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MAJ
21,7 Auditor-client relationship: the
case of audit tenure and auditor
switching in Malaysia
724
Abu Thahir Abdul Nasser and Emelin Abdul Wahid
Faculty of Accountancy, University Technology Mara, Johor, Malaysia
Sharifah Nazatul Faiza Syed Mustapha Nazri
Faculty of Accountancy, University Technology Mara, Selangor, Malaysia, and
Mohammad Hudaib
Department of Accounting and Finance, Bradford University School of
Management, Bradford, UK
Abstract
Purpose – The main purpose of this paper is to examine one aspect of auditor-client relationship,
namely audit tenure and switching behaviour, and factors affecting it. Lengthy audit tenure with the
same client has been cited as one of the threats to auditor independence. Given the importance of this
issue, this research attempts to shed some light on the effect of audit tenure and switching behaviour
on auditor independence in Malaysia.
Design/methodology/approach – This study evaluates the effects of various independent
variables on switching behaviour and audit tenure using logistic regression analysis.
Findings – An examination of 297 companies listed on the Kuala Lumpur Stock Exchange over a
period of 11 years reveals audit firm switching to be significantly associated with distressed large
clients and that the length and direction of switch depend upon the type of audit firm.
Research limitations/implications – A number of important variables such as corporate
governance characteristics, audit and non-audit fees and types of audit opinion that could enhance our
understanding of audit tenure and auditor switching in Malaysia, were not incorporated into our
regression models. Hence, future studies may consider such variables.
Originality/value – This study is the first conducted using Malaysian data where audit tenure and
switching are used as dependent variables. The results have important implications on the auditing
profession and regulators in Malaysia.
Keywords Auditors, Auditing, Customer relations, Malaysia
Paper type Research paper
1. Introduction
Auditor independence is the cornerstone of the auditing profession. In general, auditor
independence can be of two forms: “independence in fact” and “independence in
appearance”. The former requires auditors to form and express an opinion in the audit
report as a disinterested and expert observer, uninfluenced by personal bias, while the
latter expects auditors to avoid situations that might cause others to conclude that they
Managerial Auditing Journal are not maintaining an unbiased objective attitude of mind (Porter et al., 2003).
Vol. 21 No. 7, 2006
pp. 724-737
q Emerald Group Publishing Limited
0268-6902
The authors acknowledge the research funding from IRDC of University Teknologi Mara,
DOI 10.1108/02686900610680512 Malaysia in conducting this research.
Flint (1988) argued that independence will be lost if the auditor is involved in a Auditor-client
personal relationship with the client, as this may influence their mental attitude and relationship
opinion. One of such threats is lengthy tenure. He contends that lengthy tenure in office
may cause the auditors to develop “over-cosy relationships” as well as strong loyalty or
emotional relationships with their clients, which could reach a stage where auditor
independence is threatened. Lengthy tenure also results in “over familiarity” and
consequently, the quality and competence of auditors’ work may decline when they start 725
to make unjustified assumptions instead of objective evaluation of current evidence.
The GPES 1.201 (para 2.5) of the ICAEW (2001) recognised that this problem may
be perceived as a threat to auditor independence and recommends that auditors avoid
situations that may lead them to become over-influenced or to be too trusting of the
client’s directors and key personnel which could consequently lead to audit staff being
too sympathetic to the client interest. Since, the relationship between the auditor and
his client can be close in one way or another regardless of the number of years in office,
there is little the profession can do with regard to this matter (Dunn, 1996). In other
words, the profession does not object to auditors serving their clients for a long period
of time, but the objection seems to be over the worry that long period of service may
lead to “cosy relationships” that may threaten auditor independence.
Hence, to maintain public confidence in the audit function and to protect auditors’
objectivity, the profession through a series of clauses proscribes auditors from having
personal relationships with their clients that may give rise to a potential conflict of
interests. One of the proposals is to have mandatory auditor rotation (AICPA, 1978a, b)
as it may increase auditors’ ability in protecting the public via the increase in alertness
to any possible improprieties, increase in quality service and prevent closer
relationship with client (Mautz, 1974; Winters, 1976; Hoyle, 1978; Brody and Moscove,
1998). However, some are against the idea because they believe that the costs outweigh
the benefits. Frequent rotation and switching would result in increased audit fees as
the benefits to be gained from subsequent lower cost after the initial years of any audit
would not be fully realised. Another disadvantage is that the knowledge gained over
time in improving quality of audit work would be wasted with the appointment of a
new auditor (AICPA, 1992). Nevertheless, in 1994, the professional bodies in the UK
introduced a seven year rotation policy for the audit engagement partners auditing
public listed companies (Porter et al., 2003). A similar rotation policy was also
introduced for audit engagement partners involved in auditing SEC registered
companies (Wood and Sommer, 1985; Brody and Moscove, 1998).
