al-thuneibat et al - 2011 - do audit tenure and firm size contribute to audit quality - empirical evidence from jordan [at]

Empirical evidence from Jordan Ali Abedalqader Al-Thuneibat Department of Accounting, Faculty of Business, University of Jordan, Amman, Jordan Ream Tawfiq Ibrahim Al Issa Secured Service

Do audit tenure and firm size

contribute to audit quality?

Empirical evidence from Jordan

Ali Abedalqader Al-Thuneibat

Department of Accounting, Faculty of Business, University of Jordan, Amman, Jordan

Ream Tawfiq Ibrahim Al Issa

Secured Services Systems, Amman, Jordan, and

Rana Ahmad Ata Baker

Telecommunication Regulatory Commission, Amman, Jordan

Abstract

Purpose – The purpose of this paper is to analyze the effect of the length of the audit firm-client

relationship and the size of the audit firm on audit quality in Jordan.

Design/methodology/approach – To test their hypotheses, the authors use the quadratic form

approach, similar to Chi and Huang, with some modifications The population of this study

encompasses all firms in which stock is publicly traded on the Amman Stock Exchange throughout

the years (2002-2006).

Findings – Statistical analysis of data shows that, audit firm tenure affects the audit quality adversely

(negatively) Audit quality deteriorates, when audit firm tenure is extended as a result of the growth in

the magnitude of discretionary accruals Meanwhile, data analysis did not reveal that the audit firm size

has any significant impact on the correlation between audit firm tenure and audit quality.

Practical implications – If auditor independence and audit quality are to be enhanced, the audit

firm should be rotated in order to open the door for new auditors to investigate the client with greater

scrutiny and due care Moreover, the activities of big audit firms should be monitored in order to

distinguish their role from small firms.

Originality/value – The paper provides evidence from a developing country about audit quality.

It is expected to support and sustain improvement of audit quality, and therefore, financial reporting

quality The evidence provided by this paper adds to the literature internationally and this is

important because auditing is a socially constructed phenomenon.

Keywords Jordan, Auditors, Auditing standards, Developing countries, Financial reporting, Expenses

Paper type Research paper

Introduction

Management is responsible for reporting the results of the firm’s operations and financial

position to stakeholders through financial statements A possible conflict of interest

between management and external users of financial statements exists This conflict,

in addition to the asymmetry of the information provided, creates together an inevitable

need for auditing the financial statements by a third competent and independent party

Auditing financial statements is intended to reduce the information risk and improve the

decision making (Arens et al., 2008) The audit process is designed to determine whether

the figures reported in financial statements present the firm’s operating results and

true financial position in a fair manner Therefore, improving the audit quality would

www.emeraldinsight.com/0268-6902.htm

Audit tenure and firm size

317 Received 14 August 2009 Revised 12 June 2010 Accepted 11 October 2010

Managerial Auditing Journal Vol 26 No 4, 2011

pp 317-334

q Emerald Group Publishing Limited

0268-6902

provide reasonable assurance about the accuracy of reported accruals and as a result, attest for earnings of higher quality On the other hand, a poor-quality audit would impair the quality of earnings and discretionary accruals (DAs) (Chih-Ying et al., 2008)

Among the main targets, a quality audit seeks to accomplish is improving the quality

of management’s financial reporting task (Dopuch and Simunic, 1982; Watts and Zimmerman, 1986) Improving the quality of financial statements adds value to those reports as an investor tool for estimating the value of traded securities Improved quality is a function of not only the auditor’s detection of material misstatements, but also the auditor’s behavior towards this detection Therefore, if the auditor rectifies the discovered material misstatements, a higher audit quality results, while failure to correct material misstatements upon detection and prior to issuing a clean audit report (or moreover failure to uncover material misstatements) obstructs the improvement

of audit quality ( Johnson et al., 2002) In Jordan, it is widely observed that most firms retain the same audit firm for long periods of engagement with a general tendency to have confidence more in the quality of big firms’ audits While long auditor-client engagements can have adverse effects on audit quality, the size of the audit firm is presumed to contribute to the quality of financial statements reported by its clients Long auditor-client relationships have the potential to create closeness between the auditor and the client, enough to deter the auditor’s independence and reduce the audit quality

