Managerial Auditing Journal

Emerald Article: Factors influencing auditor independence: Malaysian loan officers' perceptions Nur Barizah Abu Bakar, Abdul Rahim Abdul Rahman, Hafiz Majdi Abdul Rashid

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To cite this document: Nur Barizah Abu Bakar, Abdul Rahim Abdul Rahman, Hafiz Majdi Abdul Rashid, (2005),"Factors influencing auditor independence: Malaysian loan officers' perceptions", Managerial Auditing Journal, Vol. 20 Iss: 8 pp. 804 - 822 Permanent link to this document: http://dx.doi.org/10.1108/02686900510619665 Downloaded on: 11-06-2012 References: This document contains references to 59 other documents To copy this document: [email protected] This document has been downloaded 4576 times since 2005. *

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MAJ 20,8

Factors inuencing auditor independence: Malaysian loan ofcers perceptions

Nur Barizah Abu Bakar, Abdul Rahim Abdul Rahman and Haz Majdi Abdul Rashid
Department of Accounting, Faculty of Economics and Management Sciences, International Islamic University Malaysia, Kuala Lumpur, Malaysia
Abstract
Purpose Auditor independence is fundamental to public condence in nancial reporting and the auditing profession. The study aims to provide further understanding of the factors inuencing auditor independence from the perspective of commercial loan ofcers. Loan ofcers formed the sample as they are relatively sophisticated nancial statement users who would understand the importance of audit report and the issues related to auditor independence. Design/methodology/approach The study examines the perceptions of commercial loan ofcers in Malaysian-owned commercial banks and a total of 86 ofcers responded to the self-administered questionnaire. Findings Results indicate that smaller audit rms, audit rms operating in a higher level of competitive environments, audit rms serving a given client over a longer duration, larger size of audit fees, audit rms providing managerial advisory services, and, the non-existence of an audit committee, are perceived as having a higher risk of losing independence. Audit rm size appears to be the most important factor that affects the auditor independence, followed by tenure, competition, audit committee, audit rms providing managerial advisory services and size of audit fee. Originality/value The paper provides important insights into the factors affecting auditor independence and contributes towards better understanding on the ways to improve the condence in nancial reporting and credibility of the auditing profession. Keywords Auditors, Independent experts, Malaysia, Commercial banks Paper type Research paper

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Managerial Auditing Journal Vol. 20 No. 8, 2005 pp. 804-822 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510619665

Introduction The impairment or lack of auditor independence is a main cause of many corporate collapses and corporate scandals across the world, including the US case of Enron. This important issue has been raised by the media. Media comments have demonstrated that auditor independence is the main concern when talking about corporate scandals. The paper supplies valuable input and feedback regarding auditor independence so that these corporate scandals and collapses may be minimized or reduced. The study aims to provide further understanding of the factors inuencing auditor independence from the perspective of commercial loan ofcers in Malaysia. To achieve this objective, all the 12 Malaysian-owned[1] commercial banks are included. A sample of 86 commercial loan ofcers responded to the self-administered questionnaire. The ndings of this study will provide better understanding on the factors that inuence auditor independence in Malaysia giving a better understanding of the factors that inuenced the quality of auditing as perceived by the nancial

statement users. It is vital that auditors maintain their independence and ensure that they provide a high quality of auditing, since the credibility of nancial information relies heavily on their independence. Without auditors independence, the credibility of nancial information will be reduced, and this may be detrimental to the auditing profession itself. The main objective of this study is to examine the factors that inuenced auditor independence. Commercial loan ofcers of conventional banks are chosen as the sample because they can be regarded as relatively sophisticated nancial statement users who would understand the importance of the independent audit function (Knapp, 1985). Bank loan ofcers also represent the lenders or creditors point of view, as one of the major users of nancial statements. Auditor independence: a review of the literature Since the main objective of this study is to examine the factors that inuenced auditor independence, the literature on the basic meanings of auditor independence mainly from standard auditing textbooks is rst reviewed. The literature on empirical studies mainly from academic journals is then reviewed with the main aim to identify and examine the factors that have been found inuential to either improve or impair auditor independence. The authors then synthesise the previous empirical ndings into themes that later helps to develop research questions for the study. Arens et al. (1999) dened independence in auditing as taking an unbiased viewpoint in the performance of audit tests, the evaluations of the results and the issuance of audit reports. Independence includes the qualities of integrity, objectivity and impartiality. In discussing the foundation of the concept of auditor independence, Pany and Reckers (1983) emphasize that the concept is closely originated from the reason for the existence of auditing itself. According to them, the rationale for the external auditors work (i.e. independent audit) indeed a primary justication for the existence of the public accounting profession arises from the need for reliable nancial information There are two types of auditor independence; actual and perceived independence. Independence in fact (or actual independence) can be dened as the auditors state of mind, his or her ability to make objective and unbiased audit decisions (Dykxhoorn and Sinning, 1982). It basically refers to the mental attitude of the auditor in terms of professional objectivity (Gul and Tsui, 1992). On the other hand, independence in appearance (or perceived independence) refers to the publics or others perceptions of the auditors independence. This notion of independence (i.e. perceived audit independence PAI) is one of the cornerstones of auditing theory and the sine qua non of auditing practice. Since independence in appearance relies on the perceptions of users of nancial statements, thus, it is an empirical concept (Busse von Colbe and Lutter, 1977; Dykxhoorn and Sinning, 1981). Gunz and McCutcheon (1991) found that there is a relation between independence and professional ethics especially on the issue of conict of interest. Conicts of interest might arise in many situations. Among others, conict of interest between the duty of the client and to the public at large. Another perspective of conict is in terms of the auditors duty to either the client or the public or both might conict with the perceived self-interest of the auditor. In this situation, an auditor may be breaching his/her responsibility to maintain clients condentiality, for example, by passing

