do audit tenure and firm size contribute to audit quality empirical evidence from jordan.pdf

Do audit tenure and firm sizecontribute to audit quality?

Empirical evidence from Jordan

Ali Abedalqader Al-ThuneibatDepartment of Accounting, Faculty of Business,

University of Jordan, Amman, Jordan

Ream Tawfiq Ibrahim Al IssaSecured Services Systems, Amman, Jordan, and

Rana Ahmad Ata BakerTelecommunication Regulatory Commission, Amman, Jordan

Abstract

Purpose – The purpose of this paper is to analyze the effect of the length of the audit firm-clientrelationship and the size of the audit firm on audit quality in Jordan.

Design/methodology/approach – To test their hypotheses, the authors use the quadratic formapproach, similar to Chi and Huang, with some modifications. The population of this studyencompasses all firms in which stock is publicly traded on the Amman Stock Exchange throughoutthe years (2002-2006).

Findings – Statistical analysis of data shows that, audit firm tenure affects the audit quality adversely(negatively). Audit quality deteriorates, when audit firm tenure is extended as a result of the growth inthemagnitude of discretionary accruals. Meanwhile, data analysis did not reveal that the audit firm sizehas any significant impact on the correlation between audit firm tenure and audit quality.

Practical implications – If auditor independence and audit quality are to be enhanced, the auditfirm should be rotated in order to open the door for new auditors to investigate the client with greaterscrutiny and due care. Moreover, the activities of big audit firms should be monitored in order todistinguish their role from small firms.

Originality/value – The paper provides evidence from a developing country about audit quality.It is expected to support and sustain improvement of audit quality, and therefore, financial reportingquality. The evidence provided by this paper adds to the literature internationally and this isimportant because auditing is a socially constructed phenomenon.

Keywords Jordan, Auditors, Auditing standards, Developing countries, Financial reporting, Expenses

Paper type Research paper

IntroductionManagement is responsible for reporting the results of the firm’s operations andfinancialposition to stakeholders through financial statements. A possible conflict of interestbetween management and external users of financial statements exists. This conflict,in addition to the asymmetry of the information provided, creates together an inevitableneed for auditing the financial statements by a third competent and independent party.Auditing financial statements is intended to reduce the information risk and improve thedecision making (Arens et al., 2008). The audit process is designed to determine whetherthe figures reported in financial statements present the firm’s operating results andtrue financial position in a fair manner. Therefore, improving the audit quality would

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Audit tenureand firm size

317

Received 14 August 2009Revised 12 June 2010

Accepted 11 October 2010

Managerial Auditing JournalVol. 26 No. 4, 2011

pp. 317-334q Emerald Group Publishing Limited

0268-6902DOI 10.1108/02686901111124648

provide reasonable assurance about the accuracy of reported accruals and as aresult, attest for earnings of higher quality. On the other hand, a poor-quality auditwould impair the quality of earnings and discretionary accruals (DAs) (Chih-Ying et al.,2008).

Among themain targets, a quality audit seeks to accomplish is improving the qualityof management’s financial reporting task (Dopuch and Simunic, 1982; Watts andZimmerman, 1986). Improving the quality of financial statements adds value to thosereports as an investor tool for estimating the value of traded securities. Improvedquality is a function of not only the auditor’s detection of material misstatements, butalso the auditor’s behavior towards this detection. Therefore, if the auditor rectifies thediscovered material misstatements, a higher audit quality results, while failure tocorrect material misstatements upon detection and prior to issuing a clean audit report(or moreover failure to uncover material misstatements) obstructs the improvementof audit quality ( Johnson et al., 2002). In Jordan, it is widely observed that most firmsretain the same audit firm for long periods of engagement with a general tendency tohave confidence more in the quality of big firms’ audits. While long auditor-clientengagements can have adverse effects on audit quality, the size of the audit firm ispresumed to contribute to the quality of financial statements reported by its clients.Long auditor-client relationships have the potential to create closeness between theauditor and the client, enough to deter the auditor’s independence and reduce theaudit quality.

Investigating the quality of audits conducted by big auditors in Jordan, as reflected bytheir clients’ DAs, and studying the effect of the length of the auditor-client engagement,would determine if big auditors deliver improved audit quality when compared withnon-big auditors, and would prove whether the length of the auditor-client relationshipaffects audit quality. Therefore, the question arises of whether a long audit firm-clientrelationship and the size of the audit firm have any effect on audit quality in Jordan.

This study will examine the relationship between audit firm tenure (the length ofthe audit firm-client relationship) and audit quality for industry and service firms listedon the Amman Stock Exchange (ASE) in Jordan during the period 2002-2006 and theeffect of the audit firm size on this relationship. The effect will be studied in terms ofthe quality of DAs reported by audit firms’ respective clients. DAs are widely usedin the literature as a proxy for audit quality. Amongst the parties which will benefitfrom the findings of this study are the bodies in charge of regulating the profession.Solid evidence would prove the effectiveness, and therefore establish the necessity for amandatory audit firm rotation, or such an association may be impossible to draw. In thelatter case, activating an obligatory audit firm rotation would be an additional cost forboth audit firms and their respective clients.