Investigating the quality of audits conducted by big auditors in Jordan, as reflected by their clients’ DAs, and studying the effect of the length of the auditor-client engagement, would determine if big auditors deliver improved audit quality when compared with non-big auditors, and would prove whether the length of the auditor-client relationship affects audit quality Therefore, the question arises of whether a long audit firm-client relationship and the size of the audit firm have any effect on audit quality in Jordan This study will examine the relationship between audit firm tenure (the length of the audit firm-client relationship) and audit quality for industry and service firms listed

on the Amman Stock Exchange (ASE) in Jordan during the period 2002-2006 and the effect of the audit firm size on this relationship The effect will be studied in terms of the quality of DAs reported by audit firms’ respective clients DAs are widely used

in the literature as a proxy for audit quality Amongst the parties which will benefit from the findings of this study are the bodies in charge of regulating the profession Solid evidence would prove the effectiveness, and therefore establish the necessity for a mandatory audit firm rotation, or such an association may be impossible to draw In the latter case, activating an obligatory audit firm rotation would be an additional cost for both audit firms and their respective clients

The Jordanian market aims to benefit from global expertise, which is apparent in the tendency to employ big audit firms for the audit of financial statements Therefore,

it is important to uncover whether big firm auditors deliver superior quality audits; otherwise, the door should be opened for new comers in the Jordanian audit community and industry, without the concern of competing with big auditors on the basis of their superior audit quality Additionally, it is very important to enrich the existing literature about audit rotation, firm size and audit quality at the international level because auditing is a socially constructed phenomenon and therefore we need evidence from various environments

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Literature review and hypotheses development

The accumulated literature builds on the notion that the basic objective of the audit

process is to enhance the quality of the financial reporting process by providing

improved quality audits (Dopuch and Simunic, 1982; Watts and Zimmerman, 1986)

Audit quality is commonly defined as “the market-assessed joint probability that an

auditor will both detect and report material misstatements” (DeAngelo, 1981a) It is a

function of auditors’ competence that enables them to detect material misstatements,

and auditors’ independence, that determines whether they will report those material

misstatements or not (Azizkhani et al., 2007)

Several factors determine the auditor’s ability to detect material misstatements in

financial statements, one of which is the qualifications of the auditor An auditor’s

qualifications are an initial indicator of his/her knowledge and capabilities in the audit

field This knowledge might be either client-specific knowledge (e.g the knowledge of

the client’s accounting system, assets and internal controls), or a knowledge that is more

general in scope but very essential to the audit process at hand (knowledge about the

industry within which the client is operating and the accounting principles applicable in

the country where the client is operating its business) Client-specific knowledge is

the vital element that creates, and subsequently enhances, the learning curve of new

auditors (Knapp, 1991) This argument might seem simple at the outset, while in fact it is

not Lower client-specific knowledge during the early years of an audit engagement

can result in a lower likelihood of detecting material misstatements Such knowledge

is the auditor’s comparative advantage in detecting errors over time, when the client’s

business is understood more profoundly (Beck and Solomon, 1988) Chi and Huang’s

(2004) empirical findings support the learning effect presumption, where the ability to

investigate accounting irregularities is found to be a function of the audit tenure, whether

on the audit firm or the auditor level Boone et al (2008) argue that client-specific

knowledge is crucial to building a reasonably sufficient level of familiarity with the

client’s accounting system, internal controls, assets, operations and the industry within

which those operations occur as well

In an investigation carried out by American Institute of Certified Public Accountants

(AICPA, 1992), the AICPA Quality Control Committee found the audit failures to be three

times more likely in the first two years of an engagement than in subsequent years The

investigation surveyed 406 audit failure cases alleged by SEC clients Two studies that

examined lawsuits involving auditors (St Pierre and Anderson, 1984; Stice, 1991) found

the audit failures to be more common in a three-year or less auditor-client engagement

Long-tenure auditors were found more likely, in comparison with short-tenure auditors;

to issue going-concern opinions for clients who subsequently declared bankruptcy

(Geiger and Raghunandan, 2002)

