (Fogarty,
1965). The universal acceptance of the
fiduciary principle and the boards
stewardship accountability to shareholders
serves as a normative model of corporate
oversight protection for investors. Cook
(1993, p. 43) notes:
These committees add considerable value to
the quality and credibility of our financial
reporting process. Their oversight of auditing
functions and of a companys internal control
system helps to protect shareholder interests
by keeping business on the straight and
narrow.
Ceteris paribus, these arguments suggest that

national stock exchange(s) are more likely to
adopt audit committees to increase
transparency in their member firms as well
as help minimize litigation risk.
In the context of agency theory (Jensen
and Meckling, 1976) which is a descriptive
theory of agency costs (e.g. internal and
external audit costs) produced by the
inherent conflict of interests between
owners (principals) and management
(agents), researchers (Watts, 1977; Leftwich
et al., 1981) present evidence that the quality
of external reporting and related auditing
process can reduce agency costs. Pincus et
al. (1989, USA) and Collier (1993, UK)
investigated the voluntary formation of
audit committees using agency theory and
found evidence that suggests firms with
high agency costs will voluntarily form
audit committees to ensure the quality of
audit processes and financial reporting
disclosures. This second stream of research
suggests that as the number of stockholders
[ 458 ]
increases, the motivation to establish audit

committees increases because of the risk of
greater conflicts of interest between
principals and agents. Ceteris paribus, these
arguments suggest that the formation of
audit committees is responsive to the
investing publics demand for oversight
protection. Hence, the aforementioned
discussion advances the following
hypotheses (stated in the alternative form):
H1. The demand for oversight protection
based on market capitalization (size) is
more likely to increase for non-US
commercial bank registrants without
audit committees compared to US
commercial bank registrants with
audit committees.
H2. The demand for oversight protection
based on market capitalization (size) is
more likely to increase for non-US
commercial bank registrants without
audit committees compared to non-US
commercial bank registrants with
audit committees.
H3. Non-US commercial bank registrants
without audit committees are less
likely to have the same level of ADR
activity than non-US commercial
banks with audit committees.
III. Sample selection and

description
Sample selection
During the first phase of the sample selection
process, the sample consists of 31 US
commercial bank registrants with audit
committees (SIC code 6021) and 31 non-US
committees (SIC code 6029) matched by total
assets in US currency for fiscal years ended
31 December 1996 and 1997[6]. Banks
satisfying the three following criteria are
included in the sample:
1 The annual SEC Form 10-K reports and
SEC Form 20-F reports are available from
the CD-disclosure data base.
2 The market values of equity are available
from disclosures global sccess and
Datastream data bases.
3 The market values of the American
depository receipts are available from
Compustats annual bank tape and
Datastream data bases.
The final choice-based sample of 31 non-US
committees is based on the number of SEC
Form 20-F filings for the above test periods.
In the second phase, the sample consists of 46
non-US commercial bank registrants which
Louis Braiotta, Jr
18/6/7 [2003] 456-464
filed SEC Form 20-F in the aforementioned

sample period. Of the 46 banks, 15 (33 per
cent) represent non-US commercial bank
registrants with audit committees because of
the authoritative literature as shown in the
Appendix. Panel A in Table I and panel B in
Table II provide descriptive statistics for
both the univariate tests and multivariate
test of the hypotheses in the first and second
phases of the study.
IV. Empirical results

Univariate tests
Tables I and II provide summary descriptive
statistics for the independent variables used
to test the aforementioned hypotheses. Panel

A in Table I compares variables for US
commercial bank registrants with audit
committees and non-US commercial bank
registrants without audit committees[7],
while Panel B in Table II compares non-US
commercial bank registrants with and
without audit committees[8]. As reported in
panel A, the difference in mean market value
of equity is statistically insignificant over the
sample period (p = 0.16). Similarly, the
Wilcoxon Z statistic (z = 0.07) reveals no
significant difference at conventional levels
of significance. This result suggests that the
demand for oversight protection associated
with US commercial bank registrants with
audit committees is not significantly
Table I
Panel A: Distribution of means and standard deviations and comparison of US commercial banks
with audit
Variablea
1996
BVA
BVE
MVE
1997
BVA
BVE
MVE
US commercial banks with

audit committees (n = 31)
Mean
Std. dev.
Non-US commercial banks wihtout

Mean
Std. dev.
Between sample banks

t-test
Wilcoxon Z-value
4.122
3.025
3.327
0.989
0.909
0.969
4.081
2.599
2.949
0.909
1.260
1.130
0.172
1.504
1.426
0.38
1.72
1.34
4.196
3.101
3.540
0.988
0.917
0.966
4.141
2.611
3.057
0.925
1.188
1.161
0.225
1.786
1.799
0.39
1.99
1.80
Notes: Paired t-tests for means and Wilcoxon z-values were computed and no statistically significant differences
were found; a All means and standard deviations are stated in log $ millions. Each variable is defined as follows:
BVA = The natural logarithm of the book value of total assets at the end of fiscal years 1996 and 1997;
BVE = The natural logarithm of the book value of common equity at the end of fiscal years 1996 and 1997;
MVE = The natural logarithm of the market value of common equity at the end of fiscal year 1997 and 1997; and
ADR = For panel B, the natural logarithm of the market value of American Depository Receipts at the end of fiscal
years 1996 and 1997
Table II
Panel B: Distribution of means and standard deviations and comparison of non-US commercial
banks with and wihout audit commitees
Variablea
US commercial banks with

Mean
Std. dev.
Non-US commercial banks wihtout

Mean
Std. dev.
Between sample banks

t-test
Wilcoxon Z-value
1996
BVA
BVE
MVE
ADR
4.830
3.703
3.639
3.700
0.841
0.423
1.241
0.784
4.081
2.599
2.949
3.089
0.909
1.260
1.130
0.917
2.67**
3.17***
1.88
2.01**
2.91**
3.08**
2.89
1.48*
1997
BVA
BVE
MVE
ADR
4.864
3.726
3.759
3.624
0.833
0.419
1.250
1.009
4.141
2.611
3.057
3.208
0.925
1.188
1.161
0.913
2.50**
3.38***
1.87
1.32**
2.76**
3.30**
2.96
1.48
Notes: a see Table I; Model chi-square = 15.748, d.f. 3, p = 0.0013; *, ** Statistically significant at less than
the 0.05, 0.01 level, based on two-sided tests
[ 459 ]
Louis Braiotta, Jr
18/6/7 [2003] 456-464
different for non-US commercial bank

registrants without audit committees. This
finding is consistent with the arguments
presented in the theory section and
consistent with H1.
As shown in Panel B, there is no significant
difference in the mean market value of equity
reported by the non-US commercial bank
registrants with and without audit
committees (p = 0.07). The z-value reveals no
significant difference in these proportions.
However, the univariate tests reveal an
association between the independent
variable (ADR) and banks with and without
audit committees, indicating the need for
multivariate tests. As noted in panel A, the
insignificant differences in the MVE
variables suggest that the demand for equal
oversight protection is strengthened. This
finding is consistent with H2 on a univariate
basis.
Multivariate tests
The following logistic regression model was
used to estimate the likelihood of the
presence of audit committees (oversight
protection) with respect to non-US
committees (see panel A of Table III):
AUDCOMMit B0 B1 logBVAit
B2 logBVEit B3 logMVEit Eit ;
V. Conclusions
1
where it = banks and years; AUDCOMMit =

0/1 dummy variable set to one if the bank has
an audit committee; log(BVAit) = natural
logarithm of the book value of total assets at
the end of fiscal years 1996 and 1997;
log(BVEit) = natural logarithm of the book
value of total equity at the end of fiscal years
1996 and 1997; log(MVEit) = natural logarithm
of the market value of common equity at the
end of fiscal years 1996 and 1997; and E = the
residual.
Panel A and panel B of Table III summarize
the logistic regression results for the sample
periods. In order to test H3, American
depository receipts (ADRs) are included in
the aforementioned logistic regression model
as an independent variable. This variable is
included to determine whether the presence
of audit committees could explain the
difference between non-US commercial bank
registrants with and without audit
committees and their related levels of ADRs.
This regression test provides insight on the
effect of audit committees on the banks
ability to attract foreign equity investment.
As predicted, the coefficient for the MVE
variable (size) is positive and significant at
the level p = 0.02. This variable indicates that
oversight protection is more likely to
[ 460 ]
increase as the total market capitalization

increases. This result is consistent with H1
on a univariate basis. While the coefficient of
the MVE variable in panel B is positive, it is
not significant (p = 0.45) because of the small
sample size of 15 non-US commercial banks
with audit committees. This result is not
consistent with H2 on a univariate basis.
The sign of the ADR coefficient is negative
and insignificant (p-value = 0.20), suggesting
that the presence of audit committees has no
significant effect on the likelihood of higher
levels of ADRs. Thus, the results are not
consistent with H3. As noted above, this
finding is likely affected by noting the small
sample size of 15 non-US commercial banks
with audit committees and 31 non-US
commercial banks without audit
committees[9].
The other independent variables, BVA and
BVE are not significant at conventional
levels. This result is not surprising since
there is not a great deal of variation between
the non-US banks with and without audit
committees. This result suggests that the
argument for equal oversight protection is
strengthened.
This study empirically examines the

question of whether the demand for equal
oversight protection from the investing
public through the adoption of audit
committees for US commercial bank
registrants affects non-US commercial bank
registrants without audit committees. The
evidence suggests that there is no difference
in the mean demand for oversight protection
between the aforementioned banks. The
logistic regression results indicate that the
market value of equity (size) is a predictor of
oversight protection. The results of the
multivariate test also indicate that the
presence of audit committees is less likely to
attract foreign equity investment; however,
the mean differences in the ADRs between
the non-US banks with audit committees and
non-US banks without audit committees are
statistically significant on a univariate basis.
While results reported in this study
provide empirical evidence for the formation
of audit committees by certain non-US
commercial bank registrants, additional
research is necessary to determine the
likelihood of attracting foreign equity
investment through the formation of audit
committees. Given a changing global
securities marketplace and demands from
the investing public for increased corporate
governance and accountability, future
Louis Braiotta, Jr
18/6/7 [2003] 456-464
Table III
Logistic regression results between the dichotomous dependent variable audit committees and
the independent variables
Term
Variable
Coefficients
t-statistics
Panel A: US commercial banks with audit committees and non-US commercial banks without audit committees
AUDCOMMit B0 B1 logBVAit B2 logBVEit B3 logMVEit it
Model 2 = 9.324; df = 3; p = 0.0253
1996 (n = 31)
B0
Intercept
1.932
1.75
B1
log (BVA)
2.450
4.31**
B2
log (BVE)
1.108
1.63
B3
log (MVE)
1.582
2.15*
Model 2 = 15.748; df = 3; p = 0.0013
1997 (n = 31)
B0
Intercept
1.966
1.88
B1
log (BVA)
3.635
7.91**
B2
log (BVE)
1.050
1.45
B3
log (MVE)
3.026
4.808*
Panel B: Non-US commercial banks with audit committees (n = 15) and non-US commercial banks without audit
committees (n = 31)
AUDCOMMit B0 B1 logBVAit B2 logBVEit B3 logMVEit B4 logADRit it
Model 2 = 17.697; df = 4; p = 0.0014
1997
B0
Intercept
9.726
3.30*
B1
log (BVA)
1.847
0.56
B2
log (BVE)
1.340
0.73
B3
log (MVE)
0.884
0.10
B4
log (ADR)
2.112
1.02
Model 2 = 22.270; df = 4; p = 0.0002
1996
B00
Intercept
10.837
4.68
B11
log (BVA)
1.891
0.21
B22
log (BVE)
3.761
1.54
B33
log (MVE)
3.347
0.55
B44
log (ADR)
1.861
1.62
Notes: *, ** Statistically significant at less than the 0.05, 0.01 level, based on two-sided tests
research is needed about the processes
associated with the formation of audit
committees and transparency in the
securities marketplace with a concomitant
effect on attracting foreign equity
investment.
Notes
1 In 1991 the US Congress passed the Federal
Deposit Insurance Corporation Improvement
Act which requires insured depository
institutions (total assets of $150 million or
more) to establish independent audit
committees. In addition, both the New York
Stock Exchange (1983) and the National
Association of Securities Dealers (1987)
require their domestic listed companies to
maintain audit committees.
2 In this study, the presence of audit committees
is used as a proxy variable for oversight
protection.
3 To date, a number of stock exchanges(s) have
adopted audit committees to increase
transparency and corporate governance of

their member firms (see Appendix). Whether
this requirement for audit committees has led
to an increase in attracting foreign equity
investment is not well established. This study
addresses the claims of proponents that the
stock exchanges listing requirement for audit
committees significantly affects the likelihood
of receiving significantly higher percentages
of foreign equity investment than banks
without audit committees. For example, a
number of stock exchanges have recently
amended their listing requirements in order
to establish audit committees (e.g. Kuala
Lumpur Stock Exchange, 1995; Hong Kong
Stock Exchange, 1998; Stock Exchange of
Thailand, 1999).
4 The Blue Ribbon Committee on Improving the
Effectiveness of Corporate Audit Committees
(1999, p. 31) recommends that the listing rules
for both the New York Stock Exchange and the
National Association of Securities Dealers
require that the audit committee charter for
[ 461 ]
Louis Braiotta, Jr

18/6/7 [2003] 456-464
[ 462 ]
every company specify that the outside

auditor is ultimately accountable to the board
of directors and the audit committee, as
representatives of shareholders.
Powell et al. (1992) found in their
cross-cultural study of international
professionalism in the practice of internal
auditing by members of the Institute of
Internal Auditors wide adherence to the
Internal Auditing Standards promulgated by
the Institute. Additionally, the International
Task Force on Corporate Governance
concluded: Given the development of the
global market, the inevitable expansion of
screen-based information and growth of
cross-border investment activity, corporate
behavior is coming under the scrutiny of an
increasingly large number of interested
parties. We can discern from our research that
the practice of other jurisdictions has clearly
brought about a natural process of
convergence. Examples include the
development of audit committees, first in the
USA and Canada and now common-place in
the UK, and being considered in Germany.
(International Task Force on Corporate
Governance, 1995, pp. 9-10).
In this study, the non-US commercial bank
registrants are the largest publicly traded
foreign banks in the USA. Total assets were
$3,851 billion ($4,353 billion) for 1996 (1997).
The data indicate a wide range of bank size
with BVA of $3.7 billion ($4.6 billion) at the
25th percentile compared to $61.1 billion ($72.3
billion) at the 75th percentile of the
distribution for 1996 (1997). The range
associated with BVE and MVE also reveals
substantial cross-sectional variation in bank
size (n = 62: 31 with and 31 without audit
committees).
The data also indicate a wide range of bank
size with BVA of $4.1 billion ($4.8 billion) at
the 25th percentile compared to $125.9 billion
($147.0 billion) at the 75th percentile. The
range associated with the other independent
variables reveals substantial cross-sectional
variation in bank size (n = 46: 15 with and 31
without audit committees).
To consider the possible significance of the
presence of audit committees and level of
ADRs in the sample banks, a sub-sample of 15
matched non-US commercial banks without
audit committees are compared to 15 non-US
commercial banks with audit committees. The
logistic regression model for the sub-sample
banks (n = 30) is shown in panel B in Table III.
Logistic regression analysis (not reported)
indicates that the presence of audit
committees does not have a significant effect
on the likelihood of higher levels of ADRs. As
noted previously, the results are likely
affected by the relatively small sample size.
Additionally, the sample was sub-divided
based on more than the median market value
of equity. The logistic regression results (not
separately reported) indicate that the presence

of audit committees does not have a
significant effect on higher levels of ADRs.
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Vol. 12, Spring, pp. 24-49.
Louis Braiotta, Jr
18/6/7 [2003] 456-464
The author wishes to thank

the conference participants
at the 1999 Asian-Pacific
International Accounting
Issues Conference in
Melbourne, Australia; the
2000 AAA annual mid-year
International Section
meeting in Tampa, FL; and
the 2000 AAA annual
Northeast meeting in
Boston, MA for their useful
comments on this paper.
Kirk, D.J. (1996), How directors and auditors can

improve corporate governance, Journal of
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Knapp, M.C. (1991), Factors that audit committee
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(1981), Voluntary corporate disclosure: the
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McKinneys Consolidated Laws of New York
Annotated, sec. 717, Edward Thompson
Company, Brooklyn, NY.
Marrian, I.F.Y. (1988), Audit Committees, The
Institute of Chartered Accountants of
Scotland, Edinburgh.
Mautz, R.K. and Neumann, F.L. (1970), Corporate
Audit Committees, University of Illinois,
Urbana, IL.
Mautz, R.K. and Neumann, F.L. (1977), Corporate
Audit Committees: Policies and Practices,
Ernst & Ernst, New York, NY.
National Association of Securities Dealers (1987),
NASD Manual, Commerce Clearing House,
Chicago, IL.
New York Stock Exchange (1983), Corporate
responsibility: audit committee, sec. 303.00,
New York Stock Exchange Listed Company
Manual, NYSE, New York, NY.
Pincus, K., Rusbarsky, M. and Wong, J. (1989),
Voluntary formation of corporate audit
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of Accounting and Public Policy, Vol. 8,
pp. 239-65.
Porter, B.A. and Gendall, P.J. (1992), The

potential contribution of audit committees to
securing responsible corporate governance
and reliable external financial reporting,
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Conference on International Accounting
Issues.
Powell, N.C., Strickland, S. and Burnaby, P.A.
(1992), Internal auditing: the emergence of an
international profession, Journal of
International Accounting Auditing &
Taxation, Vol. 1, pp. 209-28.
Sommer, A.A. (1978), The impact of the SEC on
corporate governance, Law and
Contemporary Problems, Vol. 41, pp. 115-16.
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Leadership and corporate audit committee
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statements, a product of the market and
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Management, Vol. 2, pp. 53-75.
Further reading
Vinten, G. (1993), Audit committees and
corporate control, Managerial Auditing
Journal, Vol. 8, pp. 11-24.
(The Appendix appears overleaf.)
[ 463 ]
Louis Braiotta, Jr
18/6/7 [2003] 456-464
Appendix
Table AI
Summary of requirements and/or recommendations for audit committees of companies listed on
stock exchanges by country
Country
Reference
Australia
Working Group on Corporate Practices and Conduct (Borsch Committee), Corporate

Practices and Conduct, 1990
The Bank Act; The Trust and Loan Companies Act, and the Insurance Company Act,
1992, Canadian Business Corporation Act 1975, Commission to Study the Publics
Expectations of Audits (MacDonald Commission) 1988, Canadian Securities
Administrators Notice on Audit Committees 1990, Auditing and Related Service
Guidelines, Commission with Audit Committees, 1991
1995 Vienot Report on Corporate Governance
Hong Kong Society of CPAs and The Stock Exchange of Hong Kong, Amendments to
Appendix 14 of its Listing Rules, May 1998
Confederation of Indian Industry, Desirable Corporate Governance in India, A Code,
Recommendation No. 8, 1997
Israeli Companies Ordinance (New Version) 5743-1983, Section 96-15
Kuala Lumpur Stock Exchange 1995 and Companies Act 1995
1995 Peters Report on Corporate Governance
Institute of Directors 1992 Draft Code of Practice for Boards of Directors
Ministry of Commerce (for joint stock companies) Regulations 1994
Companies Act of 1989
Johananburg Stock Exchange Listed Companies Manual, 1989. King Committee Report
on Corporate Governance, Code of Corporate Practices and Conduct, 1994
Stock Exchange of Thailand 1999
Recommendations of a Working Party Established by the Institute of Chartered
Accountants of Scotland, Corporate Governance Directors Responsibilities for
Financial Statements, 1992. The committee on the Financial Aspects of Corporate
Governance, The Code of Best Practice (Cadbury Committee) 1992. Statement of
Auditing Standards 610 Reports to Directors of Management, 1995
American Law Institute, Principles of Corporate Governance: Analysis and
Recommendations, 1994
American Stock Exchange Guide, Vol. 2, Sec. 121, 1993
FDIC Improvement Act of 1991 (FDIC Improvement Act is contained in Title 1 of Public
Law 102-242, December 19, 1991).
Connecticut General Statutes, Sec. 33-318 (b) (1) and (b) (2)
Statement on Auditing Standards No. 61 Communication with Audit Committees,
1988
COSO Report Internal Control Integrated Framework 1992
National Association of Securities Dealers, NASD Manual, Part III, Section (d) of
Schedule D of the NASD bylaws, 1987
New York Stock Exchange Listed Company, 1993
Public Oversight Board, A Special Report by the Public Oversight Board of the SEC
Practice Section, AICPA, 1993
Report of the National Commission on Fraudulent Financial Reporting (Treadway
Commission) 1987
Statement on Internal Auditing Standards No. 7, Communication with the Board of
Directors 1989
US Federal Sentencing Commission, Federal Sentencing Guidelines for Organizations,
1991
Canada
France
Hong Kong
India
Israel
Malaysia
The Netherlands
New Zealand
Saudi Arabia
Singapore
South Africa
Thailand
UK
USA
[ 464 ]
Developing a strategic internal audit-human resource

management relationship: a model and survey
MaryAnne M. Hyland
School of Business, Adelphi University, Garden City, New York, USA
Daniel A. Verreault
School of Business, Adelphi University, Garden City, New York, USA
Keywords
Internal auditing,
Human resources management,
Risk management
Abstract
Presents a model for analyzing the
potential for value creation of the
internal audit (IA) function, the
human resource management
(HRM) function, and the IA-HRM
pairing. A survey of 161 chief audit
executives indicated that virtually
all IA functions are risk managing
in their audit approaches, while a
great majority of HRM clients are
also moderately or strongly
strategic in their outlook. Findings
included that a productive working
relationship was strongest when a
risk managing IA function is paired
with a strategic HRM function.
Also, the IA planning process was
found to be more strategic in the
presence of the same pairing.
Analysis of written examples of
strategic findings related to HRM
supplied by the respondents
suggested that there may be a
significant gap between auditors
knowledge of strategic HRM
practices as developed in the
literature and their self-reported
examples. Future research should
use both HRM and IA responses to
reduce bias. Additionally, there is
a need for case studies of the
IA-HRM partnership.

18/6/7 [2003] 465-477
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482614]
Achieving competitive advantage is an

increasingly important focus for firms today.
Although business strategy as a means of
competition is common conversation in the
executive suite, taking a strategic approach
can be especially beneficial for staff functions
within companies, as they often are required
to justify their need for resources and their
contribution to the company since they do
not directly report a profit or loss. Two such
staff areas are internal audit (IA) and human
resource management (HRM). The practices
and systems used within these areas may
have a profound, albeit indirect, effect on
company performance. In terms of HRM,
there is a growing recognition that human
capital and the impact of related HRM
practices are critical to an organizations
success (e.g. Kling, 1995; Pfeffer, 1998;
Fitz-enz, 2000; Schmitt, 2002).
The present study cites prior evidence on
the competitive advantage of certain HRM
practices; proposes a model of how IA and
HRM functions might operate to achieve
maximum effectiveness; and examines the
relationship between IA and HRM functions
in a sample of organizations.
IA works with other functional units in the
organization by the very nature of the
profession. Internal auditors assess the risks,
internal controls, processes, practices, and
performance of functions such as marketing,
human resources, and production. IA is
under pressure to become more strategic in
an attempt to help organizations achieve
competitive advantage. The traditional
approach to internal auditing has been one of
policy and internal control compliance with
an emphasis on efficiency measures.
Although the traditional role remains a
critical part of IA today, organizations are
demanding that an audit also looks beyond

costs and compliance to the overall risk
profile of the audit subject. IAs risk profile
model should include compliance,
operational, and strategic risks. Both upside
risk (opportunity for gain) and downside risk
(potential for loss) are relevant elements of
strategic risk. The risk management
paradigm, expressly including strategic risk,
increasingly permeates the audit planning
process of IA organizations (McNamee and
Selim, 1999; Tillinghast-Towers Perrin, 2001).
According to a survey by Tillinghast-Towers
Perrin (2001), 90 percent of IA functions
conduct risk-based audits at the business
unit level. However, in terms of
comprehensive risk assessments, less than
half consider strategic risk. Moreover, while
63 percent of respondents indicated that the
finance function had a formal risk
identification and assessment process, only
21 percent reported using the same rigorous
process related to the HRM function
(Tillinghast-Towers Perrin, 2001). However,
organizations consider human capital as
critical, with a recent survey of executives
ranking people/intellectual capital first (in
a tie with reputation/rating) as the most
important out of 29 sources of risk going
forward (Tillinghast-Towers Perrin, 2001).
Progressive HRM functions are attempting
to demonstrate the link between HRM
practices and organizational performance.
However, we believe that the actual inroads
in practice lag the research findings. In the
past, HRM, known as personnel
administration was focused on
administrative tasks and lacked strategic
orientation. Today, an increasing number of
organizations now develop and use human
resource practices as a source of competitive
advantage. Theoretical developments, case
studies, and several key empirical studies
provide the underpinning for what is known

Introduction
[ 465 ]

Daniel A. Verreault
Developing a strategic
internal audit-human resource
management relationship:
a model and survey
as strategic human resource management

(SHRM). The purpose of this paper is to
explore the relationship between IA and
HRM and the potential for a value-adding
partnership between IA and HRM functions.

18/6/7 [2003] 465-477
Risk managing and control focused

internal auditing functions
IA faces challenges and opportunities on
three fronts. First, the IA profession is
responding to the paradigm shift from a
compliance and control-oriented model to a
risk managing model (McNamee and Selim,
1999). Second, IA functions must respond to
the demand from corporate boards for a
value-adding philosophy. Third, IA confronts
an array of internal clients whose service
needs vary. Excellence in client service
requires a rich understanding of client needs.
Driven by the risk managing paradigm,
corporate requirements, and client needs, IA
needs to develop and defend its own value
proposition.
Because of its expertise in risk
management and financial measurement, IA
can help clients develop their own value
proposition in the context of risk
management and can provide clients with
help in linking the clients value proposition
to firm goals. Depending on client
characteristics and audit team
characteristics, IA may not be uniformly
successful across all clients (Verreault,
1984)[1]. In particular, in the HRM area, we
believe that IA must be aware of the research
that describes practices that may yield
competitive advantage and that use new
measurements to demonstrate value creation
in the HRM area (Verreault and Hyland,
forthcoming). Only with such knowledge can
IA provide HRM with value-added by being
either a synergistic partner to a strategic
HRM function or a motivator for positive
change with a non-strategic HRM function.
Strategic and non-strategic HRM

functions
In the past, administrative activities
dominated HRM, consisting largely of
recordkeeping and maintenance activities.
Management considered personnel a
necessity, but one which added little value to
the organization in terms of productivity or
profitability. Most of the early research on
personnel focused on issues affecting
individuals, such as employee testing and
training (Ferris et al., 1999). The evolution
from personnel management to HRM was
more than simply a change in name. Rather,
[ 466 ]
it represented a conceptual change from

thinking of employees in an organization as
personnel (perhaps a cost to be minimized),
to resources that bring value to the
organization. However, it was not until
SHRM developed in the late 1980s and 1990s
that HRM began to gain credibility as a
source of competitive advantage.
SHRM stemmed from theoretical
arguments that an organizations human
resources can be a source of sustainable
competitive advantage for the organization
(e.g. Wright and McMahan, 1992). Although
other resources, such as a new product
design, also can be sources of competitive
advantage, human resources are the more
sustainable competitive advantage because
they are somewhat difficult for other
organizations to imitate (Barney, 1991).
Staffing, training, compensation, and other
policies used by an organization may
differentiate the human resources at one
organization from those at another
organization. Indeed, groups of such
practices working together may be a source
of competitive advantage. Another
perspective on SHRM suggests that fit
between HRM practices and the strategic
goals of the company is vitally important
(Butler et al., 1991). All three approaches,
adopting certain HRM practices, grouping
synergistic HRM practices, and establishing
strategic fit between HRM practices and firm
strategy, assert that SHRM goes beyond
looking at the implications of traditional
individual HRM activities. There is general
agreement among scholars that SHRM
involves designing and implementing
internally consistent policies and practices
that enable an organizations human
resources to contribute to the achievement of
business objectives (Huselid et al., 1997).
Research suggests that there is indeed a
relationship between a companys human
resources and its performance. Using a US
sample, Huselid (1995) found that groups of
high performance work practices were
related to decreased turnover, increased
productivity, and enhanced corporate
financial performance. For example, use of
certain strategic HRM practices related to
more than a $7,000 profit increase per
employee net of the cost of the practices
(Huselid, 1995). Other studies also have found
support for the notion that progressive work
practices have more of an effect on the
bottom line when used as a group than when
adopted in isolation (e.g. Ichniowski et al.,
1997; Kling, 1995). Watson Wyatt Worldwide
(2002) examined human resource practices
over time to determine that such practices
are a leading indicator of corporate financial

Daniel A. Verreault
a model and survey
18/6/7 [2003] 465-477
performance, rather than simply being

correlated with company performance.
Despite the evidence suggesting the
importance of HRM practices in achieving
competitive advantage, most organizations
are not measuring the financial impact of
these practices. One reason may be the
difficulty of doing so (Becker et al., 2001). As
acknowledged by a chief financial officer,
part of the reason for the failure to
adequately measure human resources
outcomes is the inability of traditional
accounting practices to make this link
readily apparent (Becker et al., 2001, p. 10).
The measurement issue creates a
tremendous opportunity for HRM and IA to
work together to determine the value-added
by various HRM practices. Several authors
have written books on metrics to guide
companies in measuring the cost and/or
effectiveness of HRM practices (e.g. Becker
et al., 2001; Cascio, 2000; Fitz-enz, 2000).
Although professional organizations have
endorsed such books, the question remains
as to whether organizations are taking
seriously the message of thinking
strategically and measuring the effectiveness
of HRM practices. Thus, we see an
opportunity for implementing strategic
practices that meet both the aspirations of
the risk managing IA function and the
strategically-oriented HRM organization.
Proposed framework
We set forth a framework for studying the
combined strategic impact of IA systems and
HRM systems (see Figure 1). The upper right
and lower left quadrants suggest a match in
the approaches of IA and HRM. We call these
combinations value-creating and
cost-minimizing, respectively.
Value-creating IA/HRM dyads are found
when a risk managing IA function is found in
Figure 1
The proposed framework
the same organization as a strategic HRM

function. Cost-minimizing IA/HRM dyads
exist when a compliance-focused IA function
exists in the same organization as an
administratively-focused HRM function. The
remaining two possible combinations
indicate a lack of a complementary function.
The lower right hand quadrant depicts a risk
managing IA function paired with an
administrative HRM function; we call this a
motivating combination. The upper right
hand quadrant depicts a compliance-focused
IA function paired with a strategic HRM
function; we call this a limiting
combination. The terms motivating and
limiting reflect our estimate of the likely
impact of IA on HRM (e.g. a risk managing IA
function may act as a motivator for an
administratively focused HRM function).
We discuss each quadrant in greater detail
below and suggest financial outcomes that
should be examined in future research. The
research questions that we will focus on
relate most closely to the relationship aspects
of the IA-HRM partnership. We acknowledge
that other aspects of the internal and
external organizational environment may
affect the relationships and financial
outcomes we propose; therefore the
statements we make should be considered
with these other factors (e.g. support from
upper management, approval of the board of
directors) taken into account.
Value-creating combination
When a risk managing IA function coexists
with a strategic HRM function, both of these
areas strive to assist the organization in
achieving competitive advantage. When the
HRM function uses high performance work
practices, such as incentive compensation
systems and extensive employee training
(Huselid, 1995), or other practices that fit
with the companys overall business
strategy, risk managing internal auditors
look at the value of these practices (the
strategic upside), rather than focusing solely
on operational efficiency and/or policy
compliance. Through such an approach, IA
informs the human resources function by
providing a cost/benefit analysis of the
practices, and IA benefits by creating a
receptive client who is concerned with
strategic business risks. Assuming an
environment of top management support for
SHRM practices, and a productive working
relationship between IA and HRM, the result
of a partnership between a risk managing IA
and a strategic HRM function should be
enhanced financial performance.
[ 467 ]

Daniel A. Verreault
a model and survey
18/6/7 [2003] 465-477
Cost-minimizing combination
When a compliance-focused IA function
exists in the same organization as an
administratively-focused HRM function,
neither area is targeting competitive
advantage. Rather, both areas emphasize cost
control and compliance. In an administrative
HRM function, work practices that are
legally required are considered to be most
important; whereas voluntary practices
are considered to be extras that are the first
to be cut when budgets are depleted, without
measurement of the value these practices add
to the company. In a compliance-focused IA
function, emphasis is placed on following the
rules and procedures of the company. The
benefits from alternative policies and
procedures may easily be overlooked. We
propose that these combined practices will
not have a positive effect on the financial
performance of the company because neither
IA nor HRM is concerned with value-added
practices, but rather with operational
compliance.
Motivating combination
When a risk managing IA function exists in
the same organization as an
administratively-focused HRM function, IA
can serve as a motivator for HRM to think
more strategically by examining the
value-added from various human resource
practices and procedures. However, it may
take a while for the HRM function to adopt
the recommendations of IA and take the
initiative to implement strategic practices
and procedures. If HRM does take on such
initiatives, they will move towards the
value-creating combination. Until that time,
however, the companys financial
performance will be lower than its potential
due to HRMs lack of a strategic orientation.
We recognize that in times of organizational
stress both HRM and IA can take on a
punitive role which may undermine the
ability of IA to act as a motivator.
Limiting combination
When a compliance-focused IA function
exists in the same organization as a strategic
HRM function, the IA function does not add
strategic value to the human resources
function by examining the impact of various
human resources practices and procedures
on the companys bottom line and the fit with
company strategy. The synergies created in
the value-added quadrant are not achieved,
and the limiting combination does not lend
itself to moving towards the value-creating
combination because HRM will not likely
influence the overall approach used by IA.
Therefore, we predict that the companys
financial performance will be limited by the
[ 468 ]
lack of synergy between IA and HRM and the

fact that IA cannot assist human resources in
examining the strategic value of their
practices and procedures. HRM could still
operate strategically without the guidance of
a risk managing IA function; however, the
potential to reach maximal strategic
effectiveness would be limited because IA
could provide expertise in the area of
financial measurement of HR outcomes and
independent support of the strategic value of
HRM practices.
Research questions
We consider several research questions that
stem from the proposed framework that
relate to the performance of IA in relation to
HRM. The questions focus on the
relationship between IA and HRM from the
point of view of IA, as well as questions
related to the extent of strategic focus in
audit planning and reporting. Our first
question concerns the strength of the
relationship between HRM and IA. We
predict that the best relationships will exist
when the functions match to a high degree.
We predict that the working relationship will
be best for the value-creating combination
because of the focus of both functions on
important strategic concerns. We also predict
that the next best working relationship will
be for the cost-minimizing combination,
since both functions share a similar mindset.
We predict that the relationship will be worst
for the motivating and limiting quadrants
because of the lack of match.
RQ1a. The strength of the working
relationship between HRM and IA
will be strongest for the value
creating combination, followed by
the cost-minimizing combination.
An alternative way of examining the strength
of the relationship is to look not only at the
quadrant which depicts a combined measure,
but at the strategic extent of HRM and the
risk managing extent of IA considered
separately. Independent analysis allows us to
examine the discrete effects of HRM and IA,
rather than the results of the two paired
together in a quadrant. We predict that the
working relationship will be strongest when
HRM is strategic and IA is risk managing for
all of the reasons that are listed above.
RQ1b. A strategic approach to HRM and a
risk managing approach to IA, each
considered independently, will have
positive effects on the strength of
the working relationship between
IA and HRM.

Daniel A. Verreault
a model and survey
18/6/7 [2003] 465-477
Another question concerns the extent to

which the audit planning process reflects
strategic HRM concerns. We predict that the
value-creating combination will have the
highest scores, with the motivating quadrant
having the second highest scores, due to the
fact that for IA functions in this quadrant,
risk managing issues are important. Thus,
although the process should most highly
reflect strategic HRM concerns when the
HRM function is strategic, simply having a
risk managing IA function should influence
the strategic nature of the reports, even when
HRM is not strategic.
RQ2a. The strategic nature of the IA
planning process will be strongest
for the value-creating combination,
followed by the motivating
combination.
Again, an alternative way of examining this
issue is to look not only at the quadrant, but
at the strategic extent of HRM and the risk
managing extent of IA. We predict that the
extent to which the planning process reflects
strategic HRM concerns will be highest when
HRM is strategic and IA is risk managing.
RQ2b. A strategic approach to HRM and a
strategic approach to IA, each
considered independently, will
positively affect the strategic nature
of the IA planning process.
Another question concerns the extent to
which the actual audit reports reflect
strategic HRM concerns. We predict that the
value-creating combination will have the
highest scores, with the motivating quadrant
having the second highest scores, due to the
fact that for audit functions in both of these
quadrants, strategic issues are important.
RQ3a. The strategic nature of audit
reports will be strongest for the
value-creating combination,
followed by the motivating
combination.
We also propose examining the strategic
nature of audit reports as a function of the
strategic extent of HRM and IA. As with the
planning process, we predict that the extent
to which the reports reflect strategic HRM
topics will be positively affected by the
strategic extent of HRM and IA.
RQ3b. The more strategic HRMs approach
and the more risk managing IAs
approach, each variable considered
independently, the more that the
audit reports will reflect strategic
HRM concerns.
Methodology
To examine the perspectives of IA managers
regarding the proposed model, we designed a
survey that asked chief audit executives
(CAEs) about various aspects of the strategic
and compliance foci of their organizations
and their perceptions of the same variables
for the HRM function in their firms. The
sampling frame consisted of 1,200 CAEs who
were members of the Institute of Internal
Auditors and had subscribed to participate in
selected surveys of interest to the profession.
Questionnaire
The survey questions, which used a
five-point Likert scale format, were
developed by the authors based on the
proposed model. The questions asked about
the extent of strategic and administrative
focus for HRM, and the extent of risk
managing and compliance focus for IA. For
IA functions, the questionnaire used the term
strategic to direct the respondents towards
value-added practices geared to strategic risk
management as opposed to
operationally-focused risk management.
However, in this paper, we refer to the
strategic approach as the risk managing
approach. The questions about HRM were
more descriptive due to the fact that the
auditors were less likely to be as familiar
with the HRM function as with IA.
Additional questions asked about the
practices of both functions (e.g. the extent to
which the audit planning process reflects
strategic HRM concerns) and the
relationships between the two. General
questions about the organization also were
included in the survey. The survey was
posted on the Web site of the IIA Research
Foundation for a period of 47 days. This
organization frequently posts surveys on its
Web site, so the format was familiar to the
respondents. When members accessed the
Web site, they were able to click on a link to
complete the survey. There were 161
respondents, for a response rate of 13 percent.
The IIA Research Foundation reported that
this is slightly above the typical response
rate for surveys completed by this
organization.
Analysis and results

Plotting companies on the proposed
framework
The first component of the analysis was the
plotting of the respondents approaches to
HRM and IA. Sunflower charts, in which
each petal represents a response, were used
[ 469 ]

Daniel A. Verreault
a model and survey
18/6/7 [2003] 465-477
to graph the responses (see Figure 2 and

Figure 3).
For Figure 2, the vertical axis shows the
responses to the question, In your view, to
what extent does your firms HRM
organization implement programs and
practices focused on firm goals?. The
horizontal axis shows the responses to In
your view, to what extent is your firms HRM
organization focused on the execution of
basic HRM activities (e.g. focused on
Figure 2
Chief audit executives perspectives of human resources
Figure 3
Chief audit executives self-rating
[ 470 ]
training, compensation, benefits, etc?). Most

CAEs rated their firms HRM function high
on both strategic and administrative
orientations. The lower right quadrant shows
those CAEs who rated HRM low on strategic
orientation, but high on administrative
focus, which is the traditional or older
approach to HRM. None of the respondents
classified their HRM organizations as having
a high strategic focus and a low
administrative focus. This is not surprising,
given that a strategic approach does not
mean that organizations can ignore the need
to focus on administrative issues. Indeed, our
definition of a strategic approach is that it
focuses on the strategic risks and financial
impacts of both administrative and strategic
activities. In total, 11 CAEs (7 percent) rated
HRM low on both strategic and
administrative approaches. This finding was
surprising, given that not even the
traditional approach to HRM was a focus of
the function. This finding suggests that
perhaps the respondent was unfamiliar with
the HRM function or the respondent thought
that HRM was not performing adequately in
either of these areas.
For Figure 3, the vertical axis shows the
responses to the question, In your view, to
what extent does your firms IA organization
have a strategic outlook? The horizontal
axis shows the responses to In your view, to
what extent is your firms IA organization
focused on compliance activities? Although
most organizations rated their IA functions
high on both risk managing (strategic) and
compliance orientations, there was less of a
concentration of respondents in this upper
right quadrant for IA than there was for
HRM. The second most populated quadrant
was the upper left, which represented a high
risk managing orientation combined with a
low compliance orientation. There also were
a large number of organizations on the
border of these two quadrants, with a high
risk managing score, combined with a score
of three on compliance, which represented
some focus on this issue. Thus, IAs
self-assessment placed IA functions in or
near the risk managing quadrant. There was
less focus on compliance in IA than there was
on administration in HRM. The lower right
quadrant, which shows those organizations
that rated themselves low on risk managing
IA and high on compliance-focused IA, was
sparsely populated. Only one organization
populated the lower left quadrant, combining
a low focus on both risk managing and
compliance orientations. Given our
conceptualization that organizations will
have, at a minimum, a compliance-based

Daniel A. Verreault
a model and survey
18/6/7 [2003] 465-477
focus, we were not surprised by the low

number of respondents in this quadrant.
The next aspect of the analysis was the
combined plotting of the HRM and the IA
functions. Because two questions were used
for each function (one asked about the extent
of the strategic approach and the other asked
about the extent of the compliance focus), the
following logic was used to classify each
organization:
.
Upper right quadrant (value-creating).
This match required an HRM score of four
or five, combined with an IA score of four
or five. The HRM and IA scores were
determined by looking at the responses to
the questions about the strategic extent of
each function. It was not necessary to
examine the compliance score, since a
strategic approach could be paired with a
high or low compliance focus.
.
Lower right quadrant (motivating). This
match required an HRM score of one or
two combined with an IA score of four or
five. This calculation required use of the
questions on the survey about the
strategic extent of each function, as well
as the questions about the compliance
focus of each function. An HRM score of
one or two required a high compliance
score (four or five) and a low strategic
score (one or two).
.
Upper left quadrant (limiting). This match
required an HRM score of four or five
combined with an IA score of one or two.
An IA score of one or two resulted when a
high compliance focus (four or five) was
combined with a low strategic focus (one
or two).
.
Lower left quadrant (cost-minimizing).
This match occurred when a low HRM
score (one or two) and a low IA score (one
or two) were plotted. See above for the
logic for computing the low scores.
Figure 4 shows the results of this analysis.
The logic listed above enables us to clearly
classify 75 of the organizations. The
remaining organizations fell on the
horizontal or vertical axis of the quadrants
and were therefore excluded. The most
populated quadrant was the value-creating
match in the upper right quadrant, which
contained 52 organizations. The second most
populated quadrant was the lower right,
which represents a motivating match of risk
managing IA and administratively-focused
HRM. A total of 19 organizations were in this
quadrant. Only one organization fell in the
upper left quadrant, which represents a
limiting match, and only three companies
were in the lower left quadrant, for a
cost-minimizing match. Thus, virtually all of
the CAEs categorized their IA organization

as taking a risk managing approach. There
are several possible reasons for this lack of
variability. First, there may be rating
inflation given that the audit executives
rated their own IA units and they may
perceive themselves as being more risk
managing or strategic than they actually are.
Second, there could be a response bias such
that only those audit executives who are the
most risk managing completed the survey,
while those who are less focused on risk
management opted not to participate. Third,
there may be a social desirability bias, such
that CAEs prefer to be recognized for their
risk managing philosophy than their
compliance-based work. We do see
variability in the HRM classifications. This
may be due to the fact that the data also came
from the audit executives, which reduces the
two concerns of rating inflation and response
bias listed above.
In order to include more companies, we
changed the classification system to plot the
companies that did not clearly fall into one of
the four proposed quadrants. These
companies had values of three on at least one
of the questions related to strategic
orientation or compliance/administrative
orientation. This resulted in the
categorization of an additional 71 companies,
for a total of 146; 15 companies still were not
plotted. Most of these were the companies
with a strategic score of one and a
compliance score of one for HRM. Given that
this combination does not fit our
conceptualization, they were omitted from
the analysis. Figure 5 shows that most of the
added companies were on the border of the
value-creating quadrant, with slightly more
companies high on risk managing IA than on
strategic HRM.
Quantitative analysis of the research

questions
We next examined the proposed research
questions concerning the relationships and
practices of the companies in relation to
their quadrants in the framework.
However, given that the limiting and
cost-minimizing quadrants had such a
low number of responses, we were unable to
conduct our analysis using the four
quadrants. Therefore, we conducted our
analyses based on the differences in
strategic HRM vs administrative HRM by
splitting Figure 5 into three categories: one
group representing the value-creating
quadrant, another group representing the
motivating quadrant, and another group
representing the responses that fell
between these two quadrants (see the
[ 471 ]

Daniel A. Verreault
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18/6/7 [2003] 465-477
circled areas on Figure 5). Thus we

eliminated quadrants one and two from the
analyses and included only those
respondents that clearly identified their IA
functions as risk managing. Although this
change prohibited us from testing our
research questions as proposed, we were
able to test for differences based on
the two quadrants and the borderline
area between them. We would expect
responses to the research questions for the
borderline area to fall between those for the
motivating quadrant and the value-creating
quadrant.
For RQ1a, we examined the extent to which
IA and HRM have a productive working
relationship by using ordinary least squares
Figure 4
Respondents falling clearly into one of the proposed quadrants
Figure 5
Responses including those falling in the borderline region
[ 472 ]
(OLS) regression (see Table I). Given the

categorical nature of the quadrants and the
borderline region, we used dummy variables
to represent the value-creating quadrant and
the borderline region, with the motivating
quadrant serving as the omitted category.
There was a significant positive effect for the
value-creating quadrant (semipartial r = 0.42,
p < 0.01) indicating that being in the valuecreating quadrant (having a shared strategic
emphasis) had a more positive effect on the
working relationship than being in the
motivating quadrant. There was no
significant effect for the borderline region,
which suggests that the working relationship
was not significantly different from that of
respondents in the motivating quadrant. The
model explained 24 percent of the variance in
the CAEs perceived productivity in working
relationships between IA and HRM. Given
that we were unable to test the costminimizing region, we found support for
RQ1a in so far as its prediction for the
value-creating quadrant. For RQ2a, we
examined the extent to which the IA
planning process reflects strategic HRM
concerns. Again, there was a significant
positive effect for the value-creating
quadrant (semipartial r = 0.25, p < 0.01) and
there was not a significant effect for the
borderline region. The model explained 7
percent of the variance in the audit planning
process reflecting strategic HRM concerns,
indicating support for the testable aspect of
this research question. The third research
question examined the extent to which audit
reports reflect strategic HRM concerns. This
model was not statistically significant and
there were no significant effects for the
value-creating quadrant or the borderline
region. Thus, RQ3a was not supported.
We also used OLS regression to examine
the influence of the strategic extent of human
resources and the strategic extent of IA on
the various outcomes (see Table II). We were
able to fully test the research questions
related to these variables because they were
not based on the quadrants proposed by our
model. We used the entire sample for these
analyses as we were not limited to the
responses that fell clearly within one of the
quadrants. For RQ1b, we predicted that the
strategic extent of HRM and the strategic
extent of IA both would have a positive effect
on the quality of the working relationship
between HRM and IA. We found a significant
positive effect for both the strategic extent of
HRM (semipartial r = 0.40, p < 0.01) and the
strategic extent of IA (semipartial r = 0.18,
p < 0.05), with the model explaining 23
percent of the variance, fully supporting the
research question. For RQ2b, we predicted

Daniel A. Verreault
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relation to HRM may differ from that

developed in the literature. Therefore, we
asked two questions that allowed us to probe
into the respondents definitions of these
terms by having them provide examples from
actual audits of the HRM function. First, we
asked for a specific example of an audit
finding included in the audit report for the
HRM function that recognizes a strategic
focus in HRM (e.g. the audit report notes that
HRM determined its training curriculum
based on corporate strategic objectives and
measured training outcomes in relation to
those objectives). Only 35 percent of the
respondents provided an example, with the
remainder leaving the space blank or saying
that they have not yet had a finding they
could share. The second question asked for a
specific example of an audit finding included
in the HRM audit report that reflects the
audit organizations strategic focus (e.g. the
internal audit report makes a finding that
absenteeism rates exceed benchmarked
targets resulting in lower productivity and
delayed shipments). Only 22 percent of the
respondents provided an example in
response to this question. In light of the
auditors self-assessment as highly risk
managing, we find that both the 35 percent
and 22 percent success rate in citing a
specific example are low. We expected the
auditors to have a higher success rate in,
first, recognizing strategic HRM
achievements and, second, recommending
strategic improvement to the HRM process.
Some respondents may not have
that the strategic extent of HRM and the

strategic extent of IA would be positively
related to how much the audit planning
process reflects strategic HRM concerns. We
found full support for this question, as there
were significant positive main effects for the
strategic extent of both human resources
(semipartial r = 0.18, p < 0.05) and IA
(semipartial r = 0.36, p < 0.01), with the model
explaining 20 percent of the variance. For
RQ3b, we predicted that the strategic extent
of HRM and the strategic extent of IA would
be positively related to how much the audit
reports reflect strategic HRM concerns. This
was only partially supported, as there was a
significant positive main effect for the
strategic extent of IA (semipartial r = 0.30,
p < 0.01), but not for the strategic extent of
HRM. A total of 10 percent of the variance in
the audit reports was explained by this
model.
Thus, our findings indicate that there is a
significant positive relationship of the
strategic extent of HRM on first, the
perceived quality of the working relationship
between HRM and IA, and second, the audit
planning process reflecting strategic
concerns. We did not find a significant effect
for the audit reports reflecting strategic HRM
concerns. For the strategic extent of IA, we
found a significant positive effect for all three
dependent variables.
Analysis of qualitative responses

We recognize that CAEs definition of the
terms strategic and risk managing in
Table I
Regressions using modified quadrants
Productive working relationship
between HRM and IA
b(1)
(2)
Part r (3)
Independent variable
Borderline region
Value-creating quadrant
Constant
R2
0.28 (0.24) 0.14

10.05 (0.22) 0.57**
30.16 (0.19)
0.24**
0.10
0.42**
Audit planning process reflects

strategic HRM concerns
b(4)
(5)
Part r (6)
0.42 (0.34)
0.81 (0.31)
20.58 (0.27)
0.07*
0.16
0.34*
0.12
0.25**
Audit reports reflect strategic

HRM concerns
b(7)
(8)
Part r (9)
0.30 (0.35)
0.30 (0.32)
20.74 (0.27)
0.01
0.12
0.13
0.09
0.10
Notes: n = 160; * p < 0.05; ** p < 0.01
Table II
Regressions using the strategic extent of human resources and internal audit
Independent variable
Strategic extent of human resources
Strategic extent of internal audit
Constant
R2
Productive working relationship

between HRM and IA
b(1)
(2)
Part r (3)
0.39 (0.07)
0.19 (0.08)
1.66 (0.32)
0.23**
0.41**
0.18*
0.40**
0.18*
Audit planning process reflects

strategic HRM concerns
b(4)
(5)
Part r (6)
0.21 (0.08)
0.48 (0.09)
0.33 (0.40)
0.20**
0.19*
0.37**
0.18*
0.36*
Audit reports reflect strategic

HRM concerns
b(7)
(8)
Part r (9)
0.06 (0.09)
0.39 (0.10)
1.05 (0.43)
0.10**
0.05
0.30*
0.05
0.30*
Notes: n = 160; * p < 0.05; ** p < 0.01

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Daniel A. Verreault
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[ 474 ]
distinguished between these two aspects of

the audit report, as was suggested by the 5.5
percent of the sample that cited the same
finding for both questions. For those cases we
did not include the second citation which
lowered the response rate for the second
question.
To quantify the responses, the authors
created a code sheet for each question, using
a three point rating scale with descriptive
anchors. The descriptive anchors for
strategic focus relied on the SHRM literature
and included various work practices,
cost-benefit analysis of practices, and clear
linkages of practices with firm strategy. A 3
indicated the most strategic response, a 2
indicated a somewhat strategic response, and
a 1 indicated a response that was not at all
strategic. After initially rating each of the
responses independently, the inter-rater
reliability for the two authors was 59 percent
for the first question and 54 percent for the
second question. We held a meeting to add
detail to the descriptive anchors on the code
sheet and to identify decision rules for how to
handle ambiguous responses and situations
(e.g. if a response addresses a hypothetical
situation, rather than an actual finding,
exclude it from the analysis). We then
re-rated each of the responses using the new
decision rules. The revised inter-rater
reliability for the first question was 93
percent and for the second question it was 90
percent, both being acceptable levels of
reliability (Carmines and Zeller, 1979).
For purposes of analysis using the
proposed model, we used only one authors
ratings for each question. We chose the
ratings of the author who has more human
resources experience for the first question,
and the rating of the author who has more
audit experience for the second question. For
the first question (a specific example of an
audit finding included in the audit report for
the HRM function that recognizes a strategic
focus in HRM), we found that of the 30
respondents that clearly fell into one of the
four quadrants; 13 were in the value-creating
quadrant. Of these, only two received a
rating of truly strategic based on their
qualitative example; eight received a rating
of somewhat strategic and 11 received a
rating of non-strategic. Although
respondents identified themselves as
strategic in general terms, their specific
work experience (as indicated by their
examples) often are not strategic. For
example, respondents who self-identified
themselves as being in the value-creating
quadrant listed strategic examples such as
creating and implementing a code of ethics
and creating a mission statement for the
pension plan. Although both are important

audit findings, they relate to the basic
functioning of HRM, rather than the ability
of HRM to add value to the organization
through these practices. An example of a
response that was rated truly strategic
recounted an audit finding involving
payment strategies related to the sales
compensation plan to ensure that the
strategies stimulate the correct product mix
and align with corporate strategy.
For the second question (a specific example
of an audit finding included in the HRM audit
report function that reflects the audit
organizations strategic focus), we found that
of the 20 responses that clearly fell into one of
the four quadrants in the proposed model, 13
had identified their organizations as being in
the value-creating quadrant. Of those, only
three received a rating of truly strategic,
while eight were somewhat strategic and 11
were non-strategic. Again, although
respondents identified themselves as
strategic, their actions as expressed through
audit findings often are not strategic.
Respondents who identified themselves as
being in the value-creating quadrant stated
underutilization of technology and the
update of policies after reorganization as
examples of the audit organizations strategic
focus. Although these findings are important,
they do not clearly demonstrate the ability of
IA to add value to the organization through
SHRM practices and/or related measures. An
example of a response that was rated as truly
strategic stated an audit recommendation of
the need for formalized training by human
resources for overseas-based sales staff to
ensure consistency with corporate goals
communicated to sales staff domestically.
Discussion
The ability of IA groups to add value to the
functions they audit by managing risk is a
growing trend (Bou-Raad, 2000). Our study
proposed and examined a framework for how
IA and HRM can maximize the effectiveness
of their working relationship. This
framework is based on HRM acting
strategically, combined with IA taking a risk
managing approach. When both of these
approaches are used, the expected
effectiveness of a human resources audit is
highest. We call this a value-creating
combination. The other quadrants
(motivating, limiting, and cost-minimizing)
should strive towards the value-creating
quadrant in order to improve their
effectiveness.

Daniel A. Verreault
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The quadrants of the framework enable IA

and their HRM clients to conceptualize their
relationship, to understand the self and
peer-appraisal implications of their quadrant
location, and to plan on how to move toward
the value-creating quadrant. The framework
can serve as a guide for examining the effects
of the relationship between HRM and IA for
areas such as company financial
performance, the audit planning process and
reports, and the nature of the working
relationship between the two groups.
In our test of a sample of IA executives, we
found that most of the companies did indeed
characterize themselves as having a
value-creating combination of strategic
human resources paired with risk managing
IA. This was encouraging, given that little
has been written on the effects of the
strategic approaches of the relationship
between the two units. However,
examination of the examples provided by the
respondents showed that although
companies may self-report that they are
being strategic, their actions may not be
truly strategic. This finding has
methodological implications for studying
strategic issues. McNamee and Selim (1999,
p. 19) point out two weaknesses of the current
risk paradigm:
One is that internal auditors focus too much
on measuring risk factors instead of the
underlying risk different results can occur
when the nature of risk changes and the
internal auditor continues to use the same
factors. The second weakness in risk
assessment by internal auditors is that
planning is where the focus on risk usually
ends. Once the internal audit is planned (or
the group of audits for the annual plan are
chosen), the focus is switched to the system of
internal control. In current internal audit
practice, controls, not risks, are tested,
evaluated and reported to management.
We believe that familiarity with the current

risk profile of HRM developed primarily over
the past decade is not yet included in internal
auditors risk factors for HRM. Additionally,
the dearth of appropriate strategic examples
cited by respondents may be explained by the
shift to a control or compliance focus in audit
execution leaving few examples related to
strategic risk for citation.
Self-reported performance may encourage
a positive bias in the responses, as being
strategic is viewed as desirable in most
organizations and it is a popular topic in both
academic and practitioner literature. Indeed,
we were unable to test our research
questions as proposed because of a lack of
variability in the responses for the risk
managing nature of the IA function. On the
other hand, there was sufficient variability
in the audit executives ratings of the

strategic nature of the HRM function. One
way to surmount the self-report bias would
be to have someone from outside of IA rate
the extent to which the function is strategic
or risk managing (Van de Ven and Ferry,
1980). An HRM executive could rate the audit
function and the HRM score would be
averaged with the self-reported IA score.
Another possibility is to measure actions, in
lieu of or in addition to self-ratings. Although
respondents could overstate their actions, it
is less likely that they will be able to do so, as
is evident in the number of respondents who
were unable to cite any strategic finding in
our study.
Despite the lack of responses in the
limiting and cost-minimizing quadrants, we
were able to partially test the research
questions. As stated earlier, we analyzed the
value-creating quadrant, the motivating
quadrant, and the region between these
quadrants, which we identified as the
borderline area. We found support for the
testable aspect of RQ1a, as there was a
significant positive effect of the valuecreating quadrant on the strength of the
working relationship between IA and human
resources. We also found support for RQ1b,
which we were able to test completely, as it
examined the strategic extent of human
resources and IA on the working relationship
between the two functions. For the testable
portion of RQ2a, we found a positive
significant effect for the value-creating
quadrant on the extent to which the audit
planning process reflects strategic HRM
concerns in support of the research question.
Likewise, we found support for RQ2b, which
found significant effects suggesting that a
high strategic extent of human resources and
high strategic extent of IA is associated with
the audit planning process reflecting
strategic HRM concerns. We did not find
support for the testable portion of RQ3a, as
there was not a significant effect of the
value-creating quadrant on the audit reports
reflecting strategic HRM concerns. We also
found only partial support for RQ3b, as only
the strategic extent of IA was significantly
related to how much the audit reports
reflected strategic HRM concerns. Lack of
linkage between the strategic extent of HRM
and the audit reports reflecting strategic
HRM concerns may be due to the report being
the product of the audit organization; thus
the strategic extent of the HRM function may
not have a significant impact on the audit
report.
One of the implications of this research for
businesses is that creating relationships
where both HRM and IA are in the
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Daniel A. Verreault
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[ 476 ]
value-creating quadrant should lead to an

improved opportunity to reap the financial
rewards of implementing SHRM practices.
However, this must be interpreted with
caution, as IA/HRM dyads self-reported as
value-creating often were not truly strategic
as measured by awareness of specific
strategic audit findings. For those companies
that meet the value-creating criteria, our
study serves as partial justification of their
approach. For those companies in the
cost-minimizing quadrant, this study should
serve as impetus for making a change in the
IA approach, and for encouraging change in
human resources. Although it is promising to
see support for the research questions, we
must keep in mind that even though there is
a relationship of the strategic nature of
human resources and IA with most of the
proposed outcomes, there may be an
overrepresentation of respondents in the
high end of the strategy spectrum. In
addition, the model and relationships
proposed in this study are exploratory in
nature; therefore, the findings reported are
just a first step in understanding the
potential for value creation from an IA and
HR partnership.
Future research on this topic should
further examine the implications of the
proposed framework. Although the logic
behind the four quadrants remains valid, an
alternative method for categorizing
companies into the quadrants should be
considered to reduce rating inflation due to
self-reports. The effects of being in each
quadrant on the performance of the human
resources function, as well as company
financial performance, should be evaluated.
Case studies of companies in each of the
quadrants also would provide a better
explanation of the practices employed by
companies following the various approaches.
It is important to note that for this study, all
measures were perceptions of IA executives.
Future studies also should get the
perspective of the human resources function
to mitigate bias (Van de Ven and Ferry, 1980).
Also, our survey drew on the perceptions of
CAEs. Future work would be enriched if
other audit participants views were sought,
such as audit team members. Multiple
internal viewpoints may mitigate any level of
analysis problem (Roberts et al., 1978).
Companies are beginning to realize the
importance of being strategic in the
management of their human resources. By
combining a strategic approach to human
resources with a risk managing approach to
IA, companies should be able to set
themselves apart from others and capitalize
on the value generated by progressive

management of people.
Note
1 Verreault (1984) found that the strength of
relationship between IA and selected clients
was a decreasing function of the type of other
unit. He examined IA matched with
production, marketing, and R&D. The major
reasons for the differences included auditors
level of familiarity with the paradigm used in
the other function and the limitation of the
accounting measures used by auditors. Kusel
and Oxner (1998) report on job characteristics
of internal auditing. Accounting is still the
dominant skill set just as it was in 1984. One
may expect the differences in paradigms to
still exist but to be mitigated by the move to
the risk assessment model. It is sensible to
expect variability across internal audit
engagements and therefore important to focus
on specific IA-client relationships. In the HRM
instance, we tentatively suggest that the
background of auditors on the audit team, the
relative newness of evidence regarding SHRM,
and the incomplete implementation of
rigorous risk models at the engagement level
are important factors to consider in the
analysis of IA-HRM performance. Verreault
and Hyland (forthcoming) cover in detail the
information necessary to inform IA about
current developments and the potential for
performance enhancement using SHRM
techniques.
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Daniel A. Verreault
a model and survey
18/6/7 [2003] 465-477
The authors gratefully

acknowledge the monetary
support and data collection
assistance of the Institute of
Internal Auditors Research
Foundation. They also thank
Dr Louis Primavera, Dean of
the Derner Institute for
Psychological Studies at
Adelphi University, for his
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Measuring and Assessing Organizations,
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[ 477 ]
Underreporting and premature sign-off in public

accounting
Mike Shapeero
College of Business, Bloomsburg University of Pennsylvania, Bloomsburg,
Pennsylvania, USA
Hian Chye Koh
Nanyang Business School, Nanyang Technological University, Singapore
Larry N. Killough
Pamplin College of Business, Virginia Polytechnic Institute and State University,
Blacksburg, Virginia, USA
Keywords
Ethics, Public sector accounting,
Cognition, Auditing principles
Abstract
This study uses the ethical
decision-making model to examine
underreporting and premature
audit sign-off in public accounting.
Structural equation modelling
results indicate that accountants
view premature sign-off activities
differently from underreporting
activities. For example, those
accountants who use a
teleological moral evaluation
process, and who perceive a
greater likelihood of reward are
more likely to underreport. That
these variables are not
significantly related to the
likelihood of premature sign-off
suggests that accountants may
use a consequences-based
approach when making decisions
having lesser ethical content (like
underreporting), but employ a
different decision process when
faced with decisions having
greater ethical content (like
whether to prematurely sign-off).
The results also suggest that
supervisors and managers are less
likely to underreport, and to
prematurely sign-off, than senior
and staff-level accountants, and
that accountants with an internal
locus of control are less likely
(than externals) to either
underreport or prematurely
sign-off.

