Innovative Journal of Business and Management 1: 3 May June (2012)43 47.

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INNOVATIVE JOURNAL OF BUSINESS AND MANAGEMENT

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AUDIT QUALITY AND FINANCIAL REPORTING QUALITY: CASE OF TEHRAN STOCK

EXCHANGE (TSE)
Hasan Maleki Kaklar1, Saeid Jabbarzadeh Kangarlouei2, Morteza Motavassel3
1

Department of Accounting, Salmas Branch, Islamic Azad University, Salmas, Iran.

2

Department of Accounting, Urmia Branch, Islamic Azad University, Urmia, Iran.

Department of Accounting, West Azarbyjan Science and Research Branch, Islamic Azad University, West Azarbyjan, Iran.

ARTICLE INFO

ABSTRACT

Corresponding Author:
Saeid Jabbarzadeh Kangarlouei
Department of Accounting, Urmia
Branch, Islamic Azad University,
Urmia, Iran

The purpose of this study is to investigate the relationship between audit

quality and financial reporting quality during the period of 2004-2009 in
TSE. The population of study includes 91 firms obtained from systematic
elimination. Using panel data, the results of study show that there is a
weak and negative relationship between audit firm size and financial
reporting quality. That is, when auditing is conducted by Iranian audit
organization, financial reporting quality mitigates. However, no
relationship is found between auditor rotation and financial reporting
quality.

KeyWords: Audit quality, financial

reporting quality, audit firm size,
auditor rotation and Tehran Stock
Exchange.

2012, IJBM, All Right Reserved

INTRODUCTION
On the one hand, efficient capital markets bring
high-quality financial reporting, which facilitates the
efficient raising and allocation of corporate capital and thus
creates benefits for investors (Wang and Wub, 2011:168),
and on the other hand, the global financial crisis, corporate
failures and scandals in many countries raise significant
questions about the effectiveness of financial reporting and
auditing. Auditing firms, professional and regulatory bodies
are under fire and face pressures to restore confidence in
auditing. Regulatory and professional bodies tried to
promote audit quality in an attempt to cure tarnished
image and augment their legitimacy and standing (Holma
and Zamanb, 2011:51). Therefore, it is expected that high
audit quality lead to high financial reporting quality which
in turn is a tool to prevent financial crises. Biddle et al.
(2009) define financial reporting quality as the precision
with which financial reporting conveys information about
the firms operations, in particular its expected cash flows,
that inform equity investors (p:113). Their definition is
consistent with the Financial Accounting Standards Board
Statement of Financial Accounting Concepts No. 1 (1978),
which states that one objective of financial reporting is to
inform present and potential investors in making rational
investment decisions and in assessing the expected firm
cash flows. However, audit quality is not directly
observable; therefore, it is difficult to measure empirically.
However, there are proxies to measure audit quality.
Accrual measure is one of the proxies for audit quality.
High quality auditors are more likely to detect accounting
irregularities, object to the use of questionable accounting
practices, and limit discretion over accrual choices for

client firms (Kim and Yi, 2009: 208). Giroux and Jones
(2011) number five theoretical constructs to test audit
quality: auditor type, audit experience (industry
specialization), audit fee, demographics, and local
government type (p. 62). Jamal and Sunder (2011) report
from DeAngelo (1981) Mautz and Sharaf (1961) that two
key features of the financial reporting system are that an
audit is mandated for publicly traded companies, and that
it must be conducted by accountants who are independent
in fact (i.e., have an objective state of mind) as well as in
appearance. Both these dimensions of independence are
assumed to be necessary for attaining audit quality (P:
284). Khurana and Raman (2004) define audit quality as
an auditor will (1) detect and (2) correct/reveal any
material omission or misstatements in the financial
statements(p. 475). DeAngelo (1981) hypothesizes a twodimensional 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. According to Palmrose
(1988) and Simunic and Stein (1987) there is two major
drivers of audit quality are litigation costs and reputation
loss. They argue that considering large investment on
building their brand names, the large audit firms have an
incentive to lower litigation risk and protect their
reputational capital by providing more credible financial
reports. These arguments are consistent with the notion
that audit firm size is an important determinant of audit
quality. Large size of audit firm has two consequences (1)
enables audit firms to spend on training and audit
technology (increasing their competence), and (2) Enables
43

Jabbarzadeh et. al/ Audit quality and financial reporting quality: case of Tehran Stock Exchange (TSE).
them to resist auditee pressure to issue a clean audit
opinion since they are not dependent on an individual
client.

