An assessment of auditor's independence on the quality of financial reporting: Evidence from Lagos state parastatals

Okunola, Adesola Olajumoke Article An assessment of auditor's independence on the quality of financial reporting: Evidence from Lagos state parastatals International Journal of Management, Economics and Social Sciences (IJMESS) Provided in Cooperation with: International Journal of Management, Economics and Social Sciences (IJMESS) Suggested Citation: Okunola, Adesola Olajumoke (2021) : An assessment of auditor's independence on the quality of financial reporting: Evidence from Lagos state parastatals, International Journal of Management, Economics and Social Sciences (IJMESS), ISSN 2304-1366, IJMESS International Publishers, Jersey City, NJ, Vol. 10, Iss. 2-3, pp. 88-109, https://doi.org/10.32327/IJMESS/10.2-3.2021.6 This Version is available at: https://hdl.handle.net/10419/248670 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc/3.0/ 88 International Journal of Management, Economics and Social Sciences 2021, Vol. 10(2-3), pp. 88 – 109. ISSN 2304 – 1366 http://www.ijmess.com An Assessment of Auditor’s Independence on the Quality of Financial Reporting: Evidence from Lagos State Parastatals *Adesola Olajumoke Okunola School of Management & Social Sciences, Pan-Atlantic University, Lagos, Nigeria This study investigated the effect of auditor’s independence on the financial reporting quality of Parastatals in Lagos State, Nigeria. A survey was conducted to gather data on auditor’s independence and a content analysis procedure was adopted to extract secondary data from the audited financial statement of the parastatals. Data were analyzed using binary logistic regression. The findings show that when an auditor alienates his personal interest from audit and his ability to issue a qualified audit opinion where necessary, have a statistically significant effect on improving both the fundamental and enhanced qualitative characteristics of financial reporting (FQC and EQC). Hence, the more an auditor allows his personal interests to becloud his judgement, the lower both the FQC and EQC of financial reporting. The outcome of reliance on the work of the internal auditors and auditor’s rotation gave an inconclusive result. Therefore, rotation of auditors and the reliance on the findings of internal auditors promote the relevance and how faithfully represented the financial reporting are, while the EQC has no effect on auditor’s independence. The study recommended that parastatals must place a premium on promoting auditors’ independence in order to minimize audit failure and the credibility attached to the financial reports. Keywords: Financial reporting quality, auditor’s independence, enhanced and fundamental qualitative characteristics, parastatals, binary logistic regression JEL: H83, M41, M42 The public sector represents the largest sector of the economy of all nations; it employs the largest labor force and directs the biggest part of the country’s financial and non-financial resources (Chowdhury, 1996). The evidence and information gathered in the public sector may mostly not be financial and requires subjective judgment by the auditor. Public trust can only be confidently achieved when both financial and non-financial resources reposed in the auditor have been effectively managed through systematic audit practice procedures. The public expects responsible public officers to manage public funds with absolute integrity and accountability. Auditing in the public sector has been challenged severally at the international, national, and state levels as a result of the inadequacy in the information provided by the audited financial statements (Nikoloyuk et al ., 2005). Public policy and decisions are made on this deficient annual report, which consequently leads to poor decision implementation on the part of the government (Odia, 2014). The primary objective of financial reporting is the provision of adequate financial information on an existing DOI:10.32327/IJMESS.10.2-3.2021.6 Manuscript received May 23, 2021; revised October 24, 2021; accepted November 4, 2021. © The Author(s); CC BY-NC; Licensee IJMESS *Corresponding author: aoku[email protected].ng International Journal of Management, Economics and Social Sciences 89 entity for taking an economic decision. The International Accounting Standard Board ([IASB], 2008) asserts that financial reporting is expected to provide adequate information about the financial position of an entity useful to users in making an economic decision. However, it has been revealed that there were a series of untimely deaths of many organizations due to financial scandals which were borne out of lack of auditor independence and transparency, accountability, and poor financial management. The case of Cadbury Nigeria Plc. and it’s over 40-year auditor, Akintola Williams Deloitte and Touche, who were indicted for failing