Audit Quality Control: Development of Self-Assessment - Malaysian ...

Audit Quality Control: Development of Self-AssessmentChecklist for Small and Medium Audit Practices inMalaysiaABSTRACTIn July 2006, the Malaysian Institute ofAccountant (MIA) has adopted the ISQC 1 as partof the approved standard of auditing in Malaysia.In assisting the implementation of ISQC 1 amongaudit firms, a guideline on the ISQC 1requirement is essential. This paper providesinsights on the development of InternationalStandards on Quality Control 1 (ISQC 1) selfassessmentchecklist for small and medium auditfirms in Malaysia. The checklist is developedbased on ISQC1 requirements, ISQC 1 manualand MIA By-Laws. This checklist is also in-linewith ISQC 1 questionnaires prepared by othercountries such as Australia and Pakistan. It isthen validated by audit practitioners. It is hopedthat this audit quality system would assist thesmall and medium audit firms in improving andenhancing their audit service quality with theaspiration to be at par with the larger audit firms.Keywordsaudit quality, quality control system, ISQC 1, selfassessment,small and medium audit practices1.0 INTRODUCTIONAudit quality is viewed as one of the importantfactors that affect the credibility of financialstatements (Arrunada, 2004). Users are morelikely to demonstrate high level of confidence onthe information presented in the financialstatements if the audit of the financial statementsis perceived to be of high quality. Assessment onaudit quality of audit firms ensures that an auditfirm’s processes are systematic and effective(Brinkley, 2006). Auditing the auditors throughexternal evaluations is becoming a driving forceof continuous improvement for the profession(Brinkley, 2006). To compete successfully in thisenvironment, audit firms must continually striveto improve audit quality and hence, maximizeclient satisfaction.Recent development concerning audit qualitycontrol by International Federation of Accountant(IFAC) has required audit firms to comply withthe International Standards on Quality Control(ISQC 1). Malaysian Institute of Accountant(MIA) has, in July 2006, adopted the ISQC 1 aspart of the approved standard of auditing inMalaysia. In essence, ISQC 1 focuses on thequality of audit performed by the audit firms andthey are expected comply with the standard.Nevertheless, evidence showed that theimplementation to of ISQC 1 is rather limited inMalaysian small and medium audit firms (Omar& Johari, 2007). Small and medium audit firmstend to operate based on non-standard operatingprocedures, which essentially does not reflecttotal compliance to the ISQC 1.Based on the guidelines stated in the ISQC 1,compliance to the standard is perceived as highaudit quality. Although large audit firms havebeen argued and associated with high auditquality (DeAngelo, 1981), very limited studieshave measured audit quality using an objectivemeasure (Krishnan & Schauer, 2000). Paststudies have indirectly inferred that large auditfirms as a proxy for high audit quality (DeAngelo,1981; Carcello et al., 1992; Krishnan & Schauer,2000). However, it is still unclear how and whythe levels of audit quality differ among small andmedium firms. Hence, the objective of this studyis to assess the framework on efficiency andeffectiveness of the small and medium auditfirms. Subsequently, based on that framework,standards and benchmark information would bedeveloped.This study is hoped to contribute to theimprovement in the quality control of small andmedium audit practices in Malaysia. This study isnot aimed to strengthen the proposition that largeraudit firms deliver higher audit quality compare tothe smaller ones, but to provide a more objectiveappraisal of audit quality in small and mediumaudit firms. The self-assessment quality controlchecklist extends previous studies in thedevelopment of an objective measure. Thecurrent paper focuses on the first part of thisbigger study that highlights the development of asuitable checklist for the purpose of measuringaudit quality. The checklist would enable auditfirms to self-assess their service and to recognize2

