Previous Literature On Audit Quality Accounting Essay


Previous study on audit quality found that there are a few determinants of audit quality such as the long relationship between auditor and client easier for the auditor to understand client's business, the higher audit fees paid by the client (they demand for a higher audit quality), the audit firm size (have an experienced and competent staff) and auditor industry specialization (have specific knowledge on the client's industry). The role of auditing is to reduce information asymmetry on accounting numbers, and to minimize the residual loss resulting from managers' opportunism in financial reporting. Higher quality audit is one way to reduce agency cost and to avoid accounting errors and misstatement. Audit quality is defined as the ability of the auditor to detect fraud and the auditor's action towards the fraud (De Angelo, 1981). Although the auditors are technically able to discover deviations from GAAP standard, their integrity is often jeopardized by the lack of independence and therefore do not report the misstatement, thus will affect the audit quality. According to Owusu-Ansah, Moyes, Oyelere and Hay (2002), there are a few factors that influence the likelihood of detecting fraud which is size of audit firm, auditors position tenure and auditor's years of experience. The study done by Hassink et al. (2010) discussed on the action need to be taken by the auditor once fraud is detected such as inform to the respective party to ensure that the correction can be made to the financial statement and materially misstatement in financial statement can be prevented. Chambers and Payne (2010) stated that the accrual persistence increase significantly in the post-SOX period. However the study found evidence that in the post-SOX period the subsample of companies audited by big 4 auditors with lower independence, experienced the greatest improvement in accrual persistence. Al-Ajmi (2009), stated that big 4 produce better quality reports than non big 4 and non audit services were found to affect auditor's independence hence impair audit quality. He also believed that the effective audit committee enhances the quality of the audit report. Previous study found evidence a negative association between earning management and audit quality (Rusmin, 2010; Garkaz, 2012). The study also indicates that earning management amongst firm engaging the services of a big 4 specialist audit firm is significantly lower than a firm engaging a non big 4 specialist (Rusmin, 2010). Makkawi and Schick (2003) have conducted a study on the auditors' reaction to their audit program when there is a likelihood that the fraud risk increased. They found that all auditors will increase the performance of certain procedures when they discover the material misstatement in the financial statement. The following literature will discussed on the previous study done on the relationship between audit tenure, audit fees, audit firm size and auditor industry specialization with the audit quality and do the higher audit quality can prevent fraudulent financial reporting. This literature also touch the previous study on the fraudulent financial reporting

