EFFECTS OF OUTSOURCING INTERNAL AUDIT FUNCTIONS AMONG SMALL & MEDIUM ENTERPRISES
Mohd Danial Afiq Khamar Tazilah1*, Muhammad Majid2, Nur Farhana Suffari2
1 Universiti Tunku Abdul Rahman, Kampar Campus, Jalan Universiti, bandar Barat, Kampar Perak
2 Faculty of Business & Management, DRB-HICOM University of Automotive Malaysia, Pekan Pahang
*Corresponding Author: [email protected]
Accepted: 1 March 2019 | Published: 1 April 2019
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Abstract: Small Medium Enterprises (SME) performs a crucial function as a spine in the nation economy as it represents the largest percent of formations in Malaysia. It is vital for SMEs to prepare the company’s financial statements based on the Company Act 1965 regulations and other compliances such as Financial Reporting Standards (FRS).
Furthermore, the accounts are required to be audited by an independent party to ensure its true and fair view against the accounting standard which has been followed by other companies as well. However, due to the new regulations of Company Act 2016, audit exemption is given to small size and dormant companies. Hence, several companies might not be audited by an independent party in ensuring their accounts are true and fair view. Prevalence of fraud might occur due to weak of internal controls even though it involves small businesses which are being exempted. It is necessary that the business should consider at least an internal audit function either internally established or to be outsourced in monitoring the companies’ internal controls. Few studies have been done in outsourcing the internal audit functions to oversee the significant impacts and effects of it among SME in Malaysia. Therefore, this conceptual paper aims to provide an overview of the possible effects on the demands of internal audit outsourcing among SMEs.
Therefore, two theories which are the Transaction Cost Theory (TCT) and Resource Based Views Theory (RBV) are being used to determine the awareness of the internal audit function, the perceived benefits of internal audit function and perceived financial cost.
This study shall contribute further insight and awareness to the SMEs on the importance of internal audit function and provides an overview analysis of determinants of internal audit outsourcing. Moreover, researchers are able to make use of this study as an extended research which can further improved the performance of SMEs in Malaysia.
Keywords: Internal audit outsourcing, small and medium enterprises (SMEs), Transaction Cost, Resource Based Views Theory
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1. Introduction
Company performance is one of the most widely researched topics that have been focused by many researchers among both private and public organizations that would include both financial and non-financial components (Majid, Samad, Tazilah and Hanaysha, 2017). This also includes small medium enterprise (SME) whereby their financial performance should also be assessed from the accounting and auditing perspective. According to Adeyemi, Obah and Udofia (2015), they described small medium enterprise (SME) as a group of business activity that involves in various size, sector, location and growth profiles. SME performs a crucial function as a spine in the nation economy as it represents the largest percent of
formations in Malaysia at 99.2% which contributes 32% to Gross Domestic Product (GDP) 56.4% of general work force and 19% to total exports (SME CORP, 2013). Therefore, in maintaining the business financial performance through its business activities, it is necessary for SMEs to prepare and update their financial records or the financial statements which comply with the Company Act 1965 for the tax purpose and other regulations. Furthermore, all accounts are required to be audited to ensure true and fair view of the Financial Statement against the accounting standard (Gray, C. 2010).
Currently, audit exemption has been imposed towards SMEs (Company Act, 2016) which leads to an in-house preparation of the financial statements without being audited by an independent party that is the external auditors. Alternatively, an internal audit function shall be able to perform such review and assessments towards business internal control system to ensure the preparation of the financial statements and assets are properly monitored and safeguarded. Recently it has been gaining popularity among SME where managers of SME are developing increasing interest in launching outsourcing activity due to the challenges of growing global competition (Carey, Subramanian, & Chua, 2006). One of the challenges would be due to the increase of accounting fraud and corruption worldwide, there is a demand of stronger and effective accounting system and audit procedures to be conducted by the professional accountants (Tazilah, Mohd Ali and Majid, 2017).
According to Kamari and Devi (2011), SME outsourcing is not a choice but a requirement to ascertain needs of certain regulations or parties as the business often cannot afford to build up internal resources with the required skills and efficiency. However, due to lack of resources of establishing and maintaining this internal audit function, SMEs might face major difficulties in ensuring a sound of good internal control and governance system towards preparation of financial statements. In addition, lack of studies have been conducted focusing on outsourcing the internal audit function among SMEs which need to be further explored and more attention towards financial statements preparation. Therefore, this paper tends to further explore the demand of outsourcing internal audit function among SMEs in Malaysia and its impact.