18/6/7 [2003] 478-489
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482623]
[ 478 ]
Introduction
The underreporting of chargeable time and
premature audit sign-off activities can
adversely affect the ability of public
accounting firms to generate revenues,
complete professional quality work on a
timely basis, and accurately evaluate
employee performance. While prior studies
of these activities have generally lacked a
strong theoretical foundation, this study
examines underreporting and premature
sign-offs within the context of an ethical
decision-making model that integrates
elements of cognitive moral development,
moral evaluation, opportunity and
individual moderators.
own time, or shifted chargeable hours to nonchargeable categories on their time sheets.
There are several reasons why accountants
exceed time budgets; these include:
.
increased job complexity;
.
client-created problems;
.
accountant inefficiency; and
.
unrealistic time budgets.
Public accounting firms use reported

chargeable hours to bill clients, set time
budgets for assignments, and evaluate
employee performance. A firms ability to
successfully perform these functions depends
on the accuracy of the time sheets filled out
by accountants. However, the results of prior
studies suggest that a majority of
accountants have intentionally
underreported their chargeable hours, either
by not recording time worked or by shifting
chargeable hours to non-chargeable
categories.
In a survey of AICPA members, Rhode
(1977) found that 55 percent of the
respondents admitted performing audit work
without reporting all of their chargeable
time. Lightner et al. (1983) found that 67
percent of their respondents had
underreported a portion of their chargeable
hours during the preceding year. Cook and
Kelley (1988) reported a growing number of
auditors who either performed work on their
In some cases, the additional time may be

billable a decision typically made at the
partner level. However, underreporting
circumvents the partners authority as less
experienced accountants write-off a portion
of their chargeable hours. Beyond the
potential loss of revenue to the firm, client
retention decisions may also be affected as
underreporting makes it difficult to
determine which clients might be
undesirable due to repeated billing
write-downs.
Because time budgets are often based on
the number of hours reported on the previous
years work (Kelley and Seiler, 1982;
Pasewark and Strawser, 1994),
underreporting may result in unrealistically
low time budgets. In turn, time pressures
from these unrealistic budgets may lead to
continued underreporting, assignments not
completed on a timely basis, and shortages of
available personnel. Studies also indicate
that time budget pressures are significantly
related to the incidence of audit quality
reduction behaviors, including premature
audit sign-off and a failure to adequately
pursue questionable issues (Alderman and
Deitrick, 1982; Cook and Kelley, 1988; Kelley
and Margheim, 1990; Rhode, 1977).
Time pressures may also affect a firms
ability to retain qualified employees. Cook
and Kelley (1988) found lessened job
satisfaction, particularly at staff and senior
accountant levels, to be one of the most
frequently cited problems arising from time

Underreporting of chargeable time
Mike Shapeero,
Hian Chye Koh and
Larry N. Killough
Underreporting and premature
sign-off in public accounting
18/6/7 [2003] 478-489
budget pressure a finding which may

explain why underreporters, as a group, were
more likely to consider leaving their firms
(Lightner, 1981). Underreporting may also
affect a firms ability to accurately assess
employee performance. Studies indicate that
accountants in public practice believe that
the ability to meet time budgets is an
important factor in their performance
evaluations (Kelley and Seiler, 1982; Rhode,
1977). Lightner et al. (1983) found that
underreporters believed that their behavior
would lead to better performance
evaluations, supervisor recognition of
competency, and increased job security.
However, when employees fail to report all of
their chargeable hours, the firms ability to
accurately assess employee performance is
undermined.
Unlike underreporting (where the work is

performed), premature audit sign-offs
directly affect audit quality and violate
professional standards. Graham (1985)
concluded that audit failures were often due
to the omission of important audit
procedures rather than procedures not being
applied to a sufficient number of items. In
turn, these audit failures not only
significantly increase the litigation costs of
CPA firms but may also hinder their ability
to retain experienced personnel (Dalton et al.,
1994). Further, if experienced people do leave
the profession, and are replaced by
less-experienced personnel, the potential for
substandard work increases.
Premature audit sign-off
The ethical decision-making model used in

this study was developed by Ferrell et al.
(1989) and integrates elements of models
developed by Ferrell and Gresham (1985),
Hunt and Vitell (1986) and Kohlberg (1969)
into a comprehensive framework (see
Figure 1). It was selected because its
proposed relations are consistent with the
results of prior studies of underreporting and
premature sign-off activities.
A premature audit sign-off occurs when an

auditor documents the completion of a
required procedure that is not covered by
other audit procedures, without performing
the work or noting the omission of the
procedure. Rhode (1977) found that almost 60
percent of the respondents had prematurely
signed-off on a required audit procedure
some time during their career. Because he
excluded first and second year auditors and
non-CPAs from his survey, it is possible that
Rhode may have understated the magnitude
of premature sign-off activities. In a follow-up
study (which included auditors with less
than two years of experience), Alderman and
Deitrick (1982) found the incidence of
premature sign-off to be more widespread
than that found by Rhode. In particular,
where Rhode found premature sign-off
activity at local and regional firms,
Alderman and Deitrick also found premature
sign-off activity present at the national firms.
Raghunathans (1991) survey of the Big Eight
Eight auditors found that 55 percent of the
respondents had prematurely signed-off at
least very rarely.
Interestingly, Kaplan (1995) suggested that
the conventional methodology used in
premature sign-off studies may have actually
understated the incidence of premature signoff activities. To support this view, he cited
the results of Buchman and Tracys (1982)
study which examined the incidence of
premature sign-off activity using both
conventional and a randomized response
technique designed to overcome participants
reluctance to answer sensitive questions in a
truthful manner. For six of seven audit
procedures, a higher incidence of premature
sign-off behavior was reported when the
randomized response technique was used.
The ethical decision-making model
Modifications to the decision model

Because the data for this study were collected
using a mail-in questionnaire, it was
necessary to make two modifications to the
decision model. First, consistent with prior
research, it was assumed that respondents
perceive underreporting and premature
sign-off as unethical activities. Therefore,
subject awareness of these activities as
ethical issues was not included in the model.
Further, since the surveys cover letter
promised confidentiality, respondents would
expect sensitive issues to be involved.
Second, although the model includes the
behavior and a post-behavior evaluation of
consequences, direct observation of
respondent behavior and subsequent
evaluation was not possible. Thus, the
respondents self-rated intent to underreport
chargeable time or prematurely sign-off
served as the dependent variable, and the
post-behavior evaluation was omitted. It is
noted that with this type of methodology,
intent often serves as a surrogate for
behavior. While it is possible that intentions
may differ from subsequent behavior:
. . . the best predictor of a persons behavior is
his intention to perform the behavior
(Fishbein and Ajzen, 1975, p. 381).
The modified model is given in Figure 2.
[ 479 ]
Mike Shapeero,
Hian Chye Koh and
Larry N. Killough
Figure 1
Integrated model of ethical decision making

18/6/7 [2003] 478-489
Cognitive moral development

Prior studies indicate that an individuals
level of cognitive moral development is
significantly related to their
underreporting and premature sign-off
activities. For example, Ponemon (1992a)
found staff auditors with lower levels of
cognitive moral development
underreported more frequently than

auditors with higher levels. Ponemon and
Gabhart (1993) noted that auditors with
higher levels of ethical reasoning were
more likely to view underreporting and
premature sign-off activities in a negative
light as compared to auditors with lower
levels of ethical reasoning.
Figure 2
Modified integrated model of ethical decision making
[ 480 ]
Mike Shapeero,
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Larry N. Killough
18/6/7 [2003] 478-489
Lampe and Finn (1992) found that managers

had higher levels of moral development than
staff accountants. Further, Ponemon and
Gabhart (1993) found that the level of moral
development of chartered accountants
employed by Canadian firms increased as
their job level increased. These findings,
when coupled with the results of studies that
indicate that managers and partners are less
likely than staff and senior accountants to
engage in underreporting and premature
sign-off activities, support the influence of
moral development[1]. Based on these
results, it is expected that level of cognitive
moral development is negatively related to
the intent to underreport chargeable time
and to the intent to prematurely sign-off on
audit procedures.
Moral evaluations
Hunt and Vitell (1986) suggest that ethical
judgments result from a combination of
deontological and teleological evaluations.
These processes are fundamentally different
a deontological evaluation focuses on the
inherent morality of behavior, whereas a
teleological evaluation is concerned with the
consequences of the behavior. Studies indicate
that these evaluations may be significant
during an accountants ethical decisionmaking process. For example, consistent with
a deontological approach, Ponemon and
Gabhart (1993, p. 33) suggest that:
. . . individuals with a high degree of integrity
tend to form his or her ethical judgment free
from the biases and pressures created both
within and outside the public accounting
firm . . .
While Swindle et al. (1987) found that

accountants tend to use a teleological process
when categorizing behaviors as acceptable or
unacceptable.
Consistent with the assumption that
respondents view underreporting and
premature sign-offs as ethical issues, it is
expected that the use of a deontological
evaluation process is negatively related to
and to the intent to prematurely sign-off. On
the other hand, studies indicate that
individuals who underreport and
prematurely sign-off do so with the
expectation that these activities will provide
them with certain benefits. Hence, it is
expected that the use of a teleological
evaluation process is positively related to the
intent to underreport and to the intent to
prematurely sign-off.
Job level
The results of prior studies indicate that an
individuals job level is significantly related
to his/her underreporting and premature

sign-off activities. Cook and Kelley (1988),
Lightner (1981) and Rhode (1977) all found the
incidence of underreporting to be highest
among staff and senior-staff accountants.
Cook and Kelley (1988) and Kelley and Seiler
(1982) reported that staff and senior-staff
auditors were more likely than managers and
partners to engage in acts of quality
reduction (including premature audit
sign-offs). Rhode (1977) concluded that staff
auditors were the most vulnerable to
premature sign-offs, while Raghunathan
(1991) found senior-staff accountants were the
most likely to prematurely sign-off on audit
procedures. From these results, it is expected
that experience in public accounting, as
measured by job level, is negatively related to
and to the intent to prematurely sign-off on
audit procedures.
Locus of control
Locus of control is:
. . . [a] generalized expectancy that rewards,
reinforcements, or outcomes in life are
controlled either by ones own actions
(internality) or by other forces (externality)
(Spector, 1988, p. 335).
Individuals with an internal locus of control

are more likely to rely on their own
determination of what is right and wrong and
are more likely to accept responsibility for the
consequences of their behaviors. On the other
hand, individuals with an external locus of
control believe that results are attributable to
things beyond their control, and are less
likely to take personal responsibility for the
consequences (Trevino, 1986).
Because individuals with an internal locus
make their own determination of what is
right or wrong and because they believe that
their decisions result in consequences, it
would be expected that they would be less
likely to engage in unethical behaviors.
Therefore, an internal locus of control is
expected to be negatively related to the intent
to underreport chargeable time and to the
intent to prematurely sign-off.
Opportunities
CPAs perceive numerous opportunities to
engage in unethical activities (Finn et al.,
1988). Lightner et al. (1983) found that over
80 percent of their respondents believed that
it was extremely or very possible to
successfully underreport their chargeable
time. Alderman and Deitrick (1982) reported
that more than 70 percent of their
respondents believed that premature
sign-offs resulted from inadequate
supervision and were more likely to occur in
[ 481 ]
Mike Shapeero,
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18/6/7 [2003] 478-489
areas where the risk of being caught was

small. Weaver and Ferrell (1977), Zey-Ferrell
and Ferrell (1982) and Zey-Ferrell et al. (1979)
all found the perceived opportunity to engage
in unethical behavior to be a significant
predictor of ethical decisions. Therefore, it is
expected that the belief that it is possible to
successfully underreport (prematurely
sign-off) is positively related to the intent to
underreport (prematurely sign-off).
Rewards
Accountants believe that the ability to meet
time budgets is an important factor in
determining whether they advance within
their firm (Kelley and Seiler, 1982; Lightner
et al., 1983; Rhode, 1977). Therefore, it is not
surprising that time budget pressures appear
to influence underreporting and premature
sign-off behaviors. Lightner et al. (1983) found
underreporters to be more likely to doubt
their ability to meet time budgets, and to
believe that the expected rewards
(specifically, better performance evaluations,
supervisor recognition of competency and
increased feelings of job security)
outweighed the potential punishments.
Alderman and Deitrick (1982) reported that
staff auditors believed that they were at fault
when budgets were exceeded and responded
by prematurely signing-off in order to meet
the budget. Pany et al. (1989) found that their
subjects believed others were more likely to
prematurely sign-off to meet a time budget
when exceeding the budget would lead to a
negative performance evaluation. Based on
these findings, it is expected that an
individuals expectation that underreporting
(premature sign-off) activities will lead to
rewards is positively related to their intent to
underreport chargeable time (prematurely
sign-off).
Operationalization of model elements

The defining issues test (Rest, 1979) has been
used extensively in prior studies to measure
the level of moral development. Thoma and
Rest (1986) concluded that there is a moderate
link between moral judgment measured
using the defining issues test (DIT) and
behavior. The DIT contains hypothetical
moral dilemmas[2]. For each dilemma,
subjects first rate the importance of 12
statements which represent thinking that is
typical of one of the stages of moral
development, and then rank order the four
statements which they consider to be the
most significant in resolving the dilemma.
Points are assigned to the rank-ordered
statements and result in a P score measure of
moral development, which measures the
[ 482 ]
relative importance an individual assigns to

principled considerations.
Cohen et al. (1993) constructed a
multidimensional ethics scale consisting of
15 bipolar descriptions, and four
accounting-based scenarios. Their results
included extraction of both deontological and
teleological factors. As these results are
consistent with the moral evaluation element
in the Ferrell et al. (1989) model, their scale
and three of their four scenarios were
included in the questionnaire. Consistent
with the scoring used in Cohen et al. (1994),
the deontological and teleological variables
in this study are the sum of the response
scores for those scale items that comprise the
deontological and teleological moral
constructs.
Although locus of control research has
been dominated by the use of Rotters (1966)
scale, correlations between that measure and
other work-related variables have been
rather modest (Spector, 1988, p. 335). In
response, Spector developed a scale
specifically concerned with the work domain
which, according to the results of prior
studies, correlates significantly with
work-related variables and exhibits an
acceptable level of internal consistency
(Spector, 1988). Given that this study
examines ethical issues within a work
domain, Spectors work locus of control was
included in the questionnaire.
To measure the perceived opportunity to
engage in underreporting and premature
sign-off behaviors, participants were asked to
indicate how possible it is to successfully
underreport chargeable time and to
prematurely sign-off. Responses were based
on a six-point Likert scale ranging from
extremely difficult (1) to extremely
possible (6). Participants were also asked
whether underreporting or premature
sign-off activities would lead to rewards.
Responses were based on a six-point Likert
scale ranging from extremely unlikely (1)
to extremely likely (6).
The likelihood of engaging in unethical
behavior was measured with case scenarios
and a series of questions. In the
underreporting scenario, the number of
hours that had already been worked to
perform an audit procedure exceeded the
50-hour time budget. After reading the
scenario, participants were asked a series of
questions; in particular, they were asked to
estimate the likelihood that they would
underreport their chargeable time.
Responses were based on a seven-point
Likert scale ranging from extremely
unlikely (1) to underreport to extremely
likely (7) to underreport. After completing
Mike Shapeero,
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18/6/7 [2003] 478-489
the underreporting scenario, participants

read a second scenario. In this scenario, the
auditor was evaluating internal controls (an
area identified as susceptible to premature
sign-off activity by Alderman and Deitrick,
1982), and had already worked the budgeted
50 hours without completing the procedure.
After reading the scenario, participants were
asked to estimate the likelihood that they
would prematurely sign-off. A seven-point
Likert scale was used.
Research design and methodology

A 14-page questionnaire was administered to
accountants employed by six regional and
national public accounting firms located in
the eastern USA. Upon receiving a firms
agreement to participate in the study, the
questionnaires were mailed to a contact
partner who distributed them. After
completion, each participant returned the
questionnaire to the authors in a
pre-addressed, postage-paid envelope.
The questionnaire was divided into several
parts. The first asked questions related to
demographics and locus of control. This was
followed by the short version of the defining
issues test and the multidimensional scale
and vignettes. Each participant was then
asked to assess his/her ability to successfully
underreport, to successfully prematurely
sign-off, and whether either activity would
lead to personal rewards. Participants then
read the underreporting and premature
sign-off case scenarios and estimated the
likelihood that they would engage in these
activities.
When posing sensitive questions,
researchers are faced with two main
problems: that the subjects refuse to respond
or that they respond so as to conceal
unacceptable behaviors. By having the
questionnaires distributed in-house (rather
than mailing them directly to potential
participants), it was hoped that the subjects
would be more likely to respond. To reduce
the probability of biased responses, several
procedures were used. First, the cover letter
promised anonymity and directed each
participant to return their questionnaire
directly to the authors in a pre-addressed
envelope. Second, the DIT contains both an M
score and consistency check to identify
subjects who are faking responses or not
paying attention. Participants having either
an excessive M score or who were
inconsistent in their responses were dropped
from the sample.
Although it is not possible to determine
how non-respondents would have replied, the
results of prior research indicate that the

responses of non-respondents are similar to
those of late respondents (Armstrong and
Overton, 1977; Babbie, 1979; Oppenheim,
1966). Because the questionnaires were
mailed to the different offices at different
dates, a late respondent was defined as any
completed questionnaire received more than
four weeks after receipt of the first completed
questionnaire from that same office. While
there was no significant difference regarding
the likelihood of premature sign-off, late
respondents judged themselves significantly
less likely to underreport their chargeable
time than did the other respondents.
Statistical methods
Structural equation modelling (SEM) was
used to test the proposed causal models of
(Figure 3 and Figure 4 respectively). This
method of analysis is appropriate given the
causal relationships specified in the models
and the strong theoretical foundations.
Specifically, PROC CALIS in statistical
analysis software (SAS) was used to perform
path analyses of the underreporting and
premature sign-off models. In addition,
descriptive statistics were computed to
summarize the variables and understand the
sample data, and alpha correlation
coefficients were computed to assess the
internal reliability of the constructs (locus of
control, and the deontological and
teleological moral evaluation factors).
Results
In total, 82 usable questionnaires were
returned to the authors (due to a missing
response, the sample size for testing the
premature sign-off model was reduced to 81),
a 35 percent usable response rate. The results
reported in Table I support the use of the
measures included in the questionnaire. The
mean DIT P score of 45.35 is higher, but not
significantly different than those found in
prior studies (see Ponemon and Glazer, 1990;
Ponemon, 1992b; Ponemon and Gabhart,
1993)[3]. The mean locus of control score of
38.76 is comparable to the results of prior
studies as reported by Spector (1988). The
alpha coefficients for the deontological moral
evaluation (0.69), teleological moral
evaluation (0.89), and locus of control (0.88)
indicate acceptable levels of internal
reliability (Hair et al., 1998).
Table I indicates that respondents believe
it is very possible to successfully
underreport their chargeable time
(mean = 5.18), although they think it is
[ 483 ]
Mike Shapeero,
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Larry N. Killough
Figure 3
Structural equation model underreporting

18/6/7 [2003] 478-489
Figure 4
Structural equation model premature sign-off
somewhat unlikely that underreporting

will lead to rewards (mean = 3.12).
Respondents also believe it is only
somewhat possible to successfully
prematurely sign-off (mean = 3.65), and very
unlikely that this behavior will be rewarded
(mean = 2.14). Finally, respondents indicate
that they are somewhat unlikely to
underreport their chargeable time
(mean = 2.71), and very unlikely to
prematurely sign-off (mean = 1.64).
[ 484 ]
Causal model of underreporting

The results of the causal model of
underreporting are summarized in Table II.
As indicated by the goodness-of-fit index of
0.9583, the model provides a good fit. Further,
the null hypothesis of no significant
difference between the model and the data
cannot be rejected (p = 0.2442).
The results indicate significant paths
from deontological moral evaluation
(p = 0.0216), teleological moral evaluation
Mike Shapeero,
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18/6/7 [2003] 478-489
Table I
Descriptive statistics and alpha coefficients
Variable (abbreviation)
Cognitive moral development (V1)
Deontological moral evaluation (V2)
Teleological moral evaluation (V3)
Locus of control (V5)
Possibility of successful underreporting (V6)
Reward of underreporting (V7)
Likelihood of underreporting (V8)
Possibility of successful premature sign-off (V6)
Reward of premature sign-off (V7)
Likelihood of premature sign-off (V8)
Mean
Standard
deviation
45.35
24.12
26.91
38.76
5.18
3.12
2.71
3.65
2.14
1.64
16.39
6.03
7.85
7.77
0.89
1.36
1.84
1.40
1.07
1.02
Job level (V4)

Staff and senior supervisor and manager
Frequency
Percentage
56
26
68.29
31.71
Alpha
coefficient
Deontological moral evaluation (V2)

Teleological moral evaluation (V3)
Locus of control (V4)
0.69
0.89
0.88
Notes: Responses are scored as follows: V6: The possibility of successfully underreporting or prematurely
signing-off is scored on a six-point Likert scale ranging from extremely difficult (1) to extremely possible (6); V7:
The likelihood that underreporting or premature sign-off will lead to rewards is scored on a six-point Likert scale
ranging from extremely unlikely (1) to extremely likely (6); V8: The likelihood of respondents underreporting or
prematurely signing-off is scored on a seven-point Likert scale ranging from extremely unlikely (1) to extremely
likely (7)
Table II
SEM results for underreporting
Path (to-from)
V1-V4
V2-V1
V3-V1
V8-V1
V8-V2
V8-V3
V8-V4
V8-V5
V8-V6
V8-V7
Coefficient
t-value
p-value*
4.74
0.02
0.01
0.01
0.05
0.04
0.91
0.51
0.03
0.45
1.23
0.51
0.11
0.40
2.02
2.00
2.53
2.13
0.18
3.54
0.1093
0.3038
0.4568
0.3457
0.0216#
0.0228#
0.0057#
0.0167#
0.4271
0.0002#
Notes: * 1-tailed t-test; # Significant at a 0.05 significance level.; V1 = Cognitive moral development;
V2 = Deontological moral evaluation; V3 = Teleological moral evaluation; V4 = Job level; V5 = Locus of control;
V6 = Possibility of successful underreporting; V7 = Reward of underreporting; V8 = Likelihood of underreporting;
Model goodness-of-fit index = 0.9583; Model 2 = 14.95 (p-value = 0.2442, df = 12)
(p = 0.0228), job level (p = 0.0057), locus of
control (p = 0.0167) and likelihood of reward
from underreporting (p = 0.0002) to the
likelihood of underreporting. The
numerical signs are also consistent with the
hypothesized relations. That is,
accountants who use a deontological moral
evaluation process are less likely to
underreport, while those who use a
teleological moral evaluation process are
more likely to underreport. The results also
indicate that accountants who perceive a
greater likelihood of reward are more
likely to underreport, while supervisors
and managers (vis-a` -vis staff and seniors)

and accountants having an internal
locus of control are less likely to
underreport. No statistically significant
paths are detected for cognitive moral
development (p = 0.3457) or for the
possibility of successful underreporting
(p = 0.4271).
Causal model of premature sign-off

As reported in Table III, the goodness-of-fit
index of 0.9598 indicates that the causal
model of premature sign-off has a good fit.
Further, the null hypothesis of no significant
[ 485 ]
Mike Shapeero,
Hian Chye Koh and
Larry N. Killough
Table III
SEM results for premature sign-off

18/6/7 [2003] 478-489
V1-V4
V2-V1
V3-V1
V8-V1
V8-V2
V8-V3
V8-V4
V8-V5
V8-V6
V8-V7
Path (to-from)
Coefficient
t-value
p-value*
4.68
0.01
0.01
0.01
0.01
0.01
0.39
0.53
0.01
0.06
1.21
0.35
0.17
0.42
0.73
0.68
1.74
3.48
0.01
0.62
0.1127
0.3617
0.4327
0.3361
0.2318
0.2481
0.0412*
0.0002*
0.4958
0.2680
Notes: * 1-tailed t-test; * Significant at a 0.05 significance level.; V1 = Cognitive moral development;
V2 = Deontological moral evaluation; V3 = Teleological moral evaluation; V4 = Job level; V5 = Locus of control;
V6 = Possibility of successful sign-off; V7 = Reward of sign-off; V8 = Likelihood of sign-off; Model goodness-of-fit
index = 0.9598; Model 2 = 13.80 (p-value = 0.3137, df = 12)
difference between the model and the data
cannot be rejected (p = 0.3137).
At a 0.05 level of significance, the results
indicate only two significant paths. As with
underreporting, supervisors and managers
are less likely to prematurely sign-off than are
staff and senior-level accountants (p = 0.0412).
In addition, accountants having an internal
locus of control are less likely to prematurely
sign-off (p = 0.0002). None of the other proposed
model paths is statistically significant.
Discussion and conclusion

The results suggest that accountants view
premature sign-off activities differently from
underreporting activities, and that what is
significant in the decision-making process
may be influenced by the ethical content of
the decision. For example, while almost 88
percent of respondents felt strongly (i.e. very
or extremely unlikely) that they would not
prematurely sign-off, only 61 percent felt that
way about underreporting. Further, while
reward expectation and a teleological
evaluation process were significantly related
to the likelihood of underreporting, neither
variable was significantly related to the
likelihood of premature sign-off. Finally,
respondents were more likely to believe that
underreporting activities would result in
rewards than would premature sign-off
activities.
These results suggest that while some
accountants may use a consequences-based
approach when making decisions having
lesser ethical content (like underreporting),
they employ a different decision process
when faced with decisions having greater
ethical content (like whether to prematurely
sign-off). If so, public accounting firms may
[ 486 ]
find that using a single approach to reduce

unethical behaviors will not be effective. For
example, an approach that focuses on
personal rewards (or negative rewards
through the use of organizational sanctions)
may reduce underreporting but not
premature sign-off activities. Instead,
appeals to the individuals locus of control
(perhaps during staff training or through the
use of codes of conduct) may be more
effective in reducing the incidence of
premature sign-off.
Interestingly, opportunity appears to play
little part in whether respondents are likely
to underreport or prematurely sign-off. An
overwhelming majority of the respondents
(97 percent) indicated that it was at least
somewhat possible to successfully
underreport while almost 75 percent felt this
way about their opportunity to prematurely
sign-off. This difference seems intuitive
given that underreporting is usually done in
private (when an accountant fills out his/her
time sheet), while premature sign-off occurs
in situations characterized by close
supervision (given the audit team structure
and lack of privacy at client locations) and
workpaper review.
The results also suggest that supervisors
and managers are less likely to underreport,
and to prematurely sign-off than senior and
staff-level accountants. A survival of the
fittest paradigm may explain the influence
of job level where those accountants whose
performance is weakest leave public
accounting (voluntarily or involuntarily)
before they advance within their firms.
There may be a maturation process where, as
employees gain experience, they become
more confident in their abilities and feel less
pressure to engage in unethical activities to
enhance perceptions of their performance.
Mike Shapeero,
Hian Chye Koh and
Larry N. Killough
18/6/7 [2003] 478-489
There may also be an investment aspect

where as individuals build their careers,
they are less willing to place their
investment in danger by engaging in
unethical activities. Further, there may also
be a socialization effect where as accountants
advance in their firms, their personal
interests tend to be more closely tied to their
firms interest and they become less willing
to engage in activities which might damage
their firms.
Finally, the results of prior studies indicate
that individuals with an internal locus of
control are more likely (than externals) to
rely on their own determination of right and
wrong and to take responsibility for their
actions. The results of this study also suggest
that those with an internal locus of control
are less susceptible to outside influences and
are more likely to behave ethically.
ways to disguise the objective of the study or

desensitise the sensitive nature of the survey
questions in order to minimize the response
bias caused by the sensitive nature of ethics
research. Future studies could also examine
the ethical decision-making model in other
ethical decision situations typically found in
the practice of public accounting. The
aggregation of evidence over different
settings may be useful in generating an
understanding of the ethical decision-making
process of public accountants.
Finally, the results of prior studies suggest
that codes of conduct and organizational
sanctions may influence employee ethical
decisions (see, e.g. Lightner et al., 1983; Ford
and Richardson, 1994; Boo and Koh, 2001).
Future studies could include these additional
variables in the ethical decision model.
Notes
Limitations
There are several limitations that should be
considered when evaluating the results of
this study. First, the sample included
auditors from six regional and national
public accounting firms located in the
eastern USA. To the extent that this group is
unique, the findings may not be generalizable
to the general population of auditors and
public accounting firms. Second, the usual
limitations associated with self-reported
questionnaire apply (i.e. response and
non-response bias). The potential for
response bias was mitigated by the
anonymity of the respondents, promised
confidentiality of responses and direct return
of the completed questionnaires to the
authors. Still, the sensitive nature of the
questions may lead to response bias,
especially regarding premature sign-off.
There may also be a problem with
non-response bias regarding the
underreporting questions. Analysis indicates
that the likelihood of underreporting for late
respondents was significantly less than for
the on-time respondents (there was no
significant difference for the likelihood of
prematurely signing-off).
Third, the variables investigated in the
study are not meant to be complete or
exhaustive; there may be other variables that
influence underreporting and premature
sign-off which were not included. Finally, the
study looks only at the antecedents of
behaviors but not the consequences.
1 Research results regarding the relation

between job and level of moral development
have been inconsistent. In contrast to the
findings of Lampe and Finn (1992), and
Ponemon and Gabhart (1993), Ponemon (1990)
found managers and partners had lower levels
of cognitive moral development than staff and
senior accountants. Similarly, Ponemon
(1992b) and Ponemon and Gabhart (1993) found
that the level of moral reasoning decreased as
CPAs job levels increased. Since the results of
prior studies indicate that managers and
partners are less likely to engage in
activities, the inverse relation between job
level and moral development suggests that
level of moral development and likelihood of
activities are inversely related. Part of this
inconsistency may be the result of differences
in how moral development was measured;
Ponemon (1990) used the Moral Judgment
Interview while the other studies used the
Defining Issues Test.
2 There are two versions of the DIT, a
six-vignette version and a shorter
three-vignette subset. Although not as
reliable, the short version correlates highly
(0.91 to 0.93) with the longer version and
possesses corresponding measurement
properties (Rest, 1986). Because of
considerations regarding questionnaire
length and response rates, the shorter version
of the DIT was used.
3 After removing partners from Ponemons
(1992b) sample, the mean DIT P score was 43.1.
The mean score for Canadian Chartered
Accountants in Ponemon and Gabhart (1993)
was 44.2.
Directions for future research

The limitations highlighted above suggest
possible directions for future research. For
example, future research could examine
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[ 489 ]
Internal auditors and the external audit: a transaction

cost perspective
Cameron Morrill
Department of Accounting and Finance, I.H. Asper School of Business,
University of Manitoba, Winnipeg, Manitoba, Canada
Janet Morrill
Department of Accounting and Finance, I.H. Asper School of Business,
University of Manitoba, Winnipeg, Manitoba, Canada
Keywords
Internal auditing,
External auditing,
Transaction costs, Surveys,
Canada
Abstract
Questions exist regarding the
extent to which internal auditors
should participate in the external
audit, and wide variations are
observed in practice. Many
professional bodies increasingly
advocate the view that increased
coordination between the internal
and external auditors, including
increased use of the internal
auditor for the external audit,
provides more efficient and
effective audit coverage. However,
others maintain that internal
auditors should not focus on areas
that are the subject of external
audit interest. This article
attempts to shed light on this
debate by using insights from
transaction cost economics (TCE)
to identify conditions under which
organizations encourage internal
audit participation in the external
audit. An analysis of survey data
collected from directors of
Canadian internal audit
departments indicate that some
(TCE) variables, particularly
transaction-specific investment,
are significantly associated with
internal audit participation in the
external audit.

18/6/7 [2003] 490-504
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482632]
[ 490 ]
As well, relying on internal audit can reduce

the effectiveness of the external audit if the
internal audit department is of questionable
quality (Gramling, 1999).
Evidence of this debate is confirmed by the
wide variation in the observed extent of
internal audit participation in the external
audit. Burnaby and Klein (2000) report that
internal auditors are increasingly
contributing to the work performed for the
external audit, and a study by the Canadian
Institute of Chartered Accountants asserts
that external auditors seeking direct
assistance from internal auditors is common
practice in Canada (CICA, 1989). However,
empirical studies have also documented
significant inter-company differences in

activities performed by internal audit
departments, including activities such as
assisting the external auditor, detecting
errors, and monitoring controls (Mautz et al.,
1984; Felix et al., 1998; 2001).
The decision to have the internal auditors
participate in the external audit is similar to
the vertical integration or outsourcing
decision. As in the generic make-or-buy
problem, audit services can be purchased
from outside the firm or provided from
within the firm (within, of course, some clear
limits). The optimal mix of internal and
external personnel in the external audit
depends upon the costs associated with each
of the available sources. This mix can (and,
based on the studies cited above, apparently
does) vary considerably from company to
company.
In this study, we use transaction cost
economics (TCE) (Williamson, 1985; 1991) to
help explain the variation in internal audit
According to TCE, different institutional or
organizational arrangements (e.g. internal vs
market-mediated, make vs buy) exist
principally for the purpose of facilitating
transactions, i.e. reducing the transaction
costs of conducting a particular activity. TCE
has been used as a framework for analyzing
many different transactions. To our
knowledge, our study is the first that uses it
to explain the participation of internal
auditors in the external audit[1]. This kind of
understanding could help companies and
their external auditors to identify
circumstances under which it would be
economically advantageous to involve the
internal audit department in the external
audit; and could have implications for
staffing and structuring an internal audit
department.

Introduction
While external and internal auditors occupy
distinct roles, many professional bodies
increasingly advocate that coordination of
the external and internal auditors can
provide total audit coverage more efficiently
and effectively (Brink and Witt, 1982; Engle,
1999; Felix et al., 1998; Moore and Hodgson,
1993; Institute of Internal Auditors, 1995). A
higher degree of coordination often will
include greater internal audit participation
in the external audit. For example, Engle
(1999) suggests that internal audit directors
should work aggressively with external
auditors to maximize their reliance on
internal auditors as one way to develop a
more effective strategy for collaboration.
However, the decision to encourage
internal auditors participation in the
external audit is not without controversy.
Gaston (2000, p. 37) asserts that the internal
audit is not a substitute for the external
audit, and that internal auditors should not:
. . . unduly focus on those areas of financial
controls that are the subject of external audit
interest.
Cameron Morrill and

Janet Morrill
Internal auditors and the
external audit: a transaction
cost perspective
18/6/7 [2003] 490-504
We use partial least squares (PLS)

regression to analyze survey data collected
from directors of internal audit departments,
and external auditors, of Canadian
organizations. According to our findings, two
TCE variables are significantly associated
with the extent of internal audit
The paper is organized as follows. We first
review the research into external auditor
reliance on internal auditors. We then
outline the transaction cost model and derive
testable hypotheses related to the external
audit. We then present the results of a partial
least squares analysis of the internal audit
director survey data. Next, we present the
results of an analysis of survey responses of
the external auditors of these same
organizations. Finally, we discuss the results
and offer our conclusions.
External auditors reliance on

internal auditors
In recent years, professional accounting
bodies representing both internal and
external auditors have expressed interest in
increasing the level of coordination between
the internal and the external audit. The
purpose of such coordination is to ensure
adequate total audit coverage and minimize
duplication of efforts (Institute of Internal
Auditors Specific Standard 550; Institute of
Internal Auditors, 1995). This level of
coordination implies a less rigid separation
of responsibilities between the internal and
external auditor. Advocates argue that by
adopting a joint audit approach the
efficiency of both groups is improved without
sacrificing quality or independence (Moore
and Hodgson, 1993).
Significant opportunities exist for
reduction of duplicate audit efforts and
increased efficiencies by increasing internal
auditor participation in the external audit.
Internal auditing is an independent appraisal
function established with an organization to
examine and evaluate its activities as a
service to the organization. As such, the
internal auditors overall interests go far
beyond the system of internal accounting
control, but they do nevertheless include
those accounting controls of interest to the
external auditor. As well, the internal
auditor is interested, in terms of overall
company welfare, in the procurement of the
external auditing services in a manner that
provides good value for the fees charged
and minimizes interference with other
ongoing organizational activities (Brink and
Witt, 1982).
Both US SAS No. 65 (AICPA, 1997) and

Canadian Institute of Chartered Accountants
Handbook Section 5050 (CICA, 1997) allow the
external auditor to rely on evidence
generated from internal audit work when
they are satisfied with the competence and
objectivity of the internal auditors. Should
external auditors opt to rely on the work of
the internal auditors, there are three
potential areas of reliance:
1 understanding the control structure;
2 assessing control risk; and
3 performing substantive tests (Colbert,
1993).
While external auditors would never totally
eliminate their control evaluation and
testing procedures, significant overall
reductions, and complete substitutions in
some areas, are allowable (Engle, 1999).
Indeed, it has been common practice for the
external auditor to seek direct assistance
from internal auditors (Canadian Institute of
Chartered Accountants, 1989).
According to Felix et al. (1998), the trend
towards increased coordination between the
internal and external auditors, and
specifically increased participation by the
internal auditor in the external audit[2], is
the result of three major developments. First,
the Treadway Commissions 1987 report put
pressure on organizations and external
auditors to involve the internal auditing
department in the external audit to a greater
extent. Second, pressure to reduce audit fees
has encouraged external auditors to explore
ways to use the work of internal auditors.
Third, many initiatives of the Institute of
Internal Auditors, such as the development
of professional internal auditing standards
and the growth of the professional
certification program, have served to
increase the stature of the internal auditing
profession.
Clearly, however, there are limits on the
extent to which the external audit can be
internalized and too much internal audit
participation in the external audit can be
detrimental to the effectiveness of both the
external audit and the work of internal
auditors. Gaston (2000, p. 37) agrees that the
work of the external and internal auditors
should be coordinated to remove any
unnecessary duplication, but emphasizes
that the internal audit is not a substitute for
the external audit, and that internal auditors
should not:
. . . unduly focus on those areas of financial
controls that are the subject of external audit
interest.
As well, Gramling (1999) noted that while

external auditors can rely on the work of
[ 491 ]
Cameron Morrill and

Janet Morrill
cost perspective
18/6/7 [2003] 490-504
sufficiently competent and objective internal

auditors without impairing the quality of the
audit, some external auditors, particularly
under conditions of fee pressure, could rely
on internal audit departments of more
questionable quality, which would reduce the
effectiveness of the external audit.
Several research studies have focussed on
the external auditors reliance on the
internal audit function (e.g. Abdel-Khalik
et al., 1983; Brown, 1983; Maletta, 1993;
Gramling, 1996; Brody et al., 1999). Typically,
they have looked at the external auditors
evaluation of the competence, objectivity and
work performance of the internal auditor and
his or her subsequent decision regarding the
appropriate extent of reliance.
Krishnamoorthy (2002) notes that while the
results of these (for the most part,
experimental) studies differ regarding the
relative importance of these three factors, the
studies generally find that all three have an
important impact on external auditor
reliance on the internal audit.
These studies all consider the availability
of the internal audit department as
exogenous. That is, they assume that there is
an internal audit department that is
available to the external auditor. The focus is
exclusively on the external auditors decision
regarding the extent of his or her short-term
(i.e. for this particular audit) reliance on the
internal audit department.
In this study, the availability of internal
audit is endogenous, i.e. is determined by
conditions at work prior to the external
auditors reliance decision. We attempt to
identify those conditions under which an
acceptable internal audit department is
likely to be available to the external auditor.
In order for the external auditor to rely on
the internal audit department, a client must
previously decide to:
.
create an internal audit department;
.
structure it and staff it in such a way that
the external auditor is likely to deem it
acceptable; and
.
make the internal audit staff available to
perform work relevant to the external
audit.
Under what conditions is all of this likely to
occur? Transaction cost economists suggest
that efficiency considerations heavily
influence these outcomes. In other words,
economic forces reward efficient
organizational forms, including the
appropriate structure of the internal audit
department and its relationship with the
external auditor, and punish inefficient
organizational forms[3]. The next section
[ 492 ]
uses transaction cost theory to identify these

economic forces.
A transaction cost economics

analysis of the external audit
The transaction cost economics (TCE)
framework proceeds by: (1) making the
transaction the basic unit of analysis; (2)
expressly identifying alternative market and
internal modes of contracting; (3) identifying
the critical dimensions with respect to which
transactions differed; (4) tracing out the
transaction cost ramifications; and (5)
matching modes to transactions in a
discriminating way (Williamson and Ouchi,
1981, p. 349).
Within the TCE perspective, an organization

is any stable pattern of transactions between
individuals or aggregations of individuals.
Writers in the area have identified at least
three major organizational forms: markets,
hierarchies and hybrid arrangements (see
Leblebici, 1985, for a more complete
taxonomy of organizational forms). Which
form or mode of contracting is more efficient
(and, therefore, which prevails in a
competitive setting) depends upon the level
of transaction costs associated with that
form, where transaction costs are:
. . . broadly defined as the costs of bargaining,
trading, searching, negotiating, policing, and
enforcing agreements the sources of friction
that hinder efficient transactions within
different institutional modes of organizing
(Leblebici, 1985, p. 100)[4].
For example, a consumer could acquire fresh

produce (the transaction) in one of several
different organizational settings. In a market
setting, the consumer buys the produce from
a virtually anonymous vendor. In a
hierarchical or internal setting, the
consumer grows the produce him or herself.
In a hybrid setting, the consumer always
buys the produce from the same supplier,
either under terms of a specific contract or
some informal, long-term commitment.
The organizational setting or form that
prevails is the one that best matches the
transaction in question, i.e. the one that
minimizes transaction costs. TCE identify
three dimensions for characterizing
transactions that give rise to transaction
costs:
(1) uncertainty, (2) the frequency with which
transactions recur and (3) the degree to which
durable transaction-specific investments are
required to realize least-cost supply
(Williamson and Ouchi, 1981, p. 352).
Returning to the fresh produce example, the

market setting is sufficient if the consumer is
confident that he or she can easily judge the
Cameron Morrill and

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18/6/7 [2003] 490-504
quality of the produce on simple inspection.

Suppose, however, that the consumer
requires that the produce be pesticide- and
herbicide-free, and that this condition cannot
be verified by simple inspection (i.e. there is
uncertainty). In the market setting, the
consumer might then have to incur
potentially significant costs to test the
produce. Alternatively, the consumer might
be able to reduce these transaction costs by
identifying and dealing exclusively with a
vendor who can credibly guarantee that no
chemicals were used (a hybrid arrangement);
or the consumer could grow the produce him
or herself (an internal or hierarchical
arrangement).
Empirical research within the transaction
cost framework has been concentrated in the
area of vertical integration (e.g. Walker and
Poppo, 1991; Globerman and Schwindt, 1986;
Anderson and Schmittlein, 1984). In these
studies, some specific transaction is
considered (e.g. an auto manufacturer must
acquire carburetors). Alternative modes of
contracting are explicitly identified (make
in-house or purchase from an external
supplier) and choices among them explained
by reference to uncertainty and specific
investment variables. Among studies
concerned more directly with auditors and
their clients, Levinthal and Fichman (1988)
found that complexity and specific
investment variables were positively related
to the duration of auditor-client
relationships.
The next part of the paper deals with the
application of TCE variables (frequency of
recurrence, uncertainty and
transaction-specific investment) to the
external audit. Most organizations that
undergo external audits do so on a regular
(typically annual) basis. The frequency
dimension is therefore relatively constant for
almost all external audit transactions and is
not expected to be useful in explaining
variations in the level of internalization of
external audit activities. For this reason, the
next section of the paper discusses only
uncertainty and transaction-specific
investment as they apply to the external
audit and derives testable hypotheses.
Uncertainty
Williamson (1985) identifies two kinds of
uncertainty that have transaction cost
implications. The first is environmental
uncertainty, the inability to predict all
contingencies that might affect a particular
transaction. Because the human parties to
the transaction have limited cognitive
abilities, they can only deal with these
contingencies by writing contracts that are
incomplete in some important respects.

Market contracts are cumbersome in the face
of unforeseen contingencies as
opportunistically inclined agents can try to
interpret unspecified clauses of the
agreement to their advantage. TCE theorists
argue that an appropriate response to
increased environmental uncertainty is to
internalize the transaction, where stable,
long-term administration and
communication mechanisms can be
developed to enhance information flow
between the parties and resolve conflicts as
they arise.
Significant environmental uncertainty
exists in the context of external audits
characterized by high levels of complexity[5]
or risk, as either could impose unforeseen
costs onto the external auditor through
litigation or additional audit work.
Johnstone (2000) found that high levels of
audit risk expose partners to uncertainty as
auditors seem to be unwilling or unable to
adopt proactive strategies to manage risk
(such as increasing the audit fee) once the
decision to accept the engagement has been
made.
If TCE is correct, a complex and risky audit
is associated with high transaction costs in a
pure market-based contractual arrangement.
In such an audit, the external auditor might
be faced with difficult fee or contract
renegotiations with the client, or with
accepting lower profit and/or higher risk on
the engagement if certain contingencies
materialize. This is costly for both parties as
the external auditor requires compensation
for the elevated levels of external uncertainty
he or she must assume. In contrast, internal
auditors participating in the financial
statement audit, faced with these same
contingencies, can more easily adapt through
internal administration and communication
mechanisms. Thus the transaction costs
associated with a risky or complex financial
statement audit can be reduced by increasing
the internal audit participation. This
argument leads to the following hypothesis:
H1. Internal auditors participate to a
greater extent in external audits
characterized by greater
environmental uncertainty.
The other form of uncertainty discussed by
Williamson (1985) is behavioral uncertainty,
the level of difficulty involved in evaluating
performance and/or adherence to
contractual agreements. In transactions
characterized by a high level of behavioral
uncertainty, one or more opportunistically
inclined parties might be motivated to shirk
or consume excessive levels of perquisites.
[ 493 ]
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18/6/7 [2003] 490-504
Transaction cost theory suggests that

transactions characterized by high levels of
behavioral uncertainty are best internalized.
Within a hierarchical arrangement,
monitoring mechanisms and performance
histories can be developed that allow more
accurate measurement of performance. This
motivates parties to an agreement to perform
better and/or permits identification of
inefficient or opportunistic individuals.
In the context of an external audit, the
client may have difficulty in assessing the
efficiency with which the audit is performed
and/or the quality of the audit work. This
can be costly to the client if the audit work is
performed inefficiently or ineffectively.
Where possible, the client should prefer to
entrust to internal auditors those aspects of
the audit where performance is difficult to
measure, in order to take advantage of
monitoring mechanisms that are not
available within a market setting. This
argument leads to the following hypothesis:
greater extent in external audits
characterized by greater behavioral
uncertainty.
Transaction-specific investment
A transaction-specific investment is one that
is necessary to support a particular
transaction, but is not readily redeployable
or useful to any other transaction. Joskow
(1988) discusses four different types of
transaction-specific investment:
1 Site specificity. The buyer and seller are
located very close together, typically to
minimize inventory and transportation
costs. Once in place, the assets involved
are very difficult to move.
2 Physical asset specificity. One or both
parties to the transaction make
investments in equipment that has design
characteristics specific to the transaction
and little alternative use.
3 Human asset specificity.
Transaction-specific human capital that
often arises through a learning-by-doing
process.
4 Dedicated assets. General investments
made by a supplier that would not
otherwise be made but for the prospect of
selling a significant amount of product to
a particular customer.
Examples of transaction-specific investments
which have been studied within the TCE
literature include investment in equipment
dedicated to the manufacture of some specific
product and which has no alternative use
(e.g. Lyons, 1995); specialized
communications hardware and software in
[ 494 ]
the insurance industry (e.g. Zaheer and

Venkatraman, 1994); and specialized
knowledge required of sales personnel in
order to handle particular products (e.g. John
and Weitz, 1988).
Transaction-specific investment has
important transaction cost implications
because it creates a monopolist-monopsonist
relationship between the parties (or, at the
very least, a small numbers situation). The
party who has undertaken the investment is
the least-cost supplier of the good in question,
but the only interested consumer is the other
party to the transaction. Each party is
dependent upon the other and, therefore,
vulnerable to opportunistic action. TCE
posits that transactions characterized by
high levels of transaction-specific
investments are cumbersome in a market
setting. Agents are reluctant to undertake
transaction-specific investment if there is no
guaranteed long-term return to that
investment. A long-term relationship
between the parties, either through an
internal, hierarchical structure or some less
formal alliance, provides protection for both
parties.
Transaction-specific investment in the
form of human asset specificity is often a
significant feature of the external
auditor-client relationship. Some
considerable knowledge of the clients
business is considered necessary to the
performance of the external audit,
particularly in the context of general
planning of the audit. This kind of knowledge
assists the auditor in identifying the nature
and source of audit evidence available,
identifying areas that need special
consideration, and subsequent
determination and evaluation of audit
procedures. Specific information required
includes:
.
industry data, including information on
the nature of the business and industry,
current business conditions and trends,
and the extent of government regulation;
.
client data concerning organization
structure, capital structure, nature of
products and services, major suppliers
and customers; and
.
financial data on sales and operating
results, budgeting, and the nature of
accounting records.
This knowledge is generally obtained by
reviewing prior years audit work, reading
internal client reports, meeting with client
personnel and reviewing industry
publications, research studies, periodicals
and financial statements of other enterprises
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cost perspective
18/6/7 [2003] 490-504
in the industry (Anderson, 1984; CICA, 1997,

section 5140).
The acquisition of this knowledge can
represent a substantial transaction-specific
investment on the part of the auditor. If the
client is in a very complex and dynamic
industry, considerable work is necessary to
form an adequate understanding of that
industry. If there are relatively few firms in
the industry, the industry-specific knowledge
necessary to the audit is less likely to be
readily transferable either to or from other
audit work (in that it is less likely that the
auditor will have other clients in the same
industry). TCE would predict that, in a case
like this, a client might be more likely to
involve internal auditors in the external
audit as they can more efficiently accumulate
and impart the required specific knowledge
to the external auditor, as compared to
having the external auditor acquire the
information independently. This is
consistent with the assertion by Engle (1999)
that:
. . . internal auditors who are intimately
familiar with the organization under review
are in an ideal position to provide
information about the business behind the
financial statements.
This does not imply that the existence of an

internal audit department means that the
external auditor does not need to acquire
knowledge of the clients business. Rather,
the external auditor can rely on the work of
the internal auditor, such as narratives and
descriptions of the internal control system
prepared by the internal auditor, to acquire
more efficiently the requisite knowledge of
the client.
This argument is not universally accepted
by auditing researchers. Taylor (2000), for
example, found that external auditors tended
to compensate for their relative lack of
industry-specific expertise by increasing
their inherent risk assessments. Engle (1999)
then suggests that it may be less appropriate
for external auditors to rely on the internal
auditor in areas where there is a high risk of
material financial statement
misstatements[6]. Taken together, this could
suggest that external auditors would use the
internal auditor less when the audit
engagement required high levels of specific
expertise.
The TCE specific investment hypothesis is
stated below:
greater extent in external audits which
require substantial audit-specific
knowledge.
Methodology
Data
Survey questionnaires were mailed to all
Canadian members of the Institute of
Internal Auditors who were designated
directors of their organizations internal
audit department. Of 330 questionnaires sent
out, 153 (46 percent) were returned. After
excluding questionnaires from 18 federal and
provincial government ministries and five
blank questionnaires, 130 usable
questionnaires were available for this study.
This final sample included 32 public sector
and 98 non-public sector organizations.
Method
Our analysis is difficult for several reasons.
First, the TCE constructs are not directly
observable (i.e. they are latent constructs).
Therefore, it is necessary to use multiple
measures (or indicators) in an attempt to
capture adequately each construct. Second,
many of the indicators we use are ordinal in
nature. Finally, our sample size is limited to
130 cases. Partial least squares (PLS) analysis
is well suited to the estimation of this type of
model with data of this kind (Fornell and
Bookstein, 1982; Wold, 1982) and is used
here[7].
The PLS algorithm is designed to maximize
the predictive ability of the estimated model.
It simultaneously estimates each of the latent
variables as a linear function of the
designated indicators and the path
coefficients for the relationships specified
among the latent variables. Because of its
lenient assumptions concerning the nature
and distribution of the indicators, PLS
provides no statistical tests of the path
coefficients. However, bootstrapping can be
used to build distributions of model
parameters by repeatedly analyzing different
subsets of data. This process is used here to
determine the statistical significance of the
estimated path coefficients.
Measurement of the variables

The first step in PLS analysis is to specify the
structural model (i.e. the expected
relationships among the latent variables) and
the latent-variable-to-indicators
relationships in the measurement model.
From the discussion and hypotheses above,
we identify eight latent variables related to
audit, behavioral uncertainty, external
uncertainty and specific investment. The
structural model is laid out in Figure 1 and
the latent-variable-to-indicators
relationships are described in Table I.
[ 495 ]
Cameron Morrill and

Janet Morrill
cost perspective
Figure 1
Model of internal audit participation in external audit

18/6/7 [2003] 490-504
Participation (LV1)
Three indicators are used to measure the
degree of internal audit department
participation in the external audit (hereafter,
simply participation). Internal audit
directors were asked to estimate in global
terms the proportion of external audit work
performed by the internal audit department.
It is interesting to note that the proportion of
external audit work performed by the
internal audit department varied widely,
from 0 percent to 80 percent.
Internal audit directors were also asked to
identify from a list of specific external audit
activities those in which their department
was involved (see Figure 2). We argue that
this operationalization of participation
captures elements of both the breadth and
depth of internal audit participation in the
external audit. Finally, internal audit
directors were asked their level of agreement
with the statement that there was little
internal audit involvement in the external
audit.
Behavioral uncertainty
Respondents were asked to evaluate how
difficult it was to measure the performance of
the external auditor with respect to several
dimensions of external audit work. Based on
a factor analysis of the survey results, we
[ 496 ]
identified three areas of behavioral

uncertainty, regarding: use of client
personnel (LV2); quality of audit work (LV3);
and efficiency of audit work (LV4).
Environmental uncertainty
Respondents were asked about
characteristics of their organizations that
potentially render the external audit more
complicated and unpredictable, thereby
entailing unforeseen additional audit work
or litigation risk. Specifically, we inquired
about the complexity of firm transactions
(LV5), the geographical dispersion of firm
activities (LV6) and the size of the
organization (LV7).
The size indicator was measured by the
number of organization employees, as
provided by the respondents. Sales and assets
are alternative measures of organizational
size and are both more frequently used in
empirical studies in accounting. These items
are not meaningful, however, for many
not-for-profit organizations, and were not
provided by many of our survey
respondents[8]. To maximize our sample size
for this analysis, then, we elected to use
number of employees over accounting
measures of size.
Similarly, we do not use receivables or
inventories as proxies for audit complexity,
Cameron Morrill and

Janet Morrill
cost perspective
Table I
Latent variables (LV) and their indicators (X)

18/6/7 [2003] 490-504
LV1: Participation
X1 Number of external audit activities in which your internal
audit department work is used
X2 Percentage of external audit you estimate is performed by
your internal audit department
X3 There is little internal audit involvement in external audit
(1 = strongly agree; 7 = strongly disagree)
Internal consistencyb = 0.89
Max
Loadinga
69
0.89
18.5
80
0.89
3.9
2.3
0.76
3.3
1.6
LV3: Quality of audit work

X5 Ability to detect errors
X6 Ability to detect internal control weaknesses
4.0
3.6
1.5
1.5
1
1
7
7
0.85
0.93
LV4: Efficiency of work

X7 Use of most cost-effective auditing techniques
X8 Audit work performed as quickly as possible
4.1
3.2
1.7
1.5
1
1
7
7
0.87
0.89
Environmental uncertainty
LV5: Complexity of transactions
X9 Our firm enters into many unusual transactions
(1 = strongly disagree; 7 = strongly agree)
4.8
1.8
3.1
3.4
11
7.7
1.5
3.9
11
5.3
5.1
4.8
4.4
4.4
4.2
4.8
4.6
1.4
1.4
1.6
1.6
1.5
1.5
1.4
1.5
1
1
1
1
1
1
1
1
Latent variables (LV)/indicators (X)
Behavioural uncertainty
How difficult is it to evaluate the performance of the external
auditor with respect to each of the following areas
(1 = not difficult; 7 = very difficult)?
LV2: Use of client personnel
X4 Efficient use of client personnel (excluding internal audit
personnel)
LV6: Geographical dispersion

X10 In how many provinces does your company have
divisions, branches, etc.?
LV7: Organization size
X11 Natural logarithm of number of employees
LV8: Specific investment
Specialized knowledge of this company and its industry is
necessary on the part of the external auditor in order to
perform the following activities (1=strongly disagree;
7 = strongly agree):
X12 Understanding the nature of our business
X13 Planning the audit
X14 Documenting and evaluating the internal control system
X15 Testing the internal control system
X16 Designing substantive tests
X17 Performing substantive tests
X18 Designing analytical review procedures
X19 Performing analytical review procedures
Mean
Std dev.
17.6
16.5
15.8
Min
7
7
7
7
7
7
7
7
0.69
0.77
0.82
0.84
0.8
0.89
0.87
0.86
Notes a Loading is a measure of the correlation between the specific indicator and its latent variable. Loadings of
0.7 or better indicate an adequate level of individual indicator reliability; b The internal consistency measure is
the one suggested by Fornell and Larcker (1981). Scores of 0.7 or better indicate an adequate level of latent
variable internal consistency
[ 497 ]
Cameron Morrill and

Janet Morrill
cost perspective
Figure 2
External audit activities in which internal audit work is useda

18/6/7 [2003] 490-504
as Simunic (1980) did, as these items were not

reported for many of the organizations in our
sample.
Specific expertise (LV8)

Respondents assessed the extent to which
specialized knowledge of the organization
was necessary to perform specific aspects of
the external audit.
Results
Although the measurement parameters and
path coefficients are estimated together by
the PLS algorithm, a PLS model is assessed in
two stages: first, the assessment of the
reliability and validity of the measurement
model and second, the assessment of the
[ 498 ]
structural model (i.e. the significance of the

path coefficients and percentage of variance
explained). The principle is to ensure that we
have reliable and valid measures of the latent
variables before attempting to draw
inferences regarding the relationships
among them.
The measurement model

Results in Table I indicate that all of the
latent variables exhibit acceptable levels of
internal consistency. The loading of each
indicator on its latent variable is
approximately 0.7 or higher, the rule of
thumb recommended by Carmines and Zeller
(1979). Additionally, the internal consistency
of each latent variable, using the measure
suggested by Fornell and Larcker (1981), is
Cameron Morrill and

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cost perspective
18/6/7 [2003] 490-504
well above the suggested benchmark of 0.7.