when clients move from a Big 4 to a Second Tier auditing

firm than when clients move from a Big 4 to another Big 4
firm. Their results suggest that a negative market reaction
may not represent a significant barrier to entry among
Second Tier auditing firms. Boone et al. (2010) examined
audit quality for Big 4 and Second-tier auditors during
20032006 and find weak evidence that the Big 4 have a
higher propensity to issue going concern audit opinions for
distressed companies. In addition, they find that the level of
performance-adjusted abnormal accruals for Big 4 and
Second-tier audit firm clients appears to be similar. With
respect to investor perceptions, the client-specific ex ante
equity risk premium to be lower for Big 4 clients than for
Second-tier audit firm clients. Overall, their findings
suggest little difference in actual audit quality but a more
pronounced difference in perceived audit quality. Lai
(2009) examined the association of firms with high
investment opportunities with high quality audits and
whether that association results in a lower likelihood of
earnings management. She find two results: First, firms
with high investment opportunities are more likely to hire
Big 5 auditors, than firms with low investment
opportunities. Second, firms with high investment
opportunities are more likely to have more discretionary
accruals but this relationship is weaker when they have Big
5 auditors. Rainsbury et al. (2009) examined the
association between the quality of audit committees on
financial reporting quality and external audit fees. Their
study uses a sample of 87 New Zealand firms in 2001 when
no regulations or listing rules existed for audit committees.
They do not find significant association between the quality
of an audit committee and the quality of financial reporting
after controlling alternative measures of earnings quality.
Kim and Yi (2009) investigated whether the auditor
designation rule in Korea is effective in deterring managers
from making income increasing earnings management.
They find that the level of discretionary accruals is
significantly lower for firms with designated auditors than
firms with a free selection of auditors. They also find that
firms with mandatory auditor changes (i.e., auditor
designation) report significantly lower discretionary
accruals compared to firms with voluntary auditor changes.
Overall, their results are consistent with the notion that the
auditor designation enhances audit quality and thus the
credibility of financial reporting. Firth et al. (2012) using
auditors' propensity to issue a modified audit opinion as a
proxy for audit quality document a positive effect of
mandatory audit partner rotation on audit quality in
regions with weak legal institutions. However, they fail to
find robust evidence that mandatory audit firm rotation is
significantly superior to other forms of auditor rotation.
Daniels and Booker (2011) surveyed the effects of audit
firm rotation on perceived auditor independence and audit
quality and indicate that loan officers do perceive an
increase in independence when the company follows an
audit firm rotation policy. However, the length of auditor
tenure within rotation fails to significantly change loan
officers perceptions of independence. Moreover, their
findings also indicate that neither the presence of a
rotation policy nor the length of the auditor tenure within
rotation significantly influences the loan officers
perceptions of audit quality.

LITERATURE REVIEW
The classic agency problem between shareholders
and corporate managers promotes the hiring of auditors to
provide independent assurance to the investors that the
firms financial statements is under Generally Accepted
Accounting Principles (Watts and Zimmerman, 1983).
However, global financial crisis, corporate failures and
scandals in many countries brought doubts as to
effectiveness of auditing to do so. There have been so many
attempts to restore confidence for auditing work by
passage of regulatory Acts. The passage of these Acts
supposed to increase audit quality. For example, DeFond
and Lennox (2011) find that the passage of SOX results in a
large reduction in the number of small audit firms
operating in the market. They report that nearly 50%, 607
of 1,233 small audit firms that were active during 2001
2008 exited the market and the majority of these exits
occur in 20022004, coinciding with passage of SOX, the
advent of PCAOB registrations, and the beginning of
inspections. They also show that the presence of fewer
small auditors coincides with a doubling of the average
number of clients per small audit firm. Thus, they
document a significant shift in the composition of the
market for small auditors after the adoption of SOX. In
addition, they argue that low quality auditors are more
likely to find it cost beneficial, at the margin, to exit the
market for public company audits in response to the new
regulatory environment implemented under SOX (P.22).
These results show that the passage of these Acts increased
audit quality if audit size supposed to be proxy for audit
quality. Moreover, as we put forward it is expected that
high audit quality lead to high financial reporting quality.
However, the passage of Acts led to increase financial
quality.
Al-Ajmi (2009) studied perceptions of credit and
financial analysts with regard to the relationship between
the effectiveness of audit committee, size of the auditing
firm and audit quality in the context of Bahrain. By survey
of 300 credit and financial analysts, he shows four major
findings: 1- both credit and financial analysts see the
credibility of financial statements to be a function of the
size of the auditing firm. 2- Both groups assume that the
characteristics of Big-Four firms allow them to produce
better-quality reports than non-Big firms. 3-Non-audit
services affect auditor's independence hence impair audit
quality. 4-Both the groups of analysts believe that effective
audit committee enhances the quality of audit reports. 5Financial analysts perceive financial statements to be more
credible than do credit analysts. Ding and Jia (2012)
surveyed the relationships between auditor mergers, audit
quality and audit fees. Measuring audit quality by earnings
quality of clients they show that in the post-merger period,
absolute discretionary accruals of big-X client firms
decreased compared with non-big-X client firms, indicating
less earnings management; in addition, they indicate that in
the postmerger period, earnings of big-X clients are more
related to stock-market returns, indicating that earnings
quality has improved in this period. While, they do not find
such changes for non-big-X client firms. Cullinan et al.
(2012) examined whether the stock market reacts
negatively when clients switch from a Big 4 to a non-Big 4.
They find that the market does not react more negatively

