Negative Association between Financial Reporting Fraud and the Quality of Auditors - Literature review Example

Financial Reporting Fraud and the Quality of Auditors Student’s Name Institution Affiliation The Association between Financial Reporting Fraud and the Quality of Auditors (i.e. Big five auditors), the Audit Fee, and the Size of the Company Literature Review In the past few decades, many researchers have focused on identifying the importance of quality audit especially with increased competition resulting from globalization and technology advancement. Many studies have proposed that there is a negative association between quality audit and financial reporting fraud. The main work of auditors is to articulate a judgment of how fair and just financial statements are (Doinea & Lapadat, 2012). It is important to point out that companies work to achieve quality audit in order to assure their clients and the outsiders that their financial statements are appropriately stated, accurately determined, and honestly announced. According to Krishnan (2005), auditors must make sure that their skills are competent enough to guarantee relevant and unbiased auditor’s report and audited financial statements and error-free for decision makers. Financial reporting of fraud is not just affected by the big five auditors but also other factors such as the company size and inner control systems of the company (Francis & Yu, 2009). In recent times, the worldwide monetary disaster has forced policy makers to concentrate on the significance of an efficient audit purpose in order to minimise losses through internal frauds. For some time now, it is believed that a presence of a big five audit firm leads to more quality audit and few occurrences of accounting fraud (Lennox & Pittman, 2010; Francis, Michas & Yu, 2013). However, the recent high profile financial reporting failures reported in the Australian capital markets have created doubts on whether the argument still remains valid. Indeed, many observers interpret the improvement in fraud reporting a decade by companies audited by Big Five auditors as almost enough evidence that their auditing services have weakened over time (Schmidt & Wilkins, 2013). Measuring trends in absolute audit quality is typically infeasible and hence this research aims to narrow its focus on establishing the real assocotion between finacial fraud reporting and the quality of auditors, the audit fee and the size of the company. Contrary to the recent criticism of the Big Five auditors, the literature review will reveal compelling evidence to support the theory that the apperance of a quality auditor in a farm leads to lower incidences of finacial reporting fraud. In the past, many researchers have focused on establishing the association between fraud detection and the quality of audit. However, the current review aims to focus on a new dimension on hoe the quality of auditors, the audit fee and the size of the company affects financial reporting of fraud. This focus will lead to the development of a new theory which aims to authenticate the argument that the value of auditors and the audit fee may have significant influence on financial reporting fraud in big companies. Such an association means that the presence of a big five auditor leads to lower financial reporting fraud in a big company. Research Hypothesis: There is a negative association between financial reporting fraud and the quality of auditors, the size of the firm and the auditor fees. The presence of the Big five auditors and the audit fee leads to lower financial reporting fraud in large companies. This hypothesis will guide the literature review conducted to reveal the following facts: As competition in large companies grows, audit quality becomes an important issue for manager to focus on in order to decrease incidences of financial reporting fraud. Examining the quality of audit is supposed to assist directors improve the value of audit offered by the in-house auditors in order to prevent financial reporting fraud. Practical work and experience in large companies can help in associating theoretical ideas and real practice in terms of audit value and incidences of financial statement fraud. There have been various studies on quality of audit and its measurement. Despite the many studies, few have focused on establishing the relationship between audit value and financial statement fraud. DeAngelo (1981) describes the value of audit as the assurance that an auditor will determine and detect a violation in the company’s financial statements. The determination of financial statement fraud determines the value of auditor in terms of understanding and capability, whilst reporting fraudulent financial statements is greatly determined by the the auditor’s motivation to reveal (Choi, et al., 2010; DeAngelo, 1981). This particular definition is appropriate for almost all types of auditors including external, internal and compliance and operational audits. According to Chen, et al., (2013), the most effective auditing firms have embraced the new enhanced technology such as application of computer assisted