Taken together, these results indicate
adequate internal consistency.
Discriminant validity is a measure of the
extent to which a given construct is different
from other constructs in the model. The
results in Tables II and III suggest that the
latent variables we use do have adequate
discriminant validity. Table II shows that the
correlations between each latent variable
and its indicators (printed in italics) are
higher than the correlations between those
indicators and any other latent variable.

Table III is the matrix of bivariate
correlations among the latent variables. The
diagonal elements are the square roots of the
average variances extracted (the average
variance shared between the latent variable
and its indicators). These diagonal elements
are greater than any of the off-diagonal
elements, indicating that each latent variable
is more closely associated with its indicators
than with any of the other latent variables
(Fornell and Larcker, 1981).
Table II
Bivariate correlations between latent variables and indicators
Indicators
X1
X2
X3
X4
X5
X6
X7
X8
X9
X10
X11
X12
X13
X14
X15
X16
X17
X18
X19
LV1
LV2
LV3
0.89
0.90
0.75
0.02
0.06
0.12
0.18
0.20
0.13
0.1
0.23
0.06
0.18
0.18
0.27
0.27
0.37
0.30
0.37
0.06
0.03
0.04
1
0.17
0.28
0.27
0.18
0.02
0.04
0.14
0.10
0.06
0.15
0.12
0.12
0.07
0.13
0.10
0.12
0.07
0.10
0.27
0.81
0.95
0.34
0.27
0.06
0.12
0.1
0.11
0.09
0.06
0.07
0.08
0.01
0.02
0.01
Latent variables
LV4
LV5
0.20
0.20
0.16
0.25
0.24
0.35
0.87
0.89
0.04
0.08
0.04
0.05
0.02
0.14
0.11
0.06
0.08
0.03
0.03
0.17
0.17
0.05
0.02
0.02
0.07
0.01
0.05
1
0.07
0.1
0.37
0.38
0.25
0.20
0.30
0.29
0.28
0.21
LV6
LV7
LV8
0.11
0.08
0.07
0.04
0.09
0.12
0.14
0.00
0.07
1
0.26
0.04
0.03
0.02
0.00
0.10
0.07
0.15
0.12
0.17
0.24
0.15
0.14
0.10
0.09
0.08
0.00
0.1
0.26
1
0.07
0.08
0.10
0.12
0.14
0.16
0.14
0.15
0.30
0.37
0.17
0.12
0.02
0.06
0.04
0.07
0.32
0.09
0.16
0.69
0.77
0.82
0.84
0.87
0.90
0.87
0.86
Notes LV1: Internal audit participation in external audit; LV2: Behavioral uncertainty use of client personnel;
LV3: Behavioral uncertainty quality of audit work; LV4: Behavioral uncertainty efficiency of audit work; LV5:
Environmental uncertainty complexity of transactions; LV6: Environmental uncertainty geographical
dispersion; LV7: Environmental uncertainty organization size; LV8: Specific expertise; Correlations printed in
italics are those between each latent variable and its indicators
Table III
Bivariate correlations of latent variables
LV1
LV2
LV3
LV4
LV5
LV6
LV7
LV8
LV1
LV2
LV3
LV4
LV5
LV6
LV7
LV8
0.85
0.02
0.11
0.22
0.13
0.1
0.23
0.34
1
0.27
0.25
0.02
0.04
0.14
0.12
0.88
0.35
0.06
0.12
0.1
0.04
0.88
0.04
0.08
0.04
0.02
1
0.07
0.1
0.32
1
0.26
0.09
1
0.16
0.83
Notes LV1: Internal audit participation in external audit; LV2: Behavioral uncertainty use of client personnel;
LV3: Behavioral uncertainty quality of audit work; LV4: Behavioral uncertainty efficiency of audit work; LV5:
Environmental uncertainty complexity of transactions; LV6: Environmental uncertainty geographical
dispersion; LV7: Environmental uncertainty organization size; LV8: Specific expertise; Diagonal elements (in
italics) are the square roots of average variances extracted
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The structural model

The results of the PLS estimation of the
model are presented in Figure 3. The model
explains 20.9 percent of the variability in the
participation construct.
The internal uncertainty coefficients are
not statistically significant and two of them
are negative, contrary to our prediction.
There is no support here for H1.
The results indicate some weak support for
H2 in that the geographical dispersion
coefficient is positive and statistically
significant (p < 0.10). The complexity of
transactions coefficient is not statistically
significant. Contrary to H2, the size
coefficient is negative.
Finally, the specific expertise coefficient is
positive and statistically significant. This
constitutes strong support for H3.
Public sector vs private sector

organizations
TCE is based on the assumption that
competitive forces in the market place drive
firms to adopt technologies and
administrative structures that minimize

costs. To the extent that public sector
organizations are insulated from this sort of
competition, they might be able to adopt and
maintain inefficient systems of
administration. The presence of public sector
organizations in our sample might bias
against finding results that are consistent
with TCE predictions. To test whether this is
the case here, we dropped public sector
organizations from the sample and reran the
analysis. The results obtained were not
qualitatively different from those obtained
using the full sample.
External auditor survey

The results reported above are founded upon
three maintained hypotheses. Specifically,
we assume that the internal audit director is
able to assess accurately: first, the TCE
dimensions (uncertainty,
transaction-specific investment) of the
external audit; and second, the extent of the
audit. In addition, we assume that internal
Figure 3
Results of partial least squares structural model estimation
[ 500 ]
Cameron Morrill and

Janet Morrill
cost perspective
18/6/7 [2003] 490-504
auditors in our sample who do participate in

the external audit meet the external auditors
requirements regarding competence and
objectivity, i.e. we assume that the variation
in internal audit participation is due
primarily to TCE factors, rather than the
external auditors refusal to rely upon the
internal audit department due to concerns
about internal audit quality or some personal
preference that might prevent reliance on the
internal auditor.
In order to test, at least partially, the
validity of these assumptions, we asked the
internal audit directors who responded to
our survey to send an additional, shorter,
survey to their organizations external
auditor, which was returned directly to us
using an enclosed envelope. Of the 130 firms
that responded to the internal audit survey,
69 external auditors also responded.
We compared the external and internal
auditors assessments of the internal audit
participation for the 69 firms with both
internal and external auditor responses. The
external and internal auditors evaluations
were highly and significantly correlated
(Pearsons r = 0.78 for the proportion of audit
work performed by the internal audit
department; r = 0.62 for number of external
audit activities in which internal audit work
is used), giving us some assurance as to the
validity of the internal auditors
assessments.
In addition, we re-ran our PLS sample for
the 69 firms, using the external auditor
assessments as the dependent variable rather
than the internal audit directors
evaluations. Specific expertise was still
significant and positively related to
participation, but geographical dispersion
(which was marginally significant in the
original analysis) was no longer significant.
Therefore, using the external audit responses
gives us similar results overall.
At least two features of our study provide
assurance that the internal auditors in our
sample were of acceptable quality to their
external auditors. First, all of the internal
auditors included in the survey were
members of the Institute of Internal Auditors
and possessed, therefore, some level of
professional qualifications. Second, our
survey results suggest that the external
auditors were, for the most part, impressed
with the quality of the internal audit
departments. The quality of the internal
audit departments was rated by 96 percent of
respondents as average or above. Similarly,
on a seven-point likert scale, 93 percent
agreed (score of four or above) that their
clients internal audit department possessed
sufficient independence, and 95 percent
agreed that the internal audit department

possessed sufficient competence.
Finally, the external auditors
overwhelmingly believed (98 percent giving a
score of four or above) that external auditors
should rely on internal audit whenever
possible. Taken together, these results
provide at least some assurance as to the
validity of our third maintained hypothesis,
that the internal auditors in our sample met
the external auditors standards for
competence and objectivity; and the external
auditors did not have strong reservations
about using the work of qualified internal
auditors.
Discussion and conclusions

Our results indicate that audit-related
specific expertise is strongly associated with
audit. This result is consistent with much of
the empirical research in TCE, where
Williamson (1991) has noted that, of the TCE
variables frequency, uncertainty and asset
specificity, the latter appears to contribute
most significantly to the choice of
governance structure. This result is also
consistent with those of studies more closely
related to auditing. Widener and Selto (1999)
found that asset specificity was significantly
associated with extent of outsourcing of
internal audit activities; and Levinthal and
Fichman (1988) found that specific
investment was associated with duration of
auditor-client relationships.
This result potentially gives some insight
into the controversy surrounding the
relationship between audit-specific expertise
and internal audit participation alluded to in
the development of H3. When an audit
requires substantial specific expertise,
external auditors in our sample tend to
increase reliance on internal audit.
Furthermore, our results suggest that
audit-specific expertise is a more important
determinant of internal audit participation
than measures of uncertainty or complexity.
This implies that a company whose audit
requires high levels of company-specific
expertise might achieve greater efficiencies
by promoting its internal auditors
participation in the external audit. This
implies that a company in this situation
would be well advised to staff and structure
its internal audit department in such a way
that it would meet the external auditors
professional requirements.
Our study has some limitations. First, our
measures rely heavily on the internal audit
directors impressions. To the extent that the
[ 501 ]
Cameron Morrill and

Janet Morrill
cost perspective
18/6/7 [2003] 490-504
internal audit director has a good

understanding of the external audit and how
it is carried out within his or her
organization, this feature is an advantage of
our study over archival studies like
Levinthal and Fichman (1988). If this is not
the case, however, the internal auditors
evaluations may have questionable validity.
Using external auditor assessments of
internal audit participation in our analysis,
as described above, yielded results similar to
those obtained from analyses based solely on
internal auditor assessments. This provides
some assurance regarding the validity of
internal auditor perceptions of the external
audit.
This issue might be indirectly related to
the internal uncertainty results reported
here. We found a negative association
between internal uncertainty and internal
audit participation in the external audit,
when, according to H2, internal uncertainty
(the inability to measure auditor
performance) should be associated with
increased internal audit participation in the
external audit. A possible explanation for
this finding is that as internal audit
participation increases, internal auditors
work more closely with the external auditor
and are, therefore, better able to evaluate the
work of the external auditor. If this argument
is correct, it might well induce a negative
correlation between internal audit
participation and internal uncertainty.
A second limitation pertains to the
identification of alternative modes of
contracting that are available to
organizations and their external auditors.
Our dependent variable is the extent of
audit. Levinthal and Fichman (1988),
however, find evidence that complexity and
specific investment factors are also
positively related to the duration of
auditor-client relationships. This suggests
that extensive involvement in the external
audit by internal auditors is not the only
solution to the transaction cost problem.
Future research might extend our survey
approach to analyze the duration of the
auditor-client relationship and whether this
is a complement to, or a substitute for,
internal audit involvement in the external
audit.
Notes
1 Widener and Selto (1999) use transaction cost
economics to explain firms decisions to
outsource internal auditing activities. Their
analysis identifies factors associated with the
participation of (typically) external auditors
[ 502 ]
in internal audit work, while this study is

concerned with the reverse.
Several empirical studies have examined the
extent of involvement of the internal audit
department in the external audit. For
examples, see Barett and Brink (1980); Mautz
et al. (1984); Taylor et al. (1997); and Felix et al.
(1998).
Transaction cost economics (TCE) might help
us to predict or explain the appropriate level
of internal audit participation in the external
audit, but it does not tell us how the client and
the external auditor arrive at this level. For
example, the client might inadvertently
structure the internal audit department
optimally according to TCE without any
knowledge or consideration of TCE factors.
Similarly, the client might not consider using
the internal audit in the external audit when
the internal audit department is created. TCE
predicts only that clients that have adopted
TCE-efficient structures will be rewarded with
lower costs, and therefore, have a competitive
advantage over other organizations. Other
things being equal, efficient transactional
forms will prevail, regardless of how they
come to exist.
TCE assumes that the cost of basic factors is
competitively priced and constant across
different governance structures. The choice of
governance structure affects only the
transaction costs.
Simunic (1980) suggests that audit complexity
is related to the size of the client, the diversity
of the clients operations and auditing
problems associated with the clients
receivables and inventories.
Maletta (1993), however, found that the levels
of inherent risk did not affect auditors
decisions to employ internal auditors as
assistants.
Partial least squares (PLS) is particularly
useful in analyzing relatively small data sets.
The measurement and structural parameters
of a PLS model are estimated iteratively, using
ordinary least squares estimation. According
to the rule of thumb suggested by Barclay
et al. (1995), the minimum sample size
required for consistent estimates is ten times
the number of parameters estimated in the
largest regression model within the overall
causal model. In this study, the minimum
suggested sample size is 10 7 = 70, where
seven is the number of constructs leading to
the endogenous construct participation.
We replicated our analysis using revenues and
total assets as alternative measures of size,
using only those cases that reported these
variables. The results were not qualitatively
different from those obtained using number of
employees as a measure of size, and so are not
reported here.
Cameron Morrill and

Janet Morrill
cost perspective
18/6/7 [2003] 490-504
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Janet Morrill
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The authors acknowledge

the assistance of the
Institute of Internal
Auditors and, in particular,
the Ottawa, Canada
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benefitted from the
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The Mad Hatters corporate tea party
Philomena Leung
RMIT University, Melbourne, Victoria, Australia
Barry J. Cooper
RMIT University, Melbourne, Victoria, Australia
Keywords
Corporate governance, Ethics,
Standards, Accountancy
Abstract
This paper aims to provide an
insight into the corporate greed
and consequent corporate
collapses of companies such as
HIH, One.Tel and Harris Scarfe in
Australia, while concurrently,
Enron, WorldCom and other
companies were attracting the
attention of the accounting
profession, the regulators and the
general public in the USA. It is
argued that the rise in economic
rationalism and the related
increased materialism of both the
public and company directors and
managers, fed the corporate
excesses that resulted in
spectacular corporate collapses,
including one of the worlds
largest accounting firms. The
opportunistic behaviour of
directors, and managers and the
lack of transparency and integrity
in corporations, was compounded
by the failure of the corporate
watch-dogs, such as auditors and
regulators, to protect the public
interest. If the history of bad
corporate behaviour is not to be
repeated, the religion of
materialism needs to be
recognised and addressed, to
ensure any corporate governance
reforms proposed for the future
will be effective.

18/6/7 [2003] 505-516
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482641]
Tea for two and me and you

There was a table set out under a tree in front
of the house, and the March Hare and the
Hatter were having tea at it: a Dormouse was
sitting between them, fast asleep, and the
other two were using it as a cushion, resting
their elbows on it, and talking over its head.
Very uncomfortable for the Dormouse,
thought Alice; only, as its asleep, I suppose
it doesnt mind. The table was a large one,
but the three were all crowded together at one
corner of it: No room! No room! they cried
out when they saw Alice coming. Theres
plenty of room! said Alice indignantly, and
she sat down in a large arm-chair at one end
of the table (from Alice in Wonderland, by
Lewis Carroll).
Communications, the sixth largest cable

provider in the country, which inflated its
revenue with a $3 billion off-the-books
personal borrowing by the founding family;
Xerox, which was fined $10 million to settle
fraud charges by the SEC after it improperly
reported a $6.4 billion in revenue; while the
story with WorldCom continues to unfold
(Wallis, 2002). In Australia, the demise of
One.Tel, Harris Scarfe and HIH Insurance,
Australias largest corporate collapse, have
to some extent mirrored the American
experience, albeit on a smaller scale.
The greed and consequent loss of
confidence in the corporate sector is of
concern to many Australians. According to
the Australian Prudential Regulation
Authority (2002), 46 per cent of all
superannuation funds were invested in
equities or unit trusts, totalling A$245 billion
Accordingly, a large number of Australians
have an interest in the performance of
Australian companies, as their retirement
incomes depend on the strength of the share
market. Also, many Australians have a
further interest in the share market through
direct ownership of shares. These investors
have a right to know that a company is being
properly managed and have access to the
information they need to make their
investment decisions. Judging by the
constant press, they have not been impressed
with the feeding frenzy at the Mad Hatters
corporate tea party.
In discussing the current corporate
scandals, following Enron and WorldCom,
Wallis (2002) argues that:
The tea party of corporate greed has been

exposed with a vengeance in recent times,
with the CEOs and directors (the March
Hares and The Hatters) having their fill; the
regulators (the Dormouse) caught sleeping;
and the accountants and auditors (Alice),
joining the fray at the surreal tea party.
Excess in corporate life is not new, as the
party seems to come around every decade or
so until the bubble seems to expand another
size in absurdity and cost to the community,
before it finally implodes once again (Hewett,
2002). However, this time, an increasingly
angry public have seen their superannuation
and pension savings savagely mauled and
respect for corporate managers, regulators
and the accounting profession has arguably
sunk to an all time low. One of the big five
global accounting firms, Arthur Andersen,
has disappeared in the implosion, along with
the well known collapses of Enron,
WorldCom, Global Crossing and all the
others. In many parts of the developed world,
corporations reported to have been cooking
their books have become constant news. In
America, the recent list includes Adelphia
The reactions to the recent corporate

collapses by governments and professional
bodies have generally focused on regulations
on corporate governance and on the

. . . the tree of the American economy is rooted

in the toxic soil of unbridled materialism.
[ 505 ]
Philomena Leung and

Barry J. Cooper
The Mad Hatters corporate
tea party
18/6/7 [2003] 505-516
enforcement of professional codes. However,

as the following view indicates, there might
be other fundamental elements in the
corporate regime, which need to be examined
more closely. Wallis (2002) observes that the
entrepreneurial spirit and social innovation
fostered by a market economy has benefited
many, and should not be overly encumbered
by stifling regulations. But left to its own
devices and human weaknesses, the market
will too often disintegrate into greed and
corruption. Capitalism needs rules, or it
easily becomes destructive. A healthy
balancing relationship between free
enterprise and public accountability and
regulation is morally and practically
essential.
Following a brief analysis of the concept of
materialism, this paper discusses the three
corporate collapses in Australia, namely,
One.tel, Harris Scarfe and HIH. This
examination highlights some common
threads in the collapses, which include:
.
inappropriate management
compensation;
.
creative accounting;
.
failure of directors and managers to
exercise due diligence;
.
lack of adequate regulation; and
.
lack of independence in the audit
function.
Although it is generally acknowledged that
the key failure of such collapses lies in the
lack of effective corporate governance, the
analysis that follows offers a different view. It
is argued that the relationship of materialism
and corporate collapses has been largely
overlooked by the numerous corporate
governance recommendations, which merely
scratch the surface of the problems.
The new religion of materialism

As demonstrated by Toms (2002), the collapse
of a system of open corporate accountability
was due to the rise of a clique of shareholderentrepreneurs who instigated accounting
manipulation. Toms detailed analysis of the
Lancashire cotton mills from 1870-1914,
shows that social capital (namely, the capital
contributed by workers) demanded accurate
financial information, with the support of cooperative governance. But systematic wealth
transfers in favour of cliques of promoters,
directors and institutions, narrow the social
base of share ownership, increasing the
power of the cliques and reducing proper
accountability. This cyclical effect can be
seen also in agency compensation, a
mechanism to minimise agency costs by
aligning individual agents interests with
[ 506 ]
that of the organisations. But as such a

mechanism becomes the tool for wealth
transfers, and prey to power and
materialism, agency compensation becomes
the rationale for creative accounting and
ultimately the demise of corporations. Also,
accounting and auditing rules develop
according to the accountability demanded by
collective capital, which is in turn the subject
of manipulations by managerial agents,
resulting in a failure to produce transparent
information.
Looking once again at history, Toms (2002)
claims that in many companies in the late
1890s, directors-owners consolidated their
control via the mechanism of extraordinary
general meetings. They put forward and
secured approval for the adoption of new
articles, allowing the plutocratic one share
one vote system, voting by proxy, minimum
shareholding qualifications for directors and
the removal of the obligation to forward
accounts to shareholders. Their rise to power
is consistent with Marxs (1984) description of
a new financial aristocracy. Capital
ownership centralised around cliques of
richer shareholders able to exclude residual
shareholders and to impose tightly controlled
nominee managers (Toms, 1998; Tyson, 1968).
Interlocking directorships and shareholdings
became commonplace a feature of those
collapsed corporations.
Examples of creative accounting were
facilitated by the changes in governance and
monitoring structure that occurred as early
as the 1870s. Auditors were recruited from
the shareholder body of co-operative
companies. In cases of suspected frauds,
shareholder committees of investigation
were set up but small investors lost in most
cases (Toms, 1994). Such committees were
ineffective, and although they were able to
quantify losses ex post, fraudulent managers
left companies, or were dismissed, well ahead
of any possible prosecution. Combined with
the speculative nature of the market, this
placed considerable pressure on the audit
function despite the less-than-attractive audit
fees that were then the norm. It was also
noted by Jones (1959) that the controlling
cliques use of loan finance had reduced the
dependency on professional audit. He
observed that, when necessary, boards
simply over-rode the auditors
recommendations and used the plutocratic
governance system to vote for increases in
salaries and also in remuneration for the
auditors, thereby compromising the
independence of the audit function. Toms
(2002) also noted that individual financial
status and capital maintenance reputation
were secured through accounting
Philomena Leung and

Barry J. Cooper
tea party
18/6/7 [2003] 505-516
manipulations and dividend announcements

and little reliance was placed on the
publication or auditing of financial
statements. In examining past history, Toms
(2002) has successfully provided a portrait of
how an open corporate accountability system
collapsed, with features of shareholderentrepreneurs, accounting manipulation and
the failure of reliance on the audit function.
Other authors have also highlighted the
significant pay-outs of under-performing
directors and managers (Gordon et al., 2003;
Gettler, 2002; Gray, 2000) this also questions
the validity of the agency compensation
concept.
The recent corporate excesses have not,
therefore, happened in a vacuum. Gittens
(2002) argues that in the last decade or so, we
have entered a new age of materialism, as
researched by the leading American social
psychologist, David Myers (2000), in his
recent book on the American paradox of
spiritual hunger in an age of plenty. An
appreciation of the cultural shift makes sense
of a number of developments that have
occurred in Australia and the USA and, to a
varying extent, in many other developed
countries. Gittens (2002) observes that the
rise in economic rationalism in Australia
since the early 1980s has been the politicians
reaction to the electorates increased
materialism and the higher material
standard of living that a more efficient
economy should deliver. The most senior
politician in Australia, Prime Minister John
Howard, when asked his opinion on the
current corporate governance debate, was
reported as saying that the debate was not as
important as the Commonwealth Games, or
as important as a number of other things that
are really important. This type of attitude by
the Prime Minister arguably exposes as
cheap rhetoric his claim to be the best mate
of the inspirational mum-and-dad
shareholders, superannuation holders and
self-funded retirees (Stephens, 2002).
The new religion of materialism could also
explain why Australian CEOs have been
awarding themselves unprecedented pay
rises and have become much more ruthless
in their attitudes to customers and
employees. Corporate boards often justify
astronomical salary and bonus payments by
the need to compete on the international
market and to reward CEOs for the impact
they have on the share price. However, with
the average wage for Australians with full
time jobs being $45,000 per year, it is not hard
to imagine the reaction of most wage earners
to the news that the CEO of Suncorp Metway
took home almost $30 million in salary,
shares and severance pay during his final
year at the company. When bank customers

feel they are being exploited by having to pay
higher fees for lower levels of service, their
outrage is understandably aggravated by
reports of record bank profits. The
perception of employee exploitation is
similarly heightened by revelations of
multi-million dollar salaries and perks for
senior executives, such as the remuneration
in excess of $7 million the CEO of the
Commonwealth Bank received in 2002,
including $4 million for reaching ten years in
his already well paid job. To many
Australians, the growing gap between our
highest and lowest paid employees is starting
to look like yet another factor in the
fragmentation of Australian society and
that is as much about morality and culture as
about economics (Mackay, 2002).
This heightened materialism also provides
a context for the apparent declining ethical
standards among company directors and
auditors. David Knott, the Chairman of the
corporate regulator, the Australian
Securities Investment Commission (ASIC),
has lamented the outbreak of management
greed, the failure of boards to put a brake on
excessive and structurally unsound
remuneration practices, the focus on short
term pay-offs and the behaviour of analysts,
and at least some auditors, in foregoing their
ethics in return for record level fees and
commissions (Knott, 2002b). At the same
time, others have lamented the regulators
caught sleeping. The insurance industry
regulator, the Australian Prudential
Regulation Authority (APRA), has come in
for criticism in respect of the HIH Insurance
collapse, with politicians and leading
insurance executives claiming the regulator
was not adequately staffed to identify the
weaknesses in the HIH Insurance systems
(Kemp, 2001; Elias, 2001).
There is an old saying that power corrupts
and absolute power corrupts absolutely. The
same thing can be said about greed. Enough
was never enough in a system fed by stock
options, boardroom perks and consulting and
underwriting fees (Turner, 2002). The seeds
to the present crisis, particularly in the USA,
were sown in the technology stock boom in
the early 1990s, with the now bankrupt
e-commerce companies then hailed as the
way of the future. At the same time, the
telecommunications revolution, in a new
world of unregulated competition, required
billions of investment in fibre optic cables,
satellites and microwave towers. The
strategic decision by One.Tel to invest in its
own telecommunications system was a major
reason behind its eventual downfall. These
new technologies demanded financial
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manipulation schemes to convert expenses

into capital expenditure, hide losses and
ensure that share prices held up and options
and unreal salaries and bonuses would
continue to be paid to the Mad Hatter and his
friends at the tea party. Even a first year
accounting student could work out that this
was financially unsustainable. The
accountants, investment banks and law
firms, who were the traditional gatekeepers
of market integrity, were just like Alice in
Wonderland at the Mad Hatters party. They
were caught up in the frenzy and wanted to
join the party. Their independence collapsed
under the threat of being left behind in the
new economy revolution. The belief in the
revolution was so pervasive, as well as the
belief that the old rules no longer applied,
that the gatekeepers became servants to the
new players rather than independent
guardians. The traditional brakes on the
system no longer worked (Scott, 2002).
One.Tel, Harris Scarfe and

HIH Insurance
Three corporate collapses that have most
focussed on corporate governance issues
recently in Australia are One.Tel, Harris
Scarfe and HIH Insurance. The Australian
telecommunications company One.Tel was
placed in administration and subsequently
into liquidation in May, 2001 with estimated
debts of A$600 million. At the same time, the
Australian Securities and Investment
Commission (ASIC) announced it had
commenced a formal investigation into
One.Tel for potential breaches of the
Corporations Law. The potential breaches
according to an ASIC spokeswoman included
possible insolvent trading, possible insider
trading and market disclosure issues (BBC
News, 2001). The joint managing directors,
Jodee Rich and Brad Keeling, had received
bonuses of A$7 million each the previous
year, when One.Tel reported a A$291 million
loss. At one stage, when the company had
A$33 million in bills due, there was only
$500,000 in the bank and a management
report to the directors at the time did not
mention the liquidity crisis. Creative
accounting by One.Tel in capitalising
expenses had attracted the attention of ASIC
and its insistence that accounting practices
be changed led in August 2000 to the company
declaring $245 million of costs that would
otherwise be hidden (Barry, 2002).
After six months and a parade of
high-profile corporate executives, the public
hearings into the demise of the phone
company One.Tel were wound up on
[ 508 ]
29 August, 2002, as the liquidator retired to

consider whether grounds existed for legal
action against those involved (Hughes, 2002).
During the public hearings, the liquidator
questioned 18 witnesses including One.Tel
directors Lachlan Murdoch of News Limited
and James Packer of the Australian media
giant, Publishing and Broadcasting Limited.
Civil proceedings have been commenced
against a number of former directors of
One.Tel by the Australian Securities and
Investment Commission, seeking
declarations that they contravened their
responsibilities under the Act; orders that
they be banned from managing corporations
or acting as directors; and compensation of
up to A$75 million. In the interim,
appropriate orders have been obtained to
restrict dealing in assets and to monitor
travel (Knott, 2002b).
The retailer Harris Scarfe had been in
operation for 150 years before it was placed
into voluntary administration by the
directors on 2 April, 2001, after discovering
irregularities dating back six years. Four
days later, the ANZ bank placed the company
in receivership. In their report to creditors,
the administrators highlighted that the
systematic overstatement of profit had been
funded by increased debt, both to the bank
and the creditors (Peacock, 2001). After
investigations by the Australian Securities
and Investments Commission (ASIC) and
official examinations by the companys
receivers and managers, ASIC alleged the
chief financial officer, Alan Hodgson, had
altered Harris Scarfes accounts to inflate the
companys profits. In fact, Hodgson was
found to have played a leading role in
falsifying accounts and reports and had
created a false picture that Harris Scarfe was
in good financial health, permitting it to
trade when it was virtually insolvent. In
testimony given to the South Australian
Supreme Court, Hodgson told the court that
he had effectively authorised accounts to be
changed on cue, if a particular profit result
was required by the companys managing
director or the chairman (Tabakoff, 2001).
Hodgson was jailed for six years.
The ANZ bank has filed a suit against
Harris Scarfs auditors, Ernst and Young and
PricewaterhouseCoopers, seeking recovery
of at least A$70 million and alleging the
auditors had been negligent because they
failed to uncover the accounting
discrepancies and irregular entries in the
management accounts. Also, a shareholder
has brought a class action against the
directors, alleging that they engaged in false,
deceptive and misleading conduct over a
five-year period. The shareholder claims that
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as a result of the deceptive statements,

investors paid more than the true market
value of the shares and eventually lost the
opportunity to sell their shares (Wood, 2002).
In March 2001, HIH Insurance was placed
in provisional liquidation with reported
losses of A$800 million, although more recent
estimates put the deficiency at between A$2.7
and A$4 billion, making it Australias largest
corporate collapse (Kehl, 2001). The HIH
group comprised several insurance
companies and was the biggest insurance
underwriter in Australia. Its collapse had a
widespread effect, as it was a major provider
of all types of insurance in Australia,
including much of the public risk cover. In
fact, HIH was known as a price cutter and
more willing underwriter than its
competitors in the insurance industry
(Brown, 2001) and an ex director,
Rodney Adler, had claimed that excessive
discounting was one of the contributing
factors in the failure of the company
(Gaylord, 2001). However, it was arguably the
hostile takeover of Adlers company, FAI
Insurance, for A$300 million, without proper
due diligence investigations, that marked the
beginning of the end for HIH. The founder
and CEO of HIH, Ray Williams, has since
admitted that the price was too high (Brown,
2001). Also, HIH experienced major losses in
its operations in the USA and the UK, which
contributed to its eventual demise.
The Royal Commission into the affairs of
HIH Insurance was announced in June, 2001.
The terms of reference are wide ranging and
will enable the Royal Commission to fully
investigate the circumstances surrounding
HIHs failure, the actions of Commonwealth
and State regulatory bodies and whether
changes should be made to the current legal
framework (Insurance Council of Australia,
2002). In summary, the terms of reference are
as follows.
1 The reasons for, and the circumstances
surrounding, the failure of HIH prior to
the appointment of the provisional
liquidators on 15 March 2001 and in
particular, whether, and if so the extent to
which, decisions or actions of HIH, or any
of its directors, officers, employees,
auditors, actuaries, advisers, agents, or
any other person, contributed to the
failure of HIH; or were involved in, or
contributed to, undesirable corporate
governance practices, including any
failure to make desirable disclosures
regarding the financial position of HIH.
2 Whether those decisions or actions might
have constituted a breach of any law of the
Commonwealth, a state or a territory.
3 The appropriateness of the manner in

which powers were exercised and
responsibilities and obligations were
discharged under Commonwealth, State
or Territory legislation.
4 The adequacy and appropriateness of
arrangements for the regulation and
prudential supervision of general
insurance at Commonwealth, state and
territory levels including Commonwealth
arrangements before and after the
Financial System Inquiry reforms and
different state and territory statutory
insurance and tax regimes.
As the above terms of reference indicate, the
Royal Commission into HIH Insurance was
set up with wide ranging powers of
investigation and its eventual
recommendations, expected by March 2003,
are likely to have a major impact on the
future corporate regulatory environment in
Australia. Also, civil proceedings have
already been successfully prosecuted against
three former officers of HIH in relation to a
specific breach of the Corporations Act,
involving improper use of company funds
and a breach of duty. The Australian
Securities and Investment Commission has
sought declarations, banning orders and
compensation, plus pecuniary penalties, and
an investigation into possible offences
connected with the collapse of HIH continues
(Knott, 2002b).
Where were the accountants and

auditors?
So, just like Alice in Wonderland, did the
accountants and auditors elbow their way
into the Mad Hatters corporate tea party?
From the evidence presented so far, it
appears likely that is generally the case. The
liquidators inquiry into One.Tel was told
how multi-million bonuses paid to the
founders Jodee Rich and Brad Keeling, were
effectively hidden from public scrutiny by
questionable accounting practices. The
bonuses totalling A$14 million were incurred
in 1999, but a change in accounting policy
treated the bonuses as deferred expenditure
and treated them as set up costs associated
with One.Tels businesses across Europe and
Australia. This treatment, along with other
questionable accounting adjustments, had
the effect of converting a loss into a profit. It
was also claimed that the auditors had
supported the questionable accounting (ABC
Newsonline, 2002). However, when
questioned by Michael Slattery QC for the
liquidator, the One.Tel finance manager,
Steve Hodgson, agreed that the accounting
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[ 510 ]
policy adopted was what he regarded as a bit

of a stretch (Hughes, 2002).
In the Harris Scarfe collapse, it appears
that the accountants were running two sets of
books, which was not picked up by the
auditors. Apart from the fraudulent
accounting by the chief financial officer,
Alan Hodgson, referred to earlier, there were
also, prima facie, independence problems
with the Harris Scarfe audit committee of the
board. The company had an audit committee
comprising three members, two of whom
were clearly internal (including Hodgson)
and one of which was possibly independent,
and they met only twice a year. An audit
committee is meant to be an independent
body to ensure efficient and effective
communication between external auditors
and senior management. So fundamentally, it
could not work (Correy, 2001). Also, as noted
earlier, the auditors are being sued by the
major creditor, the ANZ bank, alleging
negligence for not uncovering the
discrepancies over a number of years.
In the case of HIH Insurance, there were
also problems with the prima facie
independence of the audit committee of the
board. The chairman and another member of
the committee were both former senior
partners of Arthur Andersen, the auditors of
HIH. Also, the other two members of the
audit committee had business relationships
with the company (Correy, 2001) and the
finance director was a former Andersen
partner. Unlike Enron that hid liabilities to
boost its balance sheet, HIH attempted to pad
profits as major parts of its business eroded.
HIH did not set aside enough reserves to
cover future insurance claims and
overvalued some assets. Under questioning
at the HIH Royal Commission, the finance
director, Dominic Fodera, denied that
carrying out his acknowledged responsibility
to be prudent and conservative in assessing
policyholders claims required the use of a
safety margin in claims reserves. This was
despite the fact that the levels set by the
company had proved to be inadequate in the
past (AAP, 2002). Also, three different
actuaries and the United States regulator
warned that the companys US operations in
1999 and 2000 were under-reserved by tens of
millions of dollars, but Fodera acknowledged
that the US branch and head office in
Australia chose instead to use their own
calculations of reserves. He also admitted
that when yet another actuary recommended
an increase in reserves, the board was never
informed of the fact (Walker, 2002).
So what does this all say about the
accountants and auditors? From the
investigations undertaken and reported so
far, it is apparent that the accountants in

One.Tel, Harris Scarfe and HIH Insurance,
all joined the March Hare and the Hatter at
the tea party of corporate greed. They were
supposed to be ethical professionals
providing quality financial control and
advice to management, but just like Alice,
they were determined to join the party. At
this point in time, it is not so clear-cut with
the auditors, although the evidence to date
points to them being in Wonderland. As
discussed earlier, the auditors were the
gatekeepers, but became servants to the new
players rather than independent guardians.
Therefore, it can be argued that some
significant common issues are apparent from
the brief overview of the above three cases.
These issues are:
.
the opportunistic behaviour of directors
and managers in pursuing self-interest
and undermining governance
mechanisms. Such behaviour was
demonstrated by failure of due diligence
in corporate affairs, interfering with
controls and audit independence
functions;
.
failure of transparency and integrity in
performance measurement and
management compensation, resulting in
the financial reporting functions being
undermined, as demonstrated by the
extensive practice of creative accounting;
and
.
the apparent failure of some of the
corporate watch-dogs such as some
auditors and government supervisory
bodies.
Good corporate governance

Before discussing the issues further, it is
worthwhile to reflect on what constitutes
good corporate governance. There are many
publications in the field of corporate
governance, but a useful and recent one is the
Principles of Corporate Governance, issued by
The Business Roundtable (2002), an
association of chief executive officers of
leading corporations in the USA. This
association claims that the USA has the best
corporate governance, financial reporting
and securities markets in the world, which
works because of the adoption of best
practices by public companies within a
framework of laws and regulations.
The Business Roundtables (2002)
Principles of Corporate Governance call on
companies to adopt a number of best
practices in corporate governance, that,
for example:
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require stockholder approval of stock

options and restricted stock plans in
which directors or executive officers
participate;
create and publish corporate governance
principles so that everyone, from
employees to potential investors,
understand the rules under which the
company is operating;
provide employees with a way to alert
management and the board to potential
misconduct, without fear of retribution;
require that only independent directors
may sit on the board committees that
oversee the three functions central to
effective governance audit, corporate
governance and compensation; and
ensure that a substantial majority of the
board of directors comprises independent
directors, both in fact and appearance
(Business Roundtable, 2002).
An authoritative Australian publication on

corporate governance was issued by a group
of professional bodies in 1995, under the
chairmanship of former regulator, Henry
Bosch (Bosch, 1995). Most of the principles in
this pronouncement are similar to the
Business Roundtable, although the questions
surrounding executive options and
remuneration were not such big issues in
1995 as they are currently. What the above
reports and others such as the Cadbury
Report issued in the UK and the OECD
corporate governance guidelines
demonstrate, is that there is no simple
universal formula for good corporate
governance, as companies vary in complexity
and size and the nature of business and
community expectations are in a state of
constant change.
What is essential, however, is that all
involved in corporate governance, and
particularly boards of directors, should adopt
the practices best suited to the good
governance of their organizations in their
particular circumstances. Best practice in
Australia is arguably comparable to the best
anywhere in the world but, as Bosch (2001)
notes, there is far too little of it. Before
directors can satisfy themselves that they
understand what is really going on in the
companies for which they are responsible,
they must put in more time, pay more
rigorous attention to their duties and make
more use of the governance techniques that
have been developed.
Bad corporate governance

The above principles are indicators of good
corporate governance, but how do we know
bad corporate governance when we see it ? In

a submission to the HIH Royal Commission, a
corporate governance research and advisory
group, Institutional Analysis Pty Ltd,
provided an analysis of the bad corporate
governance practices at HIH Insurance
before its collapse, based on publicly
available empirical data from 2000/2001
company annual reports. Comparisons were
made of the corporate governance practices
at HIH with the corporate governance
practices at the top 100 companies on the
Australian Stock Exchange (the S&P/ASX
100 companies). Key findings included the
following (Institutional Analysis, 2002):
.
Among the S&P/ASX top 100 companies,
independent non-executive directors
comprised on average 45.3 per cent of the
board, whereas there were no independent
non-executive directors on the HIH board.
An independent director is not
financially or otherwise depending on the
companys affiliated persons (e.g.
members of the board, auditor) and does
not represent consultants or other
businesses, which are, or have been,
contracted by the company. The published
2000-2001 HIH annual report shows that of
the four non-executive directors, Gardner
and Cohen were both former partners of
the auditors, Arthur Andersen, and Abbot
and Stitt were both involved in the
provision of legal services to the company.
.
The HIH board was dominated by
founders or relatives of founders, with
potential conflicts of interest and loyalties
to the company history and reputation.
These issues may have coloured their
judgment. HIH had two founders on the
board and also Adler, the son of the
founder of FAI, one of the core HIH
businesses.
.
In 54 per cent of S&P/ASX top 100
companies, the audit committee is
exclusively comprised of independent
non-executive directors. At HIH, there
was not a single independent director on
the audit committee.
.
In 72 per cent of the top 100 companies,
separate nomination and remuneration
committees were established, as per the
Investment and Financial Services
Associations guidelines. HIH combined
the two committees.
.
At the top 100 companies, the average
percentage of CEO remuneration that was
at risk is 33 per cent. The higher the
proportion of a CEOs remuneration at
risk, the more closely aligned are his or
her interests with those of shareholders.
At HIH, none of the remuneration of the
CEO was at risk.
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As the above research indicates, corporate

governance practice at the company that
became the largest corporate collapse in
Australian history, was somewhat less than
world best practice.
The Ramsay Report

In October 2001, Professor Ian Ramsay
submitted his report, based on a study
commissioned by the Commonwealth
Government of Australia. Although it
provides a blueprint for reform of auditor
independence, the Commonwealth
Government is delaying implementation of
any of the recommendations until 2003.
The Ramsay recommendations include
(Ramsay, 2001):
.
the establishment of an Auditor
Independence Supervisory Board;
.
changes to the ASX listing rules requiring
listed companies to establish an audit
committee, with ASX input into its role
and composition;
.
requiring auditors to make an annual
declaration to the Board stating that they
have maintained their independence;
.
providing clarification on what
constitutes independence;
.
requiring registered auditors to adhere to
the codes of ethics set down by
professional accounting bodies; and
.
closer regulation of the operations of
auditors, including the rotation of
partners and the increased disclosure of
fees and non-audit services.
The bodies that represent the interests of
accountants and directors have been
publicly supportive of these measures. The
Institute of Chartered Accountants in
Australia (2002) welcomed the Ramsay
recommendations as a significant step
towards improving the role and
effectiveness of audits in Australia, whilst
maintaining harmony with global
standards. CPA Australia (2002) was also
supportive, noting that the report enshrines
best practice audit principles, reinforces
the vital role of auditors and gives the
public highly visible assurance on matters
of auditor independence. The Australian
Institute of Directors (2001) also welcomed
the Ramsay report and its
recommendations. However, some
further reforms to augment Ramsay could
include an outright ban on non-audit
services being provided to audit clients, as
provided for in the US Sarbanes-Oxley Act
(Stephens, 2002).
[ 512 ]
What about directors and

executives?
A serious attempt to change corporate
culture must venture into the boardroom
itself. Mooted reforms in this area, some of
which are in the US Sarbanes-Oxley Act,
include (Stephens, 2002):
.
simplifying the form of financial
statements for the average investor;
.
requiring public companies to disclose
rapidly, and in plain English, material
changes to their financial condition or
any other significant news;
.
prohibiting loans to directors and
corporate officers;
.
mandatory forfeiting of incentive
remuneration in the event of accounting
restatements;
.
making CEOs and chief financial officers
responsible for the accuracy of financial
statements;
.
requiring that stock options be expensed
in the accounts of a company;
.
subjecting officers, directors and auditors
to a greater risk of litigation; and
.
gaoling executives and directors who
deliberately mislead or who withhold
information, especially if in doing so they
benefit themselves at the expense of the
shareholders.
None of these reforms, however, would in
any way restrict the ability of directors to
make decisions. They merely strengthen the
hand of shareholders and regulators to hold
them responsible for these decisions. They
extend the principles of mutual obligation
beyond the welfare system and into corporate
governance.
Black-letter law versus principles

Bosch (2001) argues that there is little scope
for legal changes on corporate governance
and financial disclosure, in that detailed
black-letter law, or rules, are often only a
roadmap for the unscrupulous, as was
demonstrated in the Enron off-balance
sheet transactions. However, an underlying
theme to the numerous calls in the business
press for reform in Australia is that the
USA response to its corporate scandals will,
by virtue of the primacy of its capital
markets, become de facto standards that
Australia must adopt. Nevertheless, with
the notable exceptions of HIH Insurance
and One.Tel, Australia seems to have
weathered the demise of one of the longest
bull markets in history, without producing
the excesses that characterised previous
bubbles. The reforms introduced in
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Australia in response to corporate

malfeasance in the 1980s, appear to have
held up under pressure. There were reforms
to corporate law, accounting standards and
stock exchange disclosure standards after
that debacle, which threatened Australias
access to foreign capital and markets. Also,
there were reforms to corporate culture and
notions of good governance
(Bartholomeusz, 2002).
The strength to the responses in Australia
in the 1980s, lies in their nature. Unlike the
US regime (including the raft of changes
made during 2002), Australia has tended to
favour fuzzy laws and rules statements of
principle rather than black-letter law. In
combination with codes of best practice,
such an approach tends to encourage
companies and people to lift their gaze from
regulatory minimums to the principles
involved. It is arguably vital that Australia
maintains a principles-based approach to
regulation and self-regulation. As noted by
Bartholomeusz (2002), in making technical
compliance with the law less of an issue than
compliance with its spirit, the Australian
system has offered scope for good
governance and practice to evolve and
respond to the corporate environment and
community expectations.
Whilst the Australian government has not
yet committed itself to corporate governance
reforms pending the reporting of the Royal
Commission on HIH Insurance expected in
March 2003, the Labour party opposition
issued in late August 2002, a discussion
paper on Improving corporate
governance. Issued by the Shadow Minister
for Finance, Small Business and Financial
Services, Senator Conroy (Conroy, 2002), the
paper lists a range of policy commitments,
which include:
.
doubling the penalties for serious
breaches of the Corporations Act;
.
introducing legislation to protect
corporate whistleblowers;
.
implementing the recommendations of the
Ramsay Report on independence of
company auditors and, in addition,
banning the provision of certain non-audit
services to audit clients;
.
requiring auditors to specifically report to
shareholders and to a companys audit
committee on instances of aggressive
accounting;
.
requiring auditors to attend and answer
questions at annual general meetings;
.
requiring the full disclosure of
arrangements governing executive
remuneration and enforcing the
requirements for disclosure in the
Corporations Act;
.
.
expensing share options;

providing to all shareholders any
information provided to analysts during
an analyst briefing; and
improving analysts independence by
ensuring that they always act in the
interests of the users of the reports not
in the interest of the analyst or the firm
which employs the analyst.
Further policy options are suggested in the

following areas:
.
auditor independence and the integrity of
financial statements;
.
executive remuneration;
.
corporate disclosures and information for
investors;
.
the composition of boards; and
.
analyst independence.
There are undoubtedly some useful points
raised in Labours discussion paper that will
improve corporate governance in the future.
However, a careful reading of the detail
leaves the impression that this paper, if
implemented, would lead Australia down the
path of black-letter law rather than
strengthen the principles-based approach
that has arguably served Australia well in
the past.
However, despite the optimism
of writers such as Bosch (2001) and
Bartholomeusz (2002), the stories of
excess and incompetence emerging from
the public enquiries into the collapses of
companies such as One.Tel and HIH
Insurance, and the corporate scandals
surrounding WorldCom and Enron in the
USA, have made investors nervous about
the standards of corporate governance in
Australia (Skeffington, 2002). That anxiety
has prompted the Australian Stock
Exchange (ASX) to set up a corporate
governance council, which includes
representatives of key business and
professional groups, to review governance
standards as part of ASXs efforts
to ensure the Commonwealth government
does not force new legislation on
companies. The council plans to
recommend amendments to the ASXs
listing rules and to the Corporations Act.
The council has also set corporate
governance requirements for companies to
include in their annual reports to
shareholders. It wants companies to release
quality information on share and options
schemes, audit committees, external
auditors, accounting standards and
shareholder empowerment. If companies
are not able to comply, they will be required
to explain why.
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Shaping the winds of change

The Ramsay Report, the HIH Royal
Commission, investigations by ASIC and the
ongoing agitation and analysis in the
financial press, will all impact on the future
direction of audit regulation and corporate
disclosure and governance in Australia. In
particular, the recent release of the
discussion paper on the next phase in the
Commonwealth Governments Corporate
Law Economic Reform Program (CLERP 9,
2002), addresses a number of key issues.
These include recommendations on
expanding the role of Australias Financial
Reporting Council; suggestions for
improving audit quality and accounting
standards; principles for continuous
disclosure; and recommendations to improve
shareholder participation and information
availability. The current government
strategy is to introduce into parliament in
2003 what Treasurer Peter Costello claims
will be corporate accountability laws
defining worlds best practice (Gordon, 2002).
However, will the long list of proposed
corporate reforms solve the problems of the
unbounded opportunistic behaviour of
directors and managers in pursuing selfinterest to the detriment of the long-term
well-being of the companies they run? Will
compliance on mandatory disclosure of
remuneration and non-audit services,
accounting requirements for options, and
making CEOs responsible for the accuracy of
the financial statements, prevent excessive
compensation schemes, lack of audit
independence, and creative accounting?
In commenting on the dangers of
materialism as discussed earlier, Mills (2002)
identified five central dangers, which result
in:
1 displacement of an ontology of
consciousness;
2 a simplistic and fallacious view of
causality;
3 the loss of free will;
4 renunciation of the self; and
5 questionable judgements concerning
social valuation practices.
It can be argued that these five dangers in
turn can be transformed into:
1 a failure to exercise due diligence;
2 a short-term mentality of the relationship
between creative accounting and
compensation;
3 compromised integrity and objectivity;
4 socialisation with powerful groups; and
5 rationalising creative accounting and
other opportunistic behaviour.
[ 514 ]
It is startling how close the above five

deductions reflect the current corporate
world, as observed in the recent corporate
collapses in the USA and Australia.
This paper has attempted to challenge
some of the current thinking on corporate
governance reforms. It is argued that
changes in the structure of the corporate
governance and compliance regime will not
necessarily change the risks associated with
the problems in the corporate environment.
Stewardship and agency principles have
existed over decades and accountants and
directors have been champions of the capital
market and its intellectual power, but history
shows that the religion of materialism needs
to be recognised, and addressed, if
meaningful change is to occur. As the capital
market has evolved alongside the rapid
growth of technology and globalisation, there
has arguably been an unhealthy shift in
attitudes in the corporate world that has also
existed in earlier times in the development of
modern corporations. Is the history of
corporate behaviour just repeating itself? It
is important to understand this phenomenon
if any proposed reforms are to be effective.
In concluding this paper, we return once
more to the tale of the Mad Hatters Tea Party
. . . this piece of rudeness from the (corporate)
March Hare and Mad Hatter was more than
Alice (the auditor) could bear: she got up in
great disgust, and walked off; the Dormouse
(the regulator) fell asleep instantly, and
neither of the others took the least notice of
her going, though she looked back once or
twice, half hoping that they would call after
her: the last time she saw them, they were
trying to put the Dormouse into the teapot!
At any rate Ill never go there again! said
Alice as she picked her way through the
wood. Its the stupidest tea-party I ever was
at in all my life! Let us hope, at least for the
sake of the credibility of auditors and the
accounting profession, and the public that
have in the past placed their trust in them,
that history does not repeat itself.
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Credibility and expectation gap in reporting on

uncertainties
Junaid M. Shaikh
Faculty of Business and Law, Multimedia University, Melaka, Malaysia
Mohammad Talha
Faculty of Business and Law, Multimedia University, Melaka, Malaysia
Keywords
Corporate governance, Reports,
Financial reporting
Abstract
This paper analyzes and reports on
studies that examine the extent to
which international auditing
boards have accomplished the
goal of reducing the expectation
gap in reporting on uncertainties.
This is because there has been a
long-running controversy between
the auditing profession and the
community of financial statement
users concerning the
responsibilities of the auditors to
the users. Enron and WorldCom
scandals have provoked the public
to incite the government and
professional bodies to impose
stringent regulation in protecting
their interests. It also suggests
the solutions to minimize the gap
and enhance the publics
perception towards the
profession.

