Asian Review of Accounting: Article Information

Asian Review of Accounting
Investigating audit quality among Big 4 Malaysian firms

Tyrone M. Carlin, Nigel Finch, Nur Hidayah Laili,
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Tyrone M. Carlin, Nigel Finch, Nur Hidayah Laili, (2009) "Investigating audit quality among
Big 4 Malaysian firms", Asian Review of Accounting, Vol. 17 Issue: 2, pp.96-114, https://
doi.org/10.1108/13217340910975251
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ARA
17,2 Investigating audit quality among
Big 4 Malaysian firms
Tyrone M. Carlin and Nigel Finch
96 Faculty of Economics and Business, The University of Sydney,
Sydney, Australia, and
Nur Hidayah Laili
Macquarie Graduate School of Management,
Macquarie University, Sydney, Australia
Abstract
Purpose – The purpose of this paper is to contemplate the degree to which technical expertise in
Malaysian Big 4 auditing practice survives periods of material regulatory inflexion sufficiently to
underpin quality financial reporting outcomes.
Design/methodology/approach – The adoption of IAS in Malaysia in 2006 introduced a highly
technical standard (financial reporting standards – FRS 136) which impacted not only preparers but
also auditors of financial statements. This transition period represents a unique opportunity to
interrogate the content of financial statements drawn up under new and complex standards, with a view
to gaining insight into the quality of oversight offered by the audit profession.
Findings – Contrary to the view within the extant literature that there is homogeneity in audit quality
among Big 4 firms, this paper reports substantial cross-sectional variation among the sample of Big 4
Malaysian audit firms and reports on distinctly poor compliance levels.
Research limitations/implications – The research focuses on compliance with various
requirements under FRS 136 – Impairment of Assets among a sample of first-time adaptors drawn
from the FTSE Bursa Malaysia Index whose 2006 financial accounts have been audited by a Big 4 auditor.
Practical implications – The results raise questions about audit quality among the sample firms
and the robustness of regulatory oversight institutions operating within Malaysia.
Originality/value – This research illustrates a novel approach to examining the issue of audit
quality by introducing a compliance quality approach focusing on note-form disclosures.
Keywords Goodwill accounting, Malaysia, Auditing, Auditing standards, Professional standards
Paper type Research paper
1. Introduction
Auditors play an important role in assuring the production and issue of high-quality
financial reports. The question of whether auditors effectively play this role in
ensuring credible accounting information has received episodic attention over time.
The spate of collapses in the early millennium years exemplified by the Enron
bankruptcy in 2001 and the related collapse of Arthur Andersen in 2002 triggered a
bout of criticism of Big 4 audit firms, their processes and the quality of the audits being
performed by them (Francis, 2004). These criticisms were particularly jarring given the
traditional perceptions of the high quality of audits performed by large firms (Lam and
Asian Review of Accounting Chang, 1994).
Vol. 17 No. 2, 2009
pp. 96-114 That perception is clearly evident in literature relating to audit quality dating back
q Emerald Group Publishing Limited
1321-7348
over a span of at least three decades. It appears to have been a long-held view that large
DOI 10.1108/13217340910975251 audit firms provide higher quality audits and offer greater credibility to clients’ financial
statements than small audit firms (Lennox, 1999). This aura of quality has been argued Big 4 Malaysian
to stem not just from the technical expertise and processes brought to bear by larger firms
firms, but also because large firms enjoy better reputations, have higher brand equity
and are likely to be highly concerned to protect these (DeAngelo, 1981). In addition,
larger audit firms have generally been viewed as being more independent and being seen
to be more independent of their clients (Dopuch, 1984).
Of course, tensions associated with the provision of quality services and the 97
maintenance of independence do exist and have been duly noted in the literature. The
impact of the bundling of audit and non-audit services on independence, effectiveness
and quality represents an example of a concern persistently manifested in the literature
over time. Other commonly raised concerns have related to factors such as fee structures,
length of relationship and turnover of engagement partners (Healy and Lys, 1986;
Sabri, 1993; Chen et al., 2005).

