Introduction to Hong Kong
The sovereignty of Hong Kong was handed over to the Peoples’ Republic of China in 1997 (Wong, 2002). However, Hong Kong continues to maintain an independent system in most of its sectors such as taxation, accounting and auditing. This implies that Hong Kong has separate sets of rules and regulations that govern these sectors, which though almost similar to the Chinese regulations differ in some aspects. Hong Kong, which was a British territory, has rules and regulations which conform to the British rules. This paper looks into the audit control regime of Hong Kong, the rules and regulations that govern the system as well as the challenges currently facing the regime and potent solutions to the challenges.
Elements of the audit quality control regime in Hong Kong
The principles for audit quality control in Hong Kong are clearly outlined and described in the Hong Kong Standard on Quality Control 1. This document created fundamental values and vital measures and regulation concerning a company’s duties for its structure of quality control for audits and re-assessment of past financial data. The Hong Kong’s audit quality control system has several elements which include: leadership duties for quality within the company, ethical standards, establishment and enhancement of client relationships, human capital, engagement performance and supervision. Leadership begins with the development of policies and regulations that enhance an in-house tradition based on the acknowledgment that quality is necessary in carrying out engagements. The policies and regulations mandate the chief executive officer to take full responsibility for the company’s quality control system. The actions taken by the company’s leadership influence the actions taken by the subordinate employees. As a result, the leadership should set a good example by being honest and engaging in open communication with employees at all levels of the company’s management. More specifically, the leaders should ensure that their work conforms to the international professional standards and policies and regular reports are issued to the employees that address current situations. Leadership also entails engaging employees in regular training and education about the importance of maintaining integrity and high quality work. Such training and education can be carried out through workshops, seminars, formal and informal meetings as well as communicated through media channels such as newsletters and the company’s website. These measures help to nurture a culture of high quality work.
Ethical standards play an important in Hong Kong’s audit control systems (McGee, Ho and Li, 2008). The Hong Kong Standard on Quality Control 1 clearly specifies five principles of professional ethical standards that each company must uphold namely: “integrity, objectivity, professional competence and due care, confidentiality and professional behavior” (Hong Kong Standard on Quality Control 1, 2005, p.5-6). Besides these five principles, companies in Hong Kong are required to establish independence. This can be achieved through policies and regulations that are meant to offer the company with a rational guarantee that the company as well as its employees maintains independence when and if necessary. The attitude and opinions of the tax and audit professionals towards the above named ethics play an important role in the actions taken by these professionals. Shafer and Simmons (2008) argue that, “tax professionals’ perceptions of the importance of corporate ethics and social responsibility generally had a significant impact on their ethical/social responsibility, judgments, which in turn influenced their behavioral intentions.”
To ensure high quality audit control, Hong Kong firms institute guiding principles and procedures for the receipt and maintenance of customer associations and precise appointments, intended to offer the firms with rational guarantee that they would only carry out or maintain such associations under three conditions. The first condition is that the company must regard the honesty of the client and must have reliable information that proves the client’s integrity. The second condition that must be met is the competence of the companies to execute the appointment. Companies must have the potential, time and capital to execute their appointments with clients. The third condition is the ability of the client to uphold the ethical terms and standards set out by the company (Gloet, 2002).
Firms in Hong Kong recognize the importance of human resources in the control of audit quality. Firms therefore set up guiding principles and procedures that are intended to offer companies with rational guarantee that they have adequate employees with the abilities, proficiency, and dedication to uphold ethical standards in their work. Competent employees also make it possible for Hong Kong’s companies to issue reliable financial statements and reports to the members of the public and other parties that make use of such information. Companies’ policies dealing with human resources concentrate on issues such as recruitment, performance evaluation, capabilities, competence, career development, promotion, compensation and estimation of personnel needs (Hong Kong Standard on Quality Control 1, 2005, p.36). The continuous proficiency of companies’ employees relies heavily and to a substantial degree on a suitable level of regular professional maturity to enable the employees enhance their knowledge and capability. Companies in Hong Kong thus put emphasis on the continuous education and training of their employees through workshops, seminars, formal and informal meetings and media channels to equip them with much-needed knowledge and skills to uphold ethical work. They also provide their employees with adequate resources needed for their professional and personal development. Hong Kong, unlike the mainland China, has been able to align itself with the international standards of accounting and auditing of financial information due to its vigorous efforts in the professional development of its employees (Lin and Wang, 2001).