2. Literature Review
Outsourcing Internal Audit Function
Outsourcing is an administration system by which an association delegates capacities or exercises once in the past performed inside the association to specific and effective specialist organization (Barac and Motubatse, 2010). According to Padia and Yasseen (2013), they depicted outsourcing as an administration that provided or surrendered to outside gatherings.
Meanwhile, Van Peursem and Wells (2000) portrayed inner review outsourcing on the grounds that the obligation separated from coordinate business which can likewise include brief legally binding arrangements with master individuals, long haul authoritative pursuing, the utilization of remotely progressed electronic learning.
Inua and Abianga (2015), specified that bookkeeping danger can be expelled when the inside review work is outsourced from outside gatherings and it will be fit for diminish the peril of fake announcing. Despite the fact that a large portion of the exploration have bolstered that outsourcing of review have a positive accordingly avoidance from misrepresentation, Prawitt, Sharp and Wood (2011), specified that by having interior review inside the association can have more preferred standpoint as opposed to totally outsourced.
The outsourcing of internal audit function is a training that has been in presence for quite a while since it is being developed extensively because of two patterns. Firstly, right off the bat or as counseling administrators in expanding income for the firm’s bookkeeping by giving a greater amount of counseling to build their incomes and benefits. The second pattern was because of the expanded centered of controllers, administrators and bookkeepers on the viability of inner control; this prompted the expansion perceivability of the inside review work.
Audit Awareness
Awareness is known as the process of organizing information that comes to an individual’s knowledge from the external environment. It also defines as a collecting, organizing, developing and interpreting the input knowledge by personal from the surrounding environment, which compare between the information and the memory stored in the mind that leads to a specific behaviour (Jaber and Mohammad, 2016). As an auditor, they have to be aware of their duties, obligations and the purpose of audit work. Especially when it comes to the financial statements preparation that comply with the financial standards as well as the effectiveness of business internal control system.
According to Inua and Abianga (2015), by outsourcing internal audit functions, it allows internal auditors to focus on the significance of in-depth, organization-specific knowledge, loyalty and their role in handling crisis situations and fraud prevention for SMEs. This additional information allows internal auditors to be more efficient in the preparation of the company’s annual independent financial statement. When there are insufficient information given in outsourcing internal audit function, auditor’s knowledge and experience obtained can increase the efficiency of the annual independent financial statement during performing internal audit activities. Furthermore, Engku, Devi, and Chan (2012) stated that top management of SMEs shall have the.
Perceived Benefit
Gune and Puglia (2012) stated that the benefits of internal audit outsourcing is that the organization would not need to be burdened with the process of setting up an internal audit department. SMEs would be able to reduce its overhead and focus on their core business when they choose to outsource (Jayabalan, Dorasamy, Raman, & Kong, 2009). They may gain advantage through the transfer of their non-core activities to an external provider because SMEs would be able to conduct better decision-making and management. Plus, outsourcing helps companies to manage their work well because the overall cost to manage the accounting work done by an outsourcing firm is way lesser as compared to the hiring of an in-house staff. (Jayabalan et al., 2009). This can intensify the control within a company with the reduction in their administrative cost and thus, increases the companies’ competitive advantage (Dorasamy et al., 2010). Kamyabi and Devi (2011) stated that the owners and managers of SMEs should learn how to utilise the resources available outside to help the company to achieve competitive advantage while competitive pressure intensifies.
Dorasamy et al. (2010) further explains that SMEs can gain from economies of scale through outsourcing. It allows SMEs to achieve the production requirements and provides a channel for firms to share the economies of scale through the transfer of risk and reduce uncertainty to external specialized service provider. Production costs decline and diminished overhead will reduce the firm’s break-even points and these improves the performance of the firms (Kamyabi et al., 2011). SMEs can remove their fixed costs related to employment of internal staff and turn it into variable costs because they are only required to pay for the actual work
done. (Dorasamy et al., 2010). Hence, many companies have been making the outsourcing activity as part of the companies’ long term sustainable business model (Jayabalan et al., 2009).
