AUDITORS’ INDEPENDENCE AND EARNINGS MANAGEMENT OF DEPOSIT MONEY BANKS IN NIGERIA

MSC Project Topics in Accounting and Finance

ABSTRACT
Financial statements audit is a monitoring mechanism that reduces agency problem between management and the stockholders, and protect the interest of other stakeholders. This critical role of external auditor promotes the quality of accounting information; however, there is a growing concern by the regulators, investors and the general public over the credibility and integrity of audited financial statements and stakeholders’ confidence in auditors’ independence as a result of recent accounting and audit scandals in different part of the world involving earnings management. In Nigeria, there are series of default and failures in the banking sector that are connected with the management and most of the failures are not reported by the auditors but rather by the CBN. This have questioned the integrity and quality of audited financial statements of Nigerian banks, as well as the independence of external auditors on whether they are independent of management influence via audit fees and tenure. This study thus examines the effect of auditors’ independence (using total audit fees, large reputable audit firm and audit firm tenure) on earnings management of the Deposit Money Banks in Nigeria. Correlation research design was employed and Ordinary Least Square (OLS) technique was used in the analysis of the secondary data collected from a sample of 14 banks for a period of seven years (2006-2012). The study found that total audit fees have significant positive effect on the earnings management (discretionary loan loss provision) at 99% confidence level. It is also found that audit firm tenure has a significant positive effect on earnings management at 99% confidence level too. The study concludes that total audit fees and lengthy auditor tenure are a mechanism through which management influence auditors to compromise their independence in the deposit money banks of Nigeria, and therefore allow unethical practices such as earnings management. The study recommends among others that the regulators of the Nigerian banking industry should improve the safeguards for mitigating independence risks; these should include corporate governance, regulatory oversight, auditing firm policies and culture, and individual auditor characteristics.

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

The monitoring role of external auditor is critical in promoting the quality of financial statements prepared by management. By providing independent verification of financial statements, auditors lend credibility to accounting information and enhance its integrity. Watts and Zimmerman (1986) argued that financial statements audit is a monitoring mechanism that minimizes information asymmetry and protect the interest of the principals as well as existing and potential stakeholders, by providing reasonable assurance that the financial statements (prepared by management) are free from material misstatements. As such, external audit helps reduce agency costs between managers and external parties. However, these external parties cannot be expected to trust reported financial information without confidence in the Auditors‟ Independence. Recently, there is an increasing concern by regulators, investors and the general public regarding the quality and reliability of audited financial statements, because auditors compromise independence and thus diminish the quality of earnings reported, by either providing non-audit services to clients or collecting abnormal audit fees from the clients (Romano, 2004).

In Nigeria, Semiu and Kehinde (2011) and Semiu and Johnson (2012) empirically examine the perception of auditor independence in Nigeria and reported that the size of audit fee is the most influencing factor capable of deterring auditor independence in Nigeria. Similarly, they reported that, joint provision of audit and non-audit services affects auditor independence adversely. On the contrary, an investigation of stakeholders‟ perception of non-audit services provision vis-à-vis auditor independence in Nigeria by Umar (2012) reveals that non-audit services do not impair auditor independence. However, his findings reveal that there are a number of threats to auditor independence and one of which is familiarity, which comes as a results of long-term audit firm-client relationship.

The regulators‟ concern over the increase in the provision of management consultancy services impair audit firm independence is based on the premise that the provision of non-audit services increases the fees paid to the audit firm thereby increasing the economic dependence of the audit firm on the client (Ashbaugh, Lafond & Mayhew, 2003). Similarly, DeAngelo (1981) and Magee and Tseng (1990) opined that non-audit services impair auditors‟ independence because of the presence of client‟s future quasi-rents (non-audit fee) provided to the auditors. They further stressed that it is the strength of the economic bond between the audit firm and its client that reduces auditor independence. This proposition holds true in some corporate collapse in USA and has forced regulators to ban certain kinds of non-audit services with the view that the financial reporting quality and investor confidence will increase. It is in light of this proposition that excessive audit fee (abnormal fees) is related to auditor‟s incentive to compromise independence. That is because of economic bond between client and auditor; the auditor with the possible loss of revenue is more likely to comply with client‟s wishes to manage earnings. However, Simunic (1984) and Chung and Kallapur (2003) were of the view that costs related to the loss of reputation and litigation minimize the incentives for auditors to compromise their independence. They further lamented that auditors care much about their reputation and if the auditor complies with the client and damages the reputation may potentially lose fees from current and future clients.

