al-ajmi - 2009 - audit firm, corporate governance, and audit quality - evidence from bahrain

Both the groups of analysts believe that effective audit committee enhances the quality of audit reports.. Accordingly, a survey of the major users offinancial statements investors and le

Audit firm, corporate governance, and audit quality: Evidence from Bahrain

Department of Economics and Finance, College of Business Administration, University of Bahrain, P O Box 32038, Bahrain

a b s t r a c t

a r t i c l e i n f o

The aim of this research is to document the perceptions of credit andfinancial analysts with regard to the relationship between the effectiveness of audit committee, size of the auditingfirm and audit quality in the context of Bahrain, which is characterized by a developedfinancial sector, low-liquidity stock market, low turnover in board of directors of listedfirms, an inactive merger and acquisitions market and almost non-extent litigation A survey of 300 credit andfinancial analysts shows that analysts considered auditors' opinion useful Both credit andfinancial analysts see the credibility of financial statements to be a function of the size of the auditingfirm Both groups assume that the characteristics of Big-Four firms allow them to produce better-quality reports than non-Bigfirms Non-audit services were found to affect auditor's independence and hence impair audit quality Both the groups of analysts believe that effective audit committee enhances the quality of audit reports Financial analysts perceivefinancial statements to be more credible than do credit analysts

© 2009 Elsevier Ltd All rights reserved

1 Introduction

Audit service is perceived to play an important role in reducing

information asymmetry (Beatty, 1989; Willenborg, 1999) as well as in

mitigating agency problems between managers and shareholders and

between shareholders and creditors (Jensen & Meckling, 1976)

Therefore, owners hire auditors to produce information used in

contracting with managers (Antle, 1982; Watts & Zimmerman, 1986)

Meeting these two roles depend on audit quality While audit quality

is considered an important element of corporate governance, it is

unclear whether audit quality and other aspects of corporate governance

(such as director knowledge and independence) are fundamentally

complements or substitutes, according toDefond and Francis (2005)

Audit quality is a concept that has different definitions for different

people.DeAngelo (1981a)hypothesizes a two-dimensional definition of

audit quality that has set the standard for addressing the issue First, a

material misstatement must be detected, and second, the material

misstatement must be reported Audit quality as such is the increasing

function of the ability of an auditor to detect accounting misstatements

and is related to the degree of auditor independence Titman and

Trueman (1986)propose that a good auditor provides precise

informa-tion regarding thefirm's value Because the purpose of an audit is to

provide assurance as regards thefinancial statements, audit quality is

defined byPalmrose (1988)as the probability thatfinancial statements

contain no material misstatements.Davidson and Neu (1993)define

audit quality as the ability of the auditor to detect and eliminate material misstatements and manipulations in the net income reported Users of financial statements perceived audit reports to provide absolute assurance that companyfinancial statements have no material misstatements and do not perpetrate fraud (Epstein & Geiger, 1994) However, auditors perceive audit quality in terms of strict adherence to GAAS/ISA requirements Auditors working with a company also strive to reduce their business risk by minimizing auditees' dissatisfaction, avoiding litigation, and limiting the damage to their reputation, which could result from audit failure The demise of Arthur Andersen in 2002 is

an example of the ultimate results of audit failure

Regardless of any differences in the definition of audit quality, and even when users and providers of audit services question the quality of audit service, they agree on its importance I acknowledge that measuring audit quality is problematic The quality of an audit is not directly or immediately obvious, especially to creditors and investors Audit quality-control procedures are intended to maintain high standards of quality-control over the process of an audit, but an audit failure usually becomes known only in the case of a business failure; witness Enron

An auditor's role is to assuage agency problems resulting from the separation of ownership and control (management) This role can be successful only if an audit opinion reflects the true findings of the audit engagement

According to the Statement of Financial Accounting Concepts No 1 (SFAC No 1, Paragraph No 8, p 9),“financial statements are often audited by independent accountants for the purpose of enhancing confidence in their reliability.”

American Institute of Certified Public Accountants (AICPA) (1994)also acknowledges the importance of considering perceptions of investors on auditor independence A former chairman of the AICPA,Elliott (2000)

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Contents lists available atScienceDirect

Advances in Accounting, incorporating Advances in

International Accounting

j o u r n a l h o m e p a g e : w w w e l s e v i e r c o m / l o c a t e / a d i a c

says“[The AICPA] believe[s] that appearances are very important and

capital markets require confidence in financial statements and audit

reports, and the memberfirms of the AICPA are basing their business of

auditing on their reputations, and that is heavily affected by appearance.”

Despite considerable research on audit quality, studies on audit quality

in Bahrain are scarce This might be due to the relatively low number of

audit failures Since the establishment of thefirst shareholding companies

until 2008, there were only three reported cases of audit failure These

cases involve the General Trading and Food Processing Company (1994),

the Bahrain Islamic Investment Company (2002), and the Bahrain Saudi

Bank (2002) The fraud involved in thefirst case was carried out by the

company's accountant, and the court ruled against the accountant As for

the second company, the case was settled out-of-court, and the partner

involved in the case was asked to leave thefirm, whereas the third

instance resulted in replacement of the auditors without the auditors

being taken to court The low number of reported cases of audit failures

does not ensure that audits of Bahraini listedfirms are of good quality and

should not mean that users of company reports should be complacent as

to the quality of an audit Therefore, this study investigates the way users

offinancial statements determine the quality of audit reports Accordingly,

a survey of the major users offinancial statements (investors and lenders)

with respect to their perceptions of the factors that determine audit

quality, particularly with respect to the impact of corporate governance

and size of auditfirms on the quality of an audit report, is carried out

This research makes three contributions to the literature First,

although most of the research in the area uses different methodologies

to investigate the determinants and the role of audit quality on integrity

and quality of accounting information, studies on markets such as

Bahrain, which is characterized by dominance of few accountingfirms;

