1

INTRODUCTION

Entering the corporate world means facing a considerable number of risks that would

challenge the management to wisely make decisions that would not compromise the firm.

However, there are also circumstances that risks are identified within the organization and with

the managers themselves. This is an even more difficult issue to solve since it damages fiduciary

relationships in the organization. Sometimes, this internal problem extends beyond the

organization and one of these is audit collusion - private, extra-legal arrangements in which

agents agree to act in ways not intended by the owner (Bauman et al., 1991).

While external auditors can play a role in enhancing the credibility of their client firms in

the eyes of investors, this is only true as long as investors are satisfied that these auditors will not

collude with the firms they audit (Guha, n.d.). Investors usually base their investment decisions

on the financial transparency of an organization. If financial statements appear to be impeccable,

investors review their audit reports to find out whether the results are reliable.

Meanwhile, the existence of audit collusion between the company and the auditor will

result to misinformation of investors regarding the real performance of the company. This in turn

may lead to bad investment decisions which could lead to losses on the side of the investor and

could potentially disrupt the normal flow of trade. Furthermore, the company’s reputation with

stakeholders may be tarnished if such fraudulent acts surface or become exposed, affecting the

response of the market and thus, the performance of the business. Nevertheless, the risk of audit
 2

collusion can be mitigated, if not totally eliminated, if effective measures are applied by the

companies.

This research study aims to determine the measures taken by the SMEs in Bacolod City

for financial audit quality enhancement.

Statement of the Problem

This study aims to determine the measures taken by SMEs in Bacolod City for financial

audit quality enhancement.

Specifically, this study aims to answer the following questions:

a) What are the socio-demographic profile of the participants in terms of:

a. Age

b. Sex

c. Education background

d. Position in the company

e. Department affiliation

b) What is the profile of the company in terms of:

a. Total value of assets

b. Number of employees

c. Industry

c) What is the level of awareness of private companies of auditing standards against audit

collusion?

d) What are the reasons for companies being threatened by audit collusion?
 3

e) What areas of risk management process should be covered to enhance financial statement

audit quality?

f) What is the perceived level of independence of auditors from the management?

g) What suggested actions are to be undertaken by the management to enhance the quality

of financial statement audit?

Conceptual Framework

The possible occurrence of audit collusion between the auditor and the management is

one of the primary concerns of the stakeholders (i.e. creditors, customers, community, etc.)

because any fraudulent act within the company may have several effects toward the business.

Auditing standards provide bases to assess the performance of the auditor and

consequently to implement preventive measures to avoid audit collusions. For instance, based on

the research titled “Collusion in Audit” by Peyrache & Quesada (2005), top management would

offer an increase in the incentives to encourage auditors to report truthful audit conclusions and

refrain from colluding with low quality managers.

 4

Furthermore, Siregar & Tenoyo (2015) cited KPMG (2004) in their study regarding fraud

awareness which enumerated four “most common prevention methodologies” against fraud in

general undertaken by Malaysian businesses: improved internal controls, improved security

controls, pre-employment screening, and establishment of code of conduct/ethics. Moreover,

internal audit and internal control has been ranked as the most common tools used by companies

to prevent and detect fraud.

Figure 1. Conceptual Framework

 5

Scope and Limitations

A survey was conducted in order to determine measures taken by SMEs in Bacolod City

for financial audit quality enhancement. A sample of 124 SMEs from a population of 180 were

chosen as respondents through stratified sampling. This study only focused on SMEs listed in the

business licensing division of the city government. Furthermore, the study is bounded within

June 2016 – March 2017.

Since the topic of this research is sensitive in nature, the researchers encountered

constraints in data gathering. The result of this study is dependent on the discretion of the

respondents and may contain biases on the responses which are outside the researchers’ control.

Furthermore, only 38 SMEs have responded to the survey due to external factors such as the

willingness and availability of the respondents to answer, and time constraint.

Definition of Terms

The following terms are used in this paper and are defined conceptually and

operationally.

Audit Collusion. Conceptually, this refers to private, extra-legal arrangements in which

agents agree to act in ways not intended by the owner (Bauman et. al, 1991). In this paper, the

term is used to emphasize the unethical conduct done by a manager and an auditor.
 6

Fraud. Conceptually, fraud essentially involves using deception to make a personal gain

for oneself dishonestly and/or create a loss for another (Corporate Fraud Topic Gateway Series

No 57, May 2009). In this study, the term refers to intentional misrepresentations of audit

reports.

Preventive Measures. This term generally refers to an action taken to reduce or

eliminate the probability of specific undesirable events from happening in the future (Business

Dictionary, n.d.). This term is used in this study as the methods used by the company to avoid

audit collusion.

Small and Medium Enterprises. This term refers to businesses with 10-199 employees

and with assets worth 3-100 million pesos (Aldaba, 2012). In this study, the definition of the

term serves as the basis for choosing the respondents.

Significance of the Study

This study is significant to the following users:

Businesses. This is significant to businesses in general because it will bring

awareness to their company regarding audit collusion. In addition to that, the company

will be equipped to plan out strategies to prevent the existence of issues in auditing.

Investors. Investors shall have the benefits of foreseeing the potential presence of

fraud in certain companies that will help them in making wiser investment decisions.
 7

Students. This study will provide business students with ample knowledge

regarding actual auditing practices and business risks that threaten organizations.

Future Researchers. This study will serve as a learning paradigm for further

researches. Also, other researchers may find helpful information in the outcome of this

study that might be used as reference in other fields of knowledge.

Review of Related Literature

Auditing and its importance

The recent corporate scandals involving major companies (Enron, Worldcom, Qwest,

Sunbeam, Parmalat, etc.) have highlighted that the regulation of auditing and its enforcement are

key determinants of the reliability of corporate information (G. Immordino &M. Pagano, 2005).

