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The Effect of Auditing Quality Characteristics on
Accounting Conservatism: The case of Egypt
A Thesis Submitted to the Investment and Finance Institute in
Partial Fulfillment for the Degree of
Master of Science
In
Investment
Submitted By
Yasmine Hassan Ahmed
Supervised By
Prof. Dr. Ayman Ragab
Dr. Amr Abdel Aziz
2016
ii
Copywriter
This copy of the thesis has been supplied on condition that anyone who consults it is
understood to recognize that its copyright rests with its author and that no one quotation
from the thesis and no information derived from it may be published without the
author’s prior consent.
iii
Discussion Committee
Prof. Dr. Abdel Wahab Naser (External Examiner)
Prof. Dr. Mohamed Mostafa (Internal Examiner)
Dr. Amr Abdel Aziz (Supervisor)
iv
Author’s Declaration
At no time during the registration for the Master degree has the author been registered
for any other university award.
This thesis has a word count of 20,000 words.
Signature
Date 3/10/2016
v
Acknowledgement
I want to start by thanking God for this accomplishment and all previous and coming
ones inshallah, cause without his help and protection I would not have achieved any of
my dreams or plan.
It is with sincere pleasure to acknowledge the help of my supervisor Prof. Dr. Ayman
Ragab and also I want to thank Dr. Amr Abdel Aziz for his outstanding supervision,
patience, guidance, comments, encouragement, valuable advice and immense
knowledge. Dr. Amr Abdel Aziz always helped me if I had any inquiries about my
research or writing. I would also like to thank Prof. Dr. Mohamed Mostafa for his help
during my initial steps on this thesis. I would also like to thank Dr. Mohamed Bahaa for
his influential advice.
I am grateful to my colleagues in the Finance and Accounting department for their
continuous help and support specially Nihal Abo Doma, Marwa Darwish, Sara Wahid
and Rabab Khamis really without their assistance my way on the thesis would not have
been clear.
Finally, I must express my very profound gratitude to my parents, to my sister and to
my brother for always supporting me and believing me and I would express my deepest
gratitude especially to my fiance for providing me with unfailing support and
continuous encouragement throughout my years of study and through the process of
researching and writing this thesis. This accomplishment would not have been possible
without them. Thank you.
vi
Dedication
I would like to dedicate this thesis to the best father, who encouraged
me and was always there for me through my ups and downs. To the
most compassionate mother, who was completely supportive and
devoted her life to watch me grow in excellence. They loved me
unconditionally and whose good examples have taught me to work
hard for the things that I aspire to achieve. To my dearest sister, who is
an inspiration and is the main reason for me to face all the obstacles
with strength and will power to pursue my goal. To my brother, whose
presence reminded me of what actually mattered in life. Finally, I
would like to specially dedicate this thesis to my fiance, whose integrity
and patience made me realize my true potential. I was fueled by hid
external drive and passion. I am truly grateful for the contributions
and sacrifices he made to me so I can be in my current status.
vii
Abbreviations
AACF Asymmetric Cash Flow to Accruals Measure
AICPA American Institute of Certified Public Accountants
APB Accounting Principles Board
AT Asymmetric Timeliness Measure
CIMA Chartered Institute of Management Accountants
FASB Financial Accounting Standards Board
FRC United Kingdom Financial Reporting Council
GAAP Generally Accepted Accounting Principles
HR Hidden-Reserves Measure
IAASB International Auditing and Assurance Standards Board
IASB International Accounting Standards Board
IFAC International Federation of Accountants
IFRS International Financial Reporting Standards
MTB Market-to-Book Ratio
OLS Ordinary Least Squared
PCAOB Public Company Accounting Oversight Board
SEC Stock and Exchange Commission
SPSS Statistical Package for Social Science
CPA Certified Public Accountant
GAO Government Accountability Office
viii
The Effect of Auditing Quality Characteristics on Accounting
Conservatism: The case of Egypt
Yasmine Hassan Ahmed
ABSTRACT
The growing issues on the quality of audit and accounting conservatism have long been
regarded and seemed as a hot debated since both could impact on the capital market
efficiency. Prior literature on accounting conservatism examines the effect of audit
quality on conservatism show mixed results about this relationship, in this study, the
researcher extend previous studies by investigating the impact of the audit quality which
is measured by audit firm size and auditor tenure on the enhancement of the level of
accounting conservatism in the financial reports of the most active 50 non-financial
companies listed in the Egyptian stock exchange across nine years of period from 2007
to 2015.
After controlling for company size, leverage and profitability, in this study, OLS
regression analysis is used to explore the relationship between audit quality and
accounting conservatism from the most active 50 Egyptian companies listed on the
Egyptian Stock Exchange of the non-financial sector during the period 2007-2015. The
results after removing the outliers revealed that, audit firm size has significant positive
relationship with accounting conservatism, which enhances the rule of big audit firms in
the quality of financial reports. On the other hand, auditor tenure has insignificant
relationship with accounting conservatism. Based on these results, the study provided
recommendations to the interested parties.
The empirical results of this study provide support to corporate managers in increasing
the awareness of audit quality and therefore achieving a superior level of Conservatism
for companies in emerging countries such as Egypt.
ix
Table of Contents
Copywriter ………………………………………………………………………………ii
Discussion Committee ……………………………………………………………….....iii
Author’s Declaration
……………………………………………………………………iv
Abbreviations
…………………………………………………………………………...vi
Abstract
………………………………………………………………………………...vii
Chapter 1: Introduction
1.1 Preface
……………………………………………………………………………….1
1.2 Research Background
………………………………………………………………..1
1.3 Research Problem
……………………………………………………………………6
1.4 Research Aim and Objectives
………………………………………………………..7
1.5 Research Importance
………………………………………………………………...8
1.6 Research Question
…………………………………………………………………...8
1.7 Research Hypotheses
………………………………………………………………...9
x
1.8 Thesis Outline
………………………………………………………………………..9
Chapter 2: Literature Review
2.1 Introduction
………………………………………………………………..…….…11
2.2 Auditing Quality
……………………………………………………………..….….11
2.2.1 The Concept of Audit Quality
……………………………………………....…..13
2.2.2 Types of Audits
…………………………………………………………...........17
2.2.3 Types of Auditors
………………………………………………………………17
2.2.4 Types of Audit Reports ………………………………………………………...18
2.2.5 Significance of Auditing Quality in the Audit Services Market
………………..20
2.2.6 Audit Quality Decline Factors
……………………………………………….…22
2.3 Accounting Conservatism ………………………………………………………….24
2.3.1 Accounting Conservatism Concept
………………………………………….…25
2.3.2 Types of Accounting Conservatism
…………………………………………….29
2.3.2.1 Ex-ante Conservatism and Ex-post Conservatism
……………………..…...30
xi
2.3.2.2 Earnings Conservatism and Balance Sheet Conservatism
……………....…30
2.3.2.3 Conditional and Unconditional Conservatism
………………………….…..31
2.3.3 Accounting Conservatism Motivations
……………………………………..….32
2.3.3.1 Contracting Motivation ………………………………………………….…32
2.3.3.2 Litigation Motivation ………………………………………………………34
2.3.3.3 Taxation Motivation
…………………………………………………….….34
2.3.3.4 Regulation Motivation
……………………………………………………...35
2.3.4 Measures of Accounting Conservatism
…………………………………….…..35
2.3.4.1 Basu's (1997) Asymmetric Timeliness Measure
……………………….…..36
2.3.4.2 Beaver and Ryan (2000) - Market-to-Book Ratio
……………………….....36
2.3.4.3 Givoly and Hayn (2000) - Cumulative Negative Non-operating
Accruals….37
2.3.4.4 Penman and Zhang’s (2002) Hidden-Reserves Measure
…………………..37
2.3.4.5 Ball and Shivakumar’s (2005) Asymmetric Cash Flow to Accruals
Measure……………………………………………………………………………..….37
2.4 Relationships between Audit quality and Accounting Conservatism
……………...39
xii
2.4.1 Audit Firm Size
………………………………………………………………...39
2.4.2 Auditor Tenure
……………………………………………………………........40
2.5 Moderator Variables
……………………………...…………………………..…….41
2.5.1 Firm Size ……………………………………………………………………….41
2.5.2 Firm’s Financial Leverage
……………………………………………………...42
2.5.3 Firm’s Profitability
……………………………………………………………..42
2.6 Summary …………………………………………………………………………...43
Chapter 3: METHODOLOGY AND EMPIRICAL STUDY
3.1 Introduction
………………………..…………………………………………….…44
3.2 Research Strategy
……………………………..…………………………………....44
3.3 Methods of Statistical Analysis
……………………………………………..….…..45
3.4 Sample Selection and Data collection
……………………………………………....45
3.5 Variables Measurements and Measurments
…………………………………….….48
3.5.1 Dependent variable
……………………………………………………………..49
xiii
3.5.2 Independent Variables
……………………………………………………….…51
3.5.2.1 Audit Firm Size
……………………………………………………….…....52
3.5.2.2 Auditor Tenure
………………………………………………………….….53
3.5.3 Moderator Variables
…………………………………………………………....54
3.5.3.1 Firm Size …………………………………………………………………...54
3.5.3.2 Firm's Financial Leverage
……………………………………………….…54
3.5.3.3 Firm’s Profitability
………………………………………………………....55
3.6 Research Model
………………………………………………………………….…56
3.7 Summary …………………………………………………………………………...57
Chapter 4: Findings and Analysis
4.1 Introduction
………………………..…………………………………………….…58
4.2 Descriptive Statistics
…………………………………………………………….....58
4.3 Correlation Analysis
…………………………………………………………….….60
4.4 Regression Analysis
…………………………………………………………….….62
4.5 Removing Outliers …………………………………………………………………65
xiv
4.6 Correlation Analysis after Removing Outliers
………………………………….….68
4.7 Regression Analysis after Removing Outliers
……………………………………...70
4.8 Summery …………………………………………………………………………...73
Chapter 5: Conclusion and Recommendations
5.1 Introduction
………………………………………………………………………...74
5.2. Conclusion
……………………………………………………………………..…..75
5.3 Limitations …………………………………………………………………………77
5.4 Recommendations
………………………………………………………………….78
5.5 Suggestions for Future Research
…………………………………………………...79
xv
List of Tables
Chapter 2
Table 2-1 Summary of Hypotheses
……………………………………………….…….43
Chapter 3
Table 3-1 Study Sample
……………………………...……………………….………..47
Table 3-2 Sample Sector Classification
……………………………………….………..48
Table 3-3 Variables Definition and Its Measurements
……………………….………...56
Chapter 4
Table 4-1 Descriptive analysis for study variables
………………………….………….59
Table 4-2 Correlation Results - Pearson Correlation Matrix
………………..…………..61
xvi
Table 4-3 Correlation between accounting conservatism with other independent
variables
………………………………………………………………………………………….62
Table 4-4 Model Summary b
……………………………………………………….…...64
Table 4-5 ANOVA a
……………………………...……………………………….……64
Table 4-6 Coefficients a
………………………………………………………….……..64
Table 4-7 Hypotheses Test Results
…………………………………………….……….65
Table 4-8 Correlations after removing outliers
……………………………….………...69
Table 4-9 Correlation between accounting conservatism with other independent
variables after removing outliers
………………………………....………………………………70
Table 4-10 Model Summary b (after removing outliers)
….……………………………71
Table 4-11 ANOVA a (after removing outliers)
………….…………………………….72
Table 4-12 Coefficients a (after removing outliers)
……….……………………………72
Table 4-13 Hypotheses Test Results after removing Outliers
…….……………………72
xvii
List of Figures
Chapter 3
Figure 3-1 Conceptual Framework
…………………………………….…………….....49
Chapter 4
Figure 4-1 Box Plot Diagram
………………………………………….………………..66
Figure 4-2 Box Plot Diagram
………………………………………….………………..66
Figure 4-3 Box Plot Diagram
………………………………………….………………..67
Figure 4-4 Box Plot Diagram
………………………………………….………………..67
Figure 4-5 Box Plot Diagram
………………………………………….………………..68
References
………………………………………………….…………….81
xviii
1
CHAPTER ONE: INTRODUCTION
1.1 Preface
An independent and skillful audit firm is able to recognize misrepresentation of
addressed financial statements, and can be effective on its correct presentation to its
employer so that the reliable financial information is reported. To achieve this, the
desired objective completely depends upon the attributes of audit institutions which can
positively or negatively be associated with audit quality. According to Titman and
Truman (1989), audit with more quality improves the credibility of the provided
information and let investors obtain more accurate estimation from the company’s
value, and its effect on accounting conservatism should be tracked explicitly
(PourKarim, 2009).
This study highlights whether the audit quality affects companies accounting
conservatism practices that are listed on the Egyptian stock exchange, and the
relationship between audit quality and accounting conservatism is analyzed empirically
through correlation and regression analysis. Therefore, this chapter will provide an
overview for the research, and the sections included in this chapter start with research
background followed by the research problem, aim and objectives, in addition to the
research importance, question and finally hypotheses.
1.2 Research Background
There are general rules and concepts that govern the field of accounting. For
instance Generally Accepted Accounting Principles (GAAP), GAAP consists of three
important sets of rules: (1) the basic accounting principles and guidelines, (2) the
detailed rules and standards issued by FASB and its predecessor on the Accounting
2
Principles Board (APB), and (3) the generally accepted industry practices (Francis et al.,
2013).
GAAP is exceedingly useful because it attempts to standardize and regulate
accounting definitions, assumptions, and methods. Because of generally accepted
accounting principles, it is assumed that there is consistency from year to year in the
methods used to prepare any company's financial statements, but over the years the
generally accepted accounting principles have become more complex because financial
transactions have become more complex (Ernst and Young, 2012).
The basic accounting principles and guidelines form the groundwork on which
more detailed, complicated, and legalistic accounting rules are based. For example,
the Financial Accounting Standards Board (FASB) uses the basic accounting principles
and guidelines as a basis for their own detailed and comprehensive set of accounting
rules and standards. The following is a set of the ten main accounting principles and
guidelines: Economic Entity Assumption, Monetary Unit Assumption, Time Period
Assumption, Cost Principle, Full Disclosure Principle, Going Concern Principle,
Matching Principle, Revenue Recognition Principle, and finally Materiality and
Conservatism.
On the same context, the adoption of International Financial Reporting
Standards (IFRS) represents one of the most significant regulatory changes in financial
reporting. The International Accounting Standards Board (IASB) has succeeded in
establishing IFRS as the accepted set of financial reporting standards in more than 100
countries, with the primary objective of developing a single set of high quality,
understandable, enforceable and globally accepted financial reporting standards (IASCF
Constitution, part 2). These standards should help investors and other market
participants to make informed resource allocation and other economic decisions (IFRS
Foundation, 2011). In compliance with the European Commission Regulation
3
1606/2002, since 2005 all listed firms in the European Union must prepare their
consolidated financial statements according to IFRS, in order to contribute to the
convergence of accounting standards around the world, and thus improve information
quality for investors and enable a better functioning of the financial markets (Cutillas-
Gomariz el al., 2016).
