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THE ROLE OF INTERNAL AUDIT ON MANAGEMENT CONTROL SUCCESS

CHAPTER ONE

INTRODUCTION

1.1        Background to the Study

The last decade has witnessed several accounting scandals and corporate failures that were blamed on earnings management practices of firms globally, which audit function was not able to detect. Earnings management involves managers‟ manipulation of the external reporting process and structuring transactions to alter financial reports to either mislead some shareholders about the underlying economic performance of the company or to influence contractual outcomes thatdepend on reported accounting numbers (Healy & Wahlen, 1999). As a result of this practice, which went undetected or unreported by external auditors, the United Statesalone recorded ten largest bankruptcies in 2002, including the two largest in world history, namely WorldCom and Enron (Albrecht, Albrecht & Albrecht, 2004). In Nigeria, Cadbury Nig. Plc and African Petroleum are exemplar cases. The increasing incidence of corporate scandals or failures associated with earnings managementhas led to loss of public confidence in the quality of reported accounting earnings and the audit functiongenerally. Accordingly, earnings management has become a matter of great concern to regulators, practitionersas well as accounting researchers (Okolie, 2014) due to the perverse consequences it has on corporate survival.

Hlioui and Zehri (2012), Cohen and Zarowin (2010), Zang (2007) and Roychowdhury (2006)explainthat managers exercise their discretion not only via choice of accounting estimates and methods (accrual-based earnings management) but also through operational decisions (real activities manipulation). Real activities manipulation is an alternative tool of earnings management through changing operating activities and decisions (opportunistic reduction of discretionary expenses, overproduction, and offering price discounts to boost current-period sales). Separately, Graham, Harvey and Rajgopal (2005) suggested that given the stigma associated with accrual management, earnings manipulations are now more likely to be achieved through real economic actions because accrual-based earnings management is more likely to draw auditor or regulatory scrutiny than real decisions such as those related to product pricing, production, and expenditures on research and development or advertising.

It is argued that if shareholders have perfect informationabout managers‟ actions, there would be no information asymmetry between thetwo parties. Information asymmetry exists when perfect information is absent,which is the assumption of agency theory and since informationasymmetry exists, stockholders have difficulty detecting earnings management (Fama, 1980). Though, it is argued that businesses adopt some level of discretion in their decision because no firm adopts a hundred percent rule based accounting systems when reporting their economic performances and financial position. In fact, Bello (2002) is of the opinion that itisunimaginable to have accounting systems that are totally rule based without room for occasional judgments.

A considerable number of studies that include Okolie (2014), Okolie, Izedonmi and Enofe (2013), Zgarni, Hlioui and Zehri (2012),Chi; Mehmet and Emin (2012),Ahmadzade, Hassanzadeh, Pooryegane and Ebrahimi (2012), Lisic and Pevzner(2011), Francis and Yu (2009), Rusmin (2010),Roger, Frank, Erik and Ann (2003), Zhou and Elder (2003), and Gaver and Paterson(2001)have found that quality of audit is one of the constraining factors that limit managements‟ manipulation of accounting numbers. Watts and Zimmerman (1986) show that auditing is a valuable form of monitoring used by firms to reduce agency costs. The value of auditing arises, because auditing reduces the misreporting of financial information. The value of auditing on constraining managerial discretion, however, is expected to vary with the quality of the auditor. Becker, DeFond Jiambalvo and Subramanyam(1998) and Heninger (2001) report evidence consistent with the external auditor acting as a constraint on earnings management, with the effectiveness of the constraint depending on audit quality.

The demand for auditing arises from the auditor‟s monitoring role in theprincipal-agent relationship (Eilifsen & Messier, 2000). The performance quality of this monitoring function may vary. Audit quality describes how well an audit detects and reports material misstatements of financial statements, reduces the effect of information asymmetry between management and shareholder sand therefore helps protect the interests of stockholders. High audit quality should be associated with high information quality of financial statements because financial statements audited by high quality auditors may be less likely to contain material misstatements. From an agency theory perspective, audit is a monitoring mechanism that provides reasonable assurance that financial statements are free of material misstatements and therefore protects the interests of shareholders. Whenthe interests of management conflict with the interests of shareholders,management may not act in the best interests of shareholders. A high level of audit quality is therefore expected to result in lower levels of earnings management.