Without calling the significance of these matters into question, it is arguable that
other factors might also wield substantial influence on the quality of the outcomes
achieved by auditors, large or small. One such phenomenon might be labelled “technical
competence”. A general assumption in the literature appears to be that this is a given in
the context of the execution of a financial statement audit – particularly when the work
is undertaken by a global brand name provider.
This assumption may be very strongly founded on average. Yet, in the domain of
financial reporting, there exist key inflection points where an accumulation of prior
technical expertise is either rendered redundant or at least degraded substantially in its
worth. A notable trigger point for this form of disruption is the transition from one
regulatory regime or framework to another.
This type of regime transition disruption event is well exemplified by the decision on
the part of a particular jurisdiction to transition from pre-existing indigenous GAAP to a
reporting framework compliant with international financial reporting standards (IFRS).
The extent of this disruption may be more profound in jurisdictions which at the time of
transition are still in the process of rapid development and do not enjoy the depth of
human capital or regulatory institutions available to more fully developed jurisdictions.
In light of this, the decision by Malaysia to adopt the new and revised financial
reporting standards (FRS) modelled tightly on IFRS (though with some variations
applicable in the transition phase) represents an interesting opportunity for research into
the impact of expertise disruption on audit quality. The new suite of standards, effective
from 1 January 2006, contains the seeds of great challenges for auditors of financial
reports. In particular, a number of the new internationally compliant standards are
substantially more complex in their configuration, in the nature and structure of reporting
processes and disclosures that they require and consequently on the demands associated
with the production of audit services under their aegis (Carlin and Finch, 2008).
The new standards relating to asset impairment represent an excellent case in point.
Preparation of reports compliant with the requirements of IAS 36 Impairment of Assets
(or Malaysian equivalent FRS 136) requires the application of a tightly woven knit of
principles drawn from forecasting, measurement and valuation theory, under conditions
of inherent uncertainty. The result, especially when applied to the context of an unruly
asset class such as goodwill can be highly complex and potentially controversial.
Consequently, this study focuses on evidence relating to the apparent quality of
financial statement audits in the context of the transition to a new, complex regime.
ARA Specifically, the degree of technical compliance with the disclosure requirements of
17,2 FRS 136 by a sample of large Malaysian listed companies is used as a proxy for audit
quality in relation to the complex provisions of the IFRS impairment testing regime.
In investigating this theme, the remainder of this paper is structured as follows.
Section 2 contains a brief review of some pertinent prior research literature. Section 3
sets out details of the sample, data and methodology employed. Section 4 sets out a
98 discussion of key findings results, while Section 5 contains some conclusions and
suggests some potential avenues for further research.
2. Literature review
Audit quality can be defined as the probability that an error or irregularity is
detected (DeAngelo, 1981) and the willingness to report any material manipulation or
misstatements that will increase the material uncertainties or/and going concern problems
(Bradshaw et al., 2001). In other words, high audit quality is associated with an absence of
material omissions or misstatements in financial statements (Palmrose, 1988).
Within the extant literature on the subject, it has been commonplace to view audit
firm size as a surrogate for audit quality. It has often been assumed that larger audit
firms incur costs to develop a reputation for adding value to the audit and are better able
to detect and reveal management’s errors or irregularities in financial reporting (DeFond
and Jiambalvo, 1993). DeAngelo (1981) suggested that large auditors have more reason
to issue accurate reports because they have more valuable reputations and the auditor
has a greater reputation to lose if their clients misreport. This theme was later developed
as the “at risk quasi rent” explanation, pursuant to which the more extensive potential
economic loss exposures faced by large audit firms provide a strong motivational
framework for quality assurance and enhancement (Francis and Wilson, 1988).
An array of empirical evidence ostensibly consistent with the theoretical
explanations discussed above exists. For example, Becker et al. (1998) suggest that
large audit firm are able to detect earnings management because of their advanced
knowledge and act to control opportunistic earnings management to protect their
reputation. This is said to be demonstrated by the observation that clients of large audit
firms exhibit lower discretionary accruals than those of other audit firm clients.
Capital market studies have found that the stock market reacts more positively when
a company switches to a large audit firms and report higher earnings response
coefficients for clients of large audit firms compared to clients of non-large audit firms
(Nichols and Smith, 1983; Eichenseher et al., 1989; Teoh and Wong, 1993). Other studies
on the market reaction to the initial public offerings of stocks, reveals that the trading
volume on the first trading day is significantly larger for Big Eight clients than for those
of non-Big Eight firms (Jang and Lin, 1993). A range of studies have also suggested that
companies undergoing IPOs experience less under-pricing when they hire large audit
firms (Balvers et al., 1988; Firth and Smith, 1992).
The evidence above has been widely interpreted as supporting the notion that auditor
size is a robust surrogate for audit quality. However, at least in the minds of some
authors, events such as the bankruptcy of Enron and the related collapse of Arthur
Anderson have undermined confidence in the assertion that large audit firms are
associated with higher audit quality.
Thus, Fuerman (2003) examined evidence which might point to a conclusion of
quality differentiation between Big Six auditors. While the results of that study
suggested that Coopers & Lybrand, Deloitte & Touche, Ernst & Young, KPMG and Big 4 Malaysian
Price Waterhouse each produced higher quality auditors compared to non-Big Six firms, firms
the same conclusion was not supported with regard to Arthur Andersen.
By way of contrast, empirical research by Eisenberg and Macey (2003), drawing upon
data relating to earnings restatements finds no evidence of audit quality differentials
among large auditors. Other recent research has generated similar conclusions (Tilis,
2005) also supports the assertion. Thus, while the preponderance of view within the 99
audit quality literature appears to continue to support the proposition that the quality of
audits undertaken by large firms exceeds that of audits carried out by smaller firms,
there is little evidence strongly supportive of quality differentials between large firms.
In interpreting the audit quality literature and understanding its significance, it is
important to recognise that the measurement of quality has both a relative and an
absolute dimension. The estimation of audit quality on a relative basis tends to proceed
via a process of comparing observed values for some posited proxy for quality between
audit firms, while attempts to determine the absolute quality of an audit tend to examine
the audit process itself, against unique engagement specific benchmarks.
The latter approach is costly, usually requiring researchers to be embedded with
audit teams as they undertake their work, or have direct access to audit working papers
or peer review processes undertaken in relation to engagement work. There are
published examples of such work (Colbert and Murray, 1998), but these are
comparatively rare. On the other hand, work focused on relative measures of audit
quality (via proxy), including literature citing evidence of fee differentials,
litigation occurrence and resolution, earnings forecast accuracy, earnings response
coefficients – as examples, are more frequently represented in the published literature
(Behn and Choi, 2008; Lam and Chang, 1994; Palmrose, 1998; Teoh and Wong, 1993).
One consequence of the manner in which the question of audit quality has
predominantly been dealt with in the extant literature may have been a failure to focus
on situations where the most pertinent questions relating to quality relate not to the
quality of one firm’s offering versus another’s, but rather as to the capacity to deliver an
appropriate level of baseline assurance.
As argued above, periods of regulatory transition represent risk inflexion points
where skill sets and approaches to the conduct of work previously accumulated may be
deeply diminished in their value. The adoption of IFRS is a case in point, and as noted,
a particularly challenging element of the IFRS framework is that element of it which
deals with the asset impairment phenomenon, especially as it pertains to goodwill.
The need to adopt the IFRS framework for measuring and reporting on goodwill
represents a very substantial challenge to Malaysian reporting entities. Most entities
will be impacted by the more prescriptive impairment test under FRS 136. The
requirement to perform annual impairment testing for goodwill, in addition to the
requirement to test when there exists indication of impairment, is likely to prove a very
significant technical test for many entities. Under IFRS, reporting entities also need to
deal with significantly expanded disclosure requirements in particular in relation to
recoverable amount and impairment testing, including information about key
assumptions.
Whether the value of goodwill has been impaired in a given year is determined
through a process of comparing estimates of the recoverable amount of portfolios
of assets (known as cash generating units – CGUs) with the book value ascribed
ARA to those assets. Paragraph 18 of FRS 136 – Impairment of Assets, defines recoverable
17,2 amount as the higher of an asset’s or a CGU’s fair value less costs to sell and its value in
use. This provides reporting entities with a choice between fair value and value in use
as a basis for recoverable amount estimation, which choice carries substantial
implications for the types of disclosures required by the entity.
In Malaysia’s case, the absence of active and liquid markets for many types of assets
100 valuation leads to a natural tendency on the part of reporting entities to adopt the value
in used method as the dominant means of determining the recoverable amount. This
then drives a series of disclosure requirements consequent on that choice. Paragraph 134
(d) of FRS 136 – Impairment of Assets, states that the disclosure requirements if the
unit’s (group of units) recoverable amount is based on value in use are:
.
A description of each key assumption on which management has based its cash
flow projections for the period covered by the most recent budgets/forecasts. Key
assumptions are those to which the unit’s (group of units’) recoverable amount is
most sensitive.
.
A description of management’s approach to determining the value(s) assigned to
each key assumption, whether those value(s) reflect past experience or, if
appropriate, are consistent with external sources of information, and, if not, how and
why they differ from past experience or external sources of information.
.
The period over which management has projected cash flows based on financial
budgets/forecasts approved by management and, when a period greater than five
years is used for a cash-generating unit (group of units), an explanation of why
that longer period is justified.
.
The growth rate used to extrapolate cash flow projections beyond the period
covered by the most recent budgets/forecasts, and the justification for using any
growth rate that exceeds the long-term average growth rate for the products,
industries, or country or countries in which the entity operates, or for the market to
which the unit (group of units) is dedicated.
. The discount rate(s) applied to the cash flow projections.
In implementing the new standard for goodwill, companies need to deal with significantly
expanded disclosure requirements in particular in relation to recoverable amount,
impairment and information about key assumptions adopted in the value simulation
process. This has not changed the format of information recognized in the balance sheet
but has materially changed the information required in the notes to the accounts.
From an auditor’s perspective, the new IFRS requirements drive increases in disclosure
and, therefore, required effort in the conduct of the audit (Hoogendoorn, 2006). However, it
is not clear that enhanced disclosure challenges, particularly those with greatest impact in
the notes to the accounts, are universally well dealt with in the context of financial
statement audits.
The results of a recent study by Libby et al. (2006) indicate a far higher level of
sensitivity on the part of Big 4 audit firm partners to adjustments impacting the balance
sheet and or profit and loss statements than those whose impact was limited to the notes
only. In other words, auditors appear more willing to tolerate errors and discrepancies in
note form disclosures than in recognized numbers on the primary financial statements.
If these results are generalisable beyond the setting in which they were generated,
then they suggest that the implementation of FRS 136, replete as it is with complex note Big 4 Malaysian
form disclosure requirements, represents a useful focal point for research which may firms
yield interesting insights into audit quality in the face of change and complexity.
Specifically, the highly detailed disclosure requirements set out in FRS 136 present an
opportunity to interrogate the level of compliance and disclosure quality exhibited by
reporting entities – and by extension, yield insights into the quality of the oversight
provided in relation to the resulting financial statements by auditors. 101
For the purposes of this study, a number of matters are of particular interest. First, the
fact that goodwill acquired in a business combination is required to be allocated to CGUs
in order to be tested for impairment. Second, the fact that the adoption of a value in use
approach to the estimation of CGU recoverable amount requires the application of
appropriate discount rates as an integral element of the cashflow modelling central to the
valuation exercise under the value in use approach. Third, that the same modelling
exercise also requires the application of growth rate assumptions. Each of these
elements is subject to technically precise disclosure requirements and, as is becoming
evident from a growing raft of evidence, potential gaming (Ramanna and Watts, 2007;
Zhang and Zhang, 2007).
The importance of the technical processes pursuant to which goodwill impairment
testing transpires has been explored in a range of previous literature (Lonergan, 2007).
Prior research has suggested that one key challenge faced in the context of FRS 136 is the
manner in which goodwill is allocated between CGUs for the purposes of impairment
testing. A particular risk relating to this process is known as the CGU aggregation
problem (Carlin and Finch, 2007), where too few CGUs are defined and have goodwill
allocated to them. This induces the risk that impairment charges which should occur are
avoided, or at least inappropriately delayed.
The selection of appropriate discount and growth rates and the generation of
appropriate disclosures in relation to these choices also represent matters of material
concern. Arguably, the nature of choices made by reporting entities, the level of their
compliance with the precepts of FRS 136 and the quality of disclosures made pursuant to
that standard all convey evidence pertinent to an assessment of the quality of audit
oversight tendered in conditions of complexity and change. The remainder of the paper
is given over to a discussion of the methodology employed with a view to gleaning
relevant insights, the results of the application of that methodology and the conclusions
derived there from.
3. Data and methodology