18/6/7 [2003] 517-529
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482650]
1. Introduction
One of the many issues that involve the
accounting profession and the community is
the expectation gap that exists in accounting
engagements. The expectation gap was
originally defined as the difference between
levels of expected performance as envisaged
by auditors and users of financial reports. It
is:
. . . the gap between societys expectations of
auditors and auditors performance, as
perceived by society.
corporate governance and financial

reporting practices have again received wide
coverage by the media, and grabbed the
attention of regulatory bodies, stock
exchanges and the accounting profession.
2. Literature review
Companies should close credibility gap in
books
While a consensus as to the causes of the

audit expectation gap has not been achieved,
its persistence has been acknowledged and
bears testimony to the professions inability
to remove the gap, despite attempts to do so
by educating the public and codifying
existing practices.
Following recent well-publicised failures
by large listed companies in Australia and
overseas, aspects of audit independence,
In his findings, Murray (2002) has indicated

that some leading American corporations
have teamed up with unscrupulous
accountants to mislead shareholders about
how much money they make and also
mislead the Internal Revenue Service (IRS)
about how little money they make. The result
is a huge and growing gap credibility gap
which is between book income and taxable
income. If the efforts at accounting overhaul
now under way are to be successful, they will
need to close that yawning gap from both
ends.
For example, the case of WorldCom Inc.,
between 1996 and 2000, the company reported
$16 billion (e16.14 billion) in earnings to its
shareholders. But to the tax authorities, it
reported less than $1 billion of taxable
income. The truth undoubtedly lies
somewhere in between. Enron Corp. has a
similar story. To its shareholders, it reported
profits of $1.8 billion between 1996 and 2000.
But it told the IRS it lost $1 billion during the
same period, according to calculations by
Robert McIntyre of the labor-backed group,
Citizens for Tax Justice. Kmart Corp, to take
another name in the news, reported $1.6
billion in profits to its shareholders, but a
loss of $51 million to the IRS.
The games that allow companies to achieve
such anomalous results are often the
brainchildren of clever accountants and
investment bankers. One particularly

The expectation gap has been attributed

to a number of different causes
(www.corpgov.net):
.
the probabilistic nature of auditing;
.
the ignorance, naivety, misunderstanding
and unreasonable expectations of
non-auditors about the audit function;
.
the evaluation of audit performance based
upon information or data not available to
the auditor at the time the audit was
completed;
.
the evolutionary development of audit
responsibilities, which creates time lags
in responding to changing expectations;
.
corporate crises which lead to new
expectations and accountability
requirements; or
.
the profession attempting to control the
direction and outcome of the expectation
gap debate to maintain the status quo.
[ 517 ]
Junaid M. Shaikh and

Mohammad Talha
Credibility and expectation
gap in reporting on
uncertainties
18/6/7 [2003] 517-529
egregious tactic used by Enron was the now

infamous MIPS a security invented by
Goldman Sachs that counted as debt on the
companys tax return, but equity on its
public books. Regardless of whether MIPS
technically complied with the law, it was a
sham. Any honest accountant or tax lawyer
who works at one of the big accounting firms
would say that such tactics have become
increasingly common, and increasingly
outrageous. Indeed, fierce arguments have
occasionally broken out at those firms
between publicly minded tax experts who
still feel some obligation to abide by the spirit
of the tax laws, and profit-minded partners
eager to find clever new ways to exploit every
loophole in the law.
Lying to shareholders and lying to the IRS
are just opposite sides of the same coin.
Accounting is no longer a way to provide an
accurate and unified view of a companys
finances. The fact that accountants have
become so good at serving both
shareholders and the IRS is the clearest
evidence of the corruption of their
profession.
As a solution, Murray emphasizes that
publicly traded companies should be
required to make tax returns public. That
kind of information may not be much use to
the average investor. But conscientious stock
analysts surely there are some out there?
could spend their time analyzing the gaps
between book and tax income, attempting to
find truth in between. Congress and the
Securities and Exchange Commission should
work to bring the two measures of income
into closer alignment.
Protecting the public interest

In the study, Walker (2002) found out the facts
regarding Enrons failure still being gathered
to determine the underlying problems and
whether any civil and/or criminal laws have
been violated. At the same time, the Enron
situation raises a number of systemic issues
for congressional consideration to better
protect the public interest. It is fair to say
that other business failures or restatements
of financial statements have also sent signals
that all is not well with the current system of
financial reporting and auditing. As the
largest corporation failure in US history,
Enron, however, provides a loud alarm that
the current system may be broken and in
need of an overhaul.
The authors will focus on four overarching
areas corporate governance, the
independent audit of financial statements,
oversight of the accounting profession, and
accounting and financial reporting issues
where the Enron failure has already
[ 518 ]
demonstrated that serious, deeply rooted

problems may exist. It should be recognized
that these areas are the keystones to
protecting the publics interest and are
interrelated. Failure in any of these areas
places a strain on the entire system.
The effectiveness of the system of
corporate governance, independent audits,
regulatory oversight and accounting and
financial reporting, which are the
underpinnings to the capital markets, to
protect the public interest has been called
into question by the failure of Enron. The
rapid failure and bankruptcy of Enron has
led to severe criticism of virtually all areas of
the financial reporting and auditing systems,
which are fundamental to maintaining
investor confidence in the capital markets.
This situation raises a number of system
issues for most professional considerations
to better protect the public interest. These
protections would include regulation and
oversight of the accounting profession, the
independent audit function, accounting and
financial reporting model and establishment
of professional body to govern the acts of the
accounting profession.
Auditors and investors perceptions of the

expectation gap
McEnroe and Martens (2002) have extended
the prior research by directly comparing
audit partners and investors perceptions of
auditors responsibilities involving various
dimensions of the attest function. This study
surveyed public accountants and individual
investors to obtain their perceptions of the
extent to which an expectation gap exists in
several dimensions of the attest function.
Investors were surveyed because they were
the main users of financial statements and
are the most appropriate subjects to employ
as representatives of the public and financial
statement users. Audit partners were
included as the group on the other side of the
expectation gap. The research was conducted
over a decade after the release of the
expectation gap SASs and also after the
issuance of SAS No. 82 (AICPA, 1996).
Throughout the research, McEnroe and
Martens (2002) found that an expectation gap
currently exists: investors have higher
expectations for various facets and/or
assurances of the audit than do auditors. The
findings served as evidence that the
accounting profession should engage in
appropriate measures to reduce this
expectation gap. The findings also indicated
that an expectation gap exists, investors had
higher expectations for various facets and/or
assurances of the audit than do auditors in
the following areas: disclosure, internal

Mohammad Talha
gap in reporting on
uncertainties
18/6/7 [2003] 517-529
control, fraud, and illegal operations. It was

also discovered that investors expect
auditors to act as public watchdogs
(www.isaca.org/standard/guide1.htm).
The expectations-performance gap in

financial reporting from the perspective of
Hong Kong bank loan officers
Marian et al. (2002) suggest that to close the
gap more completely, the audit profession
and financial community need to reexamine
the fundamental role of an audit in society
and make sure financial statement preparers,
users and auditors all are in agreement. It
was revealed that as long as users and
auditors continue to have different
understandings of the real meaning of
present fairly, according to the GAAP, the
gap will remain. The research was carried
out by comparing the audit report from 1948
to 1988. Except for minor editorial changes,
the standard audit report remained virtually
unchanged from 1948 to 1988. During this
period, there was concern that users might
not be correctly interpreting the auditors
intended messages, and major revisions were
considered. However, these attempts to
revise the standard audit report failed to
attract widespread support. The evidence of
the research suggested that investors seek
very high levels of financial statement
assurance. Auditors should not only be
interested in, but also be aware of these
shareholder perceptions. The litigious
environment in which accountants operate
mandates that we, individually and as a
profession, monitor public opinion and
attitudes toward the level of services and
assurance provided. Marian et al. (2002)
stated that if investors expect, and courts
begin to uphold, a standard of absolute
assurance, audit liability inevitably will
increase substantially. Thus, it was
necessary from both societal and
professional perspectives that accountants
try to narrow the expectation
misunderstanding gap.
The research found out that the gap may be
narrowed partly through increased public
understanding of an audit, its nature and its
inherent limitations. Accountants should
devote substantial resources to explaining to
the public the auditors current role in the
financial reporting process and an audits
inevitable limitations. Increased educational
efforts with clients and audit committees at
shareholder meetings, in professional and
civic organizations and at every available
juncture should be used to communicate an
audits merits and limitations. A more direct
approach to increasing user awareness of the
audit function was also recommended in the
paper. In addition, the Securities and

Exchange Commission should be encouraged
to develop a similar unbiased report to be
presented with registrants filings and
financial statements. Besides, Marian et al.
(2002) suggested that a SEC communication
regarding the audit function and the
assurances provided may be more
convincing to financial statement users than
one emanating from auditors.
Theories of ethics and moral development

Ethics in general is defined as the systematic
study of behavior based on moral principles,
philosophical choices, and values of right and
wrong conduct. Similar to general ethics,
ethical behavior from a professional
standpoint also involves making choices
based on the consequences of alternative
actions. As stated in the following passage
from The Philosophy of Auditing by Mautz
and Sharaf (1961, p. 232):
Ethical behavior in auditing or in any other
activity is no more than a special application
of the general notion of ethical conduct
devised by philosophers for men generally.
Ethical conduct in auditing draws its
justification and basic nature from the
general theory of ethics. Thus, we are well
advised to give some attention to the ideas
and reasoning of some of the great
philosophers on this subject.
Previous research on ethical issues in

accounting has generally avoided
philosophical discussions about right and
wrong or good and bad choices. Instead
the focus has been on the ethical or unethical
actions of accountants based on whether they
comply with rule-oriented codes of
professional conduct. Various theories of
ethics have been made known and used to
determine ethical dilemmas, but the two
existing theories applicable to CPAs are
utilitarianism and rule deontology:
1 Utilitarian principle. Utilitarianism is
based on the greatest good criterion.
According to this principle, when faced
with an ethical problem, the consequences
of the action are evaluated in terms of
what produces the greatest amount of
good for the greatest number of people.
The stress here is on the consequences of
the action rather than on the following of
rules.
2 Rule deontology. Rule deontology is a
deontological theory and is based on a
duty to a moral law. Thus, the
accountants actions rather than their
consequences become the focus of the
ethical reasoning process. According to
this principle, an accountant is morally
bound to act according to the
[ 519 ]

Mohammad Talha
gap in reporting on
uncertainties
18/6/7 [2003] 517-529
requirements of a rule of conduct of the

code without regard for the effects of that
action.
If utilitarianism is applied, each situation
involving confidential client information
would have to be evaluated to determine if it
would be morally right to reveal the
information (this does not relate to those
situations that are specifically excluded in
Rule 301). The confidentiality rule would be
followed only if that course of action
produced the greatest good to the greatest
number of people. If rule deontology is
applied, however, the Professional Code of
Conduct would be followed in all
circumstances involving client confidential
information (except as stated in the code),
despite the consequences.
The findings of studies indicate that CPAs
usually adhere to the code (rule deontology)
in resolving issues concerning
confidentiality. However, such decisions are
not always according to what they see as
good ethical behavior. The broad principles
of the code indicate that ethical conduct
means more than abiding by a letter of a rule.
It means accepting a responsibility to do
what is honorable or doing that which
promotes the greatest good to the greatest
number of people, even if it results in some
personal sacrifice. Somehow, the profession
needs to emphasize the greatest good
criterion more strongly in applying the rules
of conduct.
3. Credibility gap and expectation

gap
The battle for credibility
During the past two decades, there has been
an increasing expectation that business
exists to serve the needs of both shareholders
and society. Many people or the community
have a stake or interest, in a business, its
activities and impacts. If the interests of
these shareholders are not respected, then
action usually occurs which is often painful
to shareholders, officers and directors. In
fact, it is unlikely that businesses or the
profession can achieve their long-run
strategic objectives without the support of
key shareholders. As a result, management
and professional accountants, who serve the
often conflicting interests of shareholders
directly and the public indirectly, must be
aware of the publics expectations for
business and other similar organizations.
More than just to serve intellectual curiosity,
this awareness must be combined with
traditional values and incorporated into a
framework for ethical decision-making and
[ 520 ]
action. Otherwise the credibility of the

organization, management, professional and
indeed, the professional will suffer.
There is no doubt that the public has been
surprised, dismayed and devastated by
periodic financial fiascos. The list of recent
classic examples includes Bre-X, Livent Inc.,
YBM Magnex International Inc., Enron, and
Worldcom. On a broader basis, continuing
financial malfeasance has led to a crisis of
confidence over corporate reporting and
governance. This lack of credibility has
spread from financial stewardship to
encompass the other spheres of corporate
activity and has become known as the
credibility gap. Audit committees and ethics
committees, both peopled by a majority of
outside directors, the widespread creation of
corporate codes of conduct, and the increase
of corporate reporting designed to promote
the integrity of the corporation all testify to
the importance being assigned to the crisis.
Besides that, professional bodies and the
Securities and Exchange Commission should
work together to bring the two measures of
income into closer alignment.
Expectation gap concerning evaluation of

internal control
In the last decades the focus on expectation
gap issues has determined many
fundamental inconsistency between
best-practice standards and the expectations
of the primary users of audit services. Maybe
the most important incongruity has been
between the view on internal control as
stated in the auditing standards and the
concept of internal control as understood by
company management.
In the USA, this was recognized in the
Treadway report on fraudulent financial
reporting, which acknowledged the necessity
for a common reference point on the content
of internal control. Since this need was
clearly affirmed in the late 1980s, the
Committee of Sponsoring Organizations of
the Treadway Commission decided to build
up an integrated framework on internal
control. The ensuing attempt to provide a
framework was published in the COSO
Report in 1992. Although the main coverage
of this report was a message regarding
internal controls intended for management
directors, it provides a framework which
unambiguously deals with the interests of all
parties involved (including auditors, board of
directors and regulating bodies). The
auditors took this into consideration by
updating the particular auditing standard on
internal control (the replacement of SAS 55
with SAS 78 Consideration of the internal

Mohammad Talha
gap in reporting on
uncertainties
18/6/7 [2003] 517-529
control structure in a financial statement

audit The COSO Report (1992).
Overall, the findings of studies suggest that
the auditors have not made the needed effort
to close a realized expectation gap. One view
of these results can be linked to the need for
future regulation initiatives. An integrated
framework should include the auditor, that is,
the auditor has to make known the level of
internal control assessments in view of the
expectations from the primary users, i.e. that
they always perform such evaluations. The
conclusion is that a major divergence still
needs to be decided on. Another perception is
to steer clear of an exact duplication of the
described efforts to close the realized
expectation gaps as carried out by other
national (European) practices in the standard
setting efforts concerning internal control.
The expectation gap between users and

auditors materiality judgments
The concept of materiality occupies a central
position in auditing. This is due to a demand
for efficiency and credibility on the auditors
report. Materiality thus permeates the kind
and range of all auditing procedures, the
selection of items, and the timing of the audit.
In auditing and accounting, materiality is
defined in different ways in different
guidelines and statutory provisions. It has,
for example, been included in frameworks in
the USA and other countries though not
Denmark with greater or lesser degrees of
precision. In Denmark, materiality is
defined in the Danish statement on auditing
standards, and has indirectly been included
in an auditing context in official audit report
regulations from 1996. In ISA No. 25 (Subject
matter 320) audit materiality the definition
of materiality is (with reference to IASCs
Framework for the preparation and
presentation of financial statements, para.
30) as follows:
Information is material if its omission or
misstatement could influence the economic
decision of use point rather than being a
primary qualitative characteristic which
information must have if it is to be useful.
Danish accounting legislation makes no

mention of materiality as an overall principle
in an accounting context, only in connection
with specific items. In Denmark, materiality
is often confused with the concept of
relevance, but the two terms should be
regarded separately, since they mean
different things. Materiality only makes
sense in connection with relevant
information, not irrelevant information.
While materiality is the same in
accounting as in auditing, it has a different
meaning for auditors tasks than for those of
users of financial statements. In both cases,

materiality must be measured in relation
to the true and fair view that the financial
statement must give. What is true and fair,
including what is material or immaterial, is
determined by the economic decisions which
users make on the basis of the financial
statements. If decisions are influenced by one
or more errors or omissions, they are
material, and if not, they are immaterial.
There are many different groups of users,
including the general public. The auditor
must take reasonable account of them all.
Most auditing firms use guidelines for
determining a starting point for their
assessment of the overall materiality in the
financial statement. The paradox of
materiality is that it is the auditor who
assesses what is material or immaterial for
users of financial statements. But does the
auditor really know what users regard as
material or immaterial?
Numerous studies and articles have dealt
with the concept of materiality. Many of
them express a lack of concensus between
participants in one group and between this
group and other groups of users, preparers
and auditors of financial statements. In the
study of Robinson and Fertuck (1985) the
participants were financial executives and
auditors. The participants in Woolseys
(1973a, b), Dyers (1975), Patillos (1976) and
Rosens (1982) studies were financial
executives, bankers, financial analysts,
academics and auditors. Of those, we have
got most inspiration from Dyer, Patillo and
Woolsey, whose studies come close to real life
situations, or have a great amount of external
validity. Cases in other studies, not
mentioned above, present not all relevant
information about the case companies (but
only few of them). These studies/cases
therefore run the risk of departing from the
financial statements users real life.
Differences between the two groups

(auditor and financial analyst) and average
materiality levels
A comparison of the groups reveals that,
overall, the auditors average materiality
levels for all four companies (Carlsberg,
Micro Matic, B&O, and DDT) are about 60
percent higher for overestimations than
those of the financial analysts, and 36 percent
for underestimations (refer to Appendix,
Table AI).
The differences appear especially in the
profit-companies, where the auditors average
levels for overestimation were 88 percent and
129 percent higher than the financial
analysts overestimation, and for
underestimation 70 percent and 107 percent
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higher. In the losing concerns there was a

better correspondence between the groups.
This seems to confirm that the two groups
in Denmark have no knowledge of each
others materiality levels.
These results do not correspond to those of
Patillo (1976). In his findings the average
materiality levels for financial analysts was
4.9 percent of net income, and the auditors
were 4.8 percent. Patillos findings indicate a
high degree of agreement. The difference
between Patillos results and this study is
probably caused by national differences.
infinite number of rules for assessing

materiality would not be able to take account
of all situations.
These provisional guidelines should
therefore be made more concrete by
supplementing them with examples (from
surveys, for example) of how the frameworks
for materiality levels can be established in
different concrete situations and in different
concrete companies. These examples will not
be able to cover all situations, of course, but
they can help determine some normative
levels.
4. Proposed solutions to the

problem
Dialogues with primary users of financial

statements about standards for materiality
in financial statements
Overall considerations
Expectation gaps are, amongst other things,
due to inadequate auditing standards and a
lack of acceptance of these standards,
together with unreasonable expectations of
auditors among users of financial statements
and the general public. These two elements
can be influenced via dialogues. The
procedures outlined below should be
implemented successively, and in the order
mentioned, over a period of several years.
The general idea is, as far as possible, to base
solutions on continuous dialogues between
the interested parties with the aim of
achieving as much consensus as possible.
Establishing standards for materiality

among auditors
The surveys conclusions appear to indicate
the need for standards, at least for auditors,
in order to ensure a degree of uniformity. In
order to establish common standards for
auditors, a Committee for Auditing
Standards should be appointed by the
Association of State Authorized Public
Accountants in Denmark (FSR) to draw up
common guidelines.
Every financial statement is unique and
individual in the sense that it sends its own
signals about a concrete firm. The form is (or
can be) the same for most firms, but
information that is very relevant and
material in one financial statement can be
relevant but immaterial in another, while in
a third both irrelevant and immaterial. The
information which the user of a financial
statement seeks about one firm can therefore
be very different from what is sought about
another firm.
As a result of this difference, the
materiality levels users employ can be
related to different items in different
financial statements, just as absolute items
are assigned different weights. Thus, even an
[ 522 ]
The guidelines drawn up by auditors should

then be discussed in structured dialogues
with the primary user groups. A starting
point for this can be FSRs Committee for
Auditing Standards in Denmark, with
representatives from the primary user
groups and public authorities. Such a
committee or panel should, of course, fully
inform all parties about its work, and hold
hearings, seminars, etc. with contributions
from different sides.
The aim of this is to include as many
informed views as possible. The task of the
committee will be, on the basis of the
provisional guidelines proposed by the
auditors, to draw up the standards that can
win the most support. In view of the results, in
order to achieve such a consensus, or even to
achieve acceptance, several of the groups will
probably have to shift their position first.
The dialogues should result in a description
of those guidelines on which agreement has
been reached in the form of a discussion paper
with examples, and later in the form of a
statement on auditing standards. This
approach will ensure that the criteria in the
statement on auditing standards conform to
the expectations/demands of the primary user
groups.
Disclosure of materiality levels in the

engagement letter
After a degree of consensus has been reached
between auditors and the primary user
groups, the auditor should be required to
disclose, and give reasons for, his materiality
levels in the engagement letter to the board.
In other words, the materiality levels can be
included as part of the agreement between
firm and auditor. This can be done in the
form of a statement on auditing standards.
Apart from the engagement letter, the
information can also be used in connection
with making an offer for the audit, of course.

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In this way, the board will get factual

information about the precision of the
auditors work, and unrealistic expectations
among board members can be adjusted. The
dialogues this information can give rise to
will probably mean that the provisional
guidelines will have to be adjusted, and thus
be made permanent at a later date.
Disclosure of materiality levels in the audit

report
Once that the auditors materiality levels are
known to the board, and once, after dialogues
with primary user groups, there is a general
guideline setting out which criteria the
materiality levels should be based on, a
logical next step would be for the auditor to
also inform users of financial statements in
his report which specific materiality levels
he has used.
Since the firm discloses the principles on
which a concrete financial statement has been
drawn up, it only seems reasonable for the
auditor to disclose the principles his audit is
based on. As far as accounting principles are
concerned, the firm can, within the limits of
the law, choose those practices it regards as
being best suited to its needs. Users can then
base their views of the financial statement on
the published accounting practice. Similarly,
users can consider audit precision on the
basis of information about the audit,
including the materiality levels used, in the
auditors report.
The advantage for the auditor is that he
can no longer be held responsible for an
unknown error under his own materiality
level, since everybody now knows the level,
even though some may disagree with it.
There is still a risk of unknown material
errors (the audit risk) in the financial
statement, of course.
In the USA, Fisher (1990) has studied the
effect of whether or not auditors disclose
their materiality levels in an experimental
market setting. She concludes that
information on materiality levels is relevant
to share dealers, and that it results in a more
efficient market. The requirement of
information about materiality levels in the
auditors report can be incorporated into
audit report regulations and in auditing
standards on the auditors report, so that, to
start with, it is made voluntary by the
regulation first coming into effect after, say,
three years. This should rule out
misunderstandings, though there can still be
disagreement about the size of the
materiality level. The not inconsiderable
difference is, however, that the
disagreement is now out in the open, which
means that it can be discussed and taken into
consideration, whether at the annual general

meeting or through interested parties direct
enquiries to the firm.
If the materiality levels are disclosed in the
auditors report, the importance of the
guidelines will probably be somewhat reduced
because they are general and the information
in the report is specific. And if users know the
actual levels, they can be assumed to be not
greatly interested in knowing how the auditor
has arrived at them.
One consequence of disclosing the
materiality levels in the auditors report, of
course, will be that there must be no doubt
that all known errors have been corrected. If
they have not been corrected, the user will
have doubts about whether the financial
statements actually contain known errors
near the materiality level. This uncertainty
can be eliminated by a legal requirement for
all known errors to be corrected, and, if
necessary, that the firm should positively
state that this has been done.
If this suggestion is not adopted, the
uncertainty must be eliminated in another
way. For example, by the auditor stating in
his report, after the disclosure of the
materiality level, that all known errors, apart
from petty errors, have been corrected.
The purpose of the above-mentioned
proposals is, of course, to help establish a
greater degree of consensus between
societys expectations (including users of
financial statements) of auditors and its
opinion of auditors performance on the one
hand, and the concept of generally accepted
auditing standards, as laid down in the
current statement of auditing standards, on
the other. This can be achieved by attitudes
on both sides being influenced. For example,
the dialogues can result in the elimination of
unreasonable expectations of auditors,
including those that are too costly to fulfill.
The dialogues can also help reconcile
generally accepted auditing standards (and
thus auditors performance) with users
expectations by means of guidelines in the
area. Or reduce, and perhaps eliminate, the
expectation gap, since, in principle,
expectation gaps should not result from
inadequate/out-of-date guidelines, but solely
from isolated cases of inadequate work from
individual auditors.
A study carried out in New Zealand by
Porter (1993) shows that 34 percent of the
reasons for the expectation gap between
auditors and society, including users of
financial statements, were due to
unreasonable expectations of the auditors, 50
percent to inadequate guidelines, and only 16
percent to inadequate work from the auditors.
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According to these results, dialogues and

standards could help reduce a huge 84
percent of the expectation gap (in New
Zealand), which is quite remarkable. And
there is no reason to think that things are
different in the rest of the world.
The aim and goal of these proposals has
been to eliminate, or at least reduce, the
general or abstract and often not
understandable content of materiality, and
instead relate materiality assessments and
levels to something concrete in the financial
statement, to the benefit of both auditors and
users of financial statements.
Reducing the expectation gap by way of

limiting liability language in engagement
letters
Engagement letters are tools that are used to
manage clients expectations. One of its
fundamental benefits is that it clearly defines
the scope of the job and has the mutual
agreement of the accountants and the clients.
Engagement letters are able to close the
expectation gap concerning who is
responsible and who will pay in liability
settlements.
Camico Mutual Insurance Company,
recommends the use of limiting liability
language in engagement letters where the
risk-versus-reward scale is not appropriately
balanced. Limiting liability language is
recommended on jobs in which the risk is
high compared to the reward. For example,
Y2K consulting obviously was a situation
that needed the use of such language. The
types of engagements appear more often
today as accountants take up more
assignments involving high technology and
investment advising, in which the risks are
less predictable than in more traditional
services.
One Camico member recently evaluated a
clients entire accounting system, in which
he would purchase, install, and test new
accounting software. He was worried about
the likelihood for liability problems if the
new system developed major glitches, so he
included the following limiting liability
language in the engagement letter:
As we discussed, our essential fees in this
engagement are very small compared to the
amount of business that will be processed by
your new accounting system. Accordingly,
our liability to you in the event of any defects
in the system will be limited to the lesser of
our fees for this engagement, or the cost to
repair any defects in the accounting system
that we may have caused.
This language shows a number of key

characteristics of effective limiting liability
language. First, it is short and
[ 524 ]
unintimidating enough to not provoke a

clients reservations about lengthy or
tricky legalese. Second, it clearly states the
area of concern (in this case the new
accounting software system). Third, it
provides a detailed explanation of the
accountants liability if there are major
problems with the system. Finally, it
recognizes that problems could be caused by
the accounting firm. Such language is more
likely to be accepted in court than other form
of disclaimers that seek to avoid
responsibility in areas where the accountant
is actually negligent.
Despite its value, there are disadvantages
to the use of limiting liability language. It
does not limit liability to any third parties in
a lawsuit and it is not enforceable in every
court. In addition, some clients might be
offended, which may lead to loss of business.
However, Camico believes that, particularly
in high risk/lower reward jobs, the
advantages of limiting liability language far
offset the disadvantages.
Advantages can be seen during the
assessment stage, by encouraging the
accountant to assess risks versus rewards, an
essentially valuable exercise. Additionally,
discussions and negotiations with the client
contribute to an environment of open
communication from the start. The
communication process can also help
identify future clients that are totally
nonflexible in sharing liability risks. This
type of client one may be better off without.
Most notably, limiting liability language can
be an important reference point in settlement
negotiations.
As to whether such language will have any
grounds in court, this will vary from state to
state and court to court. Currently, such
decisions are being made on a case-by-case
basis. On the other hand, the simple act of
communicating with the prospective client
and coming to a mutual agreement that is
formally documented is a positive step
toward limiting liability. In short, a few
short, clearly written sentences that state the
risk, describe the appropriate liability, and
acknowledge responsibility for potential
negligence may significantly reduce
settlement fees.
Reduction of expectation gap through

unqualified opinion expressed by auditors
To reduce the expectation gap, the auditors
have to exercise reasonable skill, care and
maintain their professional independence in
issuing unqualified opinion regarding true
and fair view of a clients financial statement.
This is to ensure that the auditors do not
provide any misleading information that will

Mohammad Talha
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provide a false perception to the public. An

auditor should not issue an unqualified
opinion unless the best judgment is that the
financial statements are free of misstatements
resulting from management fraud.
In the Malaysia context, MIA By-Law A-2
Integrity and Objectivity states that all
members of the accounting profession have to
be fair, intellectually honest and free of
conflicts of interest. In fact, the MIA By-Law
even specifically states that members shall be
fair in their approach to their professional
work and shall not allow any prejudice, bias
or influences of others to override their
objectivity. Thus, if the auditors are unable to
maintain their professional independence in
carrying out their audit work, an unqualified
opinion on the clients financial position
should not be issued. Otherwise the audit
report will not be based on the true judgment
of the financial position of the client.
In the public practice, members may in the
course of their professional work, be exposed
to situations which involve the possibility of
pressures being exerted on them. These
pressures may impair their objectivity. Hence,
members shall identify and assess such
situations and ensure that they uphold the
principles of integrity and objectivity in their
professional work at all times. Members shall
neither accept nor offer gifts or entertainment
which might reasonably be believed to have a
significant and improper influence on their
professional judgment or those with whom
they deal, and shall avoid circumstances
which would bring their professional standing
or the institute into disrepute.
A member in public practice shall be, and
be seen to be, free in each professional
assignment he undertakes, of any interest
which might detract from objectivity. The
fact that this is self-evident in the exercise of
the reporting function must not obscure its
relevance in respect of other professional
work. Although a member not in public
practice may be unable to be, or be seen to be,
free of any interest which might conflict with
a proper approach to his professional work,
this does not diminish his duty of integrity
and objectivity in relation to that work. The
auditor should resign from performing that
audit task and may advise the client to hire
others who are competent to perform the
work (Audit Commission, www.cipfa.org).
If the client involved in any criminal
activities which might threatened the safety
of the public, MIA By-Law A-5:
Confidentiality states that the auditor has the
legal right or duty to disclose such fact in the
qualified opinion expressed in the audit
report to warn the public of such incidence.
Creating an independent agency to

oversee audit regulation
The government could play an important role
in reducing the expectation gap by creating an
independent agency to oversee the audit
regulation. To investigate stakeholder
perceptions of the structure and function of
such an agency, three models were developed:
an Auditing Council; a Commission for Audit;
and a Securities and Exchange Commission
(SEC). Auditing Council would be a private
body analogous to the Financial Reporting
Council. Commission for Audit would be a
public sector body analogous to the Audit
Commission for local and health authorities
in England and Wales. A SEC would be a
public sector body with overall responsibility
for City regulation, including that of listed
company audit
An Auditing Council received the most
support, a Commission for Audit the least,
with a UK SEC provoking the strongest
reactions both for and against. Currently,
arguments in favor of increased regulation
were generally framed in terms of increased
openness that would materially enhance the
credibility of audits; arguments against
expressed fears that it would be
cumbersome and add a further tier of
bureaucracy. Overall, there was a significant
degree of support to make the case for
establishing an independent regulatory body.
The structure of the independent body
should match the expectation gaps main
components as revealed by the study:
independence, monitoring and discipline.
Such a body might be called a Listed
Companies Audit Board (LACB), structured
into three panels of responsibility: an auditor
independence panel; an audit quality panel;
and a disciplinary panel.
An auditor independence panels role
would be to set up to monitor independence
standards and guidelines, for example by
restricting non-audit services in whole or in
part, or by setting up procedures formally to
authorized provision of non-audit services. It
can be argued that providing audit services
should be remunerative in itself and not
conditional, or perceived as conditional, on
the auditor providing non-audit services.
The role of an audit quality panel would be
to set up and maintain a register of auditors
whom the panel recognized as capable of
undertaking listed company work, and to
monitor the quality of audit work done. A
possible consequence of such a licensing
procedure is that it might lead to increased
competition for listed company audits. These
are increasingly dominated by the Big Four
firms, partly because of the reputation effect.
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External validation procedures might

allow other firms to join the register and
compete against the Big Four, especially for
the audit of middle or lower-ranking listed
companies, where the importance of global
reach is less significant. Failure to observe
standards of auditor independence and
quality, and ignoring guidelines, would
result in referral to a disciplinary panel.
Sanctions against a firm, a firms office or a
partner might include naming and
shaming, fines, or removal from the register
of listed company auditors.
Going concern reporting developments for

standard setters
According to Monroe and Woodliff (1994) they
have formally defined the expectations gap as
the difference between the beliefs of auditors
and the public about the duties and
responsibilities assumed by the auditor, and
the message conveyed by the audit report. One
key purpose of financial statements is to foster
the optimal allocation of investing capital
between competing uses by providing all
material, relevant information to the user
community. The purpose of the audit report is
to reveal the auditors success in verifying the
financial statement assertions. Thus, it is
dismaying to find differences between the
auditors definition of their responsibilities
and that of the user community. Accordingly,
the expectations gap has prompted many
questions about audit quality in general and,
in particular, the auditors ability to make
judgments in the presence of going concern
uncertainties.
This gap has led to the issuance of new
standards in many countries. For example, in
the USA, Statement of Auditing Standards
(SAS) No. 59 entitled Auditors
consideration of an entitys ability to
continue as a going concern (AICPA, 1989)
was issued to help reduce the expectations
gap. The Australian Auditing Standards
Board issued AUS 708, entitled Going
concern (AASB, 1996). The UK issued SAS
130 entitled Going concern, to accomplish
similar objectives (APB 1996).
Financial statement users have stated that
the type of report issued is an important
element in their investing and credit-granting
decisions (AICPA, 1982). Therefore, inaccurate
reporting can result in suboptimal investment
and credit decisions. The resulting
misallocation of capital slows economic and
productivity growth. This situation arose
because, initially, auditors were not required
to search for indicators of going concern
problems. Financial statement users, on the
other hand, expected auditors to search for and
report on uncertainties that could threaten
[ 526 ]
that companys ability to survive. The US

Auditing Standards Boards (ASB)
deliberations led to the issuance of SAS No. 58,
which addressed all uncertainties, and SAS
No. 59, which had particular reference to going
concern uncertainties. A major purpose of
these standards was to enhance the auditors
reporting responsibilities in order to remedy
the financial statement users complaints.
In the USA, the goal of Auditing Standard
Board (ASB) was to reduce the expectations
gap in audit reports on uncertainties. Most
studies indicate that investors do depend on
audit reports to highlight significant
uncertainties. Nevertheless, published
research indicates that many companies
receive clean reports prior to filing for
bankruptcy. Users have frequently asked the
question, If an audit report cannot provide an
early warning signal of impending business
failure, what good is it? (Carmichael and
Pany, 1993). From the financial statements
users perspective, the new form of going
concern report should sends a clear and
unambiguous signal to them. But from the
perspective of auditors, with the new standard,
they are more likely to modify reports for
distressed companies in accordance with users
expectations (Carmichael and Pany, 1993).
The auditor should be required to evaluate
whether there is substantial doubt about
the clients ability to continue as a going
concern in every audit. They are asked to
obey the following:
.
Detection. The auditor now has an
obligation to make an assessment at the
conclusion of the audit of the clients
ability to continue as a going concern.
.
Time period. The focus of the auditors
assessment of the clients ability to
continue as a going concern is now tied to
a reasonable time period of one year.
.
Evaluation. Previously, the decision to
modify the audit report hinged on
recoverability of the assets, and recognition
and classification of liabilities. Now going
concern status is a separate issue.
.
Reporting. The subject to qualification
should be supplanted by an explanatory
paragraph for all material uncertainties
including going concern uncertainties.
The major objectives of the new standards
were to improve communication to financial
statement users, and to ensure that auditors
made an affirmative effort to evaluate and
report on each clients going concern status.
This will not only lead to addressing the issue
of auditor reputation and credibility, but it
also ensures useful, clear and unambiguous
financial statements to the user community.

Mohammad Talha
gap in reporting on
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The effect of education on reducing the

expectation gap concerning perceptions of
messages conveyed by audit and review
reports

18/6/7 [2003] 517-529
The audit expectation gap has been described

by Humphrey et al. (1992) as the gap between
the publics perception of the role of the audit
and the auditors perception of that role. The
expectation gap still continues to persist, not
only with respect to naive users, but also
with respect to sophisticated users of general
purpose financial reports. Thus, efforts must
be doubled by the profession in its attempt to
narrow the expectation gap.
According to the Middleton Report, it
recognized that education is vital to help
contain the expectation gap. This view is
supported by Jenkins (1990) who indicated
that the profession needs a continuing,
imaginative program of explaining the
inherent limitations in accounting, reporting
and auditing to the users of accounts. Also,
Smithers (1992) stated that he believes that an
education process would have to form a
major part of any campaign aimed at closing
the expectation gap. Monroe and Woodliff
(1994) found that auditing students beliefs
about auditors responsibilities, the
reliability of audited financial information
and future prospects changed significantly
over the semester. They concluded that
education is an effective approach to address
the expectation gap. Ferguson et al. (2000)
found that Canadian co-operative students
had pre-scores on an expectation gap
instrument that are closer to practicing
auditors relative to the pre-scores of
Australian non-co-operative students, which
they attributed to experience.
There were significant differences between
auditors and students who had not completed
an auditing course, about auditors
responsibilities, the reliability of audited
financial information and the decision
usefulness of audited or reviewed financial
statements. After completing their course, the
auditing students believed auditors assumed
less responsibility for soundness of internal
control, maintaining accounting records,
preventing fraud and detecting fraud;
management assumed more responsibility for
producing financial statements; the auditor/
reviewer was more independent; and the
auditor/reviewer exercised more judgment in
the selection of procedures, than they did at the
beginning of the course. These changes were in
the direction of auditors beliefs indicating a
significant reduction in expectation gap in
relation to auditors or reviewers
responsibilities.
After finishing the auditing course, students
believed to a greater extent that the auditor
agreed with the accounting policies and to a

lesser extent that the entity was free from
fraud. These changes were in the direction of
auditors beliefs indicating a significant
reduction in the expectation gap in relation to
the reliability of audited or reviewed financial
statements. However, the auditors still had a
significantly stronger belief that the audited
financial statements give a true and fair view
and believed a significantly higher level of
assurance was provided by the audit. All
groups believed that an audit provided a
higher level of assurance that there were no
material errors than a review.
After the auditing course, students believed
to a greater extent that reviewed financial
statements were useful for monitoring
performance and making decisions. These
changes were in the direction of auditors
beliefs indicating a significant reduction in the
expectation gap in relation to the usefulness of
reviewed financial statements. However, the
students still believed that the unqualified
audit/review report meant that the entity was
well managed.
The results indicate that education may be
an effective way to reduce the expectation gap.
However, several differences in expectations
still existed. Also, it must be remembered that
it may not be practical to expect all parties to
the expectation gap to undertake the
equivalent of an undergraduate auditing
course. However, it emphasizes the
importance of the accounting bodies retaining
auditing as a prescribed subject for
accreditation purposes for undergraduate
tertiary degrees, to help ensure that members
of the accounting profession do not have
misconceptions about the audit function.
5. Conclusion
The collapse of Enron and WorldCom raise a
number of issues that have a direct bearing
on the expectation gap. Public debate of these
collapses has centered on issues of:
.
corporate governance and management
style, management neglect or misconduct
as is evident by recent ASIC enforcement
actions against executives and directors of
a number of collapsed companies;
.
mandatory audit committees, their role,
structure, composition and operation,
management representations to such
committees;
.
the independence of the auditor, the
provision of non-audit services, the
rotation of auditors, attendance of
auditors at AGMs and ex-auditors serving
on the boards of companies which are
audited by the same auditor;
[ 527 ]

Mohammad Talha
gap in reporting on
uncertainties

18/6/7 [2003] 517-529
the need to reassess the effectiveness of

the audit process, including existing
auditing standards, as well as providing
them with the force of law;
the need to monitor the effectiveness of
legislation, regulations and regulatory
bodies particularly with regard to
specialised industries;
the need to review current accounting
standards, the standard setting process
and the adoption of international
accounting standards on a wholesale or
unconditional basis;
the need to reassess the financial
reporting framework, strengthening
continuous reporting requirements with
adequate sanctions for non-compliance;
the need to reassess the role and
responsibilities of the CEO and corporate
whistleblowing expectations including the
strengthening of current reporting
obligations of auditors to regulators; and
the need to assess the effectiveness of the
co-regulatory framework for the
profession and the ability of the
profession to maintain quality and
effectively sanction or discipline members
when required to do so.
In dealing with the above issues the

professional accounting bodies need to be
vigilant and proactive, working closely with
other professional bodies and regulators to
ensure that similar consequences are not
repeated in the future.
The movement to more democratic forms
of corporate governance by empowering
owners is important not only for creating
wealth; it cuts directly to our ability to
maintain a free society. It may be an
exaggeration but Corporations determine
far more than any other institution the air we
breathe, the quality of the water we drink,
even where we live. However, they are not
accountable to anyone.
The Cadbury Report (Committee on the
Financial Aspects of Corporate Governance)
was published in December 1992 with a
further Financial Reporting Council study in
June 1995.
The former reported on the propriety of
corporate governance particularly public
quoted companies. It argued for:
. . . clearly accepted division of
responsibilities at the head of a company,
which will ensure a balance of power and
authority, such that no individual has
unfettered powers of decision.
This reflects UK practice historically where

the chief executives and chairmans position
are held by two people. The chairman chairs
the board and oversees external
[ 528 ]
communications: with large investors and

government, presenting the corporations
public face, etc. The CEO attends to executive
and operational aspects coordinating the
work of other executive directors and
running the company internally.
This separation is a common UK model
whereas the USA model tends to position one
person in a combined role.
References
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Alternative Going Concern Reporting Formats:
Canadian Experience, Anandarajan, A, School
of Management, New Jersey Institute of
Technology, University Heights, Newark, NJ.
AICPA (1982), Serving the public interest: a new
conceptual framework for auditor
independence, report prepared on behalf of
the AICPA in connection with the
presentation to the Independence Standards
Board of Serving the Public Interest, AICPA,
October 20.
AICPA (1989), Bankcruptcy Prediction Models and
Going Concern Audit Opinions Before and
After SAS, No. 59.
AICPA (1996), Auditing Procedures Study, Audit
Sampling, AICPA, New York, NY.
APB (1996), The company applies APB Opinion
No. . . . that no warranty reserve was
necessary as of December 31, 1995 and 1996,
Leinenger Audit Report, 1995, 1996.
Carmichael, D.R. and Pany, S.G. (1993), The
appearance standard for auditor
independence: what we know and should
know, in International Research Implications
for Academicians and Standard Setters on
Going Concern Reporting: Evidence from the
United States, Harvard University Press,
Cambridge, MA.
COSO Report (1982), December.
Dyer, J.L. (1975), Toward the development of
objective materiality norms, The Arthur
Andersen Chronicle, October.
Ferguson, C.B., Richardson, G.D. and Wines, G.
(2000), Audit education and training: the
effect of formal studies and work experience,
Accounting Horizon, June, Vol. 14 No. 2,
pp. 137-67.
Fisher, M.H. (1990), The effects of reporting
auditor materiality levels publicly, privately,
or not at all in an experimental markets
setting, Auditing: A Journal of Practice &
Theory, Vol. 9, Supplement.
Grice, J.S. Sr (1989), Bankruptcy Prediction
Models and Going Concern Audit Opinions,
Before and After SAS, AICPA, New York, NY,
No. 59
Humphrey, C., Moizer, P. and Turley S. (1992),
The audit expectation gap plus ca change,
plus cest la meme chose?, Critical Perspectives
on Accounting, Vol. 3, May, pp. s137-61.
IASC (1995), Framework for the Preparation and
Presentation of Financial Statements, FSR,
Copenhagen.
Jenkins, W.P. (1990), The goal of price stability,
Taking Aim: The Debate on Zero Inflation,

Mohammad Talha
gap in reporting on
uncertainties
18/6/7 [2003] 517-529
Policy Study No. 10, C.D. Howe Institute,

Toronto, pp. 19-24.
McEnroe, J.E. and Martens, S.C. (2002), Taxman,
March 9, pp. 236-51.
Marian, Y.J., Gladie, M.C. and Albert, Y.H. (2002),
Malayan Law Journal, Vol. 1.
Mautz, R. and Sharaf, H. (1961), The Philosophy of
Auditing, American Accounting Association,
Sarasota, FL, ch. 9.
Monroe, G. and Woodliff, D. (1994), The audit
expectation gap: messages communicated
through the unqualified audit report,
Perspectives on Contemporary Auditing,
pp. 47-56.
Murray, A. (2002), Enron Updates, August 20,
available at: www.trinity.edu/rjensen/
fraud082002.htm
Orrenstein, P. (1995), Jenkins on the Jenkins
Report, CA Magazine, April, pp. 15-18.
Patillo, J.W. (1976), The Concept of Materiality in
Financial Reporting, Financial Executive
Research Foundation, New York, NY.
Porter, B. (1993), An empirical study of the audit
expectation-performance gap, Accounting
and Business Research, Vol. 24 No. 93.
Robinson, C. and Fertuck, L. (1985), Materiality.
An Empirical Study of Actual Auditors
Decisions, Research Monograph No. 12, The
Canadian Certified General Accountants
Research Foundation, Vancouver.
Rosen, L.S. (1982), An Empirical Study of Materiality
Judgements by Auditors, Bankers, and Analysts.
Research to Support Standard Setting in
Financial Accounting: A Canadian Perspective,
The Clarkson Gordon Foundation, Toronto.
Smithers (1992), Legislative Session: 1st Session,
35th Parliament, Hansard, Vol. 3, May 12.
Walker, D. (2002), Auditing the auditor, special
report on Enron, The Guardian, February 11.
Woolsey, S.M. (1973a), Approach to solving the
materiality problem, Journal of
Accountancy, March.
Woolsey, S.M. (1973b), Materiality survey,
Journal of Accountancy, September.
Further reading
Chapman, P. (2001), Corporate governance and
the sons of Cadbury, Management
Accounting Journal, Vol. 1 No. 4.
Danish Accounting Standards (1994), FSR,
Copenhagen.
Danish Auditing Standards (1996), FSR,

Copenhagen (Danish edition only).
Elliott, R.K. (1981), Audit materiality and myth,
D.R. Scott Memorial Lectures in Accountancy,
Vol. 11.
Elliott, R.K. (1983), Unique audit methods: Peat
Marwick International, Auditing: A Journal
of Practice & Theory, Vol. 2 No. 2, Spring.
FASB (1975), Discussion Memorandum: An
Analysis of the Issues Related to Criteria for
Determining Materiality, 21 March.
Laing, D. and Weir, C.M. (1999), Governance
structures, size and corporate performance in
UK firms, Management Decision,Vol. 37 No. 5,
pp. 457-64.
Glautier, M. and Underdown, B. (1997), Accounting
Theory and Practice, 6th ed., Pitman, London.
Godfrey, J., Hodgson, A. and Homes, S. (1997),
Accounting Theory, 3rd ed., John Wiley &
Sons, New York, NY.
Hjskov, L. (n.d.), Should errors in financial
statements be corrected?, unpublished
working paper.
ISA (1994), International Standards on Auditing
No. 320 and Glossary of Terms, International
Auditing Practices Committee (IAPC), issued
by the International Federation of
Accountants (IFAC), July, FSR, Copenhagen.
Leslie, D.A. (1985), Materiality, CICA, Toronto.
Public Sector Corporate Governance (2002),
Turnbull report, Credit Control, Vol. 23
No. 1, pp. 27-30.
Ricchiute, D. (1992), Auditing, South-Western
Thomson Learning, Mason, OH.
Schelluch, P. and Green, W. (1996), The
expectation gap: the next step, Australian
Accounting Review, Vol. 6 No. 2.
Selley, D.C. (184), The origins and development
of materiality as an audit concept, paper
presented at the Audit Symposium VII,
Touche Ross/University of Kansas
Symposium on Auditing Problems.
Vinten, G. (2002), The corporate governance
lessons of Enron, Corporate Governance,
Vol. 2 No. 4, pp. 4-9.
Wilson, I. (2000), The new rules: ethics and
social responsibility, Strategy and
Leadership, Vol. 28 No. 3, pp. 12-16.
Wolk, H. and Tearney, M. (1997), Accounting
Theory, 4th ed., Thomson, Mason, OH.
Appendix
Table AI
Comparison of the auditors and the financial analysts average levels
Index figures for auditors average levels
(average of financial analysts = 100)
Levels in the cases
Overestimation
Underestimation
Company 1: Company 2: Company 3: Company 4:

Carlsberg Micro Matic
B&O
DDT
188
170
229
207
124
(15012) 66
94
102
Average
159
(157) 136
Source: Research in Accounting Conference Proceeding, Japan, 1998
[ 529 ]
Improving corporate governance: the role of audit

committee disclosures
Zabihollah Rezaee
Fogelman College of Business and Economics, The University of Memphis,
Memphis, Tennessee, USA
Kingsley O. Olibe
Department of Accounting, Middle Tennessee State University, Murfreesboro,
Tennessee, USA
George Minmier
Fogelman College of Business and Economics, The University of Memphis,
Memphis, Tennessee, USA
Keywords
Audit committees,
Financial reporting, Auditing,
Disclosure
Abstract
restatements along with many
allegations of financial statement
fraud committed by high profile
companies (e.g. Enron, WorldCom,
Global Crossing, Adelphia) has
eroded the public confidence in
corporate governance, the
financial reporting process, and
audit functions. The SarbanesOxley Act of 2002 was an attempt
to regain confidence and trust in
corporate America and the
accounting profession. The Act
addresses corporate scandals and
the perceived crisis in the auditing
profession. Some of its provisions
relate to the audit committee
oversight function over corporate
governance, financial reporting,
internal control structure, internal
audit functions, and external audit
services. This study examines
three types of audit committee
disclosures: the annual report of
the audit committee; reporting of
the audit committee charter in the
proxy statement at least once
every three years; and disclosure
in the proxy statement of whether
the audit committee had fulfilled
its responsibilities as specified in
the charter. This study conducts a
content analysis on audit
committee disclosures of Fortune
100 companies.

18/6/7 [2003] 530-537
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482669]
[ 530 ]
Introduction
restatements by publicly traded companies
coupled with allegations of financial
statement fraud and lack of responsible
corporate governance of high-profile
companies (e.g. Enron, Global Crossing,
WorldCom, Adelphia) has sharpened the ever
increasing attention on corporate
governance in general and the audit
committee in particular. The audit
committees function has evolved over the
years and now with recommendations of the
Blue Ribbon Committee (BRC, 1999) and the
new rules of the Securities and Exchange
Commission (SEC, 1999) and organized stock
exchanges (e.g. New York Stock Exchange
(NYSE), American Stock Exchange (AMEX),
National Association of Securities Dealers
Automated Quotation NASDAQ), it is viewed
as an oversight function of corporate
governance, financial reporting process,
internal control structure, and audit
functions. The Sarbanes-Oxley Act of 2002,
also known as Public Company Accounting
Reform and Investor Protection Act of 2002,
has expanded the formal responsibilities of
audit committees[1]. These expanded
responsibilities of audit committees should
be specified in both audit committee charters
and reports. Yet, until recently, there was not
a common view of what an audit committee
charter includes, what it should achieve, and
whether to include the report by the audit
committee in annual reports. The status of
the audit committee report has evolved from
nonexistence to voluntarily and now
mandatory for publicly traded companies
under the SEC jurisdiction in the USA.
The primary purposes of this paper are to,
first, discuss current initiative on corporate
governance and audit committees; second,
examine to what extend affected companies

are in compliance with audit committee
disclosure requirements; third, determine
best practices in audit committee reporting;
and fourth, make suggestions for
improvements in corporate governance in
general and the audit committee in
particular. The determination of best
practices in audit committee reporting
should assist organizations to establish
benchmarks in assessing the adequacy and
effectiveness of their audit committee
reporting. An effective audit committee
reporting can improve corporate governance
and accountability as President Bush urged
corporate America to regain the public
confidence in financial reports through
greater accountability.
Corporate governance and audit

committee
The report of the Public Oversight Board
(POB) of the SEC Practice Section of the
Accountants (AICPA) (1993) states:
Corporate governance in the United States is
not working the way it should . . . (It) is the
failure by too many boards of directors to
make the system work the way it should . . .
more effective corporate governance depends
vitally on strengthening the role of the board
of directors.
Enron, Global Crossing, Adelphia, and

WorldCom debacles, caused by the alleged
commission of financial statement fraud,
have raised concerns regarding the lack of
vigilant oversight functions of their boards of
directors and audit committees in effectively
overseeing financial reporting process and
audit functions. Corporate governance in the
USA is coming under sharp criticism for its
lack of vigilant oversight functions.
Zabihollah Rezaee,
Kingsley O. Olibe and
George Minmier
Improving corporate
governance: the role of audit
18/6/7 [2003] 530-537
President George W. Bush, in the recent State

of the Union address, mentioned the
seriousness of the corporate governance
problem by saying that:
Through stricter accounting standards and
tougher disclosure requirement, Corporate
America must be made accountable to
employees and shareholders and held to the
highest standards of conduct (Bush, 2002).
The role of corporate governance is also

addressed by the Blue Ribbon Committee
(BRC, 1999, p. 20) as:
Good governance promotes relationships of
accountability among the primary corporate
participants to enhance corporate
performance. It holds management
accountable to the board and the board
accountable to shareholders . . . A key element
of board oversight is working with
management to achieve corporate legal and
ethical compliance. Such oversight includes
ensuring that quality accounting policies,
internal controls, and independent and
objective outside auditors are in place to
deter fraud, anticipate financial risks, and
promote accurate, high quality, and timely
disclosure of financial and other material
information to the board, to the public
markets, and to the shareholders.
The Blue Ribbon Committee (BRC, 1999)

revealed the following three conclusions
regarding the oversight responsibility of
corporate governance including the audit
committee:
1 Quality financial reporting can only be
achieved through open and candid
communication and close working
relationships among the corporations
board of directors, audit committee,
management, internal auditors, and
external auditors.
2 Strengthening corporate governance
oversight in the financial reporting
process of publicly traded companies will
reduce instances of financial statement
fraud.
3 Integrity, quality, and transparency of
financial reports improve investors
confidence in the capital market while
incidents of financial statement fraud
diminish such confidence.
Corporate governance guidelines

Corporate governance principles and
guidelines are established by several
organizations to provide best practices or
benchmarks against which to assess the
appropriateness of the corporate governance
system. For example, the Toronto Stock
Exchange (TSE) established a Committee on
Corporate Governance in 1993 to ensure
investors receive sufficient information to
assess the effectiveness of the companys
corporate governance. The committee issued

a report, known as the Dey Report, entitled,
Where Were the Directors? Guidelines for
Improved Corporate Governance in Canada in
December 1994 (TSE, 1994). The Dey Report
proposed 14 guidelines for corporate
governance primarily aimed at the activities
of the board of directors.
TSE-listed companies should report on
their corporate governance system and on
whether their system is in compliance with
the 14 guidelines. These guidelines are
primarily aimed at the board of directors by:
.
specifying the responsibility of the board
of directors in the areas of strategic
planning, risk management, and internal
control;
.
suggesting that the board of directors
should be composed of a majority of
unrelated (independent) directors;
.
approving corporate objectives;
.
discussing orientation and training for
new board members, compensation
committees, and their functions;
.
functioning independently of
management; and
.
establishing the audit committee
composed solely of outside directors
which oversees audit functions and the
system of internal control.
The Business Roundtable, an association of
chief executive officers of leading
corporations that represents itself as an
authoritative voice for American business,
has proposed six guiding principles of
corporate governance:
1 the board of directors should select a chief
executive officer (CEO) and oversee the
CEO and other top executive activities;
2 management is responsible for operating
the corporation in an effective and ethical
manner with the goal of creating
shareholder value;
3 management is responsible for preparing
financial statements, under the oversight
of the board of directors and its audit
committee, that fairly present the
financial condition and results of
operations of the corporation;
4 the board of directors and its audit
committee should engage an independent
accounting firm to perform financial
statement audits;
5 the independent accounting firm should
maintain its independence in fact and in
appearance, conduct the audit in
accordance with generally accepted
auditing standards (GAAS), inform the
board through the audit committee of any
concerns regarding the quality and
[ 531 ]
Zabihollah Rezaee,
George Minmier
Improving corporate
18/6/7 [2003] 530-537
integrity of the financial reporting

process; and
6 corporations have responsibilities to deal
with their employees in a fair and
equitable manner (BRT, 2002).
The National Association of Corporate
Directors (NACD, 2002), an independent,
not-for-profit organization devoted to
improve corporate board performance, has
recently recommended to Congress a set of
core governance principles to be endorsed by
organized stock exchanges, and used by the
SEC as disclosure requirements in order to
improve corporate governance in the USA.
The core governance principles set forth by
NACD consist of ten governance principles
and related disclosure requirements for
publicly traded companies in the USA. These
ten governance practices and principles set
forth the following expectations for boards of
directors. The board of directors should:
1 comprise a substantial majority of
independent directors;
2 require establishment of key committees
(e.g. audit, compensation, nominating) to
be composed of independent directors;
3 ensure that each key committee has a
board-approved written charter detailing
its functions and responsibilities;
4 formally designate an independent
director as chairman or lead director;
5 regularly and formally evaluate the
performance of the CEO;
6 review the adequacy of their companies
compliance and reporting systems at least
annually;
7 adopt a policy of holding periodic sessions
of independent directors;
8 require their audit committee to meet
independently with both the internal and
independent auditors;
9 be constructively engaged with
management in corporate strategy; and
10 provide new directors with a director
orientation program to familiarize them
with their companies business, industry
trends, recommended governance
practices, and then ensure continuing
education for directors (NACD, 2002).
Currently, under the pressure from the SEC
and organized stock exchanges in the USA,
interested parties are considering how to
improve corporate governance in general
and the effectiveness of the audit committee
in particular.
Audit committees
Recent high profile business failures and
corporate misconducts (e.g. Enron, Global
[ 532 ]
Crossing, WorldCom, Adelphia) have

galvanized more interest in and discussion
on the proper oversight of audit committees.
The success of audit committees in fulfilling
their oversight responsibility depends on
their working relationships with other
participants of corporate governance,
including the board of directors,
management, external auditors, internal
auditors, legal counsel, professional advisors,
regulators, and standard-setting bodies. The
new audit committee rules of the NYSE and
NASD, which govern companies listed on
both the AMEX and NASDAQ, set forth
requirements for independent directors,
charter, structure, membership, and
compliance. The emerging interest in
corporate governance underscores the
importance of audit committees as a crucial
element of corporate governance
mechanisms. Arthur Levitt, former
chairman of the SEC, rightfully stated that:
Effective oversight of the financial reporting
process depends, to a very large extent, on
strong audit committees; qualified,
committed, independent, and tough-minded
audit committees represent the most reliable
guardians of the public interest this time for
bold action (Levitt, 1999).
Rezaee (2002) states that the evolution of

audit committees shows many companies
voluntarily created audit committees in the
mid-twentieth century to provide more
effective communication between the board
of directors and external auditors. Current
audit committees are expected to oversee
corporate governance, financial reporting,
internal control structure, internal audit
functions, and external audit services. The
SEC rules on audit committees significantly
affect the structure, composition, functions,
and responsibilities of audit committees.
DeZoort and Salterio (2001) discuss audit
committee composition, functions,
responsibilities, and resources as well as the
effects of corporate governance experience
and audit knowledge on audit committee
members judgments. To effectively fulfill its
oversight function, the audit committee
should be independent, competent,
financially literate, adequately resourced
and properly compensated.
The Sarbanes-Oxley Act of 2002 enacted six
requirements for audit committees;
1 the audit committee should be composed
entirely of independent members of the
board of directors;
2 the audit committee should be directly
responsible for the appointment,
compensation, and oversight of the work
of external auditors;
Zabihollah Rezaee,
George Minmier
Improving corporate
18/6/7 [2003] 530-537
3 the audit committee should have

authority to engage advisors;
4 the audit committee should be properly
funded to effectively carry out its duties;
5 auditors must report to the audit
committee all critical accounting policies
and practices used by the client; and
6 the SEC should issue rules to require
public companies disclose whether at
least one member of their audit committee
is a financial expert.
The BRC (1999) recommended and the SEC
requires that an audit committee report be
included annually in the proxy statement.
The report should state whether the audit
committee has:
.
reviewed and discussed the audited
financial statements with management;
.
discussed with the external auditors those
matters required to be communicated to
the audit committee in accordance with
generally accepted auditing standards
(GAAS);
.
received from the external auditors a
letter revealing matters that, in the
auditors judgment, may reasonably be
thought to bear on the auditors
independence from the company and
discussed with them their independence;
and
.
recommended to the board of directors
that the companys audited financial
statements be included in the annual
report on the form 10-K or form 10-KSB
based on discussions with management
and external auditors.
The inclusion of the audit committee report
in the proxy statements presents challenges
for audit committees on the one hand; it
should improve the trust and confidence in
the financial reporting process. On the other
hand, it raises some concerns that audit
committee members are not thoroughly
involved in the preparation of financial
statements and, thus, this requirement
increases audit committees liability. This
increased oversight function and associated
liability may ultimately result in either
higher compensation for audit committee
members or fewer qualified directors willing
to serve on audit committees. This study
attempts to determine the best practices and
guidelines on audit committee disclosures.
Methods and procedures

In the presence of mandatory requirements
for the inclusion of a report by the audit
committee in the companys proxy statement,
all publicly traded companies have prepared
such reports. This study performs a content

analysis on audit committee reports of
Fortune 100 companies in the USA to
determine the information content of these
reports and the extent to which these reports
conform to the requirements of the SEC,
NSDQ, and NYSE. The final sample consists
of only 94 companies because audit
committee reports and charters of several
companies were not publicly available.
Reports on audit committees were submitted
to a content analysis to identify the title and
format of such reports. These proxy
statements were examined to determine:
.
the presence of the audit committee report
in the proxy statement;
.
the title of such report (e.g. report on audit
committee); and
.
the content of the report.
This study also examines the audit
committee charters in determining
characteristics, structure and functions of
audit committees.
Results
The currently mandatory audit committee
disclosures are, first, the annual report of the
audit committee; second, reporting of the
audit committee charter in the proxy
statement at least once every three years; and
third, disclosure in the proxy statement of
whether the audit committee had fulfilled its
responsibilities as specified in the charter.
These enhanced mandatory audit committee
disclosures are expected to:
.
encourage more vigilant audit committee
oversight function;
.
improve corporate governance;
.
foster the public confidence in the
financial reporting process; and
.
promote audit efficacy.
Results are presented in two categories of
audit committee charters and audit
committee reports.
Audit committee charters

The SEC requires that publicly traded
companies adopt formal written charters for
their audit committee describing their
responsibilities, composition, qualifications,
and functions. The charter should be
approved by the board of directors and
disclosed at least triennially in the annual
report to shareholders or proxy statement.
Publicly traded companies listed on
organized stock exchanges (NYSE, AMEX,
NASDAQ) are required to include the audit
committee charter in their proxy statement
at least once every three years (SEC, 1999).
[ 533 ]
Zabihollah Rezaee,
George Minmier
Improving corporate
18/6/7 [2003] 530-537
The audit committee charter states the

committees responsibilities, size,
composition, authority, meetings, diligence,
financial literacy, and independence.
Results presented in Table I indicate that
all of the analyzed charters specify the
responsibilities and authority of the audit
committee. Although, audit committee
charters vary in describing responsibilities
and authorities of the audit committee, the
general recurring responsibilities are:
.
recommendation to the board of directors
for nominating and/or retaining the
independent auditors;
.
reviewing the audited financial
statements and discussing them with
management and the independent
auditors;
.
issuing a report (e.g. audit committee
report) to be included in the companys
proxy statement;
.
overseeing internal audit activities; and
.
reviewing the relationship with the
independent auditors and their audit
activities.
Table I shows that more than 90 per cent of
the analyzed charters specify that the size of
their audit committee is three to four
members. All three stock exchanges (NYSE,
AMEX, NASDAQ) in the USA require that
the audit committee contain at least three
members.
Results in Table I also reveal that about 60
per cent of audit committee charters studied
specify three to four meetings of the audit
committee per year while more than 5 per cent
indicate one to two meetings, about 3 per cent
point out more than five meetings annually
and more than 35 per cent do not specify the
number of meetings of the audit committee.
The BRC recommends that the audit
committee meet at least four times per year.
Table I provides information on the audit
committee composition, qualifications,
Table I
Audit committee charter analysis
Characteristics
Responsibilities/authorities
Size
3-4 members
Not specified
Number of meetings
1-2
3-4
5+
Not specified
Composition, qualifications,
independence, financial literacy
Notes: n = 93
[ 534 ]
Number
Percentage
93
100.0
84
9
90.3
9.7
5
52
2
34
92
5.4
55.9
2.25
36.6
98.9
independence, and the requirement of

financial literacy. Almost all of the analyzed
charters provide adequate information
regarding the composition, qualifications,
independence, and financial literacy of audit
committee members. Organized stock
exchanges in the USA require that, with a
few limited exceptions, all audit committee
members be independent. For example, an
exception is permitted for one
non-independent audit committee member
which is suitably justified. The SEC,
however, requires that any such exceptions
and related justifiable reasons be fully
disclosed in the charter. The Sarbanes-Oxley
Act of 2002 defines independent as not
receiving, other than for service on the
board, any consulting, advisory, or other
compensatory fee from the company, and not
being an affiliated person of the company, or
any subsidiary thereof.
The BRC requires that at least one member
of the audit committee must have accounting
or financial management skills and members
of the audit committee be financially literate.
Financial literacy is defined as the ability to
read and understand fundamental financial
statements including balance sheet, income
statement and the statement of cash flow. The
issue is whether one financial expert is
sufficient on an audit committee to
understand the nature and impacts of
complex business transactions such as
derivative financial instruments, related
party transactions, special purpose entities.
Table I shows that almost all analyzed
charters specify composition, qualifications,
independence and financial expertise of their
committee members. The requirement of
only one financially literate audit
committee member may not be adequate to
fulfill effectively the financial oversight
function of the audit committee. The more
effective approach is the audit committee
work diligently with management and
auditors to identify the most complex
business activities, assess their relative
risks, determine their accounting treatments
and obtain complete understanding of their
impacts on fair presentation of financial
performance and conditions. The audit
committee should obtain independent advice
on these business activities and related
transactions, associated risks and proper
accounting treatments. The audit committee
should inform the board of directors about
these transactions, their risks, accounting
treatments, and ensure that they are
adequately communicated to investors. Audit
committee members should be sufficiently
knowledgeable to ask tough questions of
management as well as internal auditors and
Zabihollah Rezaee,
George Minmier
Improving corporate
external auditors regarding quality,

transparency, and reliability of financial
reports.

