The Effect of Audit Partner Rotation and Audit Firm s Fee on Audit Quality

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The Effect of Audit Partner Rotation and Audit Firm’s Fee

on Audit Quality

Eko Suprapto* and Eko Suwardi**

This study examines the determinant factors for audit quality. Based on the literature review, the study hypothesized that audit partner’scompliance on audit rotation regulation, audit firm’s annual fees, and initial balance testing have positive effect on audit quality. Additionally, this study also hypothesize that audit tenure has negative effect on audit quality. Differentfrom the previous studies, this study usedaudit partner’scompliance on professional audit standard as the proxy for actual audit quality. The empirical results show that in that model, audit firm’s annual fees, and initial balance testing are the two determinant factors which provide positive effect on audit quality. Another result shows that public accountant’s compliance on audit rotation regulation and the audit tenureprovide no effect on audit quality. It means that the restriction on audit rotation for maximumthree years does not affectthe audit quality.

Keywords : Audit Rotation, Audit Partner‟s Compliance,Regulation,AuditTenure,

AuditFirm‟sAnnualFees, InitialBalance, InitialAuditEngagement, and AuditQuality.

I. Introduction

Before the enactment of regulations on audit rotation, efforts to increase the independence of auditors and reliance of investors to financial statements of public companies have been widely debated in several countries. Likewise, after the application of any regulations on audit rotation, there are still debates, whether the regulation is effective in improving audit quality. In Indonesia, latest regulation of audit rotation was enacted by Indonesian Minister of Finance (MoF) on its decree numbered 17 by adding the rotation period from five years at previous MoF decree to six years for audit firm tenure, while the tenure of audit partner is still three years. Currently, Public Accountant Act, Number 5, enacted on May 3, 2011 does not determine the rotation period of audit firm and audit partner but it will be further regulated through government regulation.

Proponents of mandatory audit firm rotation contend that without rotation, itresults in increasing concentration of the audit market and increasing audit fees, in the end it reduces independency of audit partner, and audit quality. Auditor independence may be threatened by a large number of situations should be analyzed with caution because it cannot be interpreted in only one way.On the other hand, opponents of mandatory rotation considerthe introduction of mandatory rotation rule as an excessive tool whose benefits are not relevant. They argue that there are other factors motivating the auditor to maintain his/her independence, such ______________

*EkoSuprapto isan alumnus of Master of Accounting Program, Faculty of Economics and Business UniversitasGadjah Mada.

** Eko Suwardi is an Associate Professor of Accounting, Faculty of Economics and Business Universitas Gadjah Mada.

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as the need to preserve reputation and client revenue. There are also external safeguards useful for preserving independence. Among them, the most important are the qualitycontrol standard (e.g. peer review) and market forces (e.g. litigation costs and negative reputation)(Cameran et al. 2005).Geiger and Raghunandan (2002) conducted a research on the relationship between the length of the auditor-client relationship and the failure of the audit report. In that research they focused to issue a going concern opinion in the auditor's report and concluded that the length of the engagement are positive and significant to to issue a going concern opinion in the auditor's report, but the effect began to diminish after a period greater than five years and there are many errors in the first year of audit report.

Moreover, proponents of mandatory rotation argue that the audit market is too concentrated and that rotation could improve the competition between big and small audit firms if auditees were forced to change their current auditors. In addition, the presence of mandatory audit rotation policy that a long term auditor-client relationship is considered by the proponents of mandatory rotation as the main element that could impair independence and objectivity (Cameran et al. 2005).

Fees paid to auditors can affect audit quality in two ways: large fees paid to auditors may increase the effort exerted by auditors, hence, increasing audit quality. Alternatively, large fees paid to auditors, particularly those related to non-audit services, make auditors more economically dependent on their clients (Hoitash et al. 2007). Based on previous research related to the relationship between audit fees, non-audit fees and total fees to the audit quality havebeen concluded that the results vary i.e. positively related (Choi et al. 2010 and Yu 2007), negatively related (Hoitash et al. 2007 ), and no relationship (DeFond et al. 2002).

Many people and regulator‟s attention focus on how to improve audit quality. Audit quality is very important for transparency and smoothness of the economic system of a country, especially for investment in capital market activities. But the main problem that always arises is how to determine the level of audit quality via a reliable method accurately. Based on the previous studies, there are many different results eventhough using the same method.

