The Relationship Between Audit Tenure and Audit Quality - Evidence from Sierra Leone

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1.7 Scope of the Study

This study will be limited to Sierra Leone and specifically to firms and companies in the western area that have received some auditing services over the years. This study will not cover the provinces due to budget and time constraints.

Chapter Two: Review of Related Literature

This chapter reviews the relevant studies and includes three sections. Section 2.1 reviews the previous studies on audit quality by using different proxies and determinants while section 2.2 presents the studies on the relationship between audit tenure and audit quality. Section2.3 reviews the prior literature of accruals models.

2.1 Audit Quality

2.1.1 Different proxies of audit quality

A number of scholars have started to research audit quality based on different proxies, such as Accruals, Earnings Response Coefficients (ERC) and Audit Reporting Errors. Francis (2004) reviews the last 25 years of research on audit quality and concludes different proxies of audit quality. This section reviews different proxies used in the previous literature as highlighted below.

Discretionary accruals

Auditors are responsible for inspecting companies’ financial statements and report to the public whether they are fair and reliable. Audit quality is perceived to be high if the financial statements are transparent with less probability of manipulation (Chen et al., 2008). Therefore, an effective way to detect audit quality is to use discretionary accruals as a proxy. It has been widely used in the previous papers such as Myers et al., 2003; Renolds, 2004; Chi and Huang, 2005 and Choi et al., 2010).

Johnson et al. (2002) take the absolute value of the unexpected accruals as a proxy of earnings quality and find that the quality of financial reports is positively related to audit-firm tenure. Similarly, the absolute value of discretionary accruals is also used to proxy audit quality in Chen et al. (2008), and Chen et al. (2008) to test the association between audit quality and audit tenure and they conclude that the increasing audit tenure does not harm audit quality, while Choi et al. (2010) investigate the relationship between audit quality and abnormal audit fees. Different from the previous three papers, Myers et al. (2003) divide accruals into two categories: discretionary accruals and current accruals, in order to study whether audit firm tenure is associated with accruals. The results suggest that longer audit tenure has positive effects on audit quality. Additionally, Lim and Tan (2010) proxy audit quality by accruals and find that industry specialists provide higher audit quality.

Audit failures

An audit report plays an important role in communicating between auditors and clients. It conveys professional decisions from auditors to those stakeholders who need this information to invest. The occurrence of audit failure is naturally regarded as a low audit quality.

Audit reporting errors are one type of audit failure; therefore they can be used as a proxy of audit quality, such as in Geiger and Rama (2006). In this paper, they classify audit reporting errors into two types. The first is that the companies receiving a qualified auditing opinion do not fail later. The other is that companies issued with an unqualified opinion go into bankruptcy. Then, Geiger and Rama (2006) investigate whether or not there are more audit reporting errors in non-Big 4 firms, thus better audit quality in Big 4 firms.

Another type of audit failure is financial reporting fraud. For example, in Carcello and Nagy (2004), and Geiger and Raghunandan (2002), they examine the association between audit firm tenure and audit quality surrogated by financial reporting fraud. The results suggest that the audit quality is higher during the short audit tenure by having less possibility of financial manipulation.

Cost of debt

In Mansi et al. (2004), they find that both audit tenure and quality have effects on the cost of debt financing and there is a positive relationship between audit tenure and audit quality. Because auditors’ opinions have a great influence on the reliability of companies’ financial announcements, investors rely on audited financial reports to make aninvestmentdecision. Mansi et al. (2004) report that the cost of debt is lower with increasing audit tenureand, therefore, investorsdo not think longer audit tenure harms the quality of auditing.

Financial report restatement

Financial report restatement is the main concern for regulators and stakeholders on the audit quality and financial report quality (Palmrose and Scholz, 2004). Therefore, researchers also take it as a proxy for audit quality, such as in Myers et al. (2004), to investigate whether the audit firm tenure is correlated with the occurrence of financial report restatements, and Myers et al. (2005) to test the relation between financial report restatements and audit partner tenure. In order to give a more accurate result, their studies chose samples strictly by defining the restatement as ‘correlations of financial statements that are non--GAAP reporting’ (Myers et al., 2005).

Earning Response Coefficients (ERC)

Another group of researches use ERC as a proxy to measure audit quality such as Ghosh and Moon (2005), Chi et al. (2005), Skantz (2006) and Ghosh et al. (2009). In Ghoshand Moon (2005), they use ERC as a proxy for audit quality to examine how investors understand the relationship between audit tenure and quality. The results suggest a positive association between the two factors, that is, audit quality improves with longer audit tenure. Likewise, with a proxy ERC for audit quality, Chi et al. (2005) conclude that the implementation of a mandatory rotation policy is beneficial to audit quality by analysing Taiwanese companies. Both Higgs and Skantz (2006) and Ghosh et al. (2009) use ERC as a proxy for audit quality to investigate the relationship between audit fees and audit quality. Higgs and Skantz (2006) report a negative relation between audit fees and audit quality, while there is no evidence found in Ghosh et al. (2009) to support the idea that audit fees are correlated with audit quality.

Litigation

The number of litigation activitiesis used as a proxy of audit quality because it is generally believed that high audit quality auditors have fewer litigation cases. Palmrose(1988) analyzes the