The Impact of Auditors Independence on reliability of Financial Statements

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This chapter introduces the research agenda of this study. This chapter outlines the background of the study, statement of the problem, research questions, research objectives, research significance, definitions of terms, and organization of the remaining chapters.

1.1 Background of the Study

Accounting firms heavily depend upon independence for their basic functionality and operation ability. Independence is the only justification for the existence of accounting firms that provide outside audits; it was not for the claim of independence (Moore, Tetlock, Tanlu, and Bazerman, 2006). In addition, the assurance of independence is crucial to all of those investors, lenders, employees, and strategic partners' who rely on audited financial statements for reliable information regarding a firm's financial health (Moore et al., 2006).

Auditor independence has been a main concern for a long time. In recent times, it has become more obvious, knowing the collapse of Enron, which resulted in the closure of Arthur Andersen, one of the major international accounting firms (Vinten, 2003). In auditing industry, auditors face a lot of pressures from their clients and owners. According to Knapp (1985) it can be said that auditor independence has been defined as the ability to resist client pressure. Marry (1997) said that the importance of the audit function rests on the independence of auditors in carrying out their work. Auditors who are not independent of the audited would be of little value to the individuals to whom accountability was due, since there could be little confidence that their opinion added to what was already available (Flint, 1988). On the other hand, the collapse of Enron raises the question about the role and independence of auditors who have been paid high audit fees to provide their opinions on the company's financial statements (Faraj and Akbar, 2008). So, the audit objectives of the auditors should only be guided by the independence and accuracy. As Moore et al. (2006) said that actually, in reality, for true independence to exist, auditors' reports must not be affected by any goal other than accuracy.

Hodge (2003) concluded that the perceived auditor independence and the perceived reliability of audited financial statements have declined over the years while the perceived relevance of audited financial information has increased. In this regard, Moore et al. (2006) state that the global financial crisis of 2008 seems to affect the perceived reliability of audited financial report from one of the Big 4 audit firms, such as Ernst and Young. These auditors face conflicts of interest many times between their own self-interest and their professional obligations to provide good advice. As stated by Moore et al. (2006), that conflicts of interest played a central role in the corporate scandals that shook America at the turn of the twenty-first century as a result of inaccuracies in published financial reports.

The relevance and reliability of financial information has been critical and equally important in making judgments and decisions)Jurney ,2008). The traditional audit function focuses on reliability. This reliability along with the auditor's independence and competence provide credibility, but customers also could benefit from relevance and timeliness, while relevance and timeliness represent additional dimensions of service auditors empowered by information technology (Elliott, 1994). The importance of understanding financial information and use of relevance and reliability has become prominent over the years. According to Jurney (2008), it can be concluded that it is important to gain an understanding of how users of financial information understand and use the relevance and reliability of financial information in their judgments and decisions.