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relevant information between partners. This may be the result of auditors self-interest, whereby they did this among others, to avoid audit failure resulting in litigation against the auditor. Most of the literature on auditor independence suggests that the credibility of nancial statements depends on the perceived independence of the external auditor by the users of the nancial statements (Firth, 1980; Lavin, 1976; Dykxhoorn and Sinning, 1982). For example, Firth (1980) argues that if the auditor is not seen to be independent, users will have less condence in the nancial statements, and the auditors opinion on the companys nancial statements will be of no value. Thus, the credibility of auditors depends not only on facts but also, just as importantly, on the perception of independence. Both actual as well as perceived auditor independence are critical elements in the maintenance of public condence in the auditing profession (Pany and Reckers, 1980). However, for this study, we will only focus on independence in appearance, since the actual independence of an auditor is unobservable. The majority of empirical studies on the PAI focused upon identifying the factors which potentially inuence independence, and assessing their impact upon perceived independence since independence in fact is unobservable. Some of these studies try to nd the relationship of these factors with PAI, whether they are signicantly or insignicantly related with PAI, and then whether they are positively or negatively related with PAI (Pany and Reckers, 1980; Gul, 1989; Gul and Tsui, 1992). Another group try to rank these factors according to their degree of inuence on PAI (Shockley, 1981; Bartlett, 1993). Others do the combination of both approaches (Teoh and Lim, 1996). Among the factors that affect PAI that have been studied are (1) the effects of gifts (Pany and Reckers, 1980); (2) the purchase discount arrangement (Pany and Reckers, 1980); (3) the audit rm size (Shockley, 1981; Gul, 1989); (4) the provision of management advisory services (MAS) by the audit rm (Shockley, 1981; Knapp, 1985; Gul, 1989; Bartlett, 1993; Teoh and Lim, 1996); (5) the clients nancial condition (Knapp, 1985; Gul, 1989; Gul and Tsui, 1992); (6) the nature of conict issue (Knapp, 1985); (7) the audit rms tenure (Shockley, 1981; Teoh and Lim, 1996); (8) the degree of competition in the audit services market (Knapp, 1985; Gul, 1989); (9) the size of the audit fees or relative client size (Gul and Tsui, 1992; Bartlett, 1993; Teoh and Lim, 1996; Pany and Reckers, 1980); and (10) the audit committee (Gul, 1989; Teoh and Lim, 1996). The second type of study on PAI focused on the differences in the positions of auditor independence among various groups. Some studies focus on the differences of opinions among different groups of preparers and users (Lavin, 1976; Dykxhoorn and Sinning, 1981; Jenkins and Krawczyk, 2001; Patel and Psaros, 2000). For example, Lavin (1976) studies the opinions of CPAs and two groups of users of nancial statements, on auditors independence by presenting 12 auditor-client relationships. Three groups involved in the study are AICPA members, bank loan ofcers and nancial analysts. Their opinions are to be compared with the Securities Exchange Commission (SEC)

rulings and AICPA positions on auditor independence. Using a mail survey, he found that the consensus of the CPAs and users agrees more with the AICPA than with the SEC, and that the authorities (i.e. SEC and AICPA) at times characterize relationships as not independent that the consensus considers as independent. On the whole, it appears that the SEC rulings on independence are more conservative than these users feel necessary in these situations. Factors inuencing auditor independence There are at least six factors that have been examined by previous studies on perceptions of auditor independence. The six factors are size of audit rm; level of competition in the audit services market; tenure of audit rms serving the needs of a given client; size of audit fees received by audit rms; provision of managerial advisory services by audit rms to the audit clients; and the existence of audit committee. Size of audit rm. The majority of empirical studies that attempted to nd the relationship between audit rm size and AI, found that there is a positive relationship between them (DeAngelo, 1981b; Shockley and Holt, 1983; Nichols and Smith, 1983; Dopuch and Simunic, 1980; McKinley et al., 1985; Shockley, 1981; Gul, 1989). Basically, a positive relationship means that the larger the audit rm size, the greater the auditors independence. They prove that large rms are more resistant to client pressures, thus maintaining higher audit independence. In fact, it has been argued that large rms, due to their very size, may be more able and motivated to provide better audits. However, as pointed out by Goldman and Barlev (1974), one should not conclude that large CPA rms are immune to pressures from their clients. Competition among the ofces of some large rms for clients may be as great as the competition among small, independent CPA rms. More to the point, the few court cases which challenge the assumption that CPA rms acted independently indicate that the use of a large CPA rm is no guarantee of its ability to resist pressures from clients, as happened with Arthur Andersen and Enron. Level of competition in the audit services market. A number of empirical studies have proven that the high level of competition in the audit rm has resulted in less auditor independence (Knapp, 1985; Shockley, 1981). Gul (1989) found the opposite. Tenure of an audit rm serving the needs of a given client. An audit rms tenure, which is the length of time it has been lling the audit needs of a given client, has been mentioned as having an inuence on the risk of losing an auditors independence. Most writers, who discuss the relationship between tenure and AI, support this view. A long association between a corporation and an accounting rm may lead to such close identication of the accounting rm with the interests of its clients management that truly independent action by the accounting rm becomes difcult (US Senate, 1976). Mautz and Sharaf (1961) pointed out that in a many cases, the greatest threat to (the auditors) independence is a slow, gradual, almost casual erosion of honest disinterestedness. Complacency, lack of innovation, less rigorous audit procedures and a learned condence in the client may arise after a long association. Some critics invoke the vested interest argument to support the assertion that auditors might compromise their independence to gain continuing audit engagements, the prospect of raising audit fees if the client rm expands, and opportunities of providing non-audit services later (Hoyle, 1978). The US Congressional Subcommittee on Reports, Accounting and Management (the Metcalf Committee (1976)) considered that the above dangers are serious enough