any deficiency that could have compromised auditquality.2.0 LITERATURE REVIEW2.1 The Search for Audit QualityThe demand for auditing services arises from aneed to facilitate dealings between the partiesinvolved in business relationships-shareholders,creditors, public authorities, employees andcustomers, etc (Arrunada, 2000). The accountingprofession has faced increasing pressure fromexternal parties to monitor and improve thequality of the audit process (Sutton, 1993). Thereare numerous of previous research done onstudying multi-aspects of audit quality. Thestrong interest in examining audit quality is partlydue to the concern of issues such corporatecollapse, expectation gaps and corporategovernance.One of the main areas in audit quality literature isthe association between audit quality with auditfirm size. As suggested by DeAngelo (1981),larger firms provide higher-quality audits becauselarger firms have fewer incentives to compromisetheir standards to ensure retention of clients incomparison with smaller firms. Audits performedby large audit firms are perceived to be of higherexpected quality than audits by small firms. Also,Palmrose (1988) finds that large auditors havelower litigation rates than small auditors.Similarly, Dupoch and Simunic (1982) also foundthat audit quality is a function of the number andextent of audit procedures performed by theauditor and that larger firms have more resourceswith which to conduct tests. In addition, Mooreand Scott (1989) demonstrate analytically thataudit firm size and the extent of audit workundertaken are positively related.Although past studies have supported that highaudit quality is related to firm size, the extent ofaudit quality for each firm requires a moreobjective measurement of audit quality. Forexample, Carcello et al. (1992) assessed auditquality based on the perceptions of auditors,prepares and users. Using twelve components ofaudit quality, Carcello et al. (1992) suggested thatfour components to be most important indetermining audit quality. The componentsinclude audit team and firm experience with theclient, industry expertise (especially within theaudit team), responsiveness to client needs, andcompliance with the general standards(competence, independence, and due care) ofgenerally accepted auditing standards (GAAS).Sutton (1993) argued that there is a need foraccounting researchers to developed objectivemeasure in evaluating process quality. Sutton(1993) has attempted to develop a set of factorsfor influencing various stages of the audit process.The selection of the factors is done by the auditorsof large audit firms. An audit quality factor isdefined to the participants as any variableaffecting the audit team’s ability to achieve thelevel of audit quality desired. He identified fourstages of audit process: engagement planning,interim fieldwork, year-end fieldwork and finaladministration. The study also develops themonitoring process or performance indicators foreach quality factors included in the respectivestages (Sutton, 1993). His results support thatthere exists a consensus among experiencedauditors on a set of key audit quality factorswhich have a significant impact on overall auditquality.Krishnan and Schauer (2000) examined theassociation between auditor size and audit qualityfor a sample of non-profit organizations. Usingthe compliance score analysis on eight GAAPreporting requirements to assess audit quality,they found that audit reporting was inconsistentamong the non-profit organizations. Of the eightreporting requirements examined, noncomplianceis highest for those that pertain specifically tonon-profit organizations such as disclosures aboutpledges and donated materials. Results also showthat the extent of noncompliance decreases as onemoves from the small non-Big 6 (now known asBig 4) to the large non-Big 6 and from large non-Big 6 to the then Big 6.The development of objective audit quality hasbeen further extended to cover firm level ratherthan engagement level only. For example, aguideline has been presented by expertrepresentatives from State Auditors Institution(SAI) concerning audit quality for public auditors.After a series of discussion and meetings, thecommittee finalize that there are three differentaudit quality attributes that should be taken careof (Mazur et al., 2005). First, it involves thequality control system. Second, the study alsoincludes one important attributes of audit qualitywhich is quality assurance. Last, the audit qualitycontrol system includes the institutionalmanagement such as managing human resources,institutional risk and external relations. This3

guideline is proposed for all SAIs to apply in bothcourts and offices, and to all audits, bothregularity and performance.2.2 International Standard on Quality ControlIn 2004 the International Auditing and AssuranceBoard (IAASB), of the International Federation ofAccountants (IFAC) has approved theInternational Standard on Quality Control (ISQC1) concerning the Quality Control for Firms thatPerform Audits and Reviews of HistoricalFinancial Information and Other Assurance andRelated Services Engagements. In line with therequirement by IFAC, Malaysian Institute ofAccountants (MIA) has imposed that allregistered accountants and auditors (practitioners)in Malaysia to comply with the new QualityControl standards by 30 June 2006. The standardsintroduce several new concepts and requirementsin respect of quality control within auditing firms.As a result, practitioners face with additionalresponsibilities in respect of