J. Global Business Advancement, Vol. X, No. X, xxxx
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An empirical investigation of the Libyan audit market: perceptions of auditor’s independence Shamsaddeen Khamis Faraj and Saeed Akbar* University of Liverpool, Management School, Chatham Street, L69 7ZH, UK E-mail:
[email protected] E-mail:
[email protected] *Corresponding author Abstract: Auditor independence has received considerable attention in recent years. This is due to the fact that independently audited financial statements may result in the generation of true and fair accounting information which will help stakeholders to form rational expectations about firms and minimise the agency cost. It can also be argued that lack of independence would lead auditors to collaborate with the management of firms and would produce misleading accounting information. Accepting this premise, this study explores the effects of 12 different variables on the perceptions of auditor independence in Libya. A sample of five user groups namely; owners, investors, lenders, managers and auditors were chosen for the survey. The results suggest that all user groups regard auditor independence as an important factor in forming their decisions about firms. Amongst other variables, the non-availability of auditing standards in Libya is found to be the strongest factor which undermines auditor independence in Libya. Keywords: Libyan audit market; auditing; audit regulation; auditor independence; developing countries. Reference to this paper should be made as follows: Faraj, S.K. and Akbar, S. (xxxx) ‘An empirical investigation of the Libyan audit market: perceptions of auditor’s independence’, J. Global Business Advancement, Vol. x, No. x, pp.xx–xx. Biographical notes: Shamsaddeen Khamis Faraj is a Teaching Assistant of Accounting at the University of 7th April in Libya. He is currently, a PhD Student at the University of Liverpool Management School. His main research interest includes auditing, the auditor’s independence and accounting regulation in Libya. Dr. Saeed Akbar received his PhD from Manchester Business School in 2001. He is currently working at the University of Liverpool Management School. His research interests include: market-based accounting research, financial accounting and reporting, management accounting, auditing, intangibles and the financing of SMEs in the UK. He has supervised more than ten PhD students and published his research in reputed international journals; like Journal of Business Finance and Accounting, International Journal of Management Reviews, The International Journal of Accounting, etc. He received a number of awards during his career.
Copyright © 200x Inderscience Enterprises Ltd.
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S.K. Faraj and S. Akbar
Introduction
An independent auditor is expected to monitor and verify accounting information presented by management, on behalf of an entity’s owners. The agency theory outlines the contractual relationships between the principals and agents, and these two parties are involved in a relationship with diverse incentives (self-interest) that pose conflict of interests. An independent auditor is appointed to monitor this relationship and mitigate the agency cost. In addition, the appointment of an independent auditor creates a further agency relationship between the auditors and the appointing party (e.g. managers). The manager may exploit his/her economic power (pay and hire) to exert pressure on auditors; therefore, collaboration between managers and auditors may occur. If such collaboration were to exist, the monitoring function of an auditor would be of no value (Watts and Zimmerman, 1986). An independent auditor could, therefore, play a very important role in minimising the agency cost. However, the recent corporate failure of Enron has brought auditor independence into question. This study, therefore, aims to examine certain factors that may be perceived to undermine or enhance auditor independence. Auditor independence can be considered in terms of two concepts: actual independence and independence in appearance. The former refers to an unbiased mental attitude of the auditor, while the latter refers to the perceptions of third parties who observe that the auditor is free from the influence (relationships) of the audit client (AICPA, 1993). Furthermore, the IFAC (2007) requires both independence of mind (actual) and independence in appearance. It may be concluded that most regulatory requirements concerning auditor independence have originated in the USA. Moreover, a review of the relevant literature reveals that there is little concern about this issue within developing countries. This research focuses on perceived auditor independence (PAI), rather than on actual independence which is not observable by accounting information users. Previous research has focused on studying the impact of economic dependence, audit market competition, non-audit service (NAS, hereafter) and regulatory frameworks on auditor independence (Beattie et al., 1999; Carcello and Neal, 2003; DeAngelo, 1981a; Shockley, 1981; among others). These studies have all been conducted within the advanced countries, with little effort being made to explore the situation in developing contexts. The work of, for example, Teoh and Lim (1996) on Malaysia, Al-Mudhaki and Joshi (2004) on India and Awadallah (2006) on Egypt, represent the few studies in this area in developing countries and these all focus on just a limited number of potentially influential factors on auditor independence, with no consideration of the impact of national culture in this respect. This research study aims to contribute to that small body of literature by examining the perceptions of accounting information users towards auditor independence within the North African country of Libya, which has as its regulatory body for the country’s accounting and auditing profession, the Libyan Accountants’ and Auditors’ Association (LAAA). The LAAA was established by the Libyan government Act 116/1973, but in the absence of Libyan auditing and accounting standards, its role is extremely limited. Consequently, the Central Bank of Libya enacted Law 1 of 2005 to comply with the international accounting and auditing standards within the banking sector (CBL, 2005). The Institute of Financial Auditing (IFA) is responsible for governing all state-owned entities in Libya (IFA, 2007). Moreover, the audit market in Libya consists of large local audit offices, small local audit offices and the Big 4 audit firms,1 for instance Ernst and
An empirical investigation of the Libyan audit market
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Young, PWC, KPMG and Deloitte and Co all have their offices in Tripoli. The accounting profession in Libya is also oriented towards the UK and the USA accounting practice2 (Ahmed and Gao, 2004). The rest of this paper is organised as follows. Section 2 presents relevant literature, followed by hypotheses development. Section 3 reports a description of the research methodology and data. Section 4 presents results of the survey findings and subsequent discussions on results. The final section concludes the study by summarising the main findings and offering a comment on the limitations of the study and venues for future research.