Absolute DAs were found to decrease significantly through the passage of

the audit firm tenure (Chih-Ying et al., 2008) The researchers’ findings are consistent

with the argument that audit firm rotation might have adverse effects on the quality

of earnings; and accordingly, the accruals reported To determine the effect of the

“Mandatory Auditor Retention Law” in Korea, Bae et al (2007) studied DAs as a proxy

for audit quality The researchers found DAs to be significantly lower during the years

of retaining the same auditor Their evidence applies to both positive and negative

accruals, with stronger emphasis on negative They considered this an indicator of

firms’ adoption of conservative accounting On the other hand, some studies failed

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to establish evidence on the audit firm rotation effectiveness in providing the alleged shield from fraudulent financial reporting (Carcello and Nagy, 2004)

After a specific number of years, excessive familiarity can result and serve as a deterrent to the quality of financial reports Long tenure is assumed to lead to less objectivity in the auditor’s behavior, where a “learned confidence” in the client is developed (Hoyle, 1978; Arrunada and Paz-Ares, 1997) According to Johnson et al (2002) the learning effect will diminish when the engagement exceeds eight years They studied the auditor tenure divided into three categories: Short (2-3), Medium (4-8) and Long (9 or more) Upon approaching the medium tenure category and extending beyond towards the long tenure, the independence of the auditor is jeopardized as a result of the auditor’s excessive familiarity with the client and its industry The auditor is no longer motivated to innovate or diversify in the audit procedures at this stage of the engagement Myers et al (2003) provided evidence that earnings management is less of a concern for auditors in longer audit firm tenures Similarly, Davis et al (2003) inferred that management gains additional reporting flexibility with the progress in auditor tenure This was evident in the direct positive effect the auditor tenure had on DAs, i.e DAs increase with the progress in the auditor tenure A reasonable conclusion to draw at this stage of the argument is that it remains unclear – how long is long enough to acquire an acceptable and reasonable level knowledge and gain the necessary acquaintance with the client’s business, industry and accounting system in Jordan?

The lack of consensus on the optimal length of the audit firm-client relationship that yields better DAs’ quality constitutes the grounds for formulating the following hypothesis:

H1 The length of the audit firm-client relationship affects audit quality as measured by DAs

The literature provides some evidence on the difference in learning between audit firms relevant to their size Chi and Huang (2004) were able to substantiate their hypothesis on the learning differentiation across Big5 and Non-Big5 Data analysis revealed that Big5 auditors construct learning experience more quickly than Non-Big5 auditors Big5 auditors were significantly more proficient during the initial period of an audit engagement due to their quickness and greater expertise in acquiring the requisite knowledge and obtaining the necessary acquaintance However, their results demonstrated a diminishing variation

of audit quality between Big5 auditors and Non-Big5 auditors throughout the passage of time They attributed the leading role of the Big5 auditors to their auditing expertise in a new client and not to pure Big5 brand name effect

A study of the Malaysian market found the retention of a specific audit firm to be a function of the client’s size (measured by the total assets or the financial risk level) and the size of the audit firm A small distressed company, whose financial statements are audited by a small audit firm, was found to have a higher probability of switching the audit firm compared to a non-distressed big client whose financial statements are audited by a big audit firm In addition, the tenure before switching from a small to a big audit firm was significantly shorter than the tenure before switching from a small

to another small audit firm (Abu Thair, 2006)

The literature shows the big audit firms to be associated with superior financial reporting quality (Teoh and Wong, 1993) Researchers have suggested that the heavy spending of big audit firms on auditor training, besides their size and large portfolio

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of clients, create a distinctive advantage, whether as an actual competence of the auditor

or as a perceived independence by their clients Palmrose (1988) suggested that Big6 are

quality-differentiated suppliers, which lead to lower incidence of fraud in their case

Fraud was also identified to be less likely in the case of Big6 auditors by other

researchers (Carcello and Nagy, 2004)

While Becker et al (1998) recorded lower amounts of DAs in the case of Big5 auditors’

clients, Chih-Ying et al (2008) noticed an association between Big5 auditors’ clients and

the lower DAs they report when the accruals are negative Francis (1999) also found

firms who have a higher inclination to generate accruals, tend more towards hiring Big6

auditors They believed the selection of Big6 auditors to be consistent with the enhanced

credibility of their clients’ earnings Some researchers believe large audit firms have the

capacity to generate quality audits due to their greater monitoring ability (Watts and

