AUDIT QUALITY AND FINANCIAL REPORTING QUALITY: CASE OF TEHRAN STOCK EXCHANGE (TSE)

Innovaive Journal of Business and Managemen 1: 3 May June (2012)43 47. Conens liss available a www.innovaivejournal.in INNOVATIVE JOURNAL OF BUSINESS AND MANAGEMENT Journal homepage:hp://www.innovaivejournal.in/index.php/ijbm AUDIT QUALITY AND FINANCIAL REPORTING QUALITY: CASE OF TEHRAN STOCK EXCHANGE (TSE) Hasan Maleki Kaklar 1, Saeid Jabbarzadeh Kangarlouei 2, Moreza Moavassel 3 1 Deparmen of Accouning, Salmas Branch, Islamic Azad Universiy, Salmas, Iran. 2 Deparmen of Accouning, Urmia Branch, Islamic Azad Universiy, Urmia, Iran. 3 Deparmen of Accouning, Wes Azarbyjan Science and Research Branch, Islamic Azad Universiy, Wes Azarbyjan, Iran. ARTICLE INFO ABSTRACT Corresponding Auhor: Saeid Jabbarzadeh Kangarlouei Deparmen of Accouning, Urmia Branch, Islamic Azad Universiy, Urmia, Iran KeyWords: Audi qualiy, financial reporing qualiy, audi firm size, audior roaion and Tehran Sock Exchange. INTRODUCTION On he one hand, efficien capial markes bring high-qualiy financial reporing, which faciliaes he efficien raising and allocaion of corporae capial and hus creaes benefis for invesors (Wang and Wub, 2011:168), and on he oher hand, he global financial crisis, corporae failures and scandals in many counries raise significan quesions abou he effeciveness of financial reporing and audiing. Audiing firms, professional and regulaory bodies are under fire and face pressures o resore confidence in audiing. Regulaory and professional bodies ried o promoe audi qualiy in an aemp o cure arnished image and augmen heir legiimacy and sanding (Holma and Zamanb, 2011:51). Therefore, i is expeced ha high audi qualiy lead o high financial reporing qualiy which in urn is a ool o preven financial crises. Biddle e al. (2009) define financial reporing qualiy as he precision wih which financial reporing conveys informaion abou he firm s operaions, in paricular is expeced cash flows, ha inform equiy invesors (p:113). Their definiion is consisen wih he Financial Accouning Sandards Board Saemen of Financial Accouning Conceps No. 1 (1978), which saes ha one objecive of financial reporing is o inform presen and poenial invesors in making raional invesmen decisions and in assessing he expeced firm cash flows. However, audi qualiy is no direcly observable; herefore, i is difficul o measure empirically. However, here are proxies o measure audi qualiy. Accrual measure is one of he proxies for audi qualiy. High qualiy audiors are more likely o deec accouning irregulariies, objec o he use of quesionable accouning pracices, and limi discreion over accrual choices for The purpose of his sudy is o invesigae he relaionship beween audi qualiy and financial reporing qualiy during he period of 2004-2009 in TSE. The populaion of sudy includes 91 firms obained from sysemaic eliminaion. Using panel daa, he resuls of sudy show ha here is a weak and negaive relaionship beween audi firm size and financial reporing qualiy. Tha is, when audiing is conduced by Iranian audi organizaion, financial reporing qualiy miigaes. However, no relaionship is found beween audior roaion and financial reporing qualiy. 43 2012, IJBM, All Righ Reserved clien firms (Kim and Y 2009: 208). Giroux and Jones (2011) number five heoreical consrucs o es audi qualiy: audior ype, audi experience (indusry specializaion), audi fee, demographics, and local governmen ype (p. 62). Jamal and Sunder (2011) repor from DeAngelo (1981) Mauz and Sharaf (1961) ha wo key feaures of he financial reporing sysem are ha an audi is mandaed for publicly raded companies, and ha i mus be conduced by accounans who are independen in fac (i.e., have an objecive sae of mind) as well as in appearance. Boh hese dimensions of independence are assumed o be necessary for aaining audi qualiy (P: 284). Khurana and Raman (2004) define audi qualiy as an audior will (1) deec and (2) correc/reveal any maerial omission or missaemens in he financial saemens (p. 475). DeAngelo (1981) hypohesizes a wodimensional definiion of audi qualiy ha has se he sandard for addressing he issue. Firs, a maerial missaemen mus be deeced, and second, he maerial missaemen mus be repored. According o Palmrose (1988) and Simunic and Sein (1987) here is wo major drivers of audi qualiy are liigaion coss and repuaion loss. They argue ha considering large invesmen on building heir brand names, he large audi firms have an incenive o lower liigaion risk and proec heir repuaional capial by providing more credible financial repors. These argumens are consisen wih he noion ha audi firm size is an imporan deerminan of audi qualiy. Large size of audi firm has wo consequences (1) enables audi firms o spend on raining and audi echnology (increasing heir compeence), and (2) Enables