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Audit tenure refers to how long the same audit firm provide an audit and non audit services to the same company. Lengthy tenure with a same client is a threat to the auditor as there is a possibility that the auditor will develop a personal relationship with the client resulting a declining in a quality and competent of the auditors. Gates et al. (2007), argued that the audit firm rotation incrementally influenced individuals confidence in financial statements. A high profile audit failure such as a case of Enron and Worldcom, become a debate on the effect of lengthy auditor tenure on audit quality. A system of mandatory audit firm rotation would require companies to rotate their independent auditor periodically. Currently, listed companies in Italy and Brazil are required to rotate their independent auditor every nine and five years, respectively. The requirement of mandatory audit rotation was seen would help to avoid corporate collapse and audit failure. As cited by Fargher, Lee and Mande (2008), in 2002 the General Accounting Office conduct a research on the impact of mandatory audit firm rotation on audit quality and found that the auditor independence and audit quality cannot be improved through regulation for mandatory of audit firm rotation . The previous study on the relationship between audit tenure and audit quality shows a mixed result. Al-Thuneibat et al. (2010), found that there is a negative relationship between audit firm tenure and the audit quality. However this finding did not expose that the size of audit firm has any significant impact on the relationship between the tenure of audit firm and audit quality. It was contradict with the result showed in the study done by Carrera et al. (2007), which is the regulation made by the Spain regulator in 1988 on the mandatory audit rotation for every 9 years, was removed in 1995 after the regulators verifying that the rotation role did not work and did not achieved it objectives. According to Jackson, Michael and Peter (2008), mandatory audit firm rotation will not improve audit quality. Mandating firm rotation would lead to a loss of client knowledge when the auditor is forced to resign. Audit failures are generally higher in the first years of the auditor-client relationship as the new auditor becomes familiar with the client's operations (Arel et al., 2005). This finding is supported by Fernando, Abdel-Meguid and Elder (2010). Longer audit tenure results in a higher-quality audit; this should also reduce information risk and result in a lower cost of capital. Shafie et al. (2009) argued that, there is very limited evidence regarding the long audit firm tenure impairs auditor independence by compromising auditor reporting quality in developing countries such as Malaysia. Their study shows that a positive relationship between audit firm tenure and auditor reporting quality is in line with the recent decision by Malaysian regulators not to regulate mandatory audit firm rotation in public listed company. Gul, Basioudis & Ng (2010), indicate that auditor with short tenure may have difficulties detecting fraud and investment of time and effort in the auditor-client relationship is limited. As a result, potential loss due to auditor switch is likely to be less costly. To protect their reputation, auditors with short tenure may be more willing to issue Going Concerns to distressed clients when they detect problems. On the other hand, auditors should not have any problem detecting fraud when auditor tenure is long, but the potential loss could be large if the client decides to switch an auditor, especially when non-audit fees are relatively high. In such situations, it may be likely that the decisions to issue Going Concern depend on auditor tenure. Ghosh and Moon (2005), as cited by Kend (2008), linking the audit quality to auditor tenure and perceptions of independence. Abdul Nasser et al. (2006) found that the retention of audit firm depends on the size of the clients, level of financial risk, type of audit firm and non-financial distress company. They argued that, since the switching of auditor are more likely happened in a financially distressed companies, the smaller auditor may agreed to produce an unqualified audit report and reluctant to show disagreement with their clients for fear of being losing a client. The implication of this finding is that such relationship between auditor and the client may impair auditor independence and weaken audit quality. Besides the audit firm tenure, the audit partner tenure also should be considered as the factor that effect auditor independence. The study was done by Fargher, Lee and Mande (2008) on the audit partner tenure on client managers' accounting discretion and found that the initial years of tenure of a new audit partner, client managers' accounting discretion decreases when the new partner is from the same audit firms as the outgoing partner. However it was increased when the audit partner is from a different audit firm as the outgoing partner. This finding shows that the audit partner rotation give the big impact to the audit quality which is the audit partner rotation will increase the audit quality and this is contradict with the rotation of audit firm as it was not the most efficient way to strengthen auditor independence and improve audit quality. This finding was supported by the study done by Ho, Liu and Schaefer (2010) who found that the longer audit tenure are less likely to manage earning upwards and more likely to guide analysts' forecasts downward shows a higher audit quality in a firm with a longer audit tenure.