The Jordanian market aims to benefit from global expertise, which is apparent in thetendency to employ big audit firms for the audit of financial statements. Therefore,it is important to uncover whether big firm auditors deliver superior quality audits;otherwise, the door should be opened for new comers in the Jordanian audit communityand industry, without the concern of competing with big auditors on the basis of theirsuperior audit quality. Additionally, it is very important to enrich the existing literatureabout audit rotation, firm size and audit quality at the international level becauseauditing is a socially constructed phenomenon and therefore we need evidence fromvarious environments.

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Literature review and hypotheses developmentThe accumulated literature builds on the notion that the basic objective of the auditprocess is to enhance the quality of the financial reporting process by providingimproved quality audits (Dopuch and Simunic, 1982; Watts and Zimmerman, 1986).Audit quality is commonly defined as “the market-assessed joint probability that anauditor will both detect and report material misstatements” (DeAngelo, 1981a). It is afunction of auditors’ competence that enables them to detect material misstatements,and auditors’ independence, that determines whether they will report those materialmisstatements or not (Azizkhani et al., 2007).

Several factors determine the auditor’s ability to detect material misstatements infinancial statements, one of which is the qualifications of the auditor. An auditor’squalifications are an initial indicator of his/her knowledge and capabilities in the auditfield. This knowledge might be either client-specific knowledge (e.g. the knowledge ofthe client’s accounting system, assets and internal controls), or a knowledge that is moregeneral in scope but very essential to the audit process at hand (knowledge about theindustry within which the client is operating and the accounting principles applicable inthe country where the client is operating its business). Client-specific knowledge isthe vital element that creates, and subsequently enhances, the learning curve of newauditors (Knapp, 1991). This argumentmight seem simple at the outset, while in fact it isnot. Lower client-specific knowledge during the early years of an audit engagementcan result in a lower likelihood of detecting material misstatements. Such knowledgeis the auditor’s comparative advantage in detecting errors over time, when the client’sbusiness is understood more profoundly (Beck and Solomon, 1988). Chi and Huang’s(2004) empirical findings support the learning effect presumption, where the ability toinvestigate accounting irregularities is found to be a function of the audit tenure,whetheron the audit firm or the auditor level. Boone et al. (2008) argue that client-specificknowledge is crucial to building a reasonably sufficient level of familiarity with theclient’s accounting system, internal controls, assets, operations and the industry withinwhich those operations occur as well.

In an investigation carried out by American Institute of Certified Public Accountants(AICPA, 1992), theAICPAQuality Control Committee found the audit failures to be threetimes more likely in the first two years of an engagement than in subsequent years. Theinvestigation surveyed 406 audit failure cases alleged by SEC clients. Two studies thatexamined lawsuits involving auditors (St Pierre and Anderson, 1984; Stice, 1991) foundthe audit failures to be more common in a three-year or less auditor-client engagement.Long-tenure auditors were found more likely, in comparison with short-tenure auditors;to issue going-concern opinions for clients who subsequently declared bankruptcy(Geiger and Raghunandan, 2002).

Absolute DAs were found to decrease significantly through the passage ofthe audit firm tenure (Chih-Ying et al., 2008). The researchers’ findings are consistentwith the argument that audit firm rotation might have adverse effects on the qualityof earnings; and accordingly, the accruals reported. To determine the effect of the“Mandatory Auditor Retention Law” in Korea, Bae et al. (2007) studied DAs as a proxyfor audit quality. The researchers found DAs to be significantly lower during the yearsof retaining the same auditor. Their evidence applies to both positive and negativeaccruals, with stronger emphasis on negative. They considered this an indicator offirms’ adoption of conservative accounting. On the other hand, some studies failed


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to establish evidence on the audit firm rotation effectiveness in providing the allegedshield from fraudulent financial reporting (Carcello and Nagy, 2004).

After a specific number of years, excessive familiarity can result and serve as adeterrent to the quality of financial reports. Long tenure is assumed to lead to lessobjectivity in the auditor’s behavior, where a “learned confidence” in the client isdeveloped (Hoyle, 1978; Arrunada and Paz-Ares, 1997). According to Johnson et al. (2002)the learning effect will diminish when the engagement exceeds eight years. They studiedthe auditor tenure divided into three categories: Short (2-3), Medium (4-8) and Long(9 or more). Upon approaching the medium tenure category and extending beyondtowards the long tenure, the independence of the auditor is jeopardized as a result of theauditor’s excessive familiarity with the client and its industry. The auditor is no longermotivated to innovate or diversify in the audit procedures at this stage of the engagement.