Auditor independence

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to recommend the mandatory rotation of auditors as a possible remedy. Rotation ensures that the auditor remains independent since tenure will be limited and any vested interest will no longer be relevant (Teoh and Lim, 1996). Nevertheless, this suggestion has been opposed (Shockley, 1981; DeAngelo, 1981a). In a study conducted by Shockley (1981), tenure was not found to have a signicant impact on perceptions of independence. Teoh and Lim (1996) also nd the same and report that there is a negative relationship between tenure and AI. Size of audit fees received by audit rm (in relation to total percentage of audit revenue). Normally, when talking about the relationship between size of audit fees and AI, large size of audit fees are associated with a higher risk of losing the auditors independence. The Accountants International Study Group (1976) recommended that auditors be restrained from accepting engagements for which the fees constitute 10 per cent or more of the auditors total fee income. Additionally, both the IFACs (1996, p. 8.7) Code of Ethics for Professional Accountants and the EFAA (1998) suggest that client size (measured from size of fees) could raise doubts as to independence, but do not state what constitutes an unacceptable proportion of total fees. However, the EFAA (1998, p. 4) clearly states that, the (total) fee from one client should not exceed a certain percentage of the total turnover of the audit rm. In Malaysia, Noordin (1990) expresses his concern that a code of ethics should provide guidance to limit over-dependence on one client for revenue. The ICAEW has ruled that the size of audit fees of a major client should not exceed 15 per cent of total fees to avoid impairment of auditor independence. This 15 per cent criterion has also been the level generally used in Australia at which auditors have to consider their independent position and there is even a suggestion that the 15 per cent is too low. The Cohen Commission (AICPA, 1978) directed attention to the importance of size of audit fees as one of the crucial independence-related issues. Such attention has prompted research into the inter-relationship between size of audit fees and other independence-related issues such as the provision of MAS, the size of the audit rm and competition. As a result, most empirical studies conducted on size of audit fees do not look at that factor per se; instead they inter-relate it with other factors. For example, Burton and Faireld (1982) point out that there may be a close linkage between MAS and size of audit fees. As the provision of MAS increases, the auditor is likely to be more dependent on the client due to the size of the fees generated. It also seems plausible that smaller audit rms will be more dependent on the client if the size of audit fees generated is a signicant proportion of its overall revenue. Further, in a highly competitive environment, the auditor is also perceived to be less independent due to the increased likelihood of losing a client and the revenue the client generates. Thus, Shockley (1982) suggests that the adverse effects of MAS, the size of the audit rm and competition on a third partys PAI actually arise because of the linkage of these variables to audit fees. Nevertheless, there is a study that proves otherwise. For example, Gul (1991) hypothesized and tested the notion that size of audit fees is a major determinant of bankers PAI regardless of other variables, namely MAS, competition and the audit rm size. He showed that each independence-related variable affects bankers PAI in its own right. He also found size of audit fees to be an important determinant of bankers PAI. Another study related to the size of audit fees was by Pany and Reckers (1980). They advocated that the size of the client relative to the audit rm has a signicant

direct or modifying effect on the PAI. They dene size in terms of the audit fee measured as a percentage of ofce revenues. They found that it has no signicant effect on perceived independence. However, in their study of 1983, even though the effect of client size do not show any signicant results, they note that respondents express less condence in the auditors independence when a client was large (size is dened in terms of the audit fee measured as a percentage of ofce revenues). Management advisory services (MAS). Several empirical surveys were conducted in order to nd how third parties, auditors and rms view this issue. The results are, however, similar to its debate, which is inconclusive (Goldman and Barlev, 1974). McKinley et al. (1985) report that early research related to nancial statement users indicated that auditor independence is negatively affected when non-audit services are performed for audit clients. They believe that these collateral services create a working relationship between the auditor and the client that is too close. Similarly, the studies by Shockley (1981), Pany and Reckers (1983, 1984) and Knapp (1985) all nd that the provision of MAS negatively affected PAI. Reckers and Stagliano (1981) conclude that the loss of condence in the external auditor increased signicantly if non-audit fees paid to the auditor exceeded 50 per cent of the audit fees. Contrary to the above, some other studies found a positive relationship between MAS provision and PAI. They believe that MAS provision enhances the auditors knowledge of the client, thus increasing the auditors objectivity (Goldwasser, 1999; Wallman, 1996). According to Goldman and Barlev (1974) who support this view, the addition of management services increases the power and independence of the auditors. They argued that this occurs because most consulting-type services are non-routine and because these services benet the client rm directly. Consequently, the replacement of the consulting auditor may result in a loss of valuable advice to the rm. The bargaining position, therefore, becomes stronger; s/he is better equipped to resist interference in the performance of auditing duties and is more likely to retain independence. Finally, there are studies that have shown that the provision of MAS has no effect on PAI. For example, McKinley et al. (1985) nd that the provision of MAS did not signicantly affect bank ofcers PAI, their perceptions of nancial statement reliability or their loan decisions. Coreless and Parker (1987) nd similar results. The conicting results suggest that the effect of MAS on perceptions of auditor independence is complex (Gul, 1989; Shockley, 1982; Coreless and Parker, 1987) and other factors such as cultural differences of the subjects may also be a signicant factor in the way MAS is viewed in the context of auditor independence. Audit committees. There is much support to suggest a positive relationship between audit committees and auditor independence. Basically, a positive relationship between audit committees and AI means that the existence of an audit committee will enhance auditors independence. Teoh and Lim (1996) in their study nd that the formation of audit committees has a strong positive impact on enhancing auditor independence. Similarly, Patten and Nuckols (1970), Knapp (1985) and Lau and Ng (1994) nd that the existence of an audit committee increases the likelihood of bankers approving a loan, which is a reection of an increased condence in the auditor. On the contrary, Gul (1989) nds that audit committees did not signicantly affect the perceptions of auditor independence.