Zimmerman, 1986) Others believe the enhanced audit quality big audit firms deliver is a

product of their brand-name quality differentiated audits (Simunic and Stein, 1987)

In Australia, investors and analysts perceive Big4 audit firms as providers of higher

quality (Azizkhani et al., 2007)

Several studies that dealt with US cases have enriched the literature with remarkable

evidence on the improved credibility of financial reports resulting from Big4 audits

(Dopuch and Simunic, 1982; Teoh and Wong, 1993; Khurana and Raman, 2004;

Mansi et al., 2004; Pittman and Fortin, 2004) We further pinpoint that, Dopuch and

Simunic (1982) correlated this to the greater observable quality characteristics Big4

possess; such as quality control and specialized training DeAngelo (1981b) believed

large audit firms have more brand capital to lose and, therefore, would be more

independent and able to supply the client with better audit quality Their large portfolio

of clients as well affords them a specific ability to resist or withstand clients’ pressure

Earlier discussion lays the foundation for raising the question of how confident can

we be that the well-known and recognized position of Big4 auditors is due to auditing

expertise and not an outcome of their brand name effect in Jordan? To find the answer

to this question, this study examines the effect of Big4 audit firms on the quality of

DAs in the Jordanian market Better quality DAs reported by Big4 clients would

provide evidence that Big4 have superior auditing expertise and their position is not

due to pure brand name effect:

H2 The size of the audit firm enhances the effect of the audit firm-client

relationship length on audit quality, as measured by DAs

Study design and methodology

The population of this study consists of all Jordanian companies listed for trading on

the ASE, both in the industry and service sectors during the years 2002-2006 The

Financial sector (comprised of banks, insurance companies and financial services

companies) is excluded for two reasons:

(1) Entities in this sector have different operating characteristics (Carcello and

Nagy, 2004), and as a result, possess risk and complexity properties that are

unique in nature and different from those of other sectors

(2) The unique characteristics of those entities make it impossible to compute the

control variable “Leverage: debt-to-asset ratio”, or makes computing the

variable of no meaning (as it will not provide much value) (Boone et al., 2008)

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Firms which do not comply with the sample criteria are deducted from the sample because of the potential noise and contaminating effect they might pose on the findings The following are the sample criteria and requirements:

. The firm’s shares should be listed for trading on the ASE during the years (2002-2006)

. The firm’s financial statements must be available for the years (2002-2006), to provide for the financial data needed to calculate the study variables

. The firm’s auditor and tenure should be determined from its guide

. The firm should not have undergone an extraordinary event, such as merger or acquisition, or other similar transactions that might result in reorganization of the firm’s business segments and as a consequence affect the entity and its financial statements

. The daily closing prices of each firm’s shares should be available for not less than

180 days/year This is necessary to calculate the firm’s market value of equity The above-mentioned criteria of the population and sample should be considered as a limitation of the study, that is, as a result of these criteria a limited number of firms will be relevant for the analysis To examine audit quality, two audit firm factors deemed to affect this quality as discussed throughout literature review will be investigated: the length of the audit firm-client relationship (audit firm tenure) and the size of the audit firm

Consistent with Johnson et al (2002), we measure audit firm tenure as the number

of consecutive years the audit firm has audited the client’s financial statements Meanwhile, we further count tenure years backward starting from 2006, and trace it until the year during which the client switched to another audit firm (Boone et al., 2008) This provides sufficient data since we use the Chi and Huang’s (2004) model

To determine the size of an audit firm, the market capitalization of all firms listed for trading on the ASE was calculated All sectors were covered and all auditors auditing firms listed for trading on the ASE during the period (2002-2006) were included as well Market values of ASE firms were traced to their corresponding auditors The mean of the market value of each auditor’s client was calculated and used as a proxy for the auditor’s size Therefore, the market share of each audit firm was determined and Big4 were identified The selection of Big4 and non-Big4 in particular coincides with the adoption of this scale globally