Additionally, a study of Ittonen presents several different theories that may explain the

demand for audit services. There are four auditing theories (Hayas, 2005 as cited in Ittonen,

2010): The policeman theory claims that the auditor is responsible for searching, discovering and

preventing fraud. Meanwhile, the lending credibility theory suggests that the primary function of

the audit is to add credibility to the financial statements. In this view the service that the auditors

are selling to the clients is credibility. Audited financial statements are seen to have elements that

increase the financial statement users’ confidence in the figures presented by the management.
 8

The theory of inspired confidence or theory of rational expectations (Limperg 1932) addresses

both the demand and the supply for audit services. The demand for audit services is the direct

consequence of the participation of third parties in the company. These parties demand

accountability from the management, in return for their investments in the company.

Accountability is realized through the issuance of periodic financial reports. However, since this

information provided by the management may be biased, and outside parties have no direct

means of monitoring, an audit is required to assure the reliability of this information. With regard

to the supply of audit assurance, Limperg (1932) suggests that the auditor should always strive to

meet the public expectations. The most prominent and widely used audit theory is the agency

theory (Watts and Zimmerman 1978, 1986), which suggests that the auditor is appointed in the

interests of both the third parties as well as the management. A company is viewed as a web of

contracts. Several groups such as suppliers, bankers, customers, and employees, make some kind

of contribution to the company for a given price. The task of the management is to coordinate

these groups and contracts and try to optimize them: low price for purchased supplies, high price

for sold goods, low interest rates for loans, high share prices and low wages for employees.

Financial Audit Fraud

The word fraud is a generic term used to describe any deliberate act to deceive or mislead

another person, causing harm or injury (Rezaee, 2002 as cited Sengur, 2012).Fraud causes

tremendous losses to the business world and creates morale problems in the workplace. These

losses are serious problems to organizations that need to be managed, controlled and monitored.

Given the difficulty that auditors face in detecting financial statement fraud, coupled with their
 9

increasing responsibility to detect it, there is a definite need to develop audit procedures or

strategies more specifically focused on fraud detection (Knapp and Knapp, 2001; Guan, et al.,

2008 as cited in Salem, 2012).

The Role of Auditors

A distinction between managing and funding a business demonstrates how the separation

of the two gives rise to the need for audits. a role for auditors arises naturally from the existence

of outside ownership, or equity, claims against a firm. As managers’ share of firm ownership

declines, they have the incentive to boost their own total compensation, including all types of

fringe benefits, at the expense of the other owners. Potential investors, recognizing the owner–

managers have this incentive, reduce the price they are willing to pay for shares in the firm. But

if the owner–managers can commit to limiting their perquisites, investors will be willing to pay

more for shares, benefiting the owner–managers’ efforts to expand the firm. Subjecting the

firm’s financial records to an independent audit can enhance the credibility of such a

commitment by the owner–managers (Jensen & Meckling, 1976 as cited in J. Gunther & R.

Moore, 2002).

Internal auditors are the first-line defense against fraud because of their knowledge and

understanding of the business environment and the internal control. Internal auditors might play

a variety of roles to prevent and detect fraud in the entity, depending on the directives from

management, the board or audit committee. Although external auditors’ responsibility is to give

their opinion on the fairness of financial statement, the users of audited financial statements
 10

generally expect external auditors to detect financial statement fraud. External auditors that work

closely with internal audit can form an effective partnership to detect and prevent fraud Siregar

& Tenoyo (2015). Fraud is a broad legal concept and auditors do not make legal determinations

of whether fraud has occurred. Rather, the auditor's interest specifically relates to acts that result

in a material misstatement of the financial statements.

The auditor’s responsibility for the prevention, detection and reporting of fraud, other

illegal acts and errors is one of the most controversial issues in auditing, and has been one of the

most frequently debated areas amongst auditors, politicians, media, regulators and the public

(Gay et al 1997 as cited in O. Oluwagbemiga, 2010).

The Concept of Audit Collusion

Fraud has become very complicated in this era of technology, and increasingly difficult to

detect, especially when it is collusive in nature and committed by top management who are

capable of concealing it (Salem, 2012). An early study of Jean Tirole (1986) emphasizes that

collusive behavior is often best predicted by the analysis of group and individual incentives.

Formally, organizations can be seen as networks of overlapping or nested principal/agent

relationships. In this paper, a model of collusion was presented in principal/supervisor/agent

hierarchy, and organizational theories were derived from it. The Compounding Theory, and the

Theory of Moral Hazard in Teams. I n the compounding theory, any information held by a party

about another party (the outcome of supervision broadly defined) is transmitted honestly. There
 11

are n o side transfers and coalitions do not form. Moral hazard between members of a team arises

when only the aggregate performance of the team is observable and verifiable.

Standards against Audit Fraud/Collusion

A typical organization annually loses 5% of its revenues to fraud as stated by the 2010

Report to the Nations on Occupational Fraud and Abuse. Fraud prevention therefore impedes

fraud incidence and reduces the losses of companies. The American Institute of Certified Public

Accountants (AICPA) has issued an Exhibit in the year 2002 entitled “Management Anti-Fraud

Programs and Controls, Guidance to Help Prevent, Deter, and Detect Fraud” (SAS 99). The

exhibit points out that entities can take three actions to mitigate fraud: create a culture of honesty

and high ethics, evaluate antifraud processes and controls, and develop an appropriate oversight

process. Those programs and controls ensure the entity to reduce or eliminate the risk of

fraudulent financial statement, misappropriation of assets and corruption.

Based on the study of Tirole (1986), there is no specific standard imposed against audit

collusion, although auditing standards have been tightened over the past few years, and

regulations tend to be costly. However, in the study of Immordino et al. (2005), three lessons

have been drawn concerning the optimal standards to be imposed on auditors once it is

recognized that the enforcement of such regulation is costly: First, audit quality standards must

be based on a cost-benefit analysis of audit activity. Second, regulatory standards must be less

ambitious when auditors can collude with the managers of client companies at the expense of

shareholders, because deflecting the potential for collusion requires more intensive – and

therefore costlier – enforcement. Lastly, if client firms may “bribe” their auditors by offering
 12

them generous consulting contracts, regulators can eliminate the source of collusion by

forbidding auditors to provide consulting services.