Jabbarzadeh e. al/ Audi qualiy and financial reporing qualiy: case of Tehran Sock Exchange (TSE). hem o resis audiee pressure o issue a clean audi opinion since hey are no dependen on an individual clien. LITERATURE REVIEW The classic agency problem beween shareholders and corporae managers promoes he hiring of audiors o provide independen assurance o he invesors ha he firm s financial saemens is under Generally Acceped Accouning Principles (Was and Zimmerman, 1983). However, global financial crisis, corporae failures and scandals in many counries brough doubs as o effeciveness of audiing o do so. There have been so many aemps o resore confidence for audiing work by passage of regulaory Acs. The passage of hese Acs supposed o increase audi qualiy. For example, DeFond and Lennox (2011) find ha he passage of SOX resuls in a large reducion in he number of small audi firms operaing in he marke. They repor ha nearly 50%, 607 of 1,233 small audi firms ha were acive during 2001 2008 exied he marke and he majoriy of hese exis occur in 2002 2004, coinciding wih passage of SOX, he adven of PCAOB regisraions, and he beginning of inspecions. They also show ha he presence of fewer small audiors coincides wih a doubling of he average number of cliens per small audi firm. Thus, hey documen a significan shif in he composiion of he marke for small audiors afer he adopion of SOX. In addiion, hey argue ha low qualiy audiors are more likely o find i cos beneficial, a he margin, o exi he marke for public company audis in response o he new regulaory environmen implemened under SOX (P.22). These resuls show ha he passage of hese Acs increased audi qualiy if audi size supposed o be proxy for audi qualiy. Moreover, as we pu forward i is expeced ha high audi qualiy lead o high financial reporing qualiy. However, he passage of Acs led o increase financial qualiy. Al-Ajmi (2009) sudied percepions of credi and financial analyss wih regard o he relaionship beween he effeciveness of audi commiee, size of he audiing firm and audi qualiy in he conex of Bahrain. By survey of 300 credi and financial analyss, he shows four major findings: 1- boh credi and financial analyss see he credibiliy of financial saemens o be a funcion of he size of he audiing firm. 2- Boh groups assume ha he characerisics of Big-Four firms allow hem o produce beer-qualiy repors han non-big firms. 3-Non-audi services affec audior's independence hence impair audi qualiy. 4-Boh he groups of analyss believe ha effecive audi commiee enhances he qualiy of audi repors. 5- Financial analyss perceive financial saemens o be more credible han do credi analyss. Ding and Jia (2012) surveyed he relaionships beween audior mergers, audi qualiy and audi fees. Measuring audi qualiy by earnings qualiy of cliens hey show ha in he pos-merger period, absolue discreionary accruals of big-x clien firms decreased compared wih non-big-x clien firms, indicaing less earnings managemen; in addiion, hey indicae ha in he posmerger period, earnings of big-x cliens are more relaed o sock-marke reurns, indicaing ha earnings qualiy has improved in his period. While, hey do no find such changes for non-big-x clien firms. Cullinan e al. (2012) examined wheher he sock marke reacs negaively when cliens swich from a Big 4 o a non-big 4. They find ha he marke does no reac more negaively when cliens move from a Big 4 o a Second Tier audiing firm han when cliens move from a Big 4 o anoher Big 4 firm. Their resuls sugges ha a negaive marke reacion may no represen a significan barrier o enry among Second Tier audiing firms. Boone e al. (2010) examined audi qualiy for Big 4 and Second-ier audiors during 2003 2006 and find weak evidence ha he Big 4 have a higher propensiy o issue going