18/6/7 [2003] 530-537
The usefulness and value relevance of the

mandatory reporting by the audit committee
has been challenged. Critics (McMullen, 1996)
argue that such a mandatory reporting
requirement by the audit committee will
increase the audit committees liability
which will eventually result in either higher
compensation for audit committee members
or fewer qualified directors willing to serve
on audit committees. Furthermore, the
financial reporting oversight function of the
audit committee has its limits in the sense
that:
.
management is primarily responsible for
fair presentation of financial statements
in conforming with GAAP;
.
auditors are responsible for providing
reasonable assurance regarding fair
presentation of financial statements in
conformity with GAAP; and
.
the audit committee is not adequately
resourced and competently staffed to
shoulder the onerous legal responsibility
of reliability of financial statements.
Audit committee reports
Proponents (the BRC, SEC, NYSE, NASD) of

the mandatory audit committee reporting
argue that such reports will improve
integrity, quality, reliability, and
transparency of financial reports because the
report indicates that financial statements are
useful and reliable; the audit was thorough;
and the auditors have no flagrant conflicts of
interest. This should reduce the information
risks that may be associated with published
audited financial statements. The usefulness
of the audit committee report depends on its
format and content.
1. Title of audit committee report

Results presented in Table II indicate that
corporations use a variety of titles for the
audit committee report. The most frequently
used titles are Audit committee report
(about 46 per cent) and Report of the audit
committee (33 per cent). Other titles are
Report of the audit and finance committee;
Audit and compliance committee report;
Audit committee report and related
matters; and Report of the audit committee
of the board. The majority of corporations
(more than 85 per cent) differentiated the
audit committee report from reports
published by other committees of the board
of directors (e.g. compensation, ethics,
compliance, finance). This study suggests
that the title of Audit committee report be
used to improve consistency, comparability,
and uniformity in the audit committee

reporting process.
2. Content of audit committee report

The SEC requires that a report by the audit
committee be included annually in the proxy
statement of publicly traded companies. The
report on audit committee should state
whether the audit committee has:
.
reviewed and discussed the audited
financial statements with management;
.
discussed with the external auditors those
matters required to be communicated to
the audit committee in accordance with
GAAS;
.
received from the external auditors a letter
revealing matters that, in the auditors
judgment, may reasonably be thought to
bear on the auditors independence from
the company and discussed with them
their independence; and
.
recommended to the board of directors
that the companys audited financial
statements be included in the annual
report on the form 10-K or form 10-KSB
based on discussions with management
and external auditors.
Results presented in Table III indicate that
almost all analyzed audit committee reports
address the aforementioned items in the
audit committee report. The results also
show that the focus has been on audit
committee roles and structure rather than
the process of fulfilling oversight functions.
Many of these reports contain a disclaimer
that the audit committee does not guarantee
the financial statements adhere to GAAP and
based their recommendations solely on the
word of management and auditors. This
suggests that the audit committee charter has
been driven by regulatory bodies with
self-denial and window-dressing that do not
deal with the underlying fundamentals. The
audit committee report should provide
information regarding the audit committees
oversight functions of the financial reporting
process and audit activities. The audit
committee should ask the auditors if
managements assertions are in conformity
with GAAP assuming that GAAP is
unambiguous and GAAP compliance makes
those assertions accurate, objective, and
transparent. The existing GAAP is very
flexible and there is no clear cut criteria to
question management judgments of selecting
the appropriate accounting methods.
The reports of the audit committees are
expected to lend more credibility to audit
financial statements by affirming that:
.
financial statements present fairly in
conformity with GAAP;
[ 535 ]
Zabihollah Rezaee,
George Minmier
Improving corporate
18/6/7 [2003] 530-537
Table II
Title of the audit committee report
Title
Audit committee report
Report of the audit committee
Report of the audit and finance committee
Audit and compliance committee report
Audit committee report and related matters
Board audit committee report
Report of the audit committee of the board
Audit and ethics committee report
Audit and examination committee report
Report of audit and legal committee
Report of the audit and risk management committee
Report of the audit committee on the financial statements
Report of the board of directors audit committee
Number
Percentage
43
31
4
3
2
2
2
1
1
1
1
1
1
45.7
33.0
4.3
3.2
2.1
2.1
2.1
1.1
1.1
1.1
1.1
1.1
1.1
Notes: n = 94
.
.
.
financial statement fairly reflect the

companys financial conditions and
performance;
the financial audit was thorough; and
there were no conflicts of interest that
could possibly impair the auditors
independence.
Results show that:

.
the majority of the studied audit
committee reports contain a disclaimer
phrase, indicating that their committee
was not responsible for fair presentation
of financial statements;
.
their recommendations are primarily
based on management assertions and
auditors findings; and
.
limitations of their oversight function.
Conclusion
The audit committee is empowered to
function, on behalf of the board of directors,
by assuming an important oversight role in
the corporate governance intended to protect
investors and ensure corporate
Table III
Content of audit committee report
A statement that the committee
Number
Percentage
a. Reviewed and discussed with management the companys

audited financial statements
91
96.8
b. Discussed with independent auditors audit issues, findings

and matters related to audited financial statements
92
97.9
c. Received and reviewed the written disclosures and the

letter from the auditors regarding their independence
92
97.9
d. Recommended to the board of directors that the

companys audited financial statements be included in the
annual report on Form 10-K or KSB
94
100.0
[ 536 ]
accountability. The audit committee has

oversight responsibility over corporate
governance, the financial reporting process,
internal control structure, internal audit
functions, and external audit activities.
Recommendations of the BRC and new rules
of the SEC, NYSE and NASD require that
publicly traded companies in the USA:
.
adopt formal written charters for their
audit committees describing their
responsibilities, composition, structure,
and qualifications;
.
the adopted audit committee charter be
reviewed, revised, and included in the
proxy statement at least once every three
years; and
.
companies include a report of the audit
committee in their proxy statement
annually.
Results of this study indicate that all
companies examined have adopted
audit committee charters that are published
at least once every three years. All studied
companies currently include a report of the
audit committee in their annual report or
proxy statement. The majority of audit
committee composition, structure,
meetings, and qualification are in
compliance with the requirements of the SEC
and organized stock exchanges. The report of
audit committee is intended to ensure that
financial statements are legitimate, the audit
was thorough, and the auditors have no
flagrant conflicts of interest that may
jeopardize their objectivity, integrity, and
independence. It is expected that more
effective audit committee disclosures in
conformity with the provisions of the
Sarbanes-Oxley Act of 2002 (e.g. charter,
report) improve the trust and confidence in
corporate governance, the financial
reporting process, and audit functions.
Zabihollah Rezaee,
George Minmier
Improving corporate
18/6/7 [2003] 530-537
Note
1 Sarbanes-Oxley Act of 2002. Public Company
Accounting Reform and Investor Protection
Act of 2002, available at: www/
whitehouse.gov/infocus/
corporateresponsibility/
References
BRC (1999), Report and Recommendation of the
Effectiveness of Corporate Audit Committees.,
Blue Ribbon Committee, New York Stock
Exchange and National Association of
Securities Dealers, New York, NY.
Bush, G.W. (2002), The Presidents State of the
Union Address, 29 January, available at:
www.whitehouse.gov/news/releases/2002/
01/20020129-11.html
BRT (2002), Principles of corporate governance,
Business Roundtable, May, available at:
www.brtable.org/pdf/704.pdf
DeZoort, F.T. and Salterio, S. (2001), The effects
of corporate governance experience and audit
knowledge on audit committee members
judgments, Auditing: A Journal of Practice
and Theory, Vol. 20, September, pp. 31-47.
Levitt, A. (1999), Chairman, securities and
exchange commission, The Numbers Game,
29 September, available at: www.sec.gov/

news/speech/speecharchive/1998/
spch220.txt
McMullen, D.A. (1996), Audit committee
performance: an investing of the
consequences associated with audit
committees, Auditing: A Journal of Practice
and Theory, Spring, pp. 87-103.
NACD (2002), The NACD Boards
Recommendations for Governance Reform,
April, National Association of Corporate
Directors, Washington, DC, available at:
www.nacdonline.org
Public Oversight Board (POB) of the SEC Practice
Section, AICPA (1993), A Special Report on
Issues Confronting the Accounting Profession.
Rezaee, Z. (2002), Financial Statement Fraud:
Prevention and Detection, John Wiley & Sons,
New York, NY.
SEC (1999), Final Rule: Audit Committee
Disclosure. Release No. 34-42266, Securities
and Exchange Commission, Washington, DC.
TSE (1994), Where Were the Directors? Guidelines
for Improved Corporate Governance in
Canada (The Dey Report), December, Toronto
Stock Exchange, Toronto, available at:
http://www.tsers.com/cgi_bin/
uni_framset.cgi?content=/new/dey.html
[ 537 ]
Users perceptions of corporate social responsibility

and accountability: evidence from an emerging
economy
Khalid Al-Khater
College of Business Administration and Economics, University of Qatar, Qatar
Kamal Naser
Cardiff Business School, University of Wales, Cardiff, UK
Keywords
Social responsibility,
Annual reports, Qatar
Abstract
This study sets out to investigate
the perception of different users of
corporate information about the
notion of the accountability
process and the possibility of
widening the scope of the current
corporate annual report in Qatar to
include social responsibility
information. To achieve this
objective, four user groups were
invited to take part in the study.
The outcome of the analysis
revealed that most of those who
took part in the study would like to
see corporate social responsibility
information disclosed, either in a
separate section, or as part of the
board of directors statement
within the annual report. To
achieve accountability, the
respondents believe that a law
that encourages the disclosure of
corporate social responsibility
information should be introduced,
and different parties within the
society should have the right to
such information.

18/6/7 [2003] 538-548
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482678]
[ 538 ]
Introduction
Although corporate social responsibility
formed a major financial reporting issue in
the developed countries in the last decade, it
is still a minor issue in the developing
countries. A number of developing countries,
however, have paid a little attention to
corporate social reporting (see, for example
Abu Baker and Naser, 2000). In this study, an
attempt is made to explore the perception of
the various users of corporate information in
Qatar about corporate social responsibility
and the accountability concept[1].
Since the middle of the 1990s, Qatar took
several steps towards introducing democracy
and liberating the economy. This can be
clearly seen through the lifting of restrictions
on the media and abolishment of the
Ministry of Media and Information. This
coincided with the introduction of the
privatization programme and the creation of
the national stock market[2]. The authorities
are further debating the possibility of
establishing a national association of
accountants with the responsibility of
issuing accounting standards. Given that
Qatar is an Islamic and conservative society,
corporate social responsibility disclosure
would form an important ingredient in the
accountability concept that represents an
Islamic society. More importantly, a review
of the annual reports of the Qatari
commercial banks for the last five years
indicated that all these banks devote part of
their income to support projects that
emphasize the banks role in society[3].
Hence, a study that investigates various
users opinions of different aspects of
corporate social responsibility reporting
from an emerging economy like Qatar will
add a new dimension to the literature. So far,
one study that addresses this issue was
undertaken in an Arab country Jordan by

Naser and Abu Baker (1999). The economies
of Arab countries, however, can be classified
into those in which revenues are coming
directly from oil such as Saudi Arabia and
Qatar and those that benefit indirectly from
oil revenues, such as Jordan and Sudan,
since a significant proportion of their labour
force is working in the oil producing
countries[4]. Thus, providing empirical
evidence on corporate social responsibility
and accountability from Qatar will add to the
literature.
The remainder of the paper proceeds as
follows. The following section summarizes
the financial reporting environment in
Qatar. Previous studies on corporate social
responsibility reporting are reviewed in
section three. Study questions, data
collection and statistical tests employed in
this study are discussed in section four.
While the findings are offered in section 5,
the conclusion is presented in the final
section.
Financial reporting environment in

Qatar
In the last three decades and mainly due to
vast oil revenues, the Gulf Cooperation
Council (GCC) countries have witnessed
tremendous economic development. The
economic development coincided with an
increase in the number of companies
operating in the GCC region. Consequently,
national stock exchanges have been
established and now all GCC countries hosts
stock exchanges. The increase in the number
of publicly owned companies and the
creation of stock exchanges, however, was
not matched by development in the
accounting and auditing systems within
these countries. Hence, a gap exists between
Khalid Al-Khater and

Kamal Naser
Users perceptions of
and accountability: evidence
from an emerging economy
18/6/7 [2003] 538-548
the degree of economic development and the

development of the accounting and auditing
systems within the GCC countries. The main
problem that faces the GCC countries in
general, and Qatar in particular, is the lack of
specific accounting standards that govern the
activities of companies, whether national or
international, operating within the
country[5]. The international audit firms that
have offices in different parts of the country
influence accounting and auditing systems in
Qatar. Although GCC countries, such as
Bahrain, Kuwait, UAE and Oman, adopt the
International Accounting Standards (IASs),
while Saudi Arabia attempted to develop
their own accounting standards, until now
Qatar neither developed its own standards
nor adopted the IASs. However, most large
companies operating in Qatar are affected by
their external international auditors and
apply the IASs.
In fact, the accounting and auditing
systems in Qatar are still in a primitive
stage. Until 1974, the accounting and auditing
practice was no more than mere judgment by
practicing accountants and auditors without
any official guidelines. In 1974, however, the
Qatari authorities issued Law Number 7 that
regulated the work of the external auditor.
This was followed by the publication of Law
Number 11, the Companies Acts, in 1981 that
organized the work of companies operating
in Qatar. The two laws were then adjusted by
the publication of Law Number 9 in 1998.
Cumulatively, the Acts asked management of
publicly owned companies to publish the
traditional financial statements, together
with the basis upon which these statements
were prepared, on a regular basis after
presenting them to qualified external
auditors.
In May 2002, the 1981 Company Acts that
regulate the work of commercial companies
replaced Law Number 11. The newly issued
Companies Acts became effective 60 days
after their publication in the official
newspaper on 25 May 2002. The first chapter
of the Acts covers general rules that contain,
among other things, the definition of a
publicly owned company, a name that
reflects its purpose rather than a personal
name, specific date for its creation, a starting
capital of not less than QR10 million[6] . The
second chapter of the Acts indicates that the
publicly owned company should be created
after obtaining the permission of the
Minister of Economics and Commerce, and
with a minimum of five investors. With the
exception of cases identified by Law Number
(13) 2000, all shareholders must be Qatari
nationals. Article (119) of Companies Acts
(2002) requests all publicly owned companies
to provide shareholders at the end of every

financial year with an audited balance sheet,
profit and loss accounts, cash flow statement
and explanations in comparison with the
previous financial year together with details
of the companys activities and future plans
for the coming year. The companys board of
directors should make the information
publicly available within not more than three
months after the end of the companys
financial year to be presented to the general
meeting that should convene within not more
than four months after the end of the
financial year.
The fourth chapter of Companies Acts 2002
addresses the work of the external auditor.
According to Article (141) of the Acts, the
general assembly of the publicly owned
company should appoint one or more
external auditors for one year for a specified
fee. The company has the right to reappoint
the same auditor as long as the appointment
does not exceed five years continuously. The
Article indicates that the board of directors is
delegated with the authority to appoint the
external auditor and the founders of the
publicly owned company can appoint an
external auditor until the first meeting of the
companys general assembly. The remainder
of chapter four of the Companies Acts 2002
identifies the activities and the
responsibilities of the external auditor.
Previous studies
The Corporate Report (ASC, 1975) and other
researchers such as Samuels (1990), Hove
(1986), Wallace (1993) and Abu Baker and
Naser (2000) have referred to different
statements, reports and other items of
corporate social responsibility disclosure. In
this respect, Gray et al. (1987, p. 4) defined
corporate social responsibility as:
. . . responsibilities of actions which do not
have purely financial implications and which
are demanded of an organization under some
(implicit and explicit) identifiable contract.
Hence, corporate social disclosure implies

that corporate disclosure should not be
restricted to information that emphasizes
corporate performance, liquidity and
financial position. Corporate reporting
should be widened to accommodate social
and economic aspects of the company. In a
conservative Islamic society like Qatar,
information relating to Zakat calculation and
its sources and uses is expected to form an
important part of the corporate report[7].
Naser and Abu Baker (1999), viewed
corporate social responsibility disclosure as:
[ 539 ]

Kamal Naser
18/6/7 [2003] 538-548
. . . important and relevant information input

to the understanding, debate and, hence,
solutions of social and economic development
problems relating, for example, to
income/wealth distribution, unemployment,
safety/security at work and level of training,
balance of payments, regional imbalances,
environmental pollution, energy usage and
natural resources consumption, and
consumer/product related problems.
Corporate social responsibility reporting is

important to various users of corporate
information such as employees, consumers,
local communities, and government and its
agencies, pressure groups and society at
large. Making social responsibility
information available to the users assists
them in making more informed decisions
about a company of concern. For example,
religious groups that form pressure groups
and account for a significant proportion of
many Islamic countries, in general, and
Qatar in particular, may invest their money
in companies that pay Zakat and donate
money to charitable organizations. Qataris
also deal with banks that do not pay or
receive interests on loans. Social
responsibility information assists the
religious groups in making judgment about
corporate social involvement. Furthermore,
the corporation reflects its image by
disclosing the degree of its involvement in
social and ethical responsibility issues.
Samuels (1990), who contended that corporate
social responsibility disclosure is relevant to
the developing countries social and
economic development problems, also
highlighted this reality. Similarly, Wallace
(1993) reveals that companies operating in a
certain country are expected to be socially
responsible. Such responsibility emphasizes
the objectives and desires of the society.
Since this issue is not fully addressed by the
International Accounting Standards (IASs),
Wallace (1993) argues that the IASs are
perceived to be deficient in identifying to
what extent a company contributes to the
social and economic development of a
country. As a consequence, Wallace (1993)
believes that attention should be paid to the
social and governmental interest in the IASs.
By the same token, Ghartey (1987)
demonstrates that the aim of corporate social
responsibility is to disclose information that
assures the public that their rights, whether
individually or as groups, are protected and
gives them the chance to complain if they feel
otherwise.
Drawing on the work of Naser and Abu
Baker (1999), an increase in corporate social
responsibility disclosure in an emerging
economy like Qatar should be coupled with a
[ 540 ]
clear accountability framework that

guarantees the structure of such disclosure.
Rosenfield (1974) defines the objective of the
accountability process as:
. . . to report on the control and use of
resources by those accountable for their
control and use to those whom they are
accountable.
In the same fashion, Ijiri (1975) defined

accountability as the relationship between
two parties, the accountor and the accountee,
where the latter is accountable to the former
for his/her activities and the consequences.
Naser and Abu Baker (1999) referred to
three basic elements of the accountability
concept. First, the accountee has an
obligation to provide the accountor with
detailed information. Second, the
responsibilities of those who are held
accountable for their action and the
consequences must be spelled out clearly.
Third, stating accounts of actions and related
consequences will be used by the accountor
as a yardstick to assess the accountee. This is
expected to have implications for his/her
decision.
Naser and Abu Baker believe that the
accountability process can form a useful
basis for corporate reporting, if it observes
the following.
.
The accountability process should not be
restricted to economic issues. It should be
viewed as a social and economic concept.
The needs of the shareholders and
creditors should not be seen as being more
important than those of other users of
corporate information. The public needs
should be observed in the accountability
process. Hence, the company is expected
to disclose information that benefits
various users and the society at large.
.
The accountability process should be
viewed as a mechanism that lays down the
ethical foundations for accounting and
assures the fairness and public interest
within this framework. Williams (1987)
affirmed that fairness is a feature that
must be observed in the accountability
process.
.
The accountability process should
emphasize the notion of the right to know,
or the right to information (Ijiri, 1983;
Gray, 1992). Hence, the accountability
process ensures this right.
.
The accountability process is consistent
with the democratic movement led by the
Prince of Qatar and his government who
encourage freedom of speech and access to
information.
.
In an emerging economy like Qatar, with
the most influential television satellite
broadcasting not only to Qatari but also to

Kamal Naser
18/6/7 [2003] 538-548
Arabs all over the world, the

accountability process guarantees free
access and the flow of information
relevant to debate problems that might
influence social and economic
development in Qatar[8].
It is evident from the above discussion that
accountability is relevant to the Qatari
society and it is expected to lend legitimacy
and justification to corporate social
responsibility disclosure in an emerging
economy like Qatar. In this context, Jensen
(1977) makes the point that variation in the
impact of business on economic,
environment and society makes it difficult to
prescribe a standard solution within and
between countries. He believes that radical
solutions to emerging businesses problems
can be dealt with by making businesses
accountable to their actions. This reality is
more needed in emerging economies, since
regulations offer little protection to
investors. As such, assurances to investors
and other users of corporate information a
greater level of accountability should be
introduced.
Research questions, data

collection and statistical
techniques
Research questions
As mentioned earlier, the main purpose of
this study is to poll the opinion of different
users in Qatar of corporate information
regarding different aspects of corporate
social responsibility. In particular, the study
sets out to provide answers to the following
research questions (RQ):
RQ1. What is the perception of different
user groups in Qatar regarding the
main purpose(s) of corporate
reporting?
user groups in Qatar about the
factor(s) that prevent(s) Qatari
companies from disclosing corporate
social responsibility information?
user groups in Qatar about what
motivate(s) Qatari companies to
disclose corporate social
responsibility information?
user groups in Qatar about who has
the right to corporate social
responsibility information in Qatar?
RQ5. How do various users view the
current level of corporate social
responsibility information
disclosure by Qatari companies?
RQ6. What approach(s) should be adopted
to disclose corporate social
location of corporate social
beneficiaries of corporate social
responsibility disclosure?
Data collection
To provide answers to the above-mentioned
research questions, a questionnaire was
designed and distributed to the following
user groups in Qatar: accountants, external
auditors, academicians and bank officers.
The choice of these groups was based on the
grounds that they represent the interests of
different sections of the Qatari society. These
groups are also expected to be familiar with
different aspects of corporate reporting. In
addition, similar groups were targeted in
previous studies (Naser and Abu Baker,
1999).
The questionnaire was separated into two
parts. The first part sought general
information on the respondents background
profile and the second part of the
questionnaire was related to the respondents
opinion about different aspects of corporate
social responsibility disclosure and the
accountability concept. The respondents
were requested to indicate their opinion on a
five-point Likert scale in terms of strongly
agree to strongly disagree or very
important to not important at all. The
questionnaire covered four pages.
An early draft of the questionnaire was
piloted on lecturers at the Business
Administration and Economics College of
Qatar University. Based on the feedback from
these respondents, several modifications
were made to the wording of some questions,
and some less important questions were
deleted to reduce the length of the
questionnaire.
The questionnaire was translated into
Arabic and delivered by hand to the target
groups. Table I shows the number of
questionnaires that were distributed, the
number returned (the response rate) for each
group, and the overall response rate[9].
Two pre-analysis tests were undertaken to
generalize the results of the questionnaire
(non-response bias analysis) and to measure
its internal consistency (Cronbachs Alpha).
In the non-response bias test, early
[ 541 ]

Kamal Naser
18/6/7 [2003] 538-548
Table I
Target groups and response rates
Target groups
Distributed questionnaire
Received questionnaire
Response rate (%)
100
30
30
100
260
58
18
18
49
143
58
60
60
49
55
Accountants
External auditors
Academicians
Bank officer
Total
respondents were compared with late

respondents (as a surrogate of those who
have not responded to the questionnaire).
After conducting the Mann-Whitney U test,
no significant difference was reported
between the two groups. The Cronbachs
Alpha test, however, was used to assess the
relationship between different parts of the
questionnaire. The Cronbachs Alpha ranges
between zero and one; where zero indicates
no correlation exists between various parts
of the questionnaire and one refers to perfect
correlation between them. Huck and Cormier
(1996) indicated that 0.70 is an acceptable
level of significance for Alpha. Botosan
(1997), however, indicated that 0.80 or more is
preferable. In all cases, the value of
Cronbachs Alpha for all user groups for the
answers of all questions in the study was 0.83.
Statistical techniques
To conduct data analyses, descriptive
statistics that include frequencies and
measures of tendency were adopted. Since
the sample is taken from a number of user
groups, the Kruskal-Wallis test was
undertaken. The test is used to identify
whether the average perception of the
investigated variables used in the survey is
identical for all target groups.
Findings
Respondents backgrounds
The questionnaire sought information about
the user groups ages, levels of education,
specialization in their last academic degree,
place of education and years of experience.
The vast majority of the respondents (66 per
cent) were less than 30 years old. The average
age of the whole sample was around 35 years.
A total of 79 per cent of the participants
indicated that they hold a bachelor degree or
a higher degree and the same percentage of
the respondents revealed that they had
completed their education at Qatari or Arab
universities. A total of 5 per cent of the
respondents had completed their last degree
in America and 8 per cent at British
universities. More than 84 per cent of those
who took part in the survey had degrees in
[ 542 ]
accounting, banking and finance and 41 per

cent of the respondents had more than six
years of work experience.
The main purpose(s) of corporate

disclosure
The respondents were given a list of possible
purposes of corporate disclosure and asked to
identify the importance that they attach to
each of them. A summary of the participants
responses is presented in Table II.
It is evident from the table that the
respondents attached the highest importance
to the proposal that the main purpose of
corporate reporting is to provide information
to shareholders, investors and creditors. This
is reflected by the reported mean score and
supported by the standard deviation. The
result of the Kruskal-Wallis test represented
by the 2 and its significance, and reported in
Table II, points to significant differences in
the respondents opinions about the
importance that they assign to the
information provided to shareholders and
investors. Viewing the frequencies
associated with these two purposes revealed
that the vast majority of the participants
either strongly agreed or agreed with the two
purposes. Hence, the difference reported by
the 2 is mainly between those who agreed
and strongly agreed. The outcome of the
analysis is consistent with Naser and Abu
Baker (1999), who conducted their study in
the Jordan environment. It seems to be that
both Jordanian and Qatari users of corporate
information emphasized in their answers the
importance of the objective of corporate
reporting in assisting investors and creditors
in making informative decisions about a
company of concern.
The respondents, however, attached the
lowest importance to the proposal that
corporate report provides information to
assist corporate management and employees
in making decisions. Although the two
proposals were ranked at the bottom of the
list, the mean scores were 3.43 and 3.69
respectively. This implies that the
respondents attached a certain degree of
importance to these proposals.
The result of the analysis may be explained
on the grounds that most business

Kamal Naser
18/6/7 [2003] 538-548
management in Qatar mainly comes from the

majority shareholders. Hence, referring to
shareholders and investors as important
users of corporate reporting implies
indirectly that such information is going to
be used by management. The result also
indicates that various users of corporate
reports attach a certain degree of importance
to the annual report since it provides
information to society to enable it to judge its
policies and its impact on society. Given that
Qatar is a small country with a limited
number of companies and a sizable number
of investors, ordinary users of corporate
reports are expected to monitor corporate
policies and their impact on society.
Possible reasons behind not disclosing

corporate social information by Qatari
companies
The respondents were given a list of reasons
that might prevent Qatari companies from
disclosing corporate social responsibility
information. The reasons are mainly derived
from previous studies (see for example Naser
and Abu Baker 1999). The analysis of the
participants answers is listed in Table III.
The respondents agreed that almost all
listed reasons prevent Qatari companies
from disclosing corporate social
responsibility information. The respondents,
however, believed that Qatari companies are
not currently reporting such information due
to administrative difficulties and
management does not appreciate its social
responsibility. They also indicated that the
objectives of the company emphasize its
economic rather than social performance.
They also believed that lack of legal
requirements provides companies with little
incentive to disclose corporate social
responsibility information. The result is
partially consistent with the Naser and Abu
Baker (1999), who found that corporate social
responsibility disclosure is not widely used
by Jordanian companies since this sort of

disclosure is not requested by law.
Although the reported standard deviations
in Table III signal possible variations in the
surveyed opinions, the Kruskal-Wallis test
reported in the same table demonstrates that
no significant differences exist. Hence, the
respondents believed that all the listed
factors may prevent Qatari companies from
disclosing social responsibility information.
The result is expected to assist policy makers
in Qatar in formulating future national
accounting standards.
Respondents views of the motivation for

companies social responsibility
Drawing on Naser and Abu Baker (1999), the
respondents were asked to express their
opinion about issues that motivate the
disclosure of social responsibility
information. A summary of the participants
answers is given in Table IV.
What attracts ones attention in Table IV is
that the respondents agreed with almost all
the proposals given in the questionnaire,
except the proposal that large corporations
have no social responsibility but to make
profit for their shareholders. The highest
level of agreement among the respondents
was around the proposals that large
companies should bear some sort of social
responsibility to justify their existence
within the society and large companies
should be viewed as social organizations and
their existence is justified as long as they
satisfy the objectives of the society. The
result supports the findings of Naser and Abu
Baker (1999). The respondents, however,
were less enthusiastic about the idea of
attaching strategic companies to the public
sector to insure their social responsibility.
This implies that the respondents trust the
social role of the private sector in Qatar.
The Kruskal-Wallis test, on other hand,
revealed significant disagreement among the
Table II
The importance that the target groups attach to the purpose(s) of corporate reporting in Qatar
Purpose(s)
Provides information to:
Shareholders on the use of their funds and the legality of the uses
Investors to assist them in making investment decisions
Institutions to assist them to negotiate financial facilities
Creditors with information that assists them in protecting their interest
Tax authorities to be used as a basis to assess taxation
Managers to manage their businesses
Assist the society at large to judge a companys actions and policies
Employees to assess them to protect their interest
Mean
scorea
Std. dev.
4.16
4.14
3.76
4.12
4.02
3.43
4.04
3.69
0.82
0.91
0.95
0.99
0.98
1.01
0.90
0.99
Kruskal-Wallis test
Rank
2
1
2
6
3
5
8
4
7
11.27
6.84
4.90
2.62
2.73
0.313
1.050
4.24
Level of
significance
0.010
0.077
0.179
0.453
0.435
0.950
0.780
0.230
Note: a Mean values scoring: 1 = not important at all; 5 = very important

[ 543 ]

Kamal Naser
18/6/7 [2003] 538-548
participants on two of the possible factors

that motivate the disclosure of social
responsibility information. The respondents
opinions were mixed on whether strategic
companies should continue to be run by the
public sector to guarantee social
responsibility and whether decision makers
within the organization appreciate the
concept of social responsibility and its
importance to the organization. As in other
countries in the region, the Qataris seem to
be divided between those who support and
those who are against privatization and its
role in society. This reality is clearly
reflected in the participants answers. The
fact that the social responsibility issue is
relatively new to the Arab countries, in
general, and Qatar in particular, is also
reflected in the respondents opinions.
Variations in the participants as well as
managements knowledge of the issue of
corporate responsibility disclosure are
further reflected in the respondents

opinions.
Social responsibility and accountability

The previous discussion suggests that
various users of corporate information in
Qatar support the idea of disclosing
corporate social responsibility information.
Also in the previous sections, a broad
accountability mechanism was proposed as a
basis for corporate reporting. In the
subsections that follow, two issues are
introduced to test the notions of corporate
social responsibility and accountability.
The right to corporate information

Previous results demonstrate that various
users of corporate information in Qatar seem
to support more disclosure of corporate
social information to ensure the corporate
role within the society. Hence, the
participants were given a list of possible user
Table III
Reasons behind not disclosing corporate social information by Qatari companies
Reason
Administrative difficulties and management does not appreciate its social responsibility
The objectives of the company emphasize its economic rather than social
performance
Lack of legal requirements
Lack of knowledge about this type of information prevents companies from disclosing it
The public lacks enough knowledge of the importance of social responsibility
information
Not required by the IASs
This type of information is sensitive to disclose
The cost of disclosing this type of information outweighs its benefits
Lack of demand for this type of information
Kruskal-Wallis test
Level of
Rank
2
significance
Mean
scorea
Std. dev.
3.69
1.12
1.75
0.620
3.68
3.61
3.57
1.23
1.27
1.21
2
3
4
4.74
6.75
4.61
0.190
0.080
0.202
3.52
3.51
3.51
3.46
3.40
1.23
1.38
1.25
1.26
1.19
5
6
7
8
9
1.07
3.27
2.64
4.79
4.58
0.780
0.350
0.440
0.180
0.200
Note: a Mean values scoring: 1 = strongly disagree; 5 = strongly agree
Table IV
Respondents views of the motivation for companys social responsibility
Mean
scorea Std dev.
View
Large corporations have no social responsibility but to make profit to their shareholders
Large companies should bear some sort of social responsibility to justify their existence
within the society
Large companies should be viewed as social organizations and their existence is
justified as long as they satisfy the objectives of the society
Strategic companies such as electricity should continue to be owned by the government
to guarantee their social responsibility
Decision makers within the organization appreciate the concept of social responsibility
reporting and its importance to the organization
Decision makers within the organization understand how to adopt social responsibility
within the organization
a
Note: Mean values scoring: 1 = strongly disagree; 5 = strongly agree

[ 544 ]
Kruskal-Wallis test
Level of
Rank
2
significance
2.77
1.56
2.08
0.550
3.75
1.26
0.71
0.860
3.63
1.08
8.14
0.043
3.30
1.39
0.47
0.920
3.56
1.28
9.69
0.021
3.41
1.22
1.61
0.650

Kamal Naser
18/6/7 [2003] 538-548
groups and invited to indicate their level of

agreement about whether each of these
groups should have the right to information
about the actions for which Qatari
shareholding companies could be held
responsible. Table V reveals that the
respondents either strongly agreed, or agreed
that the traditional users of corporate
information (shareholders, investors,
creditors, management, employees and
customers) have the right to the information.
Less support, however, was given, by the
respondents, to the right of the government
and society to corporate information. This
result is partially consistent with Naser and
Abu Baker (1999). This might be due to the
fact that, unlike Jordan, national companies
in Qatar do not pay tax. Hence, the
government and its agencies have less
incentive to use corporate information than
they do in Jordan. Yet, the government and
its agencies need corporate to provide
statistics on the state of the economy.
The Kruskal-Wallis test points to no
significant disagreement among the
respondents about who has the right to
information except for management. The
difference, however, was mainly between
those who agreed and strongly agreed to
managements right to corporate information.
Methods of establishing corporate

responsibility
After establishing various users opinions of
the role of Qatari companies within the
society and the importance of corporate
social responsibility disclosure to different
sectors within the economy, it was important
to elicit the respondents opinions about how
to introduce corporate social responsibility
reporting. The respondents were given three
different approaches to introduce corporate
social disclosure and were asked to indicate
the degree of the agreement with them. The
outcome of their answers is provided in
Table VI.
It is obvious from the table that the

respondents support the more liberal
approach to introducing corporate social
responsibility reporting in Qatar. The
strongest support was given to the proposal
that corporate social responsibility
disclosure should be encouraged, rather than
enforced by law. The respondents also show a
certain degree of agreement with the
suggestion that ethical and social agreement
should underline corporate social
responsibility reporting in Qatar.
The respondents demonstrated a high
degree of consistency about how to introduce
corporate social responsibility information
as reflected by the Kruskal-Wallis Test. No
significant differences in the respondents
opinion were reported by the test. The result
may reflect the nature of the Qatari society,
which is moving towards democracy.
Methods used to disclose corporate social

responsibility information
After the respondents have shown a certain
degree of support for corporate social
reporting and indicated that its introduction
can be encouraged by law, it was then
important to ask them to express the extent
of their agreement with different methods
that can be used to disclose corporate social
responsibility information. Analysis of their
answers is provided in Table VII.
It can be noticed from Table VII that the
respondents granted support to all methods
proposed to introduce corporate social
responsibility information. The respondents,
however, gave the strongest support to a
combination of methods that include
information of descriptive, quantitative and of
monetary nature. The Kruskal-Wallis test
appears in Table VII points to no significant
difference in the respondents opinion about
any of the listed methods. Hence, the Qatari
users of corporate information seem to favor
the disclosure of corporate social information
in both financial and non-financial forms.
Table V
User groups who have a right to corporate information
Users
Corporate management
Customers
Corporate employees
Corporate creditors
Shareholders
Investors
Government and its agencies
Society at large
Kruskal-Wallis test
Level of significance
Mean scorea
Std dev.
Rank
2
4.07
4.00
4.01
4.08
4.10
4.09
3.58
3.38
0.69
0.77
0.86
1.06
0.96
1.02
1.04
1.21
4
6
5
3
1
2
7
7
12.75
0.23
0.72
3.68
5.83
6.06
3.36
0.96
0.005
0.97
0.86
0.29
0.12
0.11
0.33
0.81

[ 545 ]

Kamal Naser
Table VI
Introduction of corporate social responsibility information

18/6/7 [2003] 538-548
By law
To be encouraged by law
By ethical considerations and social agreement
Approach
Mean scorea Std dev.

3.56
4.02
3.64
Kruskal-Wallis test
Rank
2
3
1
2
0.82
0.76
1.77
1.26
0.81
1.12
0.84
0.86
0.62
Table VII
Methods to be used to disclose corporate social responsibility information
Method
Kruskal-Wallis test
Mean scorea
Std dev
Rank
2
3.76
3.47
3.50
3.77
3.68
3.84
1.23
1.23
1.28
1.12
1.18
1.23
3
6
5
2
4
1
4.45
2.56
1.52
1.48
2.49
5.13
In descriptive manner
Quantitative but not monetary (statistical)
Monetary
Descriptive and statistical
Quantitative and monetary
Descriptive, quantitative and monetary
0.21
0.46
0.67
0.68
0.47
0.16
Location of corporate social information

The participants were provided with a
number of possible locations to disclose
and asked to express the level of agreement
with each of the locations. Analysis of their
responses is presented in Table VIII.
It is evident from the table that disclosing
in a separate section entitled social
responsibility within the annual report is the
most popular location among the
respondents. A sizable number of the
participants favored the board of directors
statement within the annual report as a
venue for corporate social responsibility
information. The respondents, however, did
not seem to favor the disclosure to be in any
other sections in the annual report and
wanted it to be disclosed either in a separate
section or within the board of directors
statement. This result is in total agreement
with Naser and Abu Baker (1999).
The Kruskal-Wallis test, however, reported

in Table VIII, shows significant differences in
the respondents opinions on whether social
responsibility information should appear in
a separate section called social
responsibility, or in the board of directors
statement. In the former, the differences were
between those who strongly agreed and those
who agreed. In the latter, the differences
were between participants who agreed and
those who somehow agreed. Thus, in both
cases, the differences are not serious at all.
Potential benefits of corporate social

responsibility disclosure
The questionnaire contained a section about
the potential benefits of corporate social
responsibility disclosure by the Qatari
companies. The respondents were given a list
of potential benefits that can be obtained
from disclosing social responsibility
information and asked to express the level of
agreement with each of these benefits.
Analysis of their answers is given in Table IX.
Table VIII
Location of corporate social responsibility information
Location
In a separate section entitle social
responsibility in the annual report
Separate booklet attached to the annual report
In the directors statement within the annual report
In any section within the annual report
Mean scorea
4.05
3.58
3.72
3.23

[ 546 ]
Std dev Rank

1.03
1.16
1.23
1.45
1
3
2
4
2
Kruskal-Wallis test
7.81
0.44
7.72
8.26
0.050
0.931
0.052
0.041

Kamal Naser
Table IX
The importance of the following objectives of social responsibility to the organisation

18/6/7 [2003] 538-548
Serve society at large

Serve customers
Develop human resources (employees)
Protect environment
Emphasize the role of accounting as an effective
information system
Enforce investment environment
Benefit(s)
Mean scorea
Std dev Rank
2
Kruskal-Wallis test
4.29
4.10
4.02
3.84
3.68
0.88
0.93
1.04
1.01
1.20
1
2
3
4
6
11.54
3.84
2.68
9.25
6.69
0.009
0.270
0.440
0.026
0.082
3.71
1.18
1.31
0.720

Table IX indicates that society at large is the
main beneficiary of corporate social
responsibility information. The respondents
gave little support to the proposal that wider
disclosure of corporate social responsibility
information in the annual report would
protect the environment in Qatar. This result
is justified on the grounds that the services
sector, that includes financial institutions,
currently accounts for a high proportion of
the Qatari economy. Hence, the environment
and pollution are not issues of concern to
various users of corporate reports in Qatar.
The Krusakl-Wallis test points to
significant differences in the respondents
opinions about whether the disclosure of
in the annual report would benefit the society
at large or it would protect the environment.
Differences on whether the information
benefits society at large were mainly between
those who agreed and strongly disagreed.
The background of the respondents may have
contributed to the significant differences in
their opinion about whether the information
assists in protecting the environment. While
participants from the services industry can
see little impact of corporate social
responsibility information on the
environment, participants representing the
manufacturing, oil and gas industries see a
major impact of corporate social
responsibility disclosure on the
environment.
Conclusion
In this study, an attempt was made to
investigate the perceptions of various user
groups of Qataris corporate reports about
different aspects of corporate social
responsibility disclosure and accountability.
Four user groups took part in the survey,
namely, accountants, external auditors, bank
officers and university lecturers. The initial
response of the participants was in favor of
corporate social responsibility disclosure,

either in a separate section in the annual
report, or within the board of directors
statement.
To emphasize the accountability concept,
the participants believed that the disclosure
of corporate social responsibility
information should be encouraged by law
rather than enforced by the authorities. This
result emphasizes the governments
participative style of leadership that
encourages public freedom and ensures
openness and transparency.
Although the participants emphasized the
typical objectives of corporate reporting in
providing information to shareholders,
creditors and management, they disagreed
with the proposal that corporation do not
have social responsibility and their objective
should only be restricted to making profit.
They strongly supported the suggestion that
corporations bear some sort of social
responsibility to justify their existence
within the society. They also supported the
view that corporate existence is justified, as
long as it satisfies the societys objectives.
The participants would like to see
disclosed in both monetary and nonmonetary forms, either in a separate section
or within the board of directors statement
within the annual report. Finally, the
respondents believed that disclosing
in the annual report of the Qatari companies
would serve society at large as well as
customers and contribute to the development
of corporate human resources and protect the
environment.
Notes
1 Qatar is a member of the Gulf Cooperation
Council (GCC). It is one of the oil and natural
gas exporting countries. Qatar borders the
Persian Gulf and Saudi Arabia.
2 According to Al-Watan daily newspaper,
Wednesday 15 January 2003, No. 2691, p. 8, the
[ 547 ]

Kamal Naser

18/6/7 [2003] 538-548
6
7
government intends to privatize companies in

the petrochemicals, cement chemical and steel
sectors during this year.
A section in the 1999 annual report of Qatar
National Bank entitled Social
responsibilities states that the success of the
bank is connected with the banks interaction
with the community environment in which
the bank operates. For example, Qatar
National Bank spent in the years 1998 and 1999
QR1.1 million and QR11.2 million respectively
on social responsibilities activities. This
includes conferences, exhibitions and
sporting events, both large and small, held
throughout Qatar as part of its continued
commitment to assist the development of the
community for the benefit of the citizens
(Annual report, 1999, p. 21).
Another group of the Arab countries, their
economies mainly rely on tourism as do
Tunisia and Morocco.
The development of the accounting and
auditing systems varies from one GCC
country to another. While Qatar has no
specific accounting or auditing standards that
govern companies activities, in 1991 Saudi
Arabia established the Saudi Association of
the Certified Public Accountants that was
given the responsibility of issuing accounting
standards.
One US$ = QR3.65.
Zakat is one of the basic pillars of Islam. The
main purpose of Zakat is to achieve social
justice by collecting money from the rich and
distribute it to the needy.
Qatar is currently hosting the most influential
setline channel that broadcasts around the
clock in Arabic all over the world. The
channel enjoys complete freedom without any
interference from the Qatari authorities.
The questionnaire was distributed to the
target groups in the period between
November-December 2002.
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The usefulness of the audit report in investment and

financing decisions

Department of Accounting and Finance, Polytechnic University of Cartagena,
Cartagena, Spain
Keywords
Auditing, Reports,
Investment appraisal, Influence
Abstract
The usefulness of the auditors
report is sometimes called into
question, the validity of the
information it contains for users
when making decisions therefore
being criticized. This survey is
aimed, on the one hand, at dealers
and brokering companies, and, on
the other at banks to find out
exactly how important the audit
report is in the investment
decisions that analysts make, as
well as in lending decisions made
by credit institutions. In this
sense, the respondents are asked
about the source they consider
relevant when making decisions,
that is to say, the influence the
auditors opinion (clean, qualified,
adverse or disclaimer) has when
investing in and financing
companies. The results show that
users of audit reports consider the
information provided in the
auditors opinion as useful and
important when making decisions,
both regarding their decisions of
investing in and financing
companies as well as the amount
of the investment or the loan to
grant.
Introduction
The present study approaches the problem of
whether the auditors report is useful or not
and, following a line of experimental studies
initiated in the USA at the beginning of the
1970s, interviews two communities of users
interested in the professional opinion issued
by the financial auditor on company
financial statements, bankers and analysts.
In this sense, this study fits in with those
carried out in relation to the so-called
expectation gap[1] that occurs when there
is a difference between what the customers
expect from the auditors work and what they
in fact receive from the report. So, the fact
that the auditor incorporates value added
to the accounting information provided by
the firms is called into question. In order to
verify the usefulness of the audit report, this
study refers to two communities of users
that, by means of a questionnaire, are asked
about the importance given to the auditors
opinion when taking financial and
investment decisions in companies. The
results of our investigation show enough
evidence to sustain that the audit report is
indeed useful for those interviewed when
making decisions, proving to be so by the fact
that it affects the investment and financing
decisions carried out by dealers, brokering
firms, and credit institutions respectively.
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482687]
Do lenders, investors, and other audiences

react differently to a company if its financial
statements carry a qualified opinion? (Estes
and Reimer, 1977);
Does the form of auditor association
significantly influence the bankers decisions
regarding the acceptance of company loan
applications? (Johnson et al., 1983);
Do banks lend less money when a firms
accounts have been qualified? (Firth, 1979).
As Libby (1979) indicates financial

statement information plays a major role in
the credit evaluation phase of the
commercial loan decision . . . in that sense
bank officers as well as analysts attempt to
ensure accuracy of the financial information
by requiring the audit of that information;
Along this line of investigation, that shows

mixed results, the existing empiric studies
were previously carried out by means of two
different methodologies:
1 Laboratory experiments, that is to say,
extensive and detailed studies without
random samples or individuals, but based
on the participants convenience or easy
access or on the investigators subjective
selection criteria, which implies certain
conditions that allow the scientist to
directly control all or nearly all the
important factors that may affect the
results of the experiment (Dillon et al.,
1997). In this way, and following this
methodology, authors like Firth (1979,
1980), Gul (1987), Pringle et al. (1990),
Geiger (1992), Anandarajan and Jaenicke
(1995), Lasalle and Anandarajan (1997),
Bamber and Stratton (1997), Vico Martnez
and Pucheta Martnez (2001), have verified
the usefulness or relevance of the
information that the auditor provides in
the case of loan decisions to companies or
investment decisions on the part of
analysts. However, other investigations,
such as those by Estes and Reimer (1977),
Libby (1979), Houghton (1983) and Pany
and Johnson (1984), suggest that the

Previous research literature

18/6/7 [2003] 549-559
for this reason authors suggest the following

questions:
[ 549 ]
Antonio Durendez
Gomez-Guillamon
The usefulness of the audit
report in investment and
financing decisions
18/6/7 [2003] 549-559
information supplied by the audit report

has no effect on the bankers decisions.
2 The studies carried out regarding the
capital market, which try to give
relevance to the information contained in
the auditors report, for investors,
through its impact on share prices. In this
sense, the investigations carried out by
Firth (1978), Ball et al. (1979), Banks and
Kinney (1982), Chow and Rice (1982),
Dopuch et al. (1987), Wilkerson (1987),
Fields and Wilkins (1991), Loudder et al.
(1992), Chen and Church (1996), Jones
(1996), Sanchez Segura (1999), Gomez
Aguilar et al. (1999) and Monterrey et al.
(2000), suggest a certain degree of
usefulness; whilst the studies carried out
by Baskin (1972), Alderman (1979), Elliot
(1982), Dodd et al. (1984), Ameen et al.
(1994), Del Bro Gonzalez (1998) and Cabal
Garca (2000, 2001a, b) come to the opposite
conclusion, in such a way that the
relevance of the information contained is
considered little or null.
Unlike the methodologies used to date, the
main contribution of the present study is the
use of the survey, that allows the obtaining
of results which can be extrapolated to the
whole of the communities being interviewed,
since a considerable number of replies were
obtained.
Methodology
Objectives and hypotheses
It is our purpose to discover the perceptions
that audit report users have about the
qualitative variable that is being measured:
the usefulness of the auditing service. In
particular, we are specifically looking for
information regarding credit institution risk
by department directors and analysts
belonging to dealers and brokering
companies. With this aim in mind, a mailsurvey has been prepared containing a series
of questions for both groups in each of their
fields of performance.
The test hypotheses can be stated as
follows:
H01. Credit institutions perceive that the
information given by the auditors
opinion is not useful when making
their financing decisions.
H02. Analysts perceive that the
information given by the auditors
opinion is not useful when making
their investment decisions.
[ 550 ]
Subjects
Credit institutions
A sample design has been obtained that
includes all the credit banks, savings banks
and land banks registered with the Spanish
Central Bank, through the Registro Oficial de
entidades sujetas al control e inspeccion del
Banco de Espana (Official Registry of Entities
Subject to the Spanish Central Banks
Control and Inspection) that amounts to a
total of 231 entities: 88 credit banks, 48
savings banks and 95 land banks.
Analysts
A sample design has been used to represent
this community which has been obtained
from the listing published by the Comision
Nacional del Mercado de Valores (CNMV
Spanish Stock Exchange Commission) by the
Registro Oficial de sociedades y agencias de
valores (Official Register of Spanish Dealers
and Brokering Companies) that comprises
104 entities.
Sample
Once the study population and the
corresponding sample designs were defined,
a random selection of individuals was
carried out. Sampling errors are shown in
Table I.
Data collection
Questionnaires were sent out from
12-16 April 2000. began on 12 April 2000. Then
it was sent again by fax between 9-14 May
2000. The deadline for the reception of
surveys was established for 14 June. Two
different methods have been used to collect
the necessary information for the study, by
post and by fax. The results, which turned
out to be very satisfactory[2], are shown in
the Table II.
Participants
The people interviewed in each group are the
following:
1 Credit institutions: the credit entities
questionnaire was sent to head offices,
addressed to the risk department in
charge of loan concessions to companies.
Table I
Sampling errors
Sampling error value

n (sample)
p
q
n
Confidence level
Credit institutions
Analysts
7.615%
79
50
50
231
90.00%
12.033%
33
50
50
104
90.00%
Antonio Durendez
Gomez-Guillamon
financing decisions
Table II
Survey response
Respondent groups
Population
Mailed
Failed
Responses
Response rate (%)

18/6/7 [2003] 549-559
Credit institutions
Analysts
Total
231
104
335
229
103
332
2
1
3
79
33
112
34.50
32.04
33.73
2 Analysts: in this case, the questionnaire

was addressed to the manager of the
company.
Construction of the questionnaire

Preparation of the questions
Once the target-variable to be measured
had been defined between the groups
interviewed, the questions were then
prepared in order to get the necessary
information; for this, data that had already
been successfully used in other similar
investigations[3] was used as reference, as
well as counting, at all times, on the
collaboration of auditors who were in
practice and teaching. The questions were
edited in closed-ended format, to make
them easier to answer. The answers to the
questions were given by means of a Likert[4]
scale going from 1 in total disagreement to
5 in total agreement.
Reliability of the questionnaire

In order to verify the reliability of the
questionnaire as being internally consistent
when measuring the qualitative variable of
the usefulness of the report for the
financing and investment decisions, we have
applied the pattern of internal consistency
known as Cronbachs alpha method[5]. This
way, once the reliability analysis has been
applied, the following results have been
obtained:
.
For questions on lending decisions
taken by credit entities, an alpha value
equivalent to 0.8488 has been obtained.
.
For questions that measure the relevance
of the auditing report on investment
decisions, a value of 0.7977 has been
estimated.
From the reliability values obtained, it is
possible to conclude that the questionnaire
has an overall internal consistency[6] that is
acceptable.
Data analysis
Data recording and validation
Once the information had been processed,
with the purpose of avoiding human errors, a
statistical control of ranges was first carried
out for each variable with the aim of
detecting layers that have been corrected.

Also, and by means of random sampling, a
sample from each one of the groups in the
study was verified, the errors being
statistically non-significant. In the case of
missing values, that is to say, those
questions left unanswered by the
respondents, either deliberately or through
ignorance, they have been considered
statistically non-significant because of their
low number and influence on the results
obtained.
Techniques employed
The analysis of the data begins with an
exploratory study after which we proceed to
test the hypotheses outlined, by means of the
statistical techniques that accounting
specialists have used in the accounting
literature, besides using other more
advanced techniques in order to obtain and
interpret relevant conclusions in a better
way. The hypotheses have been tested with
the non-parametric Chi-square test, as well
as corroborating the results with the
parametric t-test[7]. A factor analysis[8]
has also been made with the purpose of
condensing the information into those
factors that best define each one of the
variables being studied. The application of a
logistic regression test also helps to clarify
the relationship between the variables
observed at aggregate level.
Descriptive analysis
In total, 79 questionnaires from credit
entities and 33 from analysts are obtained. In
the case of the credit institutions, the number
of questionnaires received has been 19 from
banks, 26 from savings banks and 34 from
land banks; as for analysts, the number of
surveys received was 14 from dealers and 17
from brokering companies.
Table III shows the position held by those
answering the survey, classified by study
groups and under six possibilities: financial
director, manager, accountant, banker,
analysts and others. Out of a total of 112
surveys received, 104 have been classified,
while eight have been counted as missing
values. Inside the option of other
employments, 39 people have been included
with other positions such as: tax manager,
[ 551 ]
Antonio Durendez
Gomez-Guillamon
financing decisions
managing director, internal auditor,

planning manager and operating control
manager.

18/6/7 [2003] 549-559
Hypotheses tests
Application of the Chi-square test for H01
In order to assess null hypotheses, H01 and
H02, the Chi-square test has been used for
those questions outlined for each group
taking part in each of the two hypotheses.
The following results regarding the group of
banks come from Table IV:
1 As for the first question, it can be
observed that the credit entities strongly
agree, statistically significantly, with the
fact that they consider the presentation of
the audit report as something essential so
that audited companies can obtain a
credit line, a short-term and long-term
loan, a bank discount and a bank
guarantee.
2 When credit entities are asked about
which is the most relevant information
when granting a loan to companies, they
are most in agreement with the fact that it
comes from the Central de Riesgos del
Banco de Espana (CIRBE Risk
Information Centre of the Spanish Central
Bank[9]), followed by personal
knowledge, financial statements and
audit report. Nevertheless, they also
express their agreement on the
importance of the information coming
from good references, tax returns and
private databases.
3 Credit institutions also highly agree with
the fact that the type of opinion given by
the auditor (clean, qualified, adverse or
disclaimer) influences their lending
decisions. In this sense, they agree,
although to a lesser extent, with the fact
that the type of opinion given by the
auditor influences the lending amount.
Geiger (1992) and Anandarajan and
Jaenicke (1995) reach the same conclusion
showing that, in the USA, the audit report
Table III
Positions of respondents
Position
Financial director
General manager
Accountant
Banker
Analyst
Other
Sub-total
Missing values
Total
[ 552 ]
Credit institutions
Respondent groups
Analysts
5
7
2
47
28
75
4
11
29
Total
5
7
2
47
4
39
104
8
112
affects financing decisions. However,

Libby (1979) concluded by pointing out
that subject to qualifications have no
significant impact on the bankers
judgments.
4 Last of all, they are requested to point out
the type of qualifications with most
influence on financing decisions, mostly
agreeing that they are those that come
from going concern uncertainties,
followed by asset valuation errors, nonfulfilment of legal regulations, scope
limitations, relationships with group
and associated companies, tax
uncertainties and non-fulfilment of
accounting standards. Firth (1980)
reaches the same conclusion, in the UK,
when contrasting that going concern
qualifications as well as valuation of
assets qualifications are the most
relevant when granting a loan to
companies.
With the results obtained, the null
hypothesis (H01) is rejected and, therefore,
it is assumed that bankers perceive the
information given by the auditors opinion as
decisive when making their lending
decisions.
Application of the t-test H01

The parametric t-test has been carried out
to check if the means are significantly
different or not from the normal distribution
in order to corroborate the statistical results
obtained with the non-parametric test (the
tested value is 3); the results are exactly the
same as those obtained with the
non-parametric Chi-square test.
Application of the Chi-square test H02

The following conclusions have been
obtained from Table V:
.
In the case of dealers and brokering
companies, the most important
information for carrying out an
investment is obtained by a fundamental
analysis, followed by a technical
analysis, financial statements and
personal knowledge.
.
Dealers and brokering companies agree
on the fact that the type of opinion issued
by the auditor does indeed influence their
investment decisions, as well as the
amount to be invested in companies.
.
This group is also in agreement about the
fact that those qualifications that most
affect their investment decisions are, in
this order: going concern uncertainties,
those referred to assets valuation,
non-fulfilment of legal regulations,
non-fulfilment of accounting standards,
Antonio Durendez
Gomez-Guillamon
financing decisions
18/6/7 [2003] 549-559
tax uncertainties, relationships with

associated and group companies and
scope limitations.
With the results of this test, it is possible to
conclude by rejecting the null hypothesis
(H02) and, therefore, assume that dealers and
brokering companies perceive that the
information given by the auditors opinion is
indeed relevant for making their investment
decisions.
Application of the t-test H02

The parametric t-test has been carried out
in order to confirm the statistical results
obtained with the non-parametric test (the
tested value is 3). When the parametric test is
applied, we get the same results as in the
Chi-square test, with the exception of the
expression that indicates the most significant
information when carrying out an
investment is obtained from tax returns,
since the t-test shows the differences are
statistically non-significant whilst the

non-parametric test indicates the opposite.
Factor analysis
A factor analysis has been applied, at
aggregate level, with the purpose of obtaining
underlying factors that are smaller in
number and greater in importance than each
one of the variables analysed. The 16
variables are reduced to five main factors
that explain 64.787 per cent of the total
variance. Sampling adequacy of the analysis
is appropriate, as the KMO[10] measure
indicates, when taking a value of 0.737.
Three main factors have been obtained
with the following characteristics:
1 The first factor refers to the question on
what type of information is considered as
most important when financing or
investing in a certain company, and is
defined as being that which comes from
those sources of information of
Table IV
Chi-square test in the case of credit institutions
Questions
Chi-square
Test
Degrees of freedom
Mean
Significance
1. The presentation of the audit report is indispensable so

that services are lent, to a company committed to audit,
in the case of obtaining a:
credit line
short-term loan
long-term loan
bank discount
bank guarantee
71
67
72
65
69
45.761
41.925
50.000
36.938
40.710
1
1
1
1
1
4.27
4.17
4.38
3.97
4.13
0.000***
0.000***
0.000***
0.000***
0.000***
2. The most relevant information when granting a loan is obtained

from:
the audit report
Risk Information Centre
private databases
personal knowledge
tax declarations
financial statements
having good references
57
64
51
63
47
61
51
24.018
56.250
8.647
51.571
11.255
42.639
10.373
1
1
1
1
1
1
1
3.68
4.18
3.42
4.15
3.47
3.97
3.44
0.000***
0.000***
0.003***
0.000***
0.001***
0.000***
0.001***
3. Express your agreement with the following statements:

the opinion type influences on the decision of granting a loan
the opinion type influences on the decision of thequantity to lend
65
64
46.538
7.563
1
1
4.03
3.36
0.000***
0.006***
4. The type of qualifications with higher influence on the

decision making process when granting a loan:
going concern uncertainties
non-fulfilment of accounting standards
tax uncertainties
assets valuation errors
non-fulfilment of legal regulations
scope limitations
relationship with associated and group companies
75
50
50
64
58
54
53
71.053
15.680
32.000
45.563
36.483
32.667
28.698
1
1
1
1
1
1
1
4.69
3.47
3.67
3.90
3.81
3.73
3.69
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
Notes: *** Significant at 1 per cent level; The obtained observations have been reclassified (old value/new value) = 1-2/0, 4-5/1; Tested values
in percentage correspond: (scale value/per cent expected value) = 0/50 per cent, 1/50 per cent; Mean values vary in a scale between 1 total
disagreement up to 5 total agreement
[ 553 ]
Antonio Durendez
Gomez-Guillamon
financing decisions
18/6/7 [2003] 549-559
compulsory elaboration for the companies

and, therefore, that which the social
agents grant an official or institutional
validity. As we can see in Table VI, they
are: the audit report, the information
obtained from the Central de Riesgos del
Banco de Espana (CIRBE Risk
Information Centre of the Spanish Central
Bank), tax declarations, which are
presented to the Inland Revenue, and
financial statements that, just like the
audit report, are of compulsory
presentation to the Registro Mercantil
(RM Companies Registration Office)
and/or at the Comision Nacional del
Mercado de Valores (CNMV the Spanish
Stock Exchange Commission).
2 The third factor, which also refers to the
question about what type of information is
considered as most significant when
financing or investing in a certain
company, is defined as being that which
comes from unofficial or private sources of
information and, therefore, is not granted
an official or institutional validity. In this
case, the information is obtained from
private databases, personal knowledge
and from the fact of having good
references on the entity being financed or

the one being invested in.
3 A second factor, the same as the fourth,
refers to the question about the most
relevant type of qualifications auditors
include in their reports when providing a
subject to opinion for financing or
investing. In this sense, a second factor
can be observed that includes
non-fulfilments of legal regulations or
accounting standards as well as assets
valuation errors and tax uncertainties;
as opposed to the fifth factor that would
include other qualifications arising from
scope limitations and problems in the
relationships with associated and group
companies. This grouping finds its sense,
on the one hand, in the most important
qualifications and, therefore, which those
interviewed know and interpret in a
better way, and the rest of qualifications
of lesser generalization, in the case of big
companies and, as various authors[11]
point out, for companies trading on the
stock exchange, where uncertainties
and non-fulfilments are the most
recurrent qualifications, and, therefore,
are more widespread and have a greater
impact.
Table V
Chi-square test in the case of dealers and brokering companies
Questions
Chi-square
1. The most relevant information when investing is obtained from:

technical analysis
fundamental analysis
-the audit report
private databases
personal knowledge
tax declarations
25
24
21
22
21
23
22
21
22
9.000
(1)
1.190
1.636
0.048
9.783
2.909
10.714
0.182

the opinion type influences on the decision of investing in a company
the opinion type influences on the decision of the quantity to invest
25
23
11.560
3.522

decision-making process when investing:
going concern uncertainties
tax uncertainties
scope limitations
25
23
27
22
23
26
26
(1)
15.696
15.385
(1)
18.182
7.348
9.846
Test
Degrees of freedom
Mean
Significance
0.003***
1
1
1
1
1
1
1
3.69
4.10
2.81
3.29
2.97
3.63
2.68
3.66
3.16
0.275
0.201
0.827
0.002***
0.088*
0.001***
0.670
1
1
3.81
3.41
0.001***
0.061*
1
1
1
1
1
4.31
3.78
3.75
4.06
3.84
3.52
3.59
0.000***
0.000***
0.000***
0.007***
0.002***
Notes: * Significant at 10 per cent level; ** Significant at 5 per cent level; *** Significant at 1 per cent level; The obtained observations have
been reclassified (old value/new value) = 1-2/0, 4-5/1; Tested values in percentage correspond: (scale value/ per cent expected value) = 0/50
per cent, 1/50 per cent; Mean values vary in a scale between 1 total disagreement up to 5 total agreement; (1) Test cannot be carried out
when taking the variable a constant value, in these cases t-test is applied
[ 554 ]
Antonio Durendez
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financing decisions
18/6/7 [2003] 549-559
Table VI
Principal components factor analysis: rotated matrix loadings
Questions
1. The most relevant information when investing or financing

is
obtained from:
the audit report
private databases
personal knowledge
tax declarations
Factors
3
0.623
0.706
0.596
0.820
0.726
0.706
0.738

the opinion type influences on the decision of lending or
investing in a company
the opinion type influences on the decision of the quantity
to invest or to lend
0.787
0.781

decision making process when investing or lending:
tax uncertainties
scope limitations
0.681
0.713
0.692
0.638
0.727
0.811
Notes: Extraction method: principal component factor analysis; Rotation method: varimax normalization with
Kaiser; Only loadings having absolute value greater than 0.50 are shown
from relationships with associated and
group companies.
The second logistic regression test takes the
influence the auditors type of opinion has on
the quantity to invest in or finance a company
as a dependent variable, in the case of credit
institutions and analysts. So, as we can see in
Table VIII, scope limitations qualifications
are taken more into account than nonfulfilment of accounting standards ones.
Analysis by logistic regression test

Once the usefulness of the auditors
professional opinion has been verified, both
in financing and investing decisions and the
amount that the respondents are willing to
invest or to lend, a logistic regression test has
been applied to check the type of
qualification that has the greatest influence
on making decisions at aggregate level.
In this sense, the first logistic regression
test[12] takes the influence of the auditors
type of opinion on the decision to invest in or
finance a company as a dependent variable.
This way, as can be seen in Table VII, tax
uncertainty is a type of qualification that is
taken more into account in the
decision-making process than that derived
Limitations
.
Due to the scarce sample design of

analysts, and in spite of having obtained
some high rates of response, the
sampling error is high.
Table VII
Logistic regression on the decision-making process of investing or lending
Independent variables: (qualifications)
Tax uncertainties
Relationship with associated or group companies
Constant
ET
Wald
Degrees of freedom
Sig.
1.557
0.885
5.642
0.795
0.536
2.921
3.833
2.728
3.731
1
1
1
0.050**
0.099*
0.053*
Notes: * Significant at 10 per cent level; ** Significant at 5 per cent level; Method of the regression: first step
enter; Only significant independent variables are shown; Model global fit (goodness of fit): 2 log
verosimilitud = 41.445; R2 of Cox and Snell = 0.172; R2 of Nagelkerke = 0.357; Chi-square = 7.165; df = 8;
Significance = 0.519 (Hosmer and Lemeshow)
[ 555 ]
Antonio Durendez
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financing decisions
Table VIII
Logistic regression on the quantity of investing or lending
Independent variables: (qualifications)
ET
Wald
Degrees of freedom
Sig.