All reporting entities with reporting dares commencing on or after 1 January 2006 are
required to comply with FRS 136’s requirements. Thus, 2006 represents the first
reporting period for Malaysian companies during which it was mandatory to apply FRS
136. The commencing sample for the research was the 100 constituent firms which
comprised the FTSE Bursa Malaysia Index as at 2006.
However, it was necessary to exclude a substantial number of these firms from the
final research sample. Some 36 companies were excluded as not having goodwill as an
element of their asset base in their 2006 consolidated financial statements. A further
28 companies were excluded by reason of having a reporting date other than
31 December. Another two companies were excluded because they were audited by
non-Big 4 auditors. Details of the 34 companies comprising the final research samples,
ARA their market capitalization and the value of their goodwill balances are set out in
17,2 Appendix 1. The research sample represented 35.2 per cent of FTSE Bursa Malaysia
total market capitalization as at the conclusion of December 2006.
To facilitate analysis of the final research sample, the 34 companies were divided into
six groups comprising organizations with related principal lines of business. At the date
of sampling, the 34 companies included in the final sample controlled assets valued at
102 RM 572,393 million, which included goodwill of RM 31,202 million. An overview of the
research sample broken down by assigned sector, the ringgit Malaysia value of
company assets within the sector, and the ringgit Malaysia value of goodwill for each
sector is shown in Table I.
Table II shows the number of companies (by sector) audited by each of the Big 4
auditors. The number of clients for each auditor varies substantially, with Ernst &
Young dominating at 47.06 per cent of the companies included in the research
sample, followed by PricewaterhouseCoopers (PWC) and KPMG at 29.41 per cent and
20.59 per cent, respectively, and Deloitte with only one, or 2.94 per cent of the companies
in the research sample.
Table III shows the key descriptive statistics for the companies in the research
sample classified by auditor. On average, Ernst & Young clients were smaller
(as measured by market capitalisation) compared to clients of other Big 4 auditors.
However, it was clients of PWC which on average had the highest levels of goodwill
relative to assets. In consequence, it is posited that the potential earnings sensitivity
of PWC clients to impairment losses on goodwill write downs was on average higher
than for clients of other Big 4 audit firms included in the sample. Key descriptive
Total
assets Total Goodwill with
(RM goodwill total assets
Sector million) (RM million) (%)
Basic materials and oil and gas (n ¼ 2) 5,695 195 3.43

