SHAC 3113-01SELECTED ISSUE IN AUDITING

Title:Effectiveness and

Challenging in AuditCommitteePrepared for:

DR. DEWI FARIHA BINTI ABDULLAHPrepared by:

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1.0 INTRODUCTION

In this report, we study about the concern of audit

committee regarding the challenges and the effectiveness of the

audit committee in practices for different country. Smith Report

(2003) in Song & Windram (2004) stated that one of the main

responsibilities in corporate audit committee is to review the

significant financial reporting issues and judgments made

regarding the preparation of the company’s financial statements,

interim reports, preliminary announcements and related formal

statements. We know that, audit committee is performing their

responsibility and it have been confirmed by the corporate

governance code, but nevertheless to which extent they are

fulfilling their responsibility? Therefore, we examine the

challenges and the effectiveness of audit committee in various

countries which are in Malaysia, Australia, New Zealand and

United Kingdom to see if there are differences in those aspects

if audit committee is being practiced in a different manner.

2.0 CHALLENGES IN AUDIT COMMITTEE

2.1 Australia

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The first challenge in audit committee that has stated by

most Australian auditors is to increase the time spent on the

audit. It becomes an issue among the audit committee because many

auditors resist doing so. Many auditors expected that increase in

hours on the audit is not associated with more substantive

testing of controls.

Another challenge is to strengthen the audit committee roles

in resolving the conflicts with management. Auditors believe that

audit committee can help to solve the conflicts and improve some

audit quality. According to Beattie et al., (2002), mention that

“audit committees appear to reduce the confrontational intensity

of interactions between the auditor and management by increasing

the level of discussion and reducing the need for negotiation”.

It shows that auditor interaction is one of the challenges

factors to test the strength of the relationship between audit

committees and their auditors. But, it is seen that audit

committee often do not play a major role in resolving the

conflicts (Gibbins et. al., 2005).

In the presence of the audit committee and the meeting

frequency, many Australian auditors believe that the audit fees

will be increased. Research by Collier & Gregory, 1996; Sharma,

2003, showed that the presence of an audit committee leads to an

increase in the demand for audit services. Therefore, audit

committee members play a key role to ensure a high quality of

services. The higher the fees increase the level of the quality

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audit. But, the most reason why they said the audit fees will be

higher is the preparation for the meetings may become costly.

Otherwise, they need increased reporting to the audit committee

and the time involves in meetings may be longer. Some of the

auditors expected that the increase in audit fees due to the

increase in testing or an extension of the audit result

identified by the audit committee.

As discussed in previous studies, it is plausible demand-

side explanation for a positive association between audit fees

and an effective audit committee (Goodwin-Stewart & Kent, 2006).

In order to avoid a financial misstatement, some independent

audit committee may demand in expanding the audit scope. Many

auditors want the audit fees to be decreased or no changes in

fees. So, it becomes a challenge in audit committee to follow

their wants. Auditors want the fees to decrease because it can

help stronger internal audit function. They want the audit

committee to lead more to the independent internal audit function

and enable the external auditor to rely more on the internal

audit work. Meanwhile, those who do not want the audit fees

change stated that they did not feel they could pass the costs to

the clients. This is because most of the clients expect that the

involvement with the audit committee was part of the business and

its risks.

Lastly, Australian auditors believe that it is effective and

appropriate if the audit committee meetings be held only 4 times

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a year. This is influenced by the age of the many auditors those

in over 40 age group and who not been used to deal with the audit

committee in the past.

2.2 New Zealand

In the case of the implementation in the New Zealand, there

they did not own any specific regulation or legislative

requirement in enforcing the audit committee as being justified

by the Institute of Chartered Accountants of New Zealand (ICANZ) in 2003 as

not mandatory for the public listed company. According to Sharma

& Kuang (2014), there are several reasons why this application is

true in the New Zealand both its public and private sector

companies; “firstly, it has small capital market that relies

considerably on foreign capital. Secondly, it has small and less

liquid market that creates greater risk for the investor. Thirdly

is its geographical isolation creates potential for information

asymmetry and increase agency costs to the foreign investor.

