Audit Quality is a Function of both the Auditor’s Competence and Independence

A principal-agent relationship is the link between a company’s management and its shareholders. Shareholders delegate essential resources to management. A management team is a group of professionals who appropriately use them in the company’s best interests (Picot, Reichwald, & Wigand 2008, p. 13). Management uses resources for a variety of investment opportunities and describes them in year-end reports. Shareholders ask auditors to check the accuracy of annual financial statements to determine whether company management has reported actual figures (Schelker 2013, p.275).

According to DeAngelo (1981, p.183), auditor competency entails identifying possible contraventions in an organization’s accounting system while independence involves reporting the major findings with utter objectivity. The two elements determine audit quality. “The primary purpose of auditors is to review organizational financial statements and evaluate the accuracy of the information provided”, such information is important to shareholders when making vital decisions and other stakeholders, such as the creditors and government (Mansouri, Pirayesh, and Salehi 2009, p.17). Therefore, it is imperative for auditors to portray competency and independency from the organization providing exactly the same information. Moreover, this was not usually the case. After big accounting scandals in history, such as the case of Enron, Parmalat, and Worldcom, auditor competency and independency became a major corporate governance issue in the contemporary business environment (Schelker 2013, p.275).

Organizations are under pressure to implement concrete corporate governance frameworks, and more emphasis is being placed on auditor competence and independence. In fact, such developments led to the implementation of the Public Company Accounting Reform and Investor Protection Act of 2002, also known as Sarbanes-Oxley Act in the U.S. The Act, which is implemented alongside corporate governance guidelines, requires the board selecting the auditor to be comprised only of independent directors. Further, the Act requires the ”Government Accountability Office (GAO) to assess such procedures and ensure obligatory rotation of the lead partner within the auditing firm” (Schelker 2013, p.276). Auditor rotation is an issue that has attracted heavy debate, albeit advocates of this particular concept believe that continuing auditor-client relationship inhibits independence. Thus, auditors should work under restricted directives. Conversely, opponents of auditor rotation assert that this kind of arrangement enhances independence and affects competence since new auditors need time to acquaint themselves with the vital organizational information and operation models for the company to get quality audit (Schelker 2013, p.277).

This essay centres on the influence of auditor competence and independence on audit quality. It shall begin by analysing three main elements to be discussed, namely audit quality, audit competence, and audit independence. After an extensive analysis of the components, the essay shall analyse how the elements interrelate.

Literature Review

In this section, the researcher shall review the available literature on the particular element of accountancy. The following conceptual framework shall act as a guideline.

Dependent variable

Independent variables

Audit Quality

Audit quality has attracted extensive research in the past three decades. Stakeholders and regulators have collectively worked to promote the indicators of audit quality. Their works have been productive, and, as a result, they have created a set of tools and frameworks designed to aid auditors in understanding audit and in evaluating firms (PricewaterhouseCoopers 2015, p.1). Quality audit is all about identifying the major risks that might affect a company’s financial statement and proactively put in place mechanisms to address the risks. Therefore, PricewaterhouseCoopers defines quality audit as a way of consistently complying with the set standards of accounting and auditing, exercising professionalism in all aspects of the audit process, and using audit expertise to raise and proactively resolve issues in a given organization. In addition, it entails enforcing a comprehensive understanding of the client’s financial and business environment (PricewaterhouseCoopers 2015, p.2).

In February 2014, the International Auditing and Assurance Standards Board (IAASB) published a set of frameworks that define audit quality. The principle purpose of the structure was to create awareness about the core aspects of audit quality, encourage the primary stakeholders to explore methods of enhancing audit quality, and enable an effective dialogue between them on this particular topic. According to the IAASB, the following elements directly determine the audit quality (Federation of European Accountants 2016, p.4).

Inputs. This component focuses on the professional ethics, values, and attitudes in a particular firm. This element also covers the auditors’ skills, knowledge, and experience in the given field and the time required to complete an audit. Inputs apply while auditing the books of accounts of private and public entities (Federation of European Accountants 2016, p.4).