In general, the measurement of audit quality can be divided into perceived and actual audit quality. However, the measurement of audit quality is actually very difficult because the measurement of actual audit quality is based on the actual audit process. SugiriandFebrianto (2011) stated thataudit quality was believed to be responsible for credible accounting information. They posited that higher audit quality will result in more accurate information. However, this proposition is difficult to prove because they have some problems in measuring audit quality. If they want to scrutinize audit quality, they have to investigate what the auditors have performed appropriate procedures during the audit. Similarly, Li Dang (2004) noticed some studies use perceivedaudit quality because of the difficulty to measure actual audit quality. Perceived audit quality as perceived by users of financial statements, whereas the actual audit quality refers to the ability of auditors to detect and report material misstatements of financial statements. Users of financial statements do not have access to gathered evidence during the audit process and the audited information. Thus, theycan not assess actual audit quality directly.

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Based on previous studies, there are inconclusive results on the effect of the issuance of audit partner rotation policy. Sometimes, using the same measures of audit quality will result in a different conclusion. The use of measurementof audit quality correctly was expected to provide a precise description of the quality of the audit partner and audit firm. Given the difficulty of measuring the actual audit quality (Sugiri&Febrianto 2011, Watkins et al., 2004 and Li Dang, 2004), allowed the researchers to re-examine audit quality in accordance with audit partner‟s compliance onprofessional auditingstandards and related regulations.

More specifically, this research will examine the influence of these variables: the audit partner‟s complianceon audit rotation regulation, the length of the audit partner engagement, and the audit firm‟s annual fees on audit quality. This study also testespeciallythe audit failure in initial audit engagementthat caused to the presence/absence of communication with the predecessor auditor and testing of the opening balance on actual audit quality.This research also different from previous studies because it uses actual (not perceived) audit quality as proxied by the auditors‟ compliance on auditing standards.

2. Literature Review

2.1 Audit Quality

One common definition of audit quality is provided by DeAngelo (1981)as “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 probability that the auditor will report the detected misstatements is defined by DeAngelo (1981) as auditor independence. Therefore, audit quality is an increasing function of an auditor‟s ability to detect accounting misstatements and auditor independence as assessed by the market.

Franzel(2003) defined audit quality as the way of auditor conduct the audit in accordance with generally accepted auditing standards (GAAS) to provide reasonable assurance that the audited financial statements and related disclosures are (1) presented in conformity with GAAP and (2) are not materially misstated whether due to errors or fraud. Material mistatement from the standard is considered to reflect poor audit quality. Li Dang (2004) argued that the audit quality describing how auditing can detect and report errors misstatement of financial statements properly, reducing the information asymmetry between management and shareholders, and helping to protect the interests of shareholders.

There is a difference between the definition of audit quality based on perceived and actual audit quality. Perceived audit quality base on user‟s consideration of financial statements, whereas the actual audit quality refers to the ability of auditors to detect and report accounting misstatements. However, users of financial statements do not have access to the gathered evidence during the audit process and audit information, and thus they can not judge the quality of the actual audit directly.

Other measurements of audit quality are by understanding the results of the audit, Knechel et al. (2012) had stated some literatures have traditionally viewed thepresenceofhigher audit quality in terms of lacking certain negative outcomes

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(such as restatements, litigations, discretionary accruals, accounting conservatism) or having certain positive outcomes (such as issuing going concern opinions).

Related to the results of prior researches, they show that higher levels of audit quality are associated with lower likelihood of accounting restatements. Auditors can be sued when there is very strong evidence of financial statement fraud, in example, auditors were negligent in their audits and did not follow GAAS.

The use of financial statements quality or earnings quality are proxied by using discretionary accruals are the accounting policies that provide flexibility to management to determine the number of transactions in a flexible accrual, or in other words, discretionary accrual method gives the opportunity to the manager to improve the profit earnings as they wish (Knechel et al., 2012). Srinidhi et al. (2010) stated that the use of the quality of earnings can be used because reported accrual results as the result of negotiations between the auditor and the client. In addition, accounting conservatism can also be used to measure the audit quality. However, different opinion was expressed by Zerni (2009) which states that the audit report is generated at least in standard form, does not contain much information about the audit quality. This is due to the quality of the auditor is multidimensional and is not observed, and no single auditor characteristic that can be used as a proxy for it. Other audit quality study is in relation to going concern opinion. But according to Geiger and Raghunandan (2002), the granting of going concern opinion for consideration in the auditor's report, proved to be difficult as a measure of audit quality associated with errors of type I and type II. This is due to the decrease in lawsuits because of policy changes in the Reform Act 1995, which resulted in using going concern opinion to a company that experiencing financial difficulties being dropped from time to time during the year 1992-1993 to 1999-2000 based on the sample used. This could indicate that the using of going concern opinion is not suitable as indicator of audit quality. If perceived audit quality does not reflect actual audit quality, then the use of audit quality to test the relationship among audit quality and other variables is problematic. Financial statement users may not be able to assess actual audit quality accurately because they do not have access to the audit process. (Salehi &Kangarlouei 2010).

