Introduction
Yearly external audit is a statutory requirement under which all limited companies are required to allow independent auditors to comment on the true and fair nature of the financial statements prepared by them. These auditors are also required to ensure that the financial statements are free from any material error that may result into a wrong judgment by the investors.
In the aftermath of corporate scandals such as Enron and more recently, Carillion, the overall importance of external audit and its scope has come under much more scrutiny. Increasingly, investors as well as regulators are demanding a better external audit function so that the overall interests of the stakeholders could be safeguarded through improved quality of external audits. Even though regulatory bodies such as Financial Reporting Council have identified the drivers for audit quality (FRC 2008), we are still facing deteriorating audit quality reports.
This research study is therefore aimed at understanding and exploring the issue of audit quality and how investors and shareholders can be more assured about the overall credibility of the audit and the factors they can consider when assessing the overall quality of the audited financials.
This review uses different articles, academic literature and theories to explore the overall nature and the extent of factors affecting the quality of the external audit. The study identifies different methods used to improve and measure the quality of external audit, the quality and nature of the impact of such factors on the overall quality of the external audit and any research gaps discovered and that possibly need to be looked into.
The rest of the paper is organised as follows. Section 2 reviews the different articles and academic literature and regulatory bodies on audit quality, section 3 describes theories that are related to audit quality, section 4 gives an overview of the methodology and section 5 is the conclusion.
2.Literature Review
Audit quality is one of the much-debated concepts given the overall concerns of the regulators and other stakeholders who trust auditors with the responsibility of ensuring a credible existing financial reporting mechanism.
The academic literature related to audit quality can be categorized into three main strands: i) inputs and outputs of audit quality, ii) audit process and audit quality, and ii) perceptions of audit quality. The ‘input’ and ‘output’ is largely built around the definition of audit quality proposed by DeAngelo (1981) (“audit quality is the market-assessed joint probability that a given auditor will detect both material misstatements in the client’s financial statements and report the material misstatements”). It is generally agreed that the good quality audit means the external auditor fulfils all his professional responsibilities and all the activities of the external auditors are always under their professional and legal mandate (DeAngelo, 1981). It therefore becomes critical that the overall quality of the audit depends upon the definition of the different roles and responsibilities which external auditors are required to undertake and perform.
However, given the unobservable features of audit quality, different proxies have been used to test their effects on the independence and competence of auditors. Input like audit size, audit fees, audit tenure and output variables such as quality of earnings, litigations and regulatory sanctions (Gul et al., 2003).
2.1 Inputs and outputs of audit quality
Under this section, we shall review the different input and output proxies that are related to audit quality.
The size of the firm is an important factor which affects the audit quality of the firm with larger audit firms being well equipped to perform the audits with relatively high quality compared to the smaller audit firms. This comes from availability of resources, less economic dependence on single client’s greater loss of reputation for big size audit firms and ability of the firms to hire skilled employees and provide rigorous training, which is all associated with high audit quality (DeFond & Lennox, 2011). The audited financial statements of clients of big size audit firms are also said to contain less earnings manipulation or restatements because the audit firms are more conservative in reporting, less economically dependent on the audit client and have an incentive to protect their professional reputation, which restricts the aggressive behaviour of corporate managers (Chin & Chi, 2009)
Long tenure is said to improve audit quality through the greater experience and knowledge that the auditors gather concerning the client’s business, which enhances their ability to detect material misstatements (Johnson et al., 2002). However, Ghosh and Mood (2005) argued the tenure of auditors may have a negative association with audit quality as the long-served auditors may surrender their independence to keep close relationship with their clients. Another proxy for audit quality that is used in prior researches is audit fee and economic dependences of auditors. Choi et al (2010) examine whether the association between audit fees and audit quality is asymmetric and thus nonlinear in the sense that the association is conditioned upon the sign of abnormal audit fees. Their results show that the proxy for audit quality is insignificantly associated with abnormal audit fees for their total sample of client firms with both positive and negative abnormal audit fees.
Outputs like financial reporting compliance with GAAP, quality control review and bankruptcy are used as a measure of audit quality. For example, Krishnan and Schauer (2000) studied the relationship between firm size and compliance with reporting requirements by non-profit entities. They found that compliance increases with increasing firm size. Most of the researches on audit tenure used issuing going concern opinion and bankruptcy as a measure for audit quality. Geiger and Raghunandan (2002) measured audit quality as whether the auditor had issued a going-concern qualification in the prior year for US clients that declared bankruptcy. They found that auditors are less likely to issue a going concern opinion during the initial years of engagement but not in later years, contrary to the expressed concern that a long auditor-client relationship negatively affects audit quality.
It is also important to understand that the different studies have highlighted the overall weaknesses of the different statistical techniques undertaken to measure the impact of different factors on the audit quality. It is argued that the larger forecast errors in the earnings forecasts and the actual earnings of the firms may suggest that the overall audit quality may be superior. However, this link is not statistically proven considering the fact that the audit as a profession has evolved over the period of time and the different and innovative techniques used by the management to under or over-estimate the earnings may go unnoticed by the auditors.
Simunic and Stein (1996) reason that as client-specific risk increases, and with it the risk of auditor litigation, the supply of audit quality may actually decrease. Their argument suggests that litigation risk is inversely related to the supply of audit quality and positively correlated with audit fees. For example, Bell et al. (2001) found that increased client risk resulted in additional audit hours incurred in the audit. This suggests that auditors servicing risky clients attempt to reduce audit failure by enhancing auditor monitoring strength and require additional performance-related fees for doing so.nGenerally, however, a positive relation is assumed to exist between audit quality and audit fees with most researchers theorizing that if larger firms are charging higher fees it reflects the higher quality of their audit services.