largely uncommon cases of switching auditfirms; weak enforcement of

regulation reverent to audit industry, with exception of those related to

financial institutions; low-liquidity stock market; and considerably less

number of different institutional setup Hence, this research provides

additional insights to audit quality Second, it responds to calls for

empirical testing of the relationship between corporate governance and

audit quality, according toDefond and Francis (2005) Third,Defond and

Francis (2005) argue that research on the effectiveness of audit

committee suffer from a number of problems such as weak statistical

explanatory power and multi-colinearity problem A survey method

that asks respondents to state their perception of the effect of effective

audit committee on audit quality overcomes these problems

The remaining part of the article is organized into four sections The

following section provides brief accounts of the audit market in Bahrain

Section 3 offers brief literature review on the relationship between

effectiveness of audit committee,firm's size, and audit quality Section 4

describes the data collection and research methodology Section 5

presents the researchfindings of questionnaire survey The final section

provides conclusions of the study, its implications, and suggestions for

future research

2 Audit market in Bahrain1

Some important features of the audit market in Bahrain must be

understood to perceive the context in which this study was undertaken

As of the end of February 2008, audit services in Bahrain are provided by 24 accountingfirms Five of these are considered local; four are operating as foreign branches; and the remaining are linked to internationalfirms The Big Four; i.e., Ernst & Young (E&Y), Deloitte & Touche (D&T), KPMG, and PricewaterhouseCoopers (PWC) have a strong presence in Bahrain D&T and KPMG operate as a joint venture, whereas the other two operate as branches of internationalfirms BDO Jawad Habib and E&Y are the only twofirms registered with the United States (US) Public Company Accounting Oversight Board (PCAOB) The Bahrain Stock Exchange (BSE) was established in June 1989 As of July 2007, there were 41 listed Bahraini incorporatedfirms (two of these have been de-listed and did not issue their reports of 2006) The majority of the companies are retail banks, wholesale banks, and investment companies

TheCentral Bank of Bahrain (CBB)requiresfinancial institutions to

be audited by one of the big auditfirms Audit services are regulated

by the Amiri Decree Number 26 of 1996, which requires auditors to obtain a license to practice and set the minimum requirements for a license In effect, auditfirms got two licenses, one to practice auditing and the second specifically to offer auditing services to financial institutions

Appointments of auditors, as per article (205) paragraph (e) of the

Bahrain Commercial Companies Law Number 21 of 2001, should be made on a yearly basis atfirm annual stockholder meetings However

in practice, boards of directors are empowered by annual meetings to appoint auditors and to determine their remuneration This practice is subject to criticism on the grounds that an auditor's role is to miti-gate agency problems that might exist between the board and the shareholders

The CBB's authority is based on article, (61) paragraph (a), of The

Central Bank of Bahrain and Financial Institutions Law Number 64 of

2006, which states: “Every Licensee shall appoint one or more qualified and experienced external auditors for its accounts for every financial year Prior written approval by the Central Bank will be required before appointing an auditor.” This approval is needed annually In cases wherein a decision has been taken to replace the external auditors before the end of the year, the respectivefinancial institutions are also required to inform the CBB about the reasons for this decision

Since 2002, only three of the Big Four have been approved to audit thefinancial statements of the locally incorporated banks Exclusion firm of the Fourth came after its audit failure of the financial statements of locally incorporated retail banks CBB guidelines specify experience of the auditors, experience of the firm, and number of partners, among other requirements Currently, only Big Fourfirms audit smallfinancial institutions

The internal guidelines of the CBB allow non-bigfirms to audit small investment companies As of September 2007, Bahraini incorpo-rated financial and non-financial firms listed on the Bahrain Stock exchange are audited byfive companies, the Big Four and one other company, which is connected with an internationalfirm The other two companies are a joint venture between a local auditfirm and regional

or international companies Unlike some other countries in the region where listedfirms are audited by two audit firms, all companies in Bahrain are audited by only one auditfirm

Audit services industry is dominated by the Big Four A total of 82.5% of the 41 listed companies on the BSE that published their annual reports in 2007 are audited by one of the Big Four, and the other 17.5% are audited by a non-Big Firm company

In Bahrain, it is not mandatory to switch auditfirms In fact, in 2006, the CBB took a position against a motion in the parliament to mandate such a requirement on the ground that small markets are distorted by such decisions Experience has shown that switching of auditfirms takes place in very rare cases and generally occurs only after an audit failure The CBB does require auditors offinancial institutions to switch auditing partners at least everyfive years Auditing firms claim that

1

Most of the contents of this section are based on interviews with the following

persons: Adnan Yusuf, Chief Executive Officer of Albarka Banking Group; Ibrahim

Zainal, Chairman of TRAFCO; Jamal Fakhro, CPA (US), Managing Partner of KPMG

Fakhro and Ex-Chairman of the Bahrain Accountants Association (BAA); Elham Hasan,

CPA (US), Managing partner of PWC-Bahrain; Abbas Radhi, CPA (US), a partner from

BDO Jawad Habib, and Chairman of the BAA; Hameed Rahma, Assistant Undersecretary

for domestic trade at the Ministry of Industry and Commerce; Jassim Abdulaal, CA

(UK), Senior Partner, Grand Thornton-Gulf Audi-Bahrain; Yusuf Hassan, director of

bank supervision at the Central Bank of Bahrain (CBB); Khalil Noor Eldeen, CFA,

Ex-investment banker, Ex-director of BIBF, and a member of the audit committee of

Ethmar Bank Group; and Waleed Bangash, CA (UK), Director, Financial Control

(Strategic Planning), Unicorn Investment bank The interviews took place between the

5th of January and the 4th of March, 2008.

they follow such a practice for otherfirms in accordance with their own

internal policies Auditors are not prevented from joining a clientfirm

at any time, even immediately after formulating an audit opinion

The presence of multinationalfirms and international financial

institutions in Bahrain, the government's long-standing policy of

attracting foreign investment, the effect of globalization, and the size

of the Bahrain economy are possible reasons for the nondevelopment

of local accounting and auditing standards As a result, companies in

Bahrain are required to comply with internationalfinancial reporting

standards (IFRS), whereas accountingfirms must comply with the

international standards on auditing (ISA) These requirements apply

to all companies, including financial institutions The latter are

required to comply with thefinancial accounting standards issued

by the Accounting and Auditing Organization for Islamic Financial

Institutions (AAOIFI) However, in accordance with the requirements

of AAOIFI, for matters on which AAOIFI standards do not exist, the

respective institutions are required to comply with the relevant IFRS

This is also applicable to conventional bank licensee units

Require-ment to comply with the IFRS and ISA are perceived by both the

government and the accountingfirms as the basis for the competitive

advantage that Bahrain enjoys

As in many other countries, the practice in Bahrain is that

accountingfirms should sign the audit reports and not the partners

who supervise the audit engagements This is due to the lack of legal

sanction for the auditors of companies operating in Bahrain to sign the

audit report in their own names Article (19) of the Amiri Decree No

26 of 1996 gives auditors the choice to sign the audit reports using

either their names or the name of the company Chairmen and chief

executive officers sign the company(ies)'s reports as representatives

of the respective board(s) of directors As such, they assume no more

personal responsibility than other members on the boards

All listed and unlistedfinancial institutions are required to form

independent audit committees Listed non-financial firms are not

required by law to form such committees Members of the audit

committees of financial institutions are nominated by the boards;

