nasser et al - 2006 - auditor‐client relationship- the case of audit tenure and auditor switching in malaysia

Findings – An examination of 297 companies listed on the Kuala Lumpur Stock Exchange over a period of 11 years reveals audit firm switching to be significantly associated with distressed

Managerial Auditing Journal

Auditor-client relationship: the case of audit tenure and auditor switching in Malaysia

Abu Thahir Abdul Nasser Emelin Abdul Wahid Sharifah Nazatul Faiza Syed Mustapha Nazri Mohammad Hudaib

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Abu Thahir Abdul Nasser Emelin Abdul Wahid Sharifah Nazatul Faiza Syed Mustapha Nazri Mohammad Hudaib, (2006),"Auditor-client relationship: the case of audit tenure and auditor switching in Malaysia", Managerial Auditing Journal, Vol 21 Iss 7 pp 724 - 737

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Auditor-client relationship: the case of audit tenure and auditor

switching in Malaysia

Abu Thahir Abdul Nasser and Emelin Abdul Wahid Faculty of Accountancy, University Technology Mara, Johor, Malaysia

Sharifah Nazatul Faiza Syed Mustapha Nazri Faculty of Accountancy, University Technology Mara, Selangor, Malaysia, and

Mohammad Hudaib Department of Accounting and Finance, Bradford University School of

Management, Bradford, UK

Abstract Purpose – The main purpose of this paper is to examine one aspect of auditor-client relationship, namely audit tenure and switching behaviour, and factors affecting it Lengthy audit tenure with the same client has been cited as one of the threats to auditor independence Given the importance of this issue, this research attempts to shed some light on the effect of audit tenure and switching behaviour

on auditor independence in Malaysia.

Design/methodology/approach – This study evaluates the effects of various independent variables on switching behaviour and audit tenure using logistic regression analysis.

Findings – An examination of 297 companies listed on the Kuala Lumpur Stock Exchange over a period of 11 years reveals audit firm switching to be significantly associated with distressed large clients and that the length and direction of switch depend upon the type of audit firm.

Research limitations/implications – A number of important variables such as corporate governance characteristics, audit and non-audit fees and types of audit opinion that could enhance our understanding of audit tenure and auditor switching in Malaysia, were not incorporated into our regression models Hence, future studies may consider such variables.

Originality/value – This study is the first conducted using Malaysian data where audit tenure and switching are used as dependent variables The results have important implications on the auditing profession and regulators in Malaysia.

Keywords Auditors, Auditing, Customer relations, Malaysia Paper type Research paper

1 Introduction Auditor independence is the cornerstone of the auditing profession In general, auditor independence can be of two forms: “independence in fact” and “independence in appearance” The former requires auditors to form and express an opinion in the audit report as a disinterested and expert observer, uninfluenced by personal bias, while the latter expects auditors to avoid situations that might cause others to conclude that they are not maintaining an unbiased objective attitude of mind (Porter et al., 2003)

www.emeraldinsight.com/0268-6902.htm

The authors acknowledge the research funding from IRDC of University Teknologi Mara, Malaysia in conducting this research

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Managerial Auditing Journal

Vol 21 No 7, 2006

pp 724-737

q Emerald Group Publishing Limited

0268-6902

Flint (1988) argued that independence will be lost if the auditor is involved in a

personal relationship with the client, as this may influence their mental attitude and

opinion One of such threats is lengthy tenure He contends that lengthy tenure in office

may cause the auditors to develop “over-cosy relationships” as well as strong loyalty or

emotional relationships with their clients, which could reach a stage where auditor

independence is threatened Lengthy tenure also results in “over familiarity” and

consequently, the quality and competence of auditors’ work may decline when they start

to make unjustified assumptions instead of objective evaluation of current evidence