HYPOTHESES DEVELOPMENT Main hypothesis: there is a

significant relationship between audit quality and financial
reporting quality in firms listed in TSE.
44

Jabbarzadeh et. al/ Audit quality and financial reporting quality: case of Tehran Stock Exchange (TSE).
considered 3 and more years. Then the results are
compared.

Sub-hypothesis 1: there is a significant relationship

between audit firm size and financial reporting quality in
firms listed in TSE.
Sub-hypothesis 2: there is a significant relationship
between auditor tenure and financial reporting quality in
firms listed in TSE.

Research hypotheses test

To test research hypotheses, first, descriptive statistic and
correlations between variables is conducted and finally
regression models analyzed.

METHODOLOGY
Considering that the present study uses historical
data, it is post facto research; researcher has no control on
collected data in these sorts of study. In addition, because
the relationship between audit quality and financial
reporting quality is investigated in TSE, the research is
descriptive-correlation study using documental method to
collect data. Research data are drawn from financial
statements and notes of firms listed in TSE and audit
reports from DenaSahm, Sahra and TadbirPardaz.

Descriptive statistic
Descriptive statistic is presented in Table 1 in which
auditor tenure has less coefficient of variation and standard
deviation than size, both as independent variable. This is
while financial reporting quality as dependent variable
according to Barth et al. (2002) model has more coefficient
of variation and standard deviation than independent
variables then has less consistency. This shows that: 1auditor tenure is reliable than audit firms size and 2. Less
amount of standard deviation of audit quality compared to
standard deviation of financial reporting quality shows that
financial reporting quality is affected by other factors other
than audit quality.

STATISTICAL POPULATION
Population of this study consists of firms listed in TSE
and sample firms must have following conditions:
1. Firms` fiscal year must be ended at the end of year
and they have not changed their fiscal year during
the period of study.
2. Sample firms must handed out their financial
statement to TSE and three years must have
passed form their listing.
3. Sample firms financial statements must be audited
during the research period.
As a result of these conditions, a sample of 91 firms are
obtained to be studied.
RESEARCH VARIABLES
In the present study, audit quality is considered as
independent variable and financial reporting quality as
independent variable. Followings present models of each
variable measurement.

Table 1. Descriptive statistic

Financial
reporting quality
Mean
0.0392
Median
0.0081
Maximum
0.9947
Minimum
0.0001
Std. Dev
0.1001
Skewness
5.1579
Kurtosis
36.2271
Jarqube-Bera
21183.07
Probability
0.0000
Sum
16.4853
Sum Sq. Dev
4.2052

Audit size
0.5642
1.0000
1.0000
0.0000
0.4964
-0.2592
1.0672
70.0791
0.0000
237.0000
103.2643

Auditor
tenure
0.6452
1.0000
1.0000
0.0000
0.4790
-0.6071
1.3686
72.3777
0.0000
271.0000
96.1404

Correlation between variables

Matrix correlation between variables is presented
in Table 2. As it is shown the most correlation between
variables is between financial audit quality and audit firm
size (-0.403). This shows that audit conducted by audit firm
organization approximately 40 percent has low financial
reporting quality. In addition, the correlation between
audit size and audit tenure is positive and strong (0.151)
indicating that auditor tenure related to audit organization.

FINANCIAL REPORTING QUALITY MEASUREMENT

MODEL
Financial information preciseness is considered as
its quality. Empirically, to evaluate financial information
preciseness, absolute value of regression errors of future
cash flows using components of operating profit in
previous period is used (Barth et al., 2001:36).
CFOi ,t 1 0 1CFOi ,t 2 ARi ,t 3 INVi ,t 4 APi ,t
5 DEPRi ,t 6 OTHERi ,t i ,t 1
Where:
CFO: operating cash flow
AR: changes in receivables
INV: changes in inventories
AP: change in accounts payable
DEPR: tangibles and intangibles depreciation expense
OTHER is the aggregate of other accruals, i.e., OTHER
EARN (CF +AR +INV AP DEPR AMORT)
OP: operating profit
: error term supposing zero mean and fixed variation
Empirical measure of financial reporting quality is absolute
value of errors that is RQi ,t i ,t 1
, smaller absolute value of
errors, and more financial reporting quality.
As it is mentioned before, variables to measure audit
quality are auditor size ans auditor tenure as following:
Auditor size: audits conducted by Iran audit organization
is considered as big size audit firms and other smaller audit
firms are considered small audit firms.
Auditor tenure: in the present study, once auditor tenure
is considered less than 3 years and the other time is