Quality audit control requires regular and strict supervision of the audit professionals and the work they do. Majority of the firms that have gone under across the globe did so due to lack of effective supervision. In Hong Kong supervision of the auditing firms and professionals is done on a frequent basis. It entails following the development and growth of companies’ associations with their clients; and taking into account the competence and proficiency of each of the employees, that is, if the employees have adequate time to finish their work within the scheduled time, if they know what they are doing, and their instructions and if they comply with the company’s policies and procedures. Closely linked to supervision is review of work done by the audit professionals (particularly the less experienced professionals). Review is usually done to ensure that work is performed according to the laid down rules and regulations and that suitable and reliable information and reports have been documented. Review is not only done on individual employees but also on entire audit firms. Cho and Lew (2000, p.432) argue that, “Considerations for time, cost, and audit comfort in completing audit engagements have gradually led to extensive use of analytical review (AR) in external audits by large accounting firms in Hong Kong.
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Challenges facing Hong Kong’s audit quality control and their solutions
Double audit requirement of listed companies
The audit quality regime of Hong Kong and the Peoples Republic of China is characterized by a double audit condition of listed companies. The A- and H-share companies that are listed as dual are required to report their quarterly and annual financial statements on a separate basis governed by both the Chinese Accounting Standards (CAS) and the Hong Kong Financial Reporting Standards (HKFRS). Preparation for the A-share companies’ financial statements are done under CAS after which they are audited by a Chinese auditing company that is registered with the Chinese certified public accountants (CPAs). On the other hand, preparation for the H-share companies’ financial statements are done under the International Financial Reporting Standards after which they are audited by a Hong Kong’s auditing company and governed either by the Hong Kong or international auditing principles. South China Morning Post (2008, p.4) states that, “In most cases, there are two firms involved in the audits of the same company and two different teams enter the company at roughly the same time, talk to the finance department and look into one set of books and records.” This is not only a waste of time and resources but it also creates duplication of roles and duties. Additionally, the listing of shares on the different stock markets implies that the companies must conform to either the Chinese or Hong Kong’s regulations governing the stock market.
Given the large number of listed companies in both China and Hong Kong, the requirement of double audit poses great burden to the auditors in terms of time and costs incurred in the process. The South China Morning Post (2008, p.4) states that, “the Industrial and Commercial Bank of China (ICBC) paid about 160 million yuan (HK$182.6 million) last year for its domestic and Hong Kong audits, and PetroChina spent almost 120 million yuan last year for its double audits.” The elimination of the costly double audit requirement may prove to be challenging due to the geographical barrier that exists between the auditors on both sides of the China-Hong Kong border. Currently, the accounting companies in China are monitored and governed by “the China Securities Regulatory Commission, the Ministry of Finance, tax bureaus, and audit regulatory bodies,” (South China Morning Post, 2008, p.4). These regulatory bodies do not have the authority to monitor and supervise the accounting firms in Hong Kong. Likewise, the regulatory bodies in Hong Kong do not have the authority to supervise Chinese accounting firms hence the need for double audit system.
The challenges brought about by double auditing can be solved by replacing the double audit system with a single audit system. However, to be able to achieve this, both Hong Kong and China need to come into an agreement that would be governed and guided by mutually agreed rules and principles. The single audit system would save auditors in both Hong Kong and China from tedious and duplicated work. Most importantly, the single audit system would enable firms listed in both the mainland and Hong Kong to save millions of money incurred during the auditing of their financial statements.