For any country to achieve economic growth and development a sound and efficient banking system is necessary to mobilize funds from the surplus units to the deficit units of the economy for productive activities. In Nigeria, banking industry witnessed different factors that slow the desired level of economic growth and development, which according to Soludo (2004) include weak internal audit, high incidence of fraud and poor corporate governance. Similarly, the Central Bank of Nigeria (CBN) Code of Corporate Governance for Banks in Nigeria Post Consolidation of 2006 identified weak internal controls, non-compliance with laid-down internal controls and operations procedures; poor risk management practices resulting in large quantum of nonperforming credits including insider-related credits, and abuses in lending, as problems of the Nigerian banking sector. Historical trend in the Nigerian banking industry shows that 59 banks have failed between 1994 and 2007, and four chief executives were sacked in 2009 in connection with unethical practices with respect to loans and advances. Similarly, the CBN in 2011 had revoked the license of four banks in connection with financial regulatory cases. These have questioned the integrity and quality of audited financial statements of Nigerian banks as well as the independence of external auditors on whether they are independent of management influence via audit fees and auditor tenure.

Auditor independence is critical to the reliability of financial statements as well as investors‟ confidence due to the psychological belief in the auditors‟ role. This together with public expectations of the audit work is critical to regulatory agencies. It is in this context that Abdelkhalik (2002) states that the value of an audit depends on independence (objectivity). The codes of Ethics of the International Federation of Accountants (IFAC, 2000) and the Institute of Chartered Accountants‟ of Nigeria (ICAN, 2010) define independence as a state of not being controlled by other people or things, such as financial benefits. The code further states that an auditor needs to be objective in the course of performing his duties. Independence is divided into two according to the code; independence of mind and independence in appearance which are to be observed by an auditor in passing his professional opinion.

In an effort to ensure independence of mind and in appearance, the International Standard on Auditing (ISA) No. 200 (objective and general principles of audit) states that “in the conduct of any audit of financial statements, auditors should comply with the ethical guidance issued by their relevant professional bodies”. These ethical rules govern auditors‟ responsibilities and guide the audit and non-audit functions performed by auditors. In this regard, the auditors‟ code, published by Auditing Practice Board (APB), titled fundamental principles of independent auditing state that auditors should be seen to be objective in all other dealings with their clients, and their opinions should be independent of its directors. Similarly, in Nigeria, ICAN‟s rules of professional conduct for members‟ regard objectivity as independence of mind, and require auditors‟ objectivity to be beyond question when conducting an audit. The code makes it mandatory for both accountants in business and in public practice with special emphasis on all professional persons to exercise professional judgement. Hence, the ICAN‟s ethical principles out rightly prohibits misconduct and ignorance of misconduct in the audit of financial statements and thus, defined misconduct as any act or default which is likely to bring disrepute to auditor, his fellow accountant, and the profession of accounting in general (ICAN, 1999).

Consequently, non-compliance with ethical code of professional conduct by auditors make auditors allows managers to manipulate financial statements figures and thus erode the quality of earnings. Earnings management according to Bello (2010), is any attempt to cook/doctor or tailor financial accounting reports to a given desired level. He regarded earnings management as ethical misconduct of accountants and relates it to the recent times corporate failures and loss of investors‟ confidence on both financial reports and auditors. One of the major incentives to manage earnings by managers is their compensation that is based on reported earnings, and hence, they can use abnormal audit fees from non-audit services to make auditors compromise their independence and allow managers to manipulate earnings, and thus impair the quality of earnings. Hence, high auditor independence should be more likely to detect and prevent earnings management. Therefore, higher level of independence is associated with lower levels of earnings management and higher quality earnings.

Abnormal audit fees and the length of client-audit relationship are seen as the major factor behind the lack of auditors‟ independence to objectively carry out their statutory audit function. This resulted in regulatory agencies placing restriction on auditor‟s non-audit services (Hope and Langli, 2007). In contrast to the regulators decision, Defond et al., (2002) argue that regulators ignore the possibility that non-audit services may actually improve audit quality. This has prompted researches on the effect of audit fees, audit firm tenure on the quality of earnings. Also, there are none or fewer studies on auditor independence and earnings management in a developing economy like Nigeria, therefore, this study examines the effect of auditor independence on earnings quality in the Nigerian banking sector.

MSC Project Topics in Accounting and Finance