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The fees charged by the audit firm to their clients inclusive of the audit services and non audit services provided to the client. There are a few factors that determined the fees charged to the clients includes auditee size, auditee risk, complexity of audit, size of the auditor and timing of the audit. According to Makkawi and Schick (2003), audit fees no longer determined by the amount of work auditors do. The fixed fees environment limits the amount of works that the auditors are inclined to do by limiting the fees client are willing to pay. The fixed fees environment requires the auditor to "audit smarter". The study done by Ho and Ng (1996) found that the auditee size is the main determinant of audit fees. The previous study on audit quality found that the level of audit fees paid by client will effect the audit quality. Rani, Ariel & Charles (2007), stated that audit fees paid to auditors can affect audit quality in two ways: large fees paid to auditors may increase the effort exerted by auditors, hence, increasing audit quality. However, large fees paid to auditors, particularly those that are related to non-audit services, make auditors more economically dependent on their clients. Such financial reliance may lead to a relationship whereby the auditor becomes reluctant to make appropriate inquiries during the audit for fear of losing highly profitable fees. Thus it will impair the auditor's independence that leads to lower quality audits. In opposition, the potential for audit failure imposes significant economic costs on the auditor. The fees paid by firms in the context of auditor profitability better captures the relation between audit quality and independence. This study shows a significant positive association between audit fees and audit quality. Higher fees will increase audit quality, improved audit quality is due to audit fees earned in one year and the estimated operational costs needed to implement the audit process. Besides audit service, the audit firm also provide non audit services to their client which will increase the total fees charged to the client. Bloomfield and Shackman (2008) found only limited evidence to support the concept that firm with higher non audit service fees are more likely to restate earnings. However they found a stronger evidence that the level of total fees paid to the audit firm is significant in the predictability of a restatement of financial statement. Mitra, Deis and Hossain (2009), argued that since non audit services are restricted in post-SOX period, it is probable that the client may use high audit fees as a vehicle to influence the auditor and impair its independence. In their study, they found that no evidence either expected or unexpected audit fees are associated with higher level of discretionary accruals, a sign for compromised auditor independence. There are mixed results shows in previous study relating to earning management and audit fees. The study done by Magee & Tseng (1990) indicates that there is a significant relation between earnings management and audit pricing. Larcker & Richardson (2004) found a contradict results which is no evidence on the earnings management is related with audit fees. Some studies show a negative association between audit fees and earning management (Frankel et al., 2002). Alali (2010) found a positive and significant association between discretionary accruals (DAs) and audit fees. This relationship is significantly higher as CFO's bonuses increase and moderated by CFO's salaries increasing. She argued that the DAs are related to accounting items that require judgement. As DAs increases, inherent risk assessment increases that would lead to require more audit work, extensive reviews and close supervision of staff to achieve a desired level of audit assurance thus will increase the audit fees. Leventis and Dimitropoulos (2010) had done a study on the audit pricing, quality of earnings and board independence in Athens stock exchange. They suggest that auditing and the existence of an independence board of directors is one way to mitigate an agency problems and managerial fraud. It was expected a negative relationship between independence directors and audit fees. With the existence of board independence, its will reduce the audit risk subsequently lower the audit fees. However the results suggest that, good corporate governance will increase the need for quality assurance services. Therefore, there is a positive relationship between corporate governance and audit fees as the stronger corporate governance demands for a higher audit quality resulted to a higher audit fees. The same result found in the study by Abdul Wahab et al. (2011) who concluded that better corporate governance demands a higher audit quality leading to a higher audit fees. Lenard et al. (2011), provide an evidence that the audit fees are higher for fraud firms in both for pre and post SOX. They also found that the corporate governance has a positive and significant influence on audit fees. Rahmat and Mohd Iskandar (2004) argued that clients pay higher audit fees to big audit firms to get a better quality audit services.