Overall, there is need for additional research beyond the association between the proxies for audit quality and the related outcomes
2.2 Audit Process and Audit Quality
This comprises of the audit environment, process performance, earning forecast and earning management and examining the factors affecting audit quality including audit procedures, auditors’ judgment and the behaviour or task performance during the audit process.
Earnings management affects the audit quality considering the fact that both managers and the shareholders may have inherent conflict with each other. (Ayres, 1994). According to Agency Theory, if both the managers as well as the shareholders act as utility maximisers, there is bound to be a conflict between the interests of the two. It is therefore suggested that if the overall performance of the managers is directly linked with the financial performance of the firm, there is strong probability that the earnings of the firm may be manipulated in order to boost the chances for higher compensation
for the managers. (Beatty, 1989)
In this case, limited attention is given to the actual audit process and most of the studies don’t even address the audit process. More studies should be done to explore the audit quality regarding the audit process, which can help to improve overall audit quality (Francis, 2011;)
2.3 The Perception of Audit Quality
The perception of auditors lies in their level of independence and competence to asses audit quality. Pervious research shows that users, preparers, and auditors rated the importance of various factors-auditors, firm and service quality – and their effect on audit quality in practice differently (Schroeder, Solomon, & Vickrey 1986). The research also highlights that service quality factors should be considered along with independence and competence, as suggested by DeAngelo (1981), to construct a broader concept of audit quality.
Beattie et al. (2011) carried out a study to examine the influence of the economic and regulatory factors on audit quality. This study shows that auditors, preparers and audit committees rate the factors related to firms, auditors and economic factors (e.g. auditor independence) as high. In comparison, the factors related to recent regulatory reforms such as requirements of audit partner rotation had minimal effect on the level of audit quality (reference)
The prepares and users of the financial statements also present and rate perceptions of audit quality differently hence indicating a lack of consensus concerning what audit quality means to different audit markets’ individuals.
2.4 Regulation on audit quality
UK Government has recently introduced changes in the regulatory framework related with the audit and corporate governance. Companies Act 2006 as well as the Statutory Auditors and Third Country Auditors Regulations 2007 have been introduced in order to update the domestic regulatory framework in order to comply with the EU directives. (Financial Reporting Council FRC, 2008). Regulators, such as the International Auditing and Assurance Standards Board (IAASB), have published a framework for audit quality, which discusses various pertinent factors affecting audit quality in practice (IAASB, 2014)
Audit Inspection Unit (AIU) under the FRC monitors the quality of audit of the publicly listed entities. Further AIU is also responsible for ensuring that the accountancy bodies remain independent and free from any influence on them. AIU has also highlighted some other operational issues which have been ignored by the audit firms hence compromising the overall quality of the audit. Issues such as obtaining confirmation from third parties, lack of confirmations for confirming the overall level of existence of assets and liabilities of the firm. Though these issues may look simpler in nature however, on a broader level they tend to create the level of audit quality deficiency thus putting the interests of the investors at stake (reference). Other factors include leadership, human resource, ethical polices of audit engagement, engagement performance and monitoring. Research in business ethics has shown that personality type is directly related to individuals’ ethical orientation (Rayburn and Rayburn, 1996).
In its various reports, AIU emphasised that in order to ensure audit quality, it is important that the senior management of the firm must take an active part in making a public commitment of the firm in achieving the desired level of audit quality. AIU however, highlighted that the different firms measure the performance of their partners based on the achievement of commercial targets rather than on ensuring audit quality. These trends therefore indicate that the firms may find it difficult to balance their commercial objectives with audit quality.
Theories
The overall requirement for the services of the auditors and the firm is formed on the basis of the agent-principal theory. Accordingly, under this theory, a principal delegate some tasks and responsibilities to the agent under the understanding that these tasks will be performed by the agent on behalf of the principal.
As such when a conflict of interest arises between agent and the principal, agents may take actions which may not be entirely in the best interests of the principals. In order to narrow that gap, a financial reporting mechanism is prepared which is duly supported by the independent external auditors to ensure that the financial reporting made by the management is free from errors and frauds. The overall concept of audit quality therefore is linked with how well the function of external audit is successful in highlighting and detecting material errors in the financial statements while at the same time reduce the information asymmetry between the shareholders and management of the firm.
Adverse selection theory which refers to the self-selection that may occur when quality is uncertain (Akerlof, 1970). In this case, audit provides one means of signalling the credibility of financial statement information and auditor reputation may be seen as a signalling sign.
Datar et al. (DFH)(1991) provide a competing theory in which entrepreneurs seek credibly to reveal certain private information to prevent under-pricing of their stock through two signals – audit quality and the percentage of retained ownership. DFH develop an analytical model that demonstrates that entrepreneurs can reduce the percentage of ownership they retain by obtaining a higher quality audit, because increasing audit quality improves investors’ abilities to estimate company value. However, other factors possibly affecting choice of auditor could include size of the IPO deal, underwriter reputation.
Methodology
Conclusion
Audit quality has been investigated within a variety of perspectives in the literature. This paper has reviewed the literature on audit quality in the current professional environment. In each case, past and recent studies that have added to the body of knowledge relating to audit quality have been discussed. Although different variables were used to measure audit quality, some these proxies are still inconclusive and require more research.
Overall, each analysis reveals a research gap that suggests for future studies. Due to the importance of having high quality audit, more research should explore other areas that relate to audit quality such as auditor’s behaviour that threatens audit quality. In particular, other relevant variables that occur in auditors’ working environment for example team structure and leadership may be identified and examined.
I also encourage studies based on qualitative data, such case studies that would allow greater in-depth insights into the reality of audit quality in practice.