On the other hand, use of the title Certified Public Accountant (CPA) is
regulated by state law through the licensing departments of each state. Within any state,
the regulations usually differ for becoming a CPA and retaining a license to practice
after the designation has been initially achieved (Arens et al., 2014).
As noted before, the conservatism principle is one of the most significant and
longstanding principles in the accounting, Watts (2003) described conservatism
principle as the general concept of recognizing expenses and liabilities as soon as
probable when there is an uncertainty about the outcome in order to only recognize
revenues and assets when they are assured of being received. This tends to yield more
conservative reporting of profits and losses. So under the conservatism principle, if
there is an uncertainty about incurring a loss, you should tend to take it into
consideration by making allowances and reserves. Conversely, if there is an uncertainty
about recording a gain, you should not record the gain, till it is recognized.
There are many definitions for conservatism in accounting literature, for
example Basu (1997) defined conservatism as having a high degree of confirmation to
recognize good news such as profit, against recognition of bad news such as loss. This
definition describes conservatism from its profit and loss view. Another definition is the
balance sheet view. According to this view, when there is a doubt about selection of
several reporting methods, the method selected has the least desirable effect on rights of
stockholders (Feltham and Ohlson, 1995). The third definition is the combinational
view of balance sheet besides profit and loss. By this view, conservatism is an
4
accounting concept that causes decrement of reported accumulated profit by late
recognition of income and early recognition of cost (Givoly and Hayn, 2000).
The need for conservatism is suggested with agency theory, through which
problems between managers and stakeholders about the separation of management and
ownerships can be solved. This issue was discussed by Watts (2003) with the
assumption that the financial reports published by managers were conservative, and
shareholders may reduce salary of managers to compensate the difference by their
attention to their personal interests. To prevent this situation, managers may provide
more conservative volume as a sign of their lack of attention to their own personal
interests (Pashaki and Kheradyar, 2015).
In recent years, there have been many critical changes in the business
environment; mainly these changes resulted from the collapse of accounting scandals,
e.g. Enron 2001, WorldCom 2002, and Adelphia 2002. These scandals brought a
question about the effectiveness of the management in companies, and whether
companies work for the best interest of shareholders or not. These events have led to
increasing calls for an increase of the quality and effectiveness of the auditing process
(Farinha, 2003).
Many of the accounting scandals and breakdowns in financial markets have
emerged in recent years, but the most important results, which were not expected for
these events, increased awareness of the importance of the role of auditing, and many of
the parties realized the crucial role played by the audit in the performance of financial
markets (Abu-Ijela and Hamdan, 2010). On the other hand, the number of audit failures
declared, as evidenced by the lawsuits and penalties imposed by the Stock and
Exchange Commission (SEC) are very small, having an annual failure rate close to zero
(DeFond and Francis, 2005).
5
The Stock and Exchange Commission (SEC), an agency of the federal
government, assists in providing investors with reliable information upon which to
make investment decisions. The SEC has considerable influence in setting generally
accepted accounting principle (GAAP) and disclosure requirements for financial
statements as a result of its authority for specifying reporting requirements considered
necessary for fair disclosure to investors (Arens et al., 2014).
However, there is no agreement on the concept of the auditing quality. Both of
the International Federation of Accountants (IFAC) and American Institute of Certified
Public Accountants (AICPA) failed to introduce an explicit concept of the auditing
quality. However, there are several attempts to define the quality of the auditing,
including the concept of auditing quality being defined as the external auditor which
detects an anomaly in financial statements and then reveals it to the users of these
statements (DeAngelo, 1981).
Issa (2008) defined audit quality as the ability of audit process to detect and
report important falsification of financial statements as well as to reduce asymmetry of
information between managers and stakeholders that are relevant to the level of quality
of information in financial statements. Also, Deis and Giroux (1992) argued that the
auditing quality is the auditor's ability to detect weaknesses and gaps in the accounting
system for the client and the reporting. However, Copley and Doucet (1993) went in
another direction by defining the auditing quality as the application of professional
standards related to field work and reporting standards. The audit quality is a set of
methods and techniques that work to reduce errors and fraud, and it is supported
through access to sufficient and convincing evidence in order to protect the interests of
relevant parties (Abu Ijela and Hamdan, 2010). The probability of detection is a matter
of competence, whereas the probability of revelation depends on the independence of
6
the auditor, i.e. his/her willingness to face the pressure exerted by the producers of
financial statements (Piot and Janin, 2005).
As noted before, the growing issues regarding the quality of audit and
accounting conservatisms have long been regarded and seemed as a hot debate since
both could impact the capital market efficiency. This study tried to answer whether
audit quality, characterized by audit firm size and auditor tenure, of firms listed in Egypt
Stock Exchange could have a significant effect on accounting conservatism in financial
reporting quality. Based on previous studies, the relationship between conservatism and
one of the attributes of audit quality, such as audit firm size or auditor’s tenure, have
been separately examined. This study aimed to investigate the effect of several
attributes of audit quality such as audit firm size and auditor tenure on accounting
conservatism, taking into consideration three control variables which are firm size,
profitability and leverage.
1.3 Research Problem
Based on a conflict of interests between owners and management, as well as
collapse of accounting scandals, e.g. Enron 2001, WorldCom 2002, and Adelphia 2002,
shareholders doubt the credibility and reliability of the financial reports. So, audit
quality and accounting conservatism appear in current business environment as tools to
solve this conflict and decrease agency cost, consequently many authors tried to study
the relationship between audit quality and accounting conservatism, to enhance
financial statement quality and contribute in solving agency problem, but the results of
these studies are mixed about the relationship between audit quality and accounting
conservatism and not agreed upon the significance and direction of the relationship
among audit quality attributes and accounting conservatism, for instance Pashaki and
Kheradyar (2015) and Hamdan et al. (2012) support this claim, Therefore, the study will
7
contribute to the clarification of the relationship between audit quality and accounting
conservatism in the Egyptian firms by collecting data over the period 2007-2015 of 50
companies, the most active companies in the Egyptian stock exchange.
1.4 Research Aim and Objectives
The overall aim of this research is to advance an understanding of the effect of
the audit quality, which is characterized by audit firm size and auditor tenure, on the
most 50 active companies in the Egyptian stock exchange in relation to accounting
conservatism of these companies, and an understanding of whether audit quality has a
significant effect on the financial reporting quality in the Egyptian business
environment for non-financial companies listed in the Egyptian stock exchange across
nine years of period from 2007 to 2015. The reason behind the exclusion of financial
companies from the sample due to the differences in the regulatory tax requirements and
the characteristics of the financial reports from those of the non-financial companies
(Alsaeed, 2006). According to Mehran et al. (2011), there is a main dissimilarity in
governance in the financial and non-financial sectors. The complexity of the financial
sectors, particularly the banking sector causes a difficulty of implementing formal
regulations. Due to the differences in regulations between banks and non-financial
firms, this study excludes the financial firms (Wilson et al., 2010).
The research should provide a basis for the firms in Egypt as to how they can
increase firm's accounting conservatism by achieving the following objectives:
Outlining the different explanations for audit quality.
8
Outlining the different explanations for accounting conservatism and its main
determinants.
Assessing and examining the relationship between audit quality and accounting
conservatism.
1.5 Research Importance
The importance of this study emerges from two main aspects; firstly, the
literature review that will provide a meaningful discussion of the audit quality and its
effect on financial reporting quality. Secondly, an analysis of the existence of audit
quality in different firms will be provided to show the consistency and divergence of the
results across firms. From this analysis, the conflicting results about the effect of audit
quality on accounting conservatism will arise. This study aims to investigate the effect
of attributes of audit quality such as audit firm size and auditor tenure on accounting
conservatism by focusing on the Egyptian firms during the period of 2007-2015 with
the use of secondary data by analyzing and explaining whether audit quality has an
effect on conservatism, and whether this effect, if exists, tends to be positive or
negative. The empirical results will be compared to the previous results across different
studies to see whether they are consistent or contradicting and finally identify the
features of similarity and differences among the Egyptian firms in this study and other
studies of different samples. As a consequence the results will be beneficial practically
to firms in identifying the audit quality that will attempt to reduce the agency-related
problems in the company and improve the firms' accounting conservatism.
1.6 Research Question
9
The research’s question expected to be answered by the end of this study is:
"Does audit quality have a significant effect on accounting conservatism of the most
active 50 firms listed in the Egyptian stock exchange that will lead to a better financial
reporting quality?”. Also examine if client characteristics (firm size, firm profitability,
and firm financial leverage) affecting accounting conservatism.
1.7 Research Hypotheses
According to the research question mentioned in the prior section, the following
hypotheses are to be tested throughout the study:
H1: It is expected that the conservatism level of the companies audited by a larger audit
companies will be greater.
H2: It is expected that conservatism level of the companies having a longer relationship
between the auditor and the client will be lower.
1.8 Study Outline
This study focuses on analyzing how the audit quality can affect the level of accounting
conservatism. It consists of five chapters which are organized as follows:
Chapter 1: Introduction
This chapter introduces the idea behind the study and explains the background of the
study as well as the hypotheses to be tested. It also clarifies the main focus of the
research along with the research question. Other very important points are mentioned in
this chapter which are: the research aim, its objective and its value. Finally, this chapter
clarifies the research outline and shows the organization of this research.
11
Chapter 2: Literature Review
After providing an overview about the topic, literature review comes with the analysis
of the previous studies, provides all the prior literature that is in the same area of study
and highlights the relation between the independent variable which is the firm’s audit
quality and the dependent variable which is accounting conservatism. And finally, some
of the confounding variables affecting this relationship are presented.
Chapter 3: Research Methodology
This chapter reviews the methods used in this research company to other studies in the
same area and how different variables were measured. In addition, the methodology
chapter explains how the research is conducted, the data is obtained, and the particular
methods are used. It requires a detailed description of the research processes and
procedures as well as an explanation of the reasons for doing so.
Chapter 4: Findings and Analysis
This chapter presents the research findings and analyses after conducting descriptive,
correlative and regressive analysis; also it concludes the results with the highlight on
specific outcomes for the reader’s attention, provides evidence (e.g. statistics,
examples), frequently presents information visually (e.g. graphs, tables, and figures) and
finally represents the results and links them to the hypotheses previously formulated in
the literature review.
Chapter 5: Conclusion and Recommendations
This chapter provides a conclusion regarding the findings of the tests performed to
study the impact of audit quality and accounting conservatism on the most active firms
listed in the Egyptian stock market. Moreover, the findings are related to the findings of
11
prior research in the same area. In addition, the limitations that constrained this study
are mentioned in this chapter as well as some recommendations on how to improve this
study in the future.
12
CHAPTER TWO: LITREATURE REVIEW
2.1 Introduction
After providing an overview on the study's aim and problem in the previous
chapter, this chapter discusses some issues that are related to the concept of accounting
conservatism, as well as the concept of audit quality, besides the relationship between
these two concepts and the reasons behind this relation. Also, the hypotheses of the
research are mentioned after each section explaining the relation between an
independent variable (audit quality) and the dependent variable (accounting
conservatism).
The chapter is made up of three sections as follows: the first section provides a
detailed review on audit quality, the second section provides a review on accounting
conservatism, and the last section provides a review about the relationship between
audit quality and accounting conservatism.
2.2 Auditing Quality
Audits can be considered a type of assurance service. However, audits are only
designed to test the validity of the financial statements, and are subject to regulation
under International Standards on Auditing. Assurance engagements designed to test
historical financial information are referred to as assurance reviews (these are regulated
by International Standard on Review Engagements (ISRE 2400), but assurance reports
can be obtained over many other subject matters and will then be subject to ISAE 3000
or other individual Standards on Assurance Engagements Copley et al. (2009).
Under an assurance engagement, accountants can provide a variety of services
ranging from information systems security reviews to customer satisfaction surveys.
13
Unlike audit and attestation services that are often highly structured, assurance services
tend to be customized and implemented when performed for a smaller group of decision
makers within the firm. Often managers must make decisions on things they have
incomplete or inaccurate data for, and decisions made on such data may be incorrect
and increase the overall business risk. In this respect, assurance services can be very
helpful in reducing such risk and help managers or decision makers make more
confident decisions within a given firm. This is similar to audits in that investors will
choose to invest in a firm that is publishing financial statements that have been audited
by an independent firm (Ruhnke and Lubitzsch 2010).
Therefore, assurance service is an independent professional service, typically
provided by Chartered or Certified Public Accountants or Chartered Certified
Accountant, with the goal of improving information or the context of information so
that decision makers can make more informed, and presumably better, decisions.
Assurance services provide independent and professional opinions that reduce
information risk (risk from incorrect information). Other examples of assurance services
include: accounts receivable review, business risk assessment, comfort letter, customer
satisfaction survey, information system security, internal audit outsourcing and medical
billing services.
But CPA firms perform numerous other services that generally fall outside the
scope of assurance services, it is called non assurance services. There specific examples
are: accounting and bookkeeping services, tax services and management consulting
services, the primary purpose of a management consulting engagement is to generate a
recommendation to management (Arens et al., 2014).
Attestation service is type of assurance service in which the CPA firm issues a
report about a subject matter or assertion that is made by another party. Attestation
services fall into five categories: audit of historical financial statements, audit of internal
14
control over financial reporting, review of historical financial statements, attestation
services on information technology and other attestation services that may be applied to
a broad range of subject matter. CPAs also provide other assurance services that do not
meet the definition of attestation services, but the CPA must still be independent and
must provide assurance about information used by decision makers. These assurance
services differ from attestation services in that the CPA is not required to issue a written
report (Arens et al., 2014).
Recent financial conditions have highlighted the critical importance of
qualitative characteristics of useful financial information which are relevance and
faithful representation, so audit quality is frequently used to enhancing comparability,
verifiability, timeliness and understandability of financial information based on that.
The following section will review the concept of auditing quality besides the
significance of auditing quality in the audit services market and audit quality decline
factors.
2.2.1 The Concept of Audit Quality
There are many attempts to define the concept of audit quality either on
professional organizations level, or academic level. On the professional organizations
level: for example, International Federation of Accountants (IFAC) pointed to the
concept of auditing quality in the international standard on quality control. It stated that
“the objective of the audit firm is to establish and maintain a system of quality control to
provide it with reasonable assurance that: (a) The firm and its personnel comply with
professional standards and applicable legal and regulatory requirements; and (b) Reports
issued by the firm or engagement partners are appropriate in the circumstances” (IFAC,
2009). This means that the concept of quality from the perspective of (IFAC) lies in the
compliance with professional standards and legal and regulatory requirements.