There is little literature involved about specific actions adapted against audit collusion.

B.Guha (n.d.) pointed out that the usual principal’s strategy to deter collusion is to offer the

auditor an extra reward if he reports wrongdoing on the part of the firm (instead of confirming

the firm’s report): however this is a costly strategy and often not worthwhile for the principal.
 13

METHODS

This chapter contains the methods undertaken to collect the data to address the objectives

of the study. This section of the paper discusses the research design, the respondents of the study,

the research instrument to be used to gather data, the procedures on how the data were gathered,

and the statistical tool that was utilized to summarize and process the data collected.

Research Design

This study used the descriptive research design. Descriptive research design helps

provide answers to questions of who, what, when, where, and how associated with a particular

research problem; a descriptive study cannot conclusively ascertain answers as to why.

Descriptive research was used to obtain information concerning the current status of the

phenomena and to describe “what exists” with respect to variables or conditions in a situation

(Lingham, 2015).

The purpose of this study is todetermine the measures of taken bySMEs in Bacolod City

for financial audit quality enhancement.

In this study, the survey method was utilized incollecting data. The study used

questionnaires in gathering the data.

 14

Participants/Subjects of the Study

The members of the population were all SMEs based in Bacolod City. All of the

participants were selected through stratified sampling.Since the population can be divided into

two categories or strata according to the number of their employees either as a small or medium

enterprise, the stratified sampling was used to ensure that a proportionate number of respondents

from each strata were selected to eliminate sampling bias. Moreover, the sample that represents

the participants was chosen considering the willingness and availability to answer the

questionnaires.

Data were collected from at least 124 repondents. Survey questionnaires were personally

given by the researchers at their respective home offices. Respondents who answered the survey

questionnaireswere part of the top management who have knowledge on the auditing practices of

the company. The respondents were given an appropriate period according to their convenience

to complete the questionnaires.

Research Instrument

The instrument included comprehensive questions addressing the objectives of this study.

The first part of the questionnaire covered the demographic profile of the respondents and the

company. It included the the basic information of the respondents such as sex, age, educational

background, position in the company, and department affiliation. It also included company
 15

details such as the total value of assets, total number of employees, and industry to which it

belongs. The second part of the questionnaire covered the awareness of the respondents on audit

issues that impair fairness on the representation of financial statements and measures on how to

prevent such issues for financial audit quality enhancement. This section of the questionnaire

took up the level of awareness of the respondents regarding audit standards and audit collusion,

possible factors that could lead to impaired objectivity in financial statement audit, the areas of

risk management processes that should be covered to enhance financial statement audit quality,

the level of independence of auditors from the management, and the suggested actions

undertaken by the management to maintain objectivity in financial statement audit.

The survey questionnaires were subjected for evaluation by experts in the field for

validity. The instrument were evaluated using the criteria authored by Carter V. Good and

Douglas F. Scates. An average of 4.0 is required from each evaluator for the questionnaire to be

considered valid. Furthermore, the questionnaire were tested for reliability by conducting a

pretest to the 10% of the population. The pretest data were then be tested to determine the

Cronbach Alpha. A Cronbach Alpha of 0.7 is needed to pass the reliability test.

Data Gathering Procedure

The data of this research were collected with the use of survey questionnaires. The survey

was created using questions adapted from related research and questions made by the

researchers. The questionnaires were subject for validity and reliability tests before conducting
 16

the actual survey.The questionnaires were then distributed to the respondents. The respondents

were given ample time to complete the questionnaire. The survey questionnaires were collected

by the researchers from the respondents upon completion.

This study has employed stratified sampling in choosing the respondents. Stratified

sampling is a statistical method of drawing representative data by selecting respondents by

dividing the population into identifiable strata. The population were divided into two strata of

Small and Medium according to the number of employees. The number of respondents were

determined using the Slovin’s formula for establishing the sample size for a given population

size. The sample size was determined using a confidence level (CL) of 95% and a margin of

error (d) of 5%.

Statistical Tool

The measures of central tendency were used to interpret the data that were collected.

Frequency distribution table with percentageswere also utilized to summarize the data and were

used as a basis for data interpretation.Pie charts and bar graphs were used to summarize the data

on the first part of the survey regarding the demographic profile of the respondents and the

companies. The second part of the survey made use of frequency distribution tables, percentages,

and measures of central tendency to interpret the data.

 17

Question 1 took up the awareness of the respondents on audit collusion. Each item was

rated from 1-5 by the respondents. The ratings of the respondents have been averaged to get the

mean for each item. The mean for each item were used to interpret the findings.

Question 2 covered the reasons for the existence of audit collusion in the company which

in turn affects the financial audit quality. Each item was ranked from 1-6 with corresponding

levels of importance. The mode of the ranks were taken in order to assign a rank for each item.

Question 3 probed the perceived level of independence of auditors from the management

for each company. A frequency table with the corresponding percentages have been developed to

determine the proportion of the respondents with regards to the perceived level of independence

of auditors.

Question 4 tackled the areas of risk management processes that should be covered to

enhance to quality of financial audit. The respondents were asked to rank each item according to

their level of importance. The mode of the ranks were taken in order to assign a rank for each

item.

Question 5 covered the proactive tools/steps that the companies have employed to

enhance financial audit quality. The respondents were asked to answer either yes or no for each

item. To summarize the data, a frequency distribution table was prepared with corresponding

percentages. A bar graph was used to present the percentage of respondentsemploying each

tool/step.
 18

Question 6 aimed to collect data regarding the system that the company uses for the

anonymous reporting of possible financial audit irregularities. The respondents were asked to

answer either yes or no for each item. A frequency distribution table with corresponding

percentages was prepared. A bar graph was used to present the percentage of respondents using

each system.