2
Literature review
Auditor independence is linked to a variety of factors which fall within three overall categories, these being: economic, regulatory and cultural. The economic relationship between auditors and their clients is highlighted in DeAngelo’s (1981a) model, according to which, the economic factors include the client-specific quasi-rents that incumbent auditors earn, when they possess a comparative advantage over competitors. The transaction costs involved in changing auditors create advantages to incumbent auditors who can capture future benefits from technological and transaction cost advantages by setting future audit fees above the avoidable cost of performing audits. Incumbent auditor and client economic relationships may create opportunistic behaviour that forms a conflict of interests which may compromise independence. However, the existence of similar client-specific quasi-rents from other clients encourages incumbent auditors not to behave opportunistically and instead to maintain their independence (DeAngelo, 1981b). This may be attributed to the existence of institutional incentives, such as litigation costs, and reputation loss. In addition, the relative impact of incentives to behave opportunistically is dependent upon both the financial condition of the audit client and the audit firm size. For instance, the results of several researchers (Awadallah, 2006; Gul, 1991; Shockley, 1981) suggest that the size of the audit firm does have an impact on the perceptions of auditor independence. They argue that, large audit firms with more clients are perceived to be more independent than small audit firms. Other evidence (Niemi, 2004), however, suggests the contrary by arguing that small audit firms with large billing rates are likely to protect their reputation by supplying high quality audits. However, it is generally accepted that big audit firms tend to protect their reputation and maintain independence by providing quality audit. This is believed to be attributed to the market-based institutional incentives which regulate both big and small audit firms. Small audit firms that incur high audit fees also are faced with difficulty in maintaining their independence. For instance, a group of studies concludes that a larger proportion of audit fees from one audit client, compared to the entire audit income, is perceived to impair auditor independence due to the auditor’s economic dependence on the client (e.g. Gul, 1991; Teoh and Lim, 1996, among others). However, DeFond et al. (2002) argue that there is no relation between audit fees and auditor tendency to compromise their independence and issue false information about an audited entity that may be experiencing financial difficulties. Indeed, one could argue that the fear of reputation loss and litigation costs support the notion of auditor independence and the
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S.K. Faraj and S. Akbar
likelihood that an auditor may become more resistant to client pressure than when audit fees are high. However, high audit fees may be a sign of a high audit quality that reflects an independent audit. For instance, the determinants of audit fees in South Asian countries are similar to those in other developed and industrial countries. Audit fees are related to client size, whether the audit client is a subsidiary of a multinational corporation or not. The subsidiaries of multinational corporations pay significantly higher audit fees and affiliate with the Big 4 audit firms which charge higher audit fees for perceived higher quality audit services in the South Asian audit market (Ahmed and Goyal, 2005). It can, therefore, be argued that the emerging audit market within South Asian countries is influenced by western and international capital market participants. A high level of audit market competition may also increase the auditor’s economic dependence which increases the risk that auditor independence may become impaired especially in the case of small audit firms which are less able to resist client pressure (e.g. Shockley, 1981). Further, a high level of audit market competition increases the risk that auditors may resolve the dispute situation in favour of their clients’ management in order to retain the client, thereby impairing their independence. In line with this, small audit firms are perceived to be more vulnerable to audit client pressure when auditors provide non-audit services along with audit services (Awadallah, 2006). This may be due to low activity enforcement within the developing economies. It can be argued that the higher the level of competition, when providing non-audit service, the more difficult it is for small audit firms to resist client pressure. The provision of non-audit services by incumbent auditors is the most controversial factor which has received considerable attention among policy makers. In this regard, the USA congress has passed the SOX3 Act 2002 which proscribes certain types of non-audit services. Researchers have also devoted considerable attention to examine the effect of NAS on auditor independence. For example, it has been argued that audit firms which provide non-audit services to audit clients are more likely to lose independence than audit firms which do not provide such services (e.g. Canning and Gwilliam, 1999; Joshi et al., 2007). The findings of these studies are supported by the view that auditor independence may be compromised when auditors with short tenure receive high non-audit fees but not when auditor tenure is long (e.g. Gul et al., 2007). It has also been argued by (Gul, 1991) that auditors who provide non-audit services are perceived to be more likely to resolve the audit dispute as the client management wishes than auditors who do not provide nonaudit services. On the contrary, other research findings suggest that lenders have more confidence in the independence of auditors who supply non-audit services in addition to audit services (Gul, 1989). One can attribute this to the insights that auditors obtain about their clients’ transactions and accounting system. For instance, Habib and Islam (2007) suggest that in Bangladesh there is no adverse impact of non-audit service on auditor independence. Thus, one could argue that the influence of multinational subsidiaries based in this country is positive, since it is accepted that although multinationals do tend to request non-audit services together with audit services, their organisational and institutional incentives seem to represent sound corporate governance. Institutional incentives including formal sanctions, auditor liability to third parties, audit committee and audit tenure all are believed to function as internal monitoring mechanisms which may mitigate the agency problem. National laws also play a major role in regulating the audit profession in general and safeguarding auditor independence
An empirical investigation of the Libyan audit market