Forth, is because high management ownership in New Zealand firms

affords management opportunities to expropriate minority

stockholders. Lastly, since audit committee in New Zealand is not

required to be completely independent of management, therefore,

they could be perceived to be associated with greater information

asymmetry, higher agency costs and higher cost of capital as

executives of firms can serve on their audit committees which are

totally prohibited in other country. ”

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However, it is of course not always true for bigger,

complex, and publicly significant public sector such as New

Zealand district health board (DHB) especially after the case of

the largest fraud in New Zealand public sector history amounting

NZ$ 16.9 million at Otago DHB in 2008 (Magrane & Malthus, 2010).

Furthermore, with the result from the survey conducted by KPMG in

2005 that shows audit committee is still a “new phenomenon”

across ministries and government department in New Zealand. It

shows that New Zealand still need to improve their management in

terms of audit committee with more enforcement by the authorities

and related bodies. Since 1996, there are a number of best

practices guides, listing rules, and recommendations on the

implementation of audit committees being issued by a number of

different bodies in New Zealand. However, regardless of

differences on them, there are several factors that being shared

by all of it that are the “independence, financial skills and

expertise, experience with organizations, relationship with

stakeholders, clarity of purpose, and willingness to commit time

to audit committee” (Magrane & Malthus, 2010). This shows that

all of the above factors could be used as the guidelines in

measuring the challenges as well as the effectiveness of the

audit committee in New Zealand.

Using the result in the (Magrane & Malthus, 2010) as an

example to illustrate the situation of public sector in the New

Zealand, it shows that, in terms of turnover, DHB’s members are

being elected and appointed every three years and there is

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possibility for the members to be entirely new and same goes with

their board of directors and audit committee members. However,

following this suggestion by Office of the Auditor-General (OAG)

(2008), they cannot maintain the consistency in their management

and operations as different person may have different approaches

or methods. Next, in term of independence, the audit committee

members of DHB are of independence from it. However, they

actually never personally have meeting with the internal auditor

without the CEO or CFO because they thought that there are still

not a need to do so. Next, in terms of skills and experience of

the audit committee members, their audit committee chair is a

chartered accountant with various experiences from different

field. However, the other members are mostly with very little or

no experience in audit committee-related activities.

Other than that, in terms of remuneration, most of the

members of audit committee thought that there is insufficient

remuneration given to them that there is possibility that there

are some of them may view spending time for DHB just does not

worth it. And last but not least are the open and effective

relationships among the stakeholders and the audit committee

members. Most of them do agree that they are having a ‘good’ and

‘open’ working relationship but there is still some arguments for

different views and opinions between the audit committee members

and the management.

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2.3 Global

The most challenge that audit committee faces is financial

reporting risk. However, according to KPMG's 2014 Global Audit

Committee Survey, there is a little risk that audit committee

need to faces. The greatest challenge for the company is

government regulation or impact of public policy initiatives

(48%), then followed by uncertainty and volatility includes

economic, political and social instability with 47%. The third

placed with 39% is the operational risk and control environment.

Legal and regulatory compliance such the procedure come after

with 33%. This shows that audit committee not only face the

financial reporting risk but there are a lot of other risk that

they should be concerned of.

3.0 EFFECTIVENESS OF AUDIT COMMITTEE

3.1 Australia

According to DeZoortet al., (2002), as cited in Jenny

Steward & Lois Munro (2007), found that three factors are

recognized as important to ensure the effectiveness of the audit

committee. Firstly, is dependent on its composition (the

independence and expertise of its members). Secondly, it is

authority (responsibilities and influence). Thirdly, it is

resources (number of members and access to other governance8

parties). DeZoortet al., (2002), also argued that audit

committees must be active and diligent to effectively discharge

their oversight responsibilities to achieve audit committee

effectiveness.

Many Australian auditors believe that the existence of audit

committee can lead to the reduction in audit risk rather than the

frequency of the meeting frequency. It is expected that the

greatest reduction will happen if the auditor attend all the

meetings which a total six meetings in a year. Audit risk can

also be reduced more than 5 percent if the audit partner only

attends two meetings rather than six meetings. Meanwhile, less

than 5 percent of audit risk can be reduced if the meeting

frequency only held twice a year and the audit partner attends

both meetings. This perception is same with the prior studies

that stated auditors’ risk assessments are influenced by the

client’s corporate governance structure (Sharma et. al., 2007).