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Malaysian accounting and auditing profession In Malaysia, the authoritative body which regulates the accountancy profession is the Malaysian Institute of Accountants (MIA), which is established under the Accountants Act 1967. The Institute is a member body of regional and international professional bodies which play a signicant role in the development and advancement of the accountancy profession globally. With regards to qualication in becoming a Certied Public Accountant, the only local body in Malaysia which conducts a professional accountancy examination which is recognised under the Accountants Act, 1967 is Malaysian Institute of Certied Public Accountants (MICPA). To date, the MICPA (formally known as MACPA) has trained more than 1,500 qualied accountants, some of whom are in senior positions in Government, public practice, commerce and industry. The MICPA instituted its examination system in 1961. Its training programmes and schemes are best described as the only means of selecting the best or the creme de la creme of accountants. MICPA, in its goals has broadened its scope of services so as to keep step with the challenges of the times, as well as its responsibilities in the advancement of the practice and the study of accountancy. The body which develops and issues accounting and nancial reporting standards is the Malaysian Accounting Standards Board (MASB), which is established under the Financial Reporting Act 1997 (the Act) as an independent authority. Basically, it adopts the International Accounting Standards (IAS). With regards to size of audit rms in Malaysia, about 91.4 per cent of Malaysian audit rms fall into the category of small rms with one to two partners. While medium size audit rms with three to eight partners constitute 7.5 per cent of the population of audit rms, the remaining gure of 1.1 per cent are of the large size audit rms with more than nine partners. Research methodology There are not many studies on perceptions of auditor independence outside the Anglo-American countries. In Malaysian, one of the few studies undertaken by Gul and Teoh (1984) investigate the effects of combined audit and management consulting services by public accounting rms on a sample of the Malaysian public comprising public accountants, bankers, managers and shareholders. They found that the expansion by audit rms into non-audit services reduced their condence in the auditors independence. It was also found that majority of respondents (except for shareholders) felt that it was not possible to separate the rendering of management services from participating in decision-making. Shareholders also believe that auditors could still remain independent if the audit rms provide non-audit services, while there are no denite conclusions for other categories of respondents. Gul and Teoh conclude ` that shareholders are less sophisticated users of nancial statements vis-a-vis the other groups. Teoh and Lim (1996) investigate the effects of ve selected variables on the PAI of Malaysian public and nonpublic accountants. They employ a repeated measures experimental design. Results show a large audit fee received from a single client is the most important factor leading to the impairment of PAI, followed by the provision of management consultancy services. The non-rotation of audit rms is not a dominant factor. The formation of audit committees is found to have a strong positive impact on

enhancing auditor independence, while the positive impact of disclosure of non-audit fees is considerably less. Lack of studies on factors inuencing perceptions on auditor independence prompted the need for such a study, especially in a non-Anglo-American environment. This study extends studies done by Gul and Teoh (1984) and Teoh and Lim (1996) in the Malaysian context. Research questions The following research questions have been developed, mainly based on the development of literature on auditor independence: RQ1. To what extent is an audit report important for the loan ofcers to make their lending decisions? RQ2. Do the loan ofcers think that the six factors (i.e. audit rm size, competition level, tenure, size of audit fees, MAS and audit committee) have any inuence on an auditors independence? RQ3. What kinds of relationships (i.e. its direction) exist between the six factors (i.e. audit rm size, competition level, tenure, size of audit fees, MAS and audit committee) and the auditors independence? RQ4. Which of the six factors (i.e. audit rm size, competition level, tenure, size of audit fees, MAS and audit committee) is the most important factor inuencing auditor independence? Data collection The subjects are bank loan ofcers who are charged with assessing the loans applied for by companies (regardless of the company size or the amount of the loan). They were selected as the sample population of this study because they are regarded as relatively sophisticated nancial statement users who would understand the importance of the independent audit function (Knapp, 1985). They were also selected, because the loan ofcers of banks make use of accounting information in business decision situations. Since they occupy strategic decision centres in the nancial community, they are chosen as the third-party population to be studied. Bank loan ofcers also represent the lenders or creditors point of view, which are among the major users of nancial statements. The commercial banks are the main players in the banking system and they operate within the ambit of the provisions of the BAFIA (Banking and Financial Insitutions Act 1989) and under the direct supervision of Bank Negara Malaysia (1999) (the Malaysian Central Bank). Prior to 2001, there were 17 Malaysian-owned (conventional) commercial banks. However, due to the merger and consolidation programme among domestic banking institutions, currently there are only ten Malaysian-owned (conventional) commercial banks, all included in this study. (Dalila, 2000). In this study, all the ten conventional commercial banks and two Islamic commercial banks in Malaysia are included. Both conventional as well as Islamic commercial banks are included since they have more or less the same characteristics, for example, in terms of the nature of their businesses and products and services offered. The only difference is that Islamic banks operate based on the Syariah law, while conventional commercial banks do not.

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In short, the sample population of the study comprises the commercial loan ofcers of all local commercial banks, including both conventional as well as Islamic commercial banks in Malaysia. Samples are chosen using stratied random sampling. Data were collected using the survey method. The questionnaire has been self developed by the researchers taking into consideration factors such as the level of difculty of the questions and the length of time needed by the respondents in answering it. The questionnaire included six main elements with three main parts A, B and C. It was pilot tested to check reliability, understandability and language. It was pilot tested on ve academicians from the Department of Accounting, International Islamic University Malaysia (IIUM) and ve postgraduate students undertaking Master of Sciences in Accounting from the same department. After the necessary technical and other revisions and amendments had been made, the questionnaires were sent to the contact persons. Twenty sets of questionnaires were sent to each of the 12 banks. In total, 240 questionnaires were sent out. Accompanying each set of questionnaires were letters addressed to the contact persons explaining the research and requesting them to cooperate in distributing as well as collecting back the questionnaires to and from their relevant ofcers. Self-addressed and post-paid envelopes were provided by the researchers to facilitate the process. Results and discussions Of the 240 questionnaires, 116 were received, a response rate of 48.3 per cent. However, out of the 116 questionnaires returned, only 86 are usable, producing usable replies of 35.8 per cent. These unusable replies are excluded from the analysis due to the failure of the respondents to complete certain parts of the questionnaires. Out of the 12 banks, one bank refused to participate at all in the study. The respondents were a heterogeneous group with an average age of 30.07 years (standard deviation 5.45, range from 22 to 48 years) and a mean experience in lending decisions of 52.26 months (equivalent to 4.355 years, standard deviation 42.92, range from 2 to 180 months). The degree of importance of the audit report The rst question in part A asked the respondents to give a score on how important they think an audit report is in making their lending decisions. There are two types of audit report, namely the nancial statement audit report and the special purpose audit report[2]. This question does not exclusively refer to only one of them, but rather refers to either or both. The level of importance is verbally anchored at the end points with 1 indicating unimportant and 9 very important. The respondents could choose any point on the scale. The range of 1-9 is chosen simply for comparable purposes with prior studies. The mean score for this question is 7.814 (standard deviation 1:2128; the mode is 9 and the median is 8. The mean score, which is quite high, indicates that the respondents regarded an audit report as being very important in lending decisions. However, when comparing this result with Firths (1980), the present study score is slightly lower. Firth (1980) in asking the loan ofcers the importance of an audit report in making lending decisions, obtained a mean score of 8.27. He concluded that the loan ofcers regarded an audit report as being very important in making lending decisions (Table I).

