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AUDIT FIRM CHARACTERISTICS AND QUALITY OF FINANCIAL REPORTING LISTED NON FINANCIAL FIRMS. A CASE STUDY OF BUILDING MATERIAL FIRMS IN NIGERIA

  • Department: ACCOUNTING
  • Chapters: 1-5
  • Pages: 167
  • Attributes: primary data
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ABSTRACT

External auditors conduct an independent examination of a firm’s financial statements, records and supporting documents and give opinion about the truth and fairness of the reports, and that the report is free from material misstatements and errors. While, this can be considered as a good control mechanism for ensuring the quality of corporate financial reporting, there is a great concern by the regulatory authorities and other stakeholders in view of the corporate scandals and failures that adversely affect corporate entities in recent times in Nigeria. This study examined the impact of audit firms‟ Characteristics on financial reporting quality of quoted building material firms in Nigeria. The study employed correlation research design using a sample of four listed building material firms for the period of ten years (2002-2011). Ordinary Least Square (OLS) multiple regression technique was employed in the analysis of the panel data collected for the study. The study found that audit compensation and audit firm independence have significant positive impact on the financial reporting quality of quoted building material firms in Nigeria at 99% confidence level. The finding suggested that, audit compensation and provision of non-audit services in the quoted building material firms in Nigeria have improved the quality of their financial reporting during the period under review. The study recommends that, policy makers (SEC and FRC) should make policies that would strengthen the auditors‟ independence in the building material firms in Nigeria. It is also recommended that SEC and FRC should make it a policy that public companies, especially building material firms, should consider in employing their auditors an optimal compensation.

CHAPTER ONE

INTRODUCTION

1.1    Background to the Study

The main objective of financial reporting is to provide high quality financial information about economic entities that is useful for economic decision making. According to International Accounting Standard Board (IASB), (2008), high quality financial reporting is critical to investors and other stakeholders in making investment, credit and similar decision. An important variable of financial reporting that is usually used as a yardstick of financial reporting quality is accounting earnings, as it is reported in the published financial report of firms is expected to provide a timely and reliable input to potential investors, shareholders, creditors, employees, management, financial analysts, regulators and other stakeholders for efficient economic decisions.

The issue of quality financial reports is of tremendous concerns not only for the final users, but the entire economy as it affects economic decisions which may have significant impact. However, managerial opportunistic behaviors as well as unethical accounting practices are identified as major challenge to the quality of accounting earnings and financial reporting quality (Shen & Hsiang-Lin, 2007). According to their study of some accounting scandal and collapse of some corporate entities (Enron, Worldcom, Xerox and Parmalat), earnings manipulation and artificial transaction are responsible for the scandal and the collapse of those entities. Moreover, most of the Chief Executive Officers (CEO) and Managers of the collapsed entities are found involved in earnings management through structuring and artificial transactions with related parties which affected earnings and financial reporting adversely (Shen and Hsiang-lin, 2007). Earnings management as a prime factor that impairs quality of earnings is regarded as unethical and includes using managerial judgments and dearth in regulation (Bello, 2010). In a study of financial reporting quality, Shehu (2012) opinedthat quality financial reporting could be achieved by full disclosure and higher level of transparency; and regarded corporate transparency as the widespread availability of relevant and reliable information about the periodic performance that is free from errors and misstatements. Therefore, the quality of financial reporting is to promote transparency and deliver high quality Annual Report through comprehensive disclosure (Shehu, 2012). As such regulators and financial statements analysts as well as auditors should ensure that financial statements information is true, fair and free from opportunistic and unethical judgments, which destroy the quality of financial reporting.

It is in view of the importance of quality financial reporting that the International Federation of Accountants (IFAC) and its audit arm International Auditing and Assurance Standards Board (IAASB), stated that audit services is an assurances service that the financial statements prepared by the managers is true and fair, and free from intentional and unintentional errors and misstatements, and conform to the relevant rules and regulations guiding the preparation and presentation of accounting information (IAASB, 2013). According to IAASB, global financial stability is supported through high quality reporting, which could be achieve through high quality audits that can help foster trust in the quality of reporting. It also highlights the importance of audit quality and its relevance to all stakeholders in the financial reporting supply chain.

One of the critical roles of auditors is that, they assure confidence to financial statements users about the reported information. Audit services have been critical to financial reporting quality since industrial revolution (that is, separation of ownership from management). However, the ability of auditors or audit firm to provide high audit quality capable of producing high financial reporting quality is attributed to some certain features of the audit firm, these features are auditor independence, audit compensation, audit firm type and size and joint audit services (DeAngelo, 1981 & Krishnan, 2003). For instance, Brown, Falaschetti and Orlando (2006) state that auditor independence improve the quality of financial disclosures based on the evidence from the recent governance scandals around the world. They further lament that a widely held belief emerged that letting auditors consult for audit-clients compromises auditors’ independence and thus diminishes the quality of earnings reports. This is also supported by most of the regulations; for instance it forms part of the provision of Sarbanes-Oxley (SOX) Act of 2002, which restricted auditors from providing non-audit services to their clients (Brown et al, 2006). On the other hand, auditor’s independence with regard non-audit services which lead to non-audit fees can improve the quality of financial reporting (Arrunada, 1999). According to him, if informational inputs for producing the audit services intersect those for producing the non-audit services, then the jointly producing audit and non-audit services can improve financial reporting quality by facilitating scope economies. However, managers are using their capacity to threaten auditors with the loss of non-audit business; in this regard, jointly producing audit and non-audit services increases the pressures the managers can place on auditors to endorse compromised financial statements (Arrunada, 1999).