however, they need to be approved by the CBB However, whether the

criteria that the CBB uses for its approval include an assurance of

independence and knowledge or merely an affirmation of the latter is

not clear

The principles of Auditor Oversight issued by the International

Organization of Securities Commissions (IOSCO) in 2002state that audit

quality is an important requirement for the integrity of financial

statements However, Bahrain lacks a formal independent audit

over-sight regulating authority, similar to the PCAOB in the US The

establishment of such an institution is considered the best practice

internationally, as it provides one of the mechanisms that increase

confidence in the quality of an audit (International Audit Networks

(IANs), 2006) IANs recognize that the establishment of independent

audit oversight regimes have reinforced the independence of auditors,

and in their view, improved the governance and regulation of the

auditing profession They state that independent audit oversight regimes

have led to auditfirms emphasizing on the quality of the audit The need

for having an audit oversight in Bahrain is a view that is shared by most of

those interviewed for the purpose of writing this section Furthermore,

peer review for other companies is uncommon in Bahrain

The Ministry of Industry and Commerce (MIC) as per article (27)

establishes a disciplinary committee composed of the Chairman, who

should be a judge from the Civil High Court, appointed by the Minster

for Justice, and two other members, who are specialists in auditing,

appointed by the MIC The disciplinary committee investigates the

cases referred by the MIC for misconduct, violations of professional

requirements, serious negligence, or violations of the Amiri Decree No

26 of 1996 However, there are no public records available regarding

the referred cases

Previous experience shows that litigation risk is very low in

Bahrain In the corporate history of Bahrain, there are neither publicly

announced out-of-court settlements between the auditors and their clients nor court judgments against erring auditors However, there is one case pending against the auditors belonging to one of the non-Big Fourfirms No decision has yet been arrived at, even though it dates back

to the mid-1990s Another case involving E&Y was settled out-of-court, and the partner involved in the case was asked to leave the firm However, the low number of litigation cases should not be seen as an indicator of high audit quality in Bahrain The fewer cases of litigation might be due to the high cost, weak regulation, less efficient court system, the difficulties of bringing such cases to the court, and passive investors However, this situation changed after the audit failure of the Bahrain Saudi Bank The role of the CBB in maintaining the stability of thefinancial system ensures the maintenance of a certain level of audit quality during the auditing offinancial institutions Furthermore, as the number of foreign investors increase, raising the awareness of investors, enhancing the efficiency of the judiciary system, increasing the probability of materialization of risk, increased government privatiza-tion programs, and reducprivatiza-tion of government ownership in listedfirms are likely to increase the probability of materialization of litigation risk Restatements of earnings are uncommon in Bahrain The only restatement between 1957 and 2007 in thefinancial statements of listed companies was in 1994 when the newly appointed auditors restated the profit figures of the General Trading and Food Processing Company

In Bahrain, it is common to outsource internal audit services to auditfirms Firms thus avoid the cost of creating an internal audit department with expertise that is not used during the year The CBB prohibits external auditors from providing routine internal audit services to their clients OM2.7.2 of the Operational Risk Management guidelines states that“The [CBB] will generally not permit licensees to outsource their internal audit function to the samefirm that acts as their external auditors However, the [CBB] may allow short-term outsourcing of internal audit operations to a licensee's external auditor, to meet unexpected urgent or short-term needs (for instance,

on account of staff resignation or illness) Any such arrangement will normally be limited to a maximum of one year.”

Universities in Bahrain use American textbooks in their business programs, including textbooks on accounting Bahrain University, the biggest and the only public university, has a policy that dictates professors teaching at the college of business to have been educated in western universities Furthermore, auditors and analysts are expected

to seek professional qualifications from the US and the United Kingdom (UK) Advertisements on the websites offinancial institu-tions and in newspapers seeking new staff state that applicants need to possess professional qualifications obtained from the US and the UK; this policy seems to be followed by both the government and the private sector For example, the Labor Fund of Bahrain (www.lf.com), which is the government arm for training, awarded two contracts to BDO Jawad Habib and Earnest & Yong in 2007, worth 14.1 million Bahraini Dinars (US$37.4 million), to train 7200 Bahrainis for obtaining American and British accounting qualifications The human resources development fund (HRD Fund) (www.hrdfund.org) and the Bahrain Institute of Banking and Finance (BIBF), the banks' arms for training their staff, offer funding for and provide training for their staff only for acquiring professional qualifications from the US and UK This policy is also followed by auditfirms that require their local staff to seek their professional qualifications from these two countries

Unlike in the US, there is no professional body in Bahrain to play a role similar to that of AICPA The Bahrain Accountants Association (BAA), which was established in 1972 as a nongovernmental organization, has a very minimal role in the further development of the profession Its activities are limited to workshops, seminars, and public lectures Membership in the BAA is voluntary Despite thousands of accountants qualifying for membership into the BAA, including all holders of an undergraduate degree in Accounting, the number of members at the end

of January 2007 was only around 250, among whom, the active members were very few

3 Brief literature review

Watkins, Hillison, and Morecroft (2004)summarize both

theore-tical and empirical work on audit quality fromDeAngelo (1981b)

through 2002.Francis (2004)offers an excellent review of published

empirical attempts over a quarter century beginning in 1981.Defond

and Francis (2005)offer a critical review of audit quality literature

after 2002 Besides these three studies, a brief review that presents the

salient feature of the relationship between firm size, corporate

governance, and audit quality is imperative to set the ground for the

stage for the author's survey results

The relationship between the audit-firm size and the quality of

audit-reporting decisions has been widely investigated; however, the results

are not conclusive Although extensive empirical evidence suggests that

the Big Fourfirms provide higher quality audits (DeAngelo (1981b),

Palmrose (1988),Deis and Giroux (1992),Mutchler, Hopwood, and

McKeown (1997),Krishnan and Schauer (2000),Fuerman (2004), there

is other evidence to suggest that no differences in quality exist between

the Big and non-Big auditfirms (Jeong and Rho (2004)andKhurana and

Raman (2004).Krishnan (2005)comments that audit quality differs

between and within the various auditfirms These results might have an

important implication for the perception of investors and lenders about

the quality of audit reports

A number of reasons are used to explain the positive effect of

audit-firm size on audit quality Audit quality is a function of how well an

audit team functions, and presumablyfirms perform best based on the

following criteria:

