DRAWINNG INFERENCES REGARDING AUDIT QUALITY IN A CODE-LAW COUNTRY: AN EMPIRICAL INVESTIGATION

Abstract

This paper explores empirically several inferences regarding audit quality as follows: auditor competence and independence, auditor rotation, regulatory regimes, audit failures, firm characteristics, audit and non-audit fees, earnings management. Using as a research instrument the questionnaire, several Romanian auditors were surveyed. The results documented were twofold. First, among the factors assessed four were documented as having the potential to impact audit quality (i.e. audit and non-audit fees, competence and independence of auditors, auditor rotation). Second, several factors were enumerated as having the potential to enhance the audit quality in the view of Romanian auditors, as follows: senior professionals and executive involvement, stricter regulatory regimes, industry and firm expertise, auditor skeptical attitude. The size of the sample used is considered to be an important limitation. Further potential research is also approached.

Headnote

Abstract

This paper explores empirically several inferences regarding audit quality as follows: auditor competence and independence, auditor rotation, regulatory regimes, audit failures, firm characteristics, audit and non-audit fees, earnings management. Using as a research instrument the questionnaire, several Romanian auditors were surveyed. The results documented were twofold. First, among the factors assessed four were documented as having the potential to impact audit quality (i.e. audit and non-audit fees, competence and independence of auditors, auditor rotation). Second, several factors were enumerated as having the potential to enhance the audit quality in the view of Romanian auditors, as follows: senior professionals and executive involvement, stricter regulatory regimes, industry and firm expertise, auditor skeptical attitude. The size of the sample used is considered to be an important limitation. Further potential research is also approached.

Keywords: audit quality, auditor competence, independence, auditor rotation, senior professionals, earnings management

JEL Classification: M42, M41.

1. Introduction

Assessed in the literature as a nebulous concept (Francis, 2004), and being a sociall y construct by nature, it is impossible to reach a common understand of what audit quality is in practice (Eilifsen & Willekens, 2007). A potential explanation for the above is the fact that audit quality is not directly observable and thus is at least difficult to measure it empirically. Similar to the process of detecting earnings management practices, audit quality is measured in practice using various proxies, leading easily to problems of measurement and interpretation.

On the other hand, a common understanding in the academia is in regard of the significant commitment to institutionalize more independent standard setting and oversight process with the goal of strengthening audit quality (Humphrey et al., 2007). Also, other common underrating in regard of audit quality is related to the notion of adding value (Peecher et al., 2007) and improving impressions of the profession (Zeff, 2003; Humphrey et al., 2007; Sikka, 2009).

Known as an important tool used in order to reduce information asymmetry (Watts & Zimmerman; Beatty, 1989; Willenborg, 1999), audit quality has the potential to mitigate agency problems between managers and stakeholders (Jensen & Meckling, 1976).

Even if it is difficult to measure it or to assess its level, high audit quality is desirable. Consistent to prior research, high quality audit is linked with a higher probability to detect accounting irregularities (Watts & Zimmerman, 1986; DeAngelo, 1981a; Raynolds & Francis, 2001) or to limit discretion over accrual choice for client firms (Frankel et al., 2002).

This paper comprises an up to date topic, its relevance and importance can be found in the light of the recent global financial crisis and the collapse of large financial institutions. Also, in the light of previous audit scandals, the quality of auditing is important to be assessed. While scholars worldwide documents in the recent years the increasing of managerial opportunism (Easley & ÒHara, 2004), used in order to avoid debt covenants or increase material compensation, audit quality is seen like a tool that can mitigate all those problems. Regarded as a potential instrument that can limit not optimal or suboptimal decisions used to harm the company in a long run, the quality of auditing can be the key to solving important problems associated with the desire of managers to increase their own benefits.

Despite considerable research conducted so far on audit quality at international level, studies on audit quality in code-law countries are scarce. One potential explanation can be found in the relatively low number of audit failures publicly available in those countries.