Myers et al. (2003) provided evidence that earnings management is less of a concernfor auditors in longer audit firm tenures. Similarly, Davis et al. (2003) inferred thatmanagement gains additional reporting flexibility with the progress in auditor tenure.This was evident in the direct positive effect the auditor tenure had on DAs, i.e. DAsincrease with the progress in the auditor tenure. A reasonable conclusion to draw at thisstage of the argument is that it remains unclear – how long is long enough to acquire anacceptable and reasonable level knowledge and gain the necessary acquaintance withthe client’s business, industry and accounting system in Jordan?

The lack of consensus on the optimal length of the audit firm-client relationshipthat yields better DAs’ quality constitutes the grounds for formulating the followinghypothesis:

H1. The length of the audit firm-client relationship affects audit quality asmeasured by DAs.

The literature provides some evidence on the difference in learning between audit firmsrelevant to their size. Chi and Huang (2004) were able to substantiate their hypothesis onthe learning differentiation across Big5 and Non-Big5. Data analysis revealed that Big5auditors construct learning experiencemorequickly thanNon-Big5 auditors.Big5auditorswere significantly more proficient during the initial period of an audit engagement due totheir quickness and greater expertise in acquiring the requisite knowledge and obtainingthe necessary acquaintance. However, their results demonstrated a diminishing variationof audit quality between Big5 auditors and Non-Big5 auditors throughout the passage oftime. They attributed the leading role of the Big5 auditors to their auditing expertise in anew client and not to pure Big5 brand name effect.

A study of the Malaysian market found the retention of a specific audit firm to be afunction of the client’s size (measured by the total assets or the financial risk level) andthe size of the audit firm. A small distressed company, whose financial statementsare audited by a small audit firm, was found to have a higher probability of switchingthe audit firm compared to a non-distressed big client whose financial statements areaudited by a big audit firm. In addition, the tenure before switching from a small to abig audit firm was significantly shorter than the tenure before switching from a smallto another small audit firm (Abu Thair, 2006).

The literature shows the big audit firms to be associated with superior financialreporting quality (Teoh and Wong, 1993). Researchers have suggested that the heavyspending of big audit firms on auditor training, besides their size and large portfolio

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of clients, create a distinctive advantage, whether as an actual competence of the auditoror as a perceived independence by their clients. Palmrose (1988) suggested that Big6 arequality-differentiated suppliers, which lead to lower incidence of fraud in their case.Fraud was also identified to be less likely in the case of Big6 auditors by otherresearchers (Carcello and Nagy, 2004).

While Becker et al. (1998) recorded lower amounts of DAs in the case of Big5 auditors’clients, Chih-Ying et al. (2008) noticed an association between Big5 auditors’ clients andthe lower DAs they report when the accruals are negative. Francis (1999) also foundfirms who have a higher inclination to generate accruals, tend more towards hiring Big6auditors. They believed the selection of Big6 auditors to be consistent with the enhancedcredibility of their clients’ earnings. Some researchers believe large audit firms have thecapacity to generate quality audits due to their greater monitoring ability (Watts andZimmerman, 1986). Others believe the enhanced audit quality big audit firms deliver is aproduct of their brand-name quality differentiated audits (Simunic and Stein, 1987).In Australia, investors and analysts perceive Big4 audit firms as providers of higherquality (Azizkhani et al., 2007).

Several studies that dealt with US cases have enriched the literature with remarkableevidence on the improved credibility of financial reports resulting from Big4 audits(Dopuch and Simunic, 1982; Teoh and Wong, 1993; Khurana and Raman, 2004;Mansi et al., 2004; Pittman and Fortin, 2004). We further pinpoint that, Dopuch andSimunic (1982) correlated this to the greater observable quality characteristics Big4possess; such as quality control and specialized training. DeAngelo (1981b) believedlarge audit firms have more brand capital to lose and, therefore, would be moreindependent and able to supply the client with better audit quality. Their large portfolioof clients as well affords them a specific ability to resist or withstand clients’ pressure.

Earlier discussion lays the foundation for raising the question of how confident canwe be that the well-known and recognized position of Big4 auditors is due to auditingexpertise and not an outcome of their brand name effect in Jordan? To find the answerto this question, this study examines the effect of Big4 audit firms on the quality ofDAs in the Jordanian market. Better quality DAs reported by Big4 clients wouldprovide evidence that Big4 have superior auditing expertise and their position is notdue to pure brand name effect:

H2. The size of the audit firm enhances the effect of the audit firm-clientrelationship length on audit quality, as measured by DAs.

Study design and methodologyThe population of this study consists of all Jordanian companies listed for trading onthe ASE, both in the industry and service sectors during the years 2002-2006. TheFinancial sector (comprised of banks, insurance companies and financial servicescompanies) is excluded for two reasons:

(1) Entities in this sector have different operating characteristics (Carcello andNagy, 2004), and as a result, possess risk and complexity properties that areunique in nature and different from those of other sectors.

(2) The unique characteristics of those entities make it impossible to compute thecontrol variable “Leverage: debt-to-asset ratio”, or makes computing thevariable of no meaning (as it will not provide much value) (Boone et al., 2008).