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in particular (e.g. Favere-Marchesi, 2000; Tahinakis and Mylonakis, 2005). However, the lack of enforcement of regulatory requirements is perceived to create barriers in transforming the modern audit profession in Russia (Samsonova, 2006). Similarly, a lack of enforcement in Egypt is highlighted by Wahdan et al. (2005), who observe the gap between legislation and practice within the profession regarding its organisation and compliance with accounting and auditing standards. These are examples of developing country difficulties in this whole arena. In the regulatory framework of auditor independence, the audit committee plays a crucial role in monitoring the audit function in general and auditor independence in particular. However, the existing literature provides conflicting evidence as to the impact of the audit committee on the PAI. For instance, a group of studies concludes that the audit committee plays a major role which is perceived to reduce the audit risk and enhance audit quality (e.g. Abbott and Parker, 2000; Mangena and Tauringana, 2008). These results represent perceptions of users from developed countries. However, Joshi and Wakil (2004) suggest that although audit committees are important, listed companies are not compliant with the international requirements of audit committees. Hence, one could observe the weak and non-existence of audit committee enforcement in the developing countries. Other empirical studies, however, report that audit committees lack the power to control the board of directors. For instance, audit committees in Saudi Arabia do not have the authority to enhance the role of external auditors nor are these able to protect investors (Al-Twaijry et al., 2002). In a similar vein, Al-Mudhaki and Joshi (2004) conclude that only 14.6% of companies investigated in their study in India have nonexecutive directors on their audit committees, thereby indicating a lack of independent representation on these very important corporate bodies. Since both studies represent the situation in developing countries, one could argue that the regulatory requirements in developed countries such as the USA, the UK and Australia, may not be applicable to immature accounting professions in developing contexts. Moreover, in addition to the variations in the monitoring function of audit committees across countries, there is also a difference in the mandatory audit tenure. The mandatory rotation of auditors may increase the audit cost, as a result of the fact that a significant amount of specific assets is destroyed in the exercise and must be rebuilt in every rotation. These assets represent the auditor’s familiarity with the client’s accounting procedures, which is lost with his/her departure, leaving the client to bear the start up cost associated with every new first audit (Arrunada and Paz-Ares, 1997). However, Shafie et al. (2004) considering clients in Malaysia, point out that lengthy tenure results in issuing a going-concern opinion. Yet another group of studies expresses contrary views, for instance in the USA, audited financial statements are perceived as more reliable for firms with longer auditor tenure (Ghosh and Moon, 2005), and the results of Kaplan and Mauldin (2008) conclude that there is no significant difference among non-professional investors’ perceptions of audit partner rotation and audit firm rotation. These findings could be attributed to the monitoring role of the audit committee in the USA. It can also be noted that corporate governance in developed countries is more effective than its counterpart in the developing world. The rotation of audit firms is, however, perceived to enhance auditor independence, it being argued (see Gates et al., 2007), that this principle is more likely to prevent auditors from developing close relationships with their clients, which may threaten their ability to behave non-prejudicially. Another group of studies concludes that the non-rotation of
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audit firms is not perceived to impact on auditor independence (e.g. Shockley, 1981; Teoh and Lim, 1996). Thus, it can be observed that the audit tenure literature provides mixed evidence on the impact of length of tenure on auditor independence. It can, therefore, be argued that perceptions of auditor independence vary across countries as a result of their differing regulatory auditing systems. Moreover, Hofstede’s (1980) wideranging work on the consequences of cultural differences across nations, confirms substantial variation in certain predispositions to particular phenomena, a fact that inevitably has impacts on practices in finance and accounting. Culture is defined by Hofstede (1997) as ‘the collective programming of the mind which distinguishes the members of one group or category of people from another’. This programming is apparent in the values, norms, traditions and beliefs of a society. Being a member of one society, individuals prefer certain states of affairs (values or/and norms) over others (Cohen et al., 1993). Cultural values as classified by Hofstede (1980, 1991) across societies or countries are: uncertainty avoidance, individualism vs. Collectivism, masculinity, power distance and long-term vs. short-term orientation. For instance, Rutledge et al. (2003) suggest that auditors and financial analysts within one region are influenced by similar contextual and environmental factors and, therefore, share similar attitudes and perceptions of auditor independence. The influence of culture on the accounting profession is introduced by several researchers (Gray, 1988; Salter and Niswander, 1995). Smith and Hume (2005) state that “accountants of individualistic (high IDV) societies are more likely to adhere to personal principles even if the results are detrimental to the organisation (whereas) accountants of collectivistic (low IDV) societies are more likely to subordinate individual values for those that benefit their organisation.”
Furthermore, (Askary et al., 2008) suggest that cultural and country-specific values affect the accounting system development. Moreover, Lord and DeZoort (2001) identify a negative relationship between social pressure and audit quality. It can, therefore, be concluded that auditors from individualistic cultures are expected to maintain independence. This concept is a cornerstone of the Anglo-American audit. However, collectivistic auditors appear to reflect the opposite of the Anglo-American independence, Ritchie and Khorwatt (2007) for instance, suggesting that auditor independence in Libya is influenced by cultural values which elevate duty to family, tribe and community, above those to employer and/or organisation. This is because auditors from collectivist societies obey the custom and tradition of their extended family and clans and are, therefore, never free from the influence of others within that network. From the work of Hofstede (1980, 1991, 1997), and other researchers such as Ritchie and Khorwatt (2007), one can legitimately conclude that other collectivist societies may have a similar attitude towards and perceptions of auditor independence. The above review of relevant literature highlights certain influential factors believed to affect auditor independence, and these can be seen to fall into three different categories concerned with economics, regulatory frameworks and cultural impacts. In light of this, it can be argued that five principal factors affect auditor independence, namely: the economic dependence of the auditor on the client, competition in the audit market, nonaudit services, regulatory factors (auditor’s liability, audit committee and audit tenure) and the influence of national culture on perceptions of auditor independence. This study investigates the impact of these five factors in the Libyan audit market.