In Malaysia, the issue of audit tenure and interval rotation of audit firms or audit
partners were not explicitly addressed in any of the relevant Malaysian official
documents such as the Companies Act 1965, the Security Commission regulations,
approved auditing standards, etc. Lack of official pronouncements on this issue could
be due to the rejection of such rotation idea by the business community. Jaffar and
Alias (2002) found only 35 per cent of the audit firms’ partners and only 32.4 per cent of
the chief finance officers surveyed favoured audit firm rotation every three years of
engagement. However, in light of the Enron case, the Chairman of the Malaysian
Accounting Standard Board announced the intention of the board to make it
mandatory to rotate the audit firm once every five years (The Edge, 2002). While some
countries are either considering or have already imposed the five-year restriction to
rotate the audit firms, the length of audit tenure and the possible effect of switching on
MAJ auditor independence in Malaysia is still unclear. Hence, the results would highlight if
21,7 audit tenure and switching should be of concerned before any rotation length is
imposed. This is our main contribution to the literature.
Our analysis involves an examination of 297 Malaysian listed companies between
1990 and 2000 using logistic regression. Results indicate the probability of switching
the audit firm is greatest for distressed large client and that the direction of switch and
726 length of tenure are dependent on type of audit firm. This implies that auditors in such
environment fear losing their tenure and being switched, hence their independence and
objectivity may be impaired. As such, we assert that rotation policy should be partially
imposed on distressed clients as a first step forward in protecting auditor independence
in the country. The paper proceeds as follows. The next section discusses the literature
review and the development of the hypotheses. Sections 3 and 4 present the research
method and results, respectively. Section 5 presents the summary and conclusions.
3. Research method
3.1 Data sources
There were 810 listed companies on both the main and second board of the Kuala
Lumpur Stock Exchange (KLSE) or Bursa Malaysia as at 10 June 2002. The sample of
this study consists of 297 randomly selected companies listed on both boards. Based on
the sample error formula (Burns and Bush, 2003), a sample size of 297 is deemed
appropriate. The relevant data had been collected from KLSE Research Institute
Database for a period of 11 years from 1990 to 2000. Besides the relevant financial
statements, the relevant audit reports of the sample firms available at KLSE were also
used in this research.
The dependent variables are auditor switching (SWITCHt) and the four directions of
switch (mxt) which are noted from the audit reports during the study period. The
independent variables consist of book value of equity (BVE) and market value of
equity (MVE), client size (CLI.SIZE), changes in total assets (Ln DTA), changes in sales
(Ln DS), type of audit firm (AUDIT), changes in income from continuing operations in
the two years preceding the audit change (Ln DRt2 2), financial distress of the client
company (Ln DZ),[1] interactive effects of length of tenure held by Big 4 and non-Big 4
before being switched (TENU*AUDITxt) and the interactive effects of length of tenure
before the first switch (TENU*B1.SWI).
SWITCHt is a binary variable indicating whether or not the audit firm was switched or 729
not switched. The other independent variables are as summarised in Table I.