Question 7 is an open ended question which asks the respondents for additional

information regarding the prevention of audit collusion in the company. This part of the

questionnaire were summarized based on the responses collected, if any.

 19

RESULTS AND DISCUSSION

This chapter contains the results of the survey and discusses the implications of the

results.

Profile of Individual Respondents

Figure 2 represents the sex of the respondents. 22 out of 38 respondents are female and

only 16 are male. From our sample companies, majority of the people in the top management are

female.

42.11%

57.89%

Male Female

Figure 2. Sex of Respondents

 20

Figure 3 shows the age of the respondents. Out of 38 respondents, 14 belong to the age

range of 41-50, 11 from below 25, 6 from 25-30, 7 from 31-40 and no one came from the age

range 50 and above. This indicates that those who belong to the top management are mostly

below 50 years old.

0%

28.95%
36.84%

15.79%

18.42%

Below 25 25-30 31-40 41-50 Above 50

Figure 3. Age of Respondents

 21

Figure 4 represents the Educational Background of the respondents. It can be seen that

majority are graduates of accounting related courses garnering 28.95% out of the total sample

size. Management graduates are on the second rank having 26.32% or 10 out 0f 38 respondents.

On the other hand, only 10.52% of the respondents are graduates of Economics, having the least

percentage in the proportion of the sample.

28.95%
30.00%
26.32%

25.00%
Economics
18.42%
20.00% Management
15.79%
Accounting
15.00%
10.52% Business Administration
10.00% Information Technology

5.00%

0.00%

Figure 4. Educational Background of Respondents

Based on the survey, the respondents are mostly composed of employees with business-

related backgrounds especially Accounting, Management, and Business Administration. This

implies that the respondents of the survey have, at the least, sufficient background on financial

audit and financial matters concerning the study.

 22

Figure 5 exhibits the different positions that the respondents hold in their respective

companies. 58% of the respondents are Management staff and 37% are Managers and

Supervisors of certain departments. Only 2% are Accountants and 3% are Directors.

Accountant Director
2% 3%

Manager/Supervisor
37%
Manager/Supervisor
Management Staff
Accountant
Director

Management Staff
58%

Figure 5. Position of the Respondents in the Company

In relation to the results presented in Figure 4, top and middle management of SMEs in

Bacolod City which are the target respondents of this study are mainly composed of employees

with a background in Accounting and/or Management. Thus, managers and/or supervisors and

the management staff are presumed to be knowledgeable on the subject of financial audit.
 23

Figure 6 shows the different departments where the respondents belong. Since this study

is anchored to financial audit quality enhancements, 47.37% or majority of the respondents are

from the Finance and Accounting division of the company. There is a slight difference to those

who belong to the Sales Division, as presented, it garnered 44.74%. Only 7.89% came from other

departments such as purchasing, quality assurance and HR.

7.89%

47.37%

44.74%

Finance/Accounting Sales Others

Figure 6. Department/Division of Respondents

Respondents of the survey mainly come from the Finance/Accounting departments of

SMEs which are precisely the target respondents to address the subject matter appropriately.

Respondents which came from the sales division are also employees on the top/middle

management which have business-related backgrounds as discussed on Figures 4 and 5 above.

 24

Profile of Company Respondents

Figure 7 shows the total value of assets of the companies subjected to this study. It can be

perceived that out of the 38 SMEs, 47.37% have assets that are valued at more than 5 million

pesos, while 15.79% of the respondent SMEs have below 5 million pesos worth of assets.

15.79%

36.84%
Below 5 Million
5-20 Million
21-50 Million

47.37%

Figure 7. Companies’ Total Value of Assets

Company respondents are classified as SMEs mostly with value of assets worth 20

million pesos and below, with others having 50 million pesos worth of company assets. With

millions of pesos invested in these companies, there is a need to enhance the quality of financial

audit as a tool in safeguarding these assets.

 25

Figure 8 exhibits the total number of employees of each company that were chosen to be

the respondents of this study. Based on the figures, majority only have few employees ranging

from 10-59 people who perform the daily business operations. This holds true since this study is

only aiming for SMEs.

2.63% 0%
7.90%

89.47%

10-59 60-99 100-159 159-199

Figure 8. Number of Employees of the Company
 26

Figure 9 shows the specific industry in which the respondent companies belong.

Having 42.12%, Retail industry ranked first as the primary avenue in which SMEs in Bacolod

market their products. Second are Financial and Manufacturing both having 21.05% and lastly

Forwarding and Distribution with 7.89%. As far as to the respondents, there are only few who

engage in product distribution.

7.89%

7.89% 21.05%

Manufacturing
Retail
Financial 21.05%
Forwarding
Distribution

42.12%

Figure 9. Companies’ Industry

Majority of the respondents come from the retail, manufacturing and financial industries.

Because of the nature of activities in these industries which involve huge sums of capital

investment, there is significance in enhancing the quality of financial audit in these industries.
 27

Awareness of SMEs on Audit Collusion

Figure 10 exhibits the awareness of the respondents regarding audit collusion. The

figures shown below are the means derived from the respondents’ answers. Looking at the graph,

most of the respondents agree with having an audit standard that would make the external auditor

responsible for colluding with the management with a mean of 4.84. On the other hand, although

respondents agree that their company has carried out audit collusion risk assessment processes,

the mean for this item solicited from the responses is the lowest among the items.

4.84
4.76

4.39
4.32

4.13 4.13 4.16

4.08

1 2 3 4 5 6 7 8

Figure 10: Awareness of Respondents on Financial Audit Quality Enhancement

LEGEND
1 Audit collusion is a major concern for SMEs in Bacolod City.
2 My company is proactive in dealing with the risk of audit collusion.
3 My company has identified and had approved by the management a policy on how entity will manage audit collusion.
4 My company has carried out audit collusion risk assessment processes.
5 My company has changed accounting or internal control systems to prevent audit collusion.
6 My company has a system in place for the anonymous reporting of suspicions of audit collusion.
7 External auditors are responsible for objectively reviewing the company they audit.
There should be an audit standard that would make external auditors responsible for colluding with the company they
8
audit.
 28

Based on the results, it can be seen that the respondents generally have a good deal of

awareness regarding the quality enhancement of financial audit. The respondents believe that

audit collusion is a major concern for SMEs in Bacolod City. However, these companies have

been proactive in dealing with the issue and have undertaken steps in order to prevent the risks of

audit collusion. Thus, audit collusion is perceived to exist in SMEs and these companies are

aware about the issue and have taken steps to prevent or minimize the risks to enhance the

quality of financial audit.