1 availability of adequate resources (human and technology) (DeAngelo,

1981b; Frantz, 1999);

2 control systems of high standard;

3 larger firms are more independent of their clients (DeAngelo,

1981b);

4 largefirms have a considerable business at stake if they lose their

reputations (DeAngelo, 1981b);

5 charging higher audit fees that allow them to spend more time and

effort in each audit engagement (Francis, 2004; Goodwin-Stewart

& Kent, 2006); and

6 high significant economic costs imposed on the auditor in the event

of audit failure (DeAngelo, 1981b)

Auditor independence from the client's management is considered

as one of the prerequisites for a good-quality audit Several definitions

can be found for the independence of the auditor Among them are the

following:“the conditional probability of reporting a discovered breach”

(DeAngelo, 1981a, p 186);“the ability to resist client pressure” (Knapp,

1985);“a function of character—with characteristics of integrity and

trustworthiness being essential” (Magill & Previts, 1991); and “an

absence of interests that creates an unacceptable risk of bias” (Beattie,

Fearnley, & Brandt, 2001) Several factors are found to have potential

influence over the independence of the auditor Among them are size of

the auditingfirm (Shockley, 1981); non-audit service (Shockley, 1981;

Knapp, 1985); the client'sfinancial conditions (Knapp, 1985); the nature

of conflict of interest (Knapp, 1985); the tenure of the audit firm,

(Shockley,1981); the degree of competition in the audit-service markets

(Knapp, 1985); and the audit committee (Teoh & Lim, 1996)

Eichenseher and Shields (1983)show that chief financial officers

believe that audit quality is a function of 11 items These are ethical

standards, reputation, industry expertise, audit-team expertise,

geogra-phical coverage, audit fees, working relationships, meeting deadlines,

technical qualifications, accessibility of the audit firm, and range of

services offered.Shockley and Holt (1983)argue that bank chieffinancial

officers rank the Big Firms in terms of 10 attributes These are prestige,

professionalism, expensiveness, competence, aggressiveness,

conserva-tiveness, impendence, reliability, helpfulness, and bureaucratic behavior

Carcello, Hermanson, and Mcgrath (1992)report 12 items that are

perceived by auditors, preparers, and users offinancial statements to

determine audit quality These are auditee size, audit team andfirm experience with the client, industry expertise, responsiveness to client needs, compliance with GAAS,firm executive involvement, firm commit-ment to quality, involvecommit-ment of audit committee, degree of personal responsibility, conduct offieldwork, auditor's skeptical attitude and firm personnel maintain freshness of perspective

Corporate governance is defined as the system by which firms are directed and controlled (Cadbury, 1992) The principles of corporate governance formulated by the Organization for Economic Cooperation and Development (OECD) state that “An annual audit should be conducted by an independent, competent and qualified, auditor to provide an external and objective assurance to the board and share-holders that the financial statements fairly represent the financial position and performance of the company in all material respects,” (OECD, 2004)).KPMG (2006, p 2)states that audit committees are responsible for oversight of the company'sfinancial reporting process, including related risks and controls as well as the company's internal and external auditors.U.S SEC (2003)states that the primary role of the audit committee is to oversee thefinancial reporting process with the ultimate objective of ensuring high-qualityfinancial reporting

KPMG (2006)outlinesfive guiding principles for audit committee for playing an effective role These are: 1) recognize that one size does notfit all, 2) have the “right” people in the committee, 3) monitor and insist on the right“tone at the top,” 4) ensure that the oversight process facilitates the committee's understanding and monitoring of key roles, responsibilities, and risks within thefinancial reporting environment, and 5) articulate and exercise the committee's direct responsibility for the external auditor

An effective independent audit Committee is seen as one of the determinants of audit quality, see for exampleDhaliwal, Naiker, and Navissi (2006) Such a committee recommends external auditors and manages the relationship between them and the company, according

toAICPA (2004)and OECD (2004).Zhang, Zhou, and Zhou (2007)

report thatfirms with an ineffective audit committee are more likely

to be identified with an internal control weakness.Krishnan (2005)

finds that there is a positive relationship between audit committee independence and the quality of internal control prior to the enact-ment of SOX However, others report that the role of audit committees

in overseeing and strengthening the audit process is not significant,

Carcello, Hermanson, Neal, and Riley (2002);Abbott, Parker, Peters, and Raghunandan (2003)

Piot and Missonier-Piera (2007)report that audit quality, unlike quality of corporate governance, measured byfirm size (Big and non-Big) does not have a significant influence on the cost of debt of non-financial French listedfirms These results are robust even after controlling for a set of auditees' characteristics such as firm size, profitability, asset structure, and interest coverage ratio However, others report that one of the most important functions corporate governance can play is ensuring quality offinancial reporting process (see for example, Blue Ribbon Commission, 1999)) Dechow, Sloan, and Sweeney (1996); Beasley (1996); Beasley, Carcello, and Hermanson (1999); Beasley, Carcello, Hermanson, and Lapides (2000);Carcello and Neal (2000); andKlein (2002)report an association between weaknesses in governance and poor financial reporting quality, earnings manipulation, financial statement fraud, and weaker internal controls

Audit quality might be impaired by a number of factors especially

by the pressure on the accountingfirms to increase profit, reduce costs, and increase fees.Otley and Pierce (1996)andWillett and Page (1996)report that it is not unusual for accountingfirms to trim their time budgets and increase control over their staff so as to increase profits, which thus leads to the response of the audit staff to these pressures by resorting to dysfunctional behavior such as falsifying audit work.Otley and Pierce (1996)also argue that a performance-evaluation system might represent a threat to audit quality Furthermore, the pressure to meet the time budget is found to lead

to a reduction of audit quality (Kelley, Margheim, & Pattison, 1999)