15
In the same context, International Auditing and Assurance Standards Board
(IAASB) in its framework for audit quality mentioned that the purpose of an audit is to
enhance the degree of confidence of intended users in the financial statements. This can
be achieved through gathering sufficient appropriate audit evidence to express an
opinion on whether the financial statements are prepared, in all material respects, in
accordance with the applicable financial reporting framework. This indicates that
IAASB linked between auditing quality and audit evidence that used to express an
opinion about firms' financial statements according to financial reporting standards.
Furthermore, Public Company Accounting Oversight Board (PCAOB) in
auditing standard no. 7 - engagement quality review and conforming amendment to the
board's interim quality control standards stated that (1 ) the engagement team failed to
obtain sufficient appropriate evidence in accordance with the standards of the PCAOB;
(2) the engagement team reached an inappropriate overall conclusion on the subject
matter of the engagement; (3) the engagement report is not appropriate in the
circumstances; or (4) the firm is not independent of its client (PCAOB, 2009, p.18).
Based on PCAOB factors, affecting the quality of well-performed audit
engagement, audit quality can be seen as a process of gathering sufficient evidence
based on professional standards to achieve appropriate overall conclusion about firm’s
conformance with applicable reporting standards.
Moreover, the Supreme Audit Institutions of the European Union proposed the
instructions and guidance about auditing quality, pointing out that the concept of
auditing quality lies in the audit faculty achieving the following: high levels of quality
in effectiveness of the planning and execution of auditing and other related works, clear
demonstration of audit reports, objectivity and fairness of the given estimates and
opinions basis, the issuance of audit reports in a timely manner to the needs of potential
users, authenticity and reliability of the views or results, and appropriateness of the
16
recommendations and other matters included in the audit reports (SAIs of European
Union, 2004).
On the other hand, in the field of academic studies, it is clear that these studies
did not agree on one definition of the concept auditing quality. For instance, DeAngelo
(1981) has defined the auditing quality as “the market-assessed joint probability that a
given auditor will both (a) discover a breach in the client’s accounting system, and (b)
report the breach” (DeAngelo, 1981, p.186).
This means that audit quality is about the possibility of the auditor detecting and
honestly reporting the fundamental errors and misrepresentations in the financial
statements of the client. So, this ability to detect fundamental errors and
misrepresentations in the financial statements of the client depends on the efficiency and
eligibility of the auditor and technical capability while the possibility of the auditor
reporting fundamental errors and misrepresentations in the financial statements of the
client depends on the degree of the auditor independence.
Also, auditing is the accumulation and evaluation of evidence about information
to determine and report on the degree of correspondence between the information and
established criteria. Auditing should be done by independent person. The criteria for
evaluating information also vary depending on the information being audited. In the
audit of historical financial statements by CPA firms, the criteria may be U.S. generally
accepted accounting principles (GAAP) or International financial reporting standards
(IFRS). The means that in an audit of Boeing’s financial statements, the CPA firms will
determine whether Boeing’s financial statements have been prepared in accordance with
GAAP (Arens et al., 2014).
Several researchers such as Knapp (1991), Flint (1988), Moizer (1997), and
Lennox (2005) followed DeAngelo's idea about the concept of auditing quality, for
17
example Lennox claimed that auditing quality is measured by the possibility to detect
problems or the possibility of the auditor reporting the existing problems. Additionally
Chaney et al. (2003) clarified that the auditing quality lies in the efficiency or the
possibility of detecting violations, independence and the possibility of the auditor
honestly reporting the detected violations.
On the other hand, Lee et al. (1999) investigated the concept of audit quality
from other point of view; he defined auditing quality as the failure of the auditor to issue
a clean or non-conservative report for the financial statements that contain substantial
errors and misrepresentations. Also, Davidson and Neu (1993) adopted a concept of
auditing quality based on the validity and accuracy of the information given by the
auditor as they showed that the high levels of auditing quality lie in the high likelihood
of detecting and getting rid of the fundamental errors and misrepresentations that exist
in the financial statements of the client, resulting in obtaining accurate information by
the auditor. Moreover, Mujahid (2001) claimed that auditing quality can be defined as
the audit facility executing an efficient and effective auditing to serve the user's goals
and requirements in accordance with the conventional professional standards.
Furthermore, Copley and Doucet (1993) have adopted a different concept in this
area as it explained that the concept of auditing quality is limited to the compliance with
all field work and reporting standards.
Depending on what has been previously mentioned, the researcher concludes that the
concept of auditing quality is about:
The possibility of the auditor detecting and honestly reporting the fundamental
errors and misrepresentations in the financial statements of the client.
The application of professional standards including the code of conduct of the
auditing profession.
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The fact that auditor doesn’t issue a clean or non-conservative report for the
financial statements that contain substantial errors and misrepresentations.
The auditor achieving high levels of quality in many areas, such as the clear
demonstration of audit reports, objectivity and fairness of the basis of the given
estimates and opinions, the authenticity and reliability of the views or results,
and finally the effectiveness of auditing planning and execution.
The researcher asserts that auditing quality can be defined as the auditor
efficiently and effectively engagement in all stages of the auditing process (planning,
implementing and reporting), with commitment to professional standards and code of
ethics in order to serve the objectives as well as requirements of the beneficiaries of the
auditing results.
2.2.2 Types of Audits
CPAs perform three primary types of audits. First: an operational audit evaluates
the efficiency and effectiveness of any part of an organization’s operating procedures
and methods. Second: a compliance audit is conducted to determine whether the auditee
is following specific procedures, rules, or regulations set by some higher authority.
Third: a financial statement audit is conducted to determine whether the financial
statements (the information being verified) are stated in accordance with specified
criteria (Arens et al., 2014).
2.2.3 Types of Auditors
In the light of what has been stated above about audit’s concept and types, this
section provides an overall view on types of auditors. For instance, some studies, such
as Taylor and Glazen (1996); Robertson et al. (1985); Arens et al. (2014); and Delaney
(1994) agree on the presence of four types for auditors that are:
19
Certified public accounting firms are responsible for auditing the published
historical financial statements of all publicly traded companies, most other reasonably
large companies, and many smaller companies and noncommercial organizations.
A government accountability office auditor is an auditor working for the U.S.
Government Accountability Office (GAO), a nonpartisan agency in the legislative
branch of the federal government.
The IRS, under the direction of the Commissioner of Internal Revenues, is
responsible for enforcing the federal tax laws as they have been defined by Congress
and interpreted by the courts. A major responsibility of the IRS is to audit taxpayers’
returns to determine whether they have complied with the tax laws. These audits are
solely compliance audits. The auditors who perform these examinations are called
internal revenue agents.
Internal auditors are employed by all types of organizations to audit for
management, much as the GAO does for Congress.
2.2.4 Types of Audit Reports
The purpose of an audit is according to International Standards of Auditing
(ISA) to enhance the degree of confidence of intended users in the financial statements.
This is achieved by the expression of an opinion by the auditor on whether the financial
statements are prepared, in all material respects, in accordance with an applicable
financial reporting framework. This opinion is on whether the financial statements give
a true and fair view. It should be based on a reason able assurance about whether the
financial statements as a whole are free from material misstatement so there are a three
main types of audit reports are issued under these conditions: qualified opinion, adverse
opinion, and disclaimer of opinion.
21
A qualified opinion report can result from a limitation on the scope of the audit
or failure to follow generally accepted accounting principles. A qualified opinion report
can be used only when the auditor concludes that the overall financial statements are
fairly stated. A disclaimer or an adverse report must be used if the auditor believes that
the condition being reported on is highly material. Therefore, the qualified opinion is
considered the least severe type of departure from an unqualified report (Arens et al.,
2014).
A qualified report can take the form of a qualification of both the scope and the
opinion or of the opinion alone. A scope and opinion qualification can be issued only
when the auditor has been unable to accumulate all of the evidence required by auditing
standards. Therefore, this type of qualification is used when the auditor's scope has been
restricted by the client or when circumstances exist that prevent the auditor from
conducting a complete audit. The use of a qualification of the opinion alone is restricted
to situations in which the financial statements are not stated in accordance with GAAP
(Delaney, 1994).
An adverse opinion is used only when the auditor believes that the overall
financial statements are so materially misstated or misleading that they do not present
fairly the financial position or results of operations and cash flows in conformity with
GAAP The adverse opinion report can arise only when the has knowledge, after an
adequate investigation, of the absence of conformity. This is uncommon and thus the
adverse opinion is rarely used (Robertson et al., 1985).
A disclaimer of opinion is issued when the auditor has been unable to satisfy
himself or herself that the overall financial statements are fairly presented. The
necessity for disclaiming an opinion may arise because of a severe limitation on the
scope of the audit or a non independent relationship under the Code of Professional
Conduct between the auditor and the client. Either of these situations prevents the
21
auditor from expressing an opinion on the financial statements as a whole. The auditor
also has the option to issue a disclaimer of opinion for a going concern problem (Taylor
and Glazen, 1996).
The disclaimer is distinguished from an adverse opinion in that it can arise only
from a lack of knowledge by the auditor, whereas to express an adverse opinion, the
auditor must have knowledge that the financial statements are not fairly stated. Both
disclaimers and adverse opinions are used only when the condition is highly material
(Arens et al., 2014).
2.2.5 Significance of Auditing Quality in the Audit Services Market
Since Fama (1980) introduced the concept of agency problems which arose in
companies as a result of the conflict of interest between shareholders and the company
management, this conflict emerged when managers had incentives to pursue their own
interests at shareholder's expense (Agrawal and Knoeber, 1996); as a result, there were
many attempts to solve this problem.
In the light of that, external audit is considered one of the important governance
mechanisms through which shareholders can monitor management as it carries out the
inspection and verification of the financial statements prepared by management and
shows the necessary reports on the quality of these statements to the shareholders.
Therefore, the significance of auditing quality lies in the reduction and mitigation of the
agency conflicts, providing confidence and credibility in the information included in the
audited financial statements (Sullivan, 2000).
Besides that, auditing quality contributes to the reduction of earnings
management, for instance, Hsieh and Tsai (2004) showed that there is a negative impact
22
of the aggregate audit adjustments1, which were used as a measure of auditing quality,
on earnings management2. They found that more qualified auditors are not just
connected with low levels of discretionary accruals, but they can also reduce the large
amount of unjustified errors in client revenues before inspection and auditing.
Once a misstatement occurs, the auditor should be motivated to discover it
promptly because of the reputational damage associated with restatements (e.g., Skinner
and Srinivasan, 2012; Mande and Son, 2013; Hennes et al., 2014; Irani et al., 2015). A
longer lasting misstatement is evidence of less timely discovery of material
misreporting, and is thus an indicator of lower audit quality. The timely discovery of
misstatements by an auditor is of great importance to firms and to market investors as
well, because not only does it prevent misstatements from exacerbating, but it also helps
investors to promptly adjust firms’ valuation, resulting in a lower likelihood of extreme
stock price volatility and crashes.
On the other hand, auditing quality is important to the auditor; this arises from
the non- exposure to the judicial proceedings, to which the auditor might be exposed as
a result of the decline of the performance level from the required quality level. Khurana
and Raman (2004) examined that whether the big four auditors provide audit services at
a higher quality compared to other small auditors in both United States (which is known
for high risk of litigation) and other Anglo-American countries (characterized by low
risk of litigation), such as Canada, Australia and the United Kingdom. The results
showed that the costs of equity capital of the big four auditors’ clients are lower than
small auditors’ clients only in the United States, which means that big four auditors
provide services of higher quality, and that is only in the United States. This explains
1- which is defined as the difference between the amount of revenue before the inspection and auditing and the amount of revenue after the inspection
and auditing, which represents an objective measure of the ability of the auditor to detect errors and misrepresentations in the financial statements and
make the necessary adjustments.
2- measured using the discretionary accruals.
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that the non- exposure to lawsuits is the reason for the high quality of audit services
provided by big four auditors and the high credibility of the financial reports.
Some studies have found that audit quality is the main feature in changing the
auditor. Woo and Koh (2001) showed that the quality of the auditing process is one
cause of changing the auditor. The study found that the rates of changing the auditor in
the companies contracting with small auditors are high because the small auditors have
few resources and capabilities in general, and it provides services of low quality since
audit quality is positively related to the size of the auditors. Therefore, this is reflected
on the rates of changing auditors.
Depending on what has been previously mentioned, the researcher concludes
that the importance of audit quality lies in the reduction and mitigation of agency
conflicts, providing confidence and credibility in the information included in the
financial statements that have been audited, the non-exposure to judicial proceedings to
which the auditor might be exposed as a result of the decline of performance levels from
the required quality, as well as its contribution to the reduction of earnings management
through the low levels of discretionary accruals. Audit quality is also considered a basic
feature in auditors’ changing and one of the criteria of choosing auditors.
Due to the increasing importance of audit quality, a number of academic studies
and researches have focused on identifying the concept of audit quality and its
distinctive characteristics as well as the factors leading to low audit quality, which will
be addressed in the next section.
2.2.6 Audit Quality Decline Factors
The purpose of an audit is according to International Standards of Auditing
(ISA) to enhance the degree of confidence of intended users in the financial statements.
This is achieved by the expression of an opinion by the auditor on whether the financial
24
statements are prepared, in all material respects, in accordance with an applicable
financial reporting framework. This opinion is on whether the financial statements give
a true and fair view. It should be based on a reasonable assurance about whether the
financial statements as a whole are free from material misstatement (Laitinen and
Laitinen, 2015). Therefore, audit quality is a goal pursued by every practitioner of the
profession. No practitioner intentionally wants to achieve a low level of audit quality,
but there are a number of factors that lead to lower audit quality, for example:
- Providing audit services for many customers at the same time in light of the
limited capabilities of the auditor: Beyer and Sridhar (2006) claimed that in light of
the limited capabilities of the auditor, the addition of another client can lead to a
reduction of the quality of the audit services provided by the auditor and increase the
likelihood of the auditor failure to correctly predict the expected economic difficulties
for the client facility in the future.
- The high value of the audit and other non-audit services fees: Markelevich et al.
(2005) showed that customers who pay high fees to the auditors, whether for audit or
other non- audit services, are more able to influence the auditors, and this consequently
leads to the decline of the auditor independence level which leads in turn to the decline
of the auditing quality level. The study detected a substantial relationship between the
audit fees and the detection of the earnings management operations that serve the
management interests only since it detected a substantial positive relationship between
audit fees and the absolute value of discretionary accruals that was used as a criterion
for the auditing. The high absolute value of the discretionary accruals indicates the low
auditing. The study also pointed out to the presence of a significant positive correlation
between the non-audit services fees and the absolute value of discretionary accruals,
which shows the reliability or economic dependency is the primary determinant of the
auditor behavior.
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Also, Choi et al. (2006) concluded that the positive abnormal audit fees, which
are defined as the difference between the actual audit fees and the expected level of
audit fees (normal audit fees), are substantially positively related to management
earnings, which have been measured using the amount of the discretionary accruals. It
turned out that when the auditor receives high audit fees from the client (positive
abnormal audit fees), these fees could lead to the creation of a kind of reliability or
economic dependency, negatively affecting the independence of the auditor as these
fees stimulate the auditors to breach the audit quality by responding to the pressures of
the client regarding providing low quality reports.
