CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Financial statements audit is a monitoring mechanism that helps reduce information asymmetry and protect the interests of the principals, especially, stockholders and potential investors, by providing reasonable assurance that financial statements prepared by managements are free from material misstatements and intentional errors (Watts and Zimmerman, 1986). This monitoring function of external auditors is critical to the quality of financial reports and the level of confidence by the users of accounting information. In this context, Wright and Wright (1997) posit that audited financial statements are the joint product of the auditor-client negotiation process. Therefore, audit quality is at the heart of the integrity of the audit process. That is, maintaining the integrity of the independent audit functions about financial reporting is mandatory for auditors and required by the laws and regulations of the accounting profession. However, recent accounting and audit scandals at companies such as Adelphia, Tyco International, Enron, Cadbury, and WorldCom have eroded public confidence in the independence of the accounting profession and the quality of audit services.
Audit quality describes how well an audit detects and reports material misstatements (including intentional and unintentional errors) of financial statements, reduces information asymmetry between management and stockholders and helps protect the interests of stockholders (Chen, Elder, & Liu, 2005). High audit quality is therefore associated with high information quality of financial statement because financial statements audited by high quality auditors should be less likely to contain material misstatements and unethical accounting practices.
In response to the global accounting and audit scandals by accounting regulatory bodies around the world headed by the International Federation of Accountants (IFAC), stringent
Regulations are established and enforced, and the existing ones are reviewed. These include International Auditing and Assurance Standards Board (IAASB), International Standards on Auditing (ISA), International Ethics Standards Board for Accountants (IESBA), International Standards on Assurance Engagements (ISAE), International Standards on Review Engagements (ISRE), International Standards on Related Services (ISRS), International Standards on Quality Control (ISQC), International Auditing Practice Notes (IAPN), and Consultation Papers (IAASB, 2013).
According to IFAC (2013), through its auditing operational arm (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. With this in mind, the IAASB developed the Framework for Audit Quality that describes in a holistic manner, the different elements that create the environment for audit quality at the engagement, firm, and national levels, as well as relevant interactions and contextual factors.
It is worth noting that the mission of IFAC and its organs is to serve
the public interest by:
contributing to the development of high-quality standards and guidance; facilitating
the adoption and implementation of high-quality
standards and guidance; contributing to the development of strong professional accountancy
organizations and accounting firms, and to high quality
practices by professional accountants, and promoting the value of professional
accountants worldwide; and speaking
out on public interest issues. Similarly, in efforts to restore public confidence in accounting
and
audit services, individual countries particularly
United State of America (US)
and
European Union (EU) has also respondents significantly. For instance, in US Sarbanes-Oxley (SOX) act of 2002 was enacted to address the issues of audit quality by increasing the independence of outside auditors who review the accuracy of
corporate financial standard. Moreover, SOX created a new agency, the Public Company
In view of this, the opponents of audit rotation suggest that the loss of experience with the audit client due to rotation reduces audit quality (Myers, Myers, & Omer, 2003). Similarly, Dopuch, King, and Schwartz (2001) reported that rotation discourages auditors from intentionally biasing their  audit  opinions  in  favor  of  management,  despite  incentives  to compromise their independence, which affects financial reporting quality negatively. On the other hand, the long association between a client and the auditor may lead to closer identification of the auditor with the interests of the client and could lead to impaired auditor independence. Thus, mandatory auditor rotation could enhance auditor independence. Moreover, the economic view of audit quality, suggests that auditor independence and audit quality could be impaired in the early years of auditor tenure because auditors could be more accommodating to the client to extract future quasi-rents to recover losses incurred due to low-balling. Thus, restricting auditor tenure could exacerbate auditor independence rather than enhancing it.
Moreover, prior research on financial reporting quality has linked audit delays and quality of financial reporting, because audit delays can cause delay in annual accounting disclosures. Delayed earnings announcements generally cause less market reaction than early announcements due to lack of timeliness or even negative reactions as they are likely to contain bad news (Alkhatib&Marji, 2012). According to Abdulla (1996), the shorter the time between the end of the accounting year and the publication date of the year’s financial statements, the greater the benefits that can be derived therefore.
Another factor affecting the quality of audit is audit remuneration (audit and non audit fees) in relation to auditor independence. It is argued that audit remuneration can strengthen
the auditor’s economic bond
with
the
client, their by increasing
the
auditor’s incentives to acquiesce to client pressure, including
pressure to allow earnings management which reduces the quality of financial reporting
(Simunic 1984, and Beck et al,1988a). On the other hand,
audit remuneration can also increase the auditor’s investment in reputational capital which
The auditor is not likely to jeopardize or satisfy the demand of any one client, and thus increase the quality of audit and financial reporting as well (Arrunda, 1999).
