Auditing Literature Review - What Influence Audit Quality?

What influence audit quality?

Abstract

This paper reviews literatures related to audit quality. The review is structured based on the four main measures to audit quality, namely auditor independence, client importance, auditor tenure and earnings quality. For each of the variables, we discuss findings related to the incentives, perception, and behaviour of the auditor and the client, the effects of each variable.

Introduction

Audit standards imply that audit quality is achieved by the issuance of the ‘‘appropriate’’ audit report on the client’s compliance with accounting principles. However, audit quality is a complex concept and cannot be reduced to a simple definition. The most widely used definition of audit quality is by DeAngelo (1981, p.186), stating that “the quality of audit services is defined to be the market-assessed joint probability that a given auditor will both (a) discover a breach in the client's accounting system, and (b) report the breach”. The auditor will be less likely to report the irregularities and the audit quality will be impaired when auditor does not remain independent.  

Since the independence of the auditor is a critical issue for the auditing profession, many studies have been performed in this area.  This review will focus on several aspects which will influence the auditor independence and audit quality. There are client importance, auditor tenure and earnings quality.

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Alternatively, we can regard auditor independence as one of the independent variable, as show in the figure.

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Client importance involves the degree of auditor being economically dependent on the client. When providing service to the client, an audit firm receives audit fee from the client, resulting in auditors being financially bonded to the client (DeAngelo, 1981a). If the client constitutes a relatively large part of an auditor’s portfolio, an auditor has an incentive to retain the client to warrant a future source of revenues and profits and therefore, to compromise independence and act in favour of the client (Blay, 2005).

Auditor tenure can lead to impairment of independence. As the auditor-client relationship lengthens, the auditor may develop a close relationship with the client and become more likely to act in favour of management, resulting in reduced objectivity and audit quality. Under the Corporations Act, companies must change their audit partner every five years, which can be extended to seven, but there are no rules about changing audit firms. Audit independence may actually decrease due to audit firm rotation no mater company change audit firm frequently or change over five years.   

Audit quality can also be inferred from earnings quality, as high quality of audit alleviates the degree of earnings management and enhances the information of financial reports. According to Balsam et al. (2003), audit quality has a positive relationship with the quality of financial reporting, which can be proxied by earnings quality. If the quality of earnings is high, the information and usefulness of earnings would be correspondingly high, hence the accuracy of the information. Therefore, Francis et al. (2011) argues that audit quality is the quality of the audited earnings.  

Literature review, Hypothesis and Framework of variable

There are five hypotheses in this research.

1. The relationship between auditor independence and audit quality

 H1: These is a significant influence of auditor independence on audit quality

According to Agoes (2012), there are two types of independence, namely: (a) independent in appearance, which is the outside view of the auditor himself in relation to the audit implementation, (b) independent in mind, that is before carrying out the audit, the auditor must free his mind from the desire to do something bad in the examination even they should not expect to get any kind of gift from client.  According to ASA 200, each auditor should be independent in mind and appearance. Independence in mind is a mental attitude that allows the auditor thought was not influenced by things that can affect professional judgment that has integrity and act objectively, and applies professional scepticism. Independence in appearance is the attitude held by auditors to avoid any action or situation which may cause a third party to doubt the integrity, objectivity, or professional scepticism of auditors.

It is suggested by Mansouri (2009) that auditor quality is positively related to audit independence. According to Listya & Sukrisno (2014), Auditor independence has t count at 3.266, greater than t table (3.266 > 1.977) as well as having a significance of 0.001 which is less than 0.05. Unfortunately, I cannot find the specific survey in Listya & Sukrisno study. I can develop the survey based on the audit quality and auditor independence to find the relationship between these two by using Australian auditor in Big4 and Non-Big4.

1. The relationship client’s importance is important to audit quality

 H2: These is a significant influence of auditor independence on audit quality

The evidence on the effect of client importance on auditor’s behaviour is mixed. Studies that employ modelling techniques provide strong theoretical ground for this research area. Many studies also use archival and experimental methods to support the theoretical arguments. A few papers support the notion that high litigation risk would decrease the likelihood that auditors will act in favour of the client (Schatzberg, and Sevcik, 1998).).