to apply professional skepticism and due diligence in the course of rendering professional services, was the pinnacle of this fall. Similar to what was obtainable in the Nigerian corporate sector, the public sector is not in any way immune to audit failure. However, suspected audit failures are concealed on the premise of classified information or the culture of secrecy of government information despite the Freedom of Information Act 2011, which is aimed at making public records and information freely accessible to citizens. Several audit practices in the public sector that ought to be a celebrated case of audit failure were concealed but for the reason of classified information. This questions the integrity and independence with which the audited accounts are prepared. The independence of an auditor is put to test by its capability to report the discovery of any breach in the client’s financial statement. Similarly, the independence deployed in the course of carrying out the audit is a function of how versatile and knowledgeable the auditor is. The undue reliance on the work of the resident auditors, personal interest or gain, and prolonged tenureship might pose a threat to the auditor’s independence. The ability to manage these will likely enhance the degree of confidence placed in the auditor and the quality of financial reporting, without exposing its opinion to public suspicion. The financial statement is a trusted communication tool for the various stakeholders, hence the independence with which it is prepared determines the worth placed on its quality. From the foregoing, it is therefore imperative to discover for the Nigerian public sector whether the auditor’s independence implies relevant, faithfully represented, and enhanced quality financial reporting. A plethora of studies have examined the auditor’s independence on several variables, such as auditor’s competence (Abdul et al ., 2014), audit fees (Abdul-Rahman et al ., 2017), non-audit services (Abdulaziz, 2009), corporate governance (Adelopo, 2010), and bank stability (Adekunle and Asaolu, 2013). However, the current study proxied auditor’s independence on auditor’s personal interest, reliance on internal auditor’s findings, auditor’s rotation as well as the ability of the auditor to issue a qualified audit opinion. Studies using this combination of proxies are relatively scanty, as evidenced in previous literature. Second, different instruments have been used in prior studies to measure financial reporting quality, such as accrual models (Jones, 1991; Dechow et al ., 1995); value relevance models (Choi et al ., 1997 ; Barth et al ., 2001; Nicholas and Wahlen, 2004) and specific Okunola 90 elements in annual reports (Beretta and Bozzolan, 2004). This study improves the methodology of these studies by adopting both the use of primary and secondary data. Questionnaires were used to gather information on auditor’s independence while the quality of financial reporting was operationalized using both the enhanced and fundamental quality of financial reporting similar to the works of Braam and Beest (2013); Puspitasari and Yurisandi (2015), Mbobo and Ekpo (2016) and Kisaku (2017). Finally, to the best of the researcher’s knowledge, previous studies focused on the private sector such as manufacturing, banking, and auditing firms (e.g., Nwanyanwu, 2017; Adekunle and Asaolu, 2013; Okolie, 2014); the non-availability of similar studies centring on the public sector with an emphasis on Lagos State parastatals is a gap to be filled. Following the introductory section, section 2 provides both the theoretical and empirical review. Section 3 describes the data and methodology used. Section 4 presents and discusses the empirical results, while sections 5, 6, and 7 conclude the study, discusses the policy implications and future directions. LITERATURE REVIEW Theoretical Underpinnings - Agency theory Historically, agency theory emanates with human civilization arising from doing business with the view of maximizing personal interests (Panda and Leepsa, 2017). This theory finds its roots in the study of Berle and Means (1932), as cited by Adelopo (2010) on the separation of ownership of a firm from its management. Smith (2011) and Kivisto (2007) postulated that the landmark achievement of the theory is credited to the work of Jensen and Meckling (1976) and Fama and Jensen (1983), where they documented that agency problems will emanate where the principal employs the service of an agent to execute some assignment in his stead. From the public sector perspective, the Office of the Lagos State Auditor-General is the supreme audit institution (SAI) which serves as the external auditor for all government establishments in the state. Therefore, the external auditors employed to audit the parastatals report to the Office of the Auditor General of Lagos State before the audit report is signed. The SAI is independent