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Firms which do not comply with the sample criteria are deducted from the samplebecause of the potential noise and contaminating effect they might pose on the findings.

The following are the sample criteria and requirements:. The firm’s shares should be listed for trading on the ASE during the years

(2002-2006).. The firm’s financial statements must be available for the years (2002-2006), to

provide for the financial data needed to calculate the study variables.. The firm’s auditor and tenure should be determined from its guide.. The firm should not have undergone an extraordinary event, such as merger or

acquisition, or other similar transactions that might result in reorganization ofthe firm’s business segments and as a consequence affect the entity and itsfinancial statements.

. The daily closing prices of each firm’s shares should be available for not less than180 days/year. This is necessary to calculate the firm’s market value of equity.

The above-mentioned criteria of the population and sample should be considered as alimitation of the study, that is, as a result of these criteria a limited number of firmswill berelevant for the analysis. To examine audit quality, two audit firm factors deemed toaffect this quality as discussed throughout literature review will be investigated:the length of the audit firm-client relationship (audit firm tenure) and the size of theaudit firm.

Consistent with Johnson et al. (2002), we measure audit firm tenure as the numberof consecutive years the audit firm has audited the client’s financial statements.Meanwhile, we further count tenure years backward starting from 2006, and trace ituntil the year during which the client switched to another audit firm (Boone et al., 2008).This provides sufficient data since we use the Chi and Huang’s (2004) model.

To determine the size of an audit firm, the market capitalization of all firms listed fortrading on the ASE was calculated. All sectors were covered and all auditors auditingfirms listed for trading on the ASE during the period (2002-2006) were included as well.Market values of ASE firms were traced to their corresponding auditors. The mean ofthe market value of each auditor’s client was calculated and used as a proxy for theauditor’s size. Therefore, the market share of each audit firm was determined and Big4were identified. The selection of Big4 and non-Big4 in particular coincides with theadoption of this scale globally.

Following previous research, this study uses DAs as a proxy for audit qualitybecause it is provides an indication of management’s active intervention in reportingearnings (Johnson et al., 2002; Krishnan, 2003; Chi and Huang, 2004; Bae et al., 2007;Dang, 2004; Zhou andElder, 2001). Johnson et al. (2002) used the absolute level of DAs asa proxy of the quality of financial reporting. The other proxy they used is the persistenceof the accrual components of earnings. Their use of the absolute level of DAs is pertinentto the nature of their study and the existence of prior concerns regarding earningsmanagement. The researchers believe the magnitude of those DAs is an indicator ofmanagement’s success in managing earnings in either direction (upward or downward);contingent on the needs of the specific year (Reynolds and Francis, 2000).

In our study, we will not use absolute level of DAs because they were proven togenerate misleading findings. Companies receiving going-concern opinions were found

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to have large negative accruals (which are income-decreasing items). Those largenegative DAs might be a product of severe financial distress. Some researchers believesuch findings are inconsistent with earnings management and auditor conservatismexplanations for the relationship between audit opinion and DAs (Butler et al., 2004).The level of DAs for firms is calculated by using the cross-sectional Jones model andthe cross-sectional modified Jones model. We start by estimating total accruals (TA)using the cross-sectional Jones Model for both sectors. Each sector encompasses aminimum of 20 firms for the duration of the study (2002-2006):

TAit

Ait21¼ B1jt

1

Ait21

� �þB2jt

DREV it 2 DAR it

Ait21

� �þB3jt

PPEit

Ait21

� �þ 1it ðIÞ

where:

TAit Total accruals for firm i in year t calculated as the difference between netincome before extraordinary items and cash flow from operations(Becker et al., 1998).

Ait21 Total assets of the previous period, i.e. at time t 2 1[1].

DREVit Revenue for firm i, in time t less revenues in time t 2 1.

PPEit Gross property, plant, and equipment for firm i in year t.

Then, we estimate non-DAs (NA) using the cross-sectional Jones model for eachindustry group containing at least 20 firms in each year. The industry-year-specificparameter estimates from the above cross-sectional Jonesmodel are used to estimate thefirm-specific NAit for every year of the study. NA are calculated as a percent of laggedtotal assets using the cross-sectional modified Jones model:

NAit

Ait21¼ B1

1

Ait21

� �þB2

DREV it 2 DARit

Ait21

� �þB3

PPEit

Ait21

� �� ðIIÞ

where:

DARit Accounts receivable in time t less accounts receivable in t 2 1.

Other variables are as defined above.DAs are the resulting residual after deducting NA from TA. Thus, (DAi,t) for firm i

in year t is calculated as:

DAit ¼TAit

Ait212

NAi;t

Ait21ðIIIÞ

Weuse the quadratic form approach due to the curvilinear relationship expected to existbetween the audit firm tenure and the quality of DAs (Chi and Huang, 2004). However,the model will be modified further for the purpose of testing our own hypotheses.