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The audit firm size which classified as big 4 and non big 4 will determine the level of compliance by auditor in performing the audit. "With the recent collapse of Enron involving the misconduct of one of the Big 4, Arthur Andersen & Co., the argument for audits by big audit firms as synonymous with quality audit has become questionable." (Iskandar, Rahmat and Ismail, 2010). Previous study on audit quality found that size of audit firm influences the selection of auditor and determination of audit fees. This is due to differential audit quality is inferred by the auditor's likelihood of issuing a going concern audit report and the auditor's willingness to restrain clients from aggressive earnings management behavior. Big 4 and non big 4 are subject to the same regularotary and professional standard, thus both type must adhere to a reasonable level of quality. Based on this argument, the audit firm size did not influence the audit quality. However the previous study on audit quality and fraudulent financial reporting found a positive association between audit firm size and audit quality and negative relationship with a fraudulent financial reporting. Francis & Yu (2009), argued that there is a systematic association between Big 4 office size and audit outcomes consistent with larger offices producing higher quality audits. The argument is the auditor in larger offices is more likely to detect material problems in the financial statements. Both regulators and audit firms should pay more attention to the behavior of small offices because they are more likely to be economically dependent on a particular client, and thus to compromise audit quality. Big 4 audit firms may need to implement strategies for providing a more homogenous level of audit services across offices of different sizes because a poor-quality audit by a small office could significantly damage the reputation of the entire firm (Choi et al, 2010). Francis and Yu (2007) argued that auditors in larger offices are more likely to detect material problems in the financial misstatements resulting in higher quality audit. This finding is supported by a result shown in a research done by Mohd Nor et al. (2010) who found that the companies using services from big 4 audit firm are less likely to commit fraud. This is because the large firms are protecting their reputation by complying more with accounting standard and audit procedures. A large office has more auditors, and these auditors have exposure to more clients which leads to greater collective human capital in the office. As a result larger offices have greater in-house experience in administering the audits of public companies and more expertise in detecting material problems in the financial statements of these clients. The larger office is more likely to be independent of clients due to a larger client base and greater mutual monitoring by partners. Therefore auditor in a larger office is more likely to risk client dismissal by reporting material problems in the financial statements of requiring the client to make appropriate adjustments. Based on their study, the results indicate that larger offices provide higher audit quality. This finding is supported by the study done by Lennox and Pittman (2010) who indicates a negative relation between big 5 and fraudulent financial reporting. Becker et al. (1998) found that, the company audited by big 6 audit firm reported a lower level of discretionary accrual. This finding was supported by the study done by Francis et al. (1999) who found that the clients of big 6 audit firm report a smaller discretionary accrual, indicate a higher audit quality. It was contradict with the result found in the study done by Alastair, Miguel & Phing (2010) who argued that non big 4 auditors have superior knowledge and better relation with the clients which enable non big 4 firms to better detect the irregularities. Bloomfield and Shackman (2010), found a strong positive association between big 5 audit firm and restatement financial statetement. In detecting fraud, Hassink et al. (2010) found that, non big 4 auditors seemed to detect the more serious fraud cases more often than big 4 auditors with the argument that companies with a serious fraud cases will appoint the non big 4 audit firm as their auditor. The study shows Big 4 auditors were followed more strictly reporting rules and in cases of material and management fraud. However Yuniarti (2011) found that CPA firm size does not significantly affect the audit quality in CPA firm in Bandung. Hussainey (2008) indicates that , the investor are able to better anticipate future earnings when financial statements are audited by the big 4 accounting firm. Poor quality of financial reporting affects the ability of auditors to perform an audit. Even where the quality of the underlying financial reporting system is good, auditors too must possess the relevant skills and experience to perform audits with appropriate professional skepticism and judgement.

Most of the study on the auditor specialization shows a positive association with the audit quality. This is due to the auditor specialization have a specific knowledge about the industry. There are a few criteria need to be fulfilled by the auditor to be recognized as an industry specialist. According to the respondent of Kend (2008) the firm need to know and understand the industry issues, know the key organizations in a given industry, involved in that industry and know how these issues affect the industry's participants. The auditor who is expert on the client's industry may reduce managerial opportunism to involve in fraudulent financial reporting, thus lead to a higher audit quality. Odette and Rogers (2009) found that the earning management is more negatively associated with board governance quality for firm with higher auditor industry specialization. This indicate that a higher auditor industry specialization resulting in a higher accounting and audit quality. They also found that high quality boards are more effective in constraining earning management when those boards hire industry specialist auditors. This finding supported by a study done by Balsam, Krishnan and Yang (2003) who found that auditor industry specialization is negatively associated with absolute discretionary accruals. The research done by Carcello and Nagy (2005) found a negative relationship between auditor industry specialization and fraudulent financial reporting and this relationship depends on the client size. From their study they found that the negative relationship between this two variables weaker for a larger client. This indicate that the fraudulent financial reporting most likely to be happen in a larger company even it was audited by an auditor industry specialization. It was support by Bloomfield and Shackman (2008) who found a negative association between audit firm industry specialization and financial statement restatement. The study by Karjalainen (2011) also found the same result which is industry specialization of audit partner is associated positively with the quality of earning reported by private companies. According to Francis, 1984 as cited by Rahmat and Mohd Iskandar (2004), the big 8 audit firm obtained a higher audit fees compared to non big 8 audit firm due to quality differentiation as a result of industry specialization. Based on empirical analysis, the higher fees are earned by engagement partners who are both industry and public specialization (Zerni, 2010). Reichelt & Wang (2011), in their study on audit quality found that the audit quality is higher when the auditor is both national and city - specific industry expert. Sun and Liu (2013), did a study on auditor industry specialization, board governance and earning management found a negative association between earning management and board independence for firms audited by industry specialist. However the study done by Abbott, Parker and Peter (2000) fail to document a positive relation between industry specialization and auditor quality. According to them the greater selection of industry-specialist auditors by more active and independent boards is consistent with an expectation that industry-specialist auditors provide higher quality services and are therefore more likely to detect financial statement misstatements, whether caused by error or fraud. The finding by Minutti-Meza (2010) also shows that no significant differences in audit quality between specialist and non-specialist auditor. Overall the results on the studies of auditor specialization found that industry specialist auditor deliver higher quality of audit than non specialist auditor.