An empirical investigation of the Libyan audit market
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2.1 Research hypotheses Based on the above review of previous studies, the following research hypotheses are formed, and tested from the viewpoint of the users and auditors. The user groups are: owners,4 investors,5 lenders, managers and external auditors. We assume that competition increases the economic bond between auditors and their clients, as a result of high audit fees or/and non-audit services (NAS hereafter). We also hypothesise that a flexible regulatory framework, such as a lack of legal and institutional incentives and lack of domestic independence standards, will decrease confidence in auditor independence. Moreover, based on the theory of Hofstede (1980) in which cultural values are classified across countries, and based on Gray’s (1988) model and the empirical findings of Salter and Niswander (1995), we predict that country-specific culture impacts upon auditor independence. Specifically, auditors from collectivist societies are members of an extended family, clan and community, requiring close social relations between its members. We therefore, hypothesise that independence of auditors from such societies is impaired. Stated formally (in an alternative form): H1: Owners, investors, lenders managers and auditors’ (OILMAs, hereafter) perceived auditor independence (PAI hereafter) is negatively affected when competition is high; as one-client audit fee exceeds 15%; when providing NAS; by weak institutional incentives and by socio-culture relationships. H1a: There is a consensus among OILMAs, regarding the negative impact on perceived auditor independence (PAI). A review of the relevant literature also indicates that there are regulatory requirements which are considered as strategies to protect and safeguard auditor independence, such as the existence of audit committees and the rotation of auditors after a certain period of time. Although the requirements for the rotation of auditors vary across countries, the majority of these regulatory frameworks require a five-year period. Therefore, we hypothesise that such rotation on a five-year basis will prevent the creation of close relationships that may lead auditors and their client managers to collaborate and work in the owners’ interests. An audit committee is expected to monitor and prevent such collaboration. We also infer that interested parties’ perceptions are affected by audit services performed by different sizes of audit firms. Specifically, we predict that when audit service is performed by a large audit office and when audit service is performed by a Big 4 audit firm, users of audited financial statements and auditors’ perception of auditor independence increases. Stated formally (in an alternative form): H2: OILMAs’ PAI positively affected by five-year auditor rotation; audit committee existence and by large audit firm size. H2a: There is a consensus among OILMAs regarding the positive impact on PAI.
3
Research methodology and data
The research method adopted in this study is the questionnaire survey. This approach is chosen, despite its limitations, due to the fact that it is considered to be reliable for data collection and subsequent analysis (Roberts, 1999). This method is also more reliable for
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S.K. Faraj and S. Akbar
studying the characteristics and inter-relationships between the variables under investigation. The exploratory research method is chosen on the grounds that such research seeks new insights by asking questions and assessing the phenomena in order to clarify ambiguous problems (Robson, 2002). Babbie (1998) argues that exploratory research is followed by researchers as a mean to satisfy their curiosity and desire in relation to understanding the research issues under investigation. We adopt exploratory research methods because over the years researchers have successfully used this method for conceptualising particular research issues. The subjects of this study contain five groups as owners, investors, lenders, managers and auditors. Owners and investors were randomly selected from the Chamber of Commerce in Tripoli. Lenders were randomly selected from the lending department of the Central Bank of Libya. Managers were also randomly selected from the directory of the Chamber of Commerce in Tripoli. Auditors were randomly selected from the LAAA directory and those who perform audit services in the capital city Tripoli, in Libya. The questionnaire first required respondents to provide general information about their job title, qualification, age and experience. Then, it asks for information about the five groups perceptions of the auditor’s independence. A five-point Likert scale is used to capture the level of response as to the influence of 12 variables generated from the existing literature on the auditor’s independence. Respondents were asked to indicate the extent to which they perceive a given variable influence the auditor independence. The points on the scale range from 1 – strongly undermines independence, to 5 – strongly enhances independence. The questionnaire was sent to 80 individuals in each group (owners, investors, lenders, managers and auditors), producing a total of 400 subjects. Out of the 80 questionnaires distributed to all groups, 31 questionnaires were returned by the owners, 42 questionnaires were returned by the investors, 51 questionnaires were returned by the lenders, 32 questionnaires were returned by the managers and 43 questionnaires were returned by the auditors. Thus, a total of 199 questionnaires returned by all five groups.
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Analyses and results
Table 1 provides the respondents’ profile. The response rates for the, owners, investors, lenders managers and auditors groups were 39%, 53%, 64%, 40% and 54%, respectively, producing a total usable response rate of around 50% (N = 199). Around 81% of respondents had from six to ten years’ work experience. It also can be revealed that 48% of respondents were between 30 and 40 years of age, while only 13% under 30 years old. The rest of the respondents’ ages varied between 41 and over 50 years. It can also be seen from Table 1 that around 53% of respondents had University degrees at BA/BSc level. While only 12% of respondents had PhD, the rest of the respondent groups held a Masters degree, high diploma or undergraduate diploma in accounting.
Table 1
Respondents’ profile
Group
Sample
Responses
Rate (%)
Owners
80
31
39
An empirical investigation of the Libyan audit market Investors
80
42
Lenders
80
51
64
Managers
80
32
40
Auditors Total
53
80
43
54
400
199
50
Less than five 6–10 years years
Experience
9
More than 10 years
Total
Owners
0
29
2
31
Investors
17
25
0
42
4
7
40
51
12
11
9
32
Lenders Managers Auditors
5
13
25
43
Total
38
85
76
199
Age
Under 30 years
30–40 years
41–50 years Over 50 years
Total
Owners
5
5
4
17
31
Investors
7
35
0
0
42
Lenders
10
17
24
0
51
3
6
13
10
32
Managers Auditors
0
33
7
3
43
Total
25
96
48
30
199
Qualification
*Other
CA
PhD
MSc
BSc
Owners
–
–
3
24
4
Total 31
Investors
–
–
4
32
6
42
Lenders
–
19
6
25
1
51
Managers
–
–
14
15
3
32
Auditors
24
4
5
10
0
43
Total
24
23
32
106
14
199
*High diploma in Accountancy and Diploma in Management and Accounting.