of the political agents’ influence, as they report directly to the House of Assembly, who review the audit report and ensure that law breakers are invited and interrogated by the Public Accounts Committee (PAC). The parties concerned are allowed to defend themselves and, when found guilty, will be brought to justice. This act reinforces the trust the governed have in the government. The House of Assembly here is the International Journal of Management, Economics and Social Sciences 91 principal, and the SAI is acting in her stead, while the agents are the various parastatals carved out to perform specialized and distinct roles outside the normal ministerial functions. The adoption of the theory in the public sector context suggests a wider and broader perspective of the principal-agent relationship. This implies that agency relationships within the public sector are expanded to accommodate at various levels of government. The public sector audit supports the principal-agent hypothesis, according to which appointed and elected office holders (agents) are expected to report to the public (principals) on a regular basis on funds and resources entrusted to their care, if they have been used wisely for the intended purpose (DeSimone, 2017). Looking at the Nigeria public sector, for example, there is a notion that government business is nobody’s business (Uzuh, 2006); this encourages a nonchalant attitude and non-accountability on the part of those saddled with the responsibility of managing government resources. Consequentially, a principal-agent problem exists where government officials (agents) pursue their inordinate goals at the expense of the citizens (principal). The multiplicity of agency problems in the public sector arises as a result of the complexity of the agent-principal relationship, such as the citizens or voters as the principal with multiple agents such as the president, the senate, house of assembly, public accounts committees, auditor general, accountant general, governors, ministers, commissioners, just to mention a few. Agency problem arises at different levels such as between the President and the Senate, Senate and the House of Assembly, Public Accounts Committee and the Auditor-General of the Federation, the Auditor-General of the Federation and the Accountant-General of the Federation, Accountant-General of the Federation and the accounting officers, accounting officers and directors within the public service, between the senior and junior cadre in the service and ultimately, between the President and the people he governs (citizens). This misalignment of interest and the pessimistic role of the agents increase the need for sound audit practices within the public sector in order to boost citizens’ trust and confidence in the sector. -Comfort Theory The birth of the theory is rooted in the medical profession. Orlando (1961) elucidates that one of the key responsibilities of a nurse is to establish a good relationship with her patients with a view to enhancing comfort creation. The imported theory was firstly applied in the auditing profession by Collins (1981) where he opined that the conduct and conclusion of an audit involves an orderly approach and an emotional procedure which forms a social order that leads to comfort. Pentland (1993) abstracted that deceitful financial information is changed to reflect its true and fair position through diligent appraisal of the financial statement, thereby producing comfort to the users. In other words, the applicability of professional care and skill on the part of the auditor help in diagnosing Okunola 92 correctly and the provision of appropriate solution thereby providing comfort for the users of the public sector financial statement. Empirical Review on Auditor’s Independence and Financial Reporting Quality Genre of researchers across the globe has studied the effect of auditor’s independence on the quality of financial reporting. He and Chen (2021) investigated the impact of audit rotation on companies’ information disclosures and it signaling effect on auditors’ strategies of listed companies in Taiwan from 2004 to 2016. The study differentiates between mandatory and voluntary auditor’s rotation. In effect, the study concludes that a company under a mandatory auditor rotation chooses an industry expertise auditor to be their successor audit partners compared to a voluntary rotation auditor. This eventually reduces rotation costs since audit partners are usually rotated rather than the audit firm. With the use of industry specialists, this consequentially improves the quality of the financial reports and the auditor’s independence as well as their signaling effect on the users. Martani et al . (2021) provide new evidence on the impact of audit tenure and rotation on audit quality. Their study concludes that an insignificant relationship exists between audit tenure and audit quality. It was