The GPES 1.201 (para 2.5) of the ICAEW (2001) recognised that this problem may

be perceived as a threat to auditor independence and recommends that auditors avoid

situations that may lead them to become over-influenced or to be too trusting of the

client’s directors and key personnel which could consequently lead to audit staff being

too sympathetic to the client interest Since, the relationship between the auditor and

his client can be close in one way or another regardless of the number of years in office,

there is little the profession can do with regard to this matter (Dunn, 1996) In other

words, the profession does not object to auditors serving their clients for a long period

of time, but the objection seems to be over the worry that long period of service may

lead to “cosy relationships” that may threaten auditor independence

Hence, to maintain public confidence in the audit function and to protect auditors’

objectivity, the profession through a series of clauses proscribes auditors from having

personal relationships with their clients that may give rise to a potential conflict of

interests One of the proposals is to have mandatory auditor rotation (AICPA, 1978a, b)

as it may increase auditors’ ability in protecting the public via the increase in alertness

to any possible improprieties, increase in quality service and prevent closer

relationship with client (Mautz, 1974; Winters, 1976; Hoyle, 1978; Brody and Moscove,

1998) However, some are against the idea because they believe that the costs outweigh

the benefits Frequent rotation and switching would result in increased audit fees as

the benefits to be gained from subsequent lower cost after the initial years of any audit

would not be fully realised Another disadvantage is that the knowledge gained over

time in improving quality of audit work would be wasted with the appointment of a

new auditor (AICPA, 1992) Nevertheless, in 1994, the professional bodies in the UK

introduced a seven year rotation policy for the audit engagement partners auditing

public listed companies (Porter et al., 2003) A similar rotation policy was also

introduced for audit engagement partners involved in auditing SEC registered

companies (Wood and Sommer, 1985; Brody and Moscove, 1998)

In Malaysia, the issue of audit tenure and interval rotation of audit firms or audit

partners were not explicitly addressed in any of the relevant Malaysian official

documents such as the Companies Act 1965, the Security Commission regulations,

approved auditing standards, etc Lack of official pronouncements on this issue could

be due to the rejection of such rotation idea by the business community Jaffar and

Alias (2002) found only 35 per cent of the audit firms’ partners and only 32.4 per cent of

the chief finance officers surveyed favoured audit firm rotation every three years of

engagement However, in light of the Enron case, the Chairman of the Malaysian

Accounting Standard Board announced the intention of the board to make it

mandatory to rotate the audit firm once every five years (The Edge, 2002) While some

countries are either considering or have already imposed the five-year restriction to

rotate the audit firms, the length of audit tenure and the possible effect of switching on

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auditor independence in Malaysia is still unclear Hence, the results would highlight if audit tenure and switching should be of concerned before any rotation length is imposed This is our main contribution to the literature

Our analysis involves an examination of 297 Malaysian listed companies between

1990 and 2000 using logistic regression Results indicate the probability of switching the audit firm is greatest for distressed large client and that the direction of switch and length of tenure are dependent on type of audit firm This implies that auditors in such environment fear losing their tenure and being switched, hence their independence and objectivity may be impaired As such, we assert that rotation policy should be partially imposed on distressed clients as a first step forward in protecting auditor independence

in the country The paper proceeds as follows The next section discusses the literature review and the development of the hypotheses Sections 3 and 4 present the research method and results, respectively Section 5 presents the summary and conclusions

2 Literature review and development of hypotheses

It has been suggested in the literature that larger audit firms (Big 4) are usually perceived as more capable of maintaining an adequate degree of independence than their smaller counterparts because they usually provide a range of services to a large number of clients, hence reducing their dependence on certain clients (Dopuch, 1984; Wilson and Grimlund, 1990) In addition, larger audit firms are generally perceived as the provider of high audit quality and enjoy a high reputation in the business environment and as such, would strive to maintain their independence to keep up their image (DeAngelo, 1981; Dopuch, 1984; Wilson and Grimlund, 1990) Furthermore, larger audit firms are also perceived to be more independent than their smaller counterparts in withstanding management’s pressure in the event of disputes as they normally have more clients and can afford to give up some of their more “difficult” clients (Chow and Rice, 1982)

In Malaysia, high dependence on a few clients has been found to affect perception of independence (Teoh and Lim, 1996) This is not surprising as the market for audit services for public companies in Malaysia is dominated by the international Big 4 (previously the Big 6) audit firms In fact, Che-Ahmad and Derashid (1996) report that the Big 6 (and their affiliates) audited 75.9 per cent of the Bursa Malaysia (Main Board) listed companies in 1991 Based on the above arguments, we expect the length of tenure

by Big 4 audit firms to be significantly longer as their clients would be less likely to switch them compared to their smaller counterparts Hence, the H1 is stated as follows: H1 The probability of switching big audit firms (Big 4) is significantly lower than the probability of switching smaller audit firms, ceteris paribus