18/6/7 [2003] 549-559
Non-fulfillment of accounting standards

Scope limitations
1.005
1.450
0.412
0.434
5.933
11.167
1
1
0.015**
0.001*
Notes: * Significant at 10 per cent level; ** Significant at 5 per cent level; Method of the regression: first step
enter; Only significant independent variables are shown; Model global fit (goodness of fit): 2 log
verosimilitud = 78.269; R2 of Cox and Snell = 0.293; R2 of Nagelkerke = 0.408; Chi-square = 5.027; df = 7;
Significance = 0.657 (Hosmer and Lemeshow)
.
As it is characteristic in every survey,

the questions used to measure the
variables being studied bear a certain
degree of subjectivity, which has been
limited by using questions successfully
used in previous studies.
The questions have not always been
answered by the people for whom the
survey was intended and, therefore, the
results cannot always be considered as
valid.
Conclusions
With the results obtained, we can conclude
by rejecting the null hypotheses that assume
the lack of usefulness of the audit report in
lending decisions made by banks, and in
investment decisions, carried out by
dealers and brokering companies.
Credit banks, savings banks and land
banks strongly agree on the fact that the type
of opinion (clean, qualified, adverse or
disclaimer) issued by the auditor in the
report influences their lending decisions. In
the same way, they agree, although to a lesser
extent, with the fact that the type of opinion
also has its influence on the amount of the
loan to be granted. In that sense analysts also
indicate that the auditors type of opinion
does have its influence on taking the decision
to invest or not in a company, as well as on
the amount to be invested.
Both groups distinguish, when making
their investment and lending decisions,
between the sources of information with
legal or public content and others that are of
a private origin. From the aggregate analysis
it can be seen that greater importance is
given to tax uncertainties qualifications
than the relationships with associated or
group companies ones, when making a
financing or investing decision. At the same
time, they consider scope limitations more
relevant than non-fulfilment of accounting
standards when deciding on the investment
or loan amount.
Through this study, we have come to the
conclusion that both credit institutions and
dealers and brokering companies consider
[ 556 ]
the information contained in the auditors

report as being relevant and useful for their
investment and lending decisions, in such a
way that it can affect their attitude when
financing or investing in a company, as well
as when they choose the amount to be loaned
and invested.
Notes
1 Porter (1993) defines the expectations gap as
the gap between societys expectations of
auditors and auditors performance, as
perceived by society. It is seen to comprise two
components: reasonableness gap (i.e. the gap
between what society expects the auditors to
achieve and what the auditors can reasonably
be expected to accomplish); and performance
gap (i.e. the gap between what society can
reasonably expect auditors to accomplish and
what auditors are perceived to achieve).
2 As Dillon et al. indicate (1997), in the case of
cold surveys, that is to say those surveys
which are sent out to people who have not
previously committed themselves to
participating, the response rate is not expected
to be any higher than 10-20 per cent. In similar
studies, such as those carried out by Garca
Benau et al. (1993) and Carro Arana (2000), a
response rate of 15.25 per cent and 23.43 per cent
are obtained respectively, whilst Herrador
Alcaides study (2000) reflects a response rate of
31.23 per cent, meaning that a satisfactory
success rate has been obtained in the answers.
3 As Rojas Tejada et al. (1998) show, the fact that
questions already successfully used in other
surveys are being used now, makes the results
more reliable and communicated in a better
way.
4 As Sarabia Sanchez et al. (1999) point out, the
use of the Likert scale has the advantage of
being a scale that are easy to understand and
to make as well as having a high degree of
validity and reliability.
5 The formula that defines the alpha coefficient is:

Np

N 1
1p
where the number questions outlined is N and
the average of the correlation between items is
, taking values of between 0 and 1, so that the
p
higher the value the higher the internal
consistency of the scale.
Antonio Durendez
Gomez-Guillamon
financing decisions
18/6/7 [2003] 549-559
6 As Sarabia et al. (1999) point out, considering

the recommendations of Nunnally (1987) and
Peterson (1994), an alpha value similar to 0.7 is
usually considered as the minimum level for
preliminary investigation, 0.8 for basic
investigation and 0.9 for applied investigation.
Nevertheless, another author, Camacho
Rosales (2000), indicates that an alpha level of
0.67 implies a moderately high coefficient of
reliability.
7 Mayper et al. (1988), apart from
non-parametric tests such as the
Mann-Whitney test use other parametric
ones such as T2 of Hotelling and the t-test.
Bailey et al. (1983) use the ANOVA test for
interval-reason scales in the case of ordinal
variables. Nevertheless, and because most
variables are of an ordinal nature,
non-parametric tests should be applied in
preference as numerous authors point out. See
Dillon et al. (1997), Sarabia Sanchez et al. (1999)
and Ato Garca (1991).
8 Hair et al. (1999) indicate, when summarizing
data with the factor analysis technique,
some underlying dimensions are obtained
that, when interpreted and understood,
describe information with a much more
reduced number of concepts than the original
individual variables.
9 The Risk Information Centre is the office that
provides on the creditworthiness of potential
clients of Spanish credit banks.
10 The Kaiser-Meyer-Olkin measure is used to
check sampling adequacy.
11 See the studies carried out by Gomez Aguilar
and Ruiz Barbadillo (1999), Gonzalez Bravo
and Martn (1999), Villarroya
Lequericaonandia (2000), Cabal Garca (2001)
and Cabal Garca and Robles Lorenzana (2001).
12 The use of this technique means that the
dependent variables analysed have been
reclassified, so both the decision of financing
or investing and the amount to finance or to be
invested, since their original values vary in a
scale of 1 entirely in disagreement up to 5
entirely in agreement. Therefore, when the
original response takes a value of 1 or 2 it is
reclassified in a binary value 0; when it takes
the values of 4 and 5 it is reclassified in the
binary value 1, the original value of 3 being
considered as a missing value.
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[ 559 ]
Auditing in support of the integration of management

systems: a case from the nuclear industry
I.A. Beckmerhagen
Bundesamt fur Strahlenschutz, Salzgitter, Germany
H.P. Berg
Bundesamt fur Strahlenschutz, Salzgitter, Germany
S.V. Karapetrovic
Department of Mechanical Engineering, University of Alberta, Edmonton, Canada
W.O. Willborn
Faculty of Management, University of Manitoba, Winnipeg, Canada
Keywords
Quality, Safety, Auditing,
Nuclear energy industry,
ISO 9000 series, Germany
Abstract
Integration of function-specific
management systems in
organizations is rapidly becoming
a topic of interest for managers
and auditors alike. This is mainly
due to the proliferation of
management system standards
that foster compliance with the
stated criteria for quality,
environmental, occupational
health and safety, social
responsibility and other different
aspects of performance. While
most of the available literature on
this topic focuses on the
integration of standards, there is
comparatively little information on
how to actually build an integrated
system internally. This paper
hypothesizes that audits can
provide an excellent basis for
these integration efforts,
discussing the prerequisites,
strategies and resources
necessary for an effective audit in
support of integrated management
systems. The paper also describes
how audits are used to improve a
combined quality and safety
management system in a German
nuclear facility.

18/6/7 [2003] 560-568
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482696]
[ 560 ]
Introduction
and some relevant experiences of a nuclear

waste disposal facility in Germany.
Integrating management systems, such as

those for quality and safety, should enhance
managerial and operational effectiveness.
Whether or not this goal can or has been
achieved is still a lingering question. A
well-proven method to assess the
effectiveness of any management system is
auditing. Audits are designed to determine
adequate compliance with applicable
standards and guidelines. Moreover, they can
and should be instrumental in identifying
problem areas and potential improvements,
along with corrective and preventive actions.
Much has been written in recent times
about management system integration and
auditing. Yet the interrelationship of an
integrated management system (IMS) with
auditing remains largely unexplored. This
paper will focus on the audit as a support
structure for system integration. The system
concept will be applied, as it is extremely
useful for the modeling and development of
both the individual function-specific
management systems and the IMS
(Karapetrovic and Willborn, 1998a). In
particular, the systems framework for the
audit will be used to support an integrated
system for quality and safety management
applied in the nuclear industry.
How can an audit assist in integrating a
quality and safety management system?
What are the requirements for an effective
audit in the various phases of integrating
these management systems? Once the
integrated system is established, how can
audits assist management to further
strengthen and improve both the IMS and the
audit? What technical resources for these
special types of audits, for example standards
and software, are available? This paper
presents general answers to these questions
A system consists of interrelated elements,

such as processes, that use various resources
to achieve set goals. A quality management
system (QMS), for instance, with all its
individual parts (processes and resources),
should attain a goal of customer satisfaction
with products and services. In other words, it
is a system for the management of quality
(Geiger, 2000; Arter, 2000). This definition of a
system also applies to an audit. For example,
Figure 1 illustrates a generic audit system
framework, adapted from Karapetrovic and
Willborn (2001b), that can be applied to the
auditing of either a function-specific or a
cross-functional (i.e. integrated) management
system (MS). Recently, it was recognized that
specialized management systems and
corresponding standards have many
essential features in common (Karapetrovic
and Willborn, 2000a). Various forms of
integrating these individual systems into an
overriding entity have been presented,
discussed, and also implemented (for
example, see Janik and Zimmerman, 1998;
Butterbrodt et al., 1999; Dilthey and
Bohlmann, 2000; Funk, 2001; Funk and
Mayer, 2001). For instance, an overriding
generic management system (GMS) may be
designed to contain the fundamentals of any
function-specific management system, for
example the ones for quality, environmental
and safety management (Karapetrovic and
Willborn, 1998a). The GMS addresses mainly
top management, executive responsibilities
and activities. Subordinated and
technically-specialized MSS, called
sub-systems, remain largely separated and
cover quality, safety, corporate

Systems approach
I.A. Beckmerhagen,
H.P. Berg,
S.V. Karapetrovic
and W.O. Willborn
Auditing in support of the
integration of management
systems: a case from the
nuclear industry
Figure 1
IMS audit framework

18/6/7 [2003] 560-568
accountability and other important

functional areas. In this system of
sub-systems, audits can also be arranged as
a specialized and partly independent
supporting sub-system (Karapetrovic and
Willborn, 2000a, b). Figure 2 illustrates the
main elements of a GMS, from the
determination and review of stakeholder
requirements to the evaluation of GMS
effectiveness and continuous improvement.
Embedded within each GMS element is the
corresponding element of an audit
sub-system.
As was mentioned above, these integrated
systems should help managers at all levels of
responsibilities to gain a clearer view and
understanding of managerial tasks at a time
of increasing complexity and risks. This is
also true for auditors. In a systematic,
well-designed and performed audit, all
participants must know the goal of the audit.
The specific goal then determines the
approach to be taken and the resources to be
deployed. Much has been written about an

effective audit of specialized management
systems. For the fairly new audit task,
namely to achieve an integrated management
system, many questions are still
unanswered. Although the development of
the first integrated audit standard for quality
and environmental management systems
(ISO 19011) started some seven years ago, the
standard is not yet published (at the time of
writing this paper). This quagmire continues
in spite of much effort of the ISO Joint Work
Group on auditing and pressures from the
various interested parties. A brief history
and analysis of the causes of problems related
to the integrated audit of management
systems can be found in Karapetrovic and
Willborn (1998b). Nevertheless, the applied
systems approach can help all people
concerned and involved to utilize human and
technical audit resources in effectively
facilitating the integration of management
systems.
[ 561 ]
I.A. Beckmerhagen,
H.P. Berg,
S.V. Karapetrovic
and W.O. Willborn
nuclear industry
Figure 2
Audit-related systems

18/6/7 [2003] 560-568
Audit as a supporting framework

for system integration
Audits are conducted in different forms and
using different approaches. These range from
a simple gap analysis or self-assessment to a
comprehensive and technically involved
audit project (Karapetrovic and Willborn,
2001a). Even the standards that describe the
major features of an audit vary in some
[ 562 ]
details. The systems view of an audit helps us

to focus on essentials of audits, especially
when a new kind of audit is to be introduced,
as it is in the case of an IMS.
Audits that have been conducted in a
function-specific management system (MS),
such as the ones for quality management, are
relatively unique regarding their goals,
approaches, resource requirements,
outcomes, and follow-up. This is not to say
I.A. Beckmerhagen,
H.P. Berg,
S.V. Karapetrovic
and W.O. Willborn
nuclear industry
18/6/7 [2003] 560-568
that such audits cannot be converted in order

to assist in the integration of
function-specific MS. As a prerequisite,
audits and the audit team themselves must be
integrated sufficiently in order to participate
effectively in a broader system integration
project. In fact, joint and combined audits,
even if only conducted in a single specialized
system, demonstrate practical cooperative
integration of audit procedures and
operations. For example, Strese et al. (2000)
state that:
. . . with the aid of combined audits, a motor
manufacturer has introduced and is
continuously improving a process-oriented,
integrated management system in its factory.
Zechmeister (2000) provides a further

example of such successful audit support:
. . . within the framework of reorganizing its
quality system, a manufacturer of electrical
products integrated its management systems
and developed and introduced a new method
of assessment.
Within a specialized MS, both internal and

external audits are often closely planned and
conducted. Moreover, auditors and auditees,
as well as other participants and
stakeholders, share responsibilities for a
useful audit outcome. Integrating audits for
the purpose of assisting in integrating
function-specific MSS is not an entirely new
phenomenon. The novelty is, however, that
auditors with specialized experience and
competence must learn to conduct a new kind
of an audit, namely an audit that assists
management to integrate function-specific
management systems.
One can envision that if an IMS consists of
an overriding GMS and specialized
sub-systems, then integrated audit teams
would be assisting mainly at the generic
system level (Karapetrovic and Willborn,
2000a, b). During prior joint audits across
function-specific management systems,
auditors should have become familiar with
commonalities of such different systems that
will serve as building blocks for the
developed IMS. The experience gained from
joint audits and from the preparation of a
GMS can be also useful for future separate
conventional audits of the modified and
integrated sub-systems. For the success of
this auditing strategy, certain essential
requirements must be met.
Requirements for an effective IMS

audit
Any audit is, by its very nature, a blend of
basic and unique requirements concerning
the initiation, planning, conduct, and
follow-up of an audit project. Auditors

themselves, and to a certain extent the
auditees and executive management as the
audit client, have to be properly motivated
and prepared for this new kind of audit. At
this time, not many truly integrated
management systems exist worldwide.
Consequently, experience for auditing such
systems is still fairly sporadic. Not
surprisingly, a respective standard for such
audits does not exist, although it would be
very timely and useful.
Theoretically, an audit can generate
important findings, insights, and
recommendations when integration is
considered, initiated, planned, established,
maintained, and improved. Most crucial for
management are the early phases of IMS
audit development, as many uncertainties,
risks and barriers exist. The situation where
an IMS is to be established from the ground
up is certainly not the rule. In such a case,
audits would most likely be delayed and
introduced once the management system is
finally established. However, a quality
management system (QMS) usually already
exists in companies, possibly along with
other management systems. To assist and
guide the management in developing this
new system, specialized management
consultants and professional auditors may be
involved in the effort. Possibilities for
gaining important benefits through system
integration commonly exist in this case,
albeit these are not readily recognized.
Auditors can help by identifying such
benefits. In the example described later in
this paper, audits were used to assist in the
integration of a quality and a safety
management system in the nuclear industry.
Audit resources and auditor competence
existing from audits of specialized
management systems need to be extended
and partly modified in the case of IMS audits.
When management considers integrating the
existing management systems, much new
knowledge and expertise is required.
Auditors, among other experts and
consultants, can effectively participate due to
their intimate knowledge of the companys
operational strengths and weaknesses,
however only in one specialized area, or
through joint audits. Auditors normally have
a close working relationship and
communication links with managers. What
is furthermore required is that auditors
acquire additional knowledge about system
integration from the early development
phases onward.
As has been pointed out, auditors of the
different function-specific MS should
cooperate in establishing joint audits as a
[ 563 ]
I.A. Beckmerhagen,
H.P. Berg,
S.V. Karapetrovic
and W.O. Willborn
nuclear industry
18/6/7 [2003] 560-568
preliminary form of IMS audits. As an IMS

does not exist at this stage, QMS auditors
might join a team of those in the safety area
and vice versa. As a next step, a joint audit
team might be able to prepare and to conduct
an audit for the development of an IMS. In
this situation, auditors might initially act
more like consultants and system developers
than independent auditors, while at the same
time assessing (and not strictly auditing) the
performance of the system (Willborn, 1979).
For further explanation of the differences
between assessments and audits, the
interested reader may refer to Karapetrovic
and Willborn (2001a).
Helping the improvement efforts

Once a recognized standard for an IMS comes
into existence, auditors will be able to
determine with more authority if a proper
integration has been achieved or not.
Registration of the system after a successful
audit will then also become feasible.
Auditors, especially those who have
participated in the integration of audits and
management systems already, will be best
prepared to continue in their task.
Integration, in whatever form or degree
achieved, will probably never end in the life
of a company. New specialized MS will
continue to emerge, for example the ones for
knowledge management, complaints
handling, financial planning, corporate
social responsibility, and these may not
immediately fit into an existing integrated
system.
The audit tasks will change somewhat once
an IMS is established to the satisfaction of
management and auditors alike. While
auditing during the development phase
involves much consulting, motivating,
learning, and improvising, it shifts now to a
more traditional and solid ground. In a
predominately stable environment,
compliance audits tend to be the rule and
self-assessments become feasible. Yet the
tasks for auditors, although changing,
remain as important as before. The ultimate
goal for audits must never be simply
maintaining effectively what has been
achieved. In todays volatile and uncertain
business environment, auditors must assist
management to identify necessary
improvements of the IMS in all its parts. This
assistance must be especially focused on
possible weaknesses and redundancies, as
these might otherwise remain undetected. Of
course, a declared and understood positive
audit approach would emphasize searching
for feasible and necessary improvements:
[ 564 ]
Integrated evaluation model indicates

potential operating improvements
(Sohrmann and Pahl, 2000). Auditors must
follow-up findings for improvement and for
problem-related corrective and preventive
action. The necessity of such a procedure can
be seen from the example provided at the end
of this paper.
Auditors themselves, now being organized
as an integrative part of the comprehensive
MS, again must set an example and
demonstrate effectiveness and improvements
in ongoing auditing. This is now true more
than ever before, because protective barriers
of former specialized MS might still exist
after integration. With the changed audit
goal and focus, some new audit methods need
to be adapted. For instance, if self-assessment
is to be facilitated, training and suitable
checklists are required. Often, resources for
auditing are curtailed, once an MS runs
fairly smoothly. The opposite should be the
case in a newly integrated MS. In other
words, adequate audit resources need to be
deployed.
Neceessary resources for an IMS

audit
It is largely up to auditors themselves to gain
and maintain adequate human and technical
resources for their tasks. Relying solely on
pressure to obtain sufficient funds from
senior management obviously does not
suffice, even once auditors have achieved
recognition by their clients. The following
technical resources are required for
continued effective auditing of an IMS.
During the IMS development phase:
1 A standard or official guideline for
integrating management systems (does
not yet exist).
2 Publications or other results of internal
research that can be used for retraining
auditors and managers.
3 Training opportunities, for example
participation in relevant congresses and
seminars.
4 System documentation structure that
allows for auditing by different external
bodies and according to different criteria.
5 Assistance by competent management
consultants and technical experts before
and during audits during this phase of
integration.
6 Understanding and acceptance of certain
risks during this system development
phase by all participants and the company
in general.
7 Special checklists and evaluation criteria.
I.A. Beckmerhagen,
H.P. Berg,
S.V. Karapetrovic
and W.O. Willborn
nuclear industry
18/6/7 [2003] 560-568
8 Adequate audit follow-up meetings with

management and auditees for feedback
about the audit, its results and further
improvements.
9 Appropriate cooperation and a helpful
attitude of audit team members, audit
participants, and managers.
10 Audit by external auditors along with
required experts to determine final
satisfactory establishment of the IMS.
After the completion of system integration:
1 Continued assistance to audit
management and individual auditors to
reorient audits to both compliance and
improvements; and to further improve the
integrated audit sub-system.
2 Adoption of innovative computer-based
auditing methods and software along with
adequate research and technical assistance.
3 Retraining if necessary.
4 Facilitation of new forms of auditing, such
as self-assessment.
5 Cooperation of external and internal
auditors to identify system improvements.
6 Fostering continuous improvement of the
integrated system as the main audit
objective.
7 Obtaining the system registration (if
feasible) and acknowledgement of
continued audit effectiveness.
Theory and practice of management systems
and their integration need to be closely
interrelated and integrated in order to be of
real value. This is especially necessary in the
case of an industry with high risks, such as
the nuclear industry. The following example
from a German nuclear facility explains how
effective auditing was applied in support of
an integrated quality and safety management
system.
Nuclear waste disposal in Germany

Since 1983, the Safety criteria for the
disposal of radioactive waste in a mine have
been used as a guideline for planning,
constructing and operating radioactive waste
repositories in Germany. Apart from
containing the basic framework and
elements of a system necessary to achieve the
desired objective of nuclear waste disposal,
these criteria require that all appropriate
laws, regulations and guidelines, including
for example mining regulations and
radiation protection guidelines are complied
with. Moreover, the criteria demand that the
safety of a waste repository be demonstrated
by a site-specific safety assessment.
The Bundesamt fur Strahlenschutz
(Federal Office for Radiation Protection: BfS)
is the responsible body for the disposal of

radioactive waste in Germany, and as such, it
ensures that the requirements resulting from
these different regulations are systematically
fulfilled. In order to address all safety aspects
of a waste repository, an effective quality
assurance system is needed. This system
must cover the whole life cycle of the
repository, including its design,
manufacture, construction, and operation.
Consequently, it must also address
geological, occupational health and safety,
and environmental requirements, as well as
a set of specific guidelines for the protection
from nuclear radiation. Therefore, an
integrated management system (IMS), which
encompasses quality, safety and other
function-specific management systems, is
required. In BfS, such a system has been
developed under the overarching quality
assurance framework.
The quality management system (QMS) of
BfS for the organizational unit dealing with
the final repository for radioactive waste
came into force in 1987. Therefore, the
operations performed in this unit of BfS have
been quality assured since then. Since this
system is cross-functional by nature, as it
addresses not only quality, but also safety,
environmental and other criteria, we will
refer to it as the quality-integrated
management system (Q-IMS), in order to
distinguish it from management systems
covering quality assurance requirements
only. The BfS Q-IMS was developed as a
process-oriented system, as required by the
Safety Standard of the German Nuclear
Standards Commission KTA 1401
(Kerntechnischer Ausschuss, 1996): General
requirements regarding quality assurance. It
is described in the BfS quality manual, which
comprises all generic quality and safety
assurance requirements and is consequently
relevant to all repository projects. The
manual is divided into two parts: a general
framework based on the requirements of
relevant standards and regulations, and a set
of procedures, which illustrate how specific
mining/geological, occupational health and
safety, environmental and radiation
protection specifications are addressed. Some
specific quality assurance measures described
in this manual include:
.
Complete or random inspection of
purchasing data, planning results and
products for compliance with quality
requirements.
.
Procedures for the documentation of
scientific work during site investigations.
.
Guarantees of the existence of adequate
flows and feedback of information,
[ 565 ]
I.A. Beckmerhagen,
H.P. Berg,
S.V. Karapetrovic
and W.O. Willborn
nuclear industry
18/6/7 [2003] 560-568
including cooperation between the

different parties involved.
Decisions in the event of significant
changes of planning of the design,
construction and operation of the nuclear
waste repository.
Ensuring that special conditions and
additional requirements resulting from the
licensing procedures are taken into
account.
Ensuring the existence and
implementation of appropriate
documentation.
Determination of requirements regarding
contractor quality assurance.
Surveillance of the contractor quality
assurance system by means of external
audits.
An independent surveillance team monitors

the implementation of the quality assurance
program in BfS and evaluates the Q-IMS at
appropriate intervals on the basis of an audit
plan. Records of these evaluations are kept
containing any nonconformities found.
Resolution of unacceptable nonconformities
is accomplished either in a separate
follow-up audit or during the next scheduled
audit. In the following section, a description
of an integrated management system, which
was developed for a nuclear waste repository
under the auspices of BfS, is given.
Example of IMS development for

nuclear waste disposal
After the unification of the Federal Republic
of Germany (FRG) and the German
Democratic Republic (GDR), BfS took over a
repository for radioactive waste in
Morsleben which had already been in
operation in the GDR. As it was necessary to
adapt FRG nuclear laws, rules and
regulations, such as the Mining Law,
Radiation Protection Ordinance, Atomic
Energy Act, Safety Standards of the Nuclear
Standards Commission, and a variety of
other German Standards, the existing quality
system for the Morsleben repository had to
be somehow adapted. While one possibility
was to create a new quality manual for the
Morsleben repository, another one was to
derive it from the existing procedures.
The operation of the Morsleben repository
was subcontracted to Deutsche Gesellschaft
fur den Bau und Betrieb von Endlagerung fur
Abfallstoffee mbH (German Company for the
Construction and Operation of Repositories
of Waste: DBE), which is the main contractor
of BfS. DBE performed a system audit of the
repository in 1990 on behalf of BfS. After the
evaluation of the audit results, a decision was
[ 566 ]
made to create an independent quality

manual for this repository. The manual
would be based on valid existing procedures
and would completely integrate the new
requirements. The way in which this was
accomplished is explained next.
The structure of the quality manual for the
Morsleben repository was based on the
requirements of the mining law, the existing
permanent operation license and the
requirements of the ISO 9001 standard. All
existing requirements of applicable laws,
rules and regulations, as well as the separate
operational requirements, were listed in a
tabular form. By having this table of
contents, it was not only possible to assign
the requirements to the corresponding
chapters of the manual, but also to illustrate
a clear framework of operation to the
differing regulatory bodies which conduct
separate external audits (e.g.
mining/geological and nuclear). In the
following step, the existing procedures were
applied to fulfil the requirements that had
been assigned to the specific chapters in the
manual. In that manner, an auditor, for
example, could clearly see which
requirement had to be fulfilled in which
manner by what procedure. This approach
was proven to be very advantageous when an
expert of the FRG Mining Authority audited
the repository in 1995, as one could see right
away how the different quality, safety,
environmental and other requirements were
fulfilled. Following the new standard DIN
ISO 10013, this table was later replaced by a
subchapter format. Each chapter had a
subchapter in which the relevant procedures
(i.e. references) were listed. Therefore, the
procedures were grouped into two categories:
the ones related to the applicable standards
(e.g. ISO 9001) and the ones related to the
operation of the repository. The appendix of
the quality manual contained a list of the
relevant operating instructions.
The operational personnel of the
Morsleben repository, the respective
personnel from the DBE headquarters and
an external advisor were the human
resources necessary for the writing of the
new manual and the completion of the
procedures. The new Q-IMS has been
audited internally by DBE and externally
by BfS. Some possibilities for improvement
were shown in the beginning, but fewer and
fewer were found later on. As the
operational personnel had been involved in
writing of the chapters of the manual and of
the specific procedures, there were no
difficulties in the implementation of Q-IMS
documentation. This active participation
by the operational personnel created a very
I.A. Beckmerhagen,
H.P. Berg,
S.V. Karapetrovic
and W.O. Willborn
nuclear industry
18/6/7 [2003] 560-568
positive effect, since any mistakes or

inaccurate formulations in the description
of work processes were quickly found and
corrected. Additional training helped the
personnel obtain confidence with the West
German laws and regulations. It is
important to note here that some of the
former GDR standards had to be used not as
guidelines but as more restrictive laws.
Therefore, it is easy to understand that the
use of the FRG rules and regulations, which
seemed to have more operational freedom,
periodically led to irritations on the part of
the East German personnel. But as audits
were performed very frequently during the
introduction phase, undesirable
developments were prevented.
On the basis of the audit results, quality
management reviews were performed
annually (Figure 3). Improvements in the

Q-IMS documentation and in the system itself
represented the output of these reviews. In
addition to the reviews, the quality
surveillance team (QST) performs annual
training. During the training, improvements
in the manual are explained and the
personnel are encouraged to understand and
implement them. Apart from the internal
DBE audits, there are also external BfS
audits to evaluate the overall effectiveness of
the Q-IMS. Therefore, a combination of
audits, reviews and training helps to
continuously improve the effectiveness and
efficiency of the Q-IMS.
It is also worth noting that original plans
for the Morsleben Q-IMS included the
integration of ISO 14001 environmental
management system requirements into the
Figure 3
Continuous improvement process using audits
[ 567 ]
I.A. Beckmerhagen,
H.P. Berg,
S.V. Karapetrovic
and W.O. Willborn
nuclear industry
18/6/7 [2003] 560-568
quality manual. This would have been done

in the same manner as occupational health
and safety requirements. However, the
disposal of radioactive waste at the
Morsleben site was stopped in 1998. In 2001,
the final decision for the decommissioning of
the repository was made.
Conclusions
The world is about to witness the first-ever
audit standard that spans over two
disciplines and functions in an organization,
namely quality and environmental auditing.
It is expected that the ISO 19011 guideline will
be finally available in the fall of 2002.
Although it is certainly a step in the right
direction of harmonizing function-specific
audits, this new guideline unfortunately does
not address the auditing of integrated
management systems, or for that matter the
integration of auditing systems in an
organization. The former issue is of
particular importance, since an
ever-increasing number of companies are
looking into the establishment of integrated
management systems (IMS).
This paper discussed some of the main
concepts and the necessary conditions for
setting up an audit system that would
support the development and
implementation of IMS in organizations.
Following an illustration of the systems
approach to IMS auditing, the manner in
which an audit can support the integration of
function-specific management systems was
analyzed. Subsequently, some of the
requirements and resources necessary to
conduct an effective IMS audit were
presented, and the ability of audits to act as a
basis for continuous improvement of such an
integrated system was addressed. Finally, a
case study from the nuclear industry was
used to demonstrate the importance of an
adequately planned audit in simultaneously
meeting the requirements of quality and
safety management systems.
References
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Progress, Vol. 33 No. 6, pp. 57-61.
Butterbrodt, D. et al. (1999), Alles unter einem
Dach, Qualitaet und Zuverlaessigkeit, Vol. 44
No. 7, pp. 866-72.
Dilthey, U. and Bohlmann, H. (2000),
Zusammenarbeiten, aber wie?, Qualitaet
und Zuverlaessigkeit, Vol. 45 No. 8, pp. 972-6.
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Qualitaet und Zuverlaessigkeit, Vol. 46 No. 6,
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Management ein Modethema laesst Fragen
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Geiger, W. (2000), Begriffe, Qualitaet und
Zuverlaessigkeit, Vol. 45 No. 10, pp. 12-24.
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und Zuverlaessigkeit, Vol. 43 No. 3, pp. 277-9.
Karapetrovic, S. and Willborn, W. (1998a),
Integration of quality and environmental
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Integrated audit of management systems,
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Quality assurance and effectiveness of audit
systems, International Journal of Quality
& Reliability Management, Vol. 17 No. 6,
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Generic audit of management systems:
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and self-assessment in quality management:
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system: concepts and practices, Total
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Prozessbewertung, integriertes
Bewertungsmodell zeigt betriebliche
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Strese, V., Thiele, J. and Winzer, P. (2000),
Auditterror eindaemmen, Kombiaudits als
Instrument zur kontinuierlichen
Verbesserung integrierter
Managementsysteme, Qualitaet und
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small business, Quality Progress, Vol. 11
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pp. 404-10.
Current accounting investigations: effect on Big 5

market shares
Christie L. Comunale
School of Professional Accountancy, Long Island University C.W. Post Campus,
Brookville, New York, USA
Thomas R. Sexton
Harriman School for Management and Policy, Stony Brook University,
Stony Brook, New York, USA
Keywords
Market share,
Accounting standards,
Accounting, Benchmarking,
Abstract
Arthur Andersens conviction and
its decision not to audit public
firms will transform the Big 5 into
the Big 4. Meanwhile, other Big 4
firms face investigations that
threaten their future market
shares. The article compares the
observed post-scandal shifts in
market share with those
estimated by a Markov model. It
then estimates the year-by-year
and long-term market shares that
the Big 4 firms would have
achieved had they remained
untouched by these
investigations. The study finds
that the absence of Arthur
Andersen alone would not have led
to excessive market share
concentration. It demonstrates
how the post-scandal shifts reveal
the impacts of the investigations
on the Big 4 firms and provides
market share benchmarks against
which the firms can evaluate the
long-term effects of the
investigations. Finally, the article
concludes that a firms long-term
gain in market share depends on
its ability to retain audit clients.

18/6/7 [2003] 569-576
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482704]
Introduction
on their market shares. Then we estimate the

year-by-year and long-term market shares
that the Big 4 firms would have achieved had
they all remained untouched by these
investigations. These estimates serve as
future reference points for the Big 4 firms.
For example, if a firms market share in a
future year is higher (lower) than its
estimated market share for that year, then
we can deduce that the firm fared better
(worse) than expected in the current turmoil.
The imminent demise of Arthur Andersen is

evidenced by its loss of many major audit
clients, including Merck, Qwest
Communications, Worldcom, Halliburton,
Freddie Mac, Wyeth, and Peregrine Systems.
Arthur Andersens recent announcement
that it would soon cease audit operations for
publicly traded firms formalizes the
transition from the Big 5 to the Big 4.
Meanwhile, other Big 4 firms are also facing
investigations into major accounting
irregularities. These developments raise
questions about the future market shares of
the remaining Big 4 accounting firms. From
the regulatory point of view, will any firm
emerge from this turbulent era to dominate
the audit industry? From the industry point
of view, what will be the short- and long-term
effects of the current accounting scandals on
the market shares of the Big 4 firms?
Extensive shifts in audit market shares
among the Big 5 firms would affect not only
the Big 5 firms, but also clients, regulators,
and corporate stakeholders. For accounting
firms, market share is a major issue, as it
determines their revenue and therefore their
profitability. For clients, excessive market
concentration could result in higher audit
fees. For regulators and corporate
stakeholders, increased market
concentration, and the concurrent lower
competition among accounting firms, would
raise concerns about reduced audit quality.
In this paper, we compare the observed
post-scandal shifts in US market share
resulting from the decline of Arthur
Andersen with those estimated by a Markov
model. The differences between the observed
and the estimated post-scandal market shares
allow us to assess the immediate impacts of
the investigations involving the Big 4 firms
We define the audit market share of a Big 5

accounting firm to be the number of
Standard & Poors (S&P) 500 client firms
audited by the given accounting firm divided
by the total number of S&P 500 client firms
audited by all Big 5 accounting firms. This
definition does not reflect the asset value of
the client firms, which would provide an
alternative definition of audit market share.
Because the S&P 500 serves as the US
component of the S&P global index family,
our results are most applicable to the US
audit market. While we restrict our analysis
to client firms listed on the S&P 500, we could
expand the model to include all auditors that
the client might retain.
We collect data from Standard & Poors
Research Insight for the years 1995-1999,
providing us with 2,000 observations (500
firms 4 opportunities to change auditors).
We construct a Markov model that depicts
the transitions of a client firm among the set
of Big 5 accounting firms during this period.
Markov models are useful in depicting the
probabilistic evolution of a system over time
among a set of states, as we show in Figure 1.
In this application, the system is one of the
S&P 500 client firms and each Big 5
accounting firm is a state. In any year, one of

Data and methods
[ 569 ]

Thomas R. Sexton
Current accounting
investigations: effect on Big 5
market shares
Figure 1
Diagram of the Markov model showing the possible transitions of an E&Y client firm among the
Big 5 accounting firms

18/6/7 [2003] 569-576
the Big 5 accounting firms will audit the

client firm, meaning that, in any year, the
system will reside in exactly one state. Each
year, the client firm decides whether to
remain with its current auditor or transition
to another member of the Big 5, movements
that the model captures using transition
probabilities.
There are two basic kinds of transitions:
those in which the client firm remains with
the same auditor, and those in which the
client firm switches to a new auditor. The
first kind of transition reflects the auditor
firms abilities to retain client firms. We
refer to the probability that a client firm
remains with a given Big 5 accounting firm
from one year to the next as the retention
probability of the Big 5 accounting firm. The
second kind of transition reflects the auditor
firms abilities to attract client firms from
other Big 5 firms. We refer to the ability of a
given Big 5 firm to attract client firms as its
attractiveness parameter, a number between
zero and one with larger values indicating
greater ability to attract. We estimate the
retention probabilities and attractiveness
parameters of each of the Big 5 firms using
the methodology described below.
The transition probabilities are important
because they allow us to calculate the state
probabilities, defined as the probability that
any given Big 5 accounting firm will audit
the client firm in any given future year. Over
many years, the state probability that a given
[ 570 ]
Big 5 accounting firm will audit the client

firm approaches a limiting value, which we
call the steady-state probability. The model
also calculates this long-term, or steady-state,
probability. We may interpret these
steady-state probabilities as the long-term
market shares for the Big 5 accounting firms.
Computing observed transition

probabilities
We compute the observed transition
probabilities as relative frequencies. The
observed transition probability from one
Big 5 accounting firm to another (possibly
the same) is the ratio of the number of
observed transitions from the first firm to the
second, divided by the total number of
transitions from the first firm to any Big 5
firm, including itself[1].
Computing estimated retention

probabilities, attractiveness parameters,
and estimated transition probabilities
We next compute those values of the
parameters that minimize the sum of the
squared differences between the observed
and estimated transition probabilities. We
use equation (1) in the Appendix for the
estimated transition probabilities. This
optimization is constrained to ensure that
the estimated transition probabilities
produce long-term market shares equal to the

Thomas R. Sexton
Current accounting
market shares
observed values. See the Appendix for

details.

18/6/7 [2003] 569-576
To model the absence of any one of the Big 5

accounting firms, we assume that the
retention probabilities of the other four
accounting firms will remain the same and
we rescale the remaining attractiveness
parameters. We then compute the new
matrix of transition probabilities for a
Markov model that contains only the
remaining Big 4 firms (see equation (1) in the
Appendix).
We compute the market shares for the
remaining Big 4 firms in the first year without
Arthur Andersen in two ways. First, we
assume that client firms currently audited by
Arthur Andersen will move to other Big 4
firms in proportion to their attractiveness
parameters. This reflects the situation that
would have prevailed had the other Big 4 firms
not undergone investigations. We refer to these
as the estimated post-scandal market shares.
We then use the estimated post-scandal market
shares and the new transition matrix to
compute the year-by-year and long-term
market shares for comparison with market
shares that preceded the Enron crisis. We do
this for each year using matrix multiplication
to multiply the market shares in the previous
year by the estimated transition matrix in the
absence of Arthur Andersen.
Second, we compute the observed
post-scandal market shares based on the
actual transitions of S&P 500 client firms
from Arthur Andersen to another member of
the Big 4 since the onset of the Enron debacle.
These market shares incorporate the effects
of the investigations into the Big 4 firms. We
refer to these as the observed post-scandal
market shares.
Table I
Observed transition probabilities
Modeling the absence of Arthur Andersen
Results
We use the following notation to denote the
Big 5 accounting firms: AA = Arthur
Andersen; EY = Ernst & Young; DT = Deloitte
& Touche; PM = KPMG Peat Marwick; and
PWC = PriceWaterhouseCoopers.
Observed transition probabilities

We show the observed matrix of transition
probabilities in Table I. For example, during
the five-year period 1995-1999, 98.8 per cent of
EYs audit clients chose to remain with EY.
We show this percentage in the cell labeled
EY for both the row and column. During
the same five-year period, 0.48 per cent of
EYs audit clients switched to DT. We show
this percentage in the cell labeled EY for
AA
EY
DT
PM
PWC
AA
(%)
EY
(%)
DT
(%)
PM
(%)
PWC
(%)
98.37
0.48
0.00
0.00
0.53
0.33
98.80
0.00
0.00
0.53
0.65
0.48
99.32
0.44
0.35
0.33
0.24
0.34
98.68
0.00
0.33
0.00
0.34
0.88
98.58
the row and DT for the column. We derive

these percentages as follows. During this
period, EYs clients made 418 decisions about
whether to remain with EY or switch to
another accounting firm. The clients decided
to remain with EY in 413 of these instances
(98.8 per cent), and to switch to DT in two of
these instances (0.48 per cent).
Estimated retention probabilities and

attractiveness parameters
From the matrix in Table I, we estimate the
parameters using the least squares
optimization procedure described in the
Appendix. We show the estimated retention
probabilities and attractiveness parameters,
the observed retention probabilities, and the
(observed and estimated) long-term audit
market shares in Table II. For example, the
estimated retention probability for EY is 98.9
per cent, which is very close to its observed
value of 98.8 per cent. The estimated
attractiveness parameter for EY is 0.194. The
attractiveness parameters reveal that EY has
greater ability to attract clients from
competitors than does either PM or DT, but
less ability than does either AA or PWC. Table
II also shows that EY has captured 23.07 per
cent of the S&P 500 firms, which equals the
market share estimated by the model because
of the constraints in the optimization step.
Estimated transition probabilities

We show the estimated transition
probabilities in Table III. We compute these
values using equation (1) in the Appendix by
substituting the estimated retention
probabilities and attractiveness parameters.
We observe that the estimated transition
probabilities in Table III are very close to the
observed values in Table I.
Estimates in the absence of Arthur

Andersen
Table IV shows the retention probabilities and
the rescaled attractiveness parameters in the
absence of AA, and Table V shows the
resulting matrix of transition probabilities. In
this matrix, the estimated retention
probabilities are on the main diagonal and
[ 571 ]

Thomas R. Sexton
Current accounting
market shares
18/6/7 [2003] 569-576
Table II
The observed and estimated retention probabilities, the estimated attractiveness parameters,
and the observed (and estimated long-term) market shares of the Big 5 accounting firms
Observed retention probability

Estimated retention probability
Estimated attractiveness parameter
Observed (and estimated long-term) market share
AA
EY
DT
PM
PWC
0.9837
0.9841
0.208
0.1689
0.9880
0.9890
0.194
0.2307
0.9932
0.9904
0.107
0.1634
0.9868
0.9863
0.120
0.1258
0.9858
0.9878
0.371
0.3113
Table III
AA
EY
DT
PM
PWC
AA
(%)
EY
(%)
DT
(%)
PM
(%)
PWC
(%)
98.41
0.28
0.22
0.32
0.40
0.39
98.90
0.21
0.30
0.38
0.22
0.15
99.04
0.17
0.21
0.24
0.16
0.13
98.63
0.23
0.74
0.51
0.40
0.58
98.78
Table IV
The estimated retention probabilities and the estimated attractiveness parameters of the
remaining Big 4 accounting firms in the absence of AA
Estimated retention probability

Estimated attractiveness parameter
EY
DT
PM
PWC
0.9890
0.244
0.9904
0.135
0.9863
0.152
0.9878
0.469
Table V
EY
DT
PM
PWC
EY
(%)
DT
(%)
PM
(%)
PWC
(%)
98.90
0.27
0.40
0.56
0.20
99.04
0.22
0.31
0.22
0.17
98.63
0.35
0.69
0.52
0.76
98.78
transition probabilities computed using

equation (1) in the Appendix are in all other
cells.
Table VI shows how the 73 S&P 500 clients
that have left AA since the Enron affair have
distributed themselves among the remaining
Big 4 firms. The table also shows the expected
number of AA clients that would have retained
each of the Big 4 firms, based on the
attractiveness parameters of the firms. A 2
test reveals that the observed and expected
numbers differ significantly (2 = 27.39, df = 3,

p-value < 0.000005). This indicates that DT
attracted significantly more of AAs S&P 500
clients than expected during the wave of recent
scandals, while PWC attracted significantly
fewer than expected. We see that EY and PM
have attracted roughly as many such firms as
predicted by their attractiveness parameters.
Table VII shows the current market shares
and the estimated and observed post-scandal
market shares in the first year without AA. By
assumption, the attractiveness parameter of a
remaining Big 4 accounting firm determines
its estimated post-scandal market share
increase had it been unaffected by its own
accounting difficulties. For example, PWC had
the largest attractiveness parameter and thus
would have received the largest post-scandal
increase in market share.
Table VIII shows current market shares,
estimated year-by-year market shares (for
Table VI
The observed and expected distributions among the remaining Big 4 firms of the 73 S&P 500
clients that have left AA since the Enron affair. A 2 test reveals that the observed and
expected numbers differ significantly
Observed number of clients attracted

Expected bumber of clients attracted
2 contribution
[ 572 ]
EY
DT
PM
PWC
Total
22
17.8
0.97
22
9.9
14.87
14
11.1
0.77
15
34.2
10.78
73
73
27.39

Thomas R. Sexton
Current accounting
market shares
Table VII
Current market shares and estimated and observed post-scandal market shares in the first year
without AA. Post-scandal increases in market share are shown in absolute and percentage
terms

18/6/7 [2003] 569-576
Current market shares

Estimated
Market shares in first year without AA
Post-scandal increase in market share
Post-scandal % increase in market share
Observed
Market shares in first year without AA
Post-scandal increase in market share
Post-scandal % increase in market share
AA
EY
DT
PM
PWC
0.169
0.231
0.163
0.126
0.311
0.272
0.041
17.7
0.186
0.023
14.1
0.151
0.025
19.8
0.390
0.079
25.4
0.279
0.048
20.8
0.220
0.057
34.8
0.154
0.028
22.1
0.347
0.036
11.7
Table VIII
Current market shares and estimated year-by-year (for selected years) and long-term market
shares following the demise of AA. Long-term increases in market share are shown in absolute
and percentage terms
Current market shares

Estimated market shares without AA
Year 1
Year 2
Year 3
Year 4
Year 5
Year 10
Year 15
Year 20
Long-term
Long-term increase in market share
Long-term % increase in market share
selected years), and estimated long-term
market shares following the demise of AA.
The values in Table VIII represent the
market shares that the remaining Big 4 firms
would have attained had all four been
unaffected by their own accounting
investigations. Therefore, these estimates
serve as future reference points for the Big 4
firms. For example, if a firms market share
in a future year is higher (lower) than its
estimated market share for that year, then
the firm can deduce that it fared better
(worse) than expected in the current turmoil.
We observe that the increases in long-term
market share among the remaining Big 4
accounting firms would have ranged from 3.4
per cent to 5.4 per cent, a relatively uniform
set of increases. Thus, we would not have
anticipated excessive long-term market share
concentration in any one of the remaining
Big 4 accounting firms.
Figure 2 shows what the market share
evolution of the Big 4 accounting firms would
have been over several decades in the
absence of AA. Following the post-scandal
AA
EY
DT
PM
PWC
0.169
0.231
0.163
0.126
0.311
0.272
0.272
0.273
0.273
0.273
0.274
0.276
0.277
0.285
0.054
23.4
0.186
0.187
0.187
0.187
0.187
0.189
0.190
0.191
0.209
0.046
28.2
0.151
0.152
0.152
0.152
0.152
0.153
0.154
0.155
0.160
0.034
27.0
0.390
0.390
0.389
0.388
0.387
0.384
0.380
0.377
0.347
0.036
11.6
increase, the market share of a firm drifts

slowly toward its long-term value. We
consider these drifts to be of no practical
importance for three of the remaining Big 4
accounting firms. Only PWC experiences a
drop in market share of 0.044 following its
post-scandal increase of 0.079.
We observe in Figure 3 that the increase in
the long-term market share of a remaining
Big 4 accounting firm is loosely associated
with the firms estimated retention
probability. This is consistent with the
commonly held view that a business
maintains its market share more readily by
retaining its existing customers rather than
attracting customers from its competitors.
Conclusions
Based on observed post-scandal shifts in
market shares immediately following the
demise of AA, DT appears to have weathered
the current scandals better than expected
while PWC has been hurt more than
[ 573 ]

Thomas R. Sexton
Current accounting
market shares
Figure 2
Evolution of market shares of the Big 5 accounting firms in the absence of AA in 2003 and
beyond, using estimated post-scandal market shares and assuming that the other four
accounting firms remained unaffected by their own accounting investigations

18/6/7 [2003] 569-576
Figure 3
Long-term increases in market share versus estimated retention probability for the remaining
Big 4 accounting firms
[ 574 ]

Thomas R. Sexton
Current accounting
market shares
18/6/7 [2003] 569-576
expected. The observed market share effects

on EY and PM are nearly equal to those
expected by the model.
Based on our model, in the absence of AA,
PWC would have experienced the greatest
post-scandal gain in market share because of
its high attractiveness parameter. However,
EY would have eventually benefited from the
greatest long-term gain because of its high
retention probability. However, as Figure 2
shows, because market shares drift slowly
following their post-scandal increases, it
would have taken until the year 2058 before
EYs market share gain would have equaled
that of PWC.
Our model illustrates that long-term gains
in market share depend on the ability of the
accounting firm to retain its audit clients.
The observed retention probabilities of the
Big 5 accounting firms are uniformly high,
ranging from 98.37 per cent to 99.32 per cent.
On the other hand, the attractiveness
parameters of these firms vary considerably,
from 0.107 to 0.371 (before the absence of AA).
This suggests that S&P 500 firms tend to
remain with their accounting firm for long
periods but, when they switch, certain of the
Big 5 accounting firms are considerably more
attractive than others. The variation in
attractiveness parameters leads to variation
in post-scandal market share increases, but
long-term market shares depend more on
retention probabilities than on
attractiveness. In other words, when a large
number of S&P 500 firms are seeking new
auditors, the more attractive Big 5
accounting firms will experience the largest
post-scandal market share increases.
However, over time, the Big 5 accounting
firms with greater ability to retain their
audit clients are more likely to achieve the
larger long-term market share gains. We note
that, while retention rates have been very
high in the past, the current environment
may cause client firms to become less
reluctant to switch auditors, resulting in
lower retention probabilities in the future.
Certain regulatory policies such as
mandatory auditor rotation would greatly
increase the frequency with which client
firms change auditors. Comunale and Sexton
(2002) extend the current Markov model to
assess the effects of mandatory auditor
rotation and retention on market share. They
find that under mandatory auditor rotation,
the long-term market share of any given
accounting firm would depend most heavily
on its ability to attract new clients. As a
result, accounting firms would be likely to
shift resources to expand their marketing
efforts possibly endangering audit quality.
Finally, the absence of AA alone will not

lead to excessive market share concentration
within the remaining Big 4 accounting firms
among the S&P 500 firms. Analysts often use
the Gini coefficient to measure market share
concentration in an industry. We compute
the Gini coefficient using the following
formula:
n
X
market share2j ;
Gina coefficient 1
j1
where n is the number of firms in the

industry. Complete market concentration
occurs, as a limiting case, when one firm has
a 100 per cent market share and all the other
firms have 0 per cent market shares. In this
situation, the Gini coefficient equals 0. In the
absence of market concentration, all n firms
have equal market share and the Gini
coefficient attains its largest value 1 1=n.
The Gini coefficient for the Big 5
accounting firms (among the S&P 500 firms)
before the accounting scandals equals 0.779,
which is 97.4 per cent of its maximum value
1 1=5 0:8. This suggests that there was
very little market concentration among the
Big 5 firms. In the first year without AA, the
Gini coefficient for the observed market
shares is 0.730, which is 97.3 per cent of its
maximum value 1 1=4 0:75. Thus, we see
that the observed post-scandal shifts in
market shares have resulted in essentially
the same market share concentration as that
which existed before the scandals.
In the first year without AA, if all the other
Big 4 firms had remained untouched by the
scandals, the Gini coefficient would have
been 0.717, which is 95.5 per cent of its
maximum value 1 1=4 0:75. Thus, the
model indicates that a slight increase in
market concentration would have occurred
in the first year without AA had the other Big
4 firms remained untouched. However, in the
long-term, the model indicates that the Gini
coefficient would have equaled 0.729, which
is 97.2 per cent of its maximum value
1 1=4 0:75, and which is almost identical
to the current percentage. Thus, market
share concentration would have returned
eventually to its current level.
Note
1 Before July 1, 1998, when Price Waterhouse
(PW) merged with Coopers & Lybrand (CL),
we treated the two separate firms as if they
were one. Specifically, if a client remained
with either PW or with CL, or switched
between PW and CL, we counted that as an
occurrence of client retention for PWC. If a
client firm switched auditors from one of the
other four accounting firms to either PW or
CL, we counted that as an occurrence of client
[ 575 ]

Thomas R. Sexton
Current accounting
market shares
18/6/7 [2003] 569-576
attraction for PWC. During the pre-merger

period, two client firms left CL for PWC and
one firm left PWC for CL, resulting in a net
change of only one client firm transition.
Reference
Comunale, C.L. and Sexton, T.R. (2002), The
impact of mandatory auditor rotation and
retention on the market shares of the Big 5
accounting firms, paper presented at the
2002 American Accounting Association
Annual and Northeast Regional Meetings.
Appendix
We construct a Markov model that depicts
the movements of a client firm among the set
of Big 5 accounting firms. We have five states
in our model, one for each of the Big 5
accounting firms. While we restrict our
analysis to client firms listed on the S&P 500,
the model is equally applicable to any client
firm if we expand the state space to include
all auditors that the client might retain. In
any given year, the client firm retains one of
the accounting firms for audit purposes.
Suppose the selected accounting firm is
represented by state i. In the next year, the
client may remain with accounting firm i,
with probability pii , or may switch to
accounting firm j, with probability pij .
Consistent with standard Markov model
axioms, we assume that these probabilities
are the same for all client firms and that they
remain constant over time.
Let P pij denote the 5 5 matrix of
transition probabilities. Clearly, our model is
ergodic, meaning that the client firm can
move from any accounting firm to any other
in a finite number of transitions. Thus, we
know that there exists a 1 5 vector j
of steady-state probabilities that are
independent of the initial state of the client
firm. The steady-state probability j is the
asymptotic probability that the client firm
will retain accounting firm j in any year.
Therefore, we can interpret the steady-state
probability j as the long-term market share
of accounting firm j. We compute the
steady-state vector as the first row of the
matrix M 1 , where M is the matrix P I with
the first column replaced by all 1s, and where
the matrix I is the 5 5 identity matrix.
We model the transition probabilities
as follows:
[ 576 ]

pij
ri ;
ij
P
1 ri Aj = k6i Ak ; i
6 j
where we define the parameters ri and Ai as

the retention probability and the
attractiveness parameter of accounting firm
i, respectively. The retention probability of
accounting firm i is the likelihood that a
client firm will remain with accounting firm
i in the next year given that it retained
accounting firm i in the current year. The
attractiveness parameter of accounting firm i
is a measure of its ability to recruit a client
firm from another accounting firm given that
the client firm has decided to change
accounting firms.
We restrict the attractiveness parameters
to sum to 1 so that the denominator of pij for
i 6 j represents the sum of the attractiveness
parameters of all accounting firms except i.
Thus, the ratio Aj =1 Ai represents the
probability that a client firm leaving
accounting firm i will move to accounting
firm j. Then, for i 6 j, pij equals this
conditional probability multiplied by the
probability 1 ri that the client firm leaves
accounting firm i.
We estimate the retention and
attractiveness parameters by determining
the values of ri and Ai that minimize the sum
of the squared differences between the
observed transition probabilities and the
estimated transition probabilities computed
using (1). We perform this minimization
subject to the constraints that the estimated
transition probabilities produced market
shares equal to the observed market shares.
In addition, we require that the retention
probabilities lie between zero and one, and
that the attractiveness parameters sum to
one. Thus, we use the Solver add-in in
Microsoft Excel to solve
(
5 X
5
X
pij p^ij 2 jj ^j ; j 1; . . . ; 5;
minri ; Ai
i1 j1
0 ri 1; i 1; . . . ; 5;
5
X
)
Aj 1
j1
The resulting retention probabilities and

attractiveness parameters thus produce an
estimated transition matrix that is as close as
possible to the observed transition matrix
while producing identical market shares for
all five accounting firms.
The efficacy of liquidation and bankruptcy prediction

models for assessing going concern
Nirosh Kuruppu
Lincoln University, Canterbury, New Zealand
Fawzi Laswad
Massey University, Palmerston North, New Zealand
Peter Oyelere
Lincoln University, Canterbury, New Zealand
Keywords
Going concern value, Liquidation,
Bankruptcy, Insolvency,
Corporate finances
Abstract
Recent research questions
whether bankruptcy is the best
proxy for assessing going concern
since filing for bankruptcy is not
synonymous with the invalidity of
the going concern assumption.
Furthermore, in contrast to debtororiented countries such as the
USA, liquidation is the most likely
outcome of corporate insolvency in
creditor-oriented countries such as
the UK, Germany, Australia and
New Zealand. This suggests that
bankruptcy prediction models have
limited use for assessing going
concern in creditor-oriented
countries. This study examines the
efficacy of a corporate liquidation
model and a benchmark
bankruptcy prediction model for
assessing company liquidation. It
finds that the former is more
accurate in predicting company
liquidations in comparison with the
latter. Most importantly, Type 1
errors for the liquidation prediction
model are significantly lower than
for the bankruptcy prediction
model, which indicates its greater
efficacy as an analytical tool for
assessing going concern. The
results also suggest that
bankruptcy prediction models
might not be appropriate for
assessing going concern in
countries where the insolvency
code is creditor-oriented.