discovered that mandatory audit firm rotation for non-big 4 audit firms is very necessary to improve the quality financial reporting (QFR) since they are constrained by the limited number of partners. Unlike the big 4, QFR will improve with audit partner rotation because they have a sufficient number of partners to rotate with varied skills, competence, and experience. Cular et al . (2020) examined the effect of an internal auditor’s engagement in risk management consulting on external auditors’ reliance decisions. Findings from the study indicate that the external auditor’s reliance on the internal audit supportive function is at its peak when the internal auditor renders risk management services under the supervision of a strong audit committee. However, reliance on the work of the internal auditor is largely dependent on the perception of the external auditor as to its independence and the objectivity of its report. Yakubu and Williams (2020) examined the effect of auditor’s independence on the quality of audit. They opined that where auditors exert more efforts in conducting a rigorous audit, it promotes independence and attracts higher fees. Similarly, mandatory auditor’s rotation promotes independence and, therefore, improves both financial report and audit quality. Bassey et al . (2020) tested whether the interaction between auditors’ independence impacts the audit quality. The outcome of the study shows that audit fees have a significantly negative effect on audit quality, while auditor’s rotation and audit tenure have a negative influence on the quality of the audit. This suggests that low audit fees beyond the acceptable benchmark will significantly reduce the International Journal of Management, Economics and Social Sciences 93 audit quality, while auditor’s rotation and audit tenure do not improve the quality of audit in any way. Marques et al . (2019) conducted a qualitative study on auditor’s independence and the perceptions of auditors. The outcome of the study suggests that auditors’ non-audit services and tenure are major factors impeding auditor’s independence, while rotation and exposure to litigation are considered as incentives to improve independence and consequently the quality of financial reporting. The conclusion lacks empirical findings; hence the outcome cannot be generalized. Argento et al . (2018) examined the reliance on the work of internal auditors (IAs) by external auditors. The study shows that the professionalism and independence of IAs might be questioned. Therefore, relying on the work of IAs may affect audit quality. However, the study concludes that the external auditor’s professionalism prevails over the emotions, communication, and body chemistry of the IAs. Nwanyanwu (2017) analyzed financial reporting and audit quality in Nigeria through a survey design. The outcome of the study establishes that there exists a statistically significant positive relationship between the auditor’s independence and the reliability of financial reports at a 0.01 level of significance. The study draws evidence from auditing firms, which makes the results inadequate to generalize, especially in the public sector. The study also lacks theoretical underpinnings. This position is in consonance with Animasaun and Adegbite (2016), who concluded that the longer the tenure of an audit firm, the greater the extent of both financial and non-financial bonding (economic bonding hypothesis), which poses a major threat to auditor’s independence. The study is flawed on the premise that it stated several theoretical underpinnings without identifying and applying any to the study. The use of diagrams along with the tabular schedule makes the study cumbersome and unnecessarily bulky. The findings of Babatolu et al . (2016) are consistent with those of Adeyemi and Okpala (2011). The outcome projects that there is a positively significant relationship between audit fees, audit firm rotation, and audit quality. Audit firm rotation curtails familiarity threat and the shorter the auditor’s tenure, the more valuable the audit is likely to be. Tepalagul and Lin (2014) conducted comprehensive academic research concerning auditor independence and audit quality. The study was analyzed based on articles that were published from nine (9) leading auditing journals in the period of 1976 to 2013. It is drawn out from the study that four main issues can pose a threat to auditor’s independence. They are client importance and its affiliation with the audit firm, auditor tenure, and the provision of non-audit services. The research is conceptual and does not have empirical evidence; however, it is useful for boosting the literature on auditor independence. Okolie (2014) contends the outcome by supporting the expertise hypothesis, that the longer the Okunola 94 better as it checkmates the opportunistic behaviors of the management. Empirical evidences were extracted from