Table 2 presents a summary of the sample response for 12 variables. Panel A shows the variables that participants perceived to threaten independence (where mean score is less than 3). Panel B shows the variables which participants perceived to enhance independence (where mean score is more than 3). The results indicate that the most important variable, amongst all those enhancing independence, is the provision of audit service by a large audit office, with a mean score of 4.20, at 0.001, level of significance. The most threatening variable amongst all is the lack of legal incentives in the audit market with a mean score of 1.50 at 0.001, level of significance. Generally, t-tests indicate that most variables are significant and they have an impact on the perceived independence. Thus, H1 and H2 are accepted. Table 2
t-Test for total sample
Factors examined
Mean score
Sig. (2-tailed)
SD
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S.K. Faraj and S. Akbar
Panel A: factors undermining independence 1
Audit fee exceeds 15% of total audit revenue
2.44
0.000
0.728
2
Non-audit services are provided to audit clients
1.97
0.000
0.758
3
Non-audit services are provided to nonclients
3.04
0.263
0.442
4
Audit market lacks legal incentives
1.50
0.000
0.602
5
Audit market lacks national independence STD
1.75
0.000
0.735
6
Audit market is highly competitive
2.11
0.000
1.024
7
Audit services is provided by small audit office
1.82
0.000
0.687
8
Socio-cultural relationships
1.94
0.000
0.528
Big 4 auditors
3.77
0.000
1.033
Large audit office
4.20
0.000
1.048
Panel B: factors enhancing independence 9 10 11
Audit committee
3.66
0.000
0.929
12
Rotation every five years
3.94
0.000
0.955
Table 3 summarises the results from the ANOVA performed on the level of response regarding the effect of 12 variables on the perceptions of auditor independence. Selected variables significantly affect lenders’, investors’, owners’, managers’ and auditors’ perceptions of auditor independence. It can be noted from Table 3 that omega statistics indicate that the most important factor among all those selected is the lack of domestic independence standards, with ω2 = 15.7%, while the large audit office factor records 13.8% of variance. However, non-audit services to non-audit client and social relationship account for the least percentage of variance. In general, omega squared results confirm that all selected variables are significant at the 0.001 and 0.005 levels. Therefore, the results shown in Table 3 support the acceptance of H1 and H2. It can be noted that the total value of ω2 for the total sample is 0.952. It has been argued by Peterson et al. (1985) that the small total value of omega squared is to be predicted in behavioural research, and that small effect sizes are the norm, not the exception. A series of t-tests were also performed comparing the means of the five groups of respondents for each variable. Tables 4–8 summarise the results of t-tests and compare the means of the sub-groups. Although, Table 2 indicates that high competition within the audit market is significant (with a mean score of 2.11, SD = 1.024 at 0.001 level) across the total sample, there are differences in the relative importance of competition at the sub-sample level. Table 8 shows that competition has more impact on the auditor subgroup than on the other sub-groups. The auditors perceived that performing audit service within a highly competitive audit market undermines independence. Among auditors, the audit competition factor mean score was 1.47, this being the strongest of all the other sub-groups. Tables 5–7 indicate that the investors, owners and managers perceived competition to undermine auditor independence with mean scores of 1.81, 2.00 and 2.03, respectively. However, the mean score for lenders is 3.02, SD = 1.334 indicating that
An empirical investigation of the Libyan audit market
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competition has no effect from their viewpoint (see Table 4). Therefore, regarding the effect of competition H1a is rejected. Table 3
ANOVA
and omega squared
Source of variance6
ω2
SS
DF
MS
F
Sig.
BIG4AUD
65.070
4
16.267
21.572
0.000
0.094
LRGOFC
87.893
4
21.973
32.926
0.000
0.138
FEE
20.192
4
5.048
11.552
0.000
0.050
AC
57.106
4
14.277
24.369
0.000
0.105
NAS
31.942
4
7.986
18.921
0.000
0.083
NASNC
2.615
4
0.654
3.510
0.009
0.012
ROTATE
45.422
4
11.355
16.322
0.000
0.071
LEGAL
3.467
4
0.867
2.463
0.047
0.007
LDISTD
47.048
4
11.762
38.103
0.000
0.157
COMPET
64.445
4
16.111
21.838
0.000
0.095
SMLOFC
29.704
4
7.426
22.587
0.000
0.098
SOCIAL
9.296
4
2.324
9.805
0.000
0.042
Total
0.952
Table 4
t-Test for lenders
Factors examined
Mean score
Sig. (2-tailed)
SD
Panel A: factors undermining independence 1
Audit fee exceeds 15% of total audit revenue
2.75
0.031
0.821
2
Non-audit services are provided to audit clients
2.35
0.000
0.820
3
Non-audit services are provided to nonclients
3.16
0.010
0.418
4
Audit market lacks legal incentives
1.71
0.000
0.729
5
Audit market lacks national independence STD
1.69
0.000
0.707
6
Audit market is highly competitive
3.02
0.917
1.334
7
Audit services is provided by small audit office
2.35
0.000
0.658
8
Socio-cultural relationships
1.71
0.000
0.642
Big 4 auditors
4.27
0.000
0.695
10
Large audit office
4.49
0.000
0.505
11
Audit committee
3.82
0.000
0.767
12
Rotation every five years
4.18
0.000
0.767
Panel B: factors enhancing independence 9
It can be seen from Table 2 that when the audit fee size exceeds 15% of the total audit revenue, the whole sample perceived this to undermine auditor independence. The mean
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S.K. Faraj and S. Akbar
score for this variable is 2.44, SD = 0.728 at 0.001, showing this to be a significant factor, yet despite its significance at the total sample level, differences in its relative importance were noted at the sub-group level. From Table 5, it can be seen that the audit fees size has a stronger effect on investors’ perceptions than it does on those of the other sub-groups. Tables 4, 6–8 show that the mean scores in respect of owners, managers, lenders and auditors are 2.16, 2.34, 2.75 and 2.77, respectively. Therefore, it can be argued that despite the differences in the relative importance of audit fee size, there seems to be a consensus that this factor undermines auditor independence. Thus, in terms of the influence of high audit fees, H1a is accepted by all sub-groups. Table 2 shows that the provision of non-audit services together with audit services to clients is perceived to undermine auditor independence. At the total sample level, the non-audit services mean score is 1.97, SD = 0.758 at 0.001 level, thereby indicating that a non-audit services factor is significant and does impair auditor independence. However, whilst this factor is significant at the total sample level, there are differences in its relative importance at the sub-sample level, and as Table 6 shows, non-audit service has a stronger impact on the perceptions of the owners’ sub-sample, with a mean score of 1.16, followed by the managers’ mean score of 1.72 (see Table 7). Moreover, the means scores for lenders, investors and auditors are 2.35, 2.12 and 2.14, respectively. In general, the provision of non-audit services to audit clients is significant across all five sub-groups. Thus, H1a is accepted. Table 5