2.3 Accounting Conservatism
The important accounting principle of conservatism can be traced back to the
early 15th century, prior to the publication of Pacioli’s pioneering text on double-entry
bookkeeping (Littleton, 1941). In its early application, conservatism can be interpreted
as lower-of-cost-or-market in modem terms. An early example of the application of
conservatism is as follows: This man's furniture and utensils were valued by appraisers
in 1408 at less than cost because the items had deteriorated.
In the same context, accounting conservatism concept is one of debatable issues
in accounting literature as a result of different views among researchers about the
advantages and disadvantages of implementing this concept. For instance, Givoly and
Hayn (2000), Watts (2003) and Lafond and Watts (2008) have shown that conservatism
has increased overtime and attributed the existence and the continuous increase of
conservatism mainly to contracting, litigation, taxation and regulation that enhance the
demand for conservatism. Based on that, this section aims to provide an overall view on
conservatism; therefore, it covers the following points:
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Accounting conservatism concept.
Types of accounting conservatism.
Accounting conservatism motivations.
Measures of accounting conservatism.
2.3.1 Accounting Conservatism Concept
The principle of conservatism was initially promulgated in France through the
Code of Commerce of 1673 (Littleton, 1941). The importance of the principle as an
ingredient of commercial law was also recognized through its incorporation into the
laws of other European countries. So, there were many denotations and names for
accounting conservatism, for example, Abdel Malek (2010) and Al Hyaly (2008)
pointed out that some consider the accounting conservatism a principle; others call it a
determinant such as Hussain (2007); moreover, some call it a method like Al Azama
(1986), and others call it a limit (El Shirazy, 1990). On the other side, sometimes
accounting conservatism is called prudence; for example, the International Accounting
Standards Board (IASB) uses the term of prudence to refer to accounting conservatism
(Pothof, 2011). Depending on that, Rashed (2010) pointed out that there is no way to
separate between the conservatism and the prudence terms because the differentiation
between them is just a linguistic terminological differentiation in the framework of
drafting the texts of the various accounting publications.
Accounting conservatism can be defined as accounting policies or tendencies
that result in the downward bias of accounting net asset value relative to economic net
asset value. It is one of the most fundamental features of accounting information, dating
back centuries (Basu, 1997; Watts, 2003a; Ruch and Taylor, 2015).
While there is little question as to conservatism’s existence, there is a debate
among researchers and standard setters as to how costly or beneficial conservatism is to
27
financial statement users. The Financial Accounting Standards Board (FASB) does not
include conservatism as one of the qualitative characteristics of financial reporting in its
conceptual framework because it believes that conservatism biases accounting
information and compromises neutrality (FASB, 2010). Some researchers have echoed
this notion, arguing that conservatism biases financial statement numbers to result in
inefficient decision-making (Gigler, Kanodia, Sapra and Venugopalan, 2009; Guay and
Verrecchia, 2006).
Alternatively, some researchers contend that accounting conservatism arises
naturally between contracting parties and is necessary as an efficient contracting
mechanism (Basu, 1997; Watts, 2003a).
Based on that, there are many attempts at accounting professional bodies’ level
to define accounting conservatism concept, for instance, Financial Accounting
Standards Board (FASB) has defined accounting conservatism as “a prudent reaction to
uncertainty to try to ensure that uncertainty and risks inherent in business situations are
adequately considered. Thus, if two estimates of amounts to be received or paid in the
future are about equally likely, conservatism dictates using the less optimistic estimate”
(FASB 1980, SFAC No. 2). Also, International Accounting Standards Board (IASB)
stated that accounting conservatism, or as it is called prudence, is “the inclusion of a
degree of caution in the exercise of the judgments needed in making the estimates
required under conditions of uncertainty so that assets or income are not overstated,
and liabilities or expenses are not understated” (IASC, 1988).
Although accounting conservatism has been an integral component of the
framework of the international financial reports' standards (Pothof, 2011) for a long
time, International Accounting Standards Board (IASB) sparked controversy regarding
this matter where accounting conservatism was deleted from the conceptual framework
of financial reporting in 2010 under the pretext of that it contradicts with neutrality and
28
causes bias in the accounting information (Salama, 2012; Francis et al. 2013). Based on
that, the United Kingdom Financial Reporting Council (FRC) has commented on the
IASB's exposure draft 'Conceptual Framework for Financial Reporting'. “The
reintroduction to the Conceptual Framework of a specific reference to prudence is very
welcome. However, the treatment of it in the Exposure Draft is wholly inadequate. The
essence of prudence is the idea referred to in the Basis for Conclusions as ‘asymmetric
prudence’ — a lower threshold for the recognition of liabilities and losses than for
assets and gains — which is absent from the text of the draft Conceptual Framework
itself” (IAS Plus, 2016, online). Also, Watts (2003) claimed that the deletion of
accounting conservatism leads to the change of administrative behavior and increase of
costs for both the investors and economy in general.
On the other hand, at academic level many authors tried to define the concept of
accounting conservatism; for example, Bliss (1924); Basu (1997); watts (2003); Pothof
(2011); and shroff et al. (2013) agreed on defining accounting conservatism as the non-
consideration of any expected profits while taking all expected losses into account.
Furthermore, Riahi-Belkaoui (1985) and El Allali (2010) defined accounting
conservatism as the disclosure of the highest values of obligations and expenses besides
the disclosure of the least values of assets and revenues, while Beaver and Ryan (2005)
and Abdel Malek (2010) stated that conservatism is the reduction amount of the book
value of company net assets from its market value. In addition, Balachandran and
Mohanram (2011) followed Beaver and Ryan (2005) and Abdel Malek (2010) approach
in defining accounting conservatism, so they claimed that accounting conservatism is
the accounting selection of (by organizational authorities, standards creator or
companies) the potential processing to reduce the net assets and accumulative income,
and they implied that the previous studies measure conservatism as the reduction of the
book values in relation to market values.
29
Additionally, Abdel Malek (2010) stated that conservatism is the consideration
of potential losses apart from potential profits in all accounting factors, which lead to a
reduction of the book values of assets from market values. Moreover, Chan et al. (2009)
implied that accounting is conservative if the percentage of the book value of operating
assets to the assets market value is less than one. Also, Lara et al. (2010) pointed out
that conservatism is the timely recognition of losses in the income statement.
Moreover, Rashed (2010) defined it as the entry or the conventional orientation
to be followed by accountants while preparing the financial statements to reflect the
effect of the uncertainties surrounding and inherent in the practice of the company's
economic activity on the information content of the financial statements so as to achieve
the non-disclosure of inflated values of assets and income or low values of the
obligations and expenses under uncertainty, provided that the accounting conservatism
does not lead to the intentional disclosure of low values of the assets and income or
inflated values for obligations and expenses.
In addition, Salama (2012) defined accounting conservatism as a conditional
conservatism, which is practiced through the disclosure and measurement of potential
losses and postponement of disclosure of potential profits, and an unconditional
conservatism due to the desire and ability of the management to choose among
accounting policies and select the conservative methods and policies in order to avoid
inflating assets and income or reducing the obligations and expenses, which promotes
and supports the quality of financial reports.
Depending on what has been previously mentioned, the researcher concludes the
multiplicity of names and definitions given to accounting conservatism, and the
presence of argument about the survival of the conservatism as a part of the conceptual
framework or not, especially among international professional organizations in some of
the criteria on one side, and between them and some academic studies on the other side.
31
Besides, the previous studies differ among themselves about defining the concept of
accounting conservatism. The researcher agrees with the concept adopted by Rashed
(2010) since he depended on several previous studies and reached the definition of the
conservatism that is consistent with the intellectual framework and does not contradict
with the international standards as much as possible, which states that accounting
conservatism is the entry or the conventional orientation to be followed by accountants
while preparing the financial statements to reflect the effect of the uncertainties
surrounding and inherent in the practice of the company's economic activity on the
information content of the financial statements so as to achieve the non-disclosure of
inflated values of assets and income or low values of the obligations and expenses under
uncertainty, provided that the accounting conservatism does not lead to the intentional
disclosure of low values of the assets and income or inflated values for obligations and
expenses.
As a result of this debate about the definition of accounting conservatism, many
types of accounting conservatism have raised, so the following section will discuss
these points.
2.3.2 Types of Accounting Conservatism
As stated from before, researchers provide various descriptive definitions of
conservatism, and previous studies pointed out several types of accounting conservatism
which include the following types:
Ex-ante conservatism and Ex-post conservatism.
Earnings conservatism and balance sheet conservatism.
Conditional and unconditional conservatism.
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2.3.2.1 Ex-ante Conservatism and Ex-post Conservatism
Chan et al. (2009) indicated two types of conservatism that are ex-ante
conservatism and ex-post conservatism; ex-ante conservatism depends on the
accounting figures and is associated with the balance sheet, but it is not related to
disclosure (unconditional), and it reflects a reduction in the book value of the net assets
exemplified by the immediate registration of the research and development expenses,
advertising costs and the accelerated depreciation of long-term tangible assets.
However, the ex-post conservatism depends on the market and is associated with
profits. This conservatism leads to the timely recognition of economic losses more than
the recognition of gains.
2.3.2.2 Earnings Conservatism and Balance Sheet Conservatism
Other authors like Beaver and Ryan (2005) and Pothof (2011) classified
conservatism to earnings conservatism and balance sheet conservatism. Earnings
conservatism, according to Basu (1997), means “a timelier recognition of bad news in
earnings relative to good news”, so earnings conservatism is related to income only.
Also, Pothof (2011) indicated that conservatism has no effect on profits since there is a
correction in a subsequent period. Based on that, earnings conservatism is called the
temporary conservatism since it has a temporal effect. For instance, Lara and Mora
(2004) claimed that if the manager expects gains that he will not admit in the first year;
consequently, the profit in this year will be of a lower value. However, upon achieving
the profit in the next year, such profits will be overstated.
On the contrary, Feltham and Ohlson (1995) defined balance sheet conservatism
as “a persistent understatement of book value of shareholders’ equity”, so assets will be
32
undervalued, also liabilities will be overvalued compared to the situation if there is no
conservatism. Based on that, balance sheet conservatism has consistent impact on the
balance sheet which contrasts the earnings conservatism. Lara and Mora (2004) claimed
that if there are unrecognized intangible assets, it will not be acknowledged, and assets
are consequently reduced.
2.3.2.3 Conditional and Unconditional Conservatism
This is one of the most famous classifications that have been adopted by many
previous authors, such as Salehi et al. (2012), Ismail and Elbolok (2011), El Allali
(2010), Beaver and Ryan (2005), Salama (2012), and Nakano et al. (2014). For instance,
Beaver and Ryan (2005) stated that conditional conservatism means that the
conservatism has to be related to a certain event, so the reduction of the book value of
the net assets from its market values in case of any bad events, while the book value of
the net assets shall not be increased over its market values in case of good events.
According to Ruch and Taylor (2015), goodwill impairment, long-lived asset
impairment, inventory recorded at the lower of cost or market, and asymmetry in
gain/loss contingencies are common examples of conditional conservatism.
Furthermore, Nakano et al. (2014) asserted that unconditional conservatism is
not associated with the occurrence of a certain event since the economic unit is
committed starting from its establishment of the accounting policies which lead to the
reduction of the book value of the net assets from its market values resulting in the
presence of unregistered fame. Besides, accelerated depreciation methods, expensing
R&D costs, expensing advertising costs, LIFO inventory, and accumulated reserves in
excess of expected future costs are common examples of unconditional conservatism
(Ruch and Taylor, 2015).
33
Depending on what has been previously mentioned, the researcher concludes
that there is no one generally accepted classification of accounting conservatism
because of the debate about the definition of accounting conservatism itself, so
researchers tend to classify accounting conservatism into conditional and unconditional
conservatism as most types of accounting conservatism can be included under this
classification of conditional and unconditional conservatism. Besides, most of the
previous studies referred to this classification of accounting conservatism as the most
common in the accounting conservatism literature.
Despite the debate among researchers and professional bodies about the
definitions, types and classifications of accounting conservatism, there is a question
which is what makes company’s management follow particular pattern of accounting
conservatism? This is what the following section will discuss.
2.3.3 Accounting Conservatism Motivations
In the light of what has been stated above about accounting conservatism’s
concept and types, this section provides an overall view on the reasons behind the
conservatism practice existence and raise overtime. For instance, some studies, such as
Lara et al. (2009); Basu (1997); Watts (2003); Heijden (2011); and AL-Garhy (2013)
agree on the presence of four major motivations for accounting conservatism that are:
Contracting Motivation
Litigation Motivation
Taxation Motivation
Regulation Motivation
2.3.3.1 Contracting Motivation
34
Financial accounting has been used for contracting purposes for centuries (Watts
and Zimmerman 1983). Because of the separation of ownership from management has
led to tackling agency problems between managers and shareholders because there has
been a conflict of interest between owners and management where each party seeks to
maximize its benefits on other parties' accounts. So, shareholders seek to maximize their
wealth by maximizing the value of the company while the management seeks to
maximize its revenues of bonuses and incentives even at the expense of the company's
value. Whenever there is a lack of uniformity in the information, this leads to a poor
capacity of management control, and thus allows the management to maximize its
benefits at the expense of other parties' account, pushing those parties to follow the
appropriate mechanisms, such as management contracts, to reduce the conflict with the
company's management.
According to Al-Garhy (2013), the most important contracts based on
accounting figures, that affect the accounting options, can be divided as follows:
a) Management Incentives Contracts: where the management functions as an
agent for shareholders in return for the rewards it obtains, which contain a fixed
part that is not linked to the achieved performance represented in the salary as a
minimum reward and another variable portion based on the achievement of
specific proportions of accounting profits. These contracts are concluded in
accordance with the accounting figures prepared according to the accounting
principles pushing the management to choose among the principles which enable
them to choose the accounting policies that maximize or reduce the profit figure.
Therefore, the role of the accounting conservatism, as a contracting motivation,
reduces the freedom of management in the over- evaluation of the assets, and it
prevents the recognition of the potential gains.
35
b) Debt Contracts: where the debt contracts are concluded in the light of the
accounting data. The conflict occurs when the shareholders try through the
management to transfer the wealth from the creditors (bondholders) via using
practices that reduce the debt with an impact on the total value of the company,
among which are the distributions to shareholders or the issuance of new debt
exposing the creditors of the current debts to the risk of decline in value of their
investments, and thus pushing them (creditors) to develop a set of restrictions to
curb these practices. Consequently, the role of the accounting conservatism is a
means to protect the interests of creditors in the debt contracts through the execution
of some procedures and restrictions to reduce the risks they are exposed to since
conservatism contributes to the reduction of the low value risk resulting from the
under- evaluation of assets. In the same context studies show that conservative
accounting is more likely to be employed by firms with severe conflicts over
dividend policies Ahmed el al., 2002) ) and to benefit borrowers by lowering the cost
of debt (Ahmed el al., 2002; Zhang, 2008).