3.3.2 Model 2. To further explain the impact of independent variables on the
switched directions of audit firms (mxt), the following logistic regression model was
adopted to test the association between auditor switching from one type of audit firm
to another and the nine independent variables, viz. type of audit firm (AUDIT), client
size (CLI.SIZE), client growth (Ln DS), financial risk (Ln Z), change in operating income
(Ln DRt2 2), change in market value of equity (Ln DMVE), the change in total assets
(Ln DTA), the interactive effects of length of tenure before the first switching
(TENU*B1.SWI) and the interactive effects of length of tenure of a large audit firm
(Big 4) remaining in the office before being switched (TENU*AUDITB4):
a0 Intercept
SWITCH A dummy variable, 1 if the audit firm is switched at time t, and 0 otherwise
mxt Four propositions of switch directions
1. m1 ¼ from non-Big 4 to non-Big 4
2. m2 ¼ from non-Big 4 to Big 4
3. m3 ¼ from Big 4 to non-Big 4
4. m4 ¼ from Big 4 to Big 4
AUDIT A dummy variable, 1 if the firm is a Big4 audit firm, and 0 otherwise
CLI.SIZE A dummy variable, 1 if the client’s TA is large (ln TA . the mean), and
0 otherwise
Ln DS The natural logarithm of squared changes in sales scaled by ln TA
½lnððDS=ln TAÞ2 Þ;
Ln Z The natural logarithm of company’s financial risk: cash flow from operations
over long-term debt [ln(Z)2] p2 ffiffiffi
SQ ln BVE The square root of natural logarithm of BVE ½ lnðBEÞ 2;
ln TA The natural logarithm of the client’s assets [ln TA]
Ln DTA The natural logarithm of squared changes in of total assets ½lnðDTAÞ2 ;
ln MVE MVE [ln MVE]
Ln DMVE The natural logarithm of squared changes in MVE ½lnðDMVEÞ2 ;
LnDRt2 2 The natural logarithm of squared changes in operating income two years
(yeart2 2) before switching in yeart2 0 ½lnðDRt22 Þ2 ;
TOT.TENU Total length of tenure (years) for the period
TENU*B1.SWI The interactive effects of length of tenure before the first switch, company j is
coded 1 up to 11 depending of the length of tenure before the first switch in
periodtx
TENU*AUDITxt Two propositions of the interactive effects of tenure length before switching
1. TENU.AUDITB4 ¼ number of years the incumbent Big4 held office before
being replaced divided by TOT.TENU
2. TENU.AUDITnB4 ¼ number of years the incumbent non-Big4 held office Table I.
before being replaced divided by TOT.TENU Variables in the logistic
1 Error term regression models
MAJ mt ¼ a0 þ b1 AUDIT þ b2 CLI:SIZE þ b3 LnDS þ b4 Ln Z þ b5 Ln DRt22
21,7
þ b6 Ln DMVEb7 Ln DTA þ b8 TENU*B1:SWI þ b9 TENU*AUDITB4 þ 1
The model is run four times to cover all switch directions taken by clients to appoint
their new audit firms after terminating the services of their incumbent audit firms.
730
4. Empirical results
4.1 Descriptive statistics
Table II (Panel A) presents descriptive statistics for the experimental, control and
dependent variables. The mean size of clients is RM 1.5 billion. The negative signs in
Panel A (Continuous)
TA 35,251 51,453,100,000 1546788049.45 4855264576.1
Ln DTA 2 15.2018 1.1077 2 5.106514 2.6
BE 2 1,882,020,548 14,518,600,000 449149349.93 1182242201.7
SQ ln BVE 5.22 6.84 6.1446 0.2
MVE 350 17,432,850 404402.64 1614674.7
Ln DMVE 2 9.6318 12.9503 2 0.753392 2.1
Ln DS 2 13.6249 9.5961 2 3.629986 3.3
Ln DRt2 2 2 18.4207 10.1909 2 1.388829 3.2
Risk (Z) 2 0.0300 1835.8700 24.510732 172.1
Ln Z 2 20.8286 15.0305 2 0.525179 4.2
TENU*B1.SWI 1 11 6.10 3.5
TENU*AUDITB4 0.00 1.00 0.5576 0.46640
TENU*AUDITnB4 0.00 1.00 0.4424 0.46640
Panel B (Dichotomous)
CLI.SIZE 0 1 129 0.43 0.497
AUDIT 0 1 175 0.59 0.493
SWITCH 0 1 87 0.29 0.457
TOT.TENU 1 11 1,987 6.69 3.619
mxt 0 4 198 0.67 1.191
m1 0 1 23 0.08 0.268
m2 0 1 36 0.12 0.327
m3 0 1 9 0.03 0.172
m4 0 1 19 0.06 0.245
Notes: n – 297; TA – total assets; ln TA – the natural logarithm of total assets; Ln DTA – the
natural logarithm of squared changes in total assets; SQ ln BVE – the square root of natural logarithm
of BVE; Ln DMVE – the natural logarithm of squared changes in MVE; LnDS – the natural logarithm