In this respect, this empirical study seeks to explore not only inferences regarding audit quality per se, but whether the audit quality in code-law countries is affected by similar inferences as it is in common-law countries, where most of the studies found in the literature are conducted. Since the quality of reported financial numbers and the legal protection of property rights are significantly lower in emerging countries compared to more developed countries (Ball et al., 2003; Leuz et al., 2003), stocks in those countries are more likely to carry a higher information risk. In this respect, the accounting information is less decision-useful. In the view of the above, it is the job of the auditors to ensure a high quality accounting information, the latter being strongly connected to a high audit quality.

The remainder of the paper is as follows: the second segment comprises the research methodology followed by the state of the art segment. The findings and discussions segment follows next, while the paper ends with the conclusions, limits of the paper of scope for future research.

2. Methodology

This segment of the paper comprises explanation regarding the methodology employed. In this respect, a survey was conducted, using Romanian auditors as respondents. The use of the questionnaire was motivated by the wording of Beattie & Fearnley (1998:264), who asserted that the use of this research instrument provides richer insights than is possible using secondary data anal ysis, focusing in the same time on economic and behavioral factors.

Out of 50 questionnaires submitted, 19 were returned, of which 17 were useful for the analysis, given a 34% response rate. All the respondents are Romanian auditors, having the age between 36 and 53 years, with an average of 8 years as working experience. The sample used was randomized. The period of submission was 13 August 2013-13 September 2013. Participation was voluntary, so no name of the auditors can be disclosed since this demarche was not authorized by the respondents. All data was gathered using a questionnaire submission as it was asserted earlier, using an internet platform specialized in those demarches (i.e. www.surveymonkey.com).

All the respondents held graduate degrees of qualifications with respect to accounting. Hence, the information gathered ought to be reliable and can be generalized to the whole population, despite the very small number of respondents assessed.

The questionnaire comprised three segments as follows: first segment was used in order to gather general data regarding the respondents (i.e. age, length of experience, qualifications); the second segment asks a number of questions found in the accounting and audit literature in order to assess the impact of several inferences on audit quality (all questions are presented in Table 1, inserted below); segment three asks respondents to state their perception on the factors that can contribute to the enhancement of audit quality (with no examples being provided).

No extra commentary space was given in the restricted form questionnaire used.

Being interested in assessing the inferences that can impact the audit quality in a code-law country comparing to common-law country, but also to gather data regarding the factors that can enhance audit quality, eight research questions were developed as follows:

H1: Is audit quality in Romania susceptible to inferences as auditor competence and independence?

H2: Is audit quality in Romania susceptible to inferences as auditor rotation?

H3: Is audit quality in Romania susceptible to inferences as regulatory regimes and the incentives they create?

H4: Is audit quality in Romania susceptible to inferences as audit failures?

H5: Is audit quality in Romania susceptible to inferences as firm characteristics? H6: Is audit quality in Romania susceptible to inferences as audit and non-audit fees?

H7: Is audit quality in Romania susceptible to inferences as earnings management?

H8: Which are the factors contributing to the enhancement of audit quality in Romania?

3. State of the art

This segment comprises a short state of the art for audit quality, as it is assessed in the literature. This review is not meant to be neither encyclopedic, neither comprehensive, moreover being very selective with the goal of identifying and analyzing some evidence on audit quality.

Defined as the ability of the auditor to detect accounting misstatements and to report it (DeAngelo, 1981b), audit quality is strongly connected to the degree of auditor independence. A similar definition was developed by Davidson & Neu (1993), who asserted that audit quality is the ability of the auditors to detect and eliminate both material misstatements and manipulations in the net income reported. Other definition is developed by Titman & Trueman (1986) and connects high audit quality to precise information regarding the firm`s value. Palmrose (1988) defines audit quality as the probability that a financial statement contains no material misstatements.

According to the literature, audit quality is mostly assessed in terms of output measures in common-law countries.