Besides the possible effect of the type of audit firms on the length of tenure, the choice

of audit firm can be related to the size of the auditee and the type of services needed

It has been argued that larger auditees, due to the complexity of their operations and the increase in the separation between management and ownership, demand highly independent audit firm to reduce agency costs (Watts and Zimmerman, 1986) and auditors’ self-interest threat (Hudaib and Cooke, 2005) Furthermore, as the size of the companies increases, it is likely that the number of agency conflicts also increases and this might increase the demand for quality-differentiated auditors (Palmrose, 1984), i.e Big 4 audit firms

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Based on the above arguments, we expect the length of tenure of auditors of large

clients to be longer than that of auditors of smaller clients in Malaysia In other words,

we expect the propensity to switch auditors to be lower for large clients than their

smaller counterparts This leads us to the following hypothesis:

H2 The probability of large clients switching audit firms is significantly lower

than the probability of small clients switching audit firms, ceteris paribus

When businesses continue to grow, the demand for the highly independent and

qualified audit firm to reduce agency costs and to provide non-audit services needed

for the expansion of the firm increases Therefore, growing businesses are expected to

be more likely to retain their audit firms than their lower growth counterparts Sinason

et al (2001) examined 16,976 COMPUSTAT companies in the US over a period of

20 years and found that audit tenure is significantly affected by client’s growth rate

Since, the literature indicates that audit tenure is affected by the client’s growth rate,

we hypothesised the length of tenure of auditors of high growth clients in Malaysia to

be longer than low growth clients In other words, high growth clients are less likely

to switch their auditors As such, our next hypothesis is:

H3 The probability of high growth clients switching audit firms is significantly

lower than the probability of low growth clients switching audit firms, ceteris paribus

The financial position of auditees may have important implications on decisions in

retaining the audit firm Auditees who are insolvent (have high gearing ratios) and are

experiencing an unhealthy financial position are more likely to engage auditors having

high independence to boost the confidence of shareholders and creditors as well as to

reduce the risk of litigation (Francis and Wilson, 1988) In addition, financially stressed

clients are more likely to replace their audit firms compared to their healthier

counterparts (Schwartz and Menon, 1985; Hudaib and Cooke, 2005)

As such, we expect auditors of distressed clients to have shorter tenure compared to

their counterparts auditing healthier clients and will in turn be less likely to be

switched The next hypothesis is stated as follows:

H4 The probability of distressed clients switching audit firms is significantly

higher than the probability of healthier clients switching audit firms, ceteris paribus

Sinason et al (2001) found the length of audit tenure to be positively affected by the

type of audit firm In other words, smaller audit firms experience shorter tenure

compared to their larger counterparts who often enjoy lengthy tenure Differences in

the length of tenure between the two types of audit firms could impair independence

because in the long run, small audit firms will find it difficult to keep their existing

clients and at the same time maintain a high degree of independence and objectivity

due to increased competition and size mismatch Ideally, the size of audit firm should

match the size of auditee A size mismatch between large auditees audited by small

audit firms could cause termination of the audit engagement (Hudaib and Cooke, 2005),

i.e a switch of auditor

Since, there are four possibilities of switching auditors, viz switch from non-Big 4 to

non-Big 4, from non-Big 4 to Big 4, from Big 4 to non-Big 4 and from Big 4 to Big 4,

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727

we expect the lengths of tenure for the four types of switches to be significantly different Specifically, we hypothesise that:

H5 The length of audit tenure for non-Big 4 replaced by Big 4 (m2) is significantly shorter than the length of audit tenure for non-Big 4 replaced by another non-Big 4 (m1) Hence,m1–m2–m3–m4

where,m1, switched from non-Big 4 to non-Big 4;m2, switched from non-Big 4 to Big 4;

m3, switched from Big 4 to non-Big 4;m4, switched from Big 4 to Big 4

3 Research method 3.1 Data sources There were 810 listed companies on both the main and second board of the Kuala Lumpur Stock Exchange (KLSE) or Bursa Malaysia as at 10 June 2002 The sample of this study consists of 297 randomly selected companies listed on both boards Based on the sample error formula (Burns and Bush, 2003), a sample size of 297 is deemed appropriate The relevant data had been collected from KLSE Research Institute Database for a period of 11 years from 1990 to 2000 Besides the relevant financial statements, the relevant audit reports of the sample firms available at KLSE were also used in this research

