Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
The Effect of Audit Partner Rotation and Audit Firm’s Fee
on Audit Quality
Eko Suprapto* and Eko Suwardi**
This study examines the determinant factors for audit quality. Based on the
literature review, the study hypothesized that audit partner’scompliance on
audit rotation regulation, audit firm’s annual fees, and initial balance testing
have positive effect on audit quality. Additionally, this study also
hypothesize that audit tenure has negative effect on audit quality.
Differentfrom
the
previous
studies,
this
study
usedaudit
partner’scompliance on professional audit standard as the proxy for actual
audit quality. The empirical results show that in that model, audit firm’s
annual fees, and initial balance testing are the two determinant factors
which provide positive effect on audit quality. Another result shows that
public accountant’s compliance on audit rotation regulation and the audit
tenureprovide no effect on audit quality. It means that the restriction on
audit rotation for maximumthree years does not affectthe audit quality.
Keywords : Audit Rotation, Audit Partner‟s Compliance,Regulation,AuditTenure,
AuditFirm‟sAnnualFees, InitialBalance, InitialAuditEngagement, and
AuditQuality.
I. Introduction
Before the enactment of regulations on audit rotation, efforts to increase the
independence of auditors and reliance of investors to financial statements of public
companies have been widely debated in several countries. Likewise, after the
application of any regulations on audit rotation, there are still debates, whether the
regulation is effective in improving audit quality. In Indonesia, latest regulation of
audit rotation was enacted by Indonesian Minister of Finance (MoF) on its decree
numbered 17 by adding the rotation period from five years at previous MoF decree to
six years for audit firm tenure, while the tenure of audit partner is still three years.
Currently, Public Accountant Act, Number 5, enacted on May 3, 2011 does not
determine the rotation period of audit firm and audit partner but it will be further
regulated through government regulation.
Proponents of mandatory audit firm rotation contend that without rotation,
itresults in increasing concentration of the audit market and increasing audit fees, in
the end it reduces independency of audit partner, and audit quality. Auditor
independence may be threatened by a large number of situations should be
analyzed with caution because it cannot be interpreted in only one way.On the other
hand, opponents of mandatory rotation considerthe introduction of mandatory
rotation rule as an excessive tool whose benefits are not relevant. They argue that
there are other factors motivating the auditor to maintain his/her independence, such
______________
*EkoSuprapto isan alumnus of Master of Accounting Program, Faculty of Economics and Business
UniversitasGadjah Mada.
** Eko Suwardi is an Associate Professor of Accounting, Faculty of Economics and Business
Universitas Gadjah Mada.
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
as the need to preserve reputation and client revenue. There are also external
safeguards useful for preserving independence. Among them, the most important
are the qualitycontrol standard (e.g. peer review) and market forces (e.g. litigation
costs and negative reputation)(Cameran et al. 2005).Geiger and Raghunandan
(2002) conducted a research on the relationship between the length of the auditorclient relationship and the failure of the audit report. In that research they focused to
issue a going concern opinion in the auditor's report and concluded that the length of
the engagement are positive and significant to to issue a going concern opinion in
the auditor's report, but the effect began to diminish after a period greater than five
years and there are many errors in the first year of audit report.
Moreover, proponents of mandatory rotation argue that the audit market is too
concentrated and that rotation could improve the competition between big and small
audit firms if auditees were forced to change their current auditors. In addition, the
presence of mandatory audit rotation policy that a long term auditor-client
relationship is considered by the proponents of mandatory rotation as the main
element that could impair independence and objectivity (Cameran et al. 2005).
Fees paid to auditors can affect audit quality in two ways: large fees paid to auditors
may increase the effort exerted by auditors, hence, increasing audit quality.
Alternatively, large fees paid to auditors, particularly those related to non-audit
services, make auditors more economically dependent on their clients (Hoitash et al.
2007). Based on previous research related to the relationship between audit fees,
non-audit fees and total fees to the audit quality havebeen concluded that the results
vary i.e. positively related (Choi et al. 2010 and Yu 2007), negatively related (Hoitash
et al. 2007 ), and no relationship (DeFond et al. 2002).
Many people and regulator‟s attention focus on how to improve audit quality. Audit
quality is very important for transparency and smoothness of the economic system of
a country, especially for investment in capital market activities. But the main problem
that always arises is how to determine the level of audit quality via a reliable method
accurately. Based on the previous studies, there are many different results
eventhough using the same method.