Process. This particular element measures the processes applied while conducting an audit, as well as the quality control systems put in place to ensure that the organization gets the best outcomes. Therefore, the process impacts the audit quality (Federation of European Accountants 2016, p.4).

Outputs. The outputs are the reports and information that the company prepares for the purpose of audit (Federation of European Accountants 2016, p.4).

Interactions within the financial reporting supply chain. This element determines the mode of communication (formal and informal) between stakeholders and the context which may affect their interactions (Federation of European Accountants 2016, p.4).

The contextual factors. From the word itself, this is the environment surrounding the process and its effects on the quality of audit (Federation of European Accountants 2016, p.4).

Audit quality is affected when auditors fail to act objectively and independently. Thus, this renders the results of the process unreliable.

Auditor Independence

According to Arens, Elder, and Mark (2008, p.111), audit independence means, ”taking an unbiased and objective viewpoint”. Neither the public nor the management can affect the auditor because they conduct the process to the utmost interest of all the relevant stakeholders.

Jusbair Baheri and Nurkholis (2017, p.1663) assert that the audit independence narrows down to the process involved in conducting the audit. The auditors must show independence from the beginning to the end of the entire process. This means that the entire audit program and process should be free from managerial interference. Halim, Sutrisno, and Achsin (2014, p.68) affirm that the company management should not assign any more audit requirements, besides those required for the whole audit process. Schelker (2013, p.276) opines that auditors should be free from managerial restrictions that can negatively affect the audit process. For instance, they should be in apposition to acquire evidence easily and should desist from personal interests or behaviours that may be detrimental to the audit results. The auditors should have the independence for verification which means that they must access all the corporation’s books of accounts and crosscheck all the firm’s assets.

Reporting the findings is also another important aspect of auditor independence. Auditors should not be compelled to alter the facts of the audit report in any way. They should not feel the pressure not to report the items of significance in the report (Octavia and Widodo 2015, p.191). Auditors should avoid word choices, whether intentionally or unintentionally, that might lead to misunderstandings in reporting the facts and recommendations. Furthermore, the word choice should not show signs of diminishing the auditor’s judgement about specific facts in the audit report (Schelker 2013, p.281).

Auditor Competence

Competence is having adequate education and extensive experience in the field of audit. The auditor acts as an expert in the field of audit and accounting while performing the process of auditing. Attaining the required level of expertise calls for adequate formal education, and this is broadened through experience in audit practices (Mansouri, Pirayesh, and Salehi, 2009). Furthermore, Samagaio and Rodrigues (2016) assert that accountants should undergo rigorous technical training that includes technical elements and general education for them to qualify as fully-fledged auditors. Junior auditors should undergo mentorship programmes to gain adequate professional experience. During the period, they work under supervision from experienced superiors to attain adequate skills for them to be in a position to perform quality audit.

Effect of Auditor Independence on Audit Quality

Regulators’ increased apprehensions about auditor independence in the past two decades led to the implementation of various laws and regulatory frameworks designed to curb such concerns (Roy and Saha 2016, p.62). After a series of scandals back in 2002, the Sarbanes-Oxley Act (SOX) was implemented. ”The Act prohibited auditors from providing non-audit services to clients, required audit partners to rotate after every 5 years, and enforced a 1-year cooling-off period for auditors before working again with their clients” (Act, 2002, Pp. 2-4). In 2013, the Public Company Accounting Oversight Board (PCAOB) proposed an amendment that required the disclosure of the name of the lead partner in a given audit programme. Exposing the partner’s name linked the person’s repute to the reviews so it played a significant role in enhancing transparency, objectivity, and independence (Tepalagul and Lin 2015, p.102). In this section, the study shall analyse the ideal factors that can interfere with auditor independence which are ”client importance, non-audit services (NAS), audit tenure, and the client affiliation with the audit firm” (Tepalagul and Lin 2015, p.103). Clients offer auditors inducements, such as the purchase of more profitable NAS, so they can easily yield to firm pressures as a way of retaining clients, thus, affecting independence.