The dependent variables are auditor switching (SWITCHt) and the four directions of switch (mxt) which are noted from the audit reports during the study period The independent variables consist of book value of equity (BVE) and market value of equity (MVE), client size (CLI.SIZE), changes in total assets (Ln DTA), changes in sales (Ln DS), type of audit firm (AUDIT), changes in income from continuing operations in the two years preceding the audit change (Ln DRt2 2), financial distress of the client company (Ln DZ),[1] interactive effects of length of tenure held by Big 4 and non-Big 4 before being switched (TENU*AUDITxt) and the interactive effects of length of tenure before the first switch (TENU*B1.SWI)

3.2 Data analysis Logistic regression was adopted to assess the relationships since the dependent variables are dichotomous The model parameters are estimated using the maximum-likelihood method whereby the coefficients that make the observed results most “likely” are selected

on the basis of an iterative algorithm Furthermore, the maximum-likelihood method has also the advantage of asymptotic normality (Hudaib and Cooke, 2005) Model 1 has the dependent variable as switching/non-switching (SWITCHt) and Model 2, direction of switching/otherwise (mxt) Model 1 provides answers to the research hypotheses associated with audit tenure and switching while Model 2 investigates the impact of independent variables on the directions of auditor switching

3.3 Model specification 3.3.1 Model 1 We use the following logistic regression model to test for the relationships between auditor switching (SWITCHt) and type of audit firm (AUDIT), client size (CLI.SIZE), client growth (Ln DS), client financial risk (Ln Z), the interactive effects of length of tenure of remaining in the office before being switched (TENU*AUDITxt), the change in operating income (Ln DRt2 2), change in market value

of equity (Ln DMVE) as well as change in total assets (Ln DTA):

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SWITCHt¼a0þb1AUDIT þb2CLI:SIZE þb3Ln DS þb4Ln Z þ

X2 i¼1

dixtTENU*AUDITxtþb7Ln DRt22þb8Ln DMVE þb9Ln DTA þ 1

SWITCHtis a binary variable indicating whether or not the audit firm was switched or

not switched The other independent variables are as summarised in Table I

3.3.2 Model 2 To further explain the impact of independent variables on the

switched directions of audit firms (mxt), the following logistic regression model was

adopted to test the association between auditor switching from one type of audit firm

to another and the nine independent variables, viz type of audit firm (AUDIT), client

size (CLI.SIZE), client growth (Ln DS), financial risk (Ln Z), change in operating income

(Ln DRt2 2), change in market value of equity (Ln DMVE), the change in total assets

(Ln DTA), the interactive effects of length of tenure before the first switching

(TENU*B1.SWI) and the interactive effects of length of tenure of a large audit firm

(Big 4) remaining in the office before being switched (TENU*AUDITB4):

a 0 Intercept

SWITCH A dummy variable, 1 if the audit firm is switched at time t , and 0 otherwise

m xt Four propositions of switch directions

1 m 1 ¼ from non-Big 4 to non-Big 4

2 m 2 ¼ from non-Big 4 to Big 4

3 m3 ¼ from Big 4 to non-Big 4

4 m 4 ¼ from Big 4 to Big 4 AUDIT A dummy variable, 1 if the firm is a Big4 audit firm, and 0 otherwise

CLI.SIZE A dummy variable, 1 if the client’s TA is large (ln TA the mean), and

0 otherwise

Ln DS The natural logarithm of squared changes in sales scaled by ln TA

½lnððDS=ln TAÞ 2 Þ
;

Ln Z The natural logarithm of company’s financial risk: cash flow from operations

over long-term debt [ln(Z)2]

SQ ln BVE The square root of natural logarithm of BVE ½ ffiffiffi

2

lnðBEÞ2 p

;

ln TA The natural logarithm of the client’s assets [ln TA]

Ln DTA The natural logarithm of squared changes in of total assets ½lnðDTAÞ2
;

ln MVE MVE [ln MVE]

Ln DMVE The natural logarithm of squared changes in MVE ½lnðDMVEÞ 2
;