In general, the measurement of audit quality can be divided into perceived and
actual audit quality. However, the measurement of audit quality is actually very
difficult because the measurement of actual audit quality is based on the actual audit
process. SugiriandFebrianto (2011) stated thataudit quality was believed to be
responsible for credible accounting information. They posited that higher audit quality
will result in more accurate information. However, this proposition is difficult to prove
because they have some problems in measuring audit quality. If they want to
scrutinize audit quality, they have to investigate what the auditors have performed
appropriate procedures during the audit. Similarly, Li Dang (2004) noticed some
studies use perceivedaudit quality because of the difficulty to measure actual audit
quality. Perceived audit quality as perceived by users of financial statements,
whereas the actual audit quality refers to the ability of auditors to detect and report
material misstatements of financial statements. Users of financial statements do not
have access to gathered evidence during the audit process and the audited
information. Thus, theycan not assess actual audit quality directly.
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
Based on previous studies, there are inconclusive results on the effect of the
issuance of audit partner rotation policy. Sometimes, using the same measures of
audit quality will result in a different conclusion. The use of measurementof audit
quality correctly was expected to provide a precise description of the quality of the
audit partner and audit firm. Given the difficulty of measuring the actual audit quality
(Sugiri&Febrianto 2011, Watkins et al., 2004 and Li Dang, 2004), allowed the
researchers to re-examine audit quality in accordance with audit partner‟s
compliance onprofessional auditingstandards and related regulations.
More specifically, this research will examine the influence of these variables: the
audit partner‟s complianceon audit rotation regulation, the length of the audit partner
engagement, and the audit firm‟s annual fees on audit quality. This study also
testespeciallythe audit failure in initial audit engagementthat caused to the
presence/absence of communication with the predecessor auditor and testing of the
opening balance on actual audit quality.This research also different from previous
studies because it uses actual (not perceived) audit quality as proxied by the
auditors‟ compliance on auditing standards.
2. Literature Review
2.1 Audit Quality
One common definition of audit quality is provided by DeAngelo (1981)as “the
market-assessed joint probability that a given auditor will both (a) discover a breach
in the client‟s accounting system, and (b) report the breach.” The probability that the
auditor will report the detected misstatements is defined by DeAngelo (1981) as
auditor independence. Therefore, audit quality is an increasing function of an
auditor‟s ability to detect accounting misstatements and auditor independence as
assessed by the market.
Franzel(2003) defined audit quality as the way of auditor conduct the audit in
accordance with generally accepted auditing standards (GAAS) to provide
reasonable assurance that the audited financial statements and related disclosures
are (1) presented in conformity with GAAP and (2) are not materially misstated
whether due to errors or fraud. Material mistatement from the standard is considered
to reflect poor audit quality. Li Dang (2004) argued that the audit quality describing
how auditing can detect and report errors misstatement of financial statements
properly, reducing the information asymmetry between management and
shareholders, and helping to protect the interests of shareholders.
There is a difference between the definition of audit quality based on perceived and
actual audit quality. Perceived audit quality base on user‟s consideration of financial
statements, whereas the actual audit quality refers to the ability of auditors to detect
and report accounting misstatements. However, users of financial statements do not
have access to the gathered evidence during the audit process and audit
information, and thus they can not judge the quality of the actual audit directly.
Other measurements of audit quality are by understanding the results of the audit,
Knechel et al. (2012) had stated some literatures have traditionally viewed
thepresenceofhigher audit quality in terms of lacking certain negative outcomes
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
(such as restatements, litigations, discretionary accruals, accounting conservatism)
or having certain positive outcomes (such as issuing going concern opinions).
Related to the results of prior researches, they show that higher levels of audit
quality are associated with lower likelihood of accounting restatements. Auditors can
be sued when there is very strong evidence of financial statement fraud, in example,
auditors were negligent in their audits and did not follow GAAS.
The use of financial statements quality or earnings quality are proxied by using
discretionary accruals are the accounting policies that provide flexibility to
management to determine the number of transactions in a flexible accrual, or in
other words, discretionary accrual method gives the opportunity to the manager to
improve the profit earnings as they wish (Knechel et al., 2012). Srinidhi et al. (2010)
stated that the use of the quality of earnings can be used because reported accrual
results as the result of negotiations between the auditor and the client. In addition,
accounting conservatism can also be used to measure the audit quality. However,
different opinion was expressed by Zerni (2009) which states that the audit report is
generated at least in standard form, does not contain much information about the
audit quality. This is due to the quality of the auditor is multidimensional and is not
observed, and no single auditor characteristic that can be used as a proxy for it.