Besides that, the Australian auditors did not expect that

the audit committee presence and their meeting frequency have a

material effect on the overall level of audit testing. They did

not find any significant differences happen based on the meeting

frequency and the attendance of audit partners in meetings held.

For the assistant auditors budgeted hours, it is expected no

change to happen in the presence of the audit committee. This is

because it is not influenced by the frequency of meetings and the

partner’s attendance at meetings. But, the budgeted hours for

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audit manager and partner are expected to be increased because

influenced of the audit committee and its meetings. For 2x2 and

6x2 treatment groups, the budgeted hours expected to be increased

between 5 and 10 percent, while 6x6 treatment groups are expected

to increase more than 10 percent.

From the Australian auditor's perspective, the presence of

audit committee can help in resolving the conflicts with

management. They also believe that the audit committee existence

may result in improvement in overall audit quality even the

effect is not great as it could be. This result consistent with

the previous studies that found the presence of the audit

committee is associated with the lower level of financial fraud

(Beasley et. al., 2000) and more reliable financial reporting

(McMullen, 1996). Thus, the Australian auditors indicate that the

meeting frequency and the attendance at meetings are not

influencing the improvement in audit quality. As stated by Song &

Windram (2004), there is no significant relationship between

audit committee effectiveness and the frequency of audit

committee meetings.

3.2 United Kingdom

There are six variables to determine audit committee

effectiveness in United Kingdom (UK) that being examined by Song

& Windram (2004). In their study, they have selected 50 samples

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of companies in United Kingdom in the period of 10 years (1991-

2000).

The first variable that they mention is the size of boards

in a company. In their study, they found that large boards does

not necessarily increase audit committee effectiveness. But

nevertheless, it may increases the tendency for the companies to

violating the financial reporting standards. In a large boards,

there are various types of people that trying to voice out their

opinion. They could pursue the other board’s member to conspiring

in a certain matter, fraud for example, by bribing the targeted

person. There is no sense if many people (directors) being

monitor the activity in the boards but no one take action or

responsible on a particular crime. In making a conclusion on

whether large boards reduce the effectiveness of audit committee

or not, Song & Windram did not examined it by using statistically

test. Thus, it needs to be further examined by future researcher.

The second variable is independent boards. Result from their

study indicates that, independent boards promote audit committee

effectiveness in financial reporting. They stated that, the

director independence increases audit committee effectiveness. In

United States (US), Beasley (1996) in Song & Windram (2004) shows

that audit committee existence and independent director reduce

financial fraud. Board with high level of independence is

effective in supervising or manages the financial reporting

matters. In increasing the level of independence, they could hire

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independent outside directors’ i.e. non-executive directors. It

is because they did not have any interest in the company and they

are not related to the companies’ daily operation especially for

the decision making. For that reason, some companies are willing

to pay highest fees for their service to make sure the audit

committee is effectively enough in controlling the company’s

financial.

The third variable is the frequency of audit activity. Song

& Windram (2004) found that, an active audit committee may

contribute to audit committee effectiveness. This result is in

line with the suggestion of Menon & William (1994), Collier &

Gregory (1999), and Vafeas (1999) in Song & Windram (2004), which

is the audit committee meeting is important in overseeing the

financial reporting. In Song & Windram (2004), they found only

10% of audit committees that met 4 times a year in accordance

with suggestion that made by Ribbon Committee and

PricewaterhouseCoopers. This is not effective enough as they

could miss the important issue that need to discuss together.

Actually, extra meetings may be recall the poor stock market or

management performance and audit committee could discuss it

together on how to rise up the performance. Besides, the meeting

is important in order to monitor the financial reporting and

internal control.

The forth variable is director financial literacy. Song &

Windram stated that, director financial literacy is one of

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important element for audit committee effectiveness. They noted

that, ‘half of Financial Reporting Review Panel (FRRP) audit

committee had no members with a formal financial qualification in

the year of 1991 (Song & Windram, 2004)’. FRRP was established in

1991 and responsible in enforcing corporate financial reporting

in UK (Dearing Committee; Song & Windram, 2004). Over the period

of 10 years, in year 2000, companies have made some progress

regarding this matter. But nevertheless, there are still more

than 20% of the companies still did not have any audit committee

members with professional accounting qualification. Actually, it

is important for companies to have at least one certified auditor

(financial expertise) in the audit committee in order to

monitoring the financial report either it is compliance with law

and regulation or not. Besides, the executive or non-executive

director in the audit committee also needs to have thorough

understanding regarding the financial field to enhance the

effectiveness of audit committee.