concern audi opinions for disressed companies. In addiion, hey find ha he level of performance-adjused abnormal accruals for Big 4 and Second-ier audi firm cliens appears o be similar. Wih respec o invesor percepions, he clien-specific ex ane equiy risk premium o be lower for Big 4 cliens han for Second-ier audi firm cliens. Overall, heir findings sugges lile difference in acual audi qualiy bu a more pronounced difference in perceived audi qualiy. Lai (2009) examined he associaion of firms wih high invesmen opporuniies wih high qualiy audis and wheher ha associaion resuls in a lower likelihood of earnings managemen. She find wo resuls: Firs, firms wih high invesmen opporuniies are more likely o hire Big 5 audiors, han firms wih low invesmen opporuniies. Second, firms wih high invesmen opporuniies are more likely o have more discreionary accruals bu his relaionship is weaker when hey have Big 5 audiors. Rainsbury e al. (2009) examined he associaion beween he qualiy of audi commiees on financial reporing qualiy and exernal audi fees. Their sudy uses a sample of 87 New Zealand firms in 2001 when no regulaions or lising rules exised for audi commiees. They do no find significan associaion beween he qualiy of an audi commiee and he qualiy of financial reporing afer conrolling alernaive measures of earnings qualiy. Kim and Yi (2009) invesigaed wheher he audior designaion rule in Korea is effecive in deerring managers from making income increasing earnings managemen. They find ha he level of discreionary accruals is significanly lower for firms wih designaed audiors han firms wih a free selecion of audiors. They also find ha firms wih mandaory audior changes (i.e., audior designaion) repor significanly lower discreionary accruals compared o firms wih volunary audior changes. Overall, heir resuls are consisen wih he noion ha he audior designaion enhances audi qualiy and hus he credibiliy of financial reporing. Firh e al. (2012) using audiors' propensiy o issue a modified audi opinion as a proxy for audi qualiy documen a posiive effec of mandaory audi parner roaion on audi qualiy in regions wih weak legal insiuions. However, hey fail o find robus evidence ha mandaory audi firm roaion is significanly superior o oher forms of audior roaion. Daniels and Booker (2011) surveyed he effecs of audi firm roaion on perceived audior independence and audi qualiy and indicae ha loan officers do perceive an increase in independence when he company follows an audi firm roaion policy. However, he lengh of audior enure wihin roaion fails o significanly change loan officers percepions of independence. Moreover, heir findings also indicae ha neiher he presence of a roaion policy nor he lengh of he audior enure wihin roaion significanly influences he loan officers percepions of audi qualiy. HYPOTHESES DEVELOPMENT Main hypohesis: here is a significan relaionship beween audi qualiy and financial reporing qualiy in firms lised in TSE. 44

Jabbarzadeh e. al/ Audi qualiy and financial reporing qualiy: case of Tehran Sock Exchange (TSE). Sub-hypohesis 1: here is a significan relaionship beween audi firm size and financial reporing qualiy in firms lised in TSE. Sub-hypohesis 2: here is a significan relaionship beween audior enure and financial reporing qualiy in firms lised in TSE. METHODOLOGY Considering ha he presen sudy uses hisorical daa, i is pos faco research; researcher has no conrol on colleced daa in hese sors of sudy. In addiion, because he relaionship beween audi qualiy and financial reporing qualiy is invesigaed in TSE, he research is descripive-correlaion sudy using documenal mehod o collec daa. Research daa are drawn from financial saemens and noes of firms lised in TSE and audi repors from DenaSahm, Sahra and TadbirPardaz. STATISTICAL POPULATION Populaion of his sudy consiss of firms lised in TSE and sample firms mus have following condiions: 1. Firms` fiscal year mus be ended a he end of year and hey have no changed heir fiscal year during he period of sudy. 2. Sample firms mus handed ou heir financial saemen o TSE and hree years mus have passed form heir lising. 