Similarly, compensation to auditors is found to be related with financial reporting quality (DeAngelo, 1981); according to this belief, quality may decrease with fee dependence if marginal forces associated with managerial influence overwhelm those associated with the scope of activities involved (Frankel, Marilyn and Karen, 2002; Francis, 2004). On the contrary, audit compensation is used as a measure of audit quality, based on this view; audit fees reflect additional audit effort which led to a higher level of audit quality (DeAngelo, 1981; Carcello, Hermanson, Neal & Riley, 2002). In this context, audit fees and non-audit fees relate to knowledge spillovers that is, transfersof knowledge from non-audit to audit services. Moreover, increase in audit fees as a result of non-audit services may enhance auditor’s incentives to stay independence.

Another audit firm characteristic commonly associated with the financial reporting quality is audit firm size (that is, Big 4). Audit firm type is conceived as financially independent and highly experienced, thus less likely to be subjected to any pressure from the clients “to look the other way” in their role in discovering accounting irregularities (DeAngelo, 1981). Moreover, Big 4 auditors have more to lose should a scandal arise, in that their brand names and reputations are more valuable compared with small non-Big 4 audit firms. For instance, Becker, Defond, Jiambalvo and Subramanian, (1998), and Francis, Maydew and Sparks (1999) opined that Big 4 audit firms have shown to have higher accrual quality (Financial reporting quality) as measured by lower absolute values of discretionary accruals, and their clients are less likely to manage earnings.

Audit firm characteristics with respect to clients include the joint audit, to ensure objective financial reporting and financial reporting quality as well. Joint audits create more differences in auditor choice and potentially in the level of earning quality than under non-joint audit. Based on joint audit perspective, DeAngelo (1981) states that audit performed by two audit firm produce the highest quality financial reporting, while the lowest level of quality occurs when a single audit firm is responsible for the audit engagement.

Therefore, this study is motivated by the critical role that the auditors have in corporate financial reporting with regard accounting irregularities and misstatements including earnings management,which impair, financial reporting quality and threaten the going concern of corporate entity. The study however, focuses on the major audit firm Characteristics (audit compensation, non-audit services, audit firm type and the provision of joint audit). These Characteristics are considered as determinants of audit quality which has defect linkage with the financial reporting quality.

Nigeria like other countries of the world witnessed corporate scandals and failures, such as Oceanic Bank, Societe Generale Bank, Savannah Bank and Cadbury Plc, which are not pointed by the financial reports in spite of the auditor’s endorsement. That financial reports are true and fair, and conform to the relevant rules and regulations; and the actual transactions. Building material firms are critical to the economic development of any country; this sector is not being given adequate attention in terms of researches on financial reporting quality particularly in relation to auditors’ characteristics. Specially, building material firms are characterized with heavy machineries, large volume of transactions and large volume of accruals. These features are potentials for hiding accounting irregularities, misstatements and earnings management, which affect financial reporting quality adversely. Therefore, the need for quality financial reports in the recent times and the negative consequences of poor quality reporting prompted the study of financial reporting quality of building material firms in Nigeria.

1.2    Statement of the Problem

Financial reports are supposed to provide relevant information to the external parties of an organization. It is thus important that financial reports provide truthful and accurate financial information to enable shareholders and other interested parties to make decision wisely. Lack of accuracy in financial reporting will lead shareholders and prospective investors to make wrong judgment about the organization. Incidentally, the heavy reliance placed on accounting numbers (as it measures the direction of business entity as well as decision base by different users of accounting information, Kothari, et al., 2000; and Bello, 2010) has provided an incentive for managers to manipulate earnings to their own advantage. This manipulation that is not supposed to go unchecked by auditors has often led to the eventual collapse of firms of various sizes and even called to questions theintegrity of auditors and characteristics of audit firms.

The credibility of financial information is vital to the growth of nay economy. Auditors on their part are expected to be independent and objective in the discharge of their responsibilities (Adelaja, 2009), because as the report of external auditors in corporate financial statement is seen as providing key assurance and protecting the interest of shareholders (Gallegos, 2004). However, as O’Connor (2006) noted, one of the most vexing problems in the financial world today is the emphasis placed on ensuring the independence of external auditors as a result of recent corporate Scandals. Beatties and Fearnley (2002) opined that after the collapse of Enron it was generally believed that rendering of non-audit services compromised the independence of external auditors. In the real world, when business entities collapse the consequences are usually enormous. The oversight function of the auditor is placed under scrutiny when a business whose financial statement once showed no indication of any failure suddenly becomes bankrupt. As a follow up to the oversight function, the independence of the auditor in such circumstance would be in doubt.