LnDR t2 2 The natural logarithm of squared changes in operating income two years

(yeart2 2) before switching in yeart2 0½lnðDR t22 Þ 2
;

TOT.TENU Total length of tenure (years) for the period

TENU*B1.SWI The interactive effects of length of tenure before the first switch, company j is

coded 1 up to 11 depending of the length of tenure before the first switch in period tx

TENU*AUDIT xt Two propositions of the interactive effects of tenure length before switching

1 TENU.AUDIT B4 ¼ number of years the incumbent Big4 held office before being replaced divided by TOT.TENU

2 TENU.AUDIT nB4 ¼ number of years the incumbent non-Big4 held office before being replaced divided by TOT.TENU

1 Error term

Table I Variables in the logistic regression models

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729

mt ¼a0þb1AUDIT þb2CLI:SIZE þb3LnDS þb4Ln Z þb5Ln DRt22

þb6Ln DMVEb7Ln DTA þb8TENU*B1:SWI þb9TENU*AUDITB4þ 1 The model is run four times to cover all switch directions taken by clients to appoint their new audit firms after terminating the services of their incumbent audit firms

4 Empirical results 4.1 Descriptive statistics Table II (Panel A) presents descriptive statistics for the experimental, control and dependent variables The mean size of clients is RM 1.5 billion The negative signs in

Minimum Maximum Sum Mean SD Panel A (Continuous)

TA 35,251 51,453,100,000 1546788049.45 4855264576.1

Ln DTA 2 15.2018 1.1077 2 5.106514 2.6

BE 2 1,882,020,548 14,518,600,000 449149349.93 1182242201.7

MVE 350 17,432,850 404402.64 1614674.7

Ln DMVE 2 9.6318 12.9503 2 0.753392 2.1

Ln DS 2 13.6249 9.5961 2 3.629986 3.3

Ln DR t2 2 2 18.4207 10.1909 2 1.388829 3.2 Risk (Z) 2 0.0300 1835.8700 24.510732 172.1

Ln Z 2 20.8286 15.0305 2 0.525179 4.2

TENU*AUDIT B4 0.00 1.00 0.5576 0.46640 TENU*AUDIT nB4 0.00 1.00 0.4424 0.46640 Panel B (Dichotomous)

Notes: n – 297; TA – total assets; ln TA – the natural logarithm of total assets; Ln DTA – the natural logarithm of squared changes in total assets; SQ ln BVE – the square root of natural logarithm

of BVE; Ln DMVE – the natural logarithm of squared changes in MVE; LnDS – the natural logarithm

of squared changes in sales scaled by ln TA; Ln DR t2 2 – the natural logarithm of squared changes in operating income; Ln Z – the natural logarithm of company’s financial risk; TENU*B1.SWI – the interactive effects of length of tenure before the first switching; TENU*AUDIT B4 – the interactive effect of years in office by Big4 before switching over total tenure period; TENU*AUDIT nB4 – the interactive effects of years in office by non-Big4 before switching over total tenure period; CLI.SIZE – a dummy variable, 1 if the client’s TA is large, and 0 otherwise; AUDIT – a dummy variable, 1 if the firm is a Big4 audit firm, and 0 otherwise; SWITCH – a dummy variable, 1 if the audit firm is switched, and 0 otherwise; TOT.TENU – total length of tenure (years) for the period; m1– switched from non-Big4 to non-Big4; m2 – switched from non-Big4 to Big4; m3 – switched from Big4 to non-Big4; m 4 – switched from Big4 to Big4

Table II.

Descriptive statistics

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the mean values indicate poor financial performance during the period of analysis.

Table II (Panel B) reports the descriptive statistics of the dichotomous variables It can

be seen from the table that the sample consisted of 43 per cent (129) large companies,

60 per cent (175) Big 4 and 29 per cent (87) cases of audit termination (switching) It also

shows that switching from small to large audit firm (i.e from non-Big 4 to Big 4) is the

most common type of auditor change (36 cases), followed by switching from small

audit firm to small audit firm (23 cases) and switching from large audit firm to large

audit firm (19 cases) Not surprising, the least common type of auditor switch is from

large audit firm to small audit firm (9 cases)