Although there is no specific standard imposed directly against audit collusion (Tirole,

1986), majority of the respondents agreed that the presence of an audit standard that would make

the concerned parties responsible for audit collusion will help alleviate the issues surrounding the

subject. Furthermore, Immordino et al (2005) argue that imposing standards against audit

collusion is costly.

Reasons of the Existence of Audit Collusion

Table 1 illustrates the reasons for companies being threatened by audit collusion. As

shown in the table, the most important reason as rated by the respondents is the prospective

financial benefits followed by management override control as the 2nd to the most important. On

the other hand, lack of ethical values represents the least important reason, followed by having

poor internal controls as the 2nd to the least important.

 29

Table 1: Reasons for Companies Being Threatened by Audit Collusion

Frequency
Mode Rank
1 2 3 4 5 6
Poor internal
10 4 0 3 20 1 5 5
controls
Lack of ethical
2 0 0 0 2 34 6 6
values
Inadequate
background
checks on
0 11 4 20 3 0 4 4
prospective
employees
and/or auditors
Management
4 19 13 2 0 0 2 2
override control
Avoid tax
0 0 23 3 10 2 3 3
consequences
Prospective
financial 22 2 0 10 4 0 1 1
benefits
TOTAL 38 38 38 38 38 38

Prospective financial benefits is viewed as the leading reason as to why audit collusion

exists in the industry. According to Jensen & Meckling (1976, as cited in Gunther & Moore,

2002), a manager of a firm has the power to boost his own total compensation, including fringe

benefits, at the expense of other owners. The respondents also believe that auditors and the

management collude to avoid tax consequences by misrepresenting the financial statements to

tax authorities, which further translates to financial benefits.

 30

Audit collusion is also believed to exist because of management override of controls

which defy the internal controls set by the company itself. These findings are in contrast to the

study of Siregar & Tenoyo (2015) which points out that inadequate background checks on

prospective employees is the top reason in Malaysia as to the existence of audit collusion in a

company. In this study, it can be emphasized that audit collusion exists in SMEs in Bacolod City

with the prospect of financial benefits rather than the quality of the employees in the company.

Perceived Level of Auditor Independence

Figure 11 presents the perceived level of independence of auditors. A pie chart with the

corresponding percentages has been developed to determine the proportion of the respondents

with regards to the perceived level of independence of auditors from the management for each

company. As shown in the chart above, most of the respondents identified that the auditors are

very independent in conduct of the audit work. This signifies that the respondent companies’

ultimately believes in the competence of the hired assessors. A rather substantial percentage is

also presented, which means that despite having established identities, some companies still do

not fully confide in the functions of their auditors. There is, however, only a trivial number of

companies which would think otherwise.

 31

Extremely Not at all

Independent, Independent,
1, 3% 6, 16%

Slightly
Independent,
Very 4, 10%
Independent,
17, 45%
Somewhat
Independent,
10, 26%

Figure 11. Perceived Level of Independence of Auditors from the Management

External auditor independence is perceived to be at an average level for most of the

respondents. Majority of the external auditors are believed to be either very independent or

somewhat independent, leaning towards the lower end of being not at all independent. As shown

on the chart, a total of 20 respondents view their external auditors to be somewhat independent at

the most, outweighing those who believe that their auditors are very and extremely independent.

Gay et al (1997, as cited in O. Oluwagbemiga) reiterated that the auditor has also the

responsibility for the prevention, detection and reporting of fraud. Thus, due to a low level of

auditor independence, SMEs in Bacolod City are prone to the risks of fraud and audit collusion.

According to Immordino & Pagano (2005), regulation of auditing and its enforcement are

significant factors in order to maintain or enhance the quality of financial information.

 32

Areas of Risk Management Processes

Question 4 tackles the areas of risk management processes that should be covered to

enhance to quality of financial audit presented in Table 2. The respondents were asked to rank

each item according to their level of importance with 1 as being the most important. The mode of

the ranks have been taken in order to assign a rank for each item.

Table 2. Importance of Risk Management Areas Covered to Enhance

the Quality of Financial Statement Audits

Frequency
Mode Rank
1 2 3 4 5
A sound ethics policy and code
2 4 0 3 29 5 5
of conduct
A well-defined whistle blowing
0 0 10 25 3 4 4
policy
Periodic risk assessment
0 14 21 0 7 3 3
regarding audit collusion
A good internal audit function 34 4 0 0 0 1 1
A pre-employment screening 2 16 7 9 4 2 2
TOTAL 38 38 38 38 38

Majority of the respondents believe that a good internal audit function is the most vital

area of risk management that is needed to enhance the quality of financial statement audit. On

the other hand, the respondents perceive sound ethics policy and code of conduct to be the least

important among the areas. These findings disagree with that of Siregar & Tenoyo (2015) which

concluded that good internal function is the least important among the the risk management

processes. On the other hand, both surveys found out that the least of all is a sound ethics policy

and code of conduct.

 33

Measures for Financial Audit Quality Enhancement

Figure 12 shows the different proactive tools/steps employed by the respondents to have

an objective financial statement audit. The figure shows that all the businesses employ internal

audit. On the other hand, the least method that companies employ in their operations is random

check on employees’ email.