18/6/7 [2003] 577-590
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482713]
The purpose of this article is to examine the

efficacy of statistical corporate liquidation
prediction models for assessing client going
concern status. Previous research shows that
statistical bankruptcy prediction models
consistently outperform auditors going
concern judgement in discriminating
between bankrupt and non-bankrupt
companies (Levitan and Knoblett, 1985;
Cormier et al., 1995; Grant et al., 1998).
However, research also questions whether
corporate bankruptcy is the best proxy for
the assessment of going concern since filing
for bankruptcy is not synonymous with the
invalidity of the going concern assumption
(Shultz, 1995; Casterella et al., 2000).
Indeed, in countries such as the USA where
the insolvency laws are debtor-oriented,
corporate bankruptcy procedures encourage
companies in financial difficulty to continue
as going concerns (Franks et al., 1996).
Therefore it is possible for companies that
file for bankruptcy to reorganise and emerge
from bankruptcy, or to merge with another
entity as a going concern (Shultz, 1995). This
is in contrast to the insolvency procedures in
creditor-oriented countries such as the UK,
Germany, Australia and New Zealand where
liquidation is the most common outcome of
corporate insolvency (Kaiser, 1996; Franks
et al., 1996). The costs of corporate liquidation
also exceed the cost of bankruptcy to
shareholders and to other stakeholders
(Alderson and Betker, 1996; 1999). Moreover,
companies in debtor-oriented countries may
also choose to file for bankruptcy for
strategic reasons other than financial
distress, such as to avoid an unprofitable
contract (Kennedy and Shaw, 1991;
Chatterjee et al., 1996; Franks et al., 1996).
These arguments suggest that a bankruptcy
prediction model might not be the best proxy

for assessing going concern, especially in
creditor-oriented countries.
This study examines the efficacy of a
statistical model to predict company
liquidation, which is a better proxy for
assessing the validity of the going concern
assumption than bankruptcy prediction
models used in previous research. Given the
differences in debtor- and creditor-oriented
insolvency frameworks, the results can assist
auditors in choosing appropriate business
failure prediction models as an analytical
technique for assessing going concern.
The study develops a liquidation
prediction model from a sample of 135 New
Zealand Stock Exchange listed companies
and analyses its classification accuracy in
terms of Type 1 and Type 2 errors, and
compares it to a benchmark bankruptcy
prediction model which has been used to
benchmark the performance of newly
developed corporate failure models. The
results indicate that the Type 1 errors for the
liquidation prediction model are
significantly lower than for the bankruptcy
prediction model. Given the high costs
associated with misclassifying failing
companies, it suggests that the liquidation
prediction model can be used as a valuable
audit tool for assessing going concern. The
high accuracy of the liquidation prediction
model also raises the implications of using
bankruptcy prediction models in countries
where the insolvency framework is creditororiented.
The remainder of the article is structured
as follows. Section 2 examines the
importance of the going concern concept in
auditing and the requirements of the current
auditing standards on going concern.
Section 3 examines the usefulness of
corporate distress models as an analytical
procedure for assessing going concern, and

1. Introduction
[ 577 ]
Nirosh Kuruppu, Fawzi Laswad

and Peter Oyelere
for assessing going concern
18/6/7 [2003] 577-590
discusses prior research in the area. Section

4 describes the research objective and
hypotheses, followed by a description of the
research design in Section 5. The data
analysis and results are presented in
Section 6, while Section 7 concludes the paper
with the main findings and opportunities for
further research.
2. The going concern concept in

auditing
The going concern assumption has been
recognised as one of the main concepts
underlying financial reporting, which
justifies accounting practices such as period
reporting, accrual accounting and asset
valuation (Boritz and Kralitz, 1987; Barnes
and Huan, 1993; International Federation of
Accountants, 2000). The going concern
concept assumes that the reporting entity
will continue in operation for the foreseeable
future, and that it will be able to realise
assets and discharge financial obligations in
the normal course of operations. If the going
concern assumption were to become invalid,
both the period reporting and accrual
concepts will also lose their relevance since
defining assets as future economic benefits
then becomes erroneous (Boritz and Kralitz,
1987). The traditional valuation of assets also
loses its relevance since the realisation of
assets at their reported value in the balance
sheet becomes uncertain (Boritz and Kralitz,
1987). Furthermore, the classification of
assets and liabilities into current and
non-current categories in the balance sheet
would also become meaningless.
Even though the going concern assumption
is a fundamental concept in financial
reporting, there has been little professional
guidance on assessing going concern prior to
the issuance of SAS 34 in the USA in 1981
(Johnson and Khurana, 1993; Guy and
Carmichael, 2000). The development of SAS
34 was motivated by the dissatisfaction with
auditors over the many company failures
that occurred soon after the issuance of an
unqualified audit report (Guy and
Carmichael, 2000). The aim of this auditing
standard was to bridge the publics
expectation gap that auditors should be held
responsible for disclosing going concern
uncertainties (Guy and Carmichael, 2000).
Other countries have since then followed suit
to issue their own auditing standards on
going concern such as SAS 130 in the UK,
AUS 708 in Australia and AS 520 in New
Zealand (Cormier et al., 1995; Loftus and
Miller, 2000).
[ 578 ]
The early auditing standards on going

concern, including SAS 34, only required a
passive approach to assessing going concern
(Asare, 1990). For instance, it was only when
matters indicating going concern issues were
detected during the course of an audit that
the auditor was required to search for more
evidence supporting or refuting the going
concern assumption. Subsequent revisions of
auditing standards on going concern have
increased in scope to minimise the
expectations gap between the financial
statement users and auditors (Geiger et al.,
1998). Current auditing standards on going
concern now require the auditor to actively
seek out circumstances that may negate the
validity of the going concern assumption.
Table I summarises the main requirements
of auditing standards on going concern in the
USA, the UK, Australia, New Zealand and
international auditing standards.
Table I shows that auditors are required to
perform procedures designed specifically to
identify going concern uncertainties.
Furthermore, since the use of analytical
procedures is mandatory in all the countries
referred to above, for example SAS 56, AUS
512 and AS 504, auditing standards are
already in place to accommodate statistical
models as an integral part of the review
process.
3. The relevance of statistical

models for assessing going concern
3.1 Introduction
The link between going concern and
bankruptcy is recognised in the accounting
and auditing literature (Blocher and
Loebbecke, 1993; Koh and Brown, 1991; Loftus
and Miller, 2000). Due to the perceived
expectations gap between auditors and
financial statement users who place greater
responsibility on the auditor for disclosing
going concern uncertainties, statistical
corporate failure models are seen as a tool
that could assist auditors in making more
accurate going concern judgements (Levitan
and Knoblett, 1985; Asare, 1990; Louwers
et al., 1999). The potential usefulness of
statistical models for assessing going concern
has been recognised in the expectations gap
literature since the late 1970s, when the
Cohen commissions report (1978) on auditor
responsibilities first suggested their use as a
means toward reducing the expectations gap
(Altman, 1983; Levitan and Knoblett, 1985;
Asare, 1990). More recently, the AICPA (1993)
in the USA has also recognised the publics
demand for an early warning system of

and Peter Oyelere
18/6/7 [2003] 577-590
corporate failure (Loftus and Miller, 2000;

Dunn et al., 2002).
Previous research shows objective
statistical models to outperform auditors in
assessing company failure (Cormier et al.,
1995; Grant et al., 1998). One of the best known
corporate failure models is Altmans ZETA
bankruptcy prediction model which is used
by over 80 commercial clients (Loftus and
Miller, 2000). Such models can help auditors
in forming more accurate assessments of
clients going concern status, and thereby
help reduce the costs associated with
inappropriate audit opinions such as
litigation from shareholders, loss of clients
and the loss of professional reputation (Koh,
1991; Carcello and Palmrose, 1994, Grant et al.,
1998).
Koh and Brown (1991) assert that an
accurate corporate distress model can help
the auditor identify high-risk companies in
the planning stages of the audit. This helps
the auditor in planning specific audit
procedures aimed at assessing the
appropriateness of the going concern
assumption (Koh and Brown, 1991).
Statistical models developed from probit and
logit analyses, which are types of conditional
probability model, also provide an objective
assessment of the probability of the client
failing. A high probability of failure alerts
the auditor to the need to apply a more
rigorous audit assessment than he or she
might have in the absence of this
information.
In the final stages of the audit, a corporate
distress model can be used to verify that the
overall audit opinion in relation to going

concern is appropriate for the clients
financial statements (Chen and Church,
1992). In the event that an adverse or
qualified opinion is rendered, an objective
statistical model can more readily help the
auditor in justifying the decision to
interested parties (Koh and Oliga, 1990; Chen
and Church, 1992).
Furthermore, statistical evidence is
accepted as evidence in court (Finkelstein
and Levin, 1990; Anderson et al., 1995; Lowe
et al., 2002). This allows an objective model to
be used as a defence in court cases claiming
audit failure (Wallace, 1983; Anderson et al.,
1995; Lowe et al., 2002). A model that can
assist auditors in minimising the risk of
client misclassification can lessen the risks
of litigation, which might subsequently filter
down to clients in the form of lower audit
fees. In the USA, for example, approximately
9 percent of auditor revenues are spent on
defending lawsuits (Grant et al., 1998).
Due to the usefulness of statistical
corporate failure models described above,
auditing standards such as in Australia
already recognise statistical models. The
Australian standard on Analytical
Procedures (AUS 512) with reference to AUS
708 on going concern draws the auditors
attention to financial models developed from
probit and discriminant analysis for
assessing going concern. The Proceedings of
the Expectations Gap Roundtable in the
United States (1993) has also called for
continued research into the effectiveness of
analytical procedures, and it has identified
Table I
Evaluation required by auditing standards on going concern
Country
Standard
Evaluation required
Audit period
USA
SAS 59 (SAS 34
was superseded by
SAS 59)
Specifically form an opinion on the going concern

assumption from the results of usual audit
procedures
Not to exceed one year from the date of the

financial statements being audited
UK
SAS 130
Plan and perform procedures specifically

designed to identify going concern uncertainties
(s21)
Not specifically defined or elaborated (s9), but

likely to be the period that management has
considered in assessing going concern s21[ii])
Australia
AUS 708
Auditor must obtain evidence that the going

concern assumption is appropriate (s10)
Must specifically assess going concern problems
as part of the audit planning process (s17)
One year (s4)
New Zealand
AS 520
Obtain audit evidence that the going concern

assumption is appropriate (s27)
Plan and perform specific procedures to identify
going concern uncertainties (s8a, 30)
One year (s25)
IAS (IFAC)
ISA 570
Auditor should consider the appropriateness of

the going concern assumption when planning and
performing audit procedures and in evaluating
their results (s2, s11, s12, s17)
One year (s18, s19)
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18/6/7 [2003] 577-590
the use of bankruptcy prediction models for

assumption (Blocher and Loebbecke, 1993).
The ability of corporate failure models to
provide objective evidence for making a
going concern judgement is also recognised
by accounting practitioners (Constable and
Woodliff, 1994).
3.2 Review of empirical findings

The pioneering work of Beaver (1966) and
Altman (1968) developed the first bankruptcy
prediction models using univariate and
multivariate approaches respectively, from
US company data. Following these early
studies, other researchers have applied
similar methodologies for development of
corporate failure models in other countries,
such as Taffler (1982) for the UK and Izan
(1984) for Australia.
Although a large number of bankruptcy
studies have been conducted, only a limited
number of studies have examined the
usefulness of corporate failure models for
assessing going concern. The seminal work
by Altman and McGough (1974) first
suggested the usefulness of bankruptcy
prediction models for assessing company
going concern status. Altman and McGough
(1974) found that their model was 82 percent
successful in predicting bankruptcy filings
when compared with auditors going concern
assessment of 46 percent accuracy. These
results were re-affirmed in a later study by
Altman (1983) where the models average
success in predicting bankruptcy was 86
percent compared to auditors 48 percent.
Table II provides a summary of empirical
studies. Most of the studies that followed the
early work of Altman and McGough (1974)
are similar in design, except that they were
applied to different samples and sample
periods, and examined bankrupt companies.
These include Levitan and Knoblett (1985),
Mutchler (1985), Koh and Killough (1990), Koh
and Brown (1991) and Cormier et al. (1995)
who developed bankruptcy prediction models
to predict company failure[1]. These studies
examined the usefulness of bankruptcy
prediction models for assessing going
concern by comparing the accuracy of the
developed models to auditors going concern
qualifications issued prior to bankruptcy.
The developed models were found to be more
accurate when compared with auditors prior
audit opinions.
The findings of the empirical studies
summarised in Table II indicate that
statistical models could assist auditors in
forming more accurate going concern
judgements. This would assist the accounting
profession in reducing the publics
[ 580 ]
expectations gap of the profession, and in

increasing the publics confidence in the
audit function.
However, even though prior research has
found bankruptcy prediction models to be
useful for assessing going concern, recent
research suggests that bankruptcy prediction
models might not be the best proxy for
assessing going concern, especially in
creditor-oriented countries, where
liquidation is the likely outcome of corporate
insolvency (Kaiser, 1996; Franks et al., 1996).
Furthermore, recent research also argues
that a bankrupt company can be regarded as
a going concern until the resolution of
bankruptcy, and that company bankruptcy is
less costly compared to company liquidation
(Shultz, 1995; Alderson and Betker, 1996;
Franks et al., 1996; Casterella et al., 2000).
Indeed, Alderson and Betker (1996) show that
the loss of going concern value forms the
largest component of liquidation cost at 32
percent of corporate value. Furthermore,
more than 50 percent of companies that
re-emerge from bankruptcy generate a return
that exceeds the return available on
benchmark portfolios, indicating that
corporate bankruptcy is not as costly as
liquidation to shareholders and to other
stakeholders (Alderson and Betker, 1996;
1999).
These findings suggests that inappropriate
audit opinions issued to liquidated
companies are more costly than
inappropriate opinions issued to companies
which emerge from bankruptcy as going
concerns. This distinction between bankrupt
and liquidated companies suggests that
company liquidation is a better proxy for
assessing clients going concern status in
statistical business continuity models.
4. Research objective and

hypotheses
The objective of this study, therefore, is to
examine the efficacy of a business continuity
model to predict company liquidation. It is
argued that liquidation is the better proxy for
assumption than bankruptcy prediction
models used in previous research. To achieve
this objective, three hypotheses are tested.
H1. A liquidation prediction model
outperforms a benchmark bankruptcy
prediction model in discriminating
between liquidated and continuing
companies.
This hypothesis examines whether a
liquidation prediction model is a better
predictor of company liquidation than a
Place
USA
USA
USA
USA
USA
Study
Altman and McGough

(1974)
Altman (1983)
Levitan and Knoblett

(1985)
Mutchler (1985)
Koh and Killough

(1990)
Definition of company failure
35 failed; 35 non-failed
companies
119 going concern qualified;

119 non-going concern
modified companies
companies
40 failed companies
Model was able to predict the GC

opinion 83 per cent of the time
Model and auditors have similar

accuracy for non-failed companies
(88.6 per cent and 88.86 per cent
respectively)
Model accuracy strongly
outperforms auditors for failed
companies (78.57 per cent to only
21.43 per cent by auditors)
MDA
Receipt of going concern

qualification
Companies reported as failed MDA

by the Wall Street Journal Index.
No further details are provided
One year prior to bankruptcy, model

84 per cent accurate compared to
auditors 66 per cent accuracy
Three year model average is 67 per
cent compared to auditors 33 per
cent
MDA
MDA
Model accuracy 82 per cent

compared to auditors 46 per cent
accuracy
Average bankruptcy model accuracy
86.2 per cent compared to auditors
48.1 per cent accuracy
Findings
Bankruptcy
Bankruptcy
MDA
Method
(continued)
Asserts that future research could

provide auditors with more
sophisticated and accurate models
problems
Urges more studies into the overall

function of the audit opinion since
the majority of these opinions could
be predicted by publicly available
information
Model accuracy is a better predictor

of bankruptcy when compared to
auditors opinion
Auditors should examine analytical

methods which can assist in the
going concern context
Bankruptcy prediction models can be

useful to auditors
Conclusions

18/6/7 [2003] 577-590
33 bankrupt; 33 non-bankrupt Bankruptcy

companies
Sample
Table II
Studies applying bankruptcy prediction models for assessing going concern

and Peter Oyelere
[ 581 ]
[ 582 ]
Canada 138 failed; 112 non-failed

companies
Cormier et al. (1995)

Annual stock return less than
50 per cent
Bankruptcy
Definition of company failure
Conclusions
Models developed in this study can

be compared with current practice in
accounting firms. From this exercise,
better specified models can be
developed
Suggests the model as a useful audit

Model predicted 82.50 per cent of
non-going concerns and 100 per cent tool
of going concerns yielding an
average success rate of 91.25 per
cent. Auditors average success rate
was 68.75 per cent, with a 40 per
cent success rate for failed
companies
Findings
Logit, MDA and Classification rates for failed

companies using logit, MDA and RP
Recursive
partitioning (RP) respectively: 76.08 per cent, 81.88
per cent, 70.3 per cent
Auditors accuracy was not
compared in this study
Probit
Method

18/6/7 [2003] 577-590
companies
USA
Koh and Brown (1991)
Sample
Place
Study
Table II

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18/6/7 [2003] 577-590
benchmark bankruptcy prediction model.

Altmans Z-score bankruptcy prediction
model is used for the comparison since it is
frequently used to benchmark the
performance of newly developed bankruptcy
prediction models (Holmen, 1988; Eidleman,
1995, Dunn et al., 2002). Furthermore, it is a
tried and tested model that has been used in a
number of different countries across various
industry settings, and it has been even found
to outperform country specific corporate
failure models (Holmen, 1988; Eidleman,
1995).
H2. Type 1 errors are lower for the
liquidation prediction model compared
to the benchmark bankruptcy
companies.
A Type 1 error is misclassifying a failed
company as non-failed. Prior research
indicates that Type 1 errors are costliest to
auditors, where it would lead to the possible
loss of audit fee, professional reputation and
litigation from shareholders (Koh, 1991;
Carcello and Palmrose, 1994; Geiger et al.,
1998). This indicates that for a corporate
failure model to be an effective analytical
technique for assessing going concern, it has
to be highly accurate in predicting failing
companies. This hypothesis identifies the
errors of misclassifying a failed company as a
non-failed company for the developed
liquidation prediction model and the
benchmark bankruptcy prediction model.
H3. Type 2 errors are lower for the
liquidation prediction model compared
to the benchmark bankruptcy
companies.
A Type 2 error is misclassifying a healthy
company as failed, and the costs of Type 2
errors include the loss of professional
reputation, loss of audit fee, and the client
companys actual demise due to the
inappropriate audit opinion (Geiger et al.,
1998; Louwers et al., 1999). This hypothesis
assesses the difference in accuracy between
the liquidation prediction model and the
benchmark bankruptcy prediction model in
misclassifying non-failed companies. The
next section describes the research design
followed to test the above hypotheses.
5. Research design
5.1 Sample selection and variables
The first stage in testing the developed
hypotheses requires the development of a
liquidation prediction model for New

Zealand companies. Most prior studies on
bankruptcy prediction were able to use
online databases such as Compact Disclosure
and NAARS to obtain the required data for
model development. New Zealand has no
such online database of failed company
financial data which makes the data
collection more difficult.
However, a large number of listed
companies failed in the years following the
stock market crash of 1987 which enables the
researcher to obtain a sufficiently large
number of failed companies. Therefore, to
enable the development of a liquidation
prediction model for New Zealand, listed
companies that were liquidated and struck
off from the Companies Register from
1987-1993 were identified from the Companies
Office database. This process identified 85
liquidated companies. A further group of 50
continuing companies that delisted during
the same period were also selected to
represent companies which are going
concerns, but which are not in sound
financial health (Zhang and Harrold, 1997;
Nasir et al., 2000). Since auditors are more
likely to issue a going concern qualification
to companies in financial stress, a model that
can discriminate between failed and other
stressed companies is argued to be especially
useful (Foster et al., 1998). Companies in the
financial and property sectors were excluded
from the sample due to significant industry
differences (Grant et al., 1998). This resulted
in a total sample size of 135 companies, which
is a significantly large sample relative to the
number of companies listed on the New
Zealand Stock Exchange.
The financial statement data for the
identified sample were then manually
obtained from the various archives of New
Zealand universities and national libraries.
For each company, 174 individual pieces of
data were entered, which resulted in over
23,000 entries.
The financial statement data collated from
the sample companies were used to derive 63
explanatory variables for the prediction
model. This includes variables found to be
useful in prior studies and additional
variables not used in prior corporate failure
studies. The new variables were identified as
potentially useful variables for corporate
failure prediction by examining the
literature on financial statement analysis
(Ketz et al., 1990; Woelfel, 1994; Bertoneche
and Knight, 2001). These new variables
include ratios calculated from total tangible
assets, interest coverage, working capital
turnover, asset turnover ratios and the audit
report lag, among others. The dependent
[ 583 ]

and Peter Oyelere
variable was coded as a binary variable,

where 1 is defined as a failure and 0 is defined
as a non-failure.

18/6/7 [2003] 577-590
5.2 Statistical modelling approach
[ 584 ]
Multiple discriminant analysis (MDA) is

used to develop the liquidation prediction
model since it is proven to be robust in
bankruptcy prediction and there is no
significant difference in accuracy between
MDA models and logit/probit analyses
(Collins and Green, 1982; Cormier et al., 1995;
Allen and Chung, 1998). Furthermore,
preliminary data analysis using both these
methods on the New Zealand sample
identified the MDA model as having greater
accuracy in predicting company liquidation
when compared with a logit model developed
from the same data.
Prior studies using multiple discriminant
analysis (MDA) have often used a sample
matching approach, for example, by
matching failed and non-failed companies by
industry. However, this approach is not
necessary since discriminant analysis
optimally classifies between the two given
sample groups. Lau (1987) and Gilbert et al.
(1990) have used this approach. Furthermore,
due to the relatively small New Zealand
sample size compared to overseas studies it is
difficult to obtain a sufficiently large number
of failed companies if sample matching is
used.
Prior studies have also used equal group
sizes when analysing the discriminant
function that maximally discriminates
between the two groups. However,
discriminant analysis does not require equal
group sizes since prior probabilities can be
computed from the individual samples by
weighing (George and Mallery, 2001). Hence,
in this study, prior probabilities of group
membership are calculated from the failed
and non-failed sample sizes.
The discriminant function that maximally
discriminates between the sample groups can
be derived from either stepwise or
simultaneous estimation (Hair et al., 1995;
George and Mallery, 2001). The stepwise
procedure is often used in preference to
simultaneous estimation because in practice,
the stepwise discriminant procedure
performs better than when all the variables
are simultaneously entered into the
discriminant function (George and Mallery,
2001). This was confirmed during
preliminary analysis on the New Zealand
sample using both simultaneous and
stepwise methods. Consequently, the
liquidation model in this study is derived by
the Wilks lambda () stepwise method. This
procedure uses the 63 variables for the 135
companies in an iterative process to retain

the most significant variables in a
discriminant function that maximally
discriminates between the two sample
groups by minimising the Wilks at each
step of variable entry.
5.3 Model validation, predictive accuracy

and hypotheses testing
The developed model can be validated by one
of two main methods, namely by using a
holdout sample or the Lachenbruch
procedure (Jones, 1987; Hair et al., 1995). The
former method entails applying the
developed model to a new sample of
companies not used to derive the model. The
Lachenbruch procedure develops a model
from n 1 observations, and applies it to the
observation not used in developing the
model. This is repeated until all the firms in
the sample are used to assess the models
accuracy. Most importantly, the
Lachenbruch method provides an unbiased
estimate of the misclassification rate (Afifi
and Clark, 1984; Jones, 1987; Hair et al., 1995).
Since the entire sample can be used for crossvalidation, this method is particularly useful
in the corporate failure setting due to the
generally small[2] sample sizes available.
Therefore, due to the suitability of the
Lachenbruch method in this context, given
the relatively small sample size that can be
used in New Zealand, it is used to
cross-validate the discriminant function.
Following on from model validation is the
important question of classification accuracy
(Hair et al., 1995). Although model validation
by the Lachenbruch method provides an
unbiased estimate of the misclassification
rate, it does not indicate how significant the
classification accuracy is compared to
chance. If the classification accuracy is
greater than what can be expected by chance,
it indicates that the developed model is useful
(Hair et al., 1995). Therefore, the significance
of the developed models classification
accuracy is examined by the proportional
chance criterion and Presss Q statistic,
which are tests of the models accuracy
against what can be expected from a chance
model (Hair et al., 1995).
Finally, the hypotheses are tested by
comparing the developed models accuracy
from the Lachenbruch cross-validation
method to Altmans Z-score bankruptcy
prediction model that is also applied to the
sample of companies used to develop the New
Zealand model. Owing to the lack of market
value information, Altmans modified Zscore model is used with adjusted coefficients
(Eidleman, 1995).

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18/6/7 [2003] 577-590
6. Data analysis and results

6.1 The model
The summary discriminant analysis results
are shown in Table III. The discriminant
analysis on the sample of New Zealand
companies using the 63 independent
variables with the stepwise methodology
results in a 12 variable discriminant
function. These 12 variables coincidently
form the optimum discriminant function that
maximally discriminates between the failed
and non-failed company groups. Out of the 12
variables found to be significant (p < 0.05),
only three are common to prior studies.
These are the current assets/current
liabilities, total sales/average total assets and
total liabilities/total assets ratios. The
remaining eight ratios have not been found
to be significant in previous bankruptcy
prediction research and are therefore unique
to this study.
The tolerances for the model at the final
step of variable entry are all above 0.001
indicating that the variables in the
discriminant function are not highly
dependent or correlated with other variables
in the function. The canonical correlation is
54.5 percent and 100 percent of the variance is
explained by the discriminant function. A
high Chi-square value which is statistically
significant at p < 0.05 indicates that the
discriminant function classifies well.
Table IV shows the results of the Lachenbruch
cross-validation procedure. Lachenbruch
cross-validation involves developing a

discriminant function from all companies in
the sample except for one that used to validate
the function. This procedure is repeated until
all the companies in the sample have been
used as a held-out company. The Lachenbruch
classification results show that 36 percent of
non-failed companies and 92 percent of failed
companies are correctly identified. This is a
robust performance given that the function
correctly classified 38 percent and 92 percent
respectively for the original cases. The model
has a Type 1 error of only 8 percent and a Type
2 error of 64 percent. The very high accuracy
for predicting failed companies and lesser
accuracy for non-failed companies is
consistent with prior research (Mutchler,
1985; Koh and Killough, 1990; Morris, 1997).
Since Type 1 errors are argued to be the most
costly to auditors, the models Type 1 error
rate of only 8 percent shows its usefulness as
an analytical technique for assessing going
concern.
The tests of predictive accuracy further
show that the models classification accuracy
significantly exceeds what a chance model
would expect. Specifically, the model has an
overall cross-validated accuracy of 71.1
percent, when the proportional chance
criterion only expects 53.4 percent accuracy.
The Presss Q statistic also exceeds the critical
chi-square value of 6.63 at one degree of
freedom, which indicates that the models
predictions is significantly better
than chance.
Table III
Discriminant function summary statistics
Step
Entered variable
1
2
3
4
5
6
7
8
9
10
11
12
Total sales/total tangible assets

Quick assets/total assets
Current assets/current liabilities
Total sales/average total assets
Net income/average total assets
Total liabilities/total assets
Net income/shareholders funds
Working capital/total sales
Sales/average accounts receivable
Sales/average working capital
Net income/total liabilities
Shareholders funds/total assets
Constant
Function
Eigenvalue
0.421(a)
Test of
function(s)
1
Wilks lambda
0.704
Unstandardised canonical
discriminant function coefficients
3.298
3.920
0.163
2.671
5.030
3.654
0.119
0.023
0.005
0.002
0.425
1.727
2.786
Eigenvalues
Per cent of variance
100.0
Wilks lambda
Chi-square
38.685
Wilks lambda ()
Tolerance at step 12
Sig.
0.952
0.903
0.875
0.847
0.801
0.775
0.760
0.746
0.732
0.722
0.713
0.704
0.051
0.673
0.566
0.051
0.232
0.167
0.829
0.936
0.970
0.968
0.263
0.196
0.017
0.003
0.002
0.001
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
Cumulative per
cent
Canonical correlation
100.0
0.545
df
Sig.
0.000
12
[ 585 ]

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18/6/7 [2003] 577-590
Table IV
Lachenbruch cross-validation results
Predicted group membership
0.00
1.00
Status
Original
Count
Per cent
Cross-validated
Count
Per cent
Tests of predictive accuracy

Proportional chance criterion
Presss Q statistic
Total
0.00
1.00
0.00
1.00
19
7
38.0
8.2
31
78
62.0
91.8
50
85
100.0
100.0
0.00
1.00
0.00
1.00
18
7
36.0
8.2
32
78
64.0
91.8
50
85
100.0
100.0
0.5338
25.785
Notes: Type 1 error: 8.2 per cent Type 2 error: 64 per cent; 71.9 per cent of original grouped cases correctly
classified. 71.1 per cent of cross-validated grouped cases correctly classified
Due to differences in debtor- and creditororiented insolvency frameworks in various
countries, this finding has significant
implications on the choice of corporate
failure model that is more appropriate for
assessing going concern. Essentially, a
non-going concern in a debtor-oriented
insolvency framework has the opportunity to
reorganise and continue operations when the
same company would have been more likely
to be liquidated in a creditor-oriented
insolvency framework.
For debtor-oriented countries such as the
USA where much of the previous corporate
failure research has taken place, bankruptcy
prediction models might still be of value
since the US bankruptcy code is designed to
keep companies as going concerns (Franks
et al., 1996). A liquidation prediction model
would not be suitable in this context since
bankrupt companies can emerge from
bankruptcy as a going concern. However, for
countries where the insolvency procedures
are creditor-oriented, such as in the UK,
Germany, Australia and New Zealand,
liquidation is the more likely outcome of
insolvency (Kaiser, 1996; Franks et al., 1996).
In the latter mentioned countries, creditors
can obtain control of the company and have
the legal right to recover their debt even
6.2 Altmans Z-score model

Altmans model was applied to the same
sample of companies used to develop the
liquidation prediction model and comprises
of five ratios, namely:
1 working capital/total assets;
2 retained earnings/total assets;
3 EBIT/total assets;
4 book value of equity/book value of debt;
and
5 sales/total assets.
The results of Altmans Z-score model are
shown below in Table V. Altmans model
correctly classifies company failures 41
percent of the time and correctly classifies
non-failed companies 54 percent of the time.
This results in a Type 1 error rate of 59
percent and a Type 2 error rate of 46 percent.
6.3 Hypotheses tests

The results support H1 that a liquidation
prediction model outperforms a bankruptcy
prediction model in discriminating between
liquidated and continuing companies. The
developed company failure model for New
Zealand companies was 92 percent successful
in predicting company failures compared to
Altmans Z-score model accuracy of 41
percent.
Table V
Altmans Z-score model accuracy
Actual membership
Non-failed
Failed
Predicted membership
Failed
Non-failed
23
35
27
50
Note: Type 1 error: 59 per cent Type 2 error: 46 per cent

[ 586 ]
Total
Per cent accuracy
50
85
54
41

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18/6/7 [2003] 577-590
though it results in the debtor companies

liquidation (Kaiser, 1996; Franks et al., 1996).
This suggests that liquidation prediction
models are better proxies for assessing going
concern in countries where the insolvency
laws are creditor-oriented.
H2, that Type 1 errors are lower for the
liquidation prediction model compared to the
bankruptcy prediction model, is also
supported. It shows that the liquidation
prediction model correctly classified a failing
company 92 percent of the time compared to
Altmans bankruptcy prediction models
accuracy of 41 percent. This results in a Type
1 error rate for the liquidation prediction
model of only 8 percent compared to Altmans
Type 1 error rate of 59 percent. Given that
Type 1 errors are most expensive to auditors
(Koh, 1991; Carcello and Palmrose, 1994;
Geiger et al., 1998), it shows that the
liquidation prediction model is a better
analytical tool for the auditor for assessing
going concern.
H3 is rejected since the developed model
has a higher Type 2 error rate of 64 percent
compared to Altmans Type 2 error rate of 46
percent. Prior bankruptcy research also
shows that corporate failure models
generally have high Type 2 errors compared
to Type 1 errors (Koh and Killough, 1990,
Morris, 1997). The liquidation prediction
model correctly classified non-failed
companies 36 percent of the time compared to
Altmans 54 percent accuracy. This indicates
that Altmans model is better at predicting
non-failures compared to the developed
liquidation prediction model.
The above findings substantiate the
liquidation prediction models accuracy over
Altmans benchmark bankruptcy prediction
model in classifying between liquidated and
continuing companies. The liquidation
prediction model is more accurate in
predicting company liquidation with an
accuracy of 92 percent. Given the high costs
associated with misclassifying failing
companies, this suggests that the developed
model can be used as a valuable analytical
tool to assist auditors in forming the going
concern judgment.
Furthermore, the findings of this study
also raise the issue of the appropriateness of
using bankruptcy prediction models in
countries where the insolvency code is
essentially creditor oriented. In countries
such as the UK, Australia and New Zealand, a
liquidation prediction model is likely to be
more appropriate because the majority of
insolvent companies are liquidated, and not
given the opportunity of remaining as a
going concern as encouraged by the US
Chapter 11 insolvency procedures.
7. Summary and conclusions

This study developed and tested the
efficiency of a liquidation prediction model
against Altmans benchmark bankruptcy
prediction model based on the premise that
company liquidation is a better proxy for
assumption than corporate bankruptcy. The
developed corporate liquidation model was
found to outperform Altmans bankruptcy
prediction model in predicting company
liquidation. This finding is significant given
that Altmans model is a proven model and
has been used to benchmark the performance
of newly developed corporate failure models
(Holmen, 1988; Eidleman, 1995). The Type 1
error of only 8 percent for the New Zealand
model is very important given the large costs
associated with not qualifying a failing
company (Koh, 1991). Furthermore, the going
concern status of a company is more likely to
be called into question for companies in
financial distress rather than for healthy
companies (Foster et al., 1998). Hence, the
New Zealand models accuracy of 92 percent
in classifying failed companies is especially
significant given that the model was
developed from failed and stressed
companies rather than failed and healthy
companies as used in prior studies.
Consistent with prior research, Type 2 errors
remain relatively high compared to Type 1
errors (Mutchler 1985; Koh and Killough,
1990; Morris, 1997).
This research therefore shows that a
company liquidation model can be used as a
valuable audit tool in assessing going
concern due to its very high accuracy with
low Type 1 errors. Given the argument that
company liquidation is a more appropriate
proxy for a companys non-going concern
status, this finding is especially important.
As a result, future research should be
directed at assessing the efficiency of
corporate liquidation prediction models as
an analytical tool for auditors. This line of
research is useful given that bankruptcy
prediction models developed in countries
where the insolvency law is debtor-oriented
may not be appropriate for countries where
the insolvency laws are essentially creditororiented, such as in the UK, Australia and
New Zealand.
Furthermore, previous research has made
inferences between auditor accuracy and
statistical models accuracy based on prior
audit opinions. Future research should more
actively seek to address how useful are
statistical corporate failure models for
auditors in the actual decision-making
environment and in different insolvency
[ 587 ]

and Peter Oyelere
18/6/7 [2003] 577-590
frameworks, which have not been addressed

in prior accounting and auditing research.
Notes
1 The most common definition of company
failure used in prior accounting research is
filing for bankruptcy. Other definitions of
corporate failure in accounting research
include large losses disproportionate to assets,
stock exchange delisting, companies in the
process of liquidation or receivership, an
arrangement with creditors, failure to pay
annual listing fees, negative stock returns and
the receipt of a going concern qualification
(Taffler, 1982; Mutchler, 1985; Cormier et al.,
1995; Zhang and Harrold, 1997; Nasir et al.,
2000).
2 For example, Grant et al. (1998) developed
their model using 17 bankrupt companies and
validated it by using 15 companies. Lau (1987)
also used a very small sample size of 15
companies.
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AICPA, New York, NY.
Accountants. (1978), Commission on Auditors
[ 589 ]

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18/6/7 [2003] 577-590
[ 590 ]
Responsibilities: Report Conclusions and

Recommendations, AICPA, New York, NY.
Accountants (1988), The Auditors
Consideration of an Entitys Ability to
Continue as a Going Concern, Statement on
Auditing Standards No. 59, AICPA,
New York, NY.
Australian Accounting Research Foundation
(1999), Analytical Procedures, ASB Auditing
Standard AUS 512, Prentice Hall, Sydney.
Australian Accounting Research Foundation
(1999), Going Concern, ASB Auditing
Standard AUS 708, Prentice Hall, Sydney.
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Concern Basis in Financial Statements,
tatements of Auditing Standards 130, APB,
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Auditing Standard No. 504, ICANZ,
Wellington.
Institute of Chartered Accountants of New
Zealand (1998), Going Concern, Auditing
Standard No. 520, ICANZ, Wellington.
Are auditors sensitive enough to fraud?
Bilal Makkawi
Morgan State University, Baltimore, Maryland, USA
Allen Schick
Morgan State University, Baltimore, Maryland, USA
Keywords
Auditing, Fraud,
Corporate governance, Auditors
Abstract
This study investigates how
auditors alter their audit program
decisions in response to an
increased likelihood of fraud risk.
A total of 48 auditors from one Big
5 CPA firm were surveyed
regarding the type of audit
procedures they would use in
response to an increased
likelihood of material
misstatements caused by fraud.
The auditors were provided with a
scenario that reflected changes in
economic and industry factors
that increase audit risk and
typically require a reevaluation of
the audit program. They were
asked to make choices as to
which tests of balances and
details and analytical procedures
to perform. The results of the
study are summarized and
tabulated and then explained in
terms of the tradeoff between
effectiveness and efficiency and
corporate governance.
Material misstatements, whether caused by

fraud (intentional) or error (unintentional),
can have a substantial negative impact on

shareholders wealth as illustrated by the
accounting problems associated with
companies like Enron and Rite Aid. These
companies had reported rapidly growing
revenues and earnings, with a corresponding
increase in stock prices. Unfortunately, this
picture of growth was inaccurate. Instead,
these companies were found to have applied
generally accepted accounting principles
inappropriately, resulting in a massive
overstatement of income. For example,
Enron recorded unrealized trading gains on
long-term futures contracts for which there
were no market prices upon which to base
valuations. Essentially, Enron made up the
prices and recognized fictitious gains. These
fictitious gains accounted for more than half
of their $1.41 billion reported pretax income
for the year 2000 (Thomas, 2002). In the case of
Rite Aid, senior management engaged in a
host of accounting trickery to manufacture
imaginary sales and other revenues and
pump up earnings. One such trick was not to
write down assets acquired as part of an
overly ambitious expansion of their drug
store chain that did not work out. Another
accounting trick used to increase income was
to inflate the dollar value of damaged and
outdated goods in order to receive a larger
credit from vendors than appropriate. The
result of all the accumulated accounting
fraud was a $1.6 billion restatement of net
income for the late 1990s, one of the largest
corporate earnings restatement ever
(Barrett, 1999; Kilman, 2002).
When the magnitude of these accounting
irregularities and the length of time over
which they occurred became known, the
companies stock prices dropped
significantly. What made matters even
worse, and what could have significant
implications for the accounting profession, is
that their independent auditors either
attested to, in the case of Enron, or failed to
recognize and/or call attention to, in the case

Auditors are caught on the horns of a

dilemma. On one horn they are asked to do
everything possible to prevent material
financial statement fraud. On the other horn
hangs the reality that auditing is a
competitive business, subject to the same
demands for profitability and the return on
capital as other businesses. These economic
demands create a conflict for auditors by
constraining their ability to detect fraud.
What then do auditors do when faced with
the increased possibility of fraudulent
financial reporting? That is the issue
examined in this article, the impetus for
which was the issuance of Statement on
Auditing Standards No. 82 (SAS No. 82),
Consideration of fraud in a financial
statement audit (AICPA, 1997). This
statement describes fraud and its
characteristics, indicates conditions under
which fraud is more likely to occur, and
requires the auditor to make an assessment
of the risk of material misstatement due to
fraud. The issue of how independent auditors
respond to an increased likelihood of
financial statement fraud is important for
two reasons. First, fraud induced material
misstatements can have a substantial
negative financial impact on users of
financial information and the capital market
system as a whole. Evidence of this impact is
indicated by the current confidence crisis of
investors over the credibility of financial
reporting. Second, it reinforces the role of
auditors in society to provide reasonable
assurance about the reliability and
dependability of financial information. The
role of an audit and auditors is to reduce the
information risk associated with financial
statements.
Fraudulent financial reporting

18/6/7 [2003] 591-598
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482722]
[ 591 ]
Bilal Makkawi and

Allen Schick
Are auditors sensitive enough
to fraud?
18/6/7 [2003] 591-598
of Rite Aid, the erroneous accounting

numbers and the associated inaccurate
financial picture of these companies. In
short, the financial statements of both these
companies were materially misstated.
Of interest in this paper is the way auditors
respond to the increased likelihood of
material misstatements caused by fraud.
Since fraudulent financial reporting is
mainly committed by management, fraud
undermines the integrity of management and
its representations. According to SAS No. 82,
there are two types of fraud. The first is
fraudulent financial reporting. In general
terms, fraudulent financial reporting occurs
when, for example, firms intentionally take
actions to overstate assets and revenues and
understate liabilities and expenses. The
second type of fraud relates to
misappropriation of assets, which is a nice
way of saying that assets are being stolen
from the company.
Pressures for fraudulent financial

reporting
One important factor that might induce
companies to commit fraud is the increased
institutional stock ownership of many
companies. Institutional competition for
investors monies and the increasing number
of financial publications reporting
short-term returns have made short-term
performance a priority for financial
institutions. In turn, this emphasis on
short-term performance has increased the
pressure on companies to meet investors
expectations concerning revenue and
earnings growth. Further, this pressure is
exacerbated when there also is substantial
insider stock ownership or executive
compensation tied to stock market
performance. Failure to meet these
expectations can result in a substantial
decline in a companys stock price (e.g.
Lucent Technology, Intel, and Apple
Computer). As a result, companies that
cannot meet these expectations through
legitimate business operations instead may
seek to do so through fraudulent financial
reporting.
Conduct of the study

To satisfy our curiosity, we surveyed 48
auditors from one of the Big Five CPA
firms regarding their choice of auditing
procedures in response to an increased
likelihood of fraudulent financial reporting.
Following the recommendation of
Abdolmohammadi (1999) that the minimum
[ 592 ]
staff level required to perform various

orientation tasks leading to the audit plan is
the rank of senior, we included only senior
auditors in the study. Contact partners from
two offices of the firm assisted us in
collecting data from practicing auditors in
their offices. The data were responses to a
case study (see Appendix) distributed to 70
senior auditors attending a continuing
professional education seminar. Auditors
were asked to complete the task, explained
below, in their own time. In total, 48
responses were returned to the contact
partners for a response rate of 69 percent. On
average, the subjects had 3.2 years of
experience with 1.16 standard deviations
(range: 1.8-7.0 years).
The case study used described a medium
size manufacturing company in the
semiconductor industry, along with a
summary of the companys past financial
performance, an outlook for the companys
future, and the future of the industry and the
economy. The case study indicated that there
had been a boom in the semiconductor
industry for the past five years, but that now
a slowdown was occurring. The slowdown
also was accompanied by a dramatic
decrease in the companys stock price and
earnings.
In order to enhance the auditors
understanding of the study, they were told
that SAS No. 82 (AICPA, 1997) requires the
auditors to assess the risk of material
misstatement due to fraud, including fraud
relating to financial reporting and
misapplication of accounting principles. The
auditors then were given a list of the
analytical review procedures and tests of
balances and details performed last year. The
auditors task was to indicate the changes, if
any, in this years analytical review
procedures and tests of balances and details
as applied to an audit of the inventory and
production cycle. The inventory and
production cycle was selected as the context
for the auditors task, since asset
overstatements often involve inventory
overstatements. After reviewing the above
information, the subjects were asked to
indicate which two analytical review
procedures and which two tests of balances
and details procedures they would increase
and/or decrease, if any, compared to last
year. They also were given the opportunity to
choose their own procedures.
Results
The results of the study indicate the
following four points:
Bilal Makkawi and

Allen Schick
to fraud?
18/6/7 [2003] 591-598
1 All auditors increased the performance of

certain procedures.
2 Some auditors chose not to reduce any
procedures.
3 A consensus existed on which procedures to
increase both for the analytical review
procedures and tests of balances and
details.
4 There was less agreement on which
procedures to reduce for those auditors
who chose to reduce some procedures.
This was the case for both the analytical
review procedures and tests of balances
and details.
Table I presents the number of auditors and
their planned increase and decrease of the
analytical review procedures. The table
shows a clear preference for two analytical
review procedures: first, the further
investigation of unusual fluctuations, and
second, comparison of inventory turnover
and number of days sales in ending
inventory. Table II presents the number of
auditors and their planned increase and
decrease of the tests of balances and details
procedures. The auditors seemed to agree
that more work should be placed first, in
testing for slow moving items, and second,
comparing carrying cost to market values.
Conversely, auditors exhibit less of a
consensus regarding the performance of a
specific procedure.
Discussion
These results indicate that auditors
emphasize effectiveness over efficiency with
respect to the performance of audit
procedures. The greater consensus among
auditors on the additional procedures to
perform is indicative of an effort to cover all
the bases in attempting to increase the

effectiveness of an audit and reduce the
potential for material misstatement. Since
the accounting profession almost
unanimously agrees on the importance of
reducing audit risk, our auditor subjects
almost seemed programmed to do more, not
less. Indeed, the results are reasonable, since
auditors are taught to be risk averse and,
consequently, trained more to reduce audit
risk than to conduct an efficient audit.
Nevertheless, in a world of cost and price
pressures, a lack of clarity about what are
redundant procedures becomes an important
issue for the profitability of the auditing
firm. When auditors are taught that the way
to reduce audit risk is by doing more work, it
should come as no surprise that our auditors
disagree on what procedures to eliminate in
auditing the inventory and production cycle.
No consensus exists on the relevant
significance and value of each auditing
procedure in the evaluation of audit risk and
the risk of material misstatement caused
by fraud.
Audit fees, however, are no longer
determined by the amount of work auditors
do. In the past if auditors did more work, they
got paid more. Today the fixed fee
environment limits the amount of work that
auditors are inclined to do by limiting the
fees clients are willing to pay. Thus, auditors
no longer can sustain profitability by doing
more work. Instead, the fixed fee
environment requires auditors to audit
smarter.
Auditing smarter means that auditors
have to achieve a greater balance between
effectiveness and efficiency. Movement
towards this balance can be fostered in two
ways. First, auditors should have a greater
awareness of the context in which the audit
takes place. Recent evidence (Beasley, 1996;
Table I
Analytical review procedures
No.
1
2
3
4
5
6
7
8
9
10
11
Procedures
The relationship of purchases to usage reports and production costs was
compared for both years for consistency. Any unusual deviation was examined
Investigation of unusual fluctuations (more than 10 per cent annually)
Consideration of the reasonableness of the cost of sales by multiplying units sold
by average cost per product line
Comparisons of inventory turnover and number of days sales in ending inventory
Comparisons of microprocessor inventory by type
Comparisons of inventory shrinkages
Comparisons of scrap and stock out report
Analysis of purchase commitments for motherboard parts (i.e. hard drive, floppy,
and microprocessors on computer base)
Analysis of production performance report
Analysis of rework reports
Inspection of large purchases near year-end
Increase
Decrease
26
2
16
4
7
8
8
6
12
2
[ 593 ]
Bilal Makkawi and

Allen Schick
to fraud?
18/6/7 [2003] 591-598
Table II
Changes to tests of balances and details procedures
No.
1
2
3
4
5
6
7
8
9
10
11
12
Procedures
Observed clients team measure, weigh, and count inventory
Performed test counts and mathematical computations to confirm clients counting
For a sample of purchase orders:
a Tested for mathematical accuracy
b Agreed details to receiving documents
Confirmations were sent for inventory on consignment
Inventory tags were observed and tested to determine that all tags used for the
physical count and only those tags are included in physical inventory summaries
Selected a representative sample of receiving documents for a few days before
and subsequent to year-end, and performed cutoff tests to ensure that
transactions were recorded properly, including accounts, amounts, and period
Reviewed and tested procedures for slow moving items
Traced inventory totals from trial balance to subsidiary ledgers and verified
agreement of details by product to general ledger total
Reviewed largest purchase returns
Obtained purchase transactions listing and traced monthly totals to general
ledger:
a Tested mathematical accuracy
b Investigated large and unusual amounts
Reviewed terms governing passage of title and freight terms, to ensure that only
valid purchases have been booked
Compared carrying cost to market values
Beasley et al., 2000) not only has indicated

that financial statement fraud is
concentrated in selective industries, but also
that the nature of financial fraud differs by
industry. For example, revenue
overstatements were found to be prevalent in
the technology industry, whereas asset
overstatements occurred more in the
financial services industry. This suggests the
need to consider the industry, when
identifying the high potential areas for
fraudulent financial reporting.
In addition, corporate governance
mechanisms have been linked to financial
statement fraud (Beasley, 1996; Beasley et al.,
2000). Specifically, fraudulent financial
reporting occurred more for companies with
fewer audit committees, fewer audit
committees composed entirely of outside
directors, fewer audit committee meetings,
fewer board of directors with a majority of
outside members and where internal audit
functions were not performed. Hence,
understanding the corporate governance
structure is becoming imperative.
The second way to move towards a better
effectiveness-efficiency balance is to develop
in auditors a greater understanding of the
relationship of audit procedures to the
different audit objectives and the greater
likelihood of certain kinds of accounting
fraud in specific industries. This
understanding can be achieved by issuing
more explicit auditing standards that specify
the types of audit procedures best suited to
[ 594 ]
Increase
Decrease
2
13
8
6
26
11
4
5
28
detect fraudulent financial reporting in these

industries. Additional training should be
directed towards making auditors pay more
attention to a companys industry and its
corporate governance structure. When
training is coupled with a more explicit
delineation of audit procedures to use in
assessing the possibility of fraudulent
financial reporting, managing the
effectiveness-efficiency tradeoff is enhanced.
Finally, it is difficult to argue against the
premise that top management is responsible
for the occurrence of financial reporting
fraud. This suggests that auditors need to be
more skeptical of management
representations and more aggressive in
assessing their integrity. Questions about
such topics as performance pressures,
compensation, personal or financial
hardships, lifestyle and the degree of
managerial domination by a strong
personality should be asked of management.
Greater skepticism and a better assessment
of management integrity can lead to a more
effective and efficient audit.
Auditors are caught on the horns of a
dilemma. They need to be sensitive to the
conditions under which fraudulent financial
reporting may flourish and be effective in
recognizing the occurrence of those
conditions. At the same time they also need
to be attuned to the financial constraints
under which they operate. The proposed
suggestions may aid auditors in striking
Bilal Makkawi and

Allen Schick
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18/6/7 [2003] 591-598
more of a balance between effectiveness and

efficiency.
References
Abdolmohammadi, M.J. (1999), A comprehensive
taxonomy of audit task structure,
professional rank, and decision aids for
behavioral research, Behavioral Research in
Accounting, Vol. 11, pp. 51-92.
AICPA (1997), Statement on Auditing Standards
No. 82: Consideration of Fraud in a Financial
Statement Audit, American Institute of
Certified Public Accountants, New York, NY.
Barrett, A. (1999), Rite Aid hasnt treated its real
ills, Business Week, 1 November, p. 46.
Beasley, M.S. (1996), An empirical
investigation of the relation between board of
director composition and financial statement
fraud, The Accounting Review, October,
pp. 443-65.
Beasley, M.S., Carcello, J.V., Hermanson, D.R.
and Lapides, P.D. (2000), Fraudulent
financial reporting: consideration of industry
traits and corporate governance
mechanisms, Accounting Horizons,
December, pp. 441-55.
Kilman, S. (2002), Rite Aid ex-officials charged in
accounting fraud probe, The Wall Street
Journal, 24 June, p. A2.
Thomas, C.W. (2002), The rise and fall of Enron,
Journal of Accountancy, April, pp. 41-52.
Appendix
Case used in the experiment
This exercise investigates audit-planning
decisions in the production/inventory cycle.
The questionnaire relates to your assessment
of audit risk at both the financial statement
level and account/cycle level. It also deals
with your planned audit program with
respect to the nature, timing, and extent of
audit procedures. There are no right or
wrong answers to the questions and there is
no time limit.
Please work independently and answer all
the questions to the best of your ability given
the information provided to you. In order to
maintain confidentiality of your responses,
only summary results will be released. After
completing the questionnaire, return the
instrument in the enclosed envelope to your
firms human resource director.
American Microchip Corporation

Your firm has been the auditor of American
Microchip Corporation for the past five
years. American Microchip Corporation
received an unqualified opinion last year. It
is 15 July 19x2, you are the senior auditor on
the job, and this is your first year. You are to
recommend/prepare the clients 19x2
detailed audit plan for the inventory/

production cycle as part of the overall audit
program. This includes assessing the risk of
material misstatements at the financial
statement level as well as at the cycle level
and determining the nature, timing, and
extent of audit procedures for the inventory/
production cycle.
History of client and industry

American Microchip Corporation, a mediumsized calendar-year corporation,
manufactures and markets semiconductor
components, microprocessors, board-level
and system-level products used in the
computer, telecommunications, and office
automation industries. The major products
(more than 50 percent of total production) are
high speed microprocessors targeted for
business use and the 4 and 16Mb D-RAMs
(dynamic random access memory), and SRAMs (static random access memory).
The semiconductor industry is cyclical and
is affected by changes in economic
conditions. The moderate growth in the
economy for the past five years along with
continual technological innovation and a
boom in personal computers provided a
steadily increasing and profitable
environment for the semiconductor industry
(a 25 percent average annual increase in
earnings).
The boom in personal computers in the
past five years has created strong demand for
microprocessors, D-RAMs, and S-RAMs. To
meet this demand, manufacturers of
semiconductors expanded capacity
aggressively. Currently, it appears that
supply is catching up and might be exceeding
demand in the next year. The book to bill
ratio (the ratio of dollar value of orders
placed to orders delivered, a measure of
strength of demand) has fallen below one for
the first time in five years suggesting that
supply has finally caught up with demand.
Initially, the excess demand created strong
support for memory chip prices and for a
profitable semiconductor industry. As the
imbalance in demand shifts, memory chip
prices are expected to fall rapidly.
This potential imbalance has taken its toll
on the semiconductor industry. Stock prices
have dropped dramatically reflecting the
downward pressure on the price of memory
chips. In addition, the economy seems to be
slowing down with an estimated increase in
gross domestic product of about 2 percent as
compared to about 3 percent for the past five
years. The slow-down in economic activity
affects the demand for durable goods such as
computers, which in turn affects the demand
[ 595 ]
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18/6/7 [2003] 591-598
for memory chips, thus putting more price

pressure on memory chips and decreasing
overall profitability of the industry.
Professional standards require the
auditor to evaluate the risk of material
misstatements at the financial statement
level (the risk that is inherent to the
financial statements as a whole) and
the audit risk at the cycle level as part
of the initial planning of the audit program.
In evaluating risk, the auditor considers,
Table AI
[ 596 ]
first, general risk factors relating to

the engagement as a whole such as industry
risk, second, overall materiality
and financial factors, and third, control
risk.
More recent auditing pronouncements
require the auditor to assess the risk of
material misstatements due to fraud. One
type of fraud relates to financial reporting,
such as the intentional misapplication of
accounting principles. The misapplication of
Bilal Makkawi and

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Table AII

18/6/7 [2003] 591-598
accounting principles might result in over

valuation of assets such as inventory or miss
classification of liabilities.
Additional information
American Microchips earnings for the past
three quarters have fallen below analysts
forecasts. The primary cause has been the
drop in market value of inventory and the
consequent need for an unexpected inventory
write-down. This write-down has been
triggered by the speed by which faster and
more efficient microprocessors are being
introduced, rendering the old
microprocessors technologically obsolete.
This year American Microchip
overstocked on many D-RAMs, S-RAMs and
other purchased parts hoping for a recovery
of the personal computer market. The
recovery never materialized and a writedown of overstocked parts was required.
The following analytical review
procedures were performed last year.
Discrepancies and unusual variations from
the prior year were discussed with
management and resolved to the auditors
satisfaction. The majority of the procedures
consisted of comparisons of financial
information with the prior years financial
information, and with comparable industry
financial information and ratios. Specific

procedures performed included:
1 The relationship of purchases to usage
reports and production costs was compared
for both years for consistency. Any
unusual deviation was examined.
2 Investigation of unusual fluctuations
(more than 10 percent annually) for
a. Cost of sales by product.
b. Gross margins by product.
c. Cost of sales for month prior to and
month following the year-end.
d. Purchase returns as a percentage of
purchases.
e. Cost of sales percentage breakdown
(labor vs material).
f. Variances in production reports
(standard cost and standard freight).
g. Comparison of ending inventory of
finished goods to sales budgets.
h. Comparison of the ending balance of
raw material to budgeted production.
i. Ratio of write down to total inventory.
3 Consideration of the reasonableness of the
cost of sales by multiplying units sold by
average cost per product line.
4 Comparisons of inventory turnover and
number of days sales in ending inventory.
5 Comparisons of microprocessor inventory
by type.
6 Comparisons of inventory shrinkages.
7 Comparisons of scrap and stock out report.
[ 597 ]
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18/6/7 [2003] 591-598
8 Analysis of purchase commitments for

motherboard parts.
9 Analysis of production performance
report.
10 Analysis of rework reports.
11 Inspection of large purchases near yearend.
The majority of tests of balances and details
performed last year consisted of inspection of
assets, vouching, re-performance and
observation. Specific procedures performed
included:
1 Observed clients team measure, weigh,
and count inventory.
2 Performed test counts and mathematical
computations to confirm clients counting.
3 For a sample of purchase orders:
a. Tested for mathematical accuracy.
b. Agreed details to receiving documents.
c. Agreed purchase price to authorized
purchase order.
d. Traced to supplier payable account.
4 Confirmations were sent for inventory on
consignment.
5 Inventory tags were observed and tested to
determine that all tags used for the
physical count and only those tags are
included in physical inventory summaries.
6 Selected a representative sample of
receiving documents for a few days before
and subsequent to year-end, and performed
cutoff tests to ensure that transactions
were recorded properly, including
accounts, amounts, and period.
7 Reviewed and tested procedures for slow
moving items.
8 Traced inventory totals from trial balance
to subsidiary ledgers and verified
[ 598 ]
agreement of details by product to general

ledger total.
9 Reviewed largest purchase returns.
10 Obtained purchase transactions listing
and traced monthly totals to general
ledger:
a) Tested mathematical accuracy.
b) Investigated large and unusual
amounts.
11 Compared carrying cost to market values.
12 Reviewed terms governing passage of title
and freight terms, to ensure that only
valid purchases have been booked.
Please answer the following questions to

the best of your knowledge
Do you expect to change the type of analytical
review procedures performed this year as
compared to last year?
Yes
No
If yes, list the two procedures that you will
decrease the most, if any.
1 __________________ 2 ___________________
List the two procedures you will increase
the most, if any.
1 __________________ 2 ___________________
Do you expect to change the type of tests of
balances and details performed this year as
compared to last year?
Yes
No
If yes, list the two procedures that you will
decrease the most, if any.
1 __________________ 2 ___________________
List the two procedures you will increase
the most, if any.
1 __________________ 2 __________________
Users perceptions of various aspects of Kuwaiti

corporate reporting
Kamal Naser
Cardiff Business School, University of Wales, Cardiff, UK
Rana Nuseibeh
Cardiff Business School, University of Wales, UK
Ahmad Al-Hussaini
Public Authority for Applied Education and Training, Kuwait
Keywords
Corporate finances,
Corporate communications,
Reports, Kuwait
Abstract
In this study an attempt is made to
provide empirical evidence on the
usefulness of different aspects of
the annual report to various
Kuwaiti user groups. To do so,
eight Kuwaiti user groups were
surveyed through a questionnaire.
The groups were individual
investors; institutional investors,
bank credit officers, government
officials, financial analysts,
academics, auditors and stock
market brokers. The analyses
indicate that the user groups
surveyed in the study rely mainly
on information made directly
available by the company and do
not consult intermediary sources
of corporate information in order
to make informative decisions.
The analyses also revealed that
credibility and timeliness are the
most important features of useful
corporate information and
traditional financial statements
are the most important and
credible parts of corporate annual
reports. Non-financial information,
however, proved to be less
credible and of less importance to
the Kuwaiti user groups.
Kuwait is one of the major oil exporting

countries in the world. As in other GCC
countries, oil revenues account for more than