Table III presents the correlation matrix for the dependent and continuous independent

variables It indicates no multicollinearity problem, as the correlations are relatively

low except the correlation between two independent variables: type of audit firm (AUDIT)

and (TENU*AUDITxt– the tenure length of Big 4 and non-Big 4) Therefore, AUDIT and

TENU*AUDITnB4are dropped when we run our regression models

4.2 Results of the logistic regressions

4.2.1 Model 1 Model 1 tests which independent variables (viz client size, client growth,

client financial risk, the length tenure in the office before being switched, the changes

in operating income, market value of equity as well as the changes in total assets)

explain the behaviour of ending audit firm tenure in office (i.e audit switching) The

results are shown in Table IV Client size, client financial risk, the changes in total

assets and the interactive effects of the length of tenure in office before switching large

audit firm (TENU*AUDITB4), were found to be significantly associated with audit

switching while client growth, changes in operating income and market value of equity

were found not to be significant The results indicate that the main factors for

switching audit firm are the increase in total assets and the financial risk of the

company The highest log odds of CLI.SIZE [Exp(B) ¼ 1.76] indicates that client size is

the most important factor followed by financial risk in explaining switching and as

such H2 and H4 are accepted However, the growth of company’s business, the

increase in operating income and increase in market value do not affect the length of

tenure of the audit firm, thus allowing us to reject H3 The fact that the length of tenure

of large audit firms (Big 4) is negatively associated with switching suggests that larger

audit firms experience fewer instances of being replaced compared to their smaller

counterparts who face shorter tenure as they tend to be replaced more often and as

such, H1 is accepted

4.2.2 Model 2 Table V shows the results of testing Model 2, i.e the impact of

various independent variables on the four switching directions (mxt) As indicated by

the results, the only factor that significantly impacts switching behaviour is the

interactive effects of length of tenure before the first switch (TENU*B1.SWI), followed

by changes in total assets of the client (Ln DTA)

Table VI (Panel A) provides details on the pattern of switching behaviour As can be

seen, switching for similar sized audit firms, i.e switching from a small audit firm to

another or from a large audit firm to another, often occurs after lengthy tenure

However, switching to dissimilar sized audit firms, i.e switching from a small to a

large audit firm or from a large to a small audit firm, occurs in a relatively shorter

period This suggests that the propensity to switch to a large audit firm is greater for

clients experiencing an increase in total assets

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731

Variable m 1 m 2 m 3 m 4 SQ ln BVE SWITCH 0.45 * * 0.58 * * 0.27 * * 0.41 * * 0.14 *

Ln DTA

Ln DMVE

Ln DS

Ln DR t2 2

Ln Z AUDIT TOT.TENU TENU*B1.SWI TENU*AUDIT B4

Variable Ln DTA Ln DMVE Ln DS Ln DR t2 2 Ln Z

m 2 0.04 2 0.09 0.12 * 2 0.00 0.05

m 3 0.09 2 0.03 0.04 0.15 * * 2 0.02

SQ ln BVE 2 0.07 2 0.07 2 0.07 2 0.04 2 0.07

Ln DTA 1 2 0.02 0.21 * * 0.03 0.02

AUDIT TOT.TENU TENU*B1.SWI TENU*AUDIT B4

Variable AUDIT TOT.TENU TENU*B1.SWI TENU*AUDIT B4 TENU*AUDIT nB4

SWITCH 0.02 0.31 * * 0.05 2 0.09 0.09

m 1 2 0.35* * 0.10 0.16 * * 2 0.35* * 0.35 * *

m 2 0.27 * * 0.19 * * 2 0.15* * 2 0.03 0.03

m 3 2 0.21* * 0.13* 2 0.05 0.00 2 0.00

m 4 0.22 * * 0.11 0.16 * * 0.25 * * 2 0.25 * *

SQ ln BVE 0.05 0.33 * * 0.29 * * 0.08 2 0.08

Ln DMVE 2 0.06 2 0.07 2 0.05 2 0.06 0.06

Ln DR t2 2 0.01 0.08 0.05 0.02 2 0.02

Ln Z 2 0.06 2 0.06 2 0.06 2 0.09 0.09 AUDIT 1 0.08 0.05 0.90 * * 2 0.90* *

Notes: * * Correlation is significant at the 0.01 level two-tailed; * correlation is significant at the 0.05 level two-tailed

Table III.

Correlation matrix

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