Perceived Cost
Accroding to Gune et al. (2012), the costs of retaining the internal audit staff are higher than the internal audit outsourcing cost. However, it is generally accepted that outsourcing is a cheaper alternative to use in-house facilities (Pirzada, 2013). The cost of recruiting, looking and retaining suitable qualification employees has increased and getting tougher (Carey, Subramaniam, & Chua, 2006) which lead the SMEs facing difficulties of hiring internal auditors into their business.
Maltz’s study (as cited in Pirzada, 2013) shows that warehouse function recognizes that key factors to outsource is due to the high cost of internal resources. Companies are able to save 20% to 40% of their cost through outsourcing of internal audit function (Iqbal & Dad, 2013).
Saving costs can be achieved by eliminating the audit effort and overlapping positions, as well as by taking variable cost staffs to substitute fixed cost (Inua & Abianga, 2015).
Cost effective able to achieve by an organization through outsourcing of internal audit (Barac
& Motubatse, 2009). The accounting firm attest to their internal audit services in the market by emphasizing on their cost effectiveness, flexibility and expertise (Inua et al., 2013). There are many advantages in outsourcing that involves costs reduction. Outsourcing is often recommended as a means to provide flexibility, capture innovation and reduce cost of organizations (Papageorgiou, Yasseen , & Padia, 2012). SMEs relies more on outsourcing for reduction costs due to the competitive pressure intensity (Hafeez, & Andersen, 2014).
Besides there are external service providers who offers a lower price where the price is not related to amount of work done to secure the appointment. However, such low costs may be unsustainable and ultimately becomes higher than the cost of retaining an in-house internal audit function (Barac et al., 2009).
Transaction Cost Economy (TCE) and Resource Based View (RBV) Theories
According to Eliraw, Tate, and Bilington (2007), Ronald Coase was the first to bring the concept of transaction cost to bear on the study of firm and market organization. Transaction costs economy (TCE) includes the costs of negotiation, monitoring and enforcing contracts that arise directly from difficulties in measuring the goods and services being exchange.
Furthermore, TCE can improve our understanding of whether it is more appropriate to outsource an activity. Outsourcing is the handover of activity to an external supplier and alternative to an internal production (Aubert, Rivard and Party, 2004).
Transaction cost theory has three underlying assumptions: bounded rationality opportunism and asset specificity. Bounded rationality refers to inability of the human find or process all the information about a transaction therefore it is conducted within a certain level of uncertainty (Hafeez, & Andersen, 2014). The second assumption is opportunism which refers to the inspiration of human actions (Williamson, 1985). This assumption indicates people act are not only acting in their self-interest way, they are also acting with guile (Bahli & Rivard, 2010; Williamson, 1985). Lastly the asset specificity. This assumption means that some assets can only be used for very specific purposes. Opportunistic behaviour in combination with asset specificity can, become relevant if a good with specific characteristics needs to be produced before it can be sold (Kamari & Devi, 2011).
Another theory related to this study is the resource base view (RBV). RBV was developed in 1984 through the work of Wernerfelt in year 1984 and Rumelt in year 1984. It is defining as a unique bundle of asset and resource that if a company utilize in its distinctive ways which can produce competitive benefit and focus mainly on production skills. (Kamyamb & Devi, 2011). Although TCE theory is used widely (Barney, 2001), the results of outsourcing recommended by TCE are not always confirmed, and insufficiencies when determining firms’ boundaries (Williamson, 1999). To overcome these limitations, several academic papers have indicated recently that the study of outsourcing should consider both the TCE and RBV theories (Mayer & Saloman, 2006) addressing a former existing gap in the literature.
Figure 1: Proposed Conceptual Framework 3. Conclusion
This study is to further explore and provides better insight the effects of audit awareness, perceived benefits and cost of outsourcing the internal audit functions among SMEs. This research is significant to all small and medium enterprises (SMEs) in Malaysia as it will provide several contributions in deciding whether to outsource or establish their own internal audit function.
In addition, this study will be able to contribute to the management control teams of SMEs to enhance their corporate governance in term of the organization’s accountability, oversight and control. Management teams will be able to judge whether the internal audit outsourcing is beneficial to their companies. According to Shang (2008), outsourcing of service will improve a firm’s performance. Firm will be able to achieve a better level of employee productivity and performance by outsourcing to external sources.
Thus, exploration from this study shall be additional references for SMEs industry in Malaysia to have better understanding and decision making of outsourcing the internal audit function or not.
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