Additionally, the low probability of bringing in litigation cases against

auditors and imposition of a limit for liabilities affect the economic

incentives that deliver good audits

4 Research methodology and sample characteristics

This study was undertaken in two stages Thefirst stage involved

the use of a mail-in questionnaire to seek the views of loan officers and

investment analysts on the issues of the auditingfirm's size and the

attributes of audit quality The second stage entailed a series of

interviews with senior auditors of auditfirms, banks, and investment

companies on the issues of size of the auditingfirms and audit quality,

with the aim of more detailed analysis

The use of the questionnaire is motivated by an argument in

Beattie and Fearnley (1998, p 264)that“the questionnaire approach

provides richer insights than is possible using secondary data analysis,

which focuses on economic factors, because the questionnaire

instrument includes both economic and behavioural factors.” They

also point out that a behavioral or qualitative technique is important

to clarify theories in accounting research because it can provide“new

insights into buyers' behavior is offered by the ‘relationships

approach’ to professional services developed in the service marketing

literature, which classifies relationships (in the present case, auditor–

client relationships) based on buyer type.” They note further that an

“economic-based framework can be expected to provide only a partial

explanation of auditor choice.”

The corporate debt secondary market in Bahrain is thin, with only

two issues, which means that companies seeking credit must rely on

bank loans There are also limited numbers of listed companies, so

considerable equity investment in local companies is directed to

non-listed companies or to companies whosefinancial statements are not

publicly available

Thus, a survey approach to examine the role of firm size in

determining audit quality from the users' perception is the best approach

in Bahrain Moreover, some of the factors the author tests in the study

(non-audit services and outsourcing internal audit services) are not

disclosed even by listed companies, which are required by law to publish

annual and quarterly reports This makes a survey approach the only

viable methodology

The survey instrument was developed upon review of literature

and after consultation withfive analysts with appropriate experience

It was comprehensively tested to improve its quality and to make sure

it was applicable to current practices in Bahrain to generate the

highest response rate The questionnaire was then pretested on a

sample of 20 credit andfinancial analysts whose comments were

incorporated in thefinal version

The survey was administered during January and February 2007 to

150 credit analysts and to 150financial analysts working in Bahrain for

retail banks, wholesale banks, and investment companies Out of the

300 questionnaires distributed, 175 questionnaires were returned, of

which 164 questionnaires were useful for the analysis, resulting in a

54.7% response rate Sixty percent response was obtained from

financial analysts and 49.3% from credit analysts

One of the most common problems cited in a survey methodology is

of non-response bias, when data from survey respondents may turn out

to be invalid To ensure the reliability and validity of the data, it is

essential to examine the sample for the possibility of a non-response

bias (seeBartlett & Chandler, 1997; Mallin & Ow-Yong, 1998) The author

followsOppenheim (1999)andWallace and Mellor (1988), and thefirst

15 questionnaires were compared with the last 15 questionnaires, using

t-test to investigate the differences The results show that there is no

significant difference between the 15 early and the 15 late responses,

implying the absence of non-response bias

The questionnaire is divided intofive sections Section I requires

respondents to provide information about the type of their

institu-tions; the positions they occupy to determine whether their work

involves analysis offinancial statements for credit and investment decisions; and their qualifications, age, and length of experience in decisions on investing and lending.Table 1describes the respondents Section II asks of a number of questions found in the accounting and corporate governance literature to determine audit quality; Section III asks respondents to state their perceptions on the important compe-tencies of auditors that might affect the credibility of an auditfirm; and Section IV asks two questions soliciting respondents' perceptions of the credibility of audit reports issued by Big Four and non-Big Four auditors Finally, Section V requires participants to state their perceptions of the effect of effectiveness of audit committee on quality of audit

The respondents work for retail banks (38.4%), wholesale banks (42.1%), and investment companies (19.5%) Although the respondents hold a variety of positions in their organizations, the author wanted to reach those who analyze company reports for the purpose of obtaining decisions on investment and lending, and respondents were asked to indicate the purpose for which they analyze reports Around 54.9% are investment analysts, whereas 45.1% are credit analysts The majority of the respondents (74.4%) held graduate degrees or qualifications with respect to accounting or investment analysis A majority of the respondents also had more than five years of experience, whereas around 60% of those with experience of less than five years had professional accounting qualifications Hence, the information gathered ought to be reliable and could be generalized to the whole population

5 Results and analysis Thefirst question the respondents were asked to answer is about their confidence in the independence of the auditors performing their audit engagements Auditor independence is seen by many as an important prerequisite for audit quality (DeAngelo, 1981b) Lack of auditors' independence indicates that clients may be exerting influence over the results of their audit If this is the case, an auditor will be unable

to carry out the necessary duties to reduce agency problems and ensure crediblefinancial statements

The majority of the respondents seem to be confident (but not extremely confident) that the auditors are independent when they express their opinion.Table 2shows the means and standard deviations

Table 1 Sample characteristics.

Position

Highest qualification

Age of the respondents

Length of experience

of the responses The mean responses show that respondents perceive

auditors in Bahrain as independent but not highly independent This

observation came from credit analysts as well asfinancial analysts,

althoughfinancial analysts thought that auditors were more

indepen-dent than credit analysts

To test whether this difference is significantly different from zero,

the author applies a Levene test and t-test The homogeneity of the

variances of the responses of two groups is confirmed by the results

obtained from the Levene test, so a t-test is performed to test the

differences in the mean of the responses between credit andfinancial

analysts The results show that the mean difference is not significantly

different from zero, indicating that both groups seem to agree that

auditors in Bahrain are independent of their clients

Another measure of audit quality is thatfinancial statements are free

from unintentional misstatements or omissions of material information

Respondents were asked to indicate their confidence level with regard

to whether the financial statements of Bahraini companies meet a

standard using such a definition of audit quality The mean rank of the

responses shows that the majority of respondents (86.6%) are at least

confident, and only 2.4% do not have any confidence at all in the financial

statements

The results also show that, on average,financial analysts are more

confident in financial statements than credit analysts (mean of response

of 3.49, 5.00 being extremely confident compared with the mean of

3.38) The t-test results indicate that the mean difference is significantly

different from zero, indicating that the two groups are homogeneous in

their perceptions of the quality of audits This can also be seen from the

results of the Levene test, which shows that variances of the responses of

the two groups do not differ significantly The relatively high confidence

offinancial analysts in financial statements might be due to 1) their

reliance on these statements as the main source of information, and

therefore, they need to believe that suchfinancial statements are more

reliable than the credit analysts do; 2)financial analysts deal mainly

withfinancial statements of listed firms which are audited by either the

Big Four or BDO Jawad Habib, whereas credit analysts deal mainly with

the small- and medium-sizedfirms, the accounts of which are audited

mainly by small auditfirms This might imply that “audit quality” has

been socially constructed tofit needs of financial analysts more than the

users offinancial statements Credit analysts, on the contrary, have

access to their clients facilitating the process of obtaining more information from clients whenever the need arises