Other audit quality study is in relation to going concern opinion. But according to
Geiger and Raghunandan (2002), the granting of going concern opinion for
consideration in the auditor's report, proved to be difficult as a measure of audit
quality associated with errors of type I and type II. This is due to the decrease in
lawsuits because of policy changes in the Reform Act 1995, which resulted in using
going concern opinion to a company that experiencing financial difficulties being
dropped from time to time during the year 1992-1993 to 1999-2000 based on the
sample used. This could indicate that the using of going concern opinion is not
suitable as indicator of audit quality. If perceived audit quality does not reflect actual
audit quality, then the use of audit quality to test the relationship among audit quality
and other variables is problematic. Financial statement users may not be able to
assess actual audit quality accurately because they do not have access to the audit
process. (Salehi &Kangarlouei 2010).
2.2. Hypothesis Development
Regulations of audit rotation were made by limiting the rotation of audit partner‟s
assignments to improve the auditquality to maintain the independence of the auditor.
It is caused by a long period of assignment that will create financial dependency to
their clients. In addition, the longer the audit engagement, the auditor‟s critical
capability will be reduced because the auditor was too familiar.
Several studies that support the regulation of audit partner‟s rotation have been
conducted i.e.Hamilton et al. (2005), Chung (2004) and Kim et al. (2004), concluded
that audit rotation regulation consistently had positive effect on audit quality.
Based on the explanation of the purpose of making audit rotation regulations on the
auditquality that has been described above, the following hypothesis are proposed,
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
H1: the audit partner’s complianceon audit rotation regulation
positively on audit quality.
affects
H2: the length of the audit partner engagement affects negatively on audit
quality.
Fees paid to auditors can affect audit quality in two ways: large fees paid to auditors
may increase the effort exerted by auditors, hence, increasing audit quality.
Alternatively, large fees paid to auditors, particularly that are related to non-audit
services, make auditors more economically dependent on their clients (Hoitash et al.,
2007). To reduce the risk of litigation in the future because of the lack of experience
of the auditor, many auditors require greater audit fee to prospective clients. Audit
fees reflect the amount of collected audit evidence and an additional premium for
protection against the risk of litigation. The greater expected audit feescanbe used
by auditfirm to fund all costs of the audit process and extend audit procedures.
Several previous studies have concluded that the amount of the audit firm‟s
feesaffect positively on audit quality i.e. the research results from Choi et al. (2010)
and Yu (2007).
Based on these arguments, the hypothesis can be proposed as follows:
H3: Audit firm’s annual feesaffect positively on audit quality.
Based on several studies that rejected the audit rotation, they were assumed that the
execution of the initial audit engagementoccured audit failures that caused by
inexperienced auditors in understanding the client's business processes. Becoming
an experienced auditor takes many times as illustrated by the learning curve. So
some of the benefits based on the length of the audit engagementmake added
experience of auditors and audit costs are cheaper. This is supported by research of
Carcello& Nagy (2004) who concludes that the financial reporting fraud most likely to
occur in the first year of the engagement. Likewise, Geiger &Raghunandan (2002)
also states that many errors occured in the first audit report on the relationship
between the auditor-client.
Based on the description of the initial audit engagement, auditor should
communicate with the predecessor auditor and initial balances testing to increase
understanding of the condition of the client and increase knowledge from the
predecessor auditor's working paper review with restrictions in accordance with the
code of ethics for public accountants, so the following hypothesis can be proposed
H4: initial balance testing affectspositively on audit quality in the initial audit
engagement.
3. Research Method
3.1 Sample Selection and Data Collection
The research populations were all inspection of audit partner ever undertaken by the
Accountant and AppraiserSupervisory Center (AASC) - Ministry of Finance.
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
Observation period of the research was conducted in 2007-2011. Audit
partnerswhichbecome samples in this research were selected based on certain
criteria (purposive sampling), as follow:
1. Audit partnerswho had been inspected by AASC and published in AASC‟s
inspection reports.
2. Annual activity report of audit firms in the period 2007-2011.
3. The availability of all required data such as name of audit partner and audit firm,
the audit client's name, audit firm‟stotal fees per year, the length of audit
engagement, inspection findings and client‟s total assets.
3.1.1 Operational Definition and Measurement of Variables
Dependent Variable
This research uses a dependent variable that is audit partner‟s compliance
onprofessional auditstandardbased on AASC‟s inspection report that has mentioned
whether audit partner breaking a professional auditstandard or not. So the audit
quality (AQ) is an indicator variable equal to 1 if audit partner adhere to professional
auditstandard, and 0 otherwise.