implementing newquality control safeguards and procedures.ISQC 1 is different from ISA 220 “QualityControl for audits of Historical FinancialInformation” which sets out the quality controlstandards to be applied to individual auditengagements. On the other hand, ISQC 1 dealswith firm wide quality control which providesreasonable assurance that firms and its personnelcomply with professional standards andregulatory and legal requirements; and reportsissued by the firm or engagement partners areappropriate in the circumstances (Holt, 2006,p.14). ISQC 1 sets out six quality controlelements that must be rigorously andcomprehensively addressed. It covers (1)leadership responsibilities for quality within thefirm; (2) Ethical requirements; (3) Acceptanceand continuance of client relationships andspecific engagements; (4) Human resource; (5)Engagement performance; and (6) Monitoring.The standard requires audit firms to documentevidence of the operation of each of the sixelements of its quality control system and retainthat documentation for an appropriate period.3.0 METHODOLOGYThe development of the checklist involved threedifferent stages. First, the researchers formedcommon themes of ISQC 1 dimensions based onseveral sources. This study refers to the ISQC1requirements (MASA 2007), ISQC 1 manualsissued by MIA, MIA Practice ReviewQuestionnaires, MIA By-Laws, AustraliaQuestionnaires on Quality Control for Firms andPakistan’s ISQC 1 Review Self-assessmentQuestionnaire. A series of brainstorming sessionshas been conducted to identify the critical factorsfor each element of ISQC 1.Second, a review with two representatives fromthe MIA was conducted. The representativeswere the manager of technical development andthe manager of practice review. MIA requires apractice review for all audit firms which includescompliance on the ISQC 1 and ISA 220. Both ofthe representatives have thoroughly checked theformat, design and questions of the checklist. Thechecklist was further revised according to theircomments.Third, this study also uses a focus group interviewwith ten audit practitioners to evaluate each itemof the checklist. This method has been appliedpreviously in Sutton (1993). In this session, thepractitioners provide their inputs and discussed indetails the relevancy and usefulness of eachquestion. The conclusion of this session wasmarked by group consensus. Participants werealso required to provide their feedback on theoverall format of the checklist.4.0 PROPOSED SELF-ASSESSMENTCHECKLISTThere are seven dimensions of the quality controlin ISQC 1 (refer to figure 1). Details of thedefinition for each dimension are shown inAppendix 1.EthicalRequirementISQC 1dimensionsClientRelationshipsLeadershipDocumentationMonitoringEngagementPerformanceHumanResourcesFigure 1: Dimensions of ISQC1 auditquality control dimensions4

The structure of the checklist consists of two parts(refer figure 2). The first part presents questionson the policy and procedures and the second partpresents questions regarding the practices.PartPolicy andProceduresExplanationThe part presents the questions onthe policy and procedures on eachelements of ISQC 1. Thequestions shall be answered using“YES” or “NO” option.5.0 SCORE ASSESSMENTAn extension on this checklist is the developmentof score assessment. The score assessment wouldbe weighted according to the importance of eachdimension as well as the type of questions (eitherpolicies and procedures or practices). Audit firmsmay receive scores for each dimension as shownin Figure 4.PracticesThe part comprises of questionson the practices of each elementsof ISQC 1. Each indicator shallbe answered using four-scaleoptions.Figure 2: ISQC1 Self-assessment checklist -formatEthical RequirementClient RelationshipsLeadership109876543210DocumentationMonitoringQuestions on the practices shall be answeredusing four different indicators. The scale enablesthe audit firm to assess the degree to whichpractices and/or processes are in place thatindicate adherence to the indicators. The auditfirm may choose if the practices and/or processesare highly functional in the firm, operational,emerging or not evident (refer to figure 3). Thefirm should use the scale as an opportunity to askitself challenging questions and to respond withaccurate answers geared toward selfimprovement.IndicatorExplanationNot evident No evidence/ documentationexistsEmerging Evidence indicates early orpreliminary stages ofimplementation of practiceOperational Evidence indicates practicesand procedures are activelyHighlyfunctionalimplementedEvidence indicates practicesand procedures are effectivelyand consistently implementedFigure 3: Self-assessment checklist - Definitionsof scaleBased on the discussion with the practitioners, thefinalized questions for each dimension wereagreed consensusly. Details of the question itemsare shown in Appendix 2.Human resourcesEngagementPerformanceFigure 4: ISQC1 Self-assessment scoreOnce the determination of the scores of eachdimensions has been calculated, audit firms willreceived the overall score. This score is rankedinto five different scales (refer to Figure 5). Theoverall assessment score indicates the firm’soverall assessment of meeting the ISQC 1.Level of achievementGood to best practice in manyareasGood to best practice in at leastone areaScore91-100%81-90%Meets minimum standards 71-80%Needs significant improvement inat least one areaNeeds significant improvement inmany areasFigure 5: Overall score assessment61-70%0-60%5