2.2. Hypothesis Development

Regulations of audit rotation were made by limiting the rotation of audit partner‟s assignments to improve the auditquality to maintain the independence of the auditor. It is caused by a long period of assignment that will create financial dependency to their clients. In addition, the longer the audit engagement, the auditor‟s critical capability will be reduced because the auditor was too familiar.

Several studies that support the regulation of audit partner‟s rotation have been conducted i.e.Hamilton et al. (2005), Chung (2004) and Kim et al. (2004), concluded that audit rotation regulation consistently had positive effect on audit quality.

Based on the explanation of the purpose of making audit rotation regulations on the auditquality that has been described above, the following hypothesis are proposed,

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H1: the audit partner’s complianceon audit rotation regulation affects positively on audit quality.

H2: the length of the audit partner engagement affects negatively on audit quality.

Fees paid to auditors can affect audit quality in two ways: large fees paid to auditors may increase the effort exerted by auditors, hence, increasing audit quality. Alternatively, large fees paid to auditors, particularly that are related to non-audit services, make auditors more economically dependent on their clients (Hoitash et al., 2007). To reduce the risk of litigation in the future because of the lack of experience of the auditor, many auditors require greater audit fee to prospective clients. Audit fees reflect the amount of collected audit evidence and an additional premium for protection against the risk of litigation. The greater expected audit feescanbe used by auditfirm to fund all costs of the audit process and extend audit procedures.

Several previous studies have concluded that the amount of the audit firm‟s feesaffect positively on audit quality i.e. the research results from Choi et al. (2010) and Yu (2007).

Based on these arguments, the hypothesis can be proposed as follows:

H3: Audit firm’s annual feesaffect positively on audit quality.

Based on several studies that rejected the audit rotation, they were assumed that the execution of the initial audit engagementoccured audit failures that caused by inexperienced auditors in understanding the client's business processes. Becoming an experienced auditor takes many times as illustrated by the learning curve. So some of the benefits based on the length of the audit engagementmake added experience of auditors and audit costs are cheaper. This is supported by research of Carcello& Nagy (2004) who concludes that the financial reporting fraud most likely to occur in the first year of the engagement. Likewise, Geiger &Raghunandan (2002) also states that many errors occured in the first audit report on the relationship between the auditor-client.

Based on the description of the initial audit engagement, auditor should communicate with the predecessor auditor and initial balances testing to increase understanding of the condition of the client and increase knowledge from the predecessor auditor's working paper review with restrictions in accordance with the code of ethics for public accountants, so the following hypothesis can be proposed

H4: initial balance testing affectspositively on audit quality in the initial audit engagement.

3. Research Method

3.1 Sample Selection and Data Collection

The research populations were all inspection of audit partner ever undertaken by the Accountant and AppraiserSupervisory Center (AASC) - Ministry of Finance.

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Observation period of the research was conducted in 2007-2011. Audit partnerswhichbecome samples in this research were selected based on certain criteria (purposive sampling), as follow:

1. Audit partnerswho had been inspected by AASC and published in AASC‟s inspection reports.

2. Annual activity report of audit firms in the period 2007-2011.

3. The availability of all required data such as name of audit partner and audit firm, the audit client's name, audit firm‟stotal fees per year, the length of audit engagement, inspection findings and client‟s total assets.

3.1.1 Operational Definition and Measurement of Variables Dependent Variable

This research uses a dependent variable that is audit partner‟s compliance onprofessional auditstandardbased on AASC‟s inspection report that has mentioned whether audit partner breaking a professional auditstandard or not. So the audit quality (AQ) is an indicator variable equal to 1 if audit partner adhere to professional auditstandard, and 0 otherwise.

Independent Variable

The regulation of audit partner rotation(REG) is defined as the audit partner‟s complianceon the regulation of audit rotation restrictionas an indicator variable equal to 1 if audit partner adhere to audit rotation restriction, and 0 otherwise.The length of the assignment or audit partner‟s tenure(TENUR) is the length of the relationship with the auditor-client in terms of general audit engagements that performed using interval scale.Initial balance testing(IB) was associated with initial audit engagement for the audit partnerwho shouldmake communication with the predecessor auditor, reviewing the predecessor auditor's working papers and perform initial balance testing as an indicator variable equal to 1 if initial balance test was done and 0 otherwise. Audit firm‟s annual fees(FEEKAP) are the total of audit fees and other services received during the year with natural log of audit firm‟s total fees.