Consumer goods (n ¼ 5) 57,375 798 1.39
Consumer services and health care (n ¼ 3) 64,667 5,200 8.04
Financials (n ¼ 11) 349,289 9,783 2.80
Table I. Industrials (n ¼ 9) 82,159 4,136 5.03
Overview of research Technology and telecommunication and utilities (n ¼ 4) 13,208 11,090 83.96
sample Total (n ¼ 34) 572,393 31,202 5.45
Sector Deloitte Ernst & Young KPMG PWC
Basic materials and oil and gas (n ¼ 2) – – 2 –

Consumer goods (n ¼ 5) – 3 1 1
Consumer services and health care (n ¼ 3) – 2 – 1
Financials (n ¼ 11) – 5 2 4
Table II. Industrials (n ¼ 9) 1 5 1 2
Number of companies Technology and telecommunication and utilities (n ¼ 4) – 1 1 2
audited by sector Total (n ¼ 34) 1 16 7 10
Big 4 Malaysian
Deloitte Ernst & Young KPMG PWC
Description (n ¼ 1) (n ¼ 16) (n ¼ 7) (n ¼ 10) firms
Mean market capitalisation (RM million) 5,155 3,301 6,870 17,280
Mean total assets (RM million) 3,817 17,511 25,540 10,962
Mean goodwill (RM million) 1,188 127 439 2,491
Mean NPBT (RM million) 212 222 459 1,216 103
Goodwill as percentage assets
Financials – 0.45 1.34 54.83 Table III.
Non-financials 27.25 1.18 6.35 18.63 Descriptive statistics
All sectors 27.25 0.72 1.72 22.73 of companies by auditors
Ratio of goodwill: NPBT 6:1 0.57:1 0.96:1 2.05:1 in 2006
statistics pertaining to the firms in the research sample, sorted by audit firm identity are
set out in Table III.
A focal question in this study is the extent to which the clients of large audit firms
strictly adhere to complex technical provisions of a new reporting standard. As discussed
in Section 2, there are three key issues under FRS 136 – Impairment of Assets which are of
potential interest and are capable of empirical investigation. These are, CGU structure,
discount rate levels and disclosures and growth rate levels and disclosures.
Consistent with Carlin et al. (2007), six analytical structures were applied to the data.
First, companies in the research sample were sorted by audit firm according to the choice
of method employed in estimating the recoverable amount of CGU assets. These
allowable choices of method include a value in use approach to recoverable amount
estimation, a fair value approach or a combination of these two (that is, the use of value in
use in some CGUs and the recourse to fair values in others). This data assisted with the
development of insight into the level of compliance with basic disclosure requirements
set out in FRS 136.
Second, the companies in the research sample were sorted by audit firm, according to
whether they allocate all the value of goodwill to the CGUs, for the purpose of
impairment testing or whether there is no meaningful information indicate that how or if
the value of goodwill being allocate to CGUs. It is a basic requirement of FRS 136 that all
goodwill be allocated to CGUs and that adequate disclosures be made allowing financial
statement users to reconcile between the headline value ascribed to goodwill on balance
sheet and the subcomponents of that balance split between CGUs. This data assisted
with the development of insight into the level of compliance with basic disclosure
requirements set out in FRS 136.
Third, the companies in the research sample were sorted by audit firm according to
the relationship between the number of industry segments they defined for reporting
purposes and the number of CGUs defined for the purposes of goodwill impairment
testing. This data provides evidence related to the likelihood of CGU aggregation
behaviour on the part of reporting entities.
Fourth, a CGU to business segment ratio was calculated for each of the sample
firms, the results being displayed according to audit firm identity. This analysis builds
upon the procedure described in step three (above) and also goes to the likelihood of
CGU aggregation behaviour among reporting entities.
Fifth, the companies in the research sample were sorted by audit firm according to
the disclosure quality of discount rates used in the impairment testing process.
ARA A multi-classification taxonomy for data categorisation was applied, comprising four
17,2 groupings. These were:
(1) “no effective disclosure”;
(2) “range of discount rates” (where a firm stipulated that the discount rates
employed laid within a disclosed range but did not link any particular discount
rate to any particular CGU);
104
(3) “single explicit discount rate” (where a single rate was used to discount the cash
flows of all defined CGUs); and
(4) “multiple explicit discount rates” (where a unique rate was used to discount the
cashflows in each different CGU).
Allocation of a company to the first category signified that the company provided
inadequate disclosure regarding the discount rate and in consequence provided no
meaningful information for external analysts relating to the impairment testing
process. Companies in this category clearly breached a key element of the disclosure
requirements stipulated under FRS 136.
Firms categorised as falling within the second category, “range of discount rates”,
provided a degree of information regarding the process of impairment testing but
given the lack of specificity of this data, it is questionable whether disclosure of this
sort meets the requirements or objectives of FRS 136.
Companies in the third category, i.e. “single explicit discount rate” disclosed the
application of a single discount rate for recoverable amount modelling in each of their
CGUs. While this treatment leaves financial statement users in no doubt as to the rate
applied to the key task of future cashflow discounting, it nonetheless raises questions
in relation to the appropriateness of the rates employed by these entities, given the
need to shape discount rates to the risk characteristics of CGUs, and the likelihood that
risk varies between CGUs.
Finally, companies in the fourth categories appeared to fully comply with the
requirements of FRS 136 in relation to discount rates by disclosing unique rates
applicable to each of their various CGUs. This form of disclosure fully complies with
the requirements of the standard, but also provides a higher assurance of process
quality through an explicit matching of applied rates to the individual risk
characteristics of defined CGUs.
A very similar taxonomy was adopted as the means of classifying growth
assumption disclosures made by firms in the research sample. Companies in the
sample were allocated between four categories, i.e. “multiple growth rates and periods
for each CGU”, “single growth rate and period for all CGUs”, “partial disclosure only”
or “no effective disclosure”. The results of the analysis are reported in Section 4.
4. Results and discussion