t-Test for investors
Factors examined
Mean score
Sig. (2-tailed)
SD
Panel A: factors undermining independence 1
Audit fee exceeds 15% of total audit revenue
2.00
0.000
0.733
2
Non-audit services are provided to audit clients
2.12
0.000
0.772
3
Non-audit services are provided to nonclients
2.90
0.103
0.370
4
Audit market lacks legal incentives
1.38
0.000
0.492
5
Audit market lacks national independence STD
1.31
0.000
0.468
6
Audit market is highly competitive
1.81
0.000
0.890
7
Audit services is provided by small audit office
1.62
0.000
0.539
8
Socio-cultural relationships
1.90
0.000
0.576
Big 4 auditors
2.71
0.194
1.402
Large audit office
2.93
0.752
1.455
Panel B: factors enhancing independence 9 10 11
Audit committee
2.83
0.351
1.146
12
Rotation every five years
3.02
0.915
1.440
An empirical investigation of the Libyan audit market Table 6
13
t-Test for owners
Factors examined
Mean score
Sig. (2-tailed)
SD
Panel A: factors undermining independence 1
Audit fee exceeds 15% of total audit revenue
2.16
0.000
0.374
2
Non-audit services are provided to audit clients
1.16
0.000
0.374
3
Non-audit services are provided to nonclients
2.87
0.211
0.562
4
Audit market lacks legal incentives
1.39
0.000
0.495
5
Audit market lacks national independence STD
2.84
0.023
0.374
6
Audit market is highly competitive
2.00
0.000
0.000
7
Audit services is provided by small audit office
1.16
0.000
0.374
8
Socio-cultural relationships
2.39
0.000
0.495
Big 4 auditors
4.13
0.000
0.718
10
Large audit office
4.74
0.000
0.445
11
Audit committee
3.26
0.003
0.445
12
Rotation every 5 years
4.23
0.000
0.425
Panel B: factors enhancing independence 9
Table 2 also shows that the provision of non-audit services to non-audit clients is not significant as a factor that may affect auditor independence. It can be seen from Table 2 that the mean score in this respect is 3.04, SD = 0.442 at a level higher than 0.05 which is 0.263, meaning that the provision of non-audit service to a non-audit client has no effect on auditor independence. Moreover, when performing the t-test across the sub-samples, there appears to be a contradiction between the sub-samples’ perceptions towards nonaudit services to non-audit clients. Tables 5, 6 and 8 show that the investors, owners and auditors perceived that the provision of non-audit services to non-audit clients has no effect on auditor independence. However, Tables 4 and 7 show the interesting results that lenders and managers perceive the provision of non-audit services to non-audit clients as impairing auditor independence. In other words, there seems no consensus regarding the effect of non-audit services to non-audit clients, and therefore H1a is rejected. Table 2 reveals that the lack of legal incentives and lack of domestic independence standards are recognised by respondents as being influential in auditor independence, at the total sample level. The t-test at the total sample level reveals that the audit market lacks legal incentives, and that there is a lack of independence standards. The mean scores are 1.50, SD = 0.602, and 1.75, SD, 0.735, respectively, both at 0.001. It can be noted that both variables are significant and are perceived to undermine auditor independence. Although, the lack of legal incentives and lack of domestic independence standards are significant, there appear to be some differences in the relative importance of these two variables across the sub-sample level. Table 5 shows that lack of domestic independence standards and lack of legal incentives, both have a stronger impact on the sub-sample of investors, with mean scores of 1.31 and 1.38, respectively. In addition, the lack of domestic independence standards is considered to be least influential by owners,
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S.K. Faraj and S. Akbar
with a mean score of 2.87. Therefore, it can be concluded that there is a consensus about the effect of weak legal incentives and lack of domestic independence standards and thus H1a is accepted amongst all sub-groups. Table 2 reveals that the socio-cultural relationship factor (with a mean score of 1.94, SD = 0.528, at 0.001 level) is significant and undermines auditor independence as perceived by the total sample, yet there are differences in the relative importance of this factor across the sub-samples. It can be noted from Table 4 that the socio-cultural relationship is perceived as having a stronger influence by lenders, with a mean score of 1.71, while owners considered this to have the least influence, with a mean score of 2.39 (see Table 6). Tables 5, 7 and 8 also indicate that the socio-cultural relationship is significant with mean scores of 1.90, 2.00 and 1.88 as indicated by investors, managers and auditors, respectively. Therefore, H1a is accepted regarding the effect of socioculture relationships by all sub-groups. Table 2 also reveals that the rotation of auditors every five years is significant at 0.001 level, with a mean score of 3.95, SD = 0.955, and it can be argued that this practice is perceived to enhance auditor independence throughout the entire sample. Although, this factor is significant across the whole sample, however, there appear to be differences in the relative importance of rotation at the sub-sample level. Table 7 shows that the managers sub-sample perceived the rotation of auditors to enhance auditor independence, with a mean score of 4.25 which is higher than those of owners, lenders and auditors, whose mean scores were 4.23, 4.18 and 4.14, respectively. However, the investors group perceived there to be no effect on auditor independence caused by the five-yearly rotation of auditors, with a mean score of 3.02. Thus, regarding rotation’s effect, H2a is rejected by the investors sub-group. Table 7
t-Test for managers
Factors examined
Mean score
Sig. (2-tailed)
SD
Panel A: factors undermining independence 1
Audit fee exceeds 15% of total audit revenue
2.34
0.000
0.602
2
Non-audit services are provided to audit clients
1.72
0.044
0.523
3
Non-audit services are provided to nonclients
3.13
0.000
0.336
4
Audit market lacks legal incentives
1.53
0.000
0.671
5
Audit market lacks national independence STD
1.53
0.000
0.621
6
Audit market is highly competitive
2.03
0.000
0.595