Control Variable

Client‟stotal assets (TA) are a measure of client size using the natural log of total assets as control variable. Several previous studies indicate generally the smaller companies tend to commit fraud (Beasley et al., 1999).So audit partner needs to apply appropriate audit procedures for the detection of fraud. Greater fraudulent financial reporting that auditedby audit partner, greater violation opportunities of auditing standards particularly relevant audit evidence.The number of audit partners(AP) are the number of partners in the audit firmbased on domicile of audit firm or audit firm‟s branch. The use of the number of audit partners based on prior research which gave results that the more amount of audit partners, the higher audit quality (Colbert &Murray, 1999).The higher audit quality can be achieved because of peer-review each other between audit partners.

3.2 Hypothesis Testing

Testing the hypothesis in this research was done by using binomial logistic regression. The model created in this research were divided into two models, namely

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model I on the relationship between the dependent variable about the audit quality and the independent variable about audit partner‟s complianceto audit rotation regulation, the length of audit partner‟s engagement, audit firm‟s annual fees, total client assets and the amount of audit partners; and model II on the relationship between audit quality as dependent variable andinitial balances testing in the first year of audit partner‟s engagement as independent variable and the number of audit partners as control variable are presented as follows below:

Regression equation in the hypothesis testing model 1 as follows:

Logit{AQ=1vs0} = α + β1REG + β2TENUR + β3FEEKAP + β4TA+ β5AP+є (1) Regression equation in the hypothesis testing model 2 as follows:

Logit{AQ=1 vs 0} = α + β1IB + β2AP + є (2)

4 Analysis and Discussion

4.1 Data Description

In this research,the data were taken from the results of the inspection and the annual activity reportof audit firm atAASCfrom 2007to 2011. Inspection resultsare part of aroutineannualinspectionplanby dividing thecategoriesinto4 categoriesaudit firm i.e.very large, large, medium and small. The dividing categoriesusethescoring systemattributesinto consideration.

Here are theresults of thefurther samplesused in the research:

Table 1: Selecting Samples Procedure

Summary Amount

Audit Partner had been inspected by AASC 314

Reports of Inspection Result cannot be collected (23)

Audit Partner didnot get engagement (8)

Audit Partner had been sick (2)

Audit Partner didnot lend working papers (1)

Reports of Inspection Resultwere not completed yet (41)

Total samples for Model I 239

Total samples for Model II 117

4.2 DescriptiveStatistics

The following tabledescribes theoverview ofthe descriptive statisticsonresearch modelI andIIare asfollows:

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Table 2: Summary of Frequency

% Model I % Model II AQ Bad 78,2 76,9 Good 21,8 23,1 RE G No adhere 7,5 Adhere 92,5 IB No testing 47,9 Testing 52,1

Table 2showsdescription of the frequencies of general audit engagements based on AQ and REG on the research model (I.) AQ are the number of audit partner‟s engagements with the bad audit quality which had56,4%greater than the good audit quality. REG are the number ofaudit partnerswho adhere on audit rotation regulation which had 85% greater than the number of audit partnerswho not adhere on audit rotation regulation. In the research model (II), description of general audit engagements based on AQ and IB. AQare the number of audit partner‟s engagements with the bad audit qualitywhich had53,8%greater than the good audit quality.IBare the number of the audit partners‟ first audit engagementwho have done communication with the predecessor audit partner and /or have tested the initial balance which had 4,2% greater than the number of the audit partners‟ first audit engagement who have not done communication with the predecessor audit partnerand/orhave tested theinitial balance.

Another descriptive statistic of Model I can be showed as follows:

Table 3: Descriptive Statistic of Model I

No Variabel Mean Median Min Max

1 TENUR 1,64 2 1 4

2 FEEKAP 21,13 20,9 16,4 27

3 TA 26,16 26,3 19,2 33,3

4 AP 2,88 2 1 23

4.3 Result of Regression Test

Statistical processing results of hypothesis testing can be shown in the following table:

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Table 4: Result of Regression Test

Model I Model II

B Sig. Exp B Sig. Exp

FEEKA P 0,931 0,000 2,536 TA -0,003 0,974 0,997 TENUR -0,307 0,290 0,736 REG -0,194 0,818 0,823 AP 0,002 0,985 1,002 0,422 0,004 1,525 IB 2,049 0,002 7,758 Constan t -20,708 0,000 0 -3,85 0,000 0,021

Table 4 shows that the model (I) just audit firm‟s annual feesare significantly and positively related to audit quality. In the model (II) shows that the independent and controls variable are significantly related to audit quality.