The mode, which is 9, shows that the majority (41.9 per cent) of respondents think that an audit report is very important in making their lending decisions. A high percentage of respondents (30.2 per cent) chose scale 7, which can be translated as important, and 15.1 per cent chose scale 8. None of the respondents chose the rst three scales on the continuum (i.e. 1, 2 and 3), while only one respondent chose scale 4. This shows that almost none of them think that the audit report is unimportant in making their lending decisions. Bearing in mind that number 5 on the scale may signify a neutral position, and any number before that reects the unimportance of an audit report in making lending decisions, while any number after ve signies its importance, it can be seen that 96.5 per cent of responses mentioned that an audit report is important in making their lending decisions, while only 1.2 per cent said that the audit report is not important. The remaining 2.3 per cent are in the neutral position. Here, it is discovered that CLOs perceived that an audit report is very important in making their lending decisions, thus making it parallel to the ndings of the previous study by Firth (1980). The implication of this nding is that it can be used to determine how the respondents perceived auditor independence. This notion has been brought up by Firth (1980), and supported by Gul and Teoh (1984), whereby Firth mentioned that the importance placed on the audit report reects how respondents view auditor independence. In this case, since the respondents view the role of the audit report as very important in making their lending decisions, it reects that that they do not perceive that there is a lack of independence in the auditing profession in general. It shows that they have condence (regardless of the degree of condence) in the credibility of the auditing profession. Factors inuencing auditor independence The second question in part A asked the respondents whether each of the six factors listed has any inuence on auditors independence. To answer, respondents just have to circle either yes or no. It is found that 75.6 per cent of the respondents indicate that the size of the audit rm does affect auditors independence, while 74.4 per cent of them mention that the level of competition in the audit services market inuences auditors independence. A relatively higher percentage of respondents mention that (1) the tenure of an audit rm serving the needs of a given client; (2) the provision of MAS by an audit rm to the audit client company; and (3) the existence of an audit committee have some inuence on auditors independence, with 90.7, 86 and 87.2 per cent, respectively. However, surprisingly, a high percentage of the respondents, i.e. 47.7 per cent indicate that the size of audit fees received by the audit rm does not affect auditors independence.

Auditor independence

813

Mean 7.814

Standard deviation 1.2128

Mode 9

Median 8

Scale: 1 unimportant, 9 very important

Table I. Level of importance of an audit report in lending decisions

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There seems to be a balance between the number of respondents that indicate that the size of audit fees has some inuence on AI, and those who believe that size of audit fees does not have any inuence on AI (Table II). Nevertheless, for all the factors discussed, the mode is Yes, which shows that a majority of respondents think that there is some sort of relationship between all the six factors and auditor independence. However, at this point, the direction and the strength of these relationships are not explored. Part B will try to explore the direction of these relationships while part C will try to explore their strengths. Part B of the questionnaire asked subjects to indicate whether they are strongly agree (1), agree (2), slightly agree (3), neutral (4), slightly disagree (5), disagree (6) or strongly disagree (7) with the statements given. Each statement provides either a positive or negative relationship between the factors and auditor independence. The 7-point Likert-scale was provided based on past studies and thus for comparable purposes. Table III shows the frequency of occurrence and percentages for the level of agreement for each of the factors and their relationships with auditor independence. Table IV above shows the mode (or most common response) for each question regarding the respondents level of agreement with the statements given. The mode or the majority of the respondents agree that: (1) the larger the size of an audit rm; (2) the shorter the duration an audit rm serves an audit client; (3) the smaller the amount of audit fees paid by the audit client company to the audit rm (in relation to the total percentage of audit revenue); and (4) the existence of an audit committee in the audit client company the greater the auditor independence will be. The majority also slightly agrees that (1) the higher the level of competition among audit rms; and (2) the provision of MAS by the audit rm to the audit client company; the more it will impair auditor independence. For the rm size and audit committee factor, the mode tend to agree with the positive relationship between the factors and AI, while for competition level, tenure, size of audit fees and MAS, the mode tend to agree with the negative relationship between those factors and AI. Results also show that the majority neither takes the position of strongly agree nor strongly disagree. They seem to prefer choosing a more moderate position by choosing a mere agree (or disagree), or, slightly agree (or disagree).

Table II. Frequency and percentage indicating Yes and No regarding factors which inuence auditors independence

Audit Firm size Competition Tenure Fees MAS committee Frequency Per cent No. Per cent No. Per cent No. Per cent No. Per cent No. Per cent Yes No Total 65 21 86 75.6 24.4 100 64 22 86 74.4 25.6 100 78 8 86 90.7 9.3 100 45 41 86 52.3 47.7 100 74 12 86 86 14 100 75 11 86 87.2 12.8 100

Factors Size of audit rm

R/ship

6 7 4 5 2 3 1 Strongly Slightly Slightly Strongly agree Agree agree Neutral disagree Disagree disagree 3 3.5 0 0 0 0 6 7.0 0 0 10 11.6 0 0 5 5.8 2 2.3 4 4.7 7 8.1 1 1.2 26 30.2 4 4.7 13 15.1 18 20.9 7 8.1 24 27.9 4 4.7 25 29.1 10 11.6 22 25.6 37 43.0 10 11.6 18 20.9 7 8.1 10 11.6 20 23.3 9 10.5 21 24.4 8 9.3 14 16.3 12 14.0 26 30.2 20 23.3 6 7.0 12 14.0 20 23.3 17 19.8 12 14.0 21 24.4 9 10.5 25 29.1 14 16.3 18 20.9 12 14.0 9 10.5 16 18.6 10 11.6 22 25.6 18 20.9 12 14.0 20 23.3 7 8.1 20 23.3 15 17.4 24 27.9 6 7.0 7 8.1 32 37.2 12 14.0 29 33.7 24 27.9 14 16.3 23 26.7 12 14.0 23 26.7 8 9.3 19 22.1 13 15.1 6 7.0 18 20.9 5 5.8 4 4.7 4 4.7 4 4.7 6 7.0 3 3.5 6 7.0 5 5.8 1 1.2 3 3.5 0 0 3 3.5