The basic question contemplated in this paper relates to the degree to which technical
expertise survives periods of material regulatory inflexion sufficiently to underpin
quality financial reporting outcomes. The onset of change in regulatory arrangements
impacts not only preparers but also auditors of financial statements. Consequently,
the initial change period represents an ideal moment at which to interrogate the content
of financial statements drawn up under new and complex standards, with a view to
gaining insight into the quality of oversight offered by the audit profession. The data Big 4 Malaysian
in Table IV represents an initial entrée into this journey, by setting out the frequency of firms
companies’ choice of method in estimating the recoverable amount of CGUs, a basic
disclosure requirement under FRS 136.
Two themes emerge from the data. First, the dominant tendency of firms to use the
value in use approach to determination of CGU recoverable amount. An explanation for
the use of the value in use approach to the virtual exclusion of the fair value approach may 105
lie in the limited existence of active and liquid asset markets in Malaysia (Fah, 2006).
Second, 9 of 34 companies (in excess of a quarter of the research sample) did not disclose
any details of the method they used in determining the recoverable amount of CGU assets.
In some cases, the explanation for this may be that goodwill though present on the
balance sheet, represents an immaterial balance. On the whole, however, the value of
goodwill as a proportion of the total asset base of the non-disclosing entities was material,
leaving no obvious justification for the lack of transparency on this basic matter.
Further, reporting entities audited by each of Deloitte, Ernst & Young and KPMG
failed this basic point of compliance, only PWC clients uniformly adhering to the
requirement to disclose the method used to determine CGU recoverable amount. Given
the limited sample of data available for review however, it would appear premature on
this basis alone to claim any distinction between the level of oversight offered by PWC
as against the level of oversight offered by the other large firms.
Having undertaken this basic level review, the next stage of the analysis employed
comprised the construction of a comparison between the total goodwill value reported
by each sample firm with the amount of goodwill allocated to CGUs by each firm.
This data is set out in Table V.
Again, substantial non-compliance with a basic (and not particularly technically
onerous) requirement of FRS 136 is clearly evident. Whilst 19 of 34 firms in the final
Number of companies Deloitte (n ¼ 1) Ernst & Young (n ¼ 16) KPMG (n ¼ 7) PWC (n ¼ 10)
Fair value method – – – – Table IV.

Value in use method – 11 3 10 Method employed by
Combination of methods – 1 – – companies to determine
No effective disclosure 1 4 4 – recoverable amount
Number of companies Deloitte (n ¼ 1) Ernst & Young (n ¼ 16) KPMG (n ¼ 7) PWC (n ¼ 10)
Fully compliant 1 8 2 8
Non-complianta – 8 5 2
Notes: aNon-compliant companies were those who failed to allocate any goodwill to CGUs. Paragraph
80 of FRS 136 Impairment of Assets requires that “For the purpose of impairment testing, goodwill
shall be allocated to each of the acquirer’s cash-generating units, or groups of CGUs, that are expected
to benefit from the synergies of the combination, irrespective of whether other assets or liabilities of
the acquiree are assigned to those units or groups of units”. Those companies and the value of their
goodwill, deemed non-compliant can be view in Appendix 2. In total, RM 7,483 million in goodwill was Table V.
not allocated to CGUs. This represents approximately 23.98 per cent of the combined goodwill of the CGU allocation
top 34 companies compliance by auditor
ARA research sample did produce disclosures which demonstrated full reconciliation
17,2 between the quantum of balance sheet reported goodwill and the amount disclosed as
having been allocated between the various CGUs defined by each, the remaining
15 (44 per cent) failed to do so.
There is some possibility that 10 of these 15 companies may have taken the view that
they had no need to comply with the requirement to disclose the amount of goodwill
106 allocated to each CGU by reason of the low materiality of goodwill on their balance
sheets relative to total assets. However, this view is likely to have been erroneous given
that the standard clearly stipulates that the relevant materiality benchmark is total
intangible assets, not total assets.
Irrespective, there could be no shadow of a doubt that there was not even the
possibility of confusion on this point in the case of the five other companies which failed
to provide this basic disclosure. Again, there is little evidence strongly consistent with
cross-sectional compliance variation according to audit firm identity, the better view of
the evidence being that slipshod practices manifested on a frequent basis without
apparent regard to audit firm identity.
The next phase of the analysis was based on the preparation of evidence pertaining to
the goodwill aggregation problem. Recall that a concern raised in prior literature on
IFRS based impairment testing is the “aggregation problem” where firms generate an
internal “portfolio diversification” effect by combining imperfectly correlated elements
of their businesses which in reality can and do generate independent streams of
cashflows and are subject to internal management reporting.
In these situations, fewer CGUs than required will be defined, with the result that the
chance of being forced to recognise impairment losses in weaker elements of the
business are reduced. This subverts the requirement that goodwill be rigorously
subjected to impairment testing and that the timing of goodwill impairment loss
recognition be driven by the underlying economics of each of the independent cashflow
streams which comprise the business, rather than by fiat of managerial discretion.
A key frustration in attempting to conduct meaningful analysis of the likelihood that
CGU aggregation behaviour has been present among large Malaysian firms reporting
subject to IFRS is that the standard of compliance with basic disclosure requirements is
so poor. Yet, even with the loss of not far off half the potential observations which might
feed such an analysis by reason of the total failure to comply with the requirement that
CGU identities and allocated goodwill amounts be disclosed, some themes emerge from
the data. Tables VI and VII set out the results of this testing.