Following previous research, this study uses DAs as a proxy for audit quality because it is provides an indication of management’s active intervention in reporting earnings ( Johnson et al., 2002; Krishnan, 2003; Chi and Huang, 2004; Bae et al., 2007; Dang, 2004; Zhou and Elder, 2001) Johnson et al (2002) used the absolute level of DAs as

a proxy of the quality of financial reporting The other proxy they used is the persistence

of the accrual components of earnings Their use of the absolute level of DAs is pertinent

to the nature of their study and the existence of prior concerns regarding earnings management The researchers believe the magnitude of those DAs is an indicator of management’s success in managing earnings in either direction (upward or downward); contingent on the needs of the specific year (Reynolds and Francis, 2000)

In our study, we will not use absolute level of DAs because they were proven to generate misleading findings Companies receiving going-concern opinions were found

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to have large negative accruals (which are income-decreasing items) Those large

negative DAs might be a product of severe financial distress Some researchers believe

such findings are inconsistent with earnings management and auditor conservatism

explanations for the relationship between audit opinion and DAs (Butler et al., 2004)

The level of DAs for firms is calculated by using the cross-sectional Jones model and

the cross-sectional modified Jones model We start by estimating total accruals (TA)

using the cross-sectional Jones Model for both sectors Each sector encompasses a

minimum of 20 firms for the duration of the study (2002-2006):

TAit

Ait21¼ B1jt 1

Ait21

þ B2jt DREVit2 DARit

Ait21

þ B3jt PPEit

Ait21

þ 1it ðIÞ where:

TAit Total accruals for firm i in year t calculated as the difference between net

income before extraordinary items and cash flow from operations

(Becker et al., 1998)

Ait2 1 Total assets of the previous period, i.e at time t 2 1[1]

DREVit Revenue for firm i, in time t less revenues in time t 2 1

PPEit Gross property, plant, and equipment for firm i in year t

Then, we estimate non-DAs (NA) using the cross-sectional Jones model for each

industry group containing at least 20 firms in each year The industry-year-specific

parameter estimates from the above cross-sectional Jones model are used to estimate the

firm-specific NAitfor every year of the study NA are calculated as a percent of lagged

total assets using the cross-sectional modified Jones model:

NAit

Ait21¼ B1

1

Ait21

þ B2

DREVit2 DARit

Ait21

þ B3

PPEit

Ait21

ðIIÞ where:

DARit Accounts receivable in time t less accounts receivable in t 2 1

Other variables are as defined above

DAs are the resulting residual after deducting NA from TA Thus, (DAi,t) for firm i

in year t is calculated as:

DAit ¼TAit

Ait 212

NAi;t

We use the quadratic form approach due to the curvilinear relationship expected to exist

between the audit firm tenure and the quality of DAs (Chi and Huang, 2004) However,

the model will be modified further for the purpose of testing our own hypotheses

The model will incorporate the control variables: size, age, financial condition and

leverage Control variables are elaborated in a section specified for this purpose Cash

flows from operations scaled by lagged total assets[2]; are incorporated into our empirical

model since they have demonstrated an inverse variation with DAs (Dechow et al., 1999)

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The following model is used to test H1:

DAit ¼ b0þ b1TENUREitþ b2TENURE2itþ b3

OCFit

Ait 21

þ b4LAit

þ b5LEVitþ b6FCit þ b7AGEit þ 1it

ðIVÞ

where:

DAit ¼ the level of DAs for company i at time t

TENUREit ¼ the length of the audit firm-client relationship for company i at

time t calculated in years

TENURE2it ¼ the squared value of the variable TENURE

OCFit ¼ operating cash flows for company i at time t

LAit ¼ the natural logarithm of total assets for company i at time t LEVit ¼ the financial leverage ratio computed by scaling total liabilities to

total assets of company i at time t

FCit ¼ the Altman Z-score for company i at time t[3]

AGEit ¼ the number of years company i has been listed in a stock exchange

at time t

H2 will be tested only if the results of testing H1 support the hypothesized relationship between the audit firm tenure and audit quality

The following model is used to test H2:

DAit ¼ b0þ b1TENUREitþ b2TENURE2it þ b3

OCFit

Ait 21

þ b4LAit

þ b5LEVitþ b6FCitþ b7AGEitþ b8BIG4itþ 1it

ðVÞ

BIG4ita dummy variable equals 1 if the company employs one of the Big4 audit firms and 0 otherwise