The fifth variable is the director share ownership. The

result from Song & Windram study indicates that, increasing in

directors’ shareholding could make reduce the audit committee

effectiveness. This means that, if the major shareholder in the

company are being participate in the audit committee, they would

have their power to voice out their opinion or to manipulate

statement or data in order to gain their interest in the company.

The shareholder in the company would have their own right in

making decision for the company as a whole. Thus, they could hide

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their crime, as they are also in the audit committee member.

Jensen (1993) in Song & Windram (2004) point out that since the

boards of directors ‘manages’ other people money, they may be

less careful in monitoring the financial affairs of the

corporation. For example, the major shareholder (Chairman) have

private affair with the Chief Executive Officer (CEO). Under the

CEO management, there are a lot of misstatement and omitted occur

in the financial report as him or her take the money from the

company for him or her interest. Then, it is known by chairman,

but due to private affair, the chairman hides it in order to

protect the CEO.

The last variable is multiple outside directorships. The

result of Song & Windram study indicates that multiple outside

directorships could reduce audit committee effectiveness in

financial reporting. They mention that, audit committee can be

effective enough when each member has sufficient time and

persistence to their job. Previous survey found that, lack of

time is a greatest obstacle to having an effective audit

committee. Core et al. (1999) in Song & Windram (2004) argue that

three or more directorships would make a director very busy.

Normally, non-executive directors will often hold a number of

other directorships that will affect his or her time management

to attain meeting at any particular company. Thus, they were

difficult to maintain their performance in the audit committee

and it leads the audit committee ineffective.

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3.3 New Zealand

For the DHB, (Magrane & Malthus, 2010) in New Zealand, they

measured the effectiveness of the audit committee using the

stakeholders’ perception regarding the matter. The interviewer

asked about whether there is a need to make the audit committee

as mandatory for DHB and then translate the answer to know

whether they could see the effectiveness of the audit committee

in the organization. The audit committee chair when being asked

this question, want it to be mandatory that shows that he agree

of the effectiveness of audit committee in improving the

organization. Same goes with DHB’s CFO and internal auditor as

they mentioned that “audit committee’s effectiveness has been

steadily improving”. However, there are some people in the

organization that could not see the effectiveness and importance

of audit committee as commented; “since DHB already have audit

committee, on what rational did they need to make it mandatory?”

However, it is better for the organization to justified audit

committee as mandatory for them to manage, control and improve

their operations in the future.

3.4 Malaysia 15

Several ways can be taken in order to increase the

effectiveness of the audit committee’s role in ensuring accurate

and transparent disclosure. The panelists at the MIA events

agreed that audit committee directors now should have to undergo

intensive training and development in order to discharge their

duties. Intensive training and development is a must for the

audit committee because there was no shortcut in performing the

work and responsibilities since there are few risks that they

need to carry and concern about.

As we knew, the audit committee consists of at least three

members which one of them are independent member with experience

in accounting or auditing and their job are to monitor the

company's financial reporting, monitor the effectiveness of the

company's internal controls, internal audit and risk management

with respect to financial reporting, remain informed about the

audit of group reporting and financial statements, review and

monitor the auditor's impartiality and independence (including

the provision of non-audit services) and assist in the

preparation of the proposal of an auditor to the Annual General

Meeting. So as in order to empowering the effectiveness of the

audit committee, the audit committee directors should engage

closely with the external auditors. By engaging closely with the

external auditors, the audit committee will be able to challenge

the external auditors and the accountant on how the standards are

being applied. It also can help the audit committee to increase

their knowledge regarding the standards this is because the

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extensive technique knowledge is the most common technique that

the audit committee directors currently lack.

The most important thing is the audit committee should

entrust the external auditors with assessing the capability and

strength of the chief financial officer and his team. According

to MIA, audit committee members nowadays face great personal,

reputational and even litigation risk and one way to overcome

this matter, a company should be more selective in taking on

audit committee directorships.