Number of companies (n ¼ 1) (n ¼ 16) (n ¼ 7) (n ¼ 10)
No effective disclosure – 8 5 2
CGUs , segments 1 4 1 5
CGUs ¼ segments – 2 – 2
Table VI. CGUs . segments – 2 1 1
Business segments Proportion of firms where
and CGU aggregation CGUs , segments or no effective
by auditor disclosure (%) 100 75 86 70
Big 4 Malaysian
Number of companies (n ¼ 1) (n ¼ 16) (n ¼ 7) (n ¼ 10) firms
No effective disclosure – 8 5 2
CGU: segment is between 0.00 and 0.50 1 1 – –
CGU: segment is between 0.51 and 0.99 – 3 1 5
CGU: segment is ¼ 1 – 2 – 2 107
CGU: segment is between 1.01 and 1.50 – 2 1 1
CGU: segment is . 1.50 – – – –
Mean CGU: segment ratio 0.50 0.44 0.28 0.71
Median CGU: segment ratio 0.50 0.25 – 0.75
Minimum CGU: segment ratio 0.50 0.00 – – Table VII.
Maximum CGU: segment ratio 0.50 1.33 1.20 0.25 Ratio of CGUs
Percentage of CGU: segment ratio .1.01 (%) NA 12.50 14.29 10 to business segments
As the data makes plain, in those instances where data pertaining to the existence and
identity of CGUs is disclosed, the tendency appears to be for fewer rather than more
CGUs to be defined. Further, as Table VII shows, where more CGUs than business
segments are defined, the difference is typically marginal, with no instances observed of
any circumstances in which more than 1.5 CGUs per segment were defined. Bearing in
mind the expectation in the standard that CGUs should be no larger than defined
business segments, it appears anomalous to see so many instances where fewer CGUs
than segments exist.
Again, the results may have been clouded in consequence of the poor quality of
disclosure relating to CGUs, but arguably this is an interesting observation in its own right.
As a tentative conclusion, there does appear to be some evidence consistent with the risk
of_ CGU aggregation, but the magnitude of that risk does not appear to vary
systematically dependent on audit firm identity.
The final strands of the analysis undertaken relate to discount and growth rate
disclosures made by the firms in the sample. Since no firms disclosed that they had made
exclusive use of the fair value approach to goodwill impairment testing (Table IV), no
means existed to conclusively exclude any firms in the sample from the requirement to
provide disclosures pertaining to discount and growth rates assumed as an element of the
impairment testing process. Table VIII contains the results of the discount rate analysis.
A theme which emerges in this dataset in common with the others discussed above
is the systematically poor quality of disclosures made by firms in relation to the

No effective disclosure 1 7 5 1
Range of discount rates – 2 – –
Single explicit discount rate – 5 1 3
Multiple explicit rates – 2 1 6
Minimum discount rate (%) NA 4.00 7.00 5.09 Table VIII.
Maximum discount rate (%) NA 31.5 10.6 18.50 Analysis of discount
Median discount rate (%) NA 9.00 7.59 11.28 rates used to test
Mean discount rate (%) NA 9.35 7.59 11.30 impairment
ARA discount dates applied for the purposes of impairment testing. In only 9 of a possible
17,2 34 instances did firms particularise discount rates specific to individual CGUs, as
required. More frequently, they either stipulated a single discount rate for the firm as a
whole (without apparent regard to risk variation between CGUs), a range of discount
rates (generally not helpful in the context of allowing detailed financial statement user
insights into the robustness of the impairment testing process), or simply failed to
108 make any meaningful disclosures at all.
The analysis also revealed the application of a number of unusually low discount
rates, the most obvious exemplar of which was the Ernst & Young client which
adopted a rate of 4 per cent, though the PWC client which adopted a rate of 5.09 per cent
also appeared to test the hard edge of credibility on this matter[1]. Thus, in addition to
demonstrating poor quality compliance, the data also hints at the adoption of
inappropriately low discount rates[2] in certain cases. However, as with prior

tabulations, little stands out which would suggest the capacity to confidently find
meaningful cross-sectional variation explained by audit firm identity.
The final form of analysis undertaken relates to the growth rates disclosed by the
firms within the sample. This data is set out in Table IX. Cursory inspection of this
data immediately reveals the profound inadequacy of firm growth rate disclosures,
with in excess of 60 per cent of the sample firms apparently ignoring the clear
requirement of FRS 136 that disclosures relating to growth rate assumptions applied in
impairment testing be published.
Discounted cashflow models used as a basis for valuation typically consist of two
components. The first is an explicit forecast period covered by the most recent
budgets/forecasts, the second may be thought of as a terminal value component during
which some form of constant growth (or steady state) assumption is made in relation to
cashflows which emerge into the model from the year after the conclusion of the
explicit forecast horizon through to perpetuity.
Under FRS 136, firms are not required to publish details of their growth
assumptions during the first of these two stages (that is, the explicit growth forecast
horizon). However, it is necessary for any growth assumptions pertaining to the