Independent Variable
The regulation of audit partner rotation(REG) is defined as the audit partner‟s
complianceon the regulation of audit rotation restrictionas an indicator variable equal
to 1 if audit partner adhere to audit rotation restriction, and 0 otherwise.The length of
the assignment or audit partner‟s tenure(TENUR) is the length of the relationship
with the auditor-client in terms of general audit engagements that performed using
interval scale.Initial balance testing(IB) was associated with initial audit engagement
for the audit partnerwho shouldmake communication with the predecessor auditor,
reviewing the predecessor auditor's working papers and perform initial balance
testing as an indicator variable equal to 1 if initial balance test was done and 0
otherwise. Audit firm‟s annual fees(FEEKAP) are the total of audit fees and other
services received during the year with natural log of audit firm‟s total fees.
Control Variable
Client‟stotal assets (TA) are a measure of client size using the natural log of total
assets as control variable. Several previous studies indicate generally the smaller
companies tend to commit fraud (Beasley et al., 1999).So audit partner needs to
apply appropriate audit procedures for the detection of fraud. Greater fraudulent
financial reporting that auditedby audit partner, greater violation opportunities of
auditing standards particularly relevant audit evidence.The number of audit
partners(AP) are the number of partners in the audit firmbased on domicile of audit
firm or audit firm‟s branch. The use of the number of audit partners based on prior
research which gave results that the more amount of audit partners, the higher audit
quality (Colbert &Murray, 1999).The higher audit quality can be achieved because of
peer-review each other between audit partners.
3.2 Hypothesis Testing
Testing the hypothesis in this research was done by using binomial logistic
regression. The model created in this research were divided into two models, namely
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
model I on the relationship between the dependent variable about the audit quality
and the independent variable about audit partner‟s complianceto audit rotation
regulation, the length of audit partner‟s engagement, audit firm‟s annual fees, total
client assets and the amount of audit partners; and model II on the relationship
between audit quality as dependent variable andinitial balances testing in the first
year of audit partner‟s engagement as independent variable and the number of audit
partners as control variable are presented as follows below:
Regression equation in the hypothesis testing model 1 as follows:
Logit{AQ=1vs0} = α + β1REG + β2TENUR + β3FEEKAP + β4TA+ β5AP+є (1)
Regression equation in the hypothesis testing model 2 as follows:
Logit{AQ=1 vs 0} = α + β1IB + β2AP + є
(2)
4 Analysis and Discussion
4.1 Data Description
In this research,the data were taken from the results of the inspection and the annual
activity reportof audit firm atAASCfrom 2007to 2011. Inspection resultsare part of
aroutineannualinspectionplanby dividing thecategoriesinto4 categoriesaudit firm
i.e.very large, large, medium and small. The dividing categoriesusethescoring
systemattributesinto consideration.
Here are theresults of thefurther samplesused in the research:
Table 1: Selecting Samples Procedure
Summary
Amount
Audit Partner had been inspected by AASC
314
Reports of Inspection Result cannot be collected
(23)
Audit Partner didnot get engagement
(8)
Audit Partner had been sick
(2)
Audit Partner didnot lend working papers
(1)
Reports of Inspection Resultwere not completed yet
(41)
Total samples for Model I
Total samples for Model II
239
117
4.2 DescriptiveStatistics
The
following
tabledescribes
theoverview
statisticsonresearch modelI andIIare asfollows:
7
ofthe
descriptive
Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
Table 2: Summary of Frequency
% Model I % Model II
AQ
RE
G
IB
Bad
Good
No
adhere
Adhere
No
testing
Testing
78,2
21,8
76,9
23,1
7,5
92,5
47,9
52,1
Table 2showsdescription of the frequencies of general audit engagements
based on AQ and REG on the research model (I.) AQ are the number of audit
partner‟s engagements with the bad audit quality which had56,4%greater than the
good audit quality. REG are the number ofaudit partnerswho adhere on audit rotation
regulation which had 85% greater than the number of audit partnerswho not adhere
on audit rotation regulation. In the research model (II), description of general audit
engagements based on AQ and IB. AQare the number of audit partner‟s
engagements with the bad audit qualitywhich had53,8%greater than the good audit
quality.IBare the number of the audit partners‟ first audit engagementwho have done
communication with the predecessor audit partner and /or have tested the initial
balance which had 4,2% greater than the number of the audit partners‟ first audit
engagement who have not done communication with the predecessor audit
partnerand/orhave tested theinitial balance.
Another descriptive statistic of Model I can be showed as follows:
Table 3: Descriptive Statistic of Model I
No Variabel Mean Median Min Max
1 TENUR
1,64
2
1
4
FEEKAP
2
21,13
20,9 16,4
27
3 TA
26,16
26,3 19,2 33,3
4 AP
2,88
2
1
23
4.3 Result of Regression Test
Statistical processing results of hypothesis testing can be shown in the
following table:
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
Table 4: Result of Regression Test
Model I
Model II
B
Sig.