7
Audit services is provided by small audit office
1.81
0.000
0.592
8
Socio-cultural relationships
2.00
0.000
0.000
Big 4 auditors
3.97
0.000
0.595
Large audit office
4.59
0.000
0.665
Panel B: factors enhancing independence 9 10 11
Audit committee
4.38
0.000
0.751
12
Rotation every five years
4.25
0.000
0.568
An empirical investigation of the Libyan audit market Table 8
15
t-Test for auditors
Factors examined
Mean score
Sig. (2-tailed)
SD
Panel A: factors undermining independence 1
Audit fee exceeds 15% of total audit revenue
2.77
0.011
0.571
2
Non-audit services are provided to audit clients
2.14
0.000
0.516
3
Non-audit services are provided to non-clients
3.07
0.323
0.457
4
Audit market lacks legal incentives
1.42
0.000
0.499
5
Audit market lacks national independence STD
1.65
0.000
0.482
6
Audit market is highly competitive
1.47
0.000
0.505
7
Audit services is provided by small audit office
1.86
0.000
0.601
8
Socio-cultural relationships
1.88
0.000
0.324
Big 4 auditors
3.79
0.000
0.600
Large audit office
4.40
0.000
0.495
Panel B: factors enhancing independence 9 10 11
Audit committee
4.02
0.000
0.408
12
Rotation every five years
4.14
0.000
0.351
Audit committee existence was perceived by all respondents as an important element that enhances auditor independence. Table 2 shows the mean score for this factor to be 3.66, SD = 0.929 at 0.001 level, which indicates the significance of the existence of an audit committee within the audited entity. However, despite this factor being significant at the total sample level, there are differences in its relative importance across the sub-samples, and it can be noted from Table 7 that the audit committee variable appears to have much more influence on managers’ perceptions than on those of the other sub-samples. The audit committee factor mean score for managers is 4.38 which is the highest, whilst as shown in Tables 4, 6 and 8, the mean scores of the auditors, lenders and owners are 4.02, 3.82 and 3.26, respectively. Table 5, however, indicates that investors perceived the existence of an audit committee within the audit client’s company to have no effect on auditor independence, with a mean score of 2.83. Thus, in terms of audit committee impact, H2a is rejected by the sub-group of investors. Big 4 audit firms and large audit office are significant variables among the total sample, but there are differences in the relative importance of these variables at the subsample level. It can be seen from Table 6 that for the owners, large audit office is more important than for the other sub-groups, with the highest mean score of 4.74, while the investors perceived that large audit office and Big 4 auditor have no effect on independence (see Table 5). However, Big 4 auditors and large audit office variables are significant at 0.001 level within the remaining sub-samples. Specifically, owners, managers, lenders and auditors perceive large audit office and Big 4 audit firms to increase their confidence in the perceived independence. In other words, there is no consensus among sub-groups regarding the impact of the Big 4 audit firms and large audit office. Therefore, H2a is rejected.
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Moreover, the provision of audit services by a small audit office is perceived to undermine independence. However, although this variable is significant at the total sample level, there are differences in the relative importance at the sub-group level. Table 6 shows that owners perceived small audit office to be more important than did other sub-groups. This argument is apparent in the mean score of 1.16 for the small audit office variable as indicated by the owners’ sub-group. In other words, the provision of audit services by small audit firms undermines independence. Moreover, there is a consensus among all sub-groups’ perceptions regarding the negative effect of the provision of audit services by a small audit office on auditor independence.
4.1 Discussion The above results highlight the perceptions of auditor independence by owners, investors, lenders, managers and auditors. The perceptions are examined in the light of 12 variables, which are tested using two main research hypotheses. Firstly, we propose that OILMAs’ perceptions of auditor independence are negatively affected by a high level of competition within audit environment. The empirical results are consistent with the view that high audit competition does increase the risk that auditor independence may become impaired; this finding is in line with the work of several other researchers (e.g. Awadallah, 2006; Shockley, 1981). Nevertheless, they do not coincide with the results of Gul (1989), who argues that providing audit services in a highly competitive audit market actually enhances auditor independence. Moreover, the results are also inconsistent with those who argue that competition has no effect on the PAI (DeAngelo, 1981a). Therefore, it can be concluded that the effect of competition on auditor independence is different from one country to another. This means that different countries have different mechanisms according to which competition for audit clients operates. Secondly, we assume that OILMAs’ perceptions of auditor independence are negatively affected when their audit fee, received from one client, exceeds 15% of their total audit revenue. The empirical results are consistent with this assumption. In addition, the results are consistent with those of, for example, Gul (1991) and Teoh and Lim (1996), as they argue that a larger proportion of audit fees from one audit client, in relation to the total audit revenue, impairs auditor independence. Therefore, one could conclude that users from emerging economies share similar perceptions regarding the impact of audit fees. This finding can be attributable to the influence inherent in Libyan accounting and auditing practice, which is oriented towards the western models of the UK and USA (Ahmed and Gao, 2004). However, the results conflict with the statement that audit fee size has no effect on the PAI as concluded by some researchers (e.g. DeAngelo, 1981a; DeFond et al., 2002). Therefore, it can be observed that the views of these researchers emanate from studies conducted in developed and mature auditing markets, which may be different from those emerging and developing audit markets. Thirdly, we hypothesis that OILMAs’ perceptions of auditor independence are negatively affected when auditors provide nonaudit services to their audit clients. The results are consistent with this hypothesis, and suggest that audit firms which provide non-audit services to audit clients are more likely to lose independence than audit firms which do not provide such services (e.g. Canning and Gwilliam, 1999; Joshi et al., 2007; Shockley, 1981).