Whether auditor reports influence credit and investment decisions is the third question in the questionnaire The mean of the responses indicates that those reports do influence analyst decisions The majority

of respondents appeared to take auditors' reports into consideration to different degrees; only 8.5% of the respondents answered that the reports do not influence their decisions at all Mean responses indicate financial analysts (3.49) appear to be influenced more by auditors' reports than credit analysts' reports (3.38)

The results of Levene's test for the equality of variances indicate no significant difference between the variances of the responses of both groups, but the results of the t-test indicate the mean responses of the groups differ significantly from each other

These results might be explained by two reasons: 1) credit analysts can obtain additional information from clients who are seeking financing, and 2) bank–client relationships give creditors more leverage

to know their clients, theirfinancial positions, and their probability of defaults Investors andfinancial analysts do not generally have these advantages Financial analysts would be expected to rely more on financial statements and auditors' reports as one way to determine the credibility of afinancial statement

The effect of non-audit services (NAS) byfirms' external auditors is one factor cited in the literature as having an impact on auditor independence and audit quality Such services tend to be regarded by regulators in the UK, the US, Australia, and various other countries as a threat to auditor independence (Craswell, 1999, p 29) In fact, research findings on a connection between the joint provision of audit and NAS and auditor independence have been inconclusive and contradictory (Ashbaugh, 2004; Brandon, Crabtree, & Maher, 2004; Chung & Kallapur, 2003; DeFond, Raghunandan, & Subramanyam, 2002; Frankel, Johnson, & Nelson, 2002; Geiger & Rama, 2003; Kleinman, Palmon, & Anandarajan, 1998; Reynolds, Deis, & Francis,

2004)

A review of the literature byBeattie and Fearnley (2002)shows no evidence to support the hypothesis that the joint provision of audit and NAS could threaten auditor independence; it is acknowledged that it might threaten the appearance of independence (but the audit quality will not be affected)

Table 2

Means and standard deviations of the responses, Levene's F test, and t-test.

analysts Credit analysts Levene's

F test t-test

1 How confident are you that the Qualified Accountants are independent in performing the audit? Mean 3.440 3.490 3.380 0.111 0.654

Std 1.075 1.008 1.155

5 = Extremely Confident, 0 = No Confidence

2 How confident are you that the financial statements are free of unintentional (alternatively, intentional) misstatements

or omissions?

Mean 3.440 3.490 3.380 0.111 0.654 Std 1.075 1.008 1.155

5 = Extremely Confident, 0 = No Confidence

3 The influence of the auditor's report on your decision-making process Mean 3.650 3.780 3.490 0.007 2.139 a

Std 0.877 0.897 0.832

5 = Great Influence, 0 = No Influence

4 In your opinion, the provision of non-audit services by the audit firms will impair its independence and

therefore its quality of services.

Mean 3.730 3.760 3.700 2.219 0.309 Std 1.086 1.042 1.144

5 = Strongly Agree, 0 = Do Not Agree

5 In your opinion, outsourcing internal auditing activities to the external auditors will enhance the audit quality Mean 1.770 1.870 1.650 0.041 1.401

Std 0.928 0.927 0.911

5 = Strongly Agree, 0 = Do Not Agree

6 In your opinion, long association of the relationship between auditors and their clients will enhance the

credibility of financial statements

Mean 2.680 2.640 2.730 0.635 −0.467 Std 1.160 1.202 1.114

5 = Strongly Agree, 0 = Do Not Agree

Std: Standard Deviation.

a Significant at less than 5% significance level.

Antle, Griffin, Teece, and Williamson (1997) contended that

auditor independence would not be affected by NAS because this

client association would improve audit quality The reasons are that an

auditor's knowledge of the client company can be improved by the

provision of NAS, resulting in increased objectivity (knowledge

spillover); independence (Goldman & Barlev, 1974; Wallman, 1996);

and economies of scope (Arrunada, 1999)

Others, including Brandon et al (2004), Frankel et al (2002),

Glezen and Millar (1985),Jenkins and Krawczyk (2002),Lowe and

Pany (1995, 1996),Raghunandan (2003), andWines (1994)argue that

performing non-audit and audit services will pressurize auditors not

to conduct the audit function objectively, impairing their

indepen-dence Auditors will end up auditing their own work, according to

“Revision of the Commission's Auditor Independence Requirement,”

2001 Auditors will be weakened if they rely on NAS (Canning &

Gwilliam, 1999) This will ultimately impair the quality of an audit

Elstein (2001)contends that high consulting fees negatively affect

auditor independence and worsen audit quality; having provided NAS,

auditors become more likely to give the client the benefit of the doubt,

including more flexibility in recording and adjusting discretionary

reserves that could lead to manipulation of earningsfigures

The respondents of the survey conducted by the author were asked

to determine how much they agree with the statement that“the

provision of non-audit services by auditfirms will impair auditor

independence and therefore its quality of services.” The results show

that the majority agreed that auditors offering non-audit along with

audit services might compromise their independence, leading to a

poorer quality of their audit The Levene test and t-test results show

that the perceptions of the two groups were similar

Abbott, Parker, Peters, and Rama (2007)argue that the effect of

outsourcing internal audit services to external auditors will lead to

economic bounding only if companies outsource routine internal

audit tasks and also will result in a loss of internal auditors'

independence, although outsourcing non-recurring internal audit

tasks will not lead to economic bonding In Bahrain, although some

non-financial non-listed companies outsource their internal audit to

non-external auditors, some companies do outsource such services to

their external auditors

To test how credit andfinancial analysts perceive the effect on audit

quality of outsourcing internal audit tasks to external auditors,

respondents were asked to express their opinion of the role of

outsourcing in the credibility offinancial statements The results show

that the majority (more than 76%) do not look favorably on outsourcing

internal audit tasks to afirm's external auditors Levene's test on the

variances of the responses shows that the variances are homogeneous

The mean difference is not significantly different from zero, indicating

that credit analysts andfinancial analysts share similar opinion

Auditor tenure is one among the factors that affect audit quality, although the relationship is complex Auditors auditing a client for the first time generally need more time to understand the client's business, which increases the risk of missing material and misstate-ments Yet, although a very long association may lead to a better understanding of the client's business and make it more likely that the auditor will detect misstatements and earnings management, it might also produce a poorer quality audit