No effective disclosure 1 11 5 4
Partial disclosure only – – – –
Single growth rate and period for all CGUs – 5 2 6
Multiple growth rates and period for each CGU – – – –
Mean explicit forecast period (years) NA 2.69 1.14 4.80
Minimum growth rate (%) NA 0.00 0.00 0.00
Maximum growth rate (%) NA 5.00 6.50 50.00a
Median growth rate (%) NA 3.00 2.75 2.97
Mean growth rate (%) NA 3.17 2.75 2.19b
Notes: aIn determining the recoverable amount, Scomi Group Berhad (SCOMI), a PWC client,
indicated that the company will grow at 50 per cent compounded, in perpetuity and justified this on the
Table IX. basis that this assumption stating that “the weighted average growth rate is consistent with the
Analysis of growth rates forecast included in industry reports”; bignores the outliers of SCOMI extreme growth rate
used to test impairment assumptions
terminal value component of the model to be made explicit. Thus, the observed growth Big 4 Malaysian
rate data set out in Table IX relates to assumptions expressed in relation to growth firms
rates used to extrapolate beyond the budget/forecast period, being the terminal value
to perpetuity element of valuation models used by firms.
As will be evident, the mean and median values for assumed growth appear
relatively conservative, given that Malaysian long run nominal GDP growth has been
in excess of these levels and can likely be expected to remain so. However, it is notable 109
that the explicit forecast horizons embedded in the valuation models of those
organisations which made meaningful disclosures tended to be short (no longer than
about five years). This raises the likelihood that the bulk of model value lies in the
terminal value component of the simulation, something generally regarded as risky
and as reducing the robustness of the valuation modelling exercise.
The extreme estimate of growth made by one reporting entity (50 per cent per annum
to perpetuity), clearly nonsensical in a mathematical sense, is noteworthy for its
inclusion in a set of audited financial statements. Nonetheless, this aside, the better view
of the data is that it reveals consistently poor practice irrespective of audit firm identity.
5. Conclusion
In the introductory sections of this paper, we postulated that the adoption of new and
complex reporting frameworks could represent a disruptive inflexion point which
might have the effect of undermining the impact of prior accumulation of technical
expertise on the part of financial statement preparers, and auditors. What we could not
have envisaged prior to the completion of the analysis we report in Section 4 is the
drastic degree to which the actual financial statement disclosures made by some of
Malaysia’s largest, best resourced and sophisticated businesses diverged from those
required under FRS 136.
This raises troubling questions. Because of the manner in which we undertook the
process of sample selection, the application of FRS 136 was mandatory for all of the
firms included in our final research sample. Yet these firms systematically failed to
comply with even basic elements of the FRS 136 disclosure framework in relation to
goodwill impairment testing. This was so even though all of the reports from which we
drew data and upon which we constructed our analysis had been subjected to audit by
“big brand” international audit franchises.
As noted in Section 4 there was no credible evidence in our dataset of meaningful
variation in compliance levels or disclosure quality levels among the clients of these
high profile firms. In a sense, the results would have been more comforting had such a
phenomenon been obvious. The lack of credible evidence of a bad apple in the basket
suggests a more worrying phenomenon, a systemic failure on the part of ostensibly
highly professional and reputable audit franchises to combat what can at best be
described as loose application of the rules by reporting entities.
Arguably, though based on a small sample, the results of this study are informative
at a variety of levels. First, they provide greater richness to the audit quality literature
by evidencing situations where firms the quality of whose services have generally been
assumed to be high show signs of strain.
Second, our results are consistent with those of researchers such as Libby et al. (2006),
who suggest that the level of attention to detail on the part of auditors is materially lower
ARA in the context of note form disclosures than in relation to recognised primary financial
17,2 statement items.
Given the substantial volume of information included in note form disclosures, the
tendency of this form of information dissemination to increase rather than atrophy over
time and the well-known admonition familiar to any financial statement reader that the
profit and loss and balance sheet must be read in conjunction with the accompanying
110 notes, this form of evidence is troubling. It may suggest that future research into the
domain of audit and audit quality pay closer attention to the potentially rich and policy
useful vein of data available in this alternative domain.
Third, our results would appear to raise questions about the robustness of regulatory
oversight institutions operating within Malaysia, as well as the standard setting process
itself. By definition, the objective of FRS is to achieve the maximum possible harmony and
minimum possible variation in practice among reporting entities. Yet the distinctly poor
compliance levels we observed in relation to FRS 136 disclosures shows that this result has
not been achieved in Malaysia, at least with respect to the first year of adoption.
If reporting entities and their auditors are not willing (or capable – we cannot tell
which) to apply clear black letter disclosure requirements stipulated under a mandatory
standard, and no other force operates to quickly enforce appropriate practice serious
questions must be raised about the integrity of reporting within a jurisdiction and the
robustness of decisions made by investors in reliance of reported financial data.
If capacity rather than will is the decisive factor, this may represent a signal to standard
setters that the limits of what is technically feasible from a reporting and measurement
perspective have begun to be tested.
Finally, we would contend that our results ought provide encouragement and
stimulation to other researchers interested in the fields of endeavour our piece touches on.
It would clearly be desirable to expand the sample, something which only the passage of
time will allow in meaningful quantities. It also seems pertinent to ponder whether
anything particular to Malaysia dominated the results we uncovered, or whether the types
of disclosure and compliance difficulties we encountered cross jurisdictional boundaries.
Notes
1. This judgment is proffered on the basis that long run sovereign risk free rates in jurisdictions
such as the United States have tended to manifest at levels in excess of 5 per cent, and in
Australia, 6 per cent. It therefore appears unusual that discount rates appropriate to risky
enterprises in a less developed economic setting should be so low.
2. With the result that the present value of CGU cashflows is overestimated and the likelihood
of the recognition of an impairment loss very substantially reduced.
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Appendix 1
Market cap Goodwill