6.0 CONCLUSIONVery limited studies have examined the issue ofaudit quality directly in small and medium auditfirms. This study develops a self-assessmentchecklist of audit quality control based on therequirements in ISQC 1 for small and mediumaudit firms. Using a focus group interviewmethod, it is hoped that the feedback from thepractitioner in small and medium audit firms maycontribute to the understanding of audit quality.Furthermore, most past studies measure auditquality using audit firm size. This study,however, shows a direct proxy measure for auditquality.The audit quality control assessment provides apractical implication such that this is to enhanceaudit quality among small and medium auditfirms. A well-recognized audit quality of theorganization would make customers’ choiceseasier and lowers their expectation of risk. It alsobuilds loyalty, leads to repeat business, andencourages current clients to refer theorganization to others (Brinkley, 2006).This self-assessment checklist is not meant for apass-fail test or a competition. It is designed as adiagnostic tool in order to enhance understandingof each firm in comparison to the aspirationalpractices described in the ISQC 1. The scoreassessment could enable firms to pinpoint areasfor improvement.REFERENCESArrunada, B. 2004. Audit failure and the crisis ofauditing. European Business OrganizationLaw Review 5: 635-643.Arrunada, B. 2000. Audit quality: attributes,private safeguards and the role of regulation.The European Accounting Review 9 (2): 205-224.Brinkley, M. 2006. Health check for the auditbrands. Internal Auditor (June): 79-83.Carcello, J.V., Hermanson, R.H. & McGrath,N.T. 1992. Audit quality attributes: Theperceptions of audit partners, preparers, andfinancial statement users. Auditing:A Journaiof Practice & Theory, 11 (1): 1-15.DeAngelo, L. E. 1981. Auditor size and auditquality. Journal of Accounting andEconomics 3: 183-199.Dupoch, N. & D. Simunic 1982. Competing inAuditing: An assessment. Paper presented atSyposium on Auditing Research IV.University of Illanois at Urbana-Champaign.Krishnan, J. & Schauer, P.C. 2000. Thedifferentiation of quality among auditors:Evidence from the not-for-profit sector.Auditing 19 (2): 9-25.Malaysian Approved Standards on Auditing(MASA). 2007. Malaysian Institute ofAccountants.Mazur, J., Revesz, J., Vella, B. & Havens, H.2005. Guidelines on Audit Quality.International Journal of GovernmentAuditing 32 (2): 10-14.Moore, G. and W.R. Scott. 1989. Auditors’ LegalLiability, Collusion with Management andInvestors’ Loss. Contemporary AccountingResearch. Spring :754 -774.Omar, N. & Mohd Alwi, M.J. 2007. Internationalstandard on Quality Conrol (ISQC 1): Asurvey report for the Malaysian Institute ofAccountants (MIA), Working Paper,Universiti Teknologi MARA.Palmrose, Z-V. 1988. An analysis of auditorlitigation and audit service quality. TheAccounting Review (January): 55–73.Sutton, S.G. 1993. Toward an understanding ofthe factors affecting the quality of the auditprocess. Decision Sciences 24 (1): 88-105.6

Appendix 1: Definition of each ISQC 1 elementsNo. Element Definition1. Leadershipresponsibilities forquality within thefirmThe firm shall establish policies and procedures designed topromote an internal culture based on the recognition that quality isessential in performing engagements. Such policies and proceduresshall require the firm’s chief executive officer (or equivalent) or, ifappropriate, the firm’s managing board of partners (or equivalent),to assume ultimate responsibility for the firm’s system of qualitycontrol2. Ethical requirements The firm shall establish policies and procedures designed to provide itwith reasonable assurance that the firm and its personnel comply withrelevant ethical requirements3. Acceptance andcontinuation of clientrelationships andspecific engagementsThe firm shall establish policies and procedures for the acceptanceand continuance of client relationships and specific engagements,designed to provide it with reasonable assurance that it will onlyundertake or continue relationships and engagements where it: (a)Has considered the integrity of the client and does not haveinformation that would lead