Auditor independence

ve Frequency Per cent 2ve Frequency Per cent Level of ve Frequency competition Per cent 2ve Frequency Per cent Tenure of ve Frequency services Per cent 2ve Frequency Per cent ve Frequency Size of audit fees Per cent 2ve Frequency Per cent MAS ve Frequency Per cent 2ve Frequency Per cent Audit ve Frequency committee Per cent 2ve Frequency Per cent

815

Table III. Frequency and percentage of occurrence of responses for each question

Factors Firm size Level of competition Tenure of service Size of audit fees MAS Audit committee

Relationship Positive Negative Positive Negative Positive Negative Positive Negative Positive Negative Positive Negative

Agree/disagree mode 2 6 6 3 6 2 4 2 5 3 2 5 (agree) (disagree) (disagree) (slightly agree) (disagree) (agree) (neutral) (agree) (slightly disagree) (slightly agree) (agree) (disagree)

Table IV. Mode for each factor

If we compare the mode between the two contradicting statements for each factor, we will nd that if the mode is to agree (or slightly agree) with one direction of the relationship, the mode of the opposite direction will be to disagree (or slightly disagree). This remains true for all of the six factors except for the size of audit fees where one direction is to agree and another is neutral. Perhaps this reversal of answers happens because most respondents think that the rst six questions and the last six

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questions are dependant on each other (please bear in mind that out of the 12 questions statements given, the last six questions are stated in just the reverse manner of the rst six). Thus, they tend to answer the questions in a mirror image to each other (Table V). The statement that has been agreed most by the respondents according to ranking is that: (1) the existence of an audit committee in the audit client company may enhance the auditors independence. This is then followed by the statement; (2) the longer the duration an audit rm serves an audit client, the more likelihood that auditors independence will be impaired; (3) auditors independence will be weakened if the audit rm provides MAS to the audit client company; (4) the larger the size of audit fees paid by the audit client company to the audit rm (in relation to the total percentage of audit revenue), the more likelihood that it will weaken the auditors independence; (5) the larger the size of an audit rm, the greater the auditors independence; and (6) the higher the level of competition among audit rms, the more likelihood that the auditors independence will be weakened. On the other hand, the statement that has been disagreed with most by the respondents, according to ranking, is: (1) the smaller the size of an audit rm, the greater the auditors independence. This is then followed by the statement; (2) the smaller the amount of audit fees paid by the audit client company to the audit rm (in relation to the total percentage of audit revenue), the more likelihood that it will weaken the auditors independence; (3) the shorter the duration an audit rm serves an audit client, the more likelihood that auditors independence will be weakened; (4) the existence of an audit committee in the audit client company may not enhance an auditors independence;

Factors Size of audit rm Level of competition Tenure of service Size of audit fees Table V. Mean score of the level of agreement for each factor and its rank MAS Audit committee

Relationship with auditor independence Positive Negative Positive Negative Positive Negative Positive Negative Positive Negative Positive Negative

Mean 3.65 4.90 4.49 3.74 4.71 3.31 4.79 3.62 4.31 3.52 2.88 4.56

Rank (according to degree of agreement) 5 12 8 6 10 2 11 4 7 3 1 9

(5) the lower the level of competition among audit rms, the more likelihood that auditors independence will be weakened; and (6) the auditors independence will not be weakened if the audit rm provides MAS to the audit client company. Comparing these results with prior studies, certain results seem to be parallel with them. For example, in prior studies, there are no supporters for (1) the positive relationship between size of audit fees and AI; and (2) the negative relationship between rm size and AI. Quite in line with that, in this study, it is found that these two statements obtain the lowest and second lowest mean regarding the degree of agreement by the respondents. In other words, these two statements are being disagreed with most by the respondents compared to other relationships for other factors. Also, in prior studies, there are no supporters for (3) the negative relationship between the existence of an audit committee and AI. Quite parallel, in this study, the positive relationship between audit committee and AI seems to have the highest level of agreement. These three circumstances show some consistencies between this studys results with those done previously. Level of importance of the factors inuencing auditor independence According to ranking, the most important factors that inuence auditor independence, are (1) the size of the audit rm; (2) the tenure of an audit rm; (3) the level of competition among audit rms; (4) the existence of an audit committee; (5) the provision of MAS; and (6) size of audit fees. Comparing the rank with the mode, it can be seen that they are almost similar, except for the last three factors, where all the modes are 6. Comparing part C results with the ndings in part A: question 2, there are a few cases that show some parallel answers. In part A: question 2, the size of audit fees is found as the factor with the highest percentage of responses that mentioned it has no inuence on AI. In parallel to that, in this part (i.e. part C), the respondents views regarding that particular factor are reected here in part C when they rank the size of audit fees as the least important factor which may affect AI. The same goes for the tenure factor. In part A: question 2, the tenure factor has the highest percentage of responses that agree that it has some inuence on AI. Almost similarly, in part C, the tenure factor is found to be the second most important factor that may inuence AI (Table VI). One study which involved factors ranking is Shockley (1981). Shockley reports the competition variable was ranked as most important, followed by the size and MAS factors. Thus, the results of this study seem inconsistent with Shockleys, except for the MAS factor which is ranked last after the other two factors.