An empirical investigation of the Libyan audit market
17
However, the results are not in line with the perceptions of bank loan officers who indicate that they have more confidence in the independence of auditors who also supply non-audit services (Gul, 1989). Moreover, the results are also inconsistent with those of DeFond et al. (2002) who argue that the provision of non-audit services together with audit service to clients has no relation to the quality of financial reporting and the appearance of independence. Thus, one could maintain that although there appears to be mixed evidence regarding the effect of non-audit services, its presence seems to cause suspicions of a lack of independence. This study’s finding is perhaps attributable to the strong Western influence on Libyan practitioners and users. Fourthly, we also presume that OILMAs’ perceptions of auditor independence are negatively affected by a lack of legal and institutional incentives and a lack of domestic independence standards. The empirical results are consistent with the view that strict legal incentives such as commercial courts and official sanctions and disciplinary referrals, play a major role in regulating the audit profession in general and safeguarding auditor independence in particular (e.g. Favere-Marchesi, 2000; Tahinakis and Mylonakis, 2005). However, the results reflect the perceptions of users within a relatively unregulated audit market in Libya, and they do express the need for legal incentives. This means that a consensus exists among the majority of users across countries, that legal incentives such as the auditor’s legal liability protect auditor independence as well as the other shareholders’ interests. Fifthly, we propose that OILMAs’ perceptions of auditor independence are negatively affected when socio-cultural relationships exist between these groups. The results are consistent with the proposition that national culture impacts on the accounting profession and auditor independence across countries or regions (Rutledge et al., 2003; Ritchie and Khorwatt, 2007). The results are also in line with the perspective that culture plays a crucial role in accountants’ disclosure judgement and that homogeneous accounting standards may not result in similar disclosure decisions being made across countries. Moreover, the results are consistent with those of Lord and DeZoort (2001), who argue that ‘obedience to social pressure significantly increases auditors’ willingness to sign-off on an account balance that is materially misstated’. Thus, in line with the general agreement between countries, and according to Hofstede’s (1980) proposition, it can be concluded that national culture has an effect on auditor independence. The effect of national culture stems from the fact that collectivist societies seem to have difficulty in keeping or maintaining a professional distance between auditors and the other members of the community of which auditors are members, whereas individualist societies that prevail in Western countries are not characterised by close social relationships imposed by the extended family or tribe, and there is consequently much less influence from other members of the community upon auditors and their independence. Sixthly, we hypothesis that OILMAs’ perceptions of auditor independence are positively affected by adopting the practice of rotating auditors every five years. The results are also consistent with the argument that such rotation is perceived to enhance auditor independence (e.g. Gates et al., 2007). However, the results are inconsistent with the proposition that not rotating the audit firm is not perceived to impact on auditor independence (e.g. Shockley, 1981). Nor are they in line with those who conclude that audited financial statements are perceived as more reliable for firms with longer auditor tenure (e.g. Ghosh and Moon, 2005; Kaplan and Mauldin, 2008). These results can be attributed to the reason that lengthy tenure between auditors and their clients (perhaps the
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result of extended family and tribal relationships and obligations within Libyan society) will erode auditor independence, since such long-standing relationships lead to further networking that negatively affects almost all aspects of everyday life and auditing is no exception. Seventhly, the researchers also propose that OILMAs’ perceptions of auditor independence are positively affected by the existence of an audit committee within an audited entity. The results are consistent with the findings that an audit committee’s existence is perceived to reduce the audit risk and enhance audit quality (e.g. Abbott and Parker, 2000; Carcello and Neal, 2003; Joshi and Wakil, 2004; Mangena and Tauringana, 2008). Therefore, one could argue that the general consensus across countries regarding the importance of an audit committee in an organisation is perhaps due to the increased concern with corporate governance and the auditor independence regulatory requirements following the Enron collapse and other key corporate failures. However, these results are opposing the view that came from a similar cultural context (e.g. Saudi Arabia) where audit committees are not empowered to control the board of directors, to enhance the role of the external auditors, or to protect shareholders (e.g. Al-Twaijry et al., 2002). This difference regarding audit committee powers can be attributed to the variation between the auditing system in these two countries, Libya and Saudi Arabia, since although they share similar contextual and cultural values, they seem to represent different perceptions regarding the audit committee and its role in corporate governance. Finally, we also assume that OILMAs’ perceptions of auditor independence are positively affected when audit services are performed by a large audit office and a Big 4 audit firm, and negatively affected when audit service is performed by a small audit office. In terms of the audit firm size, the empirical results are in line with this hypothesis. Therefore, the results are consistent with those of other researchers (e.g. Awadallah, 2006; Gul, 1991; Shockley, 1981), who argue that large audit firms are perceived to be more independent than small ones. These results can possibly be attributed to the fact that Libyan users believe that large auditing companies possess human capital (competent and highly skilled independent auditors) that is far greater than that of small auditing firms. However, a large audit office is perceived to be more influential than one of the Big 4 audit firms. This finding perhaps reflects the fact that the Big 4 audit firms have only recently entered the Libyan market and users may not be in a position to make informed comparisons.
5
Summary
The results of ANOVA show that all 12 independent variables significantly affect the perceptions of auditor independence at the total sample level. Omega squared statistics also show the effect size of these variables. A series of t-tests were also performed at the total sample level as well as at the sub-sample level, the results demonstrating that the higher the mean (>3) the more the variable is perceived to enhance independence, while the lower the mean (