2.3.3.2 Litigation Motivation
The litigation motivation arises as a result of the ability of the other stakeholder
parties of the company to sue the management and the accounting auditor in order to
cover the losses caused by the manipulation of financial statements. When there are
more cases of fraud, more asymmetry of information problems between the internal and
external parties exists; consequently, the risk of lawsuits increases. When the book
value of assets is lower than their real value, the litigation costs become less. The
accounting conservatism reduces the asymmetry of information; moreover, it reduces
the book value of assets from their real value minimizing the risk of litigation.
2.3.3.3 Taxation Motivation
36
The accounting conservatism, of both types, helps the company reducing the
current value of the taxes imposed on it through showing revenues undervalued besides
expenses of higher value than their real value and through increasing the company's
value. In the same context Watts (2003) stated that deferring the recognition of gains
and accelerating the recognition of losses promptly reduces profitable firms’ current tax
expenses and thus creates value for firms.
2.3.3.4 Regulation Motivation
The company, with high profit rates, draws the attention of various parties such
as the media, employees, consumers and other third parties. This prompts the
governmental organizations to intervene and impose political costs such as imposing
new taxes, reducing the governmental support, changing the price regulations or forcing
the company to follow the accounting conservatism in order to avoid exposure to such
political and organizational high costs.
Depending on what has been previously mentioned, the researchers conclude
that there are justifications for companies to follow conservative accounting policies
since accounting conservatism, as a contracting motivation, has an impact on the
restriction of management practices that would affect the value of the company and the
owners. On the other hand, it protects the rights of creditors through the execution of
some procedures and restrictions that reduce the low value risk. Besides, accounting
conservatism, as a litigation motivation, reduces the risk of lawsuits that may be filed
against the company. Accounting conservatism, as a taxation motivation, also helps
reducing the current value of the taxes imposed on the company. In addition, accounting
conservatism, as a regulation motivation, reduces the political and organizational high
costs to which the company may be exposed.
2.3.4 Measures of Accounting Conservatism
37
According to the increasing interest of accounting conservatism concept, as
mentioned above, many researchers tried to find an accurate measure for this concept;
as a result, there were many attempts to achieve that. For example, Wang et al. (2009)
stated five conservatism measures that are most widely applied and have the most
significant impact on the empirical literature of conservatism. The following section
will review these measures to determine which measure will be used in the empirical
section in this study.
2.3.4.1 Basu's (1997) Asymmetric Timeliness Measure (AT)
Basu (1997) model focuses on how good and bad economic news, measured by
market returns, is asymmetrically associated with accounting earnings. Under
conservative reporting, stock returns and earnings would reflect economic losses in the
same period, while stock returns reflect gains earlier than earnings. Basu's model has
been criticized by many researchers, such as Givoly et al. (2007) who claimed that the
differential timeliness measure in Basu (1997) is sensitive to factors unrelated to
accounting conservatism, such as the degree of uniformity in the contents of economic
news, the nature of economic events and the firm disclosure policies. Givoly et al.
(2007) who stated that Basu's measure is appropriate for certain research designs and
problematic in other settings.
2.3.4.2 Beaver and Ryan (2000) - Market-to-Book Ratio (MTB)
The notion underlying the market-to-book (MTB) ratio, as a measure of
conservatism, is that accounting conservatism will tend to depress the firm's net book
value relative to its true underlying economic value as reflected in its market value. In
this sense, Beaver and Ryan (2000) characterized conservatism as a persistent difference
between market and book values, with a higher market-to-book (or lower BTM) ratio
38
implying a higher degree of accounting conservatism, and vice-versa. However,
Roychowdhury and Watts (2007) suggested that MTB-based measures are likely
upwardly biased estimators because of the existence of economic rents in most firms
which are generally not recognized in book value under GAAP.
2.3.4.3 Givoly and Hayn (2000) - Cumulative Negative Non-operating Accruals
Givoly and Hayn (2000) argued that conservative accounting results in
persistently negative accruals; more negative average accruals reflect more conservative
accounting. Accruals are expected to reverse over time; therefore, persistence in the
level of cumulative negative accruals should reflect a conservatism bias within the
firm's accounting system rather than the transitory nature of accruals.
A number of issues arise when implementing this measure. The first issue is
related to what the appropriate accumulation period should be, however, Lara et al.
(2009) besides Ahmed and Duellman (2007) have adopted a 3-year period from t-1 to
t+1. A further criticism is that the exclusion of depreciation from the accruals measure
is likely to introduce an error given the importance of depreciation within the accrual
accounting although the extent and direction of the resulting bias are unknown (Wang et
al., 2009).
2.3.4.4 Penman and Zhang’s (2002) Hidden-Reserves Measure (HR)
Penman and Zhang (2002) argued that accounting conservatism creates hidden
reserves, the amount of which can be used to gauge the degree of conservatism in a
firm. They argued that if the amount of hidden reserves is higher, the firm’s financial
reporting system is more conservative. However, since hidden reserves are not
39
explicitly reported in either the financial statements or anywhere else, they can only be
estimated by the researchers themselves.
2.3.4.5 Ball and Shivakumar’s (2005) Asymmetric Cash Flow to Accruals Measure
(AACF)
Ball and Shivakumar (2005) developed the AACF measure in order to estimate
the degree of accounting conservatism in private (unlisted) companies as Basu’s AT
measure is not suitable for unlisted companies given that there is no stock price
information available for unlisted companies. To overcome this difficulty, Ball and
Shivakumar (2005) developed what is essentially the non-stock-market equivalent of the
AT measure.
Depending on what has been previously mentioned, the researcher will depend
on Givoly and Hayn (2000) “Cumulative Negative Non-operating Accruals measure” of
accounting conservatism because the other previously mentioned measures have critical
disadvantages. For instance, Basu (1997) measure is sensitive to factors unrelated to
accounting conservatism, so there are several criticisms about the model (Basu) which
can be summed up in three major points. The first is the statistical properties of the
model through the bias statistical metrics, and the second is that the model does not
detect all cases of accounting conservatism in the financial statements. Finally, under
the application of both a measure of the proportion of the market value to the Book
value and model (Basu), the results are often counterproductive. Also, Saad Eddin
(2014) indicated that the model (Basu) is built on the premise that the market is efficient
as it is assumed that stock prices reflect the good news and bad news which may not be
available in the financial emerging markets, such as the Egyptian market. Also, Beaver
and Ryan (2000) measures biased estimators and reflected the model bias accounting
when gains and losses and the extent of continuity in a decrease are recognized. Penman
41
and Zhang (2002) depended on researchers’ estimates. On the other hand, the most
commonly used measure is Givoly and Hayn (2000) measure; measuring conservatism
according to Givoly and Hayn (2000) aims to reduce the effect of temporary large
accruals which tend to reverse in one or two years (Richardson et al., 2005), and many
researchers used Givoly and Hayn (2000) measure like Lara et al. (2009), Ahmed and
Duellman (2007) and Soliman (2014).
2.4 Relationships between Audit quality and Accounting Conservatism
The relationship between audit quality and accounting conservatism has become
the subject of an active field of empirical research in accounting (Soliman, 2014).
There is a claim that there is a appositive relationship between audit quality and
accounting conservatism (Hamdan et al., 2012); this claim based on the idea that audit
role is represented in reducing the degree of information asymmetry between managers
and the stakeholder parties in the project. Therefore, the high-quality audit will
encourage the accounting policies that lead to the reduction of information asymmetry
and restrict the policies that lead to increased information asymmetry (Cano, 2010). So,
the following section will focus on the link between audit quality and accounting
conservatism, through reviewing the relationship among some widely discussed factors,
such as audit firm size, auditor tenure and accounting conservatism, based on that many
authors, for instance DeAngelo (1981), DeFond and Subramanyam (1998), Francis et al.
(1999), Sori et al. (2006), Fargher et al. (2008), Choi et al. (2010), and Lennox et al.
(2012) used audit firm size and auditor tenure as measures of audit quality.
2.4.1 Audit Firm Size
41
Becker et al. (1998) showed that companies audited by larger audit firms have
lower levels of opportunistic behavior, and also Piot (2005), based on a sample of
French companies, presented results that corroborated the findings of Becker et al.
(1998). In the same context, Cano (2010) found that the level of conditional accounting
conservatism and accounting information quality rises in the companies that are audited
by large auditing firms compared to the companies that are audited by small auditing
firms. Basu et al. (2001) found that big auditors have incentives to determine earnings
more conservatively than non-big auditors because of their greater legal liability
exposure; also Chung et al. (2003) supported this finding.
Furthermore, Francis and Wang (2008) examined whether earnings
conservatism is jointly affected by the investor’s protection environment where a firm is
located, and the firm’s choice is a big 4 versus non–big 4 auditors. Their finding
confirmed the existence of a positive relation between conditional conservatism and big
auditors for those countries with a high level of investor protection.
In addition, based on the financial reports of the most active 50 non-financial
companies listed at the Egyptian stock exchange across four years, Soliman (2014)
showed that auditor firm size had significant positive relation with accounting
conservatism.
Thus, according to the literature, audit quality positively affects the quality of
accounting information. With respect to conservatism, it is expected that accounting
conservatism is greater in the financial statements of companies that use the best
auditing services.
H1: It is expected that conservatism level of the companies audited by larger
audit companies will be greater.
42
2.4.2 Auditor Tenure3
By looking at the relationship between auditor tenure and accounting
conservatism in illiteracies, it was found that some authors, such as Ghosh and Moon
(2005), Jenkins and Velury (2008) and Azevedo and Costa (2012), claimed that when
the relationship between an auditor and its client is longer, this allows the auditor to
obtain more knowledge about the client’s activities, leading to better service. Thus, in
case of longer relationships between an auditor and a client, the quality of audit services
should be higher, and the quality of the accounting information reported is supposed to
better.
On the other hand, many authors, for instance DeFond and Subramanyam
(1998), Geiger and Raghunandan (2002), Arel et al. (2005), Chi et al. (2009) and Li
(2010) asserted that long auditor rotation has a negative impact on audit quality, as
demonstrated by Enron scandal which is unraveled and filed for Chapter 11 bankruptcy
on Dec. 2, 2001.
Based on that, the researcher agrees with the idea that the long relationship
between auditor and company causes the auditor to have greater proximity to his/her
client, which might negatively affect the quality of services provided, so if the
relationship is longer, the quality of audit services should be lower, and the quality of
the accounting information reported will be worse.
H2: It is expected that conservatism level of the companies having a longer
relationship between the auditor and the client will be lower.
2.5 Moderator Variable
3- refers to the number of consecutive years that the auditor has audited the client.
43
Besides the factors discussed above about determination of the level of
accounting conservatism, the following section will go through moderator variable that
affects the strength of the relationship between a dependent and independent variable.
These factors are company’s size, financial leverage and profitability.
2.5.1 Firm Size
Many studies focused on the relationship between accounting conservatism as a
dependent variable and other factors, and they used the company’s size as other
variable. This is all based on the claim that there is a negative association between
company’s size and accounting conservation (Arabahmadi et al., 2013). In the same
context, Hamdan et al. (2012) found that big companies adopt conservative accounting
policies, and the study explained that depending on big companies will apply
conservative accounting policies to avoid political costs; also Soliman (2014) found that
there is a positive relationship between companies’ size and accounting conservatism.
2.5.2 Firm’s Financial Leverage
According to Chartered Institute of Management Accountants (CIMA) Official
Terminology, financial leverage is defined as “amount of debt in relation to equity in
the capital structure of an entity or debt interest in relation to profit” (CIMA 2005).
Also, financial leverage is sometimes called Debt ratio which is a solvency ratio that
measures a firm's total liabilities as a percentage of its total assets, so companies with
higher levels of liabilities compared with assets are considered highly leveraged and
more risky for lenders; as a result, financial leverage represents other creditors' claims
on the assets of the company. Based on that, many authors, for example Kim and Jung
(2007), Scott (2012) and Soliman (2014) asserted that these claims may lead creditors to
force company’s management to apply more conservatism practices.
2.5.3 Firm’s Profitability
44
Profitability is a class of financial metrics that are used to assess a business's
ability to generate earnings as compared to its expenses and other relevant costs
incurred during a specific period of time (Ahmed et al., 2002, Investopedia 2015,
online). There are many measures of profitability such as profit margin ration, return on
assets and return on equity, residual income and Tobin's Q.
Many studies explained the relation between company’s profitability and
conservative accounting, for example, according to Ahmed et al. (2002), companies
with higher profitability are expected to use more conservative accounting because the
cost of making a conservative accounting choice is lower for low-profitability
companies (Soliman, 2014, p.356).
Table 2-1
Summary of Hypotheses
Dependent Variable Independent
Variable
Expected Relationships
(Hypothesis)
Accounting
Conservatism
(ACCON)
Audit Firm Size
(ASIZ) Positive
Auditor Tenure
(ATEN) Negative
2.6 Summary
To conclude this chapter, it is obvious that the relationship between the audit
quality and accounting conservatism has attracted the attention of many researchers in
the recent years.
These relationships and effects have been studied in many Asian, European and
Middle East countries, and here comes the importance of this thesis that aims to fill this
gap by studying whether audit quality affects accounting conservatism in the Egyptian
stock market which is one of the major stock markets in the Middle East.
45
This chapter showed that the relationship between the audit quality and
accounting conservatism, many variables affecting this relationship such as audit firm
size and audit tenure, and many other variable affecting this relating such as firm size,
firm profitability and firm Leverage.
The next chapter will explain the theoretical framework, research model and
identify the methodology of the research that will be applied in this study, presenting
the sample which will be selected, the hypotheses that will be discussed in more details
as well as the dependent and independent variables, data type and collection processes.
The statistical tools that will be applied to test the hypotheses in order to know whether
they will be accepted or rejected.
CHAPTER THREE: METHODOLOGY AND EMPIRICAL
STUDY
3.1 Introduction
In previous chapters, the theoretical aspects of audit quality and accounting
conservatism were examined; also research hypotheses were formulated. This chapter
will focus on reviewing research methodology that will be used in the empirical study;
accordingly the following part aims to explain how the data has been collected, and how
it has been analyzed.
Therefore, this chapter will include the following sections: the research strategy
and its methods, a sample selection, the methods for collecting the data, variables
identification and measurements and finally the research model of the study.
3.2 Research Strategy
46
The research problem is determined according to the research aim and objectives
which is whether the audit quality has a significant effect on accounting conservatism
for the most active firms listed in the Egyptian stock exchange. The hypotheses
previously mentioned are required to test the relationship between audit quality
variables which are audit firm size and audit tenure with the accounting conservatism of
listed companies in Egypt. Applied research will be used in this thesis as it is an
appropriate strategy when there are testable hypotheses.