Many studies like DeAngelo, (1986) Jones, (1991) and Dechow, Sloan, & Sweeney, (1995), Ashbaugh et al., (2003) have been conducted on the relationship between audit firm characteristics andquality of financial reporting. The studies are however based largely on US and European data, thusreflecting the advanced economies environment. Few of the studies such as Semiu and Kehinde (2011), Semiu and Johnson (2012) and Umar (2012) used data from emerging economies such as like Nigeria. Little is known about the relationship between audit firm characteristics and firms reporting quality in developing markets such as those in Nigeria particularly, using data on building materials firms. It is therefore pertinent to conduct a study that will fill this literature gap. Moreover, this study used four audit firm chrematistics variables to investigate their effects on the financial reporting quality of building materials firms in Nigeria. Hence gap to be filled in the literature because most of the studies in this area focused on usually one aspect of auditfirm characteristics.

1.3    Research Questions

It is in view of the problems stated above the following research questions are raised:

i.             How does audit firm independence affect the quality of financial reporting of quoted building material firms in Nigeria?

ii.            What is the effect of audit firm independence on the quality of financial reporting of quoted building material firms in Nigeria?

iii.           Does audit firm type have any impact on the quality of financial reporting of quoted building material firms in Nigeria?

iv.          What is the effect of joint audit on the quality of financial reporting of quoted building material firms in Nigeria?

1.4    Objectives of the Study

The overall objective of the study is to examine the impact of audit firms‟ characteristics on the financial reporting quality of quoted building material firms in Nigeria. The specific objectives are to:

i.             Determine the impact of audit fee on the financial reporting quality of quoted building material firms in Nigeria.

ii.            Assess the effect of audit firm independence on the financial reporting quality of quoted building material firms in Nigeria.

iii.           Assess the impact of auditor type on the financial reporting quality of quoted building material firms in Nigeria.

iv.          Examine the impact of joint audit on the financial reporting quality of quoted building material firms in Nigeria.

1.5    Hypotheses of the Study

In line with the objectives of this study, the following hypotheses are formulated in null form;

H01:   Audit compensation has no significant impact on the financial reporting quality of quoted building material firms in Nigeria.

H02:   Audit firm independence has no significant impact on the financial reporting quality of quoted building material firms in Nigeria.

H03:   Auditor type has no significant impact on the financial reporting quality of quoted building material firms in Nigeria.

H04:   Joint audit has no significant impact on the financial reporting quality of quoted building material firms in Nigeria.

1.6    Scope of the Study

This study focuses on audit firms’ characteristics and the quality of financial reporting, within the context of listed building material companies in Nigeria. The study covers the period of ten years, from 2002-2011. Financial reporting quality is represented by earnings quality which is proxied by absolute discretionary accruals of the quoted building material firms during the period covered by the study. On the other hand, audit firm characteristics in this study covers audit compensation/fees, audit firms’ independence, auditor type and joint auditors.

1.7    Significance of the Study

This study is significant in light of the recent search by regulators for measures that could protect and improve the financial reporting quality in the corporate world. It is also a response to the current call by the IAASB’s Framework for Audit Quality which, include raising awareness of the key elements of audit quality; encouraging key stakeholders to explore ways to improve audit quality; and facilitating greater dialogue between key stakeholders on the topic (IAASB, 2013). Moreover, the IAASB framework for audit quality attributed the primary responsibility for performing quality audits to auditors, and emphasized that audit quality is best achieved in an environment where there is support from other participants in the financial reporting supply chain. Hence, this study is an effort towards such direction.

The study is also significant as it focused on issues related to audit firm characteristics that are threatening the survival of audit firms of all sizes, on one hand and the goingconcern of corporate entities on the other hand. Therefore, the study is of importance in ensuring the credibility of financial information not only for the purpose of pointing the tendencies of corporate scandals, but most importantly the survival of their accounting and audit profession and the development of healthy financial and capital market. The study is therefore of immense value to auditors, regulators, managers, professional accounting bodies, existing and potential shareholders and researchers.

The findings from this study could assists auditors in their duties and responsibilities with regards financial reporting, as to the factors that are of eminent importance in achieving high audit quality and high financial reporting quality. The study will also offer important input to serve as a strong base for the regulators and professional accounting bodies to establish policies relating to type of audit firm characteristics, audit fees, non-audit services and joint audit. This is important because most of the issues in this area are based on anecdotal evidence, particularly in Nigerian context since evidence regarding these issues has been relatively limited. The study therefore hopes not only to help enrich the literature, but also provides important quantitative information for policy formulation.

The findings from the study could educate both existing and potential shareholders of building material firms in Nigeria on the audit firm characteristics that improve the quality of financial reporting (with respect to audit firm characteristics). The study is also of great importance to researchers, as it provides empirical evidence on the relationships between audit firm characteristics and the quality of financial reporting from listed building material firms in Nigeria.

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