Shockley (1981) and Deis and Giroux (1992) argue that long tenure has the potential to cause complacency, more relaxed audit procedures, too much dependence on management representations, and less skepticism and less diligence in gathering evidence.Myers,

long relationship improves audit quality and that mandatory limits on

an auditor's term might put on unnecessary cost burden on investors More recently, Knechel and Vanstraelen (2007) find that long associations between auditors and clients do not impair auditor independence; they do notfind evidence to support the contention that long-term relationships will make auditors better at predicting bankruptcy

The author's survey results show that opinions of the respondents vary, although the largest group perceives tenure to have little effect

on the quality of an audit Levene's test for equality of variances shows that variances of the responses of the groups are homogeneous The t-test shows no significant difference between the means of the responses of the two groups

Fourteen competencies (attributes) have been found in the literature

to contribute to the quality of the audit service and ultimately the audit report: specialization; independence; industry expertise; technical competence in applying GAAP & GAAS/IFRS & ISA, a wide range of skills such as analytical skills; provision of real value for the audit fees paid by clients; proactiveness, taking initiative; due care; commitment to providing and maintaining quality service; professional audit expertise; reputation; high ethical standards; and possessing strong accounting and auditing knowledge

Survey respondents were asked to state their perceptions with regard to the level of importance of each of those competencies for the quality of audit, using a 6-point Likert scale, where zero indicates that the competency is not important in determining audit quality and 5 indicates that it is extremely important.Table 3presents the summary statistics

Accounting and auditing knowledge is rankedfirst, followed by professional audit expertise (with a mean of 4.52) Auditor indepen-dence is ranked third with a mean of 4.49 Real value for the audit fees is ranked last by both groups of analysts with a mean of 3.46 The low ranking of this factor should come as no surprise because users of financial statement would be more concerned about the

Table 3

Descriptive statistics of competencies/factors, Levene's F test, and t-test.

F test

t-test Mean Std Deviation Mean Std Deviation Mean Std Deviation

1.830

1.153

a Significant at less than 0.05 level.

quality of the reports than the value of money; reduced auditor fees

might lead to a compromise on the quality of an audit The four factors

most important tofinancial analysts (mean is higher than 4.5) were

accounting and auditing knowledge; independence; ethical

stan-dards; and professional audit expertise Credit analysts rank only

accounting and auditing knowledge and professional audit expertise

as extremely important and rank auditor independence in third place

The Levene test and t-tests of the mean difference show no significant

difference between the variances of the responses of all factors, except

for independence, proactiveness, and reputation The test results also

indicate that the mean responses of the credit analysts and of the

financial analysts do not differ significantly, indicating that the two

groups perceive the importance of the factors similarly

To test respondents' perceptions of the effect offirm size on audit

quality, they were requested to answer two questions on how they

perceived the quality of audits performed by Big Fourfirms and the

quality of audits by non-Big Fourfirms The means of the responses

show that both groups of analysts thinkfinancial statements audited

by one of the Big Four as being more credible than those offirms that

are not classified as Big Four Financial analysts rank the credibility of

financial statements audited by Big Four significantly higher than the

rank offinancial analysts This difference should not be interpreted as

that credit analysts favor statements audited by non-Big fourfirms, as

both credit and financial analysts consider the quality of financial

statements audited by non-Bigfirms as average

These results should be interpreted along with the respondents'

perception of the importance of 14 factors that are likely to determine

the quality of the audit service These factors are shown inTable 4

Because these factors are likely to be characteristic of Big Fourfirms,

thesefirms are more likely to be perceived as providing better-quality

audit reports These results would be consistent with those of many of

the studies thatfind that Big Four firms produce better quality reports

because they have better resources This is also additional evidence

supporting the current CBB policy that non-Big Fourfirms are not

allowed to audit retail and wholesale banks and large investment

companies The results also justify the decisions of listed companies to

demand audit services from companies with an international presence

because they can access the expertise needed even if it is not available

in the auditor's local offices, providing assurance of a quality that meets the expectations of investors and creditors

Two regression models are used to test the effect of the 14 attributes

on the perception of the credibility of financial statements The dependent variable in the first model is the perception of the respondents of the credibility of reports audited by Big Fourfirms The dependent variable in the second is the perception of the respondents of the credibility of statements audited by non-Big Fourfirms In both models, the independent variable is the sum of the ratings of the 14 competency factors as perceived by respondents Each model is run three times The first assumes that the dependent variable is the perception of all the respondents; the second is the perception of the credit analysts; and the third is the perceptions of thefinancial analysts

Table 5shows the regression results

The adjusted R2in thefirst model is 17.9% and significant at less than 5%, and the coefficient of the competencies is 0.031 and significant at less than 5%, indicating that the total rating of the competencies is one of the determinants of the audit quality When the dependent variable is replaced with the perceptions of credit analysts and then with those offinancial analysts, the R2changed to 9.40% and 51.90%, respectively In both regressions, the coefficients of independent variable remain significant with a priori expected sign The adjusted R2in the second model is 0.8% and insignificant at the conventional level, and the coefficient of the competencies is 0.09 and insignificant Similar regression results are obtained when the model

is tested using the two subsamples (credit analysts and financial analysts) The outcomes of the six regression runs also indicate that both credit analysts andfinancial analysts perceived that the Big Four firms, unlike non-Big Four, are more likely to have the needed competencies to ensure audit quality from a user's perspective These results lend further support to those reported byCarcello et al (1992),

Eichenseher and Shields (1983),Shockley and Holt (1983), andFrantz (1999)

Subsequently, step-wise regression is carried out after replacing the independent variable with the individual values of the 14 competencies in the mode For the entire sample, the dependent

Table 4

Respondents' perceptions of the credibility of audit reports.