However, theoretically, audit committees can rely on

internal auditors as a valuable resource to help them carry out

their oversight responsibilities. Audit committee members also

must understand the rationale for management’s choices and the

implications for financial manipulation. There exists clear

agreement that when an accounting treatment that is open to

interpretation or requires a judgment has a material impact on

the Company’s accounts that there occurs appropriate disclosure

of the nature of this estimate. At a minimum, all directors need

to understand the business model and how the company makes money.

But audit members must understand how such transactions require

the judgments and choices management make, including the

selection and application of critical accounting policies,

judgments and estimates, and the potential for manipulation of

financial statements, by management, as a result.

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Critical accounting policies require complex, subjective

judgment and critical accounting estimates require assumptions

about uncertainty whereby different assumptions may have a

material impact. It is important that audit committee members not

only possess formal independence according to prescribed

criteria, but also have independence of thought, judgment and

action, so that independence is not only perceived or seen, but

is real and applied. Audit committee members should voice their

own opinions and not allow their trust in, or relationships with,

management to compromise their continual display of impartiality

and objectivity.

4.0 CONCLUSION

As conclusion, many Australian auditors believe that the

presence of audit committee assists in reducing perceived audit

risk. The reduction may be influenced by the meeting frequency

and the audit partner’s attendance at meetings. Even though the

impact of audit committee in audit efficiency is not so great,

but their existence is expected to help in resolving the

conflicts with management. This can also lead to the improvement

in the audit quality. There is also some expectation from

Australian auditors that the audit fees will be increased. The

increase due to the additional work they need to perform for the

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audit committee and the meetings. The additional they need to

perform are preparing and attending the meetings, and also make

reports to the audit committee. Based on the effectiveness of

audit committee, there are also some challenges faces in the

audit committee. For example, the audit committee has to

encourage the auditors to increase the time spent on the audit

even it is not associated with more substantive testing. The

audit committee should also ensure that their role is

strengthened in resolving the conflicts with management. This is

to help the auditor in producing the best quality of audit work.

The audit fees should be controlled to ensure that the auditors

are not being burdened. The fees must be fitted with the works

performed by the auditors as well as the audit committee.

In determine United Kingdom audit committee effectiveness,

there are six variables that need to be considered. In UK, the

independent boards, director financial literacy and active audit

committee are promoting audit committee effectiveness in

financial reporting. In contrast, director share ownership and

multiple directorships could reduce the effectiveness in audit

committee. Besides, the boards size is not necessarily increase

audit committee effectiveness and it need to be further research.

Next, after seeing the audit committee of the public sector

(DHB) in New Zealand from different sides it shows that even

though they are implementing audit committee in the organization,

but still not in full applications. Furthermore, there is always

some more room for them to improve in every aspect that being

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studied and one of the reasons is maybe because there is no

enforcement for them to implement as something mandatory. Other

than that, the stakeholders perception towards the audit

committee is also one of the factor most probably make audit

committee seem to be not important to them as most of the

ineffectiveness in implementing it in the small organization that

monopolize the public and private sector in New Zealand.

We can conclude that the role of the audit committee is

important in a company and private. The company as well as the

audit committees itself should put an effort to enhance and

development the skill to increase their effectiveness. Those

knowledge and skill should be improved from time to time.

Relationships between the management, audit committees and

auditors also part of the way in enhancing the audit committees’

effectiveness. Overall, we can say that audit committees hold a

bigger risk in term of financial performance report and there

should be no short cut either in recruits the committees or being

the audit committees.

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Characteristic, Incentives, and

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KPMG’s ACI. (Jan, 2014). KPMG’s 2014 Global Audit Committee

Survey. Audit Committee

Institute.

(http://www.kpmginstitutes.com/aci/insights/active/2014-kpmg-

global-audit-

committee-survey.aspx).

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Magrane, J. and Malthus, S. (2010). Audit committee

effectiveness: a public sector case study.

Managerial Auditing Journal. 25(5): 427-443.

Nazatul Izma. (April, 2013). Empowering Audit Committees. Accountants

Today.

Song, J. and Windram, B. (2004). Benchmarking Audit Committee

Effectiveness in Financial

Reporting. International Journal of Auditing. 8: 195-205.

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