Afterwards, statistical tools and techniques are applied to test these hypotheses
using quantifiable data which are stemmed from the financial statements of companies
listed on the Egyptian stock market. The statistical techniques to be used are descriptive
statistics, correlation and multiple regression analyses which will be explained in the
next chapter.
3.3 Methods of Statistical Analysis
Several statistical tools and techniques will be carried out to test the causal
relationship between audit quality and accounting conservatism. First, descriptive
statistics are carried out to describe the relevant variables in the research (accounting
conservatism, audit firm size, leverage, Tobin's Q, firm size and auditor tenure). A
Summary of these statistics is used to show the standard deviation as well as minimum
and maximum values of all variables. Then, Pearson’s correlation analysis is applied to
analyze the relationship between audit quality and accounting conservatism. Correlation
is used to show the direction and strength of the variables with one another. Correlation
measures the degree of linear association between two variables, stating if variables are
correlated, but it doesn’t show any causal relationship between them.
Second, in order to analyze the unique impact of audit quality on accounting
conservatism, regression analysis is used. Regression is a more powerful method when
47
compared to correlation because it doesn’t only show the direction and strength of a
relationship, but also determines the casual effect of this relationship. In this study, the
multiple regression models were employed in carrying out the analysis.
All statistical techniques are carried out using the Statistical Package for Social
Science (SPSS) version 23.
3.4 Sample Selection and Data collection
This study has used on non-probability – purposive sample. The non-probability
sampling method was used, so some units in the population have had a higher chance of
being selected (Greener, 2008). Besides that, purposive sample (also known as a
judgmental sample), which is one type of non-probability sampling, was used because
the main goal of purposive sampling is to focus on particular characteristics of a
population that are of interest, which will best enable to answer the research questions
(Greener, 2008). In this context, the study focuses on the most actively traded Egyptian
non-financial companies listed in the Egyptian Stock Exchange, according to disclosure
book - 50 most active companies, over the period 2007-2015. The most active listed
companies are specifically chosen due to the data availability and reliability in contrast
to non-listed companies or those that are not the most active ones.
Disclosure book - 50 most active companies- includes financial information
about the most 50 active-traded companies listed in the Egyptian Stock exchange from
different industrial sectors, so financial companies are eliminated from these companies
because of their special nature in terms of the differences in the regulatory tax
requirements and the characteristics of the financial reports from those of the non-
financial companies (Alsaeed, 2006). According to Mehran et al. (2011), there is a main
dissimilarity in governance in the financial and non-financial sectors. The complexity of
the financial sectors, particularly the banking sector causes a difficulty of implementing
48
formal regulations. Due to the differences in regulations between banks and non-
financial firms, this study excludes the financial firms (Wilson et al., 2010); moreover,
firms enter and exit the classification of 50 active-traded companies listed in the
Egyptian Stock exchange each year from 2007 to 2015. so the study sample consists of
50 common active firms during the period from 2007 to 2015 after excluding financial
services companies and banks, which are shown in table (3.1), which represent 13
different sectors stated in table (3.2), resulting in 450 observations, but for statistical
analysis the researcher exclude 7 uncompleted observations, so only 443 observations
was included in statistical analysis.
On the other hand, data which used to measure accounting conservatism, audit
quality and other variables collected mainly from Thomson Reuters Eikon database,
which is a set of software products provided by Thomson Reuters for financial
professionals to monitor and analyze financial information. It provides access to real
time market data, news, fundamental data, analytics, trading and messaging tools.
Table 3-1
Study Sample
1 Asec Co For Mining (ASCM.CA)
2 Al Ezz Dekheila Steel Company Alexandria (IRAX.CA)
3 Egptian Iron And Steel Co (IRON.CA)
4 Ezz Steel Co (ESRS.CA)
5 Abu Qir Fertilizers And Chamical Industries (ABUK.CA)
6 Egyptian Financial And Industrial (EFIC.CA)
7 Misr Chemical Industries (MICH.CA)
8 Sidi Kerir Petrochemicals (SKPC.CA)
9 Giza General Contracting And Real Estate Investment (GGCC.CA)
10 Lecico Egypt (LCSW.CA)
11 Misr Refrigeration And Air Conditioning Manufacturing (MRCO.CA)
12 Orascom Construction Industrues (OCIC.CA)
13 South Valley Cement (SVCE.CA)
14 Egyptian Company For Condtruction Development (EDBM.CA)
15 El Saeed Contracting And Real Estate Invesment Co (UEGC.CA)
16 Delta Sugar (SUGR.CA)
17 Extracted Oil And Derivatives (ZEOT.CA)
49
18 International Co For Agricultural Corps (IFAP.CA)
19 National Co For Maize Products (NCMP.CA)
20 North Cairo Flour Mills (MILS.CA)
21 Sharkia National Company For Food Security (SNFC.CA)
22 Upper Egypt Flour Mills (UEFM.CA)
23 Electro Cable Egypt (ELEC.CA)
24 Egyption Transport And Commercial Services (ETRS.CA)
25 El Sewedy Electric Co (SWDY.CA)
26 Industrial Engineering Co For Construction And Development (ENGC.CO)
27 United Arab Stevedoring Co (UASG.CA)
28 Egyptian Media Production City Co (MPRC.CA)
29 Alexandria Mineral Oils Co (AMOC.CA)
30 Alexandria Spinning & Weaving Co (SPIN.CA)
31 Arabia Cotton Ginning Co (ACGC.CA)
32 Unirab Polvara Spinning And Weaving Co (APSW.CA)
33 Eastern Co (EAST.CA)
34 El Nasr Clothing And Textiles Co (KABO.CA)
35 Nile Cotton Ginning (NCGC.CA)
36 Egyptian For Tourism Resorts (EGTS.CA)
37 Oriental Weavers Carpet Co (ORWE.CA)
Continue Table 3-1
Study Sample
38 Egyptians For Housing Development And Reconstruction Co (EHDR.CA)
39 Cairo For Housing And Development Co (ELKA.CA)
40 El Shams Housing And Urbanization Co (ELSH.CA)
41 Medinet Nasr For Housing And Development (MNHD.CA)
42 United Company For Housing And Development (UNIT.CA)
43 Raya Holding Company For Technology And Telecommunication (RAYA.CA)
44 Orange Egypt For Telecommunications (OREG.CA)
45 Telecom Egypt Co (ETEL.CA)
46 Egypt Gas (EGAS.CA)
47 Gb Auto (AUTO.CA)
48 Heliopolis Co For Housing And Development (HELI.CA)
49 Palm Hills Development Company (PHDC.CA)
50 Sixth Of October Development And Investment (OCDI.CA)
Table 3-2
Sample Sector Classification
No. Sector No. of Companies in
the Sector %
1 Basic Resources 4 8%
2 Chemicals 4 8%
3 Construction and Materials 7 14%
4 Food and Beverage 7 14 %
5 Industrial Goods, Services and Automobiles 6 12%
6 Media 1 2%
7 Oil and Gas 1 2%
51
8 Personal and Household Products 7 14%
9 Real Estate 8 16%
10 Technology 1 2%
11 Telecommunication 2 4%
12 Utilities 1 2%
13 Travel and Leisure 1 2%
Total 50 100%
3.5 Variables Identification and Measurements
Based on what has been explained in previous chapters about a conceptual
definition for study variables, this section will focus on identifying the measurement of
each variable and the reasons for its choice.
According to the previous chapter, there are 6 variables which are accounting
conservatism, audit firm size, audit tenure, company size, company profitability and
company leverage. In agreement with multiple regression models, these variables can be
classified into dependent, independent and other variables, so figure (3.1) shows the
relationship among these variables which represents the conceptual framework of the
study; hence, the following part will discuss this issue.
Figure 3-1
Conceptual Framework
Dependent Variable
Accounting
Conservatism
Moderator Variable
Firm Size
Profitability
Leverage
Independent
Variables
Audit Size
Audit Tenure
51
3.5.1 Dependent variable
As stated in the previous chapters, there are many measures for accounting
conservatism, which represent the dependent variable in this study, such as asymmetric
timeliness measure developed by Basu's (1997), market-to-book ratio by Beaver and
Ryan (2000), and too hidden-reserves measure by Penman and Zhang’s (2002).
However, these methods have many disadvantages related to the implementation and
validity of them; consequently, the study will depend on cumulative negative non-
operating accruals measurement developed by Givoly and Hayn (2000) as well as many
authors like Lara et al. (2009), Ahmed and Duellman (2007), Xia and Zhu (2009),
Soliman (2014), and Al-Sraheen et al. (2014).
According to Givoly and Hayn (2000), conservatism leads to persistently
negative accruals. More conservative accounting is reflected by more negative average
accruals. Averaging over a number of years will mitigate the effects of any temporary
large accruals since accruals will likely reverse within one to two years (Richardson et
al., 2005; and Ahmed and Duellman, 2007).
Conservatism is expressed as the choice of accounting principles that leads to a
minimization of reported earnings as it leads to consistently lower cumulative earnings
relative to operating cash flows, and higher accounting conservatism results in more
negative total accruals; it is suggested that the sign and magnitude of accumulated
accruals over time are measures of conservatism. Conservative accounting leads to
negative accruals, and the more negative are accruals, the more conservative are
financial reports (Givoly and Hayn, 2000, p.292).
According to Givoly and Hayn (2000), accounting conservatism can be
calculated as:
52
CONSVi = -1 x (1/n) x Ʃnj=1 (NOACCij/TAij) (1)
Where:
i is the firm identifier; j is the selected accumulation period.
CONSVi: is the accruals-based conservatism proxy for firm i.
NOACCij: is the non-operating accruals.
- Non-operating accruals = total accruals before depreciation - operating
accruals, Where:
o Total accruals before depreciation (TACC) = Net income before
depreciation - cash flow from operations (CFO)
o Operating accruals = Δ accounts receivables + Δ inventory + Δ
prepaid expenses - Δ accounts payable - Δ taxes payable - Δ accrued
expenses
TAij: is total assets for firm i in a time period j.
As result of the complexity of the above equation, many authors tried to simplify
it, for instance Givoly and Hayn (2000), Ahmed and Duellman (2007), and Qiang
(2007), so respectively conservatism is computed as an operational profit or income
before extraordinary items and discontinued operations plus depreciation expenses
minus operating cash flows and divided by the total asset at the beginning of the period,
then multiplying the whole equation by -1. Thus, the larger is the value of this measure,
the larger is accounting conservatism, so the simple form is shown as follows:
Accounting conservatism (ACCON) =
(2)
Total assets at the beginning of the period
Cash flow of the operation - (Depreciation cost + Operational profit) × -1
53
Based on that, the study will use the simple form of Givoly and Hayn’s
measurement which is in line with Soliman (2014) and many other authors.
3.5.2 Independent Variables
The quality of an audit is an important but still a controversial issue in both
practice and theory. Thus, research on audit area has recently focused heavily on audit
quality (Knechel el al., 2012; Laitinen and Laitinen, 2015).
According to figure (3.1) which explained the conceptual framework, audit
quality represents the independent variable in this study, so the following section will
focus on audit quality’s measures that will be used in this study.
3.5.2.1 Audit Firm Size
Many authors, for instance DeAngelo (1981), DeFond and Subramanyam
(1998), Francis et al. (1999), Sori et al. (2006), Fargher et al. (2008), Choi et al. (2010),
and Lennox et al. (2012), used audit firm’s size as a measure for audit quality because
of their belief that if the audit firm's size is greater , the audit quality will be enhanced
more greatly as big audit firms have the ability to perform their job more efficiently and
effectively than small audit firms, as result of having capability to hire more talented
employees, use superior technology, and own the best financial resources to undertake
audit process than smaller audit firms. Therefore, the likelihood to discover errors and
manipulation in client’s financial statements increases.
Hussein and MohdHanefah (2013) summarized the link between audit firm’s
size and audit quality “There is no doubt that the big audit firms have the ability,
potential qualification, qualified auditors, competent elements, use of technical
54
information, and use of sophisticated and effective methods, so the result is high-quality
audits and developed audit profession”
Based on that, the study will use audit firm’s size as a measure of audit quality,
so if the company’s audit is performed by one of the big firms (Pricewaterhouse
Coopers, Deloitte Touche Tohmatsu, KPMG and Ernst and Young), the (ASIZ) variable
assumes value 1, otherwise 0, whereas a dummy variable is the most common measure
for the firm's audit quality as a value of 1 is given to the firm if its audited by one of the
big 4 firms while it's given 0 if otherwise. (Chen et al., 2005, Soliman and Ragab, 2014;
Soliman, 2013; Klein, 2002; Piot and Janin, 2007; Peasnell et al., 2005 and Metawee,
2013)
According to many authors, for instance Chen et al. (2005), Soliman and Ragab
(2014), Soliman (2013), Klein (2002), Piot and Janin (2007), Peasnell et al. (2005) and
Metawee (2013), a dummy variable is the most common measure for the firm's audit
quality as a value of 1 is given to the firm if its audited by one of the big 4 firms while
it's given 0 if otherwise. Chen et al. (2005), Soliman and Ragab (2014), Soliman (2013),
Klein (2002), Piot and Janin (2007), Peasnell et al. (2005) and Metawee (2013).
3.5.2.2 Auditor Tenure
Auditor Tenure represents the length of the relationship between auditors and
their clients; generally there is a debate among authors about the reliability of auditor
tenure as audit quality measures. For example, (Arel et al., 2005; Jackson et al., 2008;
Chi et al., 2009; George, 2004; Ghosh and Moon’s, 2005; Arel et al., 2005; Knechel and
Vanstraelen, 2007 and Jackson et al., 2008) who asserted that there is a strong
relationship between audit quality and auditor tenure so that long auditor rotation has a
positive impact on audit quality. That can be explained by a new engagement that
involves a higher risk as auditors lack the customer-specific knowledge essential to
55
effectively conduct auditing, and this knowledge of the customer and the business
environment is something obtained by experience with the client over time.
Furthermore, other authors, e.g., (Geiger and Raghunandan, 2002; Arel et al.,
2005; and Chi et al., 2009) who asserted that long auditor rotation has a negative impact
on audit quality, and they demonstrated that by Enron scandal which was unraveled and
filed for Chapter 11 bankruptcy on Dec. 2, 2001.
Consistent with the work of Jenkins and Velury (2008), Li (2010) and Chin et al.
(2012), this study used, as a proxy for the time of service to the client (ATEN), the
number of consecutive years in which the audit is performed by the same firm.
3.5.3 Moderator Variable
As stated earlier, variables other than audit quality may have an effect on
accounting conservatism which is why moderator variable must be used to other for this
effect. There are three moderator variable that were chosen in order to minimize the
specification bias in the testing of the hypotheses, which are firm size, firm financial
leverage and firm profitability.
3.5.3.1 Firm Size
According to many authors, for instance Klien (2002), Hillman et al. (2007),
Piot and Janin (2007), Meek et al. (2007), Johari et al. (2008), Khan and Watts (2009),
Rusmin (2010), Al shubiri et al. (2012) and Soliman (2013), firm size is generally
measured as the natural log of total assets. Based on that, this study will depend on the
natural logarithm of total assets as a proxy for firm size.