1.2 Problem Statement

To make accounting information useful, relevance and reliability play a major role (Johnson, 2005; Kieso, Waygandt and Warfield, 2005; Obaidat, 2007). Relevance and reliability are the two primary qualities that make the accounting information useful for making decision (FASB, 1980; FASB, 2008). Re-stating the need for relevance and reliability, Kieso et al., (2005) mentioned that if either is missing completely from a piece of information, the information will not be useful. With numerous corporate scandals of the early 21st centuries such as Enron in 2002 and Lehman Brothers in 2008, etc. have played a significant part in the spotlight enjoyed by the topic, and it seems that there are many more questions emerging than answers. These events raise some old and new questions about the value of company audits, auditor independence and quality of audit work, economic incentives for good audits and the knowledge base of auditors (Sikka, 2009). Therefore, this situation puts financial statements under a lot of questions and criticism. This issue is important because financial statements relevance and reliability enable investors, creditors, and others to help them make investment, credit, and other decisions. Furthermore, the relevance and reliability of financial statements is said to be centered on maintaining auditors' independence. It is granted that impaired auditor independence is partially responsible for recent financial reporting failures and investor losses (Anandarajan, Kleinman, and Palmon, 2008). For example, if owners of organizations doubt the auditors' independence, financial statements will lack credibility, which could lead to the 'abrupt and arbitrary withdrawal of capital from suspect businesses' (ABI, 2002; Dart, 2009). However, lack of independence would result in collaboration between both agents and auditors who may mislead the principals and supply wrong accounting information (Faraj and Akbar, 2008). That is why (Green ,2006) concluded that auditor independence will continue to be a central problem .As a result, if auditors are less independent, they may be more incline to accept questionable management choices on reporting without qualifying their audit opinion (APB, 2009). Bruce (2010) stated that "Assignments awarded to the auditors are subject to controls by management and have been agreed by the audit committee, so that auditor independence is not compromised." However, the regulators and politicians tend to make an enormous fuss about it. Although, investors, shareholders, audit committees and all the real owners of companies tend not to worry too much about it at all, we can say that this issue seems impossible to pin down. In addition, prior studies in auditor independence show that perceptions of independence vary between stakeholders' groups: auditors; investors; creditors; managers and others (Agacer & Doupnlik, 1991; Jenkins & Krawczyk, 2002). Consequently, an assumption of homogeneity in auditing practices, and thus perceptions of auditor independence being challenge.

Securities and Exchange Commission (SEC) has suggested that auditor independence issues are threatening the usefulness of audited financial information (Hodge, 2003; Hunt, 2001b). In addition ,the American Institute of Certified Public Accountants (AICPA) suggests that independence-related research should analyze issues related to confidence in the independence of auditors, perceptions of financial statement accuracy and reliability, and discretionary decision making by financial statement users (Anandarajan et al.,2008).

(Awadallah, 2006) recommended that if confidence in the role of the accounting and auditing profession in general and in auditors and their independence in particular needed to be maintained and enhanced, more empirical research is required to be undertaken .

The dominating economic system in Libya was centralized in the past decades. Derwish, Kagiji, and Akaddar (2004) said that the dominating public sector economic system, which prevailed in Libya in the past decades, needed the financial information only for the purposes of central planning, control and taxation. They also added that this information requirement system did not encourage the development of methods for the preparation and presentation of financial information. Previously, the accounting practice in Libya was influenced by the United Kingdom (UK) and United States of America (USA) accounting procedures (Mahmud, 2005). The influence came through their owned or managed oil and non-oil firms operating in the country during the colonial period and through their advisers to Libyan firms and governmental organizations after independence (Ahmed and Gao, 2004). Derwish et al (2004, p131) mentioned that during the recently past decades the audit professionals were directly dominated by the state owned auditing mechanisms by the board named "The committee for inspection and popular control" [1] , which represented the largest proportion of the labor market audit activities. However Alruyati (2005) argued that the role of the committee for inspection and popular control, to activate the role of the auditor, regrettably did not play its part as its efforts in this matter were few. He also recommended the need to give appropriate independence to the External Auditors. Libya is trying to join World Trade Organization (WTO) and enjoy the features of General Agreement of Trade in Services (GATS). Under the urgency of the issue Derwish et al., (2004,P131) stated that Libya is trying hard to join the (WTO) while considering the conditions to comply with the norms of General Agreement of Trades in Services (GATS) which require professional qualifications from the recognized professionals in the field.

Libya has witnessed major economic and regulatory improvement including the introduction and compliance to International Accounting Standards (IASs) and International Standards on Auditing (ISAs) (CBL, 2005). These changes are believed to have effect on the auditors' independence, relevance and reliability of the audited financial statements, especially after the entrance of the Big 4 audit firms into the country.

