THE DETERMINANTS OF AUDITORS' REPUTATION IN NIGERIA
CHAPTER ONE INTRODUCTION 1.1 BACKGROUND OF THE STUDY
Knowledge of whether all audits are perceived to be of the same quality should be of value to users of audited financial statements and to audit standard setting bodies. The issue of differentiated audit services is a contentious one for professional accounting bodies which have traditionally argued that an audit by one of their members should be of the same quality as any other member. In the last 16 years, a number of papers have directly addressed the issue of the reputation of an audit firm in the financial communities of, primarily, North America, the United Kingdom and Australasia. Other studies have indirectly examined audit firm reputation by treating it as a variable that is likely to have explanatory power and therefore has to be controlled for in analyses whose primary purpose is not related to the issue of audit firm reputation.
Three types of empirical studies can be identified that consider auditor reputation: audit fee studies, studies of the issue of new shares and studies of the effects on a company of changing its auditor. These studies generally assume that there will be some kind of observable economic effect resulting from the employment of an audit firm with an above average reputation. This effect can be seen either in higher audit fees for the same sort of audit client or in more favourable share market prices for companies choosing to use an audit firm with an above average reputation. The link between the reputation of an audit firm and the quality of its audit work is provided by economic theorists such as Klein and Leffler (1981) and Shapiro (1983). The essence of their arguments is that individual firms have an economic incentive to incur above average costs in order to produce a service of above average quality, because eventually consumers will recognize this improved quality and be prepared to pay a higher fee in order to receive it. Hence, in these models, the fees that firms can earn are determined by the reputation that they have with consumers
The important element in the economic models of reputation is that higher service quality is worth undertaking as it will eventually create a better reputation for the firm, but in the case of an audit firm, the causal link between the quality of its audit work and the firm’s reputation is especially tenuous, because of the nature of the audit service and the measurability of audit quality. The service provided by an audit is that of assuring readers that a set of financial statements do not contain two possible distortions (Ng, 1978): noise (unintentional errors) and bias (intentional errors). A high quality audit will therefore ensure that the chances of there being noise and bias in the audited financial statements is at a minimum. However, as an auditor cannot verify every transaction, it is impossible to be completely certain that there are no errors or omissions in a set of audited financial statements. The difficulty faced by consumers is that, in order to assess audit quality, they will have to make three judgements: (i) whether the amount and nature of audit work undertaken is appropriate for that particular client company; (ii) how technically competent the audit staff are to undertake the work properly; and (iii) how independent the audit firm is and hence how likely it is to report any unadjusted errors or omissions that it finds (De Angelo, 1981). However, in order to make such a judgement the consumer needs to see the audit working papers and to interview the key personnel involved in the audit. Clearly, this is impossible and therefore the assessment of the quality of the audit service is problematic.
As far as readers of audited financial statements are concerned, the main check on the quality of audit work occurs in a negative sense whenever audit failure is suspected and a case pursued for damages in a court of law. However, there is little evidence of any adverse effects on a firm that has been found to have been guilty of negligence, although evidence is hard to obtain as litigation against auditors is a rare occurrence, providing only small numbers of cases from which to estimate auditors’ relative litigation activities, thereby increasing the difficulty in distinguishing amongst firms (Palmrose, 1988). Davis and Simon (1992) examined the impact of SEC disciplinary actions on the fees which affected accounting firms received for their audit services. They found that the SEC disciplinary action appeared to have a distinct but short-lived effect on fees received from new audit clients. There was a sharp and fairly immediate effect on fees occurring in the year immediately following the disciplinary action, but by the second year following the disciplinary action, fees charged by affected auditors for new clients had returned to the level paid to non-affected auditors.
Given the unobservability of audit quality, as readers of audited financial statements cannot know directly what level of audit quality has been used, they make use of indirect measures, based on what they can observe and hearsay evidence from others. From this perspective, the reputation of an audit firm is not determined primarily by the quality of its audit work, but rather how the firm is viewed more generally, i.e. by its reputation in the financial community. Reputation has been defined as follows: Reputation is the estimation of the consistency over time of an attribute of an entity. This estimation is based upon the entity’s willingness and ability to repeatedly perform an activity in a similar fashion. Reputation is an aggregate composite of all previous transactions over the life of the entity, a historical notion, and requires consistency of an entity’s actions over a prolonged time for its formation. (Herbig et al., 1994, p. 23).
Reputation is a multidimensional construct and so an accounting firm will have a composite reputation reflecting its reputation for quality work in the numerous services that it offers, e.g. auditing, accountancy, taxation, management consultancy, computer systems advice, personnel selection etc. Its reputation for quality work in one area is quite likely to affect its reputation in another, as shown by Jacoby and Mazursky (1984), who investigated the effects of selling products with either favourable or unfavourable images in stores, which themselves had either a favourable or an unfavourable image. They found that a retailer with a relatively low image could improve this image by associating it with a more favourable product image. Similarly, a very favourable retailer image was likely to be damaged, if it became connected with brands having less positive images. Consequently, it is reasonable to suppose that the various reputations for each of the services offered by an accounting firm will tend to influence each other. In addition, an audit firm is likely to benefit if it has prestigious clients with good reputations, as has been observed for Price Waterhouse in the 1980s (Stevens, 1981).
The auditing profession itself will have a generic reputation corresponding to the minimum level of audit quality associated with firms with no reputation of their own (Benston, 1985). Firms with a reputation for credible financial reporting are likely to change auditors when their audit quality is questioned to avoid the capital market consequences of potentially unreliable financial reporting (Hennes et al. 2011). However, these benefits must be balanced against the costs of switching auditors. First, firms face search costs in identifying and hiring a new audit firm. Second, incumbent auditors develop firm specific knowledge and expertise about the client that is costly for a new auditor to acquire (DeAngelo 1981). Third, the supply of auditors is constrained in the short run, especially when many firms are looking for new auditors at the same time (Kohlbeck et al. 2008; Ramnath and Weber 2008).
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