F test

t-test Mean Std Deviation Mean Std Deviation Mean Std Deviation

The credibility of a report audited by one of the Big Four 4.34 0.722 4.49 0.066 4.16 0.092 0.132 2.953 a

a Significant at less than 0.05 level.

Table 5

Regression results (Creditability of audit report i =α+β competencies i +ε i ).

(Competencies/Factors)

Adjusted R 2

F- value Coefficient Standardized beta

Credibility of a report audited by one of the Big Four Whole sample 2.566 a

0.031 a

(0.303) (0.005) Financial analysts 1.068 a

0.055 a

(0.006) (0.006) Credit analysts 0.807 a

0.031 a

(0.655) (0.011)

(0.469) (0.008) Financial analysts 4.224 a

(0.416) (0.007)

(0.653) (0.011) Standard errors are in parentheses.

a Significant at less than 0.05 level.

variable is the credibility of a report audited by one of the Big Four; in

addition to the constant, only professional audit expertise, reputation,

and wide range of skills are included in thefinal model, with an R2of

24% The coefficients of the three variables are positive and significant

at less than 2.8% When the dependent variable is replaced with the

perceptions of the credit analysts, thefinal model has an R2of 62.7%

and includes professional audit expertise, wide range of skills,

reputation, and accounting-and-auditing knowledge When the

dependent variable is replaced with the perceptions of financial

analysts, thefinal model has an R2of 70% and includes professional

audit expertise, real value for fees, wide range of skills, ethical

standards, and accounting-and-auditing knowledge When the

dependent variable is replaced with the credibility of a report audited

by one of the non-Big Four, for the entire sample, only two variables

(proactive and takes initiative) remain in the final model, with a

significant R2 of 8.9% When the sample is limited to the credit

analysts, thefinal model includes only one variable, “due care”, with a

significant R2of 5.1% Thefinal step-wise regression is carried out for

the sample that is limited tofinancial analysts The final model has a

significant R2of 34.9% and includes the following variables: due care,

expertise in the industry, and commitment to quality

The audit committee is considered an important board committee

that plays a role in implementing corporate governance guidelines

One of the most important functions of the committee is to oversee

internal and external audit performance and to advise the board on

audit matters Therefore, an effective audit committee should enhance

audit quality Corporate governance principles (OECD, 2004) outline

the importance of audit committee in enhancing audit quality.Abbott,

Parker, and Peters (2004),Yang and Krishnan (2005),DeZoort and

Salterio (2001), andLin, Li, and Yang (2006)find a positive relation

between audit quality and the effectiveness of audit committee

Banks and investment companies are required by law to have audit

committees, but not non-financial companies listed on the Bahrain

Stock Exchange To measure the impact of an audit committee on

perceived audit quality, respondents were asked about their reactions

with regard to the role of an effective audit committee in audit quality

To test the effect of the role of the committee in improving audit

quality, respondents were asked to state their perception of the

importance of effectiveness of audit committee on the quality of audit,

using a 6-point Likert scale, where 0 indicates not important in

determining audit quality and 5 indicates that it is extremely

important The survey does not elaborate on the requirements for

audit committee to be effective This is attributed to the fact that

practices“that work best for one organization may not be ideal for

another—especially in a corporate governance environment where

corporate culture,financial reporting risks, and governance needs can

vary dramatically from company to company.” The mean of the

responses of the whole sample is 4.15 and 0.82 standard deviation

The mean and the mode of the responses clearly show that these users

offinancial statements perceive that an audit committee affects the

audit quality

Splitting the responses into the groups, the mean responses of the

credit analysts is 4.12 and 0.76 standard deviation, whereas mean

responses of thefinancial analysts is 4.17 and a standard deviation of

0.88 Levene's test (F = 3.056, p value of 0.082) on the variances of the

two groups indicates no significant difference between the variances

The null hypothesis that the two groups of analysts view the effect of

the role of audit committee in determining audit quality as equally

important is accepted because the p value of 0.729 is more than the

critical value of 0.05

6 Concluding remarks

The author has reported the results of a survey of credit and

financial analysts on perceptions of audit quality and the factors that

determine that quality Consistent with the evidence in developed

markets, the bigger auditingfirms are perceived to provide better quality audits and to be more independent of the management of companies they audit compared with smaller firms Findings are similar in both the questionnaires and personal interviews The conclusion is that the Big Four auditingfirms have characteristics that place them in a better position to produce better quality audits than smallerfirms

A review of the 2007 annual reports of 41 companies listed on the Bahrain Stock Exchange shows that 82.5% of the companies are audited by one of the Big Four The author's interviews indicate that the Big Four auditors are better able to resist management pressure in cases of conflict Their greater resources, technical knowledge, and global reach allow them to deal with clients more objectively without

a fear of termination

Financial analysts rely more on the auditedfinancial statements than credit analysts This is likely because a bank–client relationship allows credit analysts to obtain more information from their clients; they are also in a better position to evaluate thefinancial position of their borrowers thanfinancial analysts Both groups of analysts think that provision of non-audit services will negatively affect auditor's independence and ultimately impair the quality of an audit An effective audit committee is seen as one factor that should improve the credibility offinancial statements

Regression results indicate that both groups of analysts perceive financial statements audited by Big-Four firms to be of better quality than those audited by non-Big firms This is because of the characteristic of Big Fourfirms, which are not matched by other auditfirms This is an evidence supporting CBB's current policy that audit of retail and wholesale banks and large investment companies should be performed by Big-Fourfirms Furthermore, credit analysts have found that the creditability of an audit report by one of the Big Four is determined by professional audit expertise, wide range of skills, reputation, and accounting-and-auditing knowledge However, forfinancial analysts, the credibility of these reports is a function of professional audit expertise, real value for fees, wide range of skills, ethical standards, and accounting-and-auditing knowledge

Future research may be directed toward determining the effect of the actual role of an audit committee on audit quality This can be carried out when companies start establishing such committees and ensure that they act in an independent and effective manner This is likely to take place when Bahrain issues its corporate governance code

Acknowledgements

I am grateful to the two anonymous reviewers for their time and efforts I would like also to thank the Journal co-editor, Professor J Timothy Sale, for his support and editorial assistance The usual caveats apply

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