Internal audit 100%

Random check on transaction data 86.84%
Pre-employment background check 84.21%
Fraud risk management (including audit collusion) 81.58%
Fraud assessment system (including audit collusion) 79.95%
IT control 76.32%
Internal controls 68.42%
Management Information System (MIS) 57.89%
Notification by third parties (employee, customer,… 57.89%
IT audit 52.63%
External audit 50%
Random check on employees’ email 47.37%

0.00% 20.00% 40.00% 60.00% 80.00% 100.00% 120.00%

Yes

Figure 12. Measures taken by Companies to Prevent Audit Collusion

Internal audit as the top management tool utilized to prevent audit collusion is consistent

with the findings of Siregar & Tenoyo (2015). Companies in Malaysia also put the least

emphasis on random email checks. However, Malaysian businesses rely more on internal

controls and external audit as compared to SMEs in Bacolod City which ranked external audit as

only second to the last among the methods to prevent audit collusion. Moreover, both studies

found out that IT controls are used by only half of the respondents.
 34

Anonymous Reporting

Figure 13 presents that most of the respondents use e-mails in making anonymous

reports. And on the other hand, the method that only few of the respondents use in making

anonymous reports is making an anonymous letter or calls. Half of the population uses the direct

approach wherein anyone in the company directly contacts the top management for purposes of

reporting any issues found in the company.

E-mail 86.84%

Direct approach 50.00%

Grapevine (an informal person-to-person means of

42.11%
circulating information)

Hotlines 28.95%

Anonymous letter/calls 26.32%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Yes

Figure 13. Anonymous reporting methods

Email has been widely used as a means to report fraudulent acts such as audit collusion

and this result is supported by Siregar & Tenoyo (2015). However, anonymous letters/calls is not

a popular method for anonymous reporting of fraud for SMEs in Bacolod City contrary to

businesses in Malaysia.
 35

CONCLUSIONS AND RECOMMENDATIONS

This chapter entails the collective summary of the findings. It concludes the entire

research study in all its aspects, if objectives set up in the first chapter have been met.

Furthermore, it recounts recommendations reached by the researchers in conducting the study.

The main objective of this study is to determine the measures taken by SMEs in Bacolod

City for financial audit quality enhancement. To accomplish this goal, the researchers have

selected a sample among the listed SMEs in the city, conducted a survey relative to questions in

the statement of the problem, and made assumptions based on the gathered data for analyses.

Thus, the researchers have reached the following conclusions:

a) The top or middle management were mostly composed of ages 41-50, female employees

with a background in accounting or management. Furthermore, a majority assumes a

position in the management staff while others were managers or supervisors themselves

affiliated in sales or in the accounting or finance division of the company, since these

employees were presumed to have business related background, and a thorough

knowledge of auditing or financial audit.

b) In terms of company profile, the average worth of company assets ranges from 5 to 20

million in peso value. When assets reach a worth of more than 50 million, it will seize to

classify as SMEs. Since most SMEs are in the median range of asset worth, these should
 36

be safeguarded through enhancing audit quality. However, there were only very few

regular employees in these companies. This is probably because management control is

maintained or the companies are looking for tax avoidance measures. Nevertheless,

behind the SMEs are small groups of people working to achieve goals or realize profits.

Meanwhile, most SMEs in Bacolod City belong to the retail industry, and some others

were into manufacturing and finance. Since these industries are competitive ones, they

are in need of management and audit controls.

c) SMEs in Bacolod City are well aware of audit collusion or the collusive behavior

between managers and auditors, and are generally concerned is enhancing the quality of

financial audit. Additionally, methods have been imposed to ensure that there are

adequate controls to avoid this unethical conduct. The most prominent of these is an

identified and approved-by-management policy on how the entity will manage audit

collusion. Furthermore, most companies in place a system for the anonymous reporting of

suspicions of this type of fraud. According to Immordino et al. (2005), imposing

standards against audit collusion can be costly. However, SMEs within Bacolod have

existing measures to account for audit collusion and these are closely implemented with

the best effort possible. Meanwhile, the need for an auditing standard were found to be

the most common endeavor between the companies.

d) Although cases of financial fraud haven’t been fully disclosed by the companies due to

confidentiality, it is understood that all of which are threatened by audit collusion. The

main reason that this behavior exists is because the people involved are looking forward
 37

to prospective financial benefits. Internal control over financial reporting can be

circumvented by improper management override, which is the second most common

reason of encountering audit collusion. Lastly, a good number of respondents also

consider the consequences of tax avoidance as one of the causes of collusion between

auditor and manager.

e) Risk management is more likely being structured on areas that direct to a good internal

audit function. The management believes that preventive measures are parallel to having

a comprehensive internal control system or processes assuring the achievement of an

organization's objectives in operational effectiveness and efficiency, reliable financial

reporting, and compliance with laws, regulations and policies. Moreover, audit quality

also relies on pre-employment screening since hiring trustworthy employees isn’t

relatively easy. Furthermore, companies also believe that audit collusion can be avoided

if there is a periodic risk assessment adapted by the company.

f) Most of the companies are confident that auditors are independent from management or

from parties that may have a financial interest in the conduct of audit work. However,

this is not an absolute since the management assessment varies with regards to the level

of independence. This only proves that there are high risks of audit collusion that are

present in a few companies. Still, most of the entities generally value integrity and

objectivity in auditing processes, as well as professional competence.

g) There is a good number of measures undertaken by SMEs to enhance financial audit

quality through preventive controls. According to every respondent, on top of these is the

conduct of internal audit. The companies value independent assurance that risk
 38

management, governance and internal control processes are operating effectively. Also,

almost equally important measures undertaken by companies are random checks on

transaction data and pre-employment processes. It is significant to implement periodic

standards to enhance financial audit. More so, companies believe that a fraud risk

management and assessment system is substantial in averting the audit collusion. It is

also noted that information technology governance which includes data management and

security are being handled by SMEs as well.

An anonymous reporting system enables safe, confidential and anonymous

communication of honesty and integrity issues related to accounting, internal controls and

audit matters to board members and senior management. Anonymous reporting through

e-mail is mutual within companies since it is fast and more convenient for employees.