The Importance of the Client

The very companies pay the auditors who analyse their financial statements. Therefore, large companies significantly influence an auditor’s portfolio which consequently exposes the auditor to client pressure, hence, compromising independence. The economic connection between auditors and clients coupled with the intense competition for audit services can lead to conflicts which alter independence (Tepalagul and Lin 2015, p.103).

Non-Audit Services (NAS)

According to the SOX Act of 2002 a ”single auditor is barred from providing most non-audit services to a client”. Such a relationship will create an economic bond between the two entities, and this will eventually compromise audit quality. The NAS are usually more profitable so the auditor may choose NAS over audit and, thus, affect audit quality (Tepalagul and Lin 2015, p.105). Srinidhi and Gul (2007, p.1) affirm that higher NAS fees may lead to a lower financial reporting quality so this scares investors.

Auditor Tenure

Proponents of auditor rotation believe that a lengthy client-auditor relationship might compromise auditor quality since auditors eventually develop close ties with the management. Opponents assert that a lengthy relationship increases the auditor’s comprehension of the client’s models of trade, and this hones their knowledge throughout the audit process leading to quality audit (Tepalagul and Lin 2015, p.108). Moreover, different research works offer conflicting arguments. Bambler and Iyer (2007, p.16) opine that incentives extended to a partner may conflict with those of the audit firm. However, this can only occur after a long-term tenure between the two entities. On the other hand, Omer, Bedard, and Falsetta (2006) aver that auditors with long-term tenures (5 to 10 years) have a higher likelihood of discovering audit errors than those with a shorter term. Johnson, Khurana, and Reynolds (2002, p.638) discovered low quality audit in the early years of operation in firms with short-term audit tenures since auditors took time to acquaint themselves with the firm’s business models.

Client Affiliation with Audit Firms

Archival research, for instance Imhoff (1978, p.842-844), identifies three issues that might affect auditor independence. According to the researcher, the auditor sees the client as a potential employer when a relationship between the two exists. For instance, airtight auditor-management relationship creates an agency problem because it creates a relationship gap between the auditor and the investors who are the auditor’s actual employers, and lastly, the auditor may find it difficult to maintain independence whilst working with former colleagues. For that reason, the SOX Act implemented the 1-year cooling off effect for auditors before another engagement. Lennox (2005, p.215) confirms that ”alma-mater affiliations” between an audit firm and corporate enterprise being audited can impede independence. Such companies have a higher probability of receiving spotless audit opinion that those without.

Appointing and Removal Procedures of Auditors

This particular element affects independence. Independence will not be attained if the management is allowed to select, administer, or own a significant stake in auditor appointment or reappointment processes (Mayhew and Pike 2004, p.811). If the management is permitted to govern the appointment of auditors, then there will be room for ”side-payments and reciprocal behaviour” (Schelker 2013, p.278). In the contemporary corporations, it is a common phenomenon for the CEO to get involved in the auditor selection process, albeit in some firms, only the independent directors are tasked with the entire process instead of inside directors or CEOs. An organization with dominant independent directors in the audit and compensation committee reflects sound financial performance.

Removal Procedures

Audit quality is affected when the management has the authority to hire or change the auditor at any given time (Schelker 2013, p.279). Threats to replace the auditor will directly affect their independence. Therefore, the auditing incentives will be aligned with the hiring body. In some worse scenarios, the management may go for ”audit shopping” in a bid to find a friendly auditor (Davidson III, Jiraporn, and DaDalt 2006, p.81). Therefore, the best approach in such a case is to vest the power of selecting and dismissing auditors to the investors (Mayhew and Pike 2004, p.799). Although (Schelker 2013, p.279) agrees that such an arrangement does not exist in the ”corporate world”, it will enhance auditor objectivity.

Effect of Auditor Competence on Audit Quality

According to Roy and Saha (2016, p.68), the recent scandals that led to the collapse of large organisations, such as Enron, Global Crossing, UAL Corporation, Satyam, and WorldCom, was not only a result of auditor independence but also incompetence. Collusion between the management and the auditors impeded auditor independence, and this created fertile grounds for frauds without any form of hindrance. Surprisingly, in the same year - 2001 - six out of the ten largest corporate collapses ever recorded in history were clients of Arthur Andersen.