Table 2. Correlation matrix

Financial reporting quality

Audit size
Audit tenure

Financial
reporting quality
1
-0.4034
0.0561

Audit size

1
0.1513

Audit
tenure

Hypotheses test
Sub-hypothesis 1: there is a significant relationship
between audit firm size and financial reporting quality in
firms listed in TSE.The results of this hypothesis test are
presented in Table 3.
Table 3. Regression model of the relationship between
size and financial reporting quality
variable
coefficient
Std.
t-Statistic
Error
Audit size
-0.0814
0.0090
-9.0158
constant
0.0851
0.0067
12.5582
R
1.1628
Mean
dependent var
Adjusted R
0.1608
S.d. dependent
var
S.E
of
0.0917
Akaike info
regression
criterion
Sum squared
3.5206
Schwarz
resid
criterion

45

audit firm
Prob.
0.0000
0.0000
0.0392
0.1001
-1.9342
-1.9149

Jabbarzadeh et. al/ Audit quality and financial reporting quality: case of Tehran Stock Exchange (TSE).
Log likelihood
DurbinWatson Stat

408.1862
1.1789

F-statistic
Prob (Fstatistic)

RESULT AND SUGGESTIONS

1-auditor tenure is reliable variable than audit firm
size due to its less amount of standard deviation and
coefficient of variation.
2- Less amount of standard deviation of audit
quality compared to standard deviation of financial
reporting quality shows that financial reporting quality is
affected by other factors other than audit quality.
3- In this research, it is shown that there is weak
and significant relationship between audit firms size and
financial reporting quality and approximately 0.16 of
changes in financial reporting quality is affected by audit
firms size.
4- Research shows that there is weak, positive and
significant relationship between auditor tenure and
financial reporting quality and approximately 0.003 of
changes in financial reporting quality is affected by audit
tenure.

81.2856
0.0000

As it is shown in Table 3, the relationship between

two variables is negative, that is, if audit is conducted by
audit organization, financial reporting quality mitigates. It
should be noticed that the relationship between audit firm
size and financial reporting quality is weak (-0.081) but
statistically is significant considering t-Statistic (0.0000).
Weakness and significance of regression coefficient
indicates that other variables other than audit firm size
affect financial reporting quality. The result of F-statistic
(0.000) shows that the model is significant considering the
significance of effect of audit firm size on financial
reporting quality and there is no auto-correlation problem
considering Durbin-Watson Stat (1.718). The result of
coefficient of determination shows that approximately 0.16
of changes in financial reporting quality is related to audit
firm size. Overall, the first sub-hypothesis is accepted
considering the significance of effect of audit firm size on
financial reporting quality.
Sub-hypothesis 2: there is a significant relationship
between auditor tenure and financial reporting quality in
firms listed in TSE.
The results of this hypothesis test are presented in Table 4.

SUGGESTION REMARKS
1-Considering weak and significant relationship
between audit firms size and financial reporting quality, it
is suggested that audit organization increases its oversight
on audits conducted by them in order to increase financial
reporting quality.
2- Considering weak and significant relationship
between audit firms size and financial reporting quality, it
is suggested that financial information users and lenders to
consider low audit quality conducted by audit organization
in investment decision.

Table 4. Regression model of the relationship between auditor

tenure and financial reporting quality
variable
coefficie
Std.
t-Statistic
Prob.
nt
Error
Auditor tenure
constant

0.0117
0.0316

0.0102
0.0082

0.0031

Adjusted R

0.0007

S.E of regression

0.1001

Sum
squared
resid
Log likelihood
Durbin-Watson
Stat

4.1920
371.5319
1.5215

1.1488
3.8614

0.2513
0.0000

Mean
dependent var
S.d. dependent
var
Akaike info
criterion
Schwarz
criterion
F-statistic
Prob (Fstatistic)

0.0392

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0.1001
1.7596
1.7404
1.3199
0.0000

As it is shown in Table 4, the relationship between

two variables is positive, that is, if auditor tenure increases
by audit organization or other firms, financial reporting
quality increases. It should be noticed that the relationship
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considering
t-Statistic
(0.2413).
Weakness
and
insignificance of regression coefficient indicates that other
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tenure on financial reporting quality.
Considering results and considering insignificance
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financial reporting quality, main hypothesis is not accepted.

46

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