95 per cent of the Kuwaiti exports. Kuwait
hosts the oldest and most developed stock
exchange in the Arab Gulf region. According
to the Investors Guide of the Kuwaiti Stock
Exchange (2000), 86 companies listed on the
exchange with market capitalisation
exceeding US$4 billion. Kuwait also hosts one
of the most developed banking sectors in the
region that accounts for more than 30 per
cent of the stock markets capitalisation.
The requirements of corporate reporting in
Kuwait are influenced by the International
Accounting Standards (IASs) and the listing
requirements of the Kuwaiti Stock Exchange
(KSE). In April 1990, the Ministry of Trade
and Industry issued directive No. 18,
requesting all companies operating in
Kuwait to comply with the international
accounting standards (IASs) effective
1 January 1991. The ministerial order
indicated that the implementation of the
International Accounting Standards should
not contradict national regulations. This
order overrode a previous ministerial
decision and referred to the accounting
principles that ought to be used when
preparing final financial statements, No. 4 for
the year 1987. In the same order, the Ministry
of Trade and Industry asked for the
formation of a permanent technical
committee that would be given the
responsibility of identifying international
accounting standards to be adopted by the
Kuwaiti companies. The technical committee
was also assigned the responsibility of
looking at the national accounting standards
that cannot be replaced by the IASs and
recommend their adoption.
In addition to the IASs, companies listed on
the Kuwaiti Stock Exchange (KSE) should
comply with its requirements. The KSE has
managed to establish regulations for Kuwaiti
shareholding companies listed on the

Introduction
The perception of various user groups of
corporate annual reports has been
investigated in a number of studies (see for
example, Lee and Tweedie, 1975a, b; 1976;
1981; Briggs, 1975; Epstein, 1975; Chang and
Most, 1977, 1985; Chenhall and Juchau, 1977;
Wilton and Tabb, 1978; Winfield, 1978;
Anderson, 1981; Arnold and Moizer, 1984;
Day, 1986; Gniewosz, 1990; Wallace, 1988;
Epstein and Pava, 1993; Streuly, 1994;
Anderson and Epstein, 1995; Bence et al.,
1995; Bartlett and Chandler, 1997). The vast
majority of these studies, however, have
covered developed economies. Little
reference has been made in the literature to
the developing countries in general and to
the Gulf Co-operation Council (GCC)
countries, in particular. Although the GCC
countries are classified as emerging
economies, huge returns from oil revenues
make them major economies.
The main purpose of this study is to
explore the perception of various user groups
of financial information about corporate
annual reporting in Kuwait. Although the
Kuwaiti economy is classified as an emerging
one, the country hosts a developed banking
sector and one of the oldest stock exchanges
in the region. More importantly, the Kuwaiti
companies adopt the International
Accounting Standards (IASs). Hence,
exploring the opinion of Kuwaiti user groups
about the various aspects of corporate annual
reports will undoubtedly add a new
dimension to the literature.
Financial reporting system in

Kuwait
18/6/7 [2003] 599-617
# MCB UP Limited
[ISSN 0268-6902]
[DOI 10.1108/02686900310482731]
[ 599 ]
Kamal Naser, Rana Nuseibeh

and Ahmad Al-Hussaini
Users perceptions of various
aspects of Kuwaiti corporate
reporting
18/6/7 [2003] 599-617
market, and to follow up on their financial

positions periodically by binding them to
submit annual or bi-annual financial
statements. Since the beginning of 1998,
companies have been required to submit
financial statements every three months, as
is the case in international stock markets.
independent verification. Consequently, the

study seeks the various users rating of
elements that form criteria for useful
corporate information.
RQ2. What are the perceptions of various
user groups of the characteristics of
useful corporate information?
The usefulness of the annual report
Previous studies and study

questions
User groups primary sources of
information
In general, corporate information user
groups refer to different sources of
information to assist them in making
informative decisions about a company.
Previous studies pointed to a number of
possible sources of corporate information.
The annual report, however, is documented
in a significant number of studies as the most
important source of corporate information
frequently used by various users in many
countries (see for example Arnold and
Moizer, 1984; Abu-Nassar and Rutherford,
1996; Bence et al., 1995; Briggs, 1975; Chang
and Most, 1985; Day, 1986; Mautz, 1968; Moizer
and Arnold, 1984; Streuly, 1994). In addition
to the annual report, financial press reports,
newspapers and magazines were reported
among the important sources of information
to the users of corporate information in a
number of studies (Anderson and Epstein,
1995; Bartlett and Chandler, 1997; Chang and
Most, 1977; Lee and Tweedie, 1975a, b;
Winfield, 1978). Other studies referred to
stockbrokers advice as an important source
of information to the users (Anderson, 1981;
Anderson and Epstein, 1995; Chang and Most,
1977; Chenhall and Juchau, 1977; Epstein and
Pava, 1993; Winfield, 1978). A further source
of corporate information that appeared in the
Bence et al. (1995) study is paying the
company a visit or holding interviews with
company officials.
It was, therefore, important to investigate
the most important sources of information
used by various Kuwaiti user groups by
asking the following research question (RQ).
RQ1. What are the sources of corporate
information used by the various
Kuwaiti user groups?
Sterling (1972) indicated that the objective of

financial reporting is to provide useful
information to the users. Zairi and Letza
(1994) concluded that the purpose of the
annual report is to convey information,
which is useful to those who have an active
interest in the organisations, mainly
shareholders. Various Kuwaiti user groups
were asked to indicate how the annual report
could be useful.
RQ3. What are the perceptions of the
various user groups of how the
annual report can be useful?
Understandability, credibility, importance

and timeliness of different parts of the
annual report
Understandability
For corporate information to be useful, it
should be presented in an understandable
manner. This reality was emphasised by
Buzby (1974), who demonstrated that the
annual report could be adequate and
readable if the information contained in it is
presented in an understandable manner and
grouped and organised appropriately.
Similarly, Wolk et al. (1992) contended that
even if users of annual reports are assumed
to be knowledgeable, the information itself
could have different degrees of
comprehensibility. Hence, the quality of
understandability is a characteristic
influenced by both users and preparers of
annual reports. Thus, the notion of
understandability is of great concern to users
of annual financial statements. It was,
therefore, important to investigate to what
extent different Kuwaiti users of the annual
report understand the information contained
in annual financial reports.
various user groups regarding the
understandability of information
contained in the annual report?
Credibility
Characteristics of useful corporate
information
Textbooks in accounting associate the
usefulness of corporate information with
characteristics such as timeliness,
availability of specific information,
understandability, neutrality, credibility,
easy access to sources of information, and
[ 600 ]
Another important characteristic of useful

corporate information used in accounting
textbooks is credibility. Credibility is viewed
as an important characteristic of corporate
information sources. Hence, the following
research question was put to the various
users of corporate information in Kuwait to
express the degree of credibility that they

reporting
18/6/7 [2003] 599-617
attach to different sections of the annual

report.
credibility of different parts of the
annual report?
Importance
The annual report contains various sections
that provide user groups with information to
facilitate their decisions. To ensure that the
corporate message is communicated to
various users of corporate information, the
company makes every effort to ensure a
correct selection of information (Neimark,
1992). Generally speaking, information
contained in the annual report can be divided
into two main parts. The first part comprises
the chairmans and directors reports. The
second part contains the main financial
statements, which include the balance sheet,
profit and loss account, cash flow statement,
auditors report, and notes to the financial
statements. The income statement and the
balance sheet are generally viewed as the
most important sections of the corporate
annual report. They are also the most
commonly used by investors in the
investment decision-making process (Epstein
and Anderson, 1994; Berry and Waring, 1995).
At present, the importance of the cash flow
statement is increasing, while the profit and
loss account is being regarded as less
significant (Epstein and Pava, 1994). On the
other hand, the importance of the
non-financial statement is derived from the
information that is included. This
information is mainly non-quantitative, and
normally includes a review of the years
operations, important projects, news of
recent developments, and progress of the
company within the prevalent economic,
social and political environments (Lee and
Tweedie, 1981). This information, contained
in the two main parts of the annual report, is
important to investors in their investment
decisions. It is, therefore, important to ask
the various groups of investors about their
perception of the importance of different
sections of the annual report.
user groups regarding the
importance of different parts of the
annual report?
Timeliness
The usefulness of information disclosed by a
company is measured, among other things,
by its relevance. Outdated information is
irrelevant and could lead to incorrect
decisions. For the corporate information to
be relevant, it must be available to
decision-makers before it loses its capacity to
influence their decisions. Barton (1982) and

Solomons (1989) indicated that timeliness of
information is one of the main aspects of
relevance. In this respect, Davies and
Whittered (1980) concluded that timeliness is
a necessary condition to be satisfied, if
financial statements are to be useful. It is,
therefore, important to ask the various
groups of investors about their perceptions
regarding the timeliness of annual financial
information.
various Kuwaiti user groups
regarding the timeliness of the
corporate annual report?
The importance of different item

disclosures requested by the IASs
In 1991, Kuwait adopted the IASs. It was,
therefore, important to identify the
importance that the Kuwaiti user groups
attach to a number of information items
requested by the standards.
user groups regarding the
importance of various disclosure
items required by IASs?
The importance of different items of

voluntary disclosures
In addition to the information requested by
the IASs, the annual reports published by the
Kuwaiti companies contain voluntary
disclosure items. While some of the items
form important information to the users,
others tend to be less important. It was,
therefore, important to ask the respondents
to rate the importance of a list of possible
voluntary disclosed items.
importance of disclosure items
voluntarily disclosed by Kuwaiti
companies?
Study instrument
To provide empirical evidence on the above
discussed research questions, data were
collected by a survey questionnaire in the
period between March and May 2000. Unlike
previous studies where a limited number of
user groups were surveyed, eight user groups
were targeted in this study: institutional
investors, individual investors, financial
analysts, bank loan officers, government
officials, auditors and stock market brokers.
The choice of the target groups was
influenced by the literature. In addition, the
target groups are expected to use the annual
report on a regular basis and hence to
[ 601 ]

reporting
18/6/7 [2003] 599-617
exercise a certain degree of knowledge and

experience to complete the questionnaire.
The target groups were asked to indicate
their opinion on a five-point scale in terms of
strongly agree to strongly disagree or very
important or not important at all.
An early draft of the questionnaire was
piloted by a number of Kuwaiti and Arab
research students at the Cardiff Business
School. Based on the feedback from these
students, it was evident that some of the
students were not familiar with some issues
contained in the questionnaire. Proper
explanations of the issues they raised were
given in the questionnaire.
The questionnaire was administered to the
target groups. Details of the number of
questionnaires that were distributed, the
number of returned questionnaires, the
response rate for each group and the overall
response rate are presented in Table I.
To generalise the results of the
questionnaire and measure its internal
consistency, a non-response bias analysis
and Cronbachs Alpha test were conducted.
Early responses were compared with late
responses to identify possible non-response
bias[1]. After conducting the Mann-Whitney
U test, minor but insignificant difference
were reported between the two groups.
Internal consistency among various sections
of the questionnaire was tested by measuring
Cronbachs Alpha[2]. The result of the test
showed that Alpha ranged between 0.82 and
0.85. While there is no acceptable level of
significance of Alpha in the literature, Huck
and Cormier (1996) indicated that 0.70 is an
acceptable level. Botosan (1997), however,
indicated that 0.80 or more is preferable.
Findings
Profile of user groups
User groups who took part in the survey were
asked to give information about their age,
level of education, latest academic degree
obtained, place from which the latest
academic degrees obtained, specialisation

and years of experience. The average age of
the respondents was 34 years and 84 per cent
of them indicated that they hold a bachelor
degree or more. While 62 per cent of the
participants showed that they completed the
latest academic degree in Kuwait and other
Arab countries, 35 per cent revealed that they
got their degrees in the USA and the UK.
Around 85 per cent of the participants
indicated that they completed a degree in
business related areas. The vast majority of
the respondents (70 per cent) showed that
they have more than six years of working
experience.
Importance of various sources of corporate

information
Various user groups who took part in the
study were asked to indicate the importance
that they attach to different sources of
corporate information and the results are
reported in Table II. At the whole sample
level, the table demonstrated that the
respondents ranked the annual report as the
first source of information, followed by
information directly obtained from the
company and specialist advice. As for the
individual user groups, however, five out of
the eight user groups (institutional investors,
government officials, financial analysts,
academics and auditors) who took part in the
survey indicated that the annual report is the
most important source of corporate
information. Individual investors and stock
market brokers indicated that information
directly obtained from the company is their
most important source of corporate
information. In addition to the annual report
and direct information from the company,
the participants indicated that they seek
specialists advice when making investment
decisions about a company. Further, the
respondents revealed that special
publications and interim reports are used
as major sources of information about
the company.
Table I
Subject groups and response rates
Subject groups
Institutional investors
Individual investors
Bank loan officers
Government officials
Financial analysts
Academics
Auditors
Stock market brokers
Total and over all response rate
[ 602 ]
Distributed questionnaire
Received questionnaire
Response rate (%)
50
50
50
50
50
50
50
50
400
41
42
36
39
36
38
39
35
306
82
84
72
78
76
78
70
77
77
306
306
306
306
306
306
306
306
4.90
4.27
4.80
3.63
3.36
4.31
4.95
4.33
0.39
4.85
4.47
4.80
3.80
3.78
4.40
4.61
3.84
0.47
4.63
3.86
4.88
3.55
3.50
4.11
4.86
3.56
0.47
4.87
3.95
4.44
3.44
3.59
4.36
4.72
3.64
0.46
4.75
4.20
4.47
3.50
3.61
4.44
4.72
4.19
0.45
4.89
4.08
4.08
3.63
3.55
3.95
4.42
3.55
0.53
4.95
4.49
4.36
3.31
3.54
4.51
4.87
4.03
0.50
4.69
4.31
4.69
4.17
4.00
4.37
4.83
4.83
0.33
4.82
4.21
4.57
3.63
3.61
4.31
4.75
3.99
0.38
0.68
0.62
0.87
0.82
0.72
0.49
1.07
0.38
1
5
3
7
8
4
2
6
Rank
0.002
0.00
0.00
0.00
0.06
0.001
0.00
0.00
KWSL
Notes: KWSL: Kruskall-Wallis significance level; Mean values scoring: 1 = not important at all; 5 = very important; 1. Individual investors; 2. Institutional investors; 3. Bank credit officers 4;
Government officials; 5. Financial analysts; 6. Academics; 7. Auditor; 8. Stock market brokers
Annual report
Interim report
Specialists advice
Friends advice
Newspapers and magazines
Special publications
Direct information from the company
Market rumours
Kendalls coefficient of concordance W
Whole sample
Mean
SD

18/6/7 [2003] 599-617
User groups
Frequency 1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35)
Table II
User groups attitudes towards various sources of information

reporting
[ 603 ]

reporting
18/6/7 [2003] 599-617
[ 604 ]
The findings regarding the importance of the

annual reports for individual investors in
Kuwait are somewhat surprising. Several
studies conducted in this area have found the
annual report to be the single most important
source of information for individual
investors. Hence the rating of the annual
report is in contrast with the findings of
Abu-Nassar and Rutherford (1996) on the
perceptions of individual investors in
Jordan. Similarly, a study by Epstein and
Pava (1993) on the perceptions of US
individual investors found the annual
corporate report to be the most important
source of information for users. Other
studies, such as those conducted by
Anderson (1981) on Australian individual
investors, and Bartlett and Chandler (1997)
on UK investors, reached similar
conclusions.
However, what attracts ones attention
about the results regarding the perceptions of
individual investors in Kuwait is that
newspapers and magazines, friends advice
as well as market rumours are not used as a
main source of information by Kuwaiti
individual investors. These three sources of
information, however, have generally been
found to be least important to various user
groups, as supported by the works of
Abu-Nassar and Rutherford (1996) on Jordan,
and Andersen (1981) on Australia. Given that
the vast majority of the respondents have
relatively more than six years of experience
and hold academic degrees in the business
related areas, it is unlikely to see them
seeking friends advice or following market
rumours. The fact that newspapers and
magazines are not used as primary sources of
corporate information is explained on the
grounds that such magazines are not in
existence in Kuwait. Newspapers and
magazines might contain a section that
covers business and economics news without
any intensive analysis. The information that
they address is of little benefit to the user
groups.
Unlike individual investors, institutional
investors chose the annual report as their
main source of information about a company.
One possible explanation for this difference
may relate to the fact that individual
investors may find it difficult to absorb and
understand all the information contained in
the annual report. They also indicated their
heavy reliance on specialists advice when
making investment decisions about a
particular company. As was the case with
individual investors, institutional investors
perceived direct contact with the company as
an important source of information[3].
An interesting point to note is that

although institutional investors and stock
market brokers ranked market rumours
among the important sources of corporate
information, this source of information was
ranked among the less important sources of
corporate information across the target
groups. Given that institutional investors
and stock market brokers recruit
professional staff to make investment
decisions, this result is surprising. This
strange result can be explained on the
grounds that the work of the institutional
investors and stock market brokers is
conducted in the stock exchange. They are
very likely to be influenced by any rumour.
Needless to say that the collapse of the
Kuwaiti stock exchange in 1982 was mainly a
reaction to rumours[4].
Be that as it may, the bank managers who
took part in the survey rely on a combination
of specialists advice, direct contact with the
company and the published annual report
when making decisions to deal with a
particular company. Specialist publications
also form another important source of
information for bank managers. On the other
hand, the table revealed that sources such
newspapers and magazines, friends advice,
interim report and market rumours are of
little use to bank mangers. Government
representatives, however, showed that they
rely on the annual report and direct contact
with the company as main sources of
corporate information. It is also evident from
Table II that government representatives
seek specialists advice and special
publications as main sources of corporate
information. Unlike the other users of
corporate information, government
representatives seem to rely on the interim
report and market rumours as main sources
of information.
The academics main sources of corporate
information are the published annual report
and direct information obtained from the
company. The academics also indicated that
they use the interim report and seek
specialists advice when making decisions
about a particular company. An interesting
point to note about Table II is that the
academics do not seem to rate highly
specialised publications as a main source of
corporate information. Since academics are
expected to use corporate information for
academic research purposes, one would have
expected different results. This, however, can
be explained on the ground that in Arab
countries in general, Kuwait not an
exception, a limited number of specialised
journals and magazines publish information
related to companies. Business and economic

reporting
18/6/7 [2003] 599-617
news are restricted to small sections in the

national newspapers. This section lacks
depth and analysis. Hence, it is not
surprising to see this source of information
of little use to the academics.
Since the groups that took part in the
survey are of different size, and users
perceptions were measured on an ordinal
scale, a non-parametric test is found to be
most appropriate for such data to investigate
the homogeneity or lack thereof, among the
target user groups in the utilisation of
various sources of corporate information
(Huck and Cormier, 1996; Siegel and
Castellan, 1998; Silver, 1997). Hence, the
Kruskal-Wallis H test was used to test
possible differences between all groups.
The results of the analysis pointed to
significant disagreements between all pairs
of groups on the importance that they attach
to various sources of corporate information.
The highest degree of agreement attained
concerned friends advice, which cannot be
used as a credible source of corporate
information. The results of the analysis also
revealed a high degree of agreement that the
annual report, specialist advice, special
papers and magazines and direct information
from the company are useful sources of
corporate information. The highest degree of
disagreement among pairs of target groups
was associated with the interim report and
stock market rumours. It is worth
mentioning that, on the whole, difference in
the importance that the respondents attach to
different sources of corporate information
seem to exist on all possible sources.
The outcome of the analysis pointed to the
fact that different users of different sources of
corporate information attach different
importance to such sources. The importance
that a group of users attach might change
from time to time and from one decision to
another.
Characteristics of useful corporate

information
To investigate how different users of
corporate information perceive the
importance of various sets of criteria that
form useful corporate information, a list of
the characteristics of corporate information
was included in the questionnaire and the
respondents were asked to rate them on a
Likert-type scale. The scale ranges from 1
not important at all to 5 very important.
The results of the analysis are given in
Table III.
The table shows that the Kuwaiti user
groups rated all listed features of useful
corporate information as being highly
important. Credibility and timeliness were
viewed by almost all groups as the most

important features of useful corporate
information. The result is consistent with the
findings of Abu-Nassar and Rutherford (1996)
on Jordan, who also found timeliness to be
one of the most important criteria to affect
users perceptions regarding the quality of
financial information.
The Kruskal-Wallis H test of differences
between all groups, presented in Table III,
showed consensus on all the characteristics
of useful corporate information. Although
the Kendalls coefficient of concordance W
showed a high degree of agreement within
individual user groups and the sample as a
whole on the importance that they attach to
the characteristics of good quality corporate
reporting, the highest degree of agreement
reported between the academics followed by
auditors. Individual investors, followed by
stock market brokers, however, achieved the
lowest degree of agreement. The results are
not surprising. Academics are expected to
support the characteristics of corporate
information, since they form the basis for
useful information. They are listed in all
accounting textbooks. Auditors are expected
to be familiar with the features of useful
corporate information since their main task
is to ensure that the companys annual
reports reflect a true and fair view of the
company. Individual investors and stock
market brokers, on the other hand, usually
rely on different sources of information.
Given that one of the main source of
corporate information used by individual
investors and stock market brokers are stock
market rumours, as reported in the previous
section, the characteristics of useful
corporate information are of little relevance
to them.
The usefulness of the annual report

The respondents were asked to give their
level of agreement with seven statements
that may reflect the areas where the annual
report can be useful to the user groups. The
outcome of their answers is presented in
Table IV. It is obvious from the table that the
respondents either strongly agreed or agreed
with all listed statements with the exception
of the proposal that information contained in
the corporate report could help investors to
predict dividends of the company. The table
also indicated that information contained in
the annual report is useful in making
informed investment decisions and assessing
the users in evaluating the companys
performance. The Kuwaiti user groups also
revealed that the annual report is useful in
monitoring their investment and in
comparing a companys performance with
[ 605 ]
[ 606 ]
306
306
306
306
306
306
306
4.76
4.37
4.44
4.61
4.83
4.12
3.95
0.42
4.98
4.57
4.57
4.43
4.79
4.50
4.64
0.55
4.58
4.53
4.58
4.75
4.89
4.67
4.28
0.51
4.79
4.59
4.59
4.87
4.95
4.67
4.59
0.51
4.81
4.69
4.72
4.89
4.97
4.72
4.58
0.57
Notes: KWSL: Kruskall-Wallis significance level; Mean values scoring: 1 = not important at all; 5 = very important
Timeliness
Availability of specific information
Understandability
Neutrality
Credibility
Easy access to sources of information
Independent verification
5.00
4.53
4.68
4.71
4.97
4.63
4.34
0.65
4.98
4.72
4.72
4.95
4.97
4.87
4.79
0.59
4.91
4.89
4.97
4.83
4.89
4.89
4.77
0.45
4.85
4.60
4.65
4.75
4.91
4.62
4.49
0.24
0.34
0.38
0.38
0.31
0.36
0.52
0.53
Whole sample
Mean
SD
2
6
4
3
1
5
7
Rank

18/6/7 [2003] 599-617
User groups
Frequency 1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35)
Table III
Users ratings of the importance of a set of criteria of corporate information quality
0.625
0.421
0.506
0.486
0.821
0.325
0.499
KWSL

reporting
4.35
4.20
4.24
3.98
3.87
4.20
4.07
0.50
306
306
306
306
306
306
306
4.15
0.52
4.23
4.26
3.83
4.34
4.32
4.41
4.51
0.54
4.22
4.30
3.95
4.41
4.33
4.64
4.62
0.55
4.21
4.46
4.06
4.48
4.27
4.44
3.97
0.51
3.97
3.93
3.56
4.18
4.25
4.40
4.08
0.52
4.22
4.12
3.85
4.28
4.26
4.38
4.32
0.53
4.14
4.28
3.92
4.36
4.34
4.51
4.02
0.52
4.07
4.14
4.08
4.34
4.26
4.39
4.27
4.21
4.17
3.90
4.33
4.27
4.43
0.89
0.53
0.89
0.86
0.97
0.80
0.85
0.82
5
6
7
2
User groups
Whole sample
1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35) Mean SD Rank
Notes: KWSL: Kruskall-Wallis significance level; Mean values scoring: 1 = not useful at all; 5 = very useful
Provide primary information to investors to help them in

making informed investment decisions
Provide information to help investors to monitor their
investment
Help investors to predict expected income and earnings per
share
To help investors in assessing liquidity of the company
Help investors to predict future dividends of the company
Help investors to evaluate companys performance over time
Help investors to make comparison between a companys
performance with other companies performance
Freq.

18/6/7 [2003] 599-617
Usefulness criterion
Table IV
Groups views about usefulness of information contained in the annual financial statement
0.025*
0.905
0.10
0.96
0.152
0.374
0.236
KWSL

reporting
[ 607 ]

reporting
18/6/7 [2003] 599-617
others. The results are in line with previous

ones obtained by Anderson (1981), Arnold
and Moizer (1984), Chenhall and Juchau
(1977), Chang and Most (1985), Lee and
Tweedie (1975a, b; 1981), Streuly (1994) and
Winfield (1978).
The indifference that the respondents
showed to the usefulness of the corporate
report in predicting future dividends could
be due to the fact that data contained in the
annual report are mainly of historic nature.
In addition, the annual reports published by
the Kuwaiti companies have little forecasted
data that would enable the users to predict
corporate dividend policy. On the other hand,
the Kruskall-Wallis test pointed to significant
differences in the respondents opinions on
whether the annual report can help in
making comparison between companies
performances. This might imply that Kuwaiti
users tend to invest in specific companies
due to the limitation in the companies
number, and hence they are unlikely to use
the annual report to compare companies
performance. Yet, the Kendalls coefficient of
concordance W test within individual user
groups and within the sample as a whole
pointed to a certain degree of agreement
about all listed statements.
Understandability, credibility, importance

and timeliness of different parts of the
annual report
Understandability
The user groups level of understandability of
different parts of the annual report is
reported in Table V. The table revealed that
all participants agreed that financial
statements and notes to the accounts are
relatively difficult to understand. This was
evident across the user groups and within the
sample as a whole. The participants,
however, believe that the auditors report is
the easiest part to understand in the annual
report. The result is not surprising and is
consistent with Abu-Nassar and Rutherford
(1996), who found the auditor report easy to
understand and the statement of accounting
policies relatively difficult to understand in a
similar environment. The auditors report is
standard, and given that the participants
have an average six years or more of
experience in the business related areas, it is
very likely to find the participants familiar
with it. Financial statements and notes to the
accounts, however, contain technical issues
that require a certain level of knowledge and
experience.
On the other hand, descriptive statistics for
the whole sample demonstrated that it is easy
to understand the directors report. The
outcome of the analysis is predictable. The
[ 608 ]
directors report contains descriptive and

simple statistical information that the user
can understand. In all cases, the general
result points to the fact that participants
from various user groups do not seem to have
major difficulties in understanding different
sections of the annual report. This might be
due to the fact that most of the participants
have either completed academic degrees or
experience in business related areas. The
results, however, may not reflect reality. In
this context, Parker (1982) stated that
although users might give the impression
that they understand corporate information,
it is difficult to identify the users actual level
of knowledge.
The Kendalls coefficient of concordance W
test reported that the highest degree of
agreement was achieved by the academics,
followed by the financial analysts. The lowest
degree of agreement was reported among
individual investors and government
officials. The result might be justified on the
grounds that academics and financial
analysts have the required qualifications and
expertise to understand the contents of the
annual report. Needless to say that most of
the academics who took part in the survey
hold high academic degrees in business
studies. Financial analysts are expected to
have high degree of experience to enable
them to perform their jobs. Individual
investors, however, are coming from
different backgrounds and very likely to have
different investment experience. Hence,
inconsistency in their answers is predictable.
As for the government representatives, they
are expected to have different backgrounds.
For example, while those representing the
finance ministry are expected to have
intensive knowledge in finance, the
participants from the Department of Zakat
are expected to have intensive knowledge in
accounting. This reality might have
contributed to variations in their answers[5].
Credibility
The respondents were asked to rank the
degree of credibility that they attach to
various sections of the annual report and the
results of their answers are given in Table V.
The table indicated that all user groups view
financial statements as the most credible part
of the annual report followed by the auditors
report. The directors report, however,
received the lowest ranking. It is worth
noting that the notes to the accounts are
associated with the highest standard
deviation. This implies variations in the
participants opinion about the extent of
credibility that they attach to the notes to the
accounts. What attracts attention is that the
credibility attached to different sections of
2.88*
4.07
4.07
3.66
0.15
4.3
4.5
4.6
4.8
4.5
4.6
3.9
0.16
4.73
3.04
1.76
1.16
1.01
0.61
306
306
306
306
306
306
306
306
306
606
306
306
306
306
306
306
3.51
3.61
3.21
3.56
0.15
4.74
2.94
1.65
1.04
1.00
0.67
4.3
4.2
4.4
4.6
4.6
4.4
3.8
0.21
2.52
4.38
4.33
4.10
0.20
3.52
3.81
3.41
3.63
0.28
2 n = (42)
4.75
2.82
1.71
1.03
0.98
0.63
3.9
4.3
4.7
4.9
4.6
4.8
4.6
0.38
2.61
4.17
4.11
4.03
0.36
3.61
3.72
3.54
3.67
0.25
4.75
2.82
1.72
1.15
0.67
0.64
3.6
4.2
4.7
5.0
4.7
4.9
4.1
0.51
2.64
3.59
3.56
3.56
0.47
3.64
3.72
3.45
3.79
0.23
User groups
3 n = (36) 4 n = (39)
4.74
2.75
1.75
1.12
1.00
0.63
4.0
4.2
4.5
4.7
4.6
4.6
4.4
0.23
2.89
3.97
3.97
3.89
0.22
3.89
4.17
3.22
4.17
0.30
5 n = (36)
4.74
2.52
1.62
1.00
0.96
0.65
4.1
4.5
4.9
5.0
4.7
4.9
4.3
0.50
2.24
3.45
3.39
3.18
0.45
3.89
3.95
3.25
4.03
0.34
6 n = (38)
4.73
3.02
1.70
1.10
1.00
0.63
4.1
4.4
4.9
4.9
4.8
4.9
4.6
0.44
2.69
4.18
4.10
3.95
0.42
3.69
3.62
3.44
3.51
0.26
7 n = (39)
4.74
2.68
1.68
1.06
0.98
0.65
4.0
4.2
4.3
4.9
4.9
4.9
3.2
0.50
3.11
3.91
3.80
2.94
0.45
4.11
4.14
3.31
4.14
0.27
8 n = (35)
4.74
2.83
1.70
1.08
0.95
0.63
4.1
4.3
4.6
4.8
4.7
4.7
4.1
0.28
2.69
3.96
3.93
3.67
0.27
3.73
3.84
3.35
3.81
0.28
0.34
0.92
0.46
0.44
0.30
0.7
0.6
0.5
0.5
0.6
0.5
1.1
0.80
0.68
0.71
1.02
0.81
0.49
1.07
0.60
Whole sample
Mean
SD
Notes: Scoring a1 = very easy to understand; 5 = very difficult to understand; b1 = not credible at all; 5 = very credible; c1 = not Important at all; 5 = very important; d1 = strongly disagree;
5 = strongly agree
Understandability
Directors report
Financial statements
Auditors report
Notes to financial statements
(Mean valuesa)
Credibility
Directors report
Financial statements
Auditors report
Notes to financial statements
(Mean valuesb)
Importance
Board of directors report
Auditors report
Balance sheet
Income statement
Retained earnings statement
Cash flow statement
Note to the accounts
(Mean valuesc)
Timeliness
Less than 30 days
From 30 to less than 60 days
120 days or more
(Mean valuesd)
1 n = (41)

18/6/7 [2003] 599-617
Freq.
Table V
Users ratings of the degree of credibility of different parts of the annual report
0.923
0.377
0.793
0.798
0.968
6
5
4
1
2
2
6
4
1
2
3
3
1
4
2
Rank

reporting
[ 609 ]

reporting
18/6/7 [2003] 599-617
the annual report by the academics was the

lowest among the target groups. The analysis
also revealed that stock market brokers
attach a low degree of credibility to the notes
to the accounts.
The results of the analysis can be explained
on the grounds that academics as well as
other user groups are mainly concerned with
the financial statements. They, therefore, pay
little attention to what the board of directors
says in its report. Yet, the average degree of
credibility the academics attach to the
financial statements may reflect their
understanding of the way in which these
statements are prepared. Academics are
aware of different methods used to arrive at
the reported profit and the ability of
companys management to manipulate their
figures. They, therefore, provided a cautious
rating to these statements. The low rating
that the academics attached to the auditors
report, in comparison with other user
groups, can be explained on the grounds that
the auditors work in Kuwait is a routine one,
since national companies do not pay taxes.
Hence, the auditors work is mainly an
administrative one[6].
The low rating of credibility that stock
market brokers attach to the notes to the
accounts might be due to the fact that this
section of the annual report is of little
importance to them. The main concern of
stock market brokers is the profitability and
liquidity of the company. They focus on a
number of financial ratios to enable them to
give the right advice to their clients.
Given that respondents from all target
groups rated credibility as the most
important feature of corporate information,
the above results reflect respondents
concern about the level of credibility of the
current information reported in the annual
report of Kuwaiti companies. Given that
various users of the corporate reports can
obtain information directly from the
company, this result is not surprising. It is,
therefore, possible that the user groups give
more credibility to such information.
The Kendalls coefficient of concordance W
test revealed that the highest degree of
agreement was achieved by government
officials, followed by the academics and stock
market brokers. The lowest degree of
agreement was reported among individual
and institutional investors.
Importance
The respondents were asked to indicate the
degree of importance that they attach to each
section of the annual report. The results of
the analysis are summarised in Table V. It
can be noticed from the table that all
individual target groups either strongly
[ 610 ]
agreed that the income statement, cash flow

statement and statement of retained earnings
are the most important sections of the annual
report. The respondents, however, attached
less importance to the balance sheet. In
addition, the table revealed that all
individual target groups either strongly
agreed or agreed that the auditors report
forms an important part of the annual report.
Although most target groups agreed with the
proposal that the board of directors report
and notes to the accounts are important, they
showed less enthusiasm than that associated
with other sections of the annual report. The
highly reported standard deviations in some
cases imply a certain degree of differences in
the target groups opinion.
The outcome of the analysis is predictable,
since a companys profitability and liquidity
are the main concern for all user groups. In a
small country like Kuwait with a limited
number of shares, investors tend to invest in
companies with a profitable track record.
The statement of retained earnings reflects a
companys profitability and assists the users
in estimating their return on investment.
The cash flow statement assists the users in
predicting the liquidity position of the
company.
To assess the degree of agreement within
the individual target groups and the whole
sample, the Kendals coefficient of
concordance W was executed and reported in
Table V. The table shows that a certain
degree of agreement has been achieved
within all individual target groups and
within the sample. The highest degree of
agreement was achieved by financial
analysts, followed by stock market brokers
and academics. However, the lowest degree of
agreement obtained was by individual and
institutional investors. The results can be
explained on the grounds that financial
analysts, stock market brokers and
academics are expected to have a high degree
of knowledge of the annual report. All of
them use the annual report for various
reasons. Hence, it is difficult to see a high
degree of disagreement among these users on
the importance of various sections of the
report. On the other hand, the low level of
agreement reported within individual and
institutional investors and government
representatives can be explained on the
grounds that these users are likely to use
specific parts of the annual report, mainly
the income statement and the statement of
retained earnings. Hence, a certain degree of
agreement is expected on the importance of
these sections of the annual report.
Disagreement is likely to occur when rating
the importance of other sections of the

reporting
18/6/7 [2003] 599-617
annual report. As for the whole sample, the

participants either strongly agreed or agreed
that all listed sections in the questionnaire
are important to their decisions about a
company.
The findings are partially in line with
previous studies undertaken in developed
and developing countries (Australia,
New Zealand, UK, and Jordan) cited earlier
in that the income statement and the balance
sheet are the most important sections of a
corporate annual report. The main difference
between the results of the current study and
a similar study undertaken in Jordan is that
the respondents attach less importance to the
auditors report. The fact that Kuwaiti
companies do not pay corporate tax like their
Jordanian counterparts might explain the
result. In this case, the auditors report is
routine work and Kuwaiti investors would
have little information of relevance to them.
The result also contradicts Wallace (1988),
who reported evidence on the significance of
auditors report in developing countries. He
found that the auditors report achieved the
highest ranking for importance across the
surveyed user groups. The result of the
current study, however, is not comparable
with Wallaces study, since in this study the
annual report is compared with other
sections of the annual report rather than
with individual disclosure items as in
Wallaces study.
Timeliness
Viewing a sample of annual reports
published by Kuwaiti companies showed
variations in the publication date of the
annual report and the end of the corporate
financial year. In some cases, it reached three
and four months. The relevancy or otherwise
of corporate information is dependant on the
speed of its publication. The longer the
period between the end of the accounting
period and the date of the publication of the
annual report, the less relevant the
information. Hence, the respondents were
asked to express the degree of agreement
with the suitable period of time that it takes
to publish the annual report to make it more
relevant. The outcome of their answers is
summarised in Table V. The table
demonstrates that almost all respondents
within individual groups or the sample as a
whole either strongly agreed or agreed that
the annual report should be published within
less than 30 days of the end of the accounting
period. The respondents, however, either
strongly disagreed or disagreed with any
longer period of time.
The Kruskall-Wallis test showed no
significant difference in the respondents
opinions. Similarly, the Kendals coefficient
of concordance W test within individual

groups or within the sample as a whole
pointed to a certain degree of consensus
among the respondents.
Rating the importance of disclosure items

required by accounting standards
A list of items required by the International
Accounting Standards that are expected to
appear in the annual report of any Kuwaiti
company formed a part of the questionnaire.
The respondents were then invited to express
the degree of importance they attach to each
of these items using a Likert-type scale,
where one referred to not important and
five to very important. The results are
summarised in Table VI. What attracts ones
attention in the table is the fact that the
respondents at the individual level as well as
the whole sample level rated all disclosure
items that appeared in the questionnaire as
either very important or important. The
results achieved by each of the target groups
were consistent in most cases. Bank credit
managers and financial analysts showed that
almost all listed items of disclosure are very
important. The results are predictable, since
the International Accounting Standards
emphasised them due to their importance to
the users.
Another important point to note from
Table VI is that items such as net profit/loss,
gross profit, gross sales and classification of
shareholders equity were viewed by almost
all respondent groups and the whole sample
as the most important disclosure items.
Although the resulted standard deviations on
both individual target group level and the
whole sample level were relatively low, they
reflected a certain degree of disagreement
among the participants. The disagreement
was mainly concentrated on whether the
disclosure items were very important or
important.
While the result is similar to that achieved
by Stanga and Tiller (1983), who found net
income to be the most important item of
disclosure to creditors, it is not consistent
with the result obtained by Firth (1978),
Ibrahim and Kim (1994) and Wallace (1988),
who found that those who took part in their
studies attach low rating to income. On the
other hand, the cost of sales rating in this
study is similar to that reported by Chandra
(1974), Firth (1978; 1979), Ibrahim and Kim
(1994) and Stanga and Tiller (1983). Yet, the
cost of sales was not among the most
important disclosure items in Wallaces
(1988) study.
Disclosure items, such as two-year
statistical figures, accounting standards
used, summary of accounting policies and
[ 611 ]
[ 612 ]
4.32
4.49
4.59
4.56
4.62
4.71
4.71
4.74
4.64
4.71
4.69
4.79
4.90
4.87
4.77
4.92
4.92
4.77
4.72
4.74
4.70
4.97
4.70
4.67
0.28
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
Notes: Mean values scoring: 1 = not important at all; 5 = very important
Two years statistical figures

Classification of assets and liabilities to current/non-current
Classification of assets in sequence current followed by
fixed assets
Accounting standards used
Major components of assets
Disclosure of total current assets
Major components of current assets
Major components of fixed assets
Net value of depreciable assets
Classification of liabilities in a specific sequence
Disclosure of current liabilities value
Disclosure of components of long-term liabilities in a specific
sequence
Classification of shareholders equity section in a specific
sequence
Gross sales
Other sources or revenue
Cost of sales
Gross profit
Administrative expenses
Selling expenses
General expenses
Research and development expenses
Net profit/loss
Nature of companys activities
Summary of accounting policies
4.86
4.31
4.31
4.50
4.19
4.31
4.19
4.33
4.90
4.38
4.17
0.37
4.62
3.90
4.36
4.33
4.19
4.14
4.29
4.31
4.29
4.19
4.26
4.21
4.31
5.00
4.83
4.44
5.00
4.42
4.50
4.39
4.53
5.00
4.69
4.53
0.33
4.83
4.53
4.64
4.67
4.72
4.72
4.61
4.75
4.75
4.78
4.64
4.56
4.64
4.92
4.90
4.74
4.92
4.67
4.69
4.67
4.51
4.95
4.59
4.46
0.21
4.77
4.67
4.69
4.74
4.74
4.74
4.59
4.67
4.62
4.62
4.59
4.69
4.72
4.86
4.75
4.78
4.81
4.67
4.75
4.64
4.58
4.89
4.56
4.53
0.23
4.67
4.50
4.41
4.58
4.53
4.47
4.47
4.47
4.50
4.47
4.53
4.50
4.50
4.95
4.71
4.61
4.71
4.58
4.55
4.58
4.66
4.92
4.24
4.29
0.49
4.68
4.34
4.66
4.66
4.66
4.66
4.47
4.84
4.66
4.66
3.66
4.55
4.82
4.87
4.77
4.92
4.92
4.77
4.72
4.74
4.70
4.97
4.70
4.67
0.16
4.90
4.56
4.62
4.71
4.71
4.74
4.64
4.71
4.69
4.79
4.41
4.49
4.59
4.60
4.43
4.34
4.74
4.31
4.31
4.34
4.26
4.94
4.60
4.49
0.27
4.86
4.49
4.51
4.51
4.49
4.43
4.37
4.37
4.40
4.40
4.46
4.40
4.40
4.87
4.64
4.59
4.79
4.49
4.57
4.52
4.50
4.94
4.50
4.43
0.29
4.78
4.39
4.55
4.59
4.57
4.55
4.45
4.57
4.56
4.58
4.35
4.47
4.56
0.34
0.51
0.54
0.50
0.60
0.55
0.62
0.65
0.24
0.61
0.67
0.45
0.80
0.60
0.51
0.56
0.63
0.61
0.50
0.54
0.56
0.75
0.56
0.55
User groups
Whole sample
1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35) Mean SD

18/6/7 [2003] 599-617
Freq.
Table VI
Groups views about usefulness of information contained in the annual financial statement
2
5
6
3
19
9
16
17
1
17
22
23
13
6
9
13
21
9
12
8
24
20
13
Rank

reporting

reporting
18/6/7 [2003] 599-617
net value of depreciable assets, were ranked

at the bottom of the list. The above results
imply that the users of Kuwaiti corporate
information are mainly concerned with
profit. They pay less attention to additional
details related to accounting standards and
detailed accounting policies.
the individual target groups and the whole
Table VI. Table VI demonstrated a certain
degree of agreement within the target groups
and the whole sample. The table revealed
that the highest degree of agreement was
registered by the academics, followed by
institutional investors, as reflected by W
scores. The lowest degree of agreement,
however, was associated with the auditors
and financial analysts. Yet, the resulted level
of significance P implied reasonable levels of
agreement within the target groups and the
sample as a whole.
Rating the importance of voluntary

disclosure items
A list of expected items of voluntary
disclosure that might appear in the annual
report was given to participants to indicate
the degree of importance that they attach to
each of these items. The results are
summarised in Table VII. It is evident from
Table VII that respondents from all target
groups, or within the sample as a whole,
attach a certain degree of importance to all
listed voluntary disclosure items. However,
the table points to variations between the
target groups. For example, while
government representatives and bank credit
managers ranked almost all listed items of
voluntary disclosure as being very
important, such consistency was not evident
in the cases of institutional investors and the
academics. This result reflects differences in
the target groups needs and, therefore, the
importance of each of the voluntary
disclosure items.
On the other hand, all respondents, with
the exception of government representatives,
viewed the disclosure of earnings per share
as the most important one, followed by
information on investment in shares.
Disclosure items such as the percentages of
salaries/total salaries paid to Kuwaitis and
the percentage of Kuwaitis/total employees
employed by a firm were ranked at the
bottom of the list. The respondents also put
voluntary disclosure items such as
recruitment policy among university
graduates and donation to charitable
organisations at the bottom of the list. As was
the case with rating mandatory disclosure
items, the main concern of the respondents

was the firms profitability and liquidity. The
respondents showed little interest in the
recruitment policy and firms involvement in
society. The results are predictable in a small
and rich society like Kuwait, where the
government plays a major role in creating job
opportunities to university graduates.
Needless to say, the public sector absorbs
most of the graduates. In addition, charitable
organisations receive massive support from
the government. In this respect, it is
important to mention that the companies
law in Kuwait requires all publicly owned
companies to devote 5 per cent of their net
profit to the benefit of the scientific institute
led by the Emir. On the other hand, since
Kuwait has a limited number of companies,
different users of the annual reports are
expected to focus on the profitability and
solvency of the firm concerned.
individual target groups and the whole
Table VI. The table showed a certain degree
of agreement within individual target
groups. Although a significant level of
agreement reported within the whole sample
as reflected by P, the level of agreement W
was relatively low. On other hand, the
highest level of agreement was registered by
financial analysts, followed by stock market
brokers and the academics, as mirrored by
the resulted W. Yet, the lowest level of
agreement was associated with government
officials, followed by individual and
institutional investors.
Conclusion
The main purpose of this study is to provide
empirical evidence on the usefulness of the
various aspects of corporate information to
Kuwait users. Consequently, eight user
groups were surveyed: individual and
institutional investors, bank credit officers,
government officials, financial analysts,
academics, auditors and stock market
brokers. The analyses revealed that external
users of corporate information in Kuwait
prefer to extract information directly from
the company, whether through the published
annual and interim report, or through direct
contact with the company itself. This reflects
both the nature of Kuwaiti business and
Kuwaiti social environment, where
companies are mainly limited to a small
population. This is expected to develop a
close relationship between companies
and investors.
[ 613 ]
[ 614 ]
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
306
Notes: Mean values scoring: 1 = strongly disagree; 5 = strongly agree
Donations to charitable organisations

Recruitment policy among university graduates
Details of plant and equipment
Pension plan
Human resources development
Factor(s) that influenced firms activities
Factor(s) expected to affect future activities
Promotion and advertisement expenses
Directors remuneration
Amount paid as directors remuneration
Percentage of Kuwaitis employed by the firm
Information on future expansion in assets
Percentage of salaries/total salaries paid to Kuwaitis
Percentage of revenue generated from foreign sources
Information on different sources of revenue
Information on investment in shares
List of directors names
List of top management names
Stock value
Information on stock contents
Details of dividends policy
Names of majority shareholders
Value of investment in bonds
Value of raw materials produced locally
Information on long-term liabilities
Auditors fees
Information on various products produced by the firm
Information on cash surplus
Information on ageing debtors
Earnings per share
Statistics for more than one year
3.73
3.71
4.12
3.80
3.59
4.46
4.37
4.15
3.98
3.88
3.49
4.61
3.27
4.68
4.54
4.90
4.44
4.49
4.41
4.32
4.66
4.63
4.54
4.63
4.51
4.05
4.46
4.39
4.41
4.80
4.66
0.25
3.57
3.71
4.12
3.80
3.59
4.46
4.37
4.15
3.98
3.88
3.49
4.61
3.27
4.68
4.54
4.90
4.44
4.49
4.41
4.32
4.66
4.63
4.54
4.63
4.51
4.05
4.46
4.39
4.41
4.80
4.66
0.27
4.39
3.71
4.12
3.80
3.59
4.46
4.37
4.15
3.98
3.88
3.49
4.61
3.27
4.68
4.54
4.90
4.44
4.49
4.41
4.32
4.66
4.63
4.54
4.63
4.51
4.05
4.46
4.39
4.41
4.80
4.66
0.42
3.38
3.38
4.26
3.36
3.92
4.90
4.70
4.79
4.36
4.36
3.21
4.15
3.18
4.82
4.82
5.00
4.38
4.38
4.92
4.92
4.69
4.23
4.95
4.77
4.82
4.31
4.62
4.72
4.74
4.85
4.74
0.55
4.58
4.53
4.72
4.53
4.69
4.86
4.81
4.78
4.56
4.53
4.61
4.75
4.61
4.83
4.83
4.78
4.47
4.50
4.83
4.67
4.83
4.47
4.81
4.64
4.81
4.72
4.75
4.64
4.72
4.78
4.72
0.09
4.26
3.37
4.63
3.97
3.74
4.95
4.95
4.44
4.37
4.42
3.29
4.00
3.42
4.92
4.92
4.92
3.53
3.53
4.92
4.66
4.92
3.74
4.89
4.66
4.71
4.37
4.78
4.68
4.50
5.00
4.92
0.52
3.87
3.79
4.05
3.72
4.03
4.28
4.33
4.51
4.08
4.10
3.54
3.92
3.46
4.69
4.72
4.79
3.95
4.02
4.79
4.77
4.41
3.90
4.64
4.49
4.54
3.92
4.54
4.44
4.46
4.82
4.59
0.35
3.06
3.17
4.63
3.77
4.57
4.94
4.91
4.54
4.46
4.46
3.20
4.71
3.31
4.74
4.83
4.91
4.71
4.74
4.77
4.63
4.89
4.69
4.89
4.74
4.74
4.46
4.71
4.69
4.74
4.94
4.89
0.52
3.73
3.62
4.40
3.75
4.12
4.68
4.66
4.52
4.19
4.15
3.47
4.36
3.42
4.70
4.71
4.83
4.27
4.35
4.74
4.62
4.69
4.32
4.75
4.63
4.66
4.23
4.64
4.59
4.58
4.85
4.70
0.10
0.91
3.62
4.40
3.75
4.12
4.68
4.66
4.52
4.19
4.15
3.47
4.36
3.42
4.70
4.71
4.83
4.27
4.35
4.74
4.62
4.69
4.32
4.75
4.63
4.66
4.23
4.64
4.59
4.58
4.85
4.70
User groups
Whole sample
1 n = (41) 2 n = (42) 3 n = (36) 4 n = (39) 5 n = (36) 6 n = (38) 7 n = (39) 8 n = (35) Mean SD

18/6/7 [2003] 599-617
Freq.
Table VII
Groups views about usefulness of voluntary information contained in the annual report
29
30
19
28
27
10
11
18
25
26
31
20
32
7
6
2
23
21
5
15
9
22
4
14
11
24
13
16
17
1
7
Rank

reporting

reporting
18/6/7 [2003] 599-617
The user groups considered credibility and

timeliness as the most important features of
useful corporate information. The users,
however, attached less importance to
independent verification and the availability
of specific information as contributing
features to the usefulness of corporate
information. This might emphasise the
previous result in that Kuwaiti users can
enjoy the privilege of directly contacting the
company to request specific information.
Independent verification is, however,
connected with the auditors report. The
analysis showed that the Kuwaiti users
attach little importance to the auditors
report, since it is only a matter of routine and
also corporate income tax is not paid in
Kuwait[7].
In the main, there was general consensus
within the target groups that all of the main
sections of the annual report published by
Kuwaiti companies are not difficult to
understand. This implies that most user
groups who participated in this study have a
certain degree of knowledge about corporate
accounting and finance. The results also
imply that annual reports published by
Kuwaiti companies ensure a certain degree
of quality, since most of them are audited by
either the big firms, or by local firms
affiliated to them.
As far as the issue of credibility and
importance of different parts of the corporate
annual report are concerned, the respondents
made it clear that they had full confidence in
all sections contained in the annual report.
They believe financial statements to be the
most credible and important part of the
report. This result might reflect the Arab
culture in general, and the GCC countries in
particular, where the focus is on the main
issues without the need to examine minor
details. Financial statements are regarded
sufficient in formulating their decisions
about a company. To emphasise the
relevance of the annual report, the
respondents asked for a speedier publication
within a period of no more than 30 days.
The analyses also revealed that the
corporate annual report is useful in making
informed decisions about a company and
assists in evaluating corporate performance.
The analysis, however, indicates that current
information published by Kuwaiti companies
is insufficient to estimate corporate dividend
policy.
Overall, the respondents attached a high
degree of importance to all disclosure items
expected to be reported in the annual report
under the IASs, with more emphasis placed
on performance items. They also viewed the
list of voluntary disclosure items presented
in the questionnaire as being important. A

high degree of importance, however, was
attached to disclosure items such as earnings
per share and investments in shares and
bonds. Nevertheless, a low rating was
attached to disclosure items such as the
recruitment policies among Kuwaiti
graduates, pension plans and charitable
donations. These issues are unlikely to be of
any concern to a rich country like Kuwait.
The public sector still forms the biggest
employer of graduates. The government also
takes care of its pensioners and donates large
sums to charities. Hence, these issues are of
least concern to the users of the corporate
annual report.
In sum, the perception of user groups to
different aspects of the annual corporate
report, from an emerging economy like
Kuwait, seems to be generally similar to that
of the users in the developed economies. Both
agree that the annual report is the main
source of information, specific criteria ought
to be met to make the corporate report useful
to the users and the information disclosed in
the annual report is not difficult to
understand. Unlike user groups in the
developed economies, the Kuwaiti user
groups obtain information directly from the
company and place little importance on the
auditors report.
Notes
1 Late responses were used as a surrogate of
those who have not responded to the
questionnaire.
2 The Cronbachs Alpha ranges between zero
and one, where zero means no correlation
exits between various parts of the
questionnaire and one refers to perfect
correlation between different parts of the
questionnaire.
3 Given that Kuwait is a small country,
companies management establish close
relationships with investors. It is, therefore,
difficult for individual investors to request
information directly from the companies.
4 In August 1982, the Kuwaiti Stock Exchange
was struck by the Al-Manakh crisis. The
crises happened in an unorganised Kuwait
stock exchange as a result of speculations and
the absence of an effective control authority.
5 Zakat is the third basic pillar of the Islamic
faith, which is built on five main pillars. Zakat
in the Arabic language means increment,
growth, and/or purification of the soul and
wealth. It is a levy on wise and rational
Muslim adults whose wealth exceeds specific
minimum value.
6 Auditors work in a country like Kuwait,
where income tax is not paid, is to emphasise
accountability by assuring investors
and lenders.
[ 615 ]

reporting
18/6/7 [2003] 599-617
7 The fact that almost all firms in Kuwait are

affiliated to large international firms ensures
accountability and makes fraud only a remote
possibility.
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Further reading
Abu-Baker N. and Naser, K. (2000), Empirical
evidence on corporate social disclosure
(CSD), practices in Jordan, International
Journal of Commerce and Management, Vol. 10
No. 3-4, pp. 18-34.
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Differences in disclosure needs of major
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(1982), Corporate financial reporting in New
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corporate characteristics and disclosure
practice for discretionary information,
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No. 49, pp. 11-20.
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reporting and accountability in developing
countries: the case of Jordan, Advances in
Naser, K. and Idris, F. (1997), Users opinions of a
useful annual report produced by Islamic
banks, Accounting Commerce and Finance:
The Islamic Perceptive Journal, December,
Vol. 1 No. 2, pp. 1-42.
[ 617 ]
Book review
Opinion Shopping and the Role of

Audit Committees when Audit Firms
are Dismissed: the US Experience
Clive Lennox
Institute of Chartered Accountants of
Scotland
2003
78 pp.
ISBN 1 871250 93 5
15
Review DOI 10.1108/02686900310482740
This is a compact, timely and valuable
publication on a topic of high significance in
the post Enron situation. It lets a few cats
out of bags that were always suspected and
often secretly acknowledged. Now there is
proof, and it makes for disturbing reading.
With the highly diversified share portfolios
held by US investors, there is little incentive
to monitor senior management (p. 2). So
there goes one control. US auditors are
permitted to disclose emphases of matter if
deemed appropriate for the interests of
shareholders, but they rarely do so in fact
only in 0.43 per cent of the sub-sample of 2,405
unqualified but modified audit opinions out
of the 19,273 sample of company-year
observations between 1996 and 1998 (pp. 3 and
28). The Americans stand accused of being
overly legalistic and rule-based in their
approach to accounting, and this is
confirmed by when they have the
opportunity to break out, they rarely take it.
So there goes another potential control.
The overall findings are deeply disturbing
and indicate senior management
manipulation reigns supreme. First,
companies do successfully engage in opinion
shopping, swapping auditors to suit their
narrow self-interest. Second, audit committee

18/6/7 [2003] 618
# MCB UP Limited
[ISSN 0268-6902]
[ 618 ]
meetings are held at a low level of activity,

and only an estimate of 85 per cent engage in
auditor dismissal decisions. Third,
companies often dismiss auditors despite
audit committee disapproval. Fourth comes
higher audit committee member turnover
when audit committees disapprove. Rather
than hang around to raise Cain and Abel,
they simply clear off, thus reinforcing the
undesirable tendency. For those innocent
investors who believe they are being well
served, the uncomfortable message is that
mandated corporate governance initiatives
may not reduce the incidence of accounting
scandals since they do not address the
temptations of senior management, well
portrayed in agency theory. Perhaps granny
was right to invest her money under the
mattress, and had a canny intuition not to
trust companies and the financial markets.
So folk, in lieu of stricter regulation,
enforcement, comprehensive treatment of
the issue, audit professionalism, and
seriousness of intent of audit committee
members, expect senior management to get
away with what they have traditionally got
away with, and await the Messianic arrival
of the next Enron-imaged anti-Christ. Unless
issues relate to going concern, you can bet on
the auditors to keep their mouths shut. There
is no impetus on either audit firms or audit
committee members to whistleblow on behalf
of investors, who are patently not well served
in the USA. May those in other jurisdictions
examine their situations and their
consciences. Thanks go to the Scottish
Institute for sponsoring such a pertinent
publication.
Professor Gerald Vinten
Editor, Managerial Auditing Journal

Managerial Auditing Journal: Dispelling The Enron Blues

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Volume 18 Number 6/7 2003

Managerial Auditing Journal

Dispelling the Enron blues

442 Access this journal online

538 Users perceptions of corporate social

448 Enronitis dispelling the disease

456 An exploratory study of adopting

549 The usefulness of the audit report in

560 Auditing in support of the integration

465 Developing a strategic internal

569 Current accounting investigations:

MaryAnne M. Hyland and

478 Underreporting and premature sign-off

490 Internal auditors and the external

Christie L. Comunale and

577 The efficacy of liquidation and

591 Are auditors sensitive enough to

505 The Mad Hatters corporate tea party

599 Users perceptions of various aspects

517 Credibility and expectation gap in

Kamal Naser, Rana Nuseibeh and

Junaid M. Shaikh and Mohammad Talha

618 Book review

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Enronitis dispelling the disease

An exploratory study of adopting

Developing a strategic internal

Managerial Auditing Journal

This study examines whether the presence of

Abstracts & keywords

Underreporting and premature sign-off

Internal auditors and the external

The Mad Hatters corporate tea party

Credibility and expectation gap in

Abstracts & keywords

Improving corporate governance: the

Users perceptions of corporate social

The usefulness of the audit report in

Abstracts & keywords

Auditing in support of the integration of

The efficacy of liquidation and

I.A. Beckmerhagen, H.P. Berg,

Nirosh Kuruppu, Fawzi Laswad and Peter Oyelere

Keywords Quality, Safety, Auditing,

Current accounting investigations:

Keywords Going concern value, Liquidation,

Abstracts & keywords

Are auditors sensitive enough to fraud?

Managerial Auditing Journal

Bilal Makkawi and Allen Schick

Users perceptions of various aspects

Enronitis dispelling the disease

Managerial Auditing Journal

which the boards of major companies carry

Corporate governance is not a new issue. It

Events in the USA often have global

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