Consequently, entities also believe in the importance of direct reports for a better

understanding of the report.

Based on the conclusions derived from this study, the following recommendations have

been made for significant users of information:

For businesses, the researchers believe that there is a need to implement sound

internal controls in order to enhance financial audit quality. Maintaining an effective

system of internal controls is vital for achieving a company's business objectives,

obtaining reliable financial reporting on its operations, preventing fraud and

misappropriation of its assets, and minimizing its cost of capital. Measures currently

undertaken by companies should be sustained and improved in order to prevent collusion

 39

within the organization as they should be more aware of its consequences. Furthermore,

these measures should include risk assessment and management plans, managing cyber

risks, fraud prevention to achieve better audit quality standards.

A sound financial audit gives assurance to investors and creditors that company

funds are handled appropriately. Therefore, the researchers are certain that auditors

should protect the public from investing in companies that use corrupt business practices

or that attempt to defraud investors with false financial audit results. At the same time

investors should be aware of risks such as financial fraud, specifically audit collusion,

within an organization.

The researchers suggest that students, especially in business-related courses,

should be knowledgeable and proactive in the possibilities of encountering fraud within

the organization that they will work for in the future. Students should be aware of the

consequences of misconduct and should be familiar with practices or methods that must

be used and implemented by company administrations.

The limitations of this study include the sensitivity of information that is targeted

by the researchers since these involve confidential matters. As a result, the respondents

tend to reject the survey questionnaires. It is recommended that the study be further

developed by future researchers through hypotheses or testing the relationships of the

different variables such as fraud awareness, auditor’s level of independence and measures

to enhance audit quality, with feasibility.

 40

APPENDIX A
Accounting Technology Department
College of Business and Accountancy
University of St. La Salle
Bacolod City

July 29, 2016

Mr. Felix Cena, Ph.D.

Professor
Accounting Technology Department

Dear Dr. Cena:

Greetings.

We are 4th year Accounting Technology students and are now taking Business Research, a venue where
we can enhance our skills in terms of critical thinking and effective communication and be able to
contribute to social change for the common good.

In line with this learning experience, we would like to request you to become our research adviser, to
guide our way until we complete our study. Rest assured that we will do our best to meet your
expectations.

We will greatly appreciate your acceptance.

Thank you. More Power and God bless.

Very truly yours,

VON IANELLE AGUILA CHLOE NARTATEZ HONESTY DAGUOB

VICTORIA VERONICA AZURIN FRITZ OLIGO GIANELLI JUDE

SUMUGAT

Conforme: Approved by:

MR. FELIX CENA, Ph.D. MS. DESSA MARIE MEDINA

Professor Professor
 41

APPENDIX B
Content Validity Form

Direction: Kindly rate or evaluate the research instrument using the rating scale
according to the following criteria set forth by Calter V. Good and Douglas F. Scates.
Please encircle your rating using the scale below:

1 – Poor 2 – Fair 3 – Good 4 – Very Good 5 -- Excellent

Criteria for Evaluation

1. The questionnaire is short enough such that the
respondent will not reject it because it will not
drain much of his precious time. 1 2 3 4 5

2. The questionnaire has face appeal such that the

respondent will be inclined to accomplish it fully. 1 2 3 4 5

3. The questionnaire can obtain some depth to the

responses & avoid superficial answers or
information. 1 2 3 4 5

4. The items and their alternative responses are not too

suggestive. 1 2 3 4 5

5. The questionnaire can elicit responses which are definite

but not mechanically forced. 1 2 3 4 5

6. The items are stated in such a way that the responses

will not be embarrassing to the person concerned. 1 2 3 4 5

7. Items are framed in such a manner as to allay suspicion

on the part of the respondent concerning hidden
purposes in the questionnaire. 1 2 3 4 5

8. The questionnaire is not too narrow, not restricted

or limited in its scope or philosophy. 1 2 3 4 5

9. The responses to the questionnaire, when taken as a

whole, could answer the basic purpose for which the
questionnaire is designed and therefore considered
valid. 1 2 3 4 5

Total Score: ____________________

Average Score : _________________
Name of Evaluator: _______________Signature: ________________________
 APPENDIX C
A Survey on the Measures taken by Small and Medium Enterprises (SMEs) in
Bacolod City for Financial Audit Quality Enhancement
Dear Respondent,

We are Accounting Technology students from the University of St. La Salle-Bacolod carrying out an
accounting thesis project for a core unit in our program. This questionnaire aims to provide information
on the practices used by SMEs to mitigate the risks of fraud in the form of audit collusion. Your
experience and opinion are highly valuable in this research and we would be very grateful if you would
spare a couple of minutes to take part in this survey. We assure you that this survey will remain
confidential and no information you give can be traced back to you, or used against you in any way.
Thank you very much for your cooperation.

Section A. Profile
Please fill-out the following by putting a check (/) on the boxes provided.
Individual
Sex: □Male □Female
Age: □<25 □25 – 30 □31 – 40 □41 – 50 □> 50
□Economics
□Management
Education
□Accounting
Background:
□Business Administration
□Others: (please specify) ___________________
□Director □Accountant
Position: □Manager/Supervisor □Management Staff
□Others (please specify): ___________________
□Finance/Accounting
Department/Division: □Internal Audit
□Others (please specify): ___________________
Company
□< 5 million
Total value of Assets □ 5 – 20 million
in Php: □21 – 50 million
□ >50 million
□ 10 – 59
Total Number of □ 60 – 99
Employees: □ 100 – 159
□ 159 – 199
□Agriculture □Mining
Industry: □Manufacture □Financial
□Telecommunications □Transportation
□Retail □Others (please specify): ________________
 43

Section B. Awareness and Measures for Financial Audit Quality Enhancement

1. Please put a check (/) on the box of the column that most clearly indicates your response
(1 = strongly disagree, 2 = disagree, 3 = neither agree nor disagree, 4 = agree, 5 = strongly agree)

No. Items 1 2 3 4 5
Audit collusion (private, extra-legal arrangements in in which agents
1 agree to act in ways not intended by the owner) is a major concern
for SMEs in Bacolod City.
2 My company is proactive in dealing with the risk of audit collusion
My company has identified and had approved by the management a
3
policy on how entity will manage audit collusion
My company has carried out audit collusion risk assessment
4
processes
My company has changed accounting or internal control systems to
5
prevent audit collusion
My company has a system in place for the anonymous reporting of
6
suspicions of audit collusion
External auditors are responsible for objectively reviewing the
7
company they audit
There should be an audit standard that would make external auditors
8
responsible for colluding with the company they audit

2. Which are the reasons for companies being threatened by audit collusion? Please rank each of the
following in order of importance (1 = most important, 6 = least important).