3. Sample firms financial saemens mus be audied during he research period. As a resul of hese condiions, a sample of 91 firms are obained o be sudied. RESEARCH VARIABLES In he presen sudy, audi qualiy is considered as independen variable and financial reporing qualiy as independen variable. Followings presen models of each variable measuremen. FINANCIAL REPORTING QUALITY MEASUREMENT MODEL Financial informaion preciseness is considered as is qualiy. Empirically, o evaluae financial informaion preciseness, absolue value of regression errors of fuure cash flows using componens of operaing profi in previous period is used (Barh e al., 2001:36). CFO CFO AR INV AP 5 1 DEPR 0 6 1 OTHER 2 1 Where: CFO: operaing cash flow AR: changes in receivables INV: changes in invenories AP: change in accouns payable DEPR: angibles and inangibles depreciaion expense OTHER is he aggregae of oher accruals, i.e., OTHER EARN (CF +ΔAR +ΔINV ΔAP DEPR AMORT) OP: operaing profi ε: error erm supposing zero mean and fixed variaion Empirical measure of financial reporing qualiy is absolue value of errors ha is RQi, 1, smaller absolue value of errors, and more financial reporing qualiy. As i is menioned before, variables o measure audi qualiy are audior size ans audior enure as following: Audior size: audis conduced by Iran audi organizaion is considered as big size audi firms and oher smaller audi firms are considered small audi firms. Audior enure: in he presen sudy, once audior enure is considered less han 3 years and he oher ime is 3 4 considered 3 and more years. Then he resuls are compared. Research hypoheses es To es research hypoheses, firs, descripive saisic and correlaions beween variables is conduced and finally regression models analyzed. Descripive saisic Descripive saisic is presened in Table 1 in which audior enure has less coefficien of variaion and sandard deviaion han size, boh as independen variable. This is while financial reporing qualiy as dependen variable according o Barh e al. (2002) model has more coefficien of variaion and sandard deviaion han independen variables hen has less consisency. This shows ha: 1- audior enure is reliable han audi firms size and 2. Less amoun of sandard deviaion of audi qualiy compared o sandard deviaion of financial reporing qualiy shows ha financial reporing qualiy is affeced by oher facors oher han audi qualiy. Table 1. Descripive saisic Financial reporing qualiy Audi size Audior enure Mean 0.0392 0.5642 0.6452 Median 0.0081 1.0000 1.0000 Maximum 0.9947 1.0000 1.0000 Minimum 0.0001 0.0000 0.0000 Sd. Dev 0.1001 0.4964 0.4790 Skewness 5.1579-0.2592-0.6071 Kurosis 36.2271 1.0672 1.3686 Jarqube-Bera 21183.07 70.0791 72.3777 Probabiliy 0.0000 0.0000 0.0000 Sum 16.4853 237.0000 271.0000 Sum Sq. Dev 4.2052 103.2643 96.1404 Correlaion beween variables Marix correlaion beween variables is presened in Table 2. As i is shown he mos correlaion beween variables is beween financial audi qualiy and audi firm size (-0.403). This shows ha audi conduced by audi firm organizaion approximaely 40 percen has low financial reporing qualiy. In addiion, he correlaion beween audi size and audi enure is posiive and srong (0.151) indicaing ha audior enure relaed o audi organizaion. Table 2. Correlaion marix Financial reporing qualiy Audi size Audi enure Financial reporing qualiy 1 Audi size -0.4034 1 Audi enure 0.0561 0.1513 1 Hypoheses es Sub-hypohesis 1: here is a significan relaionship beween audi firm size and financial reporing qualiy in firms lised in TSE.The resuls of his hypohesis es are presened in Table 3. Table 3. Regression model of he relaionship beween audi firm size and financial reporing qualiy variable coefficien Sd. -Saisic Prob. Error Audi size -0.0814 0.0090-9.0158 0.0000 consan 0.0851 0.0067 12.5582 0.0000 R² 1.1628 Mean 0.0392 dependen var Adjused R² 0.1608 S.d. dependen 0.1001 var S.E of 0.0917 Akaike info -1.9342 regression crierion Sum squared 3.5206 Schwarz -1.9149 resid crierion 45