Control variables

To eliminate alternative explanations that might arise whilst investigating the relationship between the variables, we control other cross-sectional factors that have been shown previously to contaminate the relationship because of their systematic effect on accruals Controlling those variables would mitigate their systematic effects and lend the findings greater reliability

Absolute levels of unexpected accruals might mask the true source of those accruals when they are large and negative in value As highlighted earlier, some companies with large negative accruals were found to receive going-concern opinions This is considered normal, given that large negative DAs might be a caution for financial distress (Butler et al., 2004) For this reason, we control for the client’s financial condition using the Altman Z-score, defined as the FC variable Another reason we control for the financial distress is that companies suffering a financial distress condition

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or near-debt constraints might be more motivated to manage earnings (Defond and

Jiambalvo, 1994)

We control for the client’s size using the natural log of total assets to eliminate the effect

of the firm size since large firms were proven to have larger and more stable accruals

(Dechow and Dichev, 2002) Prior research suggests that, there is more publicly available

information about larger companies and that their stock is more liquid (Brennan et al.,

1996; Gebhardt et al., 2001) The more the available information about a client and the more

liquid the stock is, the lower the perceived risk in the firm becomes (Boone et al., 2008) We

control for the client’s age using the control variable age to control the variation in the

firm’s accruals during the different stages of the firm’s life cycle (Anthony and Ramesh,

1992) In addition, older companies might be viewed as survivors and therefore perceived

as less risky (Boone et al., 2008) Collectively, age and size are controlled since large, more

mature companies, are expected to have more sophisticated financial-reporting systems

( Johnson et al., 2002) We control for the client’s leverage due to the notion that a higher

degree of financial leverage is expected to increase the perceived risk and increase the

client’s equity risk premium accordingly (Gebhardt et al., 2001)

Results and discussions

Sample statistics

Table I reports sample frequencies Firms from the industry sector constituted

approximately 67 percent of the sample, while 33 percent of the firms were from the service

sector In addition, 31 percent of firms in our sample engaged with their auditors for a

duration of 1-5 years, and 36.3 percent are engaged with their auditor for duration of

6-10 years The variation of firms’ tenure would help in carrying out the analysis of the

data and obtain a reliable conclusion about the relationship between the variables

Table II summarizes the descriptive statistics of industry and service sectors

collectively The maximum tenure for both sectors is 52 years, with an average of ten

years This could signal that some firms retained the same auditor since establishment,

or for very long engagements Average leverage is fairly low (< 0.28), which suggests

that the majority of firms assets were financed through equity rather than debt

Table I Frequencies (both sectors)

Table II Descriptive statistics (both sectors)

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The average age of firms in our sample is 21 years The mean of the market-to-book ratio (10.61), suggests an overvaluation of firms stocks by investors The average return on assets was 0.05 and the average total assets were 33 million Jordanian Dinars ( JDs) Descriptive statistics of the industry and service sectors are presented separately

in Tables III and IV consecutively

As evident in Table III, the average tenure for firms in the industry sector is approximately 11 years, while the average leverage is 0.28 The average age is 23 years and the ROA 0.04, the MB 7.43, and the total assets are 26 million JDs on average The scenario is somehow different for the service sector The average tenure for firms

in the service sector is approximately eight years However, the average leverage is 0.29, close to that of the industry sector Firms in the service sector seem to be on average, younger than firms in the industrial sector (the average age of firms in the service sector

is 17.6) Both ratios: the ROA (0.07) and the MB ratio (17.0) are higher as exhibited by the value of their means Investment in the service sector is heavier than that in the industry sector, as the average total assets (48 million JDs) suggests The differences between the statistics of the two sectors would improve the results of the study, that is, we have two sectors and for each we have one short-term and one long-term tenure The differences in tenure would open the way for observing the differences in the results of the study and for taking all possibilities in the relationship between tenure and audit quality

Hypotheses testing

We run a cross-sectional linear regression on the variables of the equation used for measuring the level of DAs in the specific hypothesis subject for testing The length

of the auditor-client relationship is defined by the number of successive years

Table IV.

Descriptive statistics

(service sector)

Table III.

Descriptive statistics

(industry sector)

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