Recently, a newspaper (Asharq Al-Awsat) has unveiled embezzlements by Libyan officials in the Economic and Social Development Fund( [2] ). (Mahmoud, 2010) the media also mentioned that officials from sixteen companies will be charged of fraud and maybe jailed. Even though there is embezzlements by official, the total assets of these companies grow by 19.0% (58 billion dinars) compared to 48.7 billion dinar at the end of the first quarter of last year. The liquid assets to total assets represented 70.5% or about 40.9 billion dinars deposits with the Central Bank of Libya (CBL). CBL also stated that commercial banks has witnessed a growth rates significantly in the first quarter of 2010 than it was during the same period last year.

These events raise questions about the role of the board of directors (if Audit Committee is existing ), the value of company's audits, auditor independence, relevance and reliability of financial statements in Libya.

The regulatory body of accounting professional in Libya is the Libyan Accountants' and Auditors' Association (LAAA) which was established by the Libyan government. However, the absence of Libyan own auditing and accounting standards reflect environmental factors to Libya as a developing country (Mahmud, 2005; Shareia, 2010; Wallace and Wilkinson, 2004), indicating the limited role of LAAA. Thus, companies in Libya become unable to take recourse to the auditing and accounting standards of international repute. That's why Mahmud (2005) confirmed the requirement of these standards by mentioning the enhancing of auditors' independence (professional competence and due care) while attaining a minimum level of confidence on the financial statements of the companies which have already been reviewed.

Hence, this study will address these changes as it is believed to have effect on both auditors' and users' perceptions of external auditors' independence. There are several factors that may affect the perceptions of auditor independence in small developing countries like Libya. So, to understand these factors as well as revealing this gap in perceiving external auditors' independence and interested parties in terms of the qualitative characteristics of audited financial statements, with respect to non-current assets according to Libyan context, the following research questions are posed.

1.3 Research Questions

The study will attempt to answer the following research questions:

What is the extent of external auditor's independence in Libya?

What is the extent of the relevance and reliability of audited financial statements in Libya?

What are the factors regarding auditor's independence in Libya?

Are the relevance and reliability of the audited financial statements of Libya are subject to auditor's independence?

1.4 Research Objectives

The objectives of the study are as follows:

To determine the extent of external auditor's independence in Libya.

To investigate the extent of relevance and reliability of the audited financial statements in Libya.

To determine the factors regarding the auditor independence in Libya.

To examine the effect of auditor independence toward relevance and reliability of audited financial statements in Libya.

1.5 Significance of the Study

The significance of the study can be seen from both theoretical and practical contribution's point of views. From a theoretical perspective, this study will helpfully support that an independent auditor may play a key role in monitoring the agency relationships between principals (e.g. shareholders, investors, analysts' financial statements and creditors) and agents (managers).

The need to study auditor independence has been well recognized over the years. Quick & Rasmnussen (2009) explicitly stated that a lack of independence harms the interests of external stakeholders. The necessity to conduct studies on auditor independence also have been documented by Dart (2009). He mentioned that institutional investors were less concerned than the private investors in doing research on auditor independence. By this we can deduct that the massive importance of auditor independence studies has had universal acceptance. Like Law (2008) postulated that it is of paramount importance for auditors to maintain an actual independence. Sori and Mohamad (2008) claimed that prior research in auditor independence within the developed economies has demonstrated to be inconclusive.

Researchers have repeatedly emphasized to conduct studies on auditor independence because of its importance and necessity over a certain period of time. Like Marianne (2006) stated that a lot of work and improvements have been carried out over the years and there should be an ongoing process of review and further efforts aimed at improvement. With a strong support to the recommendations by Marianne (2006), Alleyne (2006) postulated that further studies can focus on conducting more in depth research, exploring the underlying reasons for auditors independence. Sori (2005) reconfirmed the importance to conduct studies on auditor independence by stating that continuous efforts to carry out research on auditor independence should be undertaken because the perceptions of this may shift over time as highlighted by researchers such as Gwilliam (1987).