The model will incorporate the control variables: size, age, financial condition andleverage. Control variables are elaborated in a section specified for this purpose. Cashflows from operations scaled by lagged total assets[2]; are incorporated into our empiricalmodel since they have demonstrated an inverse variation with DAs (Dechow et al., 1999).


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The following model is used to test H1:

DAit ¼ b0 þ b1TENURE it þ b2TENURE2it þ b3

OCFit

Ait21

� �þ b4LAit

þ b5LEVit þ b6FCit þ b7AGEit þ 1it

ðIVÞ

where:

DAit ¼ the level of DAs for company i at time t.

TENUREit ¼ the length of the audit firm-client relationship for company i attime t calculated in years.

TENURE 2it ¼ the squared value of the variable TENURE.

OCFit ¼ operating cash flows for company i at time t.

LAit ¼ the natural logarithm of total assets for company i at time t.

LEVit ¼ the financial leverage ratio computed by scaling total liabilities tototal assets of company i at time t.

FCit ¼ the Altman Z-score for company i at time t[3].

AGEit ¼ the number of years company i has been listed in a stock exchangeat time t.

H2 will be tested only if the results of testingH1 support the hypothesized relationshipbetween the audit firm tenure and audit quality.

The following model is used to test H2:

DAit ¼ b0 þ b1TENUREit þ b2TENURE2it þ b3

OCFit

Ait21

� �þ b4LAit

þ b5LEVit þ b6FCit þ b7AGEit þ b8BIG4it þ 1it

ðVÞ

BIG4it a dummy variable equals 1 if the company employs one of the Big4 audit firmsand 0 otherwise.

Control variablesTo eliminate alternative explanations that might arise whilst investigating therelationship between the variables, we control other cross-sectional factors that havebeen shown previously to contaminate the relationship because of their systematiceffect on accruals. Controlling those variables would mitigate their systematic effectsand lend the findings greater reliability.

Absolute levels of unexpected accruals might mask the true source of those accrualswhen they are large and negative in value. As highlighted earlier, some companies withlarge negative accrualswere found to receive going-concern opinions. This is considerednormal, given that large negative DAs might be a caution for financial distress(Butler et al., 2004). For this reason, we control for the client’s financial conditionusing the Altman Z-score, defined as the FC variable. Another reason we controlfor the financial distress is that companies suffering a financial distress condition

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or near-debt constraints might be more motivated to manage earnings (Defond andJiambalvo, 1994).

We control for the client’s size using the natural log of total assets to eliminate the effectof the firm size since large firms were proven to have larger and more stable accruals(Dechow and Dichev, 2002). Prior research suggests that, there is more publicly availableinformation about larger companies and that their stock is more liquid (Brennan et al.,1996;Gebhardt et al., 2001).Themore the available information about a client and themoreliquid the stock is, the lower the perceived risk in the firm becomes (Boone et al., 2008).Wecontrol for the client’s age using the control variable age to control the variation in thefirm’s accruals during the different stages of the firm’s life cycle (Anthony and Ramesh,1992). In addition, older companies might be viewed as survivors and therefore perceivedas less risky (Boone et al., 2008). Collectively, age and size are controlled since large, moremature companies, are expected to have more sophisticated financial-reporting systems(Johnson et al., 2002). We control for the client’s leverage due to the notion that a higherdegree of financial leverage is expected to increase the perceived risk and increase theclient’s equity risk premium accordingly (Gebhardt et al., 2001).

Results and discussionsSample statisticsTable I reports sample frequencies. Firms from the industry sector constitutedapproximately 67percent of the sample,while 33percent of thefirmswere fromthe servicesector. In addition, 31 percent of firms in our sample engaged with their auditors for aduration of 1-5 years, and 36.3 percent are engaged with their auditor for duration of6-10 years. The variation of firms’ tenure would help in carrying out the analysis of thedata and obtain a reliable conclusion about the relationship between the variables.

Table II summarizes the descriptive statistics of industry and service sectorscollectively. The maximum tenure for both sectors is 52 years, with an average of tenyears. This could signal that some firms retained the same auditor since establishment,or for very long engagements. Average leverage is fairly low (<0.28), which suggeststhat the majority of firms assets were financed through equity rather than debt.

Sector TenureIndustry Service 1-5 years 6-10 years .10 years

Percentage of firms 67.30 32.7 31 36.30 32.70Table I.

Frequencies (both sectors)

n Minimum Maximum Mean SD

Tenure 358 1.00 52.00 9.7793 8.53491LEVERAGE 358 0.00 0.92 0.2897 0.21735AGE 358 1.00 69.00 21.2416 15.52294OCF/At21 358 21.10 0.75 0.0430 0.15825ROA 358 20.32 0.52 0.0524 0.08765MB 358 0.04 399.28 10.6172 27.40387Total ASSET (million) 358 1.00 508.00 33.3631 64.25991Valid n (listwise) 358

Table II.Descriptive statistics

(both sectors)


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The average age of firms in our sample is 21 years. The mean of the market-to-bookratio (10.61), suggests an overvaluation of firms stocks by investors. The averagereturn on assets was 0.05 and the average total assets were 33 million Jordanian Dinars( JDs). Descriptive statistics of the industry and service sectors are presented separatelyin Tables III and IV consecutively.