Literature has documented a number of attributes that explain audit quality and how the combined effect of the attributes could help checkmate managers‟ excessive earnings management practice. Of the numerous attributes identified in the literature, size of audit firm, independence and specialization of auditors seemed to stand out. Size of an audit firm is considered critical to its ability to assemble well qualified and highly experienced auditors to engage in different aspects of audit functions. Such a firm is more likely to engage in a wide range of audit assignments for different companies in view of its economies scope and scale. In line with these postulations, Francis, Maydew and Spales (1999) have documented evidence showing that the Big-4 audit firms provide a more significant constrain on earnings management than other audit firms. Thus, the size of an audit firm affects the extent to which it constraints earnings management practice.

In theory, a company‟s auditors are appointed independently by its shareholders, to whom they report. In practice however, auditors are chosen by the company‟s bosses, to whom they all too often become beholden (The Economist, 2002). Hence, auditors might be more inclined to allow aggressive and opportunistic reporting of accruals, resulting in lower quality audits and thus increase in earnings management. This places a question mark on the independence of an auditor.In addition to auditor size and auditor independence, auditors‟ industry specialization is considered to be an important attribute of auditquality as it impacts the earnings management of firms. Studieshaveshown that client firms with industry specialists are associated with higherquality of financial reporting (Balsam, Krishnan and Yand,2003; Krishnan, 2003).Like large auditors such as the Big 4 invest in brand name capital, industry specialists to make investments in industry specific accounting technology to differentiate themselves from other auditors (Craswell, Franci& Taylor1995)

The high-profile corporate scandals of 2008 through to 2009 in Nigeria has continued to raise a lot of concern about the integrity of financial and auditing reporting systems in the country. Some corporate organizations in the banking and manufacturing sub-sectors that were never suspected to have problem were found to be living in past glory due to excessive earnings management practices. The ugly practices which were later discovered to have been on for sometime went undetected or unreported by auditors. The experience hassince left its perils in the mind of shareholders, prospective investors,regulators and financial analysts.

The chemical and paints industry in Nigeria is considered one of the most susceptible sub-sectors of the country to earnings management. This is due to the ongoing effort by both government and industrialists to develop the industry as priority area of industrial investment and a support toward government housing policy for Nigerians. The sub-sector has undergone various levels of transformation from themanual based processes to more technologically advanced production methods. In view of the renewed interest in the industry owing to its recent impressive performance and high level of activities, it is imperative to examine its earnings management practices and how it is affected by audit quality.

1.2        Statement of Problem

In the wake of corporate accounting scandals and unethical behaviours despite the existence of the code of best practice for corporate governance, earnings management has become a focal point of business strategists and academic research. The interestfeatures numerous corporate governance components like audit committee characteristics, board monitoring, corporate governance characteristics, institutional monitoring) and accounting standards, as well as the role they play in reducing earnings management. This is because unethical behaviour in reporting the earnings of firms negates the rudiments of agency relationship and misrepresents the organizations financial status.

Many studies have been conducted in the area of earnings management and audit quality most of which recognized the audit quality mechanisms as effective factors that restrain excessive opportunistic behavior amongst corporate management. Most of the studies focused on developed countries, and reported mixed findings (Krishnan, 2003; Balsam, Krishnan & Yand, 2003,DeFond, Raghunandan & Subramanyam, 2002; Beasley & Petroni, 2001; Abbott & Parker, 2000; Craswell, 1999).Some of the studies documented that Big 8, Big 6,Big 5 and Big 4 audit firmsprovide higher audit quality thannon-Big 8, Big 6, Big 5 and Big 4 audit firms (Davidson & Neu, 1993; Teoh & Wong, 1993). The studies of Kim, Chung and Firth(2003) and Lam and Chang (1994) indicate that Big 8, Big 6, Big 5 and Big 4audit firms might not always provide higher quality audit service than the others. This gave rise to the issue of inconclusiveness of findings. Given that the developed markets offer different institutional settings and litigation environments from those in the developing markets, the generalization of their findings is limited.