techniques in carrying out their auditing activities since they have proved to be more effective and reliable compared to traditional data mining methods. Despite the quality of the auditors, they should be chosen independently and not based on any intimate association with the administrators to ensure full disclosure of any breaches found in financial reports. Previous research has reported a correlation amid the value of audit and the quality of auditor, the size of the firm and the audit fee (Collier & Gregory 1996; Carcello & Nagy 2004). To develop the current association/theory of financial reporting fraud, quality of auditor, the size of the firm and the audit fee, this research considers the following variables: Quality/Proficiency of the Auditor The major objective of the auditor is to guarantee the clients and the outside world that the monetary reports are accurate and unbiased (Mohd-Nor, Ahmad & Mohd-Saleh, 2010). Financial reports can only be accurate and unbiased if the auditor has the skills and proficiency to identify any breaches in financial reporting system. Identifying the breaches in financial reporting makes an auditor knowledgeable but to be efficient, the auditor must have meet the moral obligation to report the identified breaches not only to the internal stakeholders but also the outside world (Reidy & Theobald, 2011). These qualities are very important for an auditor in preventing financial reporting fraud especially in large firms. Many researchers in this field have identified a direct correlation amid the value of auditor and the audit quality. Schmidt and Wilkins (2013) and Sundgren and Svanström (2012) agree that the level of quality of auditor greatly influences the quality of the audit. The current theory suggest that quality auditors offer quality audit and hence lead to reduced incidences of financial reporting fraud in large firms. According to Collier and Gregory (1996), audit firms with learned personnel, who are skilled and experienced, tend to charge higher audit fees for their audit services. Such an argument implies that the size of the auditing firm and the ability of the audit are related with the audit charge. In order to be termed as a quality auditor, who is able to detect and report breaches in financial reporting, certain distinguishing credentials must be achieved. For example, a financial auditor should be well equipped in terms of knowledge and experience in reading and interpreting financial reports and compare them with the actual financial status of the firm to determine whether they are accurate and unbiased. On the other hand, an auditor for evaluating performance should have the knowledge and skills in assessment methods in order to ensure accurate and reliable performance evaluation. Unique understanding of the various practical departments to be assessed is important. However, extraordinary experience in detecting fraud in financial reports is not always essential in evaluating performance. According to Venkataraman, Weber, and Willenborg (2008), large performing firms have separated their financial auditing with performance auditing in order to ensure quality audit is done in both fields assuring firm’s good performance. Salehi and Mansoury (2009) argue that non-certified auditors have a higher probability of modifying the audit statements implying that small non experienced auditors have very low probability of offering quality audit. Research shows that certified quality auditors can never compromise their integrity by altering financial reports implying that the higher the quality of auditor the lower the probability of financial reporting fraud. According to Reidy and Theobald (2011), with increased competition, there is a great need for large firms aiming to enhance their financial performance to invest in quality firms. Existing research suggest that certified auditors offer more quality audit but their clients have to pay for the quality in terms of higher fee. Large firms should not consider the cost incurred in audit fee but the quality audit offered which ensures minimal if any financial reporting fraud. The Audit Fee According to Gregory and Collier (1996), audit fee can be described as the money which companies give out to pay for the external audit services. Auditing fees is comprised of the salaries and reimbursement of the audit firm’s office and field employees, field expenses, and other expenses essential for the audit and other associated related activities. The audit fee is equivalent to approximated expenditure on staff time and the real expense incurred in travel errands and the income to be realized. Jamal and Sunder (2011) suggest that the risk to fraudulent financial reporting can be minimal when large quality firms are hired. Numerous studies have practically evaluated the association amid audit value and audit fee. Blankley, Hurtt and MacGregor, (2012) presuppose that audit services are distinguished on basis of audit and in our today’s aggressive economical markets, variations in the value of audit is detected through variations in audit charges. On the other hand, because there are various