Table 5: Coefficient of etermination

Model I Model II

Cox & Snell

R² 0,281 0,264

Nagelkerke

R² 0,432 0,399

Table 5shows that Nagelkerke R Square value on the modeI means the variability ofthe dependent variablecan explained bythe independent variableby43.2%and the remaining56.8%can be explainedbythe other independent variables. In the research model, Nagelkerke R Square value means that the variability of the dependent variable explained by the independent variable by 39.9% and the remaining 60.1% can be explained by the other independent variables.

4.4 Analysis and Discussion of Hypothesis

The first hypothesis testing resultssignificancevalue 0.818 greater than 0.05. Based on this result the first hypothesis can not be accepted which audit partner‟s compliance on audit rotation regulation did not affect significantly on audit quality. The result of this research has strengthened the results of a previous research conducted by Gold et al. (2012) with dummy variables to measure independent variable such as the change of the audit partner or not. So the results of this research can be considered for policy makers that audit rotation restriction until maximum three years does not affect on the audit quality.

The second hypothesis testing resultssignificance value 0.290 greater than 0.05. Based on this result the second hypothesis was not accepted, which the length of the assignment of audit partner did not affect significantly on the audit quality. The result is consistent with the results of research of Jackson et al. (2008) when proxied

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by the level of discretionary expenses and Knechel & Vanstraelen (2007) when proxied by the propensity to issue a going-concern opinion is weak. However, these results are contrast with researchs that is resulted by Gold et al. (2012) using total accruals as quality audit who concluded that the length of the assignment of reviewer partneraffect positively on audit quality.

The third hypothesis testing resultssignificance value 0.000 less than 0.05. Based on this result the third hypothesis is accepted, that means the amount of audit firm‟s annual feesaffect positivelyand significantly on audit quality. With an odds ratio of 2.536 can also be interpreted if other variables held constant, each unit increase in audit firm‟s annual fees will increase log of odds of good audit qualitywith the number 0.931. The results corresponded with the results from Choi et al (2010) and Yu (2007), with value of discretionary accruals as proxy for audit quality. However, these studies differ from the results from Hoitash et al. (2007) which concluded that there was significant negatively and the results from DeFondet al. (2002) which concluded that there was no significant relationship between total fees and audit quality.

The fourth hypothesis testing gives significance value 0.002 less than 0.05. Based onthis result the fourth hypothesis testing is accepted, which means the initial balance testing in initial audit engagement significantly and positively effect on the audit quality than not initial balancetesting. The magnitude of the odds ratio 2.049 means that when the other independent variables constant, the log of odds of audit quality will increase to 2.049 for the initial balance testing ininiatial audit engagement compared with not doing that procedure. Based on this result should encourage professionals and regulators to provide a strong emphasis on the necessity of the initial balance testing, so that it would increase the audit quality in the first year of the audit engagement.

5. Conclusion

This research conclude that audit firm‟s annual fee and initial balance affect significantly and positively on the audit quality, but the audit partner‟s compliance on audit rotation regulation and the length of the audit partner engagement do not affect significantly on the audit quality. The control variables in the research model (1), client size and the number of audit partners do not affect significantly on the audit quality, but the research model (II), the number of audit partners affect significantly and positively on audit quality.

Limitations to this research, namely the length of audit partner engagement tends to be short between one to three years because the samples were taken in the period of applying audit rotation regulation. Further, audit partner‟s compliance on audit rotation regulation based on clients which had not been inspected byAASC.

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Figure

Table 1: Selecting Samples Procedure

Table 1:

Selecting Samples Procedure p.7
Table 3: Descriptive Statistic of Model I  No  Variabel  Mean  Median  Min  Max

Table 3:

Descriptive Statistic of Model I No Variabel Mean Median Min Max p.8
Table  2showsdescription  of  the  frequencies  of  general  audit  engagements  based  on  AQ  and  REG  on  the  research  model  (I.)  AQ  are  the  number  of  audit  partner‟s  engagements  with  the  bad  audit  quality  which  had56,4%greater  than

Table 2showsdescription

of the frequencies of general audit engagements based on AQ and REG on the research model (I.) AQ are the number of audit partner‟s engagements with the bad audit quality which had56,4%greater than p.8
Table 4: Result of Regression Test

Table 4:

Result of Regression Test p.9