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Audit tenure
Do audit tenure and firm size and firm size
contribute to audit quality?
Empirical evidence from Jordan
317
Ali Abedalqader Al-Thuneibat
Department of Accounting, Faculty of Business, Received 14 August 2009
University of Jordan, Amman, Jordan Revised 12 June 2010
Accepted 11 October 2010
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 Managerial Auditing Journal
Vol. 26 No. 4, 2011
decision making (Arens et al., 2008). The audit process is designed to determine whether pp. 317-334
the figures reported in financial statements present the firm’s operating results and q Emerald Group Publishing Limited
0268-6902
true financial position in a fair manner. Therefore, improving the audit quality would DOI 10.1108/02686901111124648
MAJ provide reasonable assurance about the accuracy of reported accruals and as a
26,4 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
318 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.
Literature review and hypotheses development Audit tenure
The accumulated literature builds on the notion that the basic objective of the audit and firm size
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, 319
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
MAJ to establish evidence on the audit firm rotation effectiveness in providing the alleged
26,4 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)
320 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
of clients, create a distinctive advantage, whether as an actual competence of the auditor Audit tenure
or as a perceived independence by their clients. Palmrose (1988) suggested that Big6 are and firm size
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 321
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.
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 NAit for every year of the study. NA are calculated as a percent of lagged
total assets using the cross-sectional modified Jones model:
NA it 1 DREV it 2 DAR it PPE it
¼ B1 þ B2 þ B3 ðIIÞ
A it21 A it21 A it21 A it21
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:
TA it NA i;t
DA it ¼ 2 ðIIIÞ
A it21 A it21
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).
MAJ The following model is used to test H1:
26,4 OCF it
DA it ¼ b 0 þ b 1 TENURE it þ b 2 TENURE2it þ b3 þ b 4 LA it
A it21
ðIVÞ
þ b 5 LEV it þ b 6 FC it þ b 7 AGE it þ 1it
324 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.
TENURE 2it 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:
OCF it
DA it ¼ b 0 þ b 1 TENURE it þ b 2 TENURE2it þ b 3 þ b 4 LA it
A it21
ðVÞ
þ b 5 LEV it þ b 6 FC it þ b 7 AGE it þ b 8 BIG4 it þ 1 it
BIG4it a 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
or near-debt constraints might be more motivated to manage earnings (Defond and Audit tenure
Jiambalvo, 1994). and firm size
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 325
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).
Sector Tenure
Industry Service 1-5 years 6-10 years .10 years
Table I.
Percentage of firms 67.30 32.7 31 36.30 32.70 Frequencies (both sectors)
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
Unstandardized
coefficients Standardized coefficients
Model B SE b t Sig.
Unstandardized
coefficients Standardized coefficients
Model B SE b t Sig.
The researchers emphasize in this context that the distinctive character of Jordanian
society being divided into tribal communities and the resulting mutual trust amongst
individuals, in addition to the necessity to favor personal interests and social relations,
could also be a risk factor even for professional engagements. The small size of the
Jordanian community may have built such personal, rather than professional-like
relationships more quickly and developed an acquaintance with the client, where in Audit tenure
either case, the product would be an impaired audit quality. The argument at this point and firm size
establishes reasonable justification for the mandatory audit firm rotation. Therefore,
we infer that rotating the audit firm will enhance auditor independence and audit quality
in Jordan.
This study also shows that, the size of the audit firm does not enhance the effect of
the audit firm-client relationship length on the quality of audits in Jordan. The longer 331
the audit firm tenure, the lower the audit quality regardless of the audit firm size. The
result coincides with the nature of the Jordanian market being dominated by big audit
firms. As shown earlier in the sample statistics, the majority of publicly traded firms
(89 percent) were engaged with big auditors. In addition, the mean tenure reflected
lengthy engagements with auditors (nine years or more). Prior literature that proved
employing big audit firms improve the quality of audits delivered, substantiated the
improvement exists in the early years of the engagement when auditors are not familiar
with the client. When the auditor constructs sufficient client-specific knowledge, the
effect of the size of the audit firm on the audit quality becomes insignificant (Knapp,
1991; Johnson et al., 2002; Chi and Huang, 2004).
Finally, on the basis of the findings of the study, the researchers would suggest that the
audit firm should be rotated in order to enhance auditor independence and audit quality
and increase shareholders’ and stakeholders’ confidence in financial statements. Such
rotation will open the door for new auditors to investigate the client with better scrutiny
and due care. We encourage future research to uncover all variables that could possibly
affect the audit quality and establish robust evidence on either the necessity of the
mandatory audit firm rotation, or the disadvantages of such rotation on the audit quality.
The researchers would suggest also that audit quality is measured using other proxies,
such as the persistence of the accrual component of earnings (Johnson et al., 2002) and
other types of DAs (Krishnan, 2003). In addition, other factors that affect audit quality and
are auditor-specific factors, e.g. the specialization in the audit industry (Schauer, 2002,
2003), should be examined in future research. An investigation of the auditor size effect on
audit quality from the perception of other groups, e.g. investors (Lie et al., 2007), or using
other measures like questioned costs (Tate, 2002) is encouraged as well.
Notes
1. Also known as lagged total assets.
2. Total assets of the previous period.
3. The Altman Z-score for the financial condition is computed using the following equation:
Working Capital Retained Earnings
1:2* þ 1:4*
Total Assets Total Assets
Earnings before Interest and Taxes
þ 3:3*
Total Assets
Market Value of Equity Sales
þ 0:6* þ 1:0*
Book Value of Total Debt Total Assets
Further reading
Altman, E. and McGouh, T. (1974), “Evaluation of a company as a going concern”, Journal of
Accountancy, Vol. 138 No. 12, pp. 50-7.
Balachandran, B.V. and Nagarajan, N.J. (1987), “Imperfect information, insurance and auditors’
legal liability”, Contemporary Accounting Research, Vol. 3 No. 2, pp. 281-301.
Ghosh, A. and Moon, D. (2005), “Auditor tenure and perceptions of audit quality”, The Accounting
Review, Vol. 80 No. 2, pp. 585-612.
Myers, J., Myers, L., Palmrose, Z. and Scholz, S. (2004), “Mandatory auditor rotation:
evidence from re-statements”, working paper, University of Illinois at Urbana-Champaign,
Urbana, IL.
Web sites
www.ase.com.jo
www.cbj.gov.jo
Corresponding author
Ali Abedalqader Al-Thuneibat can be contacted at: aaaldu@ju.edu.jo