Jabbarzadeh e. al/ Audi qualiy and financial reporing qualiy: case of Tehran Sock Exchange (TSE). Log likelihood 408.1862 F-saisic 81.2856 Durbin- 1.1789 Prob (Fsaisic) 0.0000 Wason Sa As i is shown in Table 3, he relaionship beween wo variables is negaive, ha is, if audi is conduced by audi organizaion, financial reporing qualiy miigaes. I should be noiced ha he relaionship beween audi firm size and financial reporing qualiy is weak (-0.081) bu saisically is significan considering -Saisic (0.0000). Weakness and significance of regression coefficien indicaes ha oher variables oher han audi firm size affec financial reporing qualiy. The resul of F-saisic (0.000) shows ha he model is significan considering he significance of effec of audi firm size on financial reporing qualiy and here is no auo-correlaion problem considering Durbin-Wason Sa (1.718). The resul of coefficien of deerminaion shows ha approximaely 0.16 of changes in financial reporing qualiy is relaed o audi firm size. Overall, he firs sub-hypohesis is acceped considering he significance of effec of audi firm size on financial reporing qualiy. Sub-hypohesis 2: here is a significan relaionship beween audior enure and financial reporing qualiy in firms lised in TSE. The resuls of his hypohesis es are presened in Table 4. Table 4. Regression model of he relaionship beween audior enure and financial reporing qualiy variable coefficie n Sd. Error -Saisic Prob. Audior enure 0.0117 0.0102 1.1488 0.2513 consan 0.0316 0.0082 3.8614 0.0000 R² 0.0031 Mean 0.0392 dependen var Adjused R² 0.0007 S.d. dependen 0.1001 var S.E of regression 0.1001 Akaike info crierion - 1.7596 Sum squared 4.1920 Schwarz - resid crierion 1.7404 Log likelihood 371.5319 F-saisic 1.3199 Durbin-Wason Sa 1.5215 Prob (Fsaisic) 0.0000 As i is shown in Table 4, he relaionship beween wo variables is posiive, ha is, if audior enure increases by audi organizaion or oher firms, financial reporing qualiy increases. I should be noiced ha he relaionship beween audior enure and financial reporing qualiy is very weak (0.011) and saisically is no significan considering -Saisic (0.2413). Weakness and insignificance of regression coefficien indicaes ha oher variables oher han audior enure affec financial reporing qualiy. The resul of F-saisic (0.2152) shows ha he model is no significan considering he insignificance of effec of audi firm size on financial reporing qualiy bu here is no auo-correlaion problem considering Durbin-Wason Sa (1.521). The resul of coefficien of deerminaion shows ha approximaely 0.003 of changes in financial reporing qualiy is relaed o audior enure. Overall, he firs sub-hypohesis is no acceped considering he insignificance of effec of audior enure on financial reporing qualiy. Considering resuls and considering insignificance of effec of one of variables, ha is, audior enure on financial reporing qualiy, main hypohesis is no acceped. RESULT AND SUGGESTIONS 1-audior enure is reliable variable han audi firm size due o is less amoun of sandard deviaion and coefficien of variaion. 2- Less amoun of sandard deviaion of audi qualiy compared o sandard deviaion of financial reporing qualiy shows ha financial reporing qualiy is affeced by oher facors oher han audi qualiy. 3- In his research, i is shown ha here is weak and significan relaionship beween audi firms size and financial reporing qualiy and approximaely 0.16 of changes in financial reporing qualiy is affeced by audi firms size. 4- Research shows ha here is weak, posiive and significan relaionship beween audior enure and financial reporing qualiy and approximaely 0.003 of changes in financial reporing qualiy is affeced by audi enure. SUGGESTION REMARKS 1-Considering weak and significan relaionship beween audi firms size and financial reporing qualiy, i is suggesed ha audi organizaion increases is oversigh on audis conduced by hem in order o increase financial reporing qualiy. 2- Considering weak and significan relaionship beween audi firms size and financial reporing qualiy, i is suggesed ha financial informaion users and lenders o consider low audi qualiy conduced by audi organizaion in invesmen decision. REFERENCES 1. Al-Ajm J. (2009). Audi firm, corporae governance, and audi qualiy: Evidence from Bahrain, Advances in Accouning, incorporaing Advances in Inernaional Accouning 25, 64 74. 2. Barh, M.; Cram, D. P. & K., Nelson (2001). Accruals and he Predicion of Fuure Cash Flows, The Accouning Review, Vol. 76, 25-58. 3. Biddle, G.C., Hilary, G., Verd R. S. (2009). How does financial reporing qualiy relae o invesmen efficiency?, Journal of Accouning and Economics 48, 112 131. 4. Boone, J. P., Khurana, I. 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