of squared changes in sales scaled by ln TA; Ln DRt2 2 – the natural logarithm of squared changes in
operating income; Ln Z – the natural logarithm of company’s financial risk; TENU*B1.SWI – the
interactive effects of length of tenure before the first switching; TENU*AUDITB4 – the interactive
effect of years in office by Big4 before switching over total tenure period; TENU*AUDITnB4 – the
interactive effects of years in office by non-Big4 before switching over total tenure period; CLI.SIZE – a
dummy variable, 1 if the client’s TA is large, and 0 otherwise; AUDIT – a dummy variable, 1 if the
firm is a Big4 audit firm, and 0 otherwise; SWITCH – a dummy variable, 1 if the audit firm is
switched, and 0 otherwise; TOT.TENU – total length of tenure (years) for the period; m1 – switched
Table II. from non-Big4 to non-Big4; m2 – switched from non-Big4 to Big4; m3 – switched from Big4 to
Descriptive statistics non-Big4; m4 – switched from Big4 to Big4
the mean values indicate poor financial performance during the period of analysis. Auditor-client
Table II (Panel B) reports the descriptive statistics of the dichotomous variables. It can relationship
be seen from the table that the sample consisted of 43 per cent (129) large companies,
60 per cent (175) Big 4 and 29 per cent (87) cases of audit termination (switching). It also
shows that switching from small to large audit firm (i.e. from non-Big 4 to Big 4) is the
most common type of auditor change (36 cases), followed by switching from small
audit firm to small audit firm (23 cases) and switching from large audit firm to large 731
audit firm (19 cases). Not surprising, the least common type of auditor switch is from
large audit firm to small audit firm (9 cases).
Table III presents the correlation matrix for the dependent and continuous independent
variables. It indicates no multicollinearity problem, as the correlations are relatively
low except the correlation between two independent variables: type of audit firm (AUDIT)
and (TENU*AUDITxt – the tenure length of Big 4 and non-Big 4). Therefore, AUDIT and
TENU*AUDITnB4 are dropped when we run our regression models.
We further extended our analysis by using ordinary least squares regression where
TENU*B1.SWI is the independent variable to test the H5. The results are reported in
Table VI (Panel B). The results show that the length of tenure is longer for similar sized
switching of audit firms and shorter for dissimilar sized switching of audit firms.
Hence, based on the results, H5 is accepted.
Panel A Panel B
Regression results
Dependent variable:
Switched from TENU*B1.SWI
TENU*B1.SWI m1 m2 m3 m4 Estimate
1 0 8 1 0 m1 2.260 * * *
2 0 4 0 0 m2 21.397 * *
3 3 4 2 2 m3 21.783
4 3 2 1 1 m4 0.935
5 1 2 1 2 CLI.SIZE 2.486 * * *
6 1 4 1 2 Ln Z 0.013
7 1 4 0 1 TENU*AUDITB4 5.448 * * *
8 2 4 3 0 TENU*AUDITnB4 4.431 * * *
9 1 2 0 2
10 1 2 0 0
11 10 0 0 9
Total 23 36 9 19
x 2 ¼ 10.9 x 2 ¼ 46.5 * * * x 2 ¼ 19.4 * * x 2 ¼ 14.8 Adj. R 2 0.796
Notes: TENU*B1.SWI: interactive effects of length of tenure before the first switch; m1: switched from Table VI.
non-Big4 to non-Big4; m2: switched from non-Big4 to Big4; m3: switched from Big4 to non-Big4; Crosstabs between length
m4: switched from Big4 to Big4; TENU*AUDITB4: interactive effects of years in office by Big4 before of tenure with the four
being switched; TENU*AUDITnB4: interactive effects of years in office by non-Big4 before being directions and regression
switched; * * *1 per cent significance, * *5 per cent significance, *10 per cent significance results
audit opinion and how receiving qualified opinion might affect the decision to switch or
retain the audit firm. Hence, future studies should consider such variables in the
models to enhance our understanding of the Malaysian audit environment.
Note
1. Beaver (1968) used the ratio of cash flow from operations over long-term debt to diagnose
financial risk of the company.
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Corresponding author
Mohammad Hudaib can be contacted at: m.hudaib@Bradford.ac.uk