Few studies have been conducted in emerging economies like Nigeria. The studies also documented mixed and inconclusiveness findings (Okolie, et. al.2013; Okolie, 2014; Gabriel & Ioraver, 2015).While these studies have covered some important aspects of audit quality, none of them used auditor tenure in measuring the independence of audit firms despite the strong relationship that exist between auditor tenure and quality of audit.

In addition, the studies used ordinary least square procedure with pooled data (which tends to be biased,to generate serial correlation, cross-sectional correlation and differing variances)instead of extracting panel data to test for cross-sectional effect in line with best practice in earnings management and audit quality studies.This study therefore represents a modest effort to fill the gaps identified in the literature. The study extends its analysis to cover variables that are often neglected in audit quality. The study also extends to a sub-sector that has attracted little attention with regard to earnings management despite its strategic importance to the economy of Nigeria.

1.3         Research questions

This study sets to provide answers to the following questions:

1.      To what extent does audit firm size affect earnings management in Ministry of finance, Akwa ibom state?

2.      What is the effect of auditor independence on earnings management in the listed chemical and paints firms in Nigeria?

§  How does industry specialist auditor affect earnings management in the listed chemical and paints firms in Nigeria?

1.4         Objectives of the study

The main objective of this study is to examine the impact of audit quality on earnings management of listed chemical and paints firms in Nigeria. The specific objectives of the study are to:

1.      examine the impact of audit firm size on earnings management in listed chemical and paints firms in Nigeria;

2.      assessthe impact of auditor independence on earnings management in Ministry of finance , Akwa ibom state

1.5        Hypotheses of the Study

Based on the objectives of the study, the following hypotheses were formulated:

HO1: Audit firm size has no significant effect on earnings management.

HO2: Auditor independence has no significant impact on earnings management.

HO3:Industry specialist auditorhas no significant impact on earnings management.

1.6        Scope of the Study

The study covers the period of seven (7) years, from 2006 to 2012.The period was considered adequate because prior studies on this subject matter used maximum of five(5) years. Extending the study to cover seven(7) years would enhance the robustness of the analysis. The period also covers 2007 and 2008 when the global economic crisis that exposed many world corporate scandals started. The justification for the choice ofthe domainis that chemical and paints sector has received little attention from researchers in Nigeria despite the important role it plays in the country and its contribution to the country‟s economy.

1.7        Significance of the Study

Apart from contributing to the existing literature on the subject matter, the findings of this study will be of interest to policy makers, audit firms and professional accounting bodies, as well as existing and potential investors.Policy makers may use the findings of the study regarding the auditor independence to consider the potential benefits of regulating the minimum length of audit firm tenure, in years, that same auditor should audit the financial statements of a company. It has been posited that as the auditor tenure increases, the auditor is better at assessing risk of material misstatements by gaining experience and better insights into the client‟s operations and business strategies as well as internal controls over financial reporting (Arens, Elder&Beasley,2003). Therefore, this study will provide a yardstick which professional accounting bodies will use in establishing policies, procedures to guide members on improving the quality of their audit in order to reduce the way and manner earnings are being manipulated by firms.

Financial analysts may also use the findings of this study to understand how the market interprets higher audit quality in constraining earnings management effect on capital market decisions. If the market sees the firms with industry specialization, longer audit tenure and audited by a big-4 auditor as being associated with higher financial reporting quality, the reported financial statements may be viewed as more reliable for investment decision and credit assessment.Also, both existing and potential investors may be educated on earnings management‟s indicators, patterns and how well to monitor and make good out of their investments. In addition, the study will contribute to increasing the available studies on audit quality and earnings management, especially in this sector.

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