56
3.5.3.2 Firm's Financial Leverage
There are several different specific ratios that can be used as measures of firm’s
financial leverage, for example Watts and Zimmerman (1986) used debt to equity ratio
which is total debt divided by total equity; also, Al shubiri et al. (2012), Waweru and
Riro (2013) and Habbash (2010) used a long term portion only of the debt in calculating
debt to equity ratio. Other authors, such as Peasnell et al. (2005), Weber (2006), Rusmin
(2010), Warrad et al. (2012), Abed et al. (2012), and Soliman (2013) and Uwuigbe et al.
(2015) used total debt ratio which is calculated by dividing total debt by total assets of
the firm, so total debt ratio will be used in this study as a measure of firm’s financial
leverage.
3.5.3.3 Firm’s Profitability
Firm profitability is about firm's ability to generate earnings as compared to its
expenses and other relevant costs incurred during a specific period of time, so there are
many financial metrics that used to measure firm’s ability to achieve that, for example,
profit margin, return on assets (ROA), return on capital employed and return on equity
(ROE), residual income and Tobin's Q. Each ratio assesses a different aspect of
profitability, for instance, return on assets is an indicator of how profitable a company is
relative to its total assets.
By reviewing literatures by, such as Dittmar et al. (2003), Ferreira and Vilela
(2004), Kusnadi et al. (2015), Saddour (2006), Harford et al. (2012) and Flipse (2012)
that studied factors affecting accounting conservatism, they generally depended on
Tobin's Q as a measure of firm profitability, so this study will use Tobin's Q as a metric
57
of firm profitability which calculates by dividing total market value over total book
value.
The Tobin's Q ratio is a ratio devised by James Tobin of Yale University, Nobel
laureate in economics, who hypothesized that the combined market value of all the
companies on the stock market should be about equal to their replacement costs. The Q
ratio is calculated as the market value of a company divided by the replacement value of
the firm's assets (Brainard and Tobin, 1968).
For example, a low Q (between 0 and 1) means that the cost to replace a firm's
assets is greater than the value of its stock. This implies that the stock is undervalued.
Conversely, a high Q (greater than 1) implies that a firm's stock is more expensive than
the replacement cost of its assets, which implies that the stock is overvalued. This
measure of stock valuation is the driving factor behind investment decisions in Tobin's
model (Tobin, 1969).
Correspondingly, the following table 3-3 summarizes the variables applied in
this study and the methods used to measure each of them.
Table 3-3
Study Variables and its Measurements
Variable Code Measurement
Independent Variables
Audit Firm Size ASIZ Dummy value (1 = if the audit firm among the
big four auditing firms; 0 = otherwise).
Auditor Tenure ATEN Continuous variable: length of years the auditor
audit their client.
Dependent Variable
Accounting
Conservatism ACCON Givoly and Hayn (2000)
58
Moderator Variables
Firm Size FSIZ Natural logarithm of total assets
Firm Profitability Q Tobin’s Q Ratio
(Total market value/ Total book value)
Firm Financial Leverage LEV Total debt ratio
(Total debt/ Total Assets)
3.6 Research Model
To test the casual relationship between audit quality, audit firm size and auditor
tenure which represent independent variables and accounting conservatism which
represents dependent variable, a multiple regression model is used, so the following
regression model tests this causal relationship.
ACCON= β0 + β1 ASIZ + β2 ATEN + β3 FSIZ + β4 LEV + β5 Q + ε
Where:
ACCON = Accounting conservatism index
ASIZ = The audit firm’s size
ATEN = Auditor tenure
FSIZ = Firm’s size
LEV = Firm’s financial leverage
Q = Firm’s profitability
ε = The error term
3.7 Summary
As acknowledged in chapter one, the overall aim of this study is to progress an
understanding of the effect of audit quality variables, which are audit firm size and
59
auditor tenure independence, on accounting conservatism for the most 50 active
companies in the Egyptian stock exchange. The vital aim is to conclude whether audit
quality has a significant effect on accounting conservatism of the firms in Egypt for the
period (2007-2015).
The relationship tested in this research examines the relationship between audit
quality as an independent variable and accounting conservatism as a dependent variable.
Three other variables are included in this relationship: firm size, firm profitability and
financial leverage. The accounting conservatism was measured by Givoly and Hayn’s
measure of conservatism, and audit quality is measured through certain proxies which
will be discussed later in the coming parts.
CHAPTER FOUR: FINDINGS AND ANALYSIS
4.1 Introduction
After determine research methodology that will be used in this study in previous
chapter; which included the identification in details of the sample chosen in this study,
the period covered, the statistical tools which are applied, and the model that is followed
in order to be able to test the relationship between the dependent (accounting
conservatism) and independent variables (audit size and auditor tenure) and other
variables (firm size, firm leverage, and firm profitability). This chapter will focus on the
findings and analysis of the results of descriptive statistics and regression analysis.
61
Based on that, this chapter aims to achieve an intensive analysis of the results
obtained, starting with the descriptive analysis for the data, and following by the
correlation analysis of variables. After that testing the research hypotheses and
identifying whether these hypotheses will be accepted or rejected.
4.2 Descriptive Statistics
This section provides simple summaries about the sample (50 most active
companies, over the period 2007-2015) and about the observations that have been made
(443 observations), so analysis results of the sample will be discussed in terms of mean,
maximum, minimum and standard deviation which used to quantify the amount of
variation or dispersion of a set of data values. Table 4-1 provides summary of
descriptive analysis of study variables (accounting conservatism, audit firm size, auditor
tenure, firm profitability, firm size and firm leverage).
Table 4-1
Descriptive analysis of study variables
variables Min. – Max. Mean ±SD
Accounting conservatism -0.35 - 2.41 0.03 0.16
Firm Leverage 0.02 - 3.18 0.48 0.32
Firm Profitability -0.70 – 3.65 0.33 0.44
Audit firm size 0.0 – 1.0 0.45 0.50
Firm Size 7.14 - 10.98 9.13 0.72
Auditor Tenure 1.0 – 9.0 4.12 2.46
According to table 4-1 accounting conservatism (dependent variable, which is
calculated using Givoly and Hayn (2000) model) mean is 0.03, a maximum is 2.41, a
minimum is -0.35 and a standard deviation is 0.16, which is the lowest standard
61
deviation among study variables. So that indicates that the data points for accounting
conservatism tend to be close to the mean.
The second variable is audit firm size (which measured by using a dummy
variable, 1 is given to the firm if it’s audited by one of the big 4 firms while its given 0
if otherwise) mean is 0.45, a maximum is 1, a minimum is 0 and a standard deviation is
0.50.
Descriptive analysis for the third variable which is auditor tenure (measured by
the number of consecutive years in which the audit is performed by the same firm)
shows that minimum number of consecutive years in which the audit is performed by
the same firm is one year and maximum consecutive years are 9 years, with mean 4.12
and 2.46 standard deviation which is the largest standard deviation among study
variables. So the data points are spread out over a wider range of values.
The fourth variable is the firm’s size that is represented by logarithm of total
assets. The mean for this variable 9.13 with a standard deviation 0.72. Logarithms of
total assets for the sample are ranged from 7.14 to 10.98. Also, table 4-1 showed that
firm financial leverage which is calculated as total debts divided by total assets, mean is
0.48, a maximum is 3.18, minimum is 0.02, and a standard deviation is 0.32.
Finally, firm profitability mean is 0.33, a maximum is 3.65, a minimum is -0.70 and a
standard deviation is 0.44.
4.3 Correlation Analysis
To show the strength and direction between variables, this section provides the
correlation results using the Pearson’s correlation coefficients among all study variables
in table 4-2, also table 4-3 summarizes the results of Pearson’s correlation coefficients
between the dependent variable (accounting conservatism) and independent variables
62
(audit firm size, firm leverage, firm profitability, firm size and auditor tenure) which is
the main focus of this study.
The correlation matrix in table 4-3 shows firm profitability, audit firm size,
auditor tenure and firm leverage have significant relationship with accounting
conservatism. For instance, firm profitability has the highest significant relationship
with accounting conservatism with P value 0.003 (negative significant relationship),
also audit firm size has second significant relationship with accounting conservatism
with P value 0.008 (positive significant relationship), too auditor tenure has the third
significant relationship with accounting conservatism with P value 0.013 (negative
significant relationship), finally firm leverage has less significant relationship with
accounting conservatism with P value 0.027 (positive significant relationship). On the
other hand, firm size has a positive insignificant relationship with accounting
conservatism with P value 0.112.
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Table 4-2
Correlation Results - Pearson Correlation Matrix
Firm Size
Firm
Leverage
Firm
Profitability
Accounting
Conservatism
Audit Firm
Size Auditor Tenure
Firm Size Pearson Correlation 1 .155** -.034 .076 .376** .189**
Sig. (2-tailed) .001 .475 .112 .000 .000
N 443 443 443 443 443 443
Firm Leverage Pearson Correlation .155** 1 .337** .105* .107* .057
Sig. (2-tailed) .001 .000 .027 .025 .233
N 443 443 443 443 443 443
Firm Profitability Pearson Correlation -.034 .337** 1 -.141** .027 .144**
Sig. (2-tailed) .475 .000 .003 .567 .002
N 443 443 443 443 443 443
Accounting
Conservatism
Pearson Correlation .076 .105* -.141** 1 .126** -.118*
Sig. (2-tailed) .112 .027 .003 .008 .013
N 443 443 443 443 443 443
Audit Firm Size Pearson Correlation .376** .107* .027 .126** 1 -.025
Sig. (2-tailed) .000 .025 .567 .008 .601
N 443 443 443 443 443 443
Auditor Tenure Pearson Correlation .189** .057 .144** -.118* -.025 1
Sig. (2-tailed) .000 .233 .002 .013 .601
N 443 443 443 443 443 443
**. Correlation is significant at the 0.01 level (2-tailed).
*. Correlation is significant at the 0.05 level (2-tailed).
64
Table 4-3
Correlation between accounting conservatism with other independent variables
variables Accounting Conservatism
r p
Audit Firm Size 0.126* 0.008*
Auditor Tenure -0.118* 0.013*
Firm Size 0.076 0.112
Firm Leverage 0.105* 0.027*
Firm Profitability -0.141* 0.003*
r: Pearson coefficient
*: Statistically significant at p ≤ 0.05
4.4 Regression Analysis
After finding that there is correlation between accounting conservatism with
other independent variables except firm size in previous part, the next step is to
determine the casual effect between accounting conservatism and other variables
(audit firm size, auditor tenure, firm leverage and firm profitability) and determined
which of study hypotheses will be supported and which will be rejected, so the
researcher will depend on ordinary least squared method (OLS), because of from
previous parts (descriptive statistics and correlation analysis) we can conclude that the
model is linear in parameters, also the data are a random sample of the population,
independent variables are not too strongly collinear, independent variables are
measured precisely, in the same context the researcher used the Statistical Package
for Social Science (SPSS) program version 23 to analysis study data.
Table 4-4, table 4-5 and table 4-6 show the results of regression analysis, for
instance R square of the model as shown in table 4-4 amount is (0.069) which means
that 6.9% variation in the dependent variable (accounting conservatism) is explained
65
by the independent variables (audit firm size, auditor tenure, firm leverage, firm size
and firm profitability). This value is somehow low but this is due to the existence of
many other factors that might affect accounting conservatism rather than variables
included in this study, also The value of the multiple correlation coefficient (R) of this
model is (0.262) as shown in table 4-4, this value indicates a positive low relation
between the actual values (Y) and the predicted values (ŷ) as it isn’t so close to the
value of 0.5, and the higher this value the better, therefore the sample of this study
moderately represents the population.
Moreover, in table 4-5, the significance level of the model is shown which is
equal to (0.000) and that’s an indication that this model is highly significant as the
criteria for the significance level is 0.05, if it's 0.05 or below the model is significant
and if its above 0.05, the model will be considered insignificant and F value is 6.463.
The Durbin Watson statistics is 1.814 which is near to 2, this means that error terms
are uncorrelated, and thus there is no autocorrelation problem.
Table 4-6 shows that audit firm size has a positive significant relationship with
accounting conservatism with standardized coefficients .102, also auditor tenure has a
negative significant relationship with accounting conservatism with standardized
coefficients -.103, based on that H1 is accepted: It is expected that the conservatism
level of the companies audited by a larger audit companies will be greater and H2: It is
expected that conservatism level of the companies having a longer relationship
between the auditor and the client will be lower. Additionally, firm leverage has a
positive significant relationship with accounting conservatism. On the other hand,
firm profitability has a negative significant relationship with accounting conservatism.
Likewise, firm size has a positive insignificant relationship with accounting
conservatism. Table 4-7 summarize hypotheses test results.
66
Table 4-4
Model Summary b
Model R R
Square
Adjusted R
Square
Std. Error of the
Estimate
Durbin-
Watson
1 .262a .069 .058 .15710 1.814
a. Predictors: (Constant), auditor tenure, audit firm size, firm leverage, firm Profitability,
firm size
b. Dependent Variable: Conservatism index
Table 4-5
ANOVA a
Model Sum of
Squares df Mean Square F Sig.
1
Regression .798 5 .160 6.463 .000b
Residual 10.786 437 .025
Total 11.583 442
a. Dependent Variable: Conservatism index
b. Predictors: (Constant), auditor tenure, audit firm size, firm leverage, firm Profitability,
firm size
Table 4-6
Coefficients a
Model
Unstandardized
Coefficients
Standardized
Coefficients t Sig.
B Std. Error Beta
1
(Constant) -.023 .102 -.227 .821
Firm Size .006 .012 .026 .508 .612
Firm Leverage .080 .025 .157 3.143 .002
Firm Profitability -.066 .018 -.181 -3.628 .000
Audit Firm Size .033 .016 .102 2.024 .044
Auditor Tenure -.007 .003 -.103 -2.150 .032
a. Dependent Variable: Conservatism index
67
Table 4-7
Hypotheses Test Results
Hypothesis Supported/Rejected
H1: It is expected that the conservatism level of the companies
audited by a larger audit companies will be greater. Supported
H2: It is expected that conservatism level of the companies having
a longer relationship between the auditor and the client will be
lower.
Supported
4.5 Removing Outliers
An outlier is a value that is very different from the other data in data set. It has
an effect on the study results because it can skew results, so in this part the researcher
will depend on box plot diagram to identify outliers for the dependent and
independent variables to exclude them from the study data set and fined the effect on
regression results shown in tables 4-4, 4-5 and 4-6.