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The tenure factor, which is ranked as the second most important factor affecting AI, has a signicant implication. It implies that any policy action taken to reduce the average tenure of auditors (e.g. mandatory rotation of audit rms) may have a strong (positive) effect on PAI. The factor size of audit fees is ranked as the least important. One possible explanation is that the loan ofcers themselves do not have that information available. Usually they only assess the nancial statements of the loan applicants. It is rare that the loan ofcers will ask the auditor of the loan applicants to hand over their nancial statement, where this information may be available. Normally, only the audit rms themselves know the size of audit fees, as a percentage of their total revenue, which they receive from their clients. Conclusions The high level of importance attached by the commercial loan ofcers to an audit report in making their lending decisions can be attributed to their views on the auditors independence in Malaysia. It cannot be denied that it is only when auditors appear to be highly independent, that an audit report will be seen as useful and, in turn, will be seen as highly important in decision-making. An audit report will not be seen as very important in making any decisions, be it lending or investment decisions, if there is no integrity, objectivity and independence on the part of those preparing it, and most importantly, of those who are given the right to provide an opinion regarding it is true and fair representations, which are the auditors. Thus, there is an important link or relationship among the auditors independence, the usefulness of the audit report and the importance attached to the audit report. Generally, regarding the factors of (1) The size of an audit rm. (2) The existence of an audit committee, the commercial loan ofcers perceived that their relationship with auditor independence is of a positive kind. Commercial loan ofcers generally perceived that the larger the size of an audit rm, the more likely it is that it may enhance the auditors independence. The existence of an audit committee in an audit client company is also believed to increase the external auditors independence. For the other four factors, namely: (3) The level of competition among audit rms. (4) An audit rms tenure of service. (5) The size of audit fees.

Factors Firm size Competition Tenure Fees MAS Audit

Mean score 2.97 3.36 2.99 4.08 3.94 3.65

Rank 1 3 2 6 5 4

Mode 1 3 2 6 6 6

Table VI. Mean and rank of factors

(6) The provision of MAS, a negative relationship between them and auditor independence seems to gain more support from the commercial loan ofcers. The commercial loan ofcers seem to believe that an auditors independence is more easily impaired in four situations. Among the situations are when there is a higher level of competition among audit rms as compared to when the competition level is lower. Secondly, when there is a longer duration of service provided by the auditor for a given client as compared to when the auditor serves a given client over a shorter duration of time. Thirdly, when there is a larger size of audit fees provided by the audit client to the auditor as compared to when the auditor receives a smaller size of audit fees. Finally, when there are MAS provided by the auditor to its audit client as compared to when there is no provision of MAS by the auditor to its audit client. In all these four situations, commercial loan ofcers believe that the auditors independence will easily be weakened. The ranking of factors, according to their importance in inuencing the auditors independence, are: (1) audit rm size; (2) tenure of an audit rm serving the needs of a given client; (3) level of competition among audit rms; (4) existence of an audit committee; (5) provision of MAS; and nally (6) size of audit fees. The main limitation of the study is that it only considers each factor per se. It ignores any interaction effects which may exist between any two factors. For example, in a few of the prior studies, they nd the interaction effects between (1) rm size and fees; (2) competition and tenure; (3) fees and MAS; and (4) fees and competition. It is suggested that further studies could be undertaken by adding subjects such as accountants and nancial analysts. Comparisons could be made among these three groups which represents preparers (i.e. accountants) and users (i.e. CLO and nancial analysts).
Notes 1. It is important to note that the term Malaysian-owned is different from local. Local bank does not necessarily mean that it is owned by Malaysians. 2. Special purpose audit report basically provides the auditors opinion on statements other than the normal nancial statements. References Accountants International Study Group (1976), Independence of Auditors, Study No. 16, AICPA, New York, NY. American Institute of Certied Public Accountants, Commission on Auditors Responsibilities (1978), Report, Conclusions and Recommendations, AICPA, New York, NY.

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Arens, A.A., Loebbecke, J.K., Iskandar, T.M., Susela, S.D., Isa, S. and Boh, M. (Eds) (1999), Auditing in Malaysia: An Integrated Approach, Prentice-Hall, Selangor. Bank Negara Malaysia (1999), The Central Bank and the Financial System in Malaysia A Decade of Change, BNM, Kuala Lumpur. Bartlett, R.W. (1993), A scale of perceived independence: new evidence on an old concept, Accounting, Auditing & Accountability Journal, Vol. 6 No. 2, pp. 52-67. Burton, J.C. and Faireld, P. (1982), Auditing evaluation in a changing environment, Auditing: A Journal of Practice and Theory, Vol. 1 No. 2, pp. 1-22. Busse von Colbe, W. and Lutter, M. (Eds) (1977), Wirtschaftsprofung Heute: Entwicklung oder Reform?, paper presented at the Ein Bochumer Symposium. Coreless, J.C. and Parker, L.M. (1987), The impact of MAS on auditor independence: An experiment, Accounting Horizon, pp. 707-18. Dalila, A.B. (2000), Merger exercise completed, News Straits Times, p. 9, 1 September. DeAngelo, L.E. (1981a), Auditor independence, low-balling and disclosure regulation, Journal of Accounting and Economics, Vol. 29, pp. 60-97. DeAngelo, L.E. (1981b), Auditor size and audit quality, Journal of Accounting and Economics, Vol. 3, pp. 183-99. Dopuch, N. and Simunic, D. (1980), The nature of competition in the auditing profession, in Buckley, J.W. and Weston, J.F. (Eds), Regulation and the Accounting Profession, Lifetime Learning, New York, NY, pp. 77-94. Dykxhoorn, H.J. and Sinning, K.E. (1981), Wirtschaftsprufer perception of auditor independence, The Accounting Review, Vol. LVI No. 1, pp. 97-107. Dykxhoorn, H.J. and Sinning, K.E. (1982), Perceptions of auditor independence: its perceived effect on loan and investment decisions of German nancial statement users, Accounting, Organizations and Society, Vol. 7 No. 4, pp. 337-47. European Federation of Accountants and Auditors (1998), Position Paper Auditor Independence, EFAA, pp. 1-29. Firth, M. (1980), Perceptions of auditor independence and ofcial ethical guidelines, The Accounting Review, pp. 451-66, July. Goldman, A. and Barlev, B. (1974), The auditor-rm conict of interests: Its implication for independence, The Accounting Review, pp. 707-17, October. Goldwasser, D.L. (1999), The task awaiting the ISB, Accounting Today, Vol. 7, pp. 52-4, 7-20 June. Gul, F. (1989), Bankers perceptions of factors affecting auditor independence, Accounting, Auditing & Accountability Journal, Vol. 2 No. 3, pp. 40-51. Gul, F.A. (1991), Size of audit fees and perceptions of auditors ability to resist management pressure in audit conict situations, Abacus, pp. 162-72, September. Gul, F. and Teoh, H.P. (1984), The effects of combined audit and management services on public perception of auditor independence in developing countries: the Malaysian case, International Journal of Accounting Education and Research, pp. 95-107, Fall. Gul, F. and Tsui, J.S.L. (1992), An empirical analysis of Hong Kong bankers perceptions of auditor ability to resist management pressure in an audit conict situation, Journal of International Accounting, Auditing and Taxation, Vol. 1 No. 2, pp. 177-90. Gunz, S. and McCutcheon, J. (1991), Some unresolved ethical issues in auditing, Journal of Business Ethics, Vol. 10, pp. 777-85.