Company code Company name (RM million) (RM million)
Financial sector
1 AFFIN Affin Holdings Berhad 3,183 990
2 COMMERZ Bumiputra-Commerce Holdings Berhad 33,492 4,503
3 BURSA Bursa Malaysia Berhad 6,076 48
4 EONCAP EON Capital Berhad 4,714 138
5 MIDF Malaysian Industrial Development Finance Berhad 1,448 155
6 MULPHA Mulpha International Berhad 2,384 13
7 MPHB Multi-Purpose Holdings Berhad 2,623 548
8 OSK OSK Holdings Berhad 2,155 149
9 PACMAS PacificMas Berhad 575 10
10 PBB Public Bank Berhad 32,099 2,065
11 RHBCAP RHB Capital Berhad 8,607 1,168
(n ¼ 11) Sub-total Financial 97,354 9,783
Non-financial sector
Basic materials and oil and gas
12 CCM Chemical Company of Malaysia Berhad 1,265 191
13 TAANN Ta Ann Holdings Berhad 2,339 4
(n ¼ 2) Sub-total 3,604 195
Consumer goods
14 BAT British American Tobacco (Malaysia) Berhad 13,134 412
15 GUTHRIE Kumpulan Guthrie Berhad 6,316 255
16 NESTLE Nestle (Malaysia) Berhad 5,651 61
Table AI. 17 PPBOIL PPB Oil Palms Berhad 6,697 51
Research sample (continued)
Market cap Goodwill
Big 4 Malaysian
Company code Company name (RM million) (RM million) firms
18 UMW UMW Holdings Berhad 5,849 20
(n ¼ 5) Sub-total 37,647 799
Consumer services and health care
19 GENTING Genting Berhad 32,325 5,126 113
20 KFC KFC Holdings (Malaysia) Berhad 1,140 43
21 MAGNUM Magnum Corporation Berhad 5,157 31
(n ¼ 3) Sub-total 38,622 5,200
Industrials
22 BPORT Bintulu Port Holdings Berhad 2,000 11
23 BSTEAD Boustead Holdings Berhad 1,525 108
24 KNM KNM Group Berhad 3,227 4

25 LCEMENT Lafarge Malayan Cement Berhad 5,155 1,188
26 MMC MMC Corporation Berhad 9,668 1,714
27 SCOMI SCOMI Group Berhad 1,259 547
28 UEMBLDR UEM Builders Berhad 1,590 80
29 UEMWRLD UEM World Berhad 5,858 474
30 WTK WTK Holdings Berhad 1,376 9
(n ¼ 9) Sub-total 31,659 4,136
Technology and telecommunication and utilities
31 MAXIS MAXIS Communications Berhad 31,290 3,487
32 PUNCAK Puncak Niaga Holdings Berhad 1,497 186
33 TELEKOM Telekom Malaysia Berhad 35,124 6,826
34 TIMECOM TIME dotCom Berhad 2,063 591
(n ¼ 4) Sub-total 69,974 11,090
(n ¼ 23) Sub-total Non-Financial 181,506 21,420
(n ¼ 34) Grand Total 278,860a 31,203
Notes: aMarket capitalisation as on January 2007 quoted from FTSE Bursa Malaysia. The total
market capitalisation of the 100 FTSE Bursa Malaysia January 2007 was approximately RM 792,314
million, hence this sample of 36 companies represents 35.2 per cent of the total market value of the
bourse
Source: FTSE Bursa Malaysia as at January 2007 Table AI.
ARA Appendix 2
17,2
Company code Company name Goodwill (RM million)
1 BPORT Bintulu Port Holdings Berhad 11

114 2 BSTEAD Boustead Holdings Berhad 108
3 BAT British American Tobacco (Malaysia) Berhad 412
4 CCM Chemical Company of Malaysia Berhad 191
5 GENTING Genting Berhad 5,126
6 KNM KNM Group Berhad 4
7 GUTHRIE Kumpulan Guthrie Berhad 255
8 MAGNUM Magnum Corporation Berhad 31

9 MPHB Multi-Purpose Holdings Berhad 548
10 NESTLE Nestle (Malaysia) Berhad 61
11 PACMAS PacificMas Berhad 10
12 PBBOIL PPB Oil Palms Berhad 51
13 TAANN Ta Ann Holdings Berhad 4
Table AII. 14 TIMECOM TIME dotCom Berhad 591
Value of goodwill not 15 UEMBLDR UEM Builders Berhad 80
allocated to CGUs Grand total 7,483
Corresponding author
Tyrone M. Carlin can be contacted at: t.carlin@econ.usyd.edu.au
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Asian Review of Accounting

Investigating audit quality among Big 4 Malaysian firms

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Sabri, 1993; Chen et al., 2005).

3. Data and methodology

Basic materials and oil and gas (n ¼ 2) 5,695 195 3.43

Sector Deloitte Ernst & Young KPMG PWC

Basic materials and oil and gas (n ¼ 2) – – 2 –

4. Results and discussion

Fair value method – – – – Table IV.

Deloitte Ernst & Young KPMG PWC

Deloitte Ernst & Young KPMG PWC

inappropriately low discount rates[2] in certain cases. However, as with prior

Deloitte Ernst & Young KPMG PWC

Market cap Goodwill

24 KNM KNM Group Berhad 3,227 4

1 BPORT Bintulu Port Holdings Berhad 11

8 MAGNUM Magnum Corporation Berhad 31

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