As evident in Table III, the average tenure for firms in the industry sector isapproximately 11 years, while the average leverage is 0.28. The average age is 23 yearsand the ROA 0.04, the MB 7.43, and the total assets are 26 million JDs on average.

The scenario is somehow different for the service sector. The average tenure for firmsin the service sector is approximately eight years. However, the average leverage is 0.29,close to that of the industry sector. Firms in the service sector seem to be on average,younger than firms in the industrial sector (the average age of firms in the service sectoris 17.6). Both ratios: the ROA (0.07) and theMB ratio (17.0) are higher as exhibited by thevalue of their means. Investment in the service sector is heavier than that in the industrysector, as the average total assets (48 million JDs) suggests. The differences between thestatistics of the two sectors would improve the results of the study, that is, we have twosectors and for eachwe have one short-term and one long-term tenure. The differences intenure would open the way for observing the differences in the results of the study andfor taking all possibilities in the relationship between tenure and audit quality.

Hypotheses testingWe run a cross-sectional linear regression on the variables of the equation used formeasuring the level of DAs in the specific hypothesis subject for testing. The lengthof the auditor-client relationship is defined by the number of successive years



Table IV.Descriptive statistics(service sector)



Table III.Descriptive statistics(industry sector)

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the auditor has audited the client, producing variant number of years for different firms.Tenure years were classified typically in the literature into one of three categoriesaccording to their length: short (two to three years), medium (four to eight years) or long(nine years or more).

Audit quality is measured using the level of DAs as a proxy. Levels of DAs show theproportions of differences amongst the observations in explicit figures, close in conceptto the ratio scale. Therefore, to reveal the differences among the sample observations asper their varying tenure levels, the researchers will use the analysis of variance(ANOVA) (Uma Sekaran, 2003). To assess the explanatory power of the models we usefor testing the study hypotheses, we calculate the adjusted R 2.

Recall our H1 is:

H01. The length of the audit firm-client relationship does not have a significanteffect on audit quality.

And in the alternate format:

HA1. The length of the audit firm-client relationship has a significant effect on auditquality.

We run a linear regression on the variables of equation (IV): DA, TENURE, TENURE2,LA, LEVERAGE, AGE, FC, and OCF/T.ASSET to test the H1.

The ANOVA test for Model 1, used for testing H1, in Table V provides informationabout the overall regression model. The value of the significance is 0.000, indicating astatistically significant relationship between audit firm tenure and the quality of audit[4].

The adjusted R 2 is used to assess the explanatory power of models employed fortesting our hypotheses. It determines, in percentage, how much of the variation in DAslevel (the study’s proxy for audit quality) is attributed to the length of the audit-firmclient relationship and the other variables in our models.

The summary of Model 1, Table VI, shows an adjusted R 2 of 43.8 percent. As thepercentage indicates, 43.8 percent of the level of DAs and the change in the level of DAsis a product of the length of the audit firm-client relationship and the model’s othervariables.

Such percentage suggests: other factors that would improve Model 1 explanatorypower and contribute to the remaining variation in the level of DAs and audit quality,are existent but have not been enclosed in our model.

Model R R 2 Adjusted R 2 SE of the estimate

1 0.671 0.450 0.438 0.14757

Table VI.Model summary (both

sectors) – H1

Model Sum of squares Mean square F Sig.

1 Regression 5.927 0.847 38.880 0.000Residual 7.252 0.022Total 13.178

Table V.ANOVA

(both sectors) – H1


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TableVII shows the correlation coefficients for thevariableTENUREtobe0.281 significantat 0.05 and 0.365 for the variable TENURE2 significant at 0.05. The variables’ significancesupports the correlation, between DAs and audit firm tenure, revealed earlier in theANOVA analysis. Therefore, the null hypothesis is rejected and the alternate is accepted.

Given that the signs of the variables’ TENURE and TENURE2 coefficients arepositive, we conclude that DAs and audit firm tenure are positively correlated, whichmeans that the longer the audit firm tenure, the higher the DAs and accordingly thelower the audit quality. The finding implies that as the audit-firm client relationshipextends into more lengthy engagements, management’s incentives to manage earningsand affect them deliberately intensify, resulting in the delivery of lower audit quality.The correlation coefficient for the variable LA is 0.230 significant at 0.01, whichhighlights a positive relationship between DAs reported and the client’s size. Therefore,the larger the size of the firm, the greater management incentives to manage earnings(measured by DAs), and the lower the quality of audits.