Very few studies are assessing the audit quality in code-law countries (Iatridis, 2012). Knowing the differences between common-law countries and code-law countries, this study seeks to identify whether the same inferences impact audit quality in code-law countries as in common-law countries. In this respect, Romania was chosen as a code-law country, the respondents comprised in this study being Romanian auditors.

In regard of common-law countries, Ball et al. (2000) asserted that those countries are characterized by active stock markets, professional investors, strong investor protection, strong corporate governance mechanisms, high litigation risks and shareholder oriented. On the other side, code-law countries are characterized b y less active stock markets, weak investor protection, weak corporate governance mechanisms, lender-oriented, less public disclosure, lower litigation risks. Both Coppens & Peek (2005) and Daske et al. (2006) documented that code-law countries are characterized by a higher rate of earnings management comparing to common-law countries. The latter are known as less earnings management practices found, and higher audit quality, assessed by a large variety of measures.

In this respect various measures are taken into account when assessing the audit quality in common-law countries, several of them being the most cited, as: auditor competence and independence (Watkins et al., 2004); auditor rotation (Davis et al., 2003); enforcement actions by regulatory bodies (Palmrose, 2000); audit failures (Francis & Krishnan, 2002); firm characteristics (Beattie & Fearnley, 1995; Bierstaker & Wright, 2001); audit fees (Higgs & Skantz, 2006; Dart, 2011); non-audit fees (Frankel et al., 2002); audit committees (Carcello & Neal, 2000); earnings management (Ashbaugh et al., 2003; Iatridis, 2012).

Auditor competence and independence is directly connected to audit quality (Watkins et al., 2004), similar empirical evidence being found also for the accuracy of the auditor judgment (Knechel & Vanstraele, 2007). Regarded as an important prerequisite for audit quality (DeAngelo, 1981a), auditor independence is extremely important in any audit process, otherwise, when dealing with the lack of it, clients may be exerting influence over the results of their audit.

Auditor rotation seems to have an impact upon the audit quality. This assertion is supported by extensive evidence. In this respect various empirical studies documented that audit quality decreases as lenght of tenure increases (Myers et al., 2003; Davis et al., 2003).

Audit quality is affected by legal regimes and the incentives they create. Enforcement actions by regulatory bodies, part of countries legal systems, affects auditor behavior, since auditors must meet to legally conditions in order to satisfy their statutory audit responsibilities.

An audit failure occurs in two cases: when the auditor does not employ the generally accepted principles and when the auditor fails to issue a modified of qualified audit report in the appropriate circumstances. In this case, the audit quality is indirectly associated with the audit failure, in this regard, the higher the failure rate is the lower the audit quality is.

When it comes to audit fees and audit quality, it is known that a higher audit fee implies higher audit quality (Dart, 2011) since more effort is comprised (i.e. more hours) or a greater expertise of the auditor. Firm and team characteristics are also assessed in the literature and are found to impact the audit quality. In this respect firm size is considered a proxy for audit quality (DeAngelo, 1981b; DeFond & Jiambalvo, 1994). Various authors documented that big audit companies report with greater accuracy (Lennox, 1999; Nelson et al., 2002; Lai, 2009). When it comes to non-audit fees, various empirical studies documented for companies which pay their auditors relatively more non-audit fees have larger abnormal accruals and more likely to meet analysts' forecasts (Frankel et al., 2002). In both cases this suggests lower audit quality and also lower earnings quality.

Empirical research has linked the audit committees with audit quality. In this regard, audit quality is higher when audit committees are more independent (i.e. more outside directors) (Carcello & Neal, 2000; 2003).

Earnings management is a proxy used to assess the quality of audit. In this respect various scholars has sought to link audit quality to earnings management (Becker et al., 1998; Francis et al., 1999; Ashbaugh et al., 2003; Iatridis, 2012), documenting an inverse relationship.

All the above measures are found accurate in measuring audit quality, but not without important associated errors, conducting to the general view that measuring audit quality is problematic.