Although the importance to study auditor independence has been narrated by several authors over the years, yet the findings of the previous studies came out to be inconsistent and portraying mixed results. Like Beattie and Fernley (2002) mentioned that independence in fact is unobservable and so indirect measures have been used. They also mentioned that there has been a lack of publicly available data on the subject. This scenario warranted further empirical studies on the subject matter. The researcher wanted to fill this gap by conducting this proposed study on auditor independence as a theoretical contribution to the ever growing stream of knowledge pertaining to this subject matter.

This study clarifies doubts about auditor independence and its effect on financial statements. Maybe, the results support the suggestion given by SEC regarding the auditor's independence issues are threatening the usefulness of audited financial information , furthermore, AICPA (1997) also supported that independence-related research should analyze issues related to confidence in the independence of auditors, perceptions of financial statement accuracy and reliability, and discretionary decision making by financial statement users .Overall, the results support regulatory efforts in improving the quality of financial reporting thus improving auditor independence.

The Libyan market needs to have the audited financial statements relevance and reliability of financial statements for several parties; such as shareholders, investors, creditors and managers. Consequently, the quality of audited financial statements relevance and reliability of financial statements will improve thus reducing market losses and boosting shareholders, investors, creditors and managers confidence.

Dart (2009) found that tests revealed that private investors were more concerned about the auditor-client relationships than the institutional investors. It also provides evidence which will serve to educate users and auditors about the contextual factors surrounding the role of auditor as well as the possible threats and enhancement factors, affecting auditor independence in Libya.

Further, the results from this study could carry potential value to enhance the linkages between perceptions of auditors' independence, the perceived relevance and the reliability of audited financial statements in Libya. It can also inform policy makers, government, Libyan stock market and the Libyan Accountants' and Auditors' Association in Libya (LAAA). The results should be of direct interest to policy-makers. In particular, this study's findings can assist Libyan policy-makers in the establishment of a common core of independence principles, and can assist LAAA in their evaluation of the impact of recent regulatory changes and the likely impact of proposed changes.

1.6 Definitions of Terms

For the purposes of this research study, the following terms will be utilized:

1. Auditor's Independence:

This study refers Independence, which includes the qualities of integrity, objectivity and impartiality as stated by Arens, A.A., Loebbecke, J.K., Iskandar, T.M., Susela, S.D., Isa, S. and Boh, M. (1999).

2. Audit Firm Size:

This refers to the Big 4 audit firms and Non-Big 4 audit firms. Big 4 audit firms are: (Price Waterhouse Coopers, Deloitte Touche Tohmatsu, Ernst & Young, and KPMG). While the Non-Big 4 audit firms are other than the Big 4 audit firms.

3. Audit Firm Fees:

Audit fees refer to fees generated from the auditing engagements.

4. Level of Competition in the Audit Market:

Competition in the audit market is auditing market concentration, auditor's ability to resist client pressure, and audit fees discounting/low-balling.

5. Non Audit Services:

Non-audit services (NAS) refer to services given to clients other than the following: (i) An auditor cannot function in the role of management, (ii) An auditor cannot audit its own work; and (iii) Auditor cannot service in an advocacy role for its client.

6. Audit Committee:

An audit committee is defined as a "committee of directors of a corporation whose specific responsibility is to review the annual financial statements before submission to the board of directors" (Accountants International Study Group -AISG, 1977).

7. Auditor Rotation (switching):

Auditor rotation refers to the frequency of auditor change.

8. Size and Composition of Board of Directors:

Size and Composition of Boards of directors refer to members, designation, and type of directors in the organizations.

9. Flexibility of the Financial Reporting:

This refers to the requirements of the financial statement, whether flexible in presenting the company's financial position and performance.

10. Prior Employment:

This refers to whether the audit clients had employed former auditors of their current audit firms in accounting positions.