it to conclude that the client lacksintegrity; (b) Is competent to perform the engagement and has thecapabilities, time and resources to do so; and (c) Can comply withrelevant ethical requirements4. Human resources The firm should establish policies and procedures designed toprovide it with reasonable assurance that it has sufficient personnelwith the capabilities, competence, and commitment to ethicalprinciples necessary to perform its engagements in accordance withprofessional standards and regulatory and legal requirements, and toenable the firm or engagement partners to issue reports that areappropriate in the circumstances5. EngagementperformanceThe firm should establish policies and procedures designed toprovide it with reasonable assurance that engagements areperformed in accordance with professional standards and regulatoryand legal requirements, and that the firm or the engagement partnerissues reports that are appropriate in the circumstances6. Monitoring The firm should establish policies and procedures designed toprovide it with reasonable assurance that the policies andprocedures relating to the system of quality control are relevant,adequate, operating effectively and complied with in practice. Suchpolicies and procedures should include an ongoing considerationand evaluation of the firm’s system of quality control, including aperiodic inspection of a selection of completed engagements7. Documentation The firm shall establish policies and procedures for thedocumentation to provide evidence of the operation of each elementof the system of quality control(Source: MASA 2007)7

Appendix 2: Question items for each element of quality control checklistLEADERSHIP RESPONSIBILITIES FOR QUALITY WITHIN THE FIRM Allocates sufficient resources Assigns appropriate person Aims in achieving quality in all engagements Emphasizes on firm’s quality control system Exerts quality auditing cultureETHICAL REQUIREMENTS Complies with the fundamental principles of professional ethics Identifies and promptly notify the threats to independence Requires the rotation of the engagement partner and the engagement quality control reviewer Takes action on non-compliance with relevant ethical requirements Requires partners and staff members to make independence declaration at least annuallyACCEPTANCE AND CONTINUANCE OF CLIENT RELATIONSHIPS AND SPECIFIC ENGAGEMENTS Address the element of acceptance and continuance of client relationship and specific engagements Ensures that the personnel assigned the following matters in acceptance and continuance of client relationshipand specific engagements Employs an assessment criteria on client’s integrity Discusses with the appropriate level of client management and those charged with governance regarding thereasons for withdrawal and the appropriate action to be takenHUMAN RESOURCE Establishes policies and procedures dealing with the personnel issues Communicates the above policies and procedures to the partners and staff members Plans future staffing needs Provides continuous training for partners and staff members Communicates the identity and role of the engagement partner to client Ensures the engagement partner(s) has the capabilities, competencies, authorities and time to perform theirengagements Defines and communicates clearly to the engagement partner of his or her responsibility Assigns appropriate staff with the necessary capabilities, competency and time to perform engagements Conducts partners and staff members’ appraisals on regular basis Offers appropriate remuneration packageENGAGEMENT PERFORMANCE Designs the quality of engagement performance for example through audit manual, standardizeddocumentation, specific guidance materials and software tools Undertakes appropriate consultation with experts within or outside the firm to resolve difficult and contentiousmatters Resolves differences of opinion by consulting other practitioners, professional body or regulatory body Completes the assembly of final engagement files on a timely basis after the engagement reports have beenfinalized Maintains the confidentiality, safe custody, integrity, accessibility and retrievability of engagementdocumentation Conducts quality control review in a timely mannerMONITORING Establishes policies and procedures designed to provide reasonable assurance that the system of qualitycontrol is relevant and adequate Establishes policies and procedures on complaints and allegations relating to the system of quality control Ensures inspections of the engagement are conducted regularly Evaluates the effect of deficiencies noted as a result of the monitoring processDOCUMENTATION OF SYSTEM OF QUALITY CONTROL Establishes policies and procedures requiring appropriate documentation to provide evidence on the operationof the six elements of the quality control system8