Taking into account the latter, we turn to practitioners to assess which measures impact audit quality in this respect. Based on the fact that audit failure usuall y becomes known onl y after the business failure (i.e. Enron case), is obvious that its quality is not directly observable or immediately recognized, especiall y to investors or creditors.

Overall previous empirical findings support the idea that audit quality can b e affected by inferences as the ones discussed above, but the results are not always conclusive, due to contradictory results obtained so far.

4. Findings and discussion

According to the literature, the quality of auditing was captured so far using measures like: auditor competence and independence, auditor rotation, regulatory regimes, audit failures, firm characteristics, audit and non-audit fees, earnings management.

Based on the results presented in Table 1, Romanian auditors accept the idea that audit quality can vary according to above cited factors, as follows:

Based on the results presented in Table 1, the large majority of the respondents agree upon 4 measures that have the potential to impact audit quality as follows: non-audit fees, audit fees, competence and independence of the auditor and auditor rotation. From all the measures assessed, non-audit fees is the measure that is largely accepted by the respondents as having an impact on the quality of audit, in this regard 59% of the respondents strongl y agreeing in its favor. None of the respondents did not disagree or strongly disagreed upon its impact. This measure in terms of acceptance by the audit fees, case in which 53% of the respondents strongly agreed that this measure can have the potential to impact audit quality.

On the other hand, audit failures and firm characteristics seem to have the lower influence on audit quality, based on the opinion of the auditors. Despite the fact that after the fall of Enron in 2001, there were excessive discussions in regard of audit failures and their impact, the large majority of the respondents (41%) were undecided wither this measure has or not the potential to impact audit quality. A possible explanation can be found in the fact that in Romania not many local audit failures are documented.

Even if earnings management was documented extensively in the literature as impacting the audit quality in common-law countries, 35% of the respondents were undecided in terms of assessing its impact. Moreover, 24% of the respondents disagreed or strongly disagreed upon its impact on audit quality.

The third segment of the questionnaire submitted asked the respondents to enumerate some factors contributing to the enhancement of audit quality. Since no list of factors was given, the respondents had to enumerate according to their expertise and experience what factors are having the potential to increase the quality of auditing. From 19 questionnaires received, 17 had this last segment completed. Among the factors enumerated by the respondents were the ones presented in Table 2.

The large majority of the respondents (47%) agreed upon the senior professional involvement as enhancing the audit quality, followed by the stricter regulator y regimes (23%). Firm executive evolvement in the process of auditing was also found to be an important factor contributing to the enhancement of audit quality (12%). Other factors contributing to the enhancement of audit quality were as follows: firm experience with the client, industry expertise and auditor skeptical attitude. No other factors were enumerated by the respondents.

5. Conclusions, limits and scope for future research

The study contributes by providing evidence regarding audit quality and the potential inferences in a code-law country.

The results of this empirical study document that inferences like non-audit fees, audit fees, competence and independence of the auditor or auditor rotation have the potential to impact audit quality in a code-law country.

On the other side, according to the practitioners' opinion, audit quality can be enhanced using two directions: first, by involving more senior professionals relative to a traditional audit and second, to develop stricter standards, related to ethics and independence. Other factors contributing to the enhancement of audit quality documented by the respondents were: firm executive involvement, firm expertise with the client, industry expertise, auditor skeptical attitude. Those factors documented can be comprised in a function that can be used to explain how well an audit team functions and how presumably firms perform best, based on those criteria, in code-law countries.

By comprising more senior professionals in the auditing process, the audit qualit y will be increasing, based on the fact that senior professionals possess a greater understanding of the client, comparing to junior professionals. Second, the large majority of the respondents acknowledged that stricter audit standards are need in the light of a constant increasing of manipulative behavior of clients.

In terms of limits, this study comprised some important shortcomings: first, the size of the sample; second, the small period of time for submitting the questionnaires. Future research can enlarge the sample and assess more factors impacting audit quality (i.e. conservatism, team characteristics, accounting firm alumni, audit committees, earnings quality, corporate governance quality) using other research instruments.

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