Figure 4-4 shows box plot diagram for all 443 study observation, according to
figure 4-1 (21 observations) appear to be outlier observations, so all 21 outlier
observations shown in figure 4-1 removed from data set, then box plot diagram drawn
again for the rest of study data set (422 observations) shown in figure 4-2, based on
that outlier observations in figure 4-2 (9 observations) excluded from study data set
and again box plot diagrams drawn for the rest of study data set (413 observations)
shown in figure 4-3, based on figure 4-3 researcher exclude 4 outlier observations,
after that researcher draw box plot diagram for the rest study data set (409
observations) shown in figure 4-4, 3 outlier observations excluding from study data
set shown in figure 4-4 and box plot diagram drawn for the rest of study data set (406
68
observations), finally figure 4-5 show no outlier observations, based on that study data
set will contain 406 observations.
Figure 4-1
Box Plot Diagram
Figure 4-2
Box Plot Diagram
69
Figure 4-3
Box Plot Diagram
Figure 4-4
Box Plot Diagram
71
Figure 4-5
Box Plot Diagram
4.6 Correlation Analysis after Removing Outliers
The correlation matrix in table 4-8 and the summary in table 4-9 show firm
leverage, firm profitability, and audit firm size have strong significant relationship
with accounting conservatism. For instance, firm profitability has negative significant
relationship with accounting conservatism; also audit firm size and firm leverage have
significant positive relationship with accounting conservatism, further after removing
outliers from study data set, auditor tenure has insignificant relationship with
accounting conservatism, instated of having negative significant relationship before
removing outliers, on the other hand, firm size has a positive significant relationship
with accounting conservatism, instead of having insignificant relationship before
removing outliers, based on that the following part will show the effect of removing
outliers on the result of regression analysis.
71
Table 4-8
Correlations after removing outliers
Firm Size Leverage Tobin’s Q
Conservatism.
index Audit Firm Size
Auditor
Tenure
Firm Size
Pearson Correlation 1 .376** .095 .145** .353** .207**
Sig. (2-tailed) .000 .056 .003 .000 .000
N 406 406 406 406 406 406
Firm Leverage
Pearson Correlation .376** 1 .066 .173** .247** .063
Sig. (2-tailed) .000 .183 .000 .000 .209
N 406 406 406 406 406 406
Firm Profitability
Pearson Correlation .095 .066 1 -.186** .124* .090
Sig. (2-tailed) .056 .183 .000 .012 .069
N 406 406 406 406 406 406
Conservatism index
Pearson Correlation .145** .173** -.186** 1 .235** -.027
Sig. (2-tailed) .003 .000 .000 .000 .590
N 406 406 406 406 406 406
Audit Firm Size
Pearson Correlation .353** .247** .124* .235** 1 -.011
Sig. (2-tailed) .000 .000 .012 .000 .825
N 406 406 406 406 406 406
Auditor Tenure
Pearson Correlation .207** .063 .090 -.027 -.011 1
Sig. (2-tailed) .000 .209 .069 .590 .825
N 406 406 406 406 406 406
**. Correlation is significant at the 0.01 level (2-tailed).
*. Correlation is significant at the 0.05 level (2-tailed).
72
Table 4-9
Correlation between accounting conservatism with other independent variables
after removing outliers
Variables Accounting conservatism
r p
Firm Size 0.145* 0.003*
Firm Leverage 0.173* 0.000*
Firm Profitability -0.186* 0.000*
Audit Firm Size 0.235* 0.000*
Auditor Tenure -0.027 0.590
r: Pearson coefficient
*: Statistically significant at p ≤ 0.05
4.7 Regression Analysis after Removing Outliers
Table 4-10, table 4-11 and table 4-12 show the results of regression analysis
after removing outliers, for instance R square of the model as shown in table 4-10
amount is (.120) which means that 12% variation in the dependent variable
(accounting conservatism) is explained by the independent variables (audit firm size,
auditor tenure, firm leverage, firm size and firm profitability), and comparing R
square value before (is .069) and after (is .120) removing outliers, it is found that R
square value almost double, which means that the regression model after removing
outliers explains more the behavior of accounting conservatism, also the value of the
multiple correlation coefficient (R) of this model is (.347) as shown in table 4-10, is
closer to the value of 0.5 than its value before removing outliers (0.262), and the
higher this value the better, therefore the sample of this study represents the
population.
Moreover, in table 4-11, the significance level of the model is shown which is
equal to (0.000) and that’s an indication that this model is highly significant as the
criteria for the significance level is 0.05, and F value is 10.947. The Durbin Watson
73
statistics is 1.712 which is still near to 2, which means that error terms are
uncorrelated, and thus there is no autocorrelation problem.
Table 4-12 shows that audit firm size has a positive significant relationship
with accounting conservatism with standardized coefficients 0.216, so H1 is accepted:
It is expected that the conservatism level of the companies audited by a larger audit
companies will be greater, additionally, firm leverage has a positive significant
relationship with accounting conservatism. On other hand, firm profitability has a
negative significant relationship with accounting conservatism. Also firm size has a
positive insignificant relationship with accounting conservatism. On the contrary to
the result of regression analysis before removing outliers, table 4-12 shows that
auditor tenure has a negative insignificant relationship with accounting conservatism,
based on that H2 is rejected: It is expected that conservatism level of the companies
having a longer relationship between the auditor and the client will be lower. Table 4-
13 summarize hypotheses test results.
Table 4-10
Model Summary b (after removing outliers)
Model R R Square Adjusted R
Square
Std. Error of
the Estimate Durbin-Watson
1 .347a .120 .109 .06992 1.712
a. Predictors: (Constant), auditor tenure, audit firm size, firm profitability, firm leverage,
firm size
b. Dependent Variable: Conservatism index
74
Table 4-11
ANOVA a (after removing outliers)
Model Sum of Squares df Mean Square F Sig.
1
Regression .268 5 .054 10.947 .000b
Residual 1.956 400 .005
Total 2.223 405
a. Dependent Variable: Conservatism index
b. Predictors: (Constant), auditor tenure, audit firm size, firm profitability, firm leverage,
firm size
Table 4-12
Coefficients a (after removing outliers)
Model
Unstandardized
Coefficients
Standardized
Coefficients t Sig.
B Std. Error Beta
1
(Constant) -.043 .050 -.870 .385
Firm Size .005 .006 .051 .939 .348
Firm Leverage .037 .016 .116 2.281 .023
Firm Profitability -.045 .010 -.223 -4.698 .000
Audit Firm Size .032 .008 .216 4.230 .000
Auditor Tenure -.001 .001 -.022 -.458 .647
a. Dependent Variable: Conservatism index
Table 4-13
Hypotheses Test Results after removing Outliers
Hypothesis Supported/Rejected
H1: It is expected that the conservatism level of the companies
audited by a larger audit companies will be greater.
Supported
H2: It is expected that conservatism level of the companies having
a longer relationship between the auditor and the client will be
lower.
Rejected
75
4.8 Summary
This chapter presented the findings and detailed analysis of the empirical
study. Firstly, descriptive statistics were used to describe the data and then correlation
analysis was conducted to show the direction and strength between accounting
conservatism and audit quality measured by audit firm size and auditor tenure,
Afterwards, regression analysis was carried out using ordinary least square (OLS)
regression and results show that audit quality significantly related to accounting
conservatism. But after removing outliers, results indicated that there are a significant
positive relationship between audit firm size and accounting conservatism, and
insignificant negative association between auditor tenure and accounting
conservatism; therefore supporting the hypotheses H1 and reject H2.
The following chapter concludes the study and presents a summary of the
research methods and main findings. Moreover, recommendations and opportunities
for further studies will be provided, and the limitations in the current research will be
stated.
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CHAPTER FIVE: CONCLUSION AND
RECOMMENDATIONS
5.1 Introduction
Audit quality and accounting conservatism implementation is considered from
the newly established areas of special interest for academia and practitioners in
developed and developing countries. Although the audit quality has been in the center
of this attention, of course, knowing current approaches towards the application of
audit quality could be useful to regulatory authorities and professional associations as
they develop their own policies, standards and educational programs regarding this
matter.
Even though many studies have been conducted on audit quality recently, an
obvious lack of research in the field is evident in Egypt. This thesis aims to fill the
gap in Egypt by analyzing the effect of audit quality on accounting conservatism for
the most active firms listed on the Egyptian stock market. This study investigates how
an effective audit quality system is able to provide sound and well-performing
accounting conservatism within Egyptian firms by studying audit firm size, auditor
tenure, firm size, firm leverage, and firm probability.
Based on that this chapter summarizes this study and its main findings, as well
as wrapping out this thesis by giving an overview of the main aim and objectives of
this thesis, along with the value of this thesis and a summary of research methods, so
this chapter consists of several sections each with different aim, first conclusion
section, summarizes the impact of the independent variables on the dependent
variable as well as summarizing the results and findings of the different analysis
77
conducted and a multiple regression analysis applied to check the relationship
between audit quality and accounting conservatism, followed by that a section that
provides some recommendations for future studies that will explore more and better
understanding for this research area. Finally, any research can face some limitations
that are sometime unavoidable, so this study will explain the limitations faced in the
last section of this chapter.
5.2 Conclusion
The primary objective of this study is to explore the effect of audit quality on
accounting conservatism of firms listed on the Egyptian stock market. This objective
has been achieved through detailed literature review and empirical analysis.
Additionally, the empirical examination of the hypotheses developed from the
conceptual framework presented in this study is used to explore the effects of audit
quality on accounting conservatism.
Consistent with prior research the study uses audit firm size and auditor tenure
as measurements of audit quality (Hamdan et al., 2012; Choi et al., 2010; Lennox et
al., 2012; Jackson et al,. 2008, and Chi et al., 2009). The study computes accounting
conservatism in terms of Givoly and Hayn (2000) measure of conservatism as
previously computed in various studies (Ho, 2009; Behrghani and Pajoohi, 2013).
This study selected the Egyptian companies of the top 50 most active
companies listed in the Egyptian Stock Exchange over the period 2007-2015. The
financial sectors are not included in this study as the characteristics of these firms are
different from the firms in other industrial sectors in terms of financial statement,
profitability measures and liquidity assessment. Also, they were specialized in nature
and were subject to different regulations, tax and accounting rules (Wilson et al.,
78
2010). This gave a sample of 50 firms. Five hypotheses are derived to consider
whether audit quality affect firms' accounting conservatism.
The research results, findings and detailed analyses of the empirical study
were presented in the following manner: The descriptive statistics were used to
describe the data and then correlation analysis was conducted to show the direction
and strength between audit quality and accounting conservatism. Afterwards,
regression analysis was carried out using ordinary least square (OLS) regression and
results show that audit firm size has a positive significant relationship with accounting
conservatism. Also auditor tenure has a negative significant relationship with
accounting conservatism
After excluding outliers from study data set the regression analysis shows that
audit firm size, firm leverage and firm profitability play a major role in effect on
accounting conservatism in Egyptian firms whereas audit firm size has a positive
significant relationship with accounting conservatism, firm leverage has a positive
significant relationship with accounting conservatism, and firm profitability has a
negative significant relationship with accounting conservatism, while firm size and
auditor tenure have a weak role whereas firm size has a positive insignificant
relationship with accounting conservatism, and auditor tenure has a negative
insignificant relationship with accounting conservatism.
To sum up, this thesis fills the gap in research on audit quality in Egypt,
highlights the importance of audit quality and each of its components on accounting
conservatism. The following section presents recommendations for future research on
audit quality in light of the results above.
79
5.3 Recommendations
This study examined whether these characteristics (or attributes) of audit
quality which is characterized by audit firm size and auditor tenure effect on the
quality of financial reporting, specifically accounting conservatism of the more active
50 non-financial companies listed at Egyptian stock exchange across nine years of
period from 2007 to 2015.
The financial information reported by a firm is of great importance to the
stakeholders as based on the provided information, stakeholders take several decisions
including investing decisions by investors and institutions and providing loans
decisions by banks and other lenders, and many other decisions are based on the
information provided by firms. Therefore, in order to avoid the risk of losing the
financial information credibility and the trust of the financial information users and in
order not to face problems with the auditing firms, firms must have an accounting
conservatism to provide credible and reliable information.
One of the research hypotheses is about the size of the audit firm and the level
of conservatism. Based on the evidence presented, this study can confirm that the
level of accounting conservatism is greater in the numbers reported by companies
audited by major independent auditing firms (Big) than smaller ones. Thus, the largest
independent accounting firms, now called Big Four, have higher audit quality, which
positively affects the level of conservatism. The evidence presented in this paper
indicates that auditor tenure did not influence the conservatism of accounting
numbers.
Based on these results, the study recommends that the professional
associations in Egypt and the government work to improve the auditing quality in
81
Egypt, as the characteristics of auditing quality have impact on the enhancement the
level of conservatism, through enhancing law and regulations that enforce companies
to adopt accounting conservatism principle in their financial system, also encourage
audit firms to increase audit quality and focus on auditing companies accounting
conservatism practices. On the other hand academics need to investigate other factors
that affect financial information quality in general, also the determinations and
motivations of accounting conservatism practices, as well as audit quality in
Egyptians business environment, especially in the light of this study results which
indicate that not all audit quality attributes affecting the level of accounting
conservatism in Egypt.
5.4 Limitations
In this study, several of limitations and obstacles were encountered; due to
Egypt is a developing country where the electronic databases are unavailable. This
leads to limitations in the data availability, which made this research more important
and vital to shed light on country-related deficiencies that should not exist in order for
Egypt to be able to become a developed country.
Generalizing the results for all firms (other than the sampled firms)
becomes limited due to the nature of empirical model used and study
sample.
The quality of the study depends entirely upon the accuracy, consistency,
reliability and quality of secondary data. However, collecting financial
data in Egypt was a challenge, due to its unavailability, for instance there
are many measures of audit quality other than audit firm size, auditor
tenure, but according to data unavailability we used these two measures.
81
According to statistical analysis results R square of the study model is
(.120), which means that only 12% variation in the dependent variable
(accounting conservatism) is explained by the independent variables
(Audit firm size, Auditor Tenure, Leverage, firm size and Tobin's Q) so
there are many other variables affecting accounting conservatism didn’t
include in this study.
The research is based on the period from 2007 until 2015; this period
includes financial crisis and Egyptian revolution which may have negative
effect on financial statements, resulting in misleading findings.
5.5 Suggestions for Future Research
The results of this study show a diversity of results in audit quality and
therefore, create a strong trend between audit quality and accounting conservatism,
which increases the research gap further and proves that audit quality is applied
efficiently in Egypt.
Another path for further research is to test additional audit quality
characteristics that may influence firm performance. Examples for such additional
characteristics are; specialization of the audit firm, also provision of non-auditing
services to the client, type of client, importance of the client, delay in issuing the audit
report and may be other attributes.
However, there is a need for further research to consider more factors that
might affect conservatism as environmental and cultural factors and industry type.
Such investigation can be carried out using data of a large sample of listed firms to
test the relationship between auditing quality and accounting conservatism on wide
82
spectrum of variables as earning’s quality, stock prices, firm valuation, cost of capital,
and corporate governance mechanisms.
Finally, further research can be conducted as comparative studies between
Egypt and a developed country for the same period of time in order to be able to
compare the results and conclude broader conclