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Busy Auditors, Ethical Behavior, and Discretionary Accruals Quality in Malaysia

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Abstract

The required professional and ethical pronouncements of accountants mean that auditors need to be competent and exercise due care and skill in the performance of their audits. In this study, we examine what happens when auditors take on more clients than they should, thus raising doubts about their ability to maintain competence and audit quality. Using 2803 observations of Malaysian companies from 2010 to 2013, we find that auditors with multiple clients are associated with lower earnings quality, proxied by total accruals and discretionary accruals. Our results demonstrate that associating client firms’ reported discretionary accruals with individual auditors, rather than their firms or offices, is important in determining audit quality. Moreover, we demonstrate that the disclosure of auditors’ signatures on their reports is useful for assessing auditor quality at the individual level, thus contributing to the debate on the usefulness of having auditor identities on reports.

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Notes

  1. Details are available at http://www.ifac.org/sites/default/files/meetings/files/20130415-IAASB-Supplement_to_Agenda_Item_2-Question_12_Responses-Disclosure_of_Engagement_Partner_Name-v1.pdf.

  2. According to Howton et al. (2008), both the National Association of Corporate Directors and the Council of Institutional Investors recommend limiting directorships to three for outside directors.

  3. The busy season for most audit clients is the end of the financial year.

  4. Office size is measured by the audit fees.

  5. See Wahab et al. (2014) for background discussion on the institutional characteristics of the Malaysian corporate setting.

  6. This study covers the period after the financial crisis of 2008–2009; including the years with the financial crisis may distort the results.

  7. We control for client size by using LnAT. Following prior studies (e.g., Gul et al. 2009), the square term is included to estimate the non-linear relationship between size and accrual measures. However, since there is high collinearity between LnAT and LnAT 2, we use the adjusted values following Davidson and Gist (1996, p. 114) as a way of reducing collinearity between the two variables.

  8. We replace one-year asset growth with one-year sales growth and we find similar results. We also find that the model fit is better with asset growth, since the adjusted R 2 is 1.5 % or higher for all three models in Table 4.

  9. CI_ia is measured by the client’s natural logarithm of total assets divided by the sum of an individual auditor’s client portfolio size, measured as the sum of the natural logarithm of total assets of all the clients handled by the auditor.

  10. Petersen argues that ‘When both a firm effect and a time effect are present in the data, researchers can address one parametrically (e.g., by including time dummies) and then estimate standard errors clustered on the other dimension’ (p. 475). In this way, the standard errors clustered by firms capture the unspecified correlation between observations of the same firm in different years. Conversely, the standard errors clustered by time capture the unspecified correlation between observations of different firms in the same year (Petersen 2009).

  11. We follow Bartov et al. (2000) and Dechow et al. (1995) by including the adjustment for current maturities of long-term debt.

  12. Following Bartov et al. (2000), the only adjustment relative to the original Jones model is the change in revenues adjusted for the change in receivables in the event year. This is based on the assumption that during the estimation period, there is no systematic earnings management.

  13. In their paper, Gul et al. (2014) generate a dummy variable HighNClient that equals 1 if an audit partner has four or more clients and 0 otherwise.

  14. We also use variance inflation factors (VIF) to detect the existence of multicollinearity. More discussion is provided in Sects. 4 and 5.

  15. This negative correlation could also suggest that the more clients an auditor is in charge of, the less important the individual client is to the auditor’s total portfolio.

  16. As suggested by Neter et al. (1983), a VIF that is greater than 10 can be taken as a sign of multicollinearity.

  17. We obtain similar results using Big 4 firms instead of Big 5 audit firms.

  18. Compustat Global does not provide any data that are commonly used as proxies for complexity (e.g., the number of business segments, the number of consolidated subsidiaries, and foreign sales or foreign assets).

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Acknowledgments

We acknowledge and are grateful for the support of BDO Malaysia in conducting this study.

Author information

Authors and Affiliations

  1. Monash Business School, Monash University, Caulfield East, Australia

    Karen M. Y. Lai

  2. Department of Accounting, Faculty of Business and Law, Deakin University, Burwood, Australia

    Andriyawan Sasmita & Ferdinand A. Gul

  3. School of Business, Monash University, Bandar Sunway, Malaysia

    Yee Boon Foo

  4. QUT Business School, Queensland University of Technology, Brisbane, Australia

    Marion Hutchinson

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  1. Karen M. Y. Lai
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  2. Andriyawan Sasmita
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  3. Ferdinand A. Gul
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Corresponding author

Correspondence to Karen M. Y. Lai.

Appendix 1: Variable Definition

Appendix 1: Variable Definition

TA :

Measured by TA t  = ΔCA t − ΔCash t − ΔCL t  + ΔDCL t − DEP t , where ΔCA t is the change in total assets in year t; ΔCash t is the change in cash and equivalent in year t; ΔCL t is the change in current liabilities in year t; ΔDCL t is the change in debt included in current liabilities in year t; and DEP t is the depreciation and amortization expense in year t.

Jones_DA :

Absolute value of discretionary accruals (DA) derived from Jones Model (DA it ). It is the residual term of the equation TA it /A it−1) = β 1 (1/A it−1) + β 2 [(∆REV it )/A it − 1] + β 3 (PPE it /A it − 1) + ε it , where ∆REV it is the total revenues of firm i in year t less the total revenues of firm i in year t−1, PPE it is the gross property plant and equipment of client i in year t, and A it−1 is the lagged total assets for firm i.

ModJones_DA :

Absolute value of discretionary accruals (DA) derived from Modified Jones Model. The only adjustment relative to the Jones Model is that the change in accounts receivable is subtracted from the change in revenues.

NClient :

Number of clients handled by each individual audit partner in charge per year.

LnAT(Adj) :

The natural logarithm of total assets at the end of the year adjusted by subtracting the sample mean of the natural logarithm of total assets.

LnAT(Adj) 2 :

Square term of the natural logarithm of the adjusted total assets at the end of the year.

ROA :

Return on assets, measured by net income over total assets at year-end.

Loss :

Dummy variable for loss, 1 if a client observation reports a negative net income, 0 otherwise.

Growth :

Total assets at the year-end minus total assets at the beginning of the year over total assets at the beginning of the year.

Lev :

Total liabilities over total assets at the year-end.

Turnover :

Total revenue over average total assets.

CI_ia :

Client importance of the individual auditors measured by the client’s natural logarithm of total assets divided by the sum of an individual auditor’s client portfolio size, measured as the sum of the natural logarithm of total assets of all the clients handled by the auditor in year t.

YE :

Year-end dummy, 1 if the client’s financial year-end is in December, 0 if otherwise.

Big4 :

Big 4 auditors dummy, 1 if the client is audited by a Big 4 accounting firm, 0 if otherwise.

Big5 :

Big 5 auditors dummy, 1 if the client is audited by a Big 5 accounting firm (includes BDO), 0 if otherwise.

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Lai, K.M.Y., Sasmita, A., Gul, F.A. et al. Busy Auditors, Ethical Behavior, and Discretionary Accruals Quality in Malaysia. J Bus Ethics 150, 1187–1198 (2018). https://doi.org/10.1007/s10551-016-3152-4

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