factors which determine audit fee, audit fee cannot be used singly as the determinant of audit quality (Gregory & Collier, 1996). A prior research which scrutinized to find out if in Australian firms, the presence of an audit committee, the board qualities and the application of in-house audit are linked to high audit fees imply that a higher audit fee imply better audit in terms of quality (Schmidt & Wilkins, 2013). Several researchers argue that directors and enterpreneurs are very ready to spend more in order to get quality audit and accurate finacial reports. Several other studies, including Sundgren and Svanström (2012) and Sweeney and Roberts (1997) document a relationship between the reputation of the audit firm, the quality of the audit and the audit fees. Sundgren and Svanstrom not only report an association within the above named three parameters i.e. audit fee, audit quality and auditor organizational image but also indirectly suggest that audit firms which ask for higher remuneration are likely to enhance the accuracy of financial reports meaning reduced financial reporting frauds. Although audit fee cannot be used as a single verifier for audit quality, there is enough evidence that managers and administrators are ready to pay more for what is alleged as assurance of quality audit and bias-free financial statements (Venkataraman, Weber &Willenborg, 2008). Large firms are ready to hire auditors with more skills and experience who ask for higher remuneration but ensure the firm achieves quality audit. According to Icerman and Hillison (1990), suggest an relationship amid the size of the audit firm, the audit fee and detection of errors in financial reports. The two researchers point out that big audit firms tend to ask for more in terms of audit fees since they are well equipped in terms of audit personnel and experience to guarantee quality audit and accurate financial statements. This is an indication that the Big Five auditors get higher remuneration since they are argued to offer valuable audit services. The observed higher fee associated with the Big Five auditors is interpreted as evidence that the Big Five auditors offer higher quality audits and error-free financial statements. The Firm Size The challenge in determining the quality of audit has forced various scholars to utilize audit firm size as a proxy. Huge audit firms are argued to undertake more authenticate test that result into accurate financial reports and quality audit (Doyle, Frecknall-Hughes & Summers, 2014). As a result, big firms are often associated with reliable and authenticate audit compared to less significant audit firms (Francis, Michas & Yu 2013; Bauwhede, Willekens & Gaeremynck, 2003). Analytical research has suggested a positive association between audit firm size and the audit quality. The current research supports this association by arguing that there is a negative association between the size of the audit firm and financial reporting fraud. Since large firms are associated with quality audit, they should also lead to minimal or nil financial statement fraud. DeAngeio (1981) suggests that large audit firms provides more authentic audit because they have fewer incentives to compromise their standards, reputation and image in order to retain and attract more important clients. Similarly, researchers such as Chen et al., and Carcello and Nagy, 2004) agree that large audit firms are not only associated with quality audit but also ensure accurate and reliable financial statements free from any modification or alteration. Therefore, it can be concluded that there is enough evidence from the existing literature that there is a positive correlation between audit firm size and the occurrences of financial statement fraud. Conclusion From the literature reviewed, it can be concluded that there is enough evidence to support this paper’s theory that there is an association between financial statement fraud and the quality of auditors, the size of the firm, the audit fees. Recent research indicates that quality audit is provided by quality auditors (The Big Five Auditors) who charge high audit fees. However, in this competitive business world, almost every manager is willing to pay for the high fee to the big auditing firms who can guarantee quality audit and error free financial statements. Many researchers have suggested that since quality auditors can rarely compromise their integrity, they can rarely lead to fraudulent financial reporting. However, it is important that future research be carried out to authenticate the theory that connects financial reporting fraud and the three variables: quality of auditors, audit firm size, and the audit fee. References Bauwhede, H. V., Willekens, M. &Gaeremynck, A. (2003). Audit firm size, public ownership, and firms’ discretionary accrual management. The International Journal of Accounting, 38(1), 1-22. Blankley, A. I., Hurtt, D. N., & MacGregor, J. E. (2012). Abnormal audit fees and restatements. Auditing: A Journal of Practice and Theory, 31(1), 79–96. Carcello, J. V. & Nagy, A. L. (2004). 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