Exp
B
Sig.
Exp
FEEKA
P
TA
TENUR
REG
AP
IB
Constan
t
0,931
0,000
2,536
-0,003
-0,307
-0,194
0,002
0,974
0,290
0,818
0,985
0,997
0,736
0,823
1,002
20,708
0,000
0
0,422
0,004
1,525
2,049
0,002
7,758
-3,85
0,000
0,021
Table 4 shows that the model (I) just audit firm‟s annual feesare significantly
and positively related to audit quality. In the model (II) shows that the independent
and controls variable are significantly related to audit quality.
Table 5: Coefficient of etermination
Model I
Model II
Cox & Snell
R²
0,281
0,264
Nagelkerke
R²
0,432
0,399
Table 5shows that Nagelkerke R Square value on the modeI means the
variability
ofthe
dependent
variablecan
explained
bythe
independent
variableby43.2%and the remaining56.8%can be explainedbythe other independent
variables. In the research model, Nagelkerke R Square value means that the
variability of the dependent variable explained by the independent variable by 39.9%
and the remaining 60.1% can be explained by the other independent variables.
4.4 Analysis and Discussion of Hypothesis
The first hypothesis testing resultssignificancevalue 0.818 greater than 0.05.
Based on this result the first hypothesis can not be accepted which audit partner‟s
compliance on audit rotation regulation did not affect significantly on audit quality.
The result of this research has strengthened the results of a previous research
conducted by Gold et al. (2012) with dummy variables to measure independent
variable such as the change of the audit partner or not. So the results of this
research can be considered for policy makers that audit rotation restriction until
maximum three years does not affect on the audit quality.
The second hypothesis testing resultssignificance value 0.290 greater than
0.05. Based on this result the second hypothesis was not accepted, which the length
of the assignment of audit partner did not affect significantly on the audit quality. The
result is consistent with the results of research of Jackson et al. (2008) when proxied
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
by the level of discretionary expenses and Knechel & Vanstraelen (2007) when
proxied by the propensity to issue a going-concern opinion is weak. However, these
results are contrast with researchs that is resulted by Gold et al. (2012) using total
accruals as quality audit who concluded that the length of the assignment of reviewer
partneraffect positively on audit quality.
The third hypothesis testing resultssignificance value 0.000 less than 0.05.
Based on this result the third hypothesis is accepted, that means the amount of audit
firm‟s annual feesaffect positivelyand significantly on audit quality. With an odds ratio
of 2.536 can also be interpreted if other variables held constant, each unit increase
in audit firm‟s annual fees will increase log of odds of good audit qualitywith the
number 0.931. The results corresponded with the results from Choi et al (2010) and
Yu (2007), with value of discretionary accruals as proxy for audit quality. However,
these studies differ from the results from Hoitash et al. (2007) which concluded that
there was significant negatively and the results from DeFondet al. (2002) which
concluded that there was no significant relationship between total fees and audit
quality.
The fourth hypothesis testing gives significance value 0.002 less than 0.05.
Based onthis result the fourth hypothesis testing is accepted, which means the initial
balance testing in initial audit engagement significantly and positively effect on the
audit quality than not initial balancetesting. The magnitude of the odds ratio 2.049
means that when the other independent variables constant, the log of odds of audit
quality will increase to 2.049 for the initial balance testing ininiatial audit engagement
compared with not doing that procedure. Based on this result should encourage
professionals and regulators to provide a strong emphasis on the necessity of the
initial balance testing, so that it would increase the audit quality in the first year of the
audit engagement.
5. Conclusion
This research conclude that audit firm‟s annual fee and initial balance affect
significantly and positively on the audit quality, but the audit partner‟s compliance on
audit rotation regulation and the length of the audit partner engagement do not affect
significantly on the audit quality. The control variables in the research model (1),
client size and the number of audit partners do not affect significantly on the audit
quality, but the research model (II), the number of audit partners affect significantly
and positively on audit quality.
Limitations to this research, namely the length of audit partner engagement tends to
be short between one to three years because the samples were taken in the period
of applying audit rotation regulation. Further, audit partner‟s compliance on audit
rotation regulation based on clients which had not been inspected byAASC.
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Proceedings of 8th Annual London Business Research Conference
Imperial College, London, UK, 8 - 9 July, 2013, ISBN: 978-1-922069-28-3
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Proceedings of 8th Annual London Business Research Conference
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