Fraudulent reporting
The issue of ethical behaviour of auditors has attracted the attention of many scholars such as Louwers et al., 1997 and Tsui and Gul, 1996. More specifically, the concern surrounding the auditors’ moral duty for noticing and documenting fallacious statements has been the centre of much debate (Gilliam, 1991; Humphrey et al., 1993). Recently, the debate has been stirred mainly by the rising number of publicized cases made against professionals in the auditing field. Underlying this issue is the increasing cases of fallacious financial documentation and the fact that this behavior is currently a key aspect in accounting companies (Catlett, 1975, p. 13). To ensure that high ethical standards are met by auditors, various strategies have been put in place by firms in Hong Kong and across the globe. One of the strategies is the use of red flags to detect any fraudulent intentions of the auditors or the firm. Price Waterhouse (1985, p. 31) states that, “Red flags may be described as potential symptoms existing within the company’s business environment that would indicate a higher risk of an intentional misstatement of the financial statements.”
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Some of the commonly used red flags include “difficult-to-audit transactions, indicators of going-concern problem, management operating style, management attitude to financial reporting, and contentious accounting issue,” (Majid, Gul and Tsui, 2001, p.269). The presence of the red flags in a firm will influence the auditors’ evaluation of existing risks which will ultimately impact on the pre-determined detection risk (Colbert, 1988). A low pre-determined detection risk will influence the degree of audit proof and assessment techniques used by the auditor. The audit risk model is normally followed by accounting firms in Hong Kong to set and assess the audit and control risk of auditing. Majority of auditors in Hong Kong set the control risk at a level below 1.00 (where level 1.00 indicates lack of confidence in the internal control mechanisms) on the basis of their understanding and knowledge of the internal control mechanisms and compliance assessment tests used in the firm. In addition, the existing risk is assessed based on a large number of external and internal elements and auditing guiding principles provided by the firms and the HKSA. To ensure ethical reporting, auditors in Hong Kong are required to pay close attention to the red flags mentioned above and particularly the existence of prior misstated financial reports and going-concern problems, which are the two most crucial indicators of fraud and irregularity risks (Majid, Gul and Tsui, 2001, p.269).
Mandatory audit of small companies
One of the key features of Hong Kong’s audit quality control regime is the mandatory audit of small companies. Many countries including the United Kingdom and the United States eliminated the mandatory audit of small companies citing the fact that such laws place heavy burdens on the vulnerable small companies. Hong Kong however mandates the audit of small companies. In Hong Kong, a study of active Certified Professional Accountants of the Hong Kong Society of Accountants (HKSA) portrayed that the accountants were by and large content with the audit conditions for small limited companies (Lau et al., 1990). Even though they preferred a different extent in small company audits, the Hong Kong CPAs asserted that similar sets of auditing principles ought to be utilized for both the large and small firms. The major reason why small firms prefer to be audited is the fact that the benefits that result from auditing far outweigh the costs incurred (annual audit fees). These benefits include the reliability of information and client loyalty. Audited firms have the assurance that their financial statements would be reliable as compared to the un-audited firms’ financial statements. Reliability of information in turn attracts many clients to such firms. Ultimately, the profits earned from many clients outweigh the costs incurred the auditing process. The second reason why small firms agree to the mandatory audit law is the lack of an alternative means such as reviews. Chung and Narasimhan (2001, p.123) states that, “compilations and/or reviews may provide the same benefits as an annual audit while the costs of such engagements would be lower than that of an audit.”
Conclusion
The Hong Kong’s audit quality control regime is governed by stringent rules and regulations which govern the auditing process as well as the auditing professionals. Given the conformity nature of the Hong Kong’s society, majority of auditing professionals conform to the laid down rules and regulations in their work. However, various challenges still exist and include fraudulent reporting, double auditing of listed companies and mandatory auditing of small companies. The recommendations given above would go a long way in reducing costs involved in the audit process. Most importantly, they would enhance the efficiency and effectiveness of Hong Kong’s audit regime and increase its competitive edge within the region.
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