The variable LEVERAGE is significant at 0.01, and is negatively correlated withDAs. The higher the leverage is; the greater management incentives tomanage earningsby reducing DAs, to meet debt constraints, and the better the resulting audit quality.OCF to total assets ratio is negatively related to DAs. The correlation coefficient for theratio is 0.647 significant at 0.000. This indicates that the higher the cash flow fromoperations; the lower management incentives to manage earnings, and the better theresulting audit quality. This specific finding (results of testing H1) corroborates the“learned confidence effect”, where the auditor becomes less objective and his/herindependence is threatened because of employing less effort to detect materialmisstatements. The confidence is established after the repeated multiple engagementswith the client in the case of lengthy auditor-client relationships, Johnson et al. (2002).

Since our H1 was substantiated, we will further scrutinize the Big4 variable toexamine if it enhances the effect the audit-firm tenure has on audit quality.

Recall our H2 is:

H02. The size of the audit firm does not enhance the effect of the audit firm-clientrelationship length on audit quality.

And the alternate:

HA2. The size of the audit firm enhances the effect of the audit firm-clientrelationship length on audit quality.

Unstandardizedcoefficients Standardized coefficients

Model B SE b t Sig.

1 (Constant) 20.473 0.115 24.097 0.000Tenure 0.010 0.005 0.281 2.133 0.034Tenure2 0.000 0.000 0.365 2.746 0.006LA 0.085 0.017 0.230 5.068 0.000LEVERAGE 20.165 0.043 20.183 23.882 0.000AGE 0.000 0.001 20.061 21.400 0.162OCF/T.ASSET 20.791 0.051 20.647 215.432 0.000FC 0.000 0.000 0.051 1.215 0.225

Table VII.Coefficients(both sectors) – H1

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We run a linear regression on the variables of equation (V): TENURE, TENURE2, LA,LEVERAGE, AGE, FC, OCF/T.ASSET, and BIG4 to test the H2.

The ANOVA test for Model 2, used for testing H2, in Table VIII was performed on asignificance level of 0.000 (,0.01), indicating a statistically significant relationship.However, we will drill deeper to explore the significance of the auditor size variable tocapture its precise effect on the audit-firm tenure-audit quality relationship (Table IX).

The adjustedR 2 forModel 2, after theBig4 variablewas added, is 43.8 percent; similarto that ofModel 1. This implies that Big4 variable did not improve the explanatory powerof Model 1, and therefore, the size of the audit firm does not affect the audit firmtenure-audit quality association. It also supports our explanation of Model 1, in terms ofthe existence of other factors which were not investigated in this study but would affectthe level of DAs, and audit quality accordingly.

As appears in Table X, the variable BIG4 is not significant at 0.05. Such significancelevel establishes for accepting the null hypothesis, under which scenario the size of theaudit firm will have no effect on the audit-firm tenure-audit quality correlation. Stateddifferently, the size of the audit firm does not foster the effect the length of theauditor-client relationship has on audit quality. Hence, the longer the audit firm tenureextends; the lower the audit quality descends regardless the size of the audit firm.

The failure of the auditor size in Jordan to enhance the effect the auditor tenure has onthe level ofDAscanbeexplainedasanormal result of our sample characteristics.Being the

Model Sum of squares Mean square F Sig.

2 Regression 5.943 0.743 34.092 0.000Residual 7.235 0.022Total 13.178

Table VIII.ANOVA (both sectors) –

H2

Model R R 2 Adjusted R 2 SE of the estimate

2 0.672 0.451 0.438 0.14762

Table IX.Model summary

(both sectors) – H2

Unstandardizedcoefficients Standardized coefficients

Model B SE b t Sig.

2 (Constant) 20.503 0.119 24.218 0.000Tenure 0.012 0.005 0.311 2.304 0.022Tenure2 0.000 0.000 0.393 2.895 0.004LA 0.090 0.017 0.243 5.151 0.000LEVERAGE 20.166 0.043 20.183 23.894 0.000AGE 0.000 0.001 20.056 21.280 0.202OCFASS 20.787 0.051 20.644 215.339 0.000FC 0.000 0.000 0.048 1.140 0.255BIG4 20.018 0.018 20.044 21.003 0.317

Table X.Coefficients (both sectors)

– H2


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majority of our sample firms’ auditors, and having engagements positioned mostly in thelong tenure category as well, it is probable that the “learned confidence”, rather thanthe “learning effect” governed big audit firms engagements with their clients. The size ofthe audit firm was proved to afford it an auditing advantage, reflected by superior auditquality, only during the early years of the audit engagement (Chi and Huang, 2004;Teoh and Wong, 1993; Dopuch and Simunic, 1982; Watts and Zimmerman, 1986).