11. Relevance and Reliability of Audited Financial Statement:

- Relevance: Relevant information is defined as capability of influencing a decision by assisting users of the information in making predictions about the outcomes of present and future events or to confirm or correct prior expectations (Jurney S, 2008, P9). - Reliability: To be reliable, information must have representational faithfulness, and it must be verifiable and neutral (Barua A, 2006, P7).

- Audited Financial Statement: An audit of financial statements is the review of the financial statements of a company or any other legal entity (including governments), resulting in the publication of an independent opinion on whether or not those financial statements are relevant, reliable, accurate, complete, and fairly presented.

1.7 Organization of the Study

This study is organized into five chapters:

Chapter One introduces the study. It also contains problem statement, research questions, research objectives, research significance, definitions of terms, and organization of the remaining chapters.

Chapter Two continues with the literature review and previous research which are related to this study.

Chapter Three explains the research framework, methodology employed in the study, hypothesis, research design, sample and data collection, research instrument, operational definition and measurement of the variables and method of data analysis.

Chapter Four analyses and interprets the results of the study. It also analyses the unsolicited as well as requested responses to the survey form and an interpretation of the statistical findings.

Finally, Chapter Five organizes and discusses the major findings, implications and limitations of the study as well as a statement leading to the conclusion. Above all, it also makes recommendations for further research in this field of study.

1.6 Hypotheses:

This research uses a framework of audito independence, perceived relevance and reliability of Audited Financial Statements. This will include factors, which are detrimental as well as enhancing to the factors. This research addresses the issues of auditor independence by evaluating relevance and reliability of audited financial statements.

H1: Audit firm size has a positive influence on auditors' independence.

H2: Audit firm fees have a positive influence on auditors' independence.

H3: Level of competition has a negative influence on auditors' independence.

H4: Non audit services have a negative influence on auditors' independence.

H5: The existence of audit committee characteristics has an influence on auditors' independence.

H6: Auditor rotation has a negative influence on auditors' independence.

H7: Size and Composition of board of directors have a positive influence on auditors' independence.

H8: Flexibility of the financial reporting has a negative influence on auditors' independence.

H9: Prior Employment has an adverse impact on auditors' independence.

H10: Auditor independence has a positive influence on the level of relevance and reliability of audited financial statements.

The population for this study is defined as:

Four user groups were included in the survey: bank lending officers, investors, members of boards of directors of companies and banks and auditors. Following Agacer and Doupnik (1991, 227), the study focuses on professional preparers because of the familiarity of this group with the concept of independence. However, to provide a benchmark for comparison purposes, bank lending officers, who proxy for sophisticated users. Furthermore, this study explores how investors' perception to auditor independence, perceive relevance and reliability financial statements. Investors should be more careful on the quality of reported financial information prepared by senior financial executives (Zulkarnain Bin Muhamad Sori, Shamsher Mohamad, 2008,P 42) .According to Ahmed (2010,P.21) the number of private investors in the Libyan stock market has increased. Since the transfer some public areas of economic activities to the private sector (privatization).For the sake of, they were randomly selected from the Chamber of commerce in Tripoli.

Two main samples, one of the members of boards of directors (MBODs) and one of the auditors, were selected. These groups were selected because of their direct involvement in the production of audited financial statements. MBODs were surveyed because several writers have recently criticised financial reporting studies generally for focusing on users and failing to consider the perceptions of preparers (Bence et al. 1992; Edwards 1995). Moreover, the members of boards of directors and the auditors are surveyed because of their proximity and insight into the issues involved (Imhoff 1978, 875).

The providers were 90 "Non-Big 4" auditors were randomly selected from the publicly accessible Directory of a booklet from Central Bank of Libya (CBL).

In addition, Three of the Big 4 international accounting firms (Deloitte, 2010; Ernst and Young, 2010; KPMG, 2010; Pricewaterhouse and Coopers, 2010)4 have established a presence in Libya since its economy has opened up, a development that will drive Libya's accounting profession further towards a western model, typified by the UK/US influence already identified.

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