A research conducted by Jusbair Baheri and Nurkholis (2017, p.1664) established that auditor competence had a positive and significant impact on the quality of audit. Therefore, the studies confirm that quality of an audit can only be enhanced by improving auditor competence. Competent auditors can easily perform quality audit and vice versa. Mansouri, Pirayesh, and Salehi (2009, p.18) affirm, ”Sound knowledge and competence commands a premium.” Lately, the corporate demand has recorded a high affinity for competence in the field of auditing, and this includes satisfactory and constant professional education programmes to ensure auditors stay abreast of the latest auditing techniques. Auditors are required to have a solid educational and professional experience in all the facets of the work which include taxation, accounting, auditing, and any other areas relevant to this particular field.

Halim, Sutrisno, and Achsin (2014, p.65) assert that competence aids auditors achieve to superior performance. In their research, they outline the four indicators of competence, namely ability to plan an audit process, knowledgeable, experience, and impeccable supervision skills. Planning is essential in competence since the auditor will have the needed capabilities to find material misstatements. In addition, the auditor will be in a position to develop substantive testing processes, assess audit risk and the firm’s internal control system. Asmara (2016, p.44) connotes that a knowledgeable auditor has the required technical competence. Knowledge is imperative in auditors’ task structures. Benz, Matthias, and Bruno (2007, p.98) opine that experienced auditors have lower probability of making erroneous judgments as compared to the inexperienced ones so this affects competence. Furthermore, supervision is paramount because supervised audits produce quality results, as well as the correct disclosure.

Asmara (2016, p.46) postulates that auditors are obligated to maintain professional knowledge and skills on a continuous basis. As a result, they will be in a position to uphold audit services in line with the investors’ expectations. An auditor should have a certain level of education, experience, and professional expertise to understand the type and amount of evidence to be collected, examined, and tested to arrive at an accurate and objective conclusion. According to Tepalagul and Lin (2015, p.108), competence is not limited to the skills and knowledge only but involves the attitudes and ethical behaviours as well. Auditors should reflect attitudes suitable enough to carry out their profession. Cohen, Krishnamoorthy, and Wright (2010, p.761) state the same and agree that auditors need the cognitive skills (knowledge), the affective skills (ethical behaviours and attitudes and spiritual intelligence), and the psychomotor skills (technical and physical capabilities).

In addition, Ericsson (2006, p.689) states that besides knowledge, expertise is also important. Expertise is a comprehensive understanding of the company’s business models and environment, understanding of the surrounding environment and the required skills to solve the problems. Tarantino (2008, p.88) asserts that increased mergers, acquisitions, restructurings, globalisation, and the complexities surrounding the field of accounting have impacted auditing. Therefore, for auditors to be competent, they need to hone the technical expertise and the non-technical competence: technical to comprehend the complexities surrounding the contemporary business environment (multinationals and the multiproduct corporations) and non-technical to operate in different cultures, speak foreign languages, facilitate group sessions, and provide training.

Conclusion

The research established positive relationship between auditor competence and independence on audit quality. Competence is the ability to identify errors while independence is reporting the errors without any alterations. The essay established that collusion between the management and the auditors is the greatest impediment to auditor independence. Eliminating possible side-payments and reciprocal behaviour can enhance independence. Furthermore, the legal provisions require the auditing company not to be linked directly to the firm being audited. However, the above measures cannot guarantee full independence. The provisions of audit and NAS services to the same client, auditor tenure, client importance, appointment, and dismissal procedures, as well as the psychological ties to the appointing entity, can have an effect on auditor independence, and this may significantly affect audit quality. However, rules and regulations such as the SOX Act of 2002 can enhance auditor independence and finally audit quality.

Conversely, auditor competence is also important since it aids auditors is easily plan and carry out an audit process. The essay established that audit quality is positively correlated with auditor competence. The requisite educational skills, auditing experience, professional qualifications, and acceptable behavioural ethics in the field of accountancy aid the auditor in determining the type and volume of evidence needed for a given audit process, examining the reports, and identifying the errors in the reports.

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