Conclusion and recommendationsThis study examines the relationship between audit qualitymeasured by the level of DAsand two auditor specific factors: the length of the audit firm-client relationship (audit-firmtenure) and the size of the audit firm in Jordan. The length of the audit-firm clientengagement was found to negatively affect the quality of audit reported by publiclytraded firms in Jordan. This result is consistent with previous studies that revealed anegative correlation between audit quality and audit tenure (Deis and Giroux, 1992;Deis and Giroux, 1996; Copley and Doucet, 1993; Geiger and Raghunandan, 2002;Casterella et al., 2002). Furthermore, the result aligns with the nature of the JordanianMarket where most firms, as the mean tenure demonstrated, engaged with their auditorsfor long tenures (nine years or more). Long engagements might have created a learnedconfidence in the client, jeopardizing the auditors’ independence and objectiveness. Itmayproducebiasedbehaviorwhen the auditor develops a loyal, personal andnon-professionalattachment with the client, and loses the motive to perform the audit process with dueprofessional care and in compliance with the latest and best practices in the industry.

This conclusion is pertinent to the debate surrounding mandatory audit-firmrotation, where proponents of the necessity to rotate audit firms argue that lengthy auditfirm-client relationships produce declining audit quality as a result of either of thefollowing:

. Some clients have a good reputation in terms of the financial reporting controls,accurate financial statements and the integrity and competence of topmanagement. Under this scenario, a certain satisfaction resulting from thelearned confidence, might develop between the audit team, if they expect the client’properties to persist in the future Therefore, the conventional level of skepticismrequired to conduct the audit professionally with due care will deteriorate. Theopposite would be the case if a new unaware auditor deals with the sameengagement, driven by the necessity to obtain client-specific knowledge, usinginnovative techniques in the client’s audit and considering the client’s financialstatements, controls and management behavior as subjects to skepticism andprofessional criticism (Johnson et al., 2002; Carcello and Nagy, 2004).

. Some audit firms might view their long tenure clients as a perpetual annuitysource, or client-specific quasi-rents that represent an annuity. In both cases, theauditor’s independence would be compromised when trying to sustain suchannuity (DeAngelo, 1981b; Carcello and Nagy, 2004).

The researchers emphasize in this context that the distinctive character of Jordaniansociety being divided into tribal communities and the resulting mutual trust amongstindividuals, in addition to the necessity to favor personal interests and social relations,could also be a risk factor even for professional engagements. The small size of theJordanian community may have built such personal, rather than professional-like

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relationships more quickly and developed an acquaintance with the client, where ineither case, the product would be an impaired audit quality. The argument at this pointestablishes reasonable justification for the mandatory audit firm rotation. Therefore,we infer that rotating the audit firmwill enhance auditor independence and audit qualityin Jordan.

This study also shows that, the size of the audit firm does not enhance the effect ofthe audit firm-client relationship length on the quality of audits in Jordan. The longerthe audit firm tenure, the lower the audit quality regardless of the audit firm size. Theresult coincides with the nature of the Jordanian market being dominated by big auditfirms. As shown earlier in the sample statistics, the majority of publicly traded firms(89 percent) were engaged with big auditors. In addition, the mean tenure reflectedlengthy engagements with auditors (nine years or more). Prior literature that provedemploying big audit firms improve the quality of audits delivered, substantiated theimprovement exists in the early years of the engagement when auditors are not familiarwith the client. When the auditor constructs sufficient client-specific knowledge, theeffect of the size of the audit firm on the audit quality becomes insignificant (Knapp,1991; Johnson et al., 2002; Chi and Huang, 2004).

Finally, on thebasis of thefindings of the study, the researcherswould suggest that theaudit firm should be rotated in order to enhance auditor independence and audit qualityand increase shareholders’ and stakeholders’ confidence in financial statements. Suchrotation will open the door for new auditors to investigate the client with better scrutinyand due care. We encourage future research to uncover all variables that could possiblyaffect the audit quality and establish robust evidence on either the necessity of themandatory audit firm rotation, or the disadvantages of such rotation on the audit quality.The researchers would suggest also that audit quality is measured using other proxies,such as the persistence of the accrual component of earnings (Johnson et al., 2002) andother types ofDAs (Krishnan, 2003). In addition, other factors that affect audit quality andare auditor-specific factors, e.g. the specialization in the audit industry (Schauer, 2002,2003), should be examined in future research.An investigation of the auditor size effect onaudit quality from the perception of other groups, e.g. investors (Lie et al., 2007), or usingother measures like questioned costs (Tate, 2002) is encouraged as well.

Notes

1. Also known as lagged total assets.

2. Total assets of the previous period.

3. The Altman Z-score for the financial condition is computed using the following equation:

1:2*Working Capital

Total Assets

� �þ 1:4*

Retained Earnings

Total Assets

� �

þ 3:3*Earnings before Interest and Taxes

Total Assets

� �

þ 0:6*Market Value of Equity

Book Value of Total Debt

� �þ 1:0*

Sales

Total Assets

� �

4. Note that: 0.000 , 0.01.


331

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Web siteswww.ase.com.jowww.cbj.gov.jo

Corresponding authorAli Abedalqader Al-Thuneibat can be contacted at: [email protected]

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