2.2 Previous literature on fraudulent financial reporting

There are a few factors that contribute to the corporate fraud. The corporate fraud may happen due to the weaknesses of corporate governance and internal control in the company and the ineffectiveness and inefficient of auditor which creates the loopholes and opportunities for the management to manipulate the financial statement. Previous study found that, the fraud case is related to management incentives (Robison and Santore, 2011 and Warren, Zey, Granston and Roy, 2011). In today's business environment the fraud become very complicated which is difficult to be detected, especially when it involved and committed by top management. Due to this, the auditors claimed that detecting fraud is not their responsibility. The corporate environment with a complexity of transaction and the accounting practices is another factor that led to a corporate fraud. Based on the study done by Hwang and Stailey (2005), the failures in auditing and accounting is due to the following: 1)the betrayal of CEOs' and CFOs' fiduciary duties to act for the benefits of shareholders, 2) the conflict of interest regarding for whom the company's auditor work, 3) the holes in GAAP and personal relationships. In the case of Enron, the fraud happens due to the holes in the General Accepted Accounting Principle (GAAP) itself which allowed the special purposes entity which being abused by Enron. The study done by Kalbers (2009) indicates that the fraudulent financial reporting is higher in a firm with a weaker corporate governance. It also influenced by the corporate ethic and corporate culture. It was supported by the study done by Crutchley et al. (2007), Uzun et al. (2004) and Beasley (1996) who found that the firms with fewer outsiders on the audit committee and firms with overcommitted outside directors are more likely to involve in fraud. The same result found in the study done by Rezaee (2005), who found that the opportunity to engage in financial statement fraud increases as the firm's control structure weakens, its corporate governance becomes less effective, and the quality of its audit functions deteriorates. This finding was supported by the study done by Law (2011), who found that the audit committee effectiveness, internal audit effectiveness, the tone at the top managerial level and ethical guidelines and policies are positively associated with a lack of fraud in organisations. It was contradict with the result found by Chen, Firth, Gao and Rui (2006), which indicate that no significance difference in a proportion of outside directors, board size and CEO duality across the fraud firm and non-fraud firm. Fraud firm have more board meetings and their chairman have shorter tenure. According to Firth et al. (2005), the auditors are more likely to be sanctioned when they failed to detect and report frequently occurring transaction based fraud such as overstated of assets and income rather than disclosure fraud. Hassink et al. (2010) found that the auditor fail to comply with some important elements of auditing standard thus will lead to a corporate fraud. In a case of Adelphia, auditor needs to properly asses the related party transaction and adjusts the risk assessment accordingly (Peursen et al., 2009). They found that in HIH's case the auditor failed to display either independence in mind or in appearance. Their apparent lack may have affected the quality of audit performed. Accounting manipulation is one type of fraud whereby executives of a firm distort or change financial statement information to portray a falsely positive image of their company, has proven to be particularly damaging to our capital markets system (Skousen and Twedt, 2009). Tillman (2008) discovered that the board members, auditors and banks willing to collaborate with senior management in manipulation the financial statement. The auditor willing to assist their clients as the auditors shifting from stressing adherence to accounting rules to maximizing the revenue and pleasing the clients. The directors failed to perform the control function as they had been bought off with stock options. Beasley et al. (1999) summarize the following criteria for the companies involved in fraud:

The nature of the companies involved in fraudulent financial reporting was a small companies and experiencing in net losses or in close to break even position in period before the fraud

The control environment is very weak which is normally involved the top senior executives and most audit committee meeting is very rare about once a year or the company had no audit committee at all. Board of directors were dominated by insiders and family relationship among directors and officers.

In terms of audit firm, all sizes of audit firm were associated with companies committing financial statement frauds and all type of audit reports were issued during the fraud period. Some companies changed auditors during the fraud period.