Hoyle, J. (1978), Mandatory auditor rotation: the arguments and an alternative, The Journal of Accountancy, pp. 69-78, May. International Federation of Accountants (1996), IFAC Handbook, International Federation of Accountants, New York, NY. Jenkins, J.G. and Krawczyk, K. (2001), The inuence of nonaudit services on perceptions of auditor independence, Journal of Applied Business Research, Vol. 17 No. 3, pp. 73-8. Knapp, M.C. (1985), Audit conict: an empirical study of the perceived ability of auditors to resist management pressure, The Accounting Review, Vol. LX No. 2, pp. 202-11. Lau, P.T.Y. and Ng, P.P.H. (1994), The impact of audit committee and client nancial condition on bankers loan decisions, Asia-Pacic Journal of Accounting, Vol. 1, pp. 19-28. Lavin, D. (1976), Perceptions of the independence of the auditor, The Accounting Review, pp. 41-50, January. McKinley, S., Pany, K. and Reckers, P.M.J. (1985), An examination of the inuence of CPA rm type, size, and MAS provision on loan ofcer decisions and perceptions, Journal of Accounting Research, Vol. 23 No. 2, pp. 887-96. Mautz, R.K. and Sharaf, H.A. (1961), The Philosophy of Auditing, American Accounting Association. Nichols, D.R. and Smith, D.B. (1983), Auditor credibility and auditor changes, Journal of Accounting Research, pp. 534-44, Autumn. Noordin, H. (1990), Ethical standards in the accountancy profession, National Accountant (Malaysia), pp. 3-9, July. Pany, K. and Reckers, P.M.J. (1980), The effects of gifts, discounts and client size on perceived auditor independence, The Accounting Review, Vol. LV No. 1, pp. 50-61. Pany, K. and Reckers, P.M.J. (1983), Auditor independence and non-audit services: Director views and their policy implications, Journal of Accounting and Public Policy, pp. 43-62, Spring. Pany, K. and Reckers, P.M.J. (1984), Non-audit services and auditor independence: A continuing concern, Auditing: A Journal of Practice and Theory, pp. 89-97, Spring. Patel, C. and Psaros, J. (2000), Perceptions of external auditors independence, The British Accounting Review, Vol. 32 No. 3, pp. 311-38. Patten, R.J. and Nuckols, J.R. Jr (1970), Competence and independence The issue of management services, The Louisiana Certied Public Accountant, pp. 20-30, Fall. Reckers, P.M.J. and Stagliano (1981), Non-audit services and perceived independence: Some new evidence, AUDITING: A Journal of Practice & Theory, pp. 23-37, Spring. Shockley, R.A. (1981), Perceptions of auditors independence: an empirical analysis, The Accounting Review, Vol. LVI No. 4, pp. 785-800. Shockley, R.A. (1982), Perceptions of auditor independence: A conceptual model, Journal of Accounting, Auditing and Finance, pp. 126-43, Winter. Shockley, R.A. and Holt, R.N. (1983), A behavioural investigation of supplier differentiation in the market for audit services, Journal of Accounting Research, pp. 545-64, Autumn. Teoh, H.Y. and Lim, C.C. (1996), An empirical study of the effects of audit committees, disclosure of nonaudit fees and other issues on audit independence: Malaysian evidence, Journal of International Accounting, Auditing and Taxation, Vol. 5 No. 2, pp. 231-48. Wallman, S.M.H. (1996), The future of accounting, Part III: Reliability and Auditor Independence, Accounting Horizons, pp. 76-97, 10 December.

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Further reading American Institute of Certied Public Accountants (1991), AICPA Professional Standards 1 & 2, AICPA, New York, NY. Guan, C.K. (1995), Financial Institutions in Malaysia, 2nd ed., Institut Bank-Bank Malaysia, Kuala Lumpur, Trans. Yin, T.S.. Lowe, D.J. and Pany, K. (1996), An examination of the effects of type of engagement, materiality and structure on CPA consulting engagements with audit client, Accounting Horizon, Vol. 10 No. 4, pp. 32-51. Malaysian Institute of Accountants (1990), A case for the establishment of audit committees, (a memorandum submitted to the Registrar of Companies, the Capital Issues Committee, and the Kuala Lumpur Stock Exchange; reproduced in summary form in) National Accountant (Malaysia) October. Messier, W.F. and Boh, M. (2002), Auditing and Assurance Services in Malaysia, 2nd ed., McGraw-Hill, Selangor. Pang, J. (1996), Understanding Banking Services and Facilities, 2nd ed., Federal Publications, Selangor. Pany, K. and Reckers, P.M.J. (1988), Auditor performance of MAS: a study of its effects on decisions and perceptions, Accounting Horizons, June, pp. 31-8. Peng, L.T. (1998), The Business of Banking in Malaysia, Pelanduk Publications, Selangor. Pirok, K.R. (1994), Commercial Loan Analysis, Probus Publishing, Chicago, IL. Raja Tun Arshad, R.T.U. (2002), Auditor independence, The Edge, 11 November, pp. 12-13. SPSSw Base 10.0 (1999), Application Guide, SPSS Inc., Chicago, IL. Schulte, A.A. (1966), Management services: a challenge to audit independence?, The Accounting Review, pp. 721-8, October. The Basics: SPSS 10.0 for Windows (1999), SPSS Inc., Chicago, IL. Wilcox, E.B. (1952) in Robert, L.K. Jr (Ed.), CPA Handbook, Chapter 13, The American Institute of Accountants, New York, NY, p. 8. Zikmund, W.G. (2000), Business Research Methods, 6th ed., Dryden Press, Oklahoma, OK.