No. Reasons Rank

1 Poor internal controls
2 Lack of ethical values
3 Inadequate background checks on prospective employees and/or auditors
4 Management override control
5 Avoid tax consequences
6 Prospective financial benefits

3. What is the perceived level of independence of auditors from the management? Please put a check (/)
on the corresponding box.

□not at all independent

□slightly independent
□somewhat independent
□very independent
□extremely independent
 44

4. What areas of risk management process should be covered to enhance the quality of financial statement
audit? Kindly rank each of the following in order of importance (1 = most important, 6 = least
important).

No. Methods Rank

1 A sound ethics policy and code of conduct
2 A well-defined whistle blowing policy
3 Periodic risk assessment regarding audit collusion
4 A good internal audit function
5 A pre-employment screening

5. What proactive tools/steps have been employed by your company to have an objective financial
statement audit? Please check (/) the corresponding column of your choice.

No. Tools/Steps/Methods Yes No

1 Fraud assessment system (including audit collusion)
2 Fraud risk management (including audit collusion)
3 Notification by third parties (employee, customer, vendor, or anonymous source)
4 Internal audit
5 Internal controls
6 External audit
7 IT control
8 IT audit
9 Management Information System (MIS)
10 Pre-employment background check
11 Random check on employees’ email
12 Random check on transaction data
13 Others (please specify):

6. Which system your company has in place for the anonymous reporting of possible financial audit
irregularities? Please check (/) the corresponding column of your choice.

No. Tools/Steps/Methods Yes No

1 E-mail
2 Grapevine (an informal person-to-person means of circulating information)
3 Hotlines
4 Anonymous letter/calls
5 Direct approach
6 Others (please specify):

7. Please provide additional information regarding audit collusion prevention in your company or which
you think your company should have, which would be a helpful contribution to this research.
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
 45

REFERENCES

Aldaba, R., (2012). Small and Medium Enterprises’ (SMEs) Access to Finance:

Philippines. Discussion Paper Series No. 2012.05, p. 2. Retrieved from

dirp3.pids.gov.ph/ris/dps/pidsdps1205.pdf

Anonymous, (2002). Consideration of Fraud in a Financial Statement Audit, p. 1721.

Baiman, S., J. Evans and N. Nagarajan (1991) : “Collusion in Auditing”, Journal of Accounting

Research, 25: 217-244.

Asare, S. K., Wright A., Zimbelma M. F., (2015). Challenges Facing Auditors in

Detecting Financial Statement Fraud: Insights from Fraud Investigations. Journal of Forensic &

Investigative Accounting, 7(2).

Guha, B. (n.d.), Collusion and Concentration: Can Firm-Auditor Collusion Possibilities

Cause Concentration in the Auditing Market? A Game Theoretic Analysis. Singapore

Management University. Retrieved from www.mysmu.edu/faculty/bguha/Audit.pdf

Gunther, J. W., & Moore, R. R. (2002). Auditing the Auditors: Oversight or Overkill?.

Federal Reserve Bank of Dallas Economic and Financial Policy Review, 1(5). Retrieved from

http://dallasfedreview.org/pdfs/v01_n05_a01.pdf

Immordino G. & Pagano, M. (2005). Optimal Regulation of Auditing.Working Paper no.

3. Centre for Studies in Economics and Finance. University of Salerno. Retrieved from

cesifo.oxfordjournals.org/content/early/2006/12/31/cesifo.ifm016.full.pdf.

Khalil, F. and J. Lawarree (2006) : “Incentives for Corruptible Auditors in the Absence of

Commitment”, Journal of Industrial Economics, 54: 269-291.

 46

Ittonen, K., (2010). A Theoretical Examination of the Role of Auditing and the

Relevance of Audit Reports.

Oluwagbemiga, O., (2010). The Role of Auditors in Fraud Detection, Prevention and

Reporting in Nigeria. Library Philosophy and Practice (e-journal), p. 2.

Salem M., (2012). An Overview of Research on Auditor’s Responsibility to Detect Fraud

on Financial Statements. The Journal of Global Business Management, 8 (2), pp. 218-229

Sengur, E. D., (2012). Auditors’ Perception of Fraud Prevention Measures: Evidence From

Turkey.

Silver, S. E., Fleming, A. S., & Riley,Richard A.,,Jr. (2008). Preventing and detecting

collusive management fraud. The CPA Journal, 78(10), 46-48. Retrieved from

http://search.proquest.com/docview/212273993?accountid=33508

Siregar, S. V., Tenoyo, B., (2015). Fraud awareness survey of private sector in Indonesia.

Journal of Financial Crime 22 (3), pp. 329-346.

Ratanasongtham, W., & Ussahawanitchakit, P. (2015). Strategic audit planning and audit

quality: An empirical research of CPAs in thailand, 7(1) 384-394. Retrieved from

http://search.proquest.com/docview/1757281532?accountid=33508

Tirole, J. (1986). Hierarchies and Bureaucracies: On the Role of Collusion in

Organizations. Journal of Law, Economics, and Organization, 2 (2), 181-214. Retrieved from

www.oxfordjournals.org/page/5814/10.