quoted companies. As a result, the study’s findings cannot be used to form a broad opinion about the public sector. The use of discretionary accrual affects judgment because it is exposed to human manipulation. Likewise, the study lacks theoretical foundations to compliment the research output. Supportively, Amake and Okafor (2012) argued that when tenureship is prolonged, it is not an indication that the auditor’s independence will be compromised, rather brings about the display of expertise in the approach to audit assignment. Adeyemi and Okpala (2011) investigated the impact of an auditor’s independence on financial reporting in Nigeria. The results show that the quality of external audits would be weakened where auditors sourced loans from their client organizations, and as such, the auditor’s independence is impaired. The outcome was criticized on the grounds that it had no theoretical underpinnings to support the findings. The study has developed two null hypotheses arising from the literature above on the auditor’s independence and the quality of financial reporting: H01: Auditor’s independence does not have significant effect on the fundamental qualitative characteristics (FQC) of reporting quality. H02: Auditor’s independence does not have significant effect on the enhanced qualitative characteristics (EQC) of reporting quality. METHODOLOGY -Sample and Procedure The study adopted both survey research through questionnaire administration and content analysis of the audited financial statements. The survey focused mainly on investigating the effect of the auditor’s independence on the financial reporting quality of some selected Lagos State Parastatals. Data on the dependent variables were extracted from the published audited financial statements of sixty-three (63) audited financial statements of the selected parastatals for six (6) consecutive years, totaling 378 audited financial statements. The dependent variable adopts Nijmegen Center for Economics (NiCE) instrument as developed by Beest, Braam and Boelens (2009) and IASB (2008) quality indicators and adopted by Braam and Beest (2013), Puspitasari and Yurisandi (2015), Mbobo and Ekpo (2016) and Kisaku (2017); however, with slight modifications to meet the requirements of Lagos State its usage is scarcely found in the public sector. The study considered four items from R1 to R4 for relevance (R); four items from FR1 to FR4 for faithful representation (FR); three items from V1 to V3 for verifiability International Journal of Management, Economics and Social Sciences 95 (V), four items from U1 to U4 for understandability (U); four items from C1 to C4 for comparability (C) and one item for timeliness (T). Relevance and faithful representation represent the fundamental qualitative characteristics (FQC) while verifiability, comparability, understandability, and timeliness make up the enhanced qualitative characteristics (EQC). The dependent variable qualities were analysed by answering YES or NO as to the compliance of the audited financial statements. While the questionnaire was administered to six (6) senior officers from each of the selected parastatals, totaling three hundred and fifteen (378) respondents, but only two hundred and ninetyseven (297) were found valid. The study sample on auditor’s independence was selected using purposive sampling, with four questions asked for each of the proxies. The independent variable was proxied on auditor’s personal interest, reliance on internal auditors, qualified audit opinion, and auditor’s rotation. This study covered the activities of selected parastatals within the public sector of Lagos State from 2014-2019. This period was selected on the premise that Lagos state public service adopted the Audit Law of 2011 in 2012, which repealed the 64-years old 1956 Audit Act of the Federal Republic of Nigeria. The State began compliance with International Public Sector Accounting Standards (IPSASs) in 2016 (accrual accounting), although necessary apparatus had been deployed to ensure the State’s compliance with IPSAS since 2014 (Alamu, 2014; Oyewobi, 2019). The choice of Lagos was also influenced by the fact that it is the commercial nerve-center of Nigeria with the highest foreign and domestic debt of over $1.45 billion (Debt Management Office, 2018) and ranks first as the state with the highest internally generated revenue (IGR) of N268.2b (National Bureau of Statistics, 2018). -Model The principal-agent relationship as posited by the agency theory provided the hypothesis that connects the auditor’s independence with the quality of financial reporting. The binary logistic regression (BLR) was employed to analyze the effect of auditor’s independence on the quality of financial reporting. The BLR was chosen because it helps in establishing the relationship that subsists between binary or dichotomous dependent variables as abstracted from the work of Ezenwoke (2017). This study, however, deviated from Ezenwoke (2017) by focusing on the auditor’s personal interest, reliance on the work of the internal auditor, issuance of a qualified audit report, and auditor’s rotation. The BLR model is presented as follows: FQCit=β0+β1APINit+β2RINAit+ β3QAOPit+β4AUDRit+µit……(i) EQCit=α0+α1APINit+α2RINAit+α3QAOPit+α4AUDRit+  it ……(ii) where: Okunola 102 non-availability of data for the prior period and non-preparation of audited accounts for the parastatals as due. Another shortcoming of this study is in the fact that Ministries, Departments and Agencies (MDAs) are not considered for analysis, and this is so because some of the variables used are not available for the MDAs. It is also noteworthy that the study focusses on Lagos State only without considering the remaining 35 states of the Federal Republic of Nigeria. The current study is centered on the auditor’s independence and the financial reporting quality within the Lagos State Parastatals. However, an avenue for further research is to look at the effects of corporate governance practices and financial reporting quality within the public sector context. A comparative analysis of the quantitative financial reporting quality can be carried out to determine whether a similar or a contradictory result will be arrived at. 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Corporate Ownership and Control , 17(2): 124-141. https://doi.org/10.22495/cocv17i2art11 International Journal of Management, Economics and Social Sciences 105 Appendix-I Response Rate Frequency Percentage (%) Valid 297 78.6 Invalid 12 3.2 Not returned 69 18.3 Total 378 100.00 Rank/ Cadre of the Respondents Frequency Percentage (%) Internal Auditor IISenior Internal Auditor 140 47.1 Principal Internal AuditorChief Internal Auditor 125 42.1 Assistant Director (Audit)- Director (Audit) 25 8.4 Auditor General (LS) 2 0.7 Others 5 1.7 Gender of the Respondents Frequency Percentage (%) Female 142 47.8 Male 155 52.2 Academic Qualifications Frequency Percentage (%) High School 11 3.7 OND 21 7.1 HND 81 27.3 B.Sc. 147 49.5 MBA/MSc. /MA 37 12.5 Source: Author’s computation Table 1. Demographic Distribution of the Respondents Okunola 106 Appendix-II SN Questions 5 (%) 4 (%) 3 (%) 2 (%) 1 (%) Mean SD 1 APIN 124 (41.8) 93 (31.3) 16 (5.4) 42 (14.1) 22 (7.4) 3.14 0.6500 2 QAOP 78 (26.3) 121 (40.7) 36 (12.1) 41 (13.8) 21 (7.1) 3.65 0.6035 3 RINA 88 (29.6) 94 (31.6) 43 (14.5) 45 (15.2) 27 (9.1) 2.10 0.5610 4 AUDR 152 (51.2) 96 (32.3) 24 (8.1) 9 (3) 16 (5.4) 4.21 0.5385 Source: Author’s computation Key:1=Strongly Disagree, 2=Disagree, 3=Undecided, 4=Agree, 5=Strongly Agree Table 2. Descriptive Statistics of Components of Auditor’s Independence International Journal of Management, Economics and Social Sciences 107 Appendix-III Indicator B S.E. Wald df Sig. Exp(B) Auditor's Personal Interest -.396 .072 29.778 1 .000 ٭ .673 Reliance on Internal Auditors -.034 .063 .287 1 .592 .967 Qualified Audit Opinion .199 .070 8.196 1 .004 ٭ 1.220 Auditor's Rotation .163 .082 3.964 1 .046 ٭ 1.177 Constant .322 .523 .379 1 .538 1.380 C&S R² 0.475 NR² 0.513 H-L Test 0.101 Source: Author’s Computation B= logistic regression coefficient; S.E.= standard error; Wald= Wald statistics; df= degree of freedom; Sig.= significance level; Exp(B)= odds ratio Table 3. Coefficients Binary Logistic Regression Results of Auditor’s Independence on Fundamental Qualitative Characteristics of Financial Reporting Okunola 108 Appendix-IV Indicator B S.E. Wald df Sig. Exp(B) Auditor's Personal Interest -1.369 .112 149.570 1 .001 .254 Reliance on Internal Auditors 0.579 .095 37.300 1 .001 1.783 Qualified Audit Opinion 0.192 .092 4.348 1 .037 1.211 Auditor's Rotation 0.171 .100 2.922 1 .087 1.186 Constant 0.925 .671 1.904 1 .168 2.523 C&S R² 0.475 NR² 0.513 H-L Test 0.101 Source: Author’s Computation B= logistic regression coefficient; S.E.= standard error; Wald= Wald statistics; df= degree of freedom; Sig.= significance level; Exp(B)= odds ratio Table 4. Binary Logistic Regression Results of Auditor’s Independence on Enhanced Qualitative Characteristics of Financial Reporting International Journal of Management, Economics and Social Sciences 109 Appendix-V Hypothesis Description Indicators Sig. Decision H01(a) Auditor’s personal interest does not have a significant effect on the financial reporting quality APIN on FQC .001 Reject H01(b) APIN on EQC .001 Reject H02(a) Reliance on internal auditor’s findings does not have any significant effect on financial reporting quality RINA on FQC .001 Reject H02(b) RINA on EQC .592 Accept H03(a) Issuance of qualified audit opinion does not significantly affect financial reporting quality QAUR on FQC .004 Reject H03(b) QAUR on EQC .037 Reject H04(a) Auditor's Rotation does not significantly affect financial reporting quality AUDR on FQC .046 Reject H04(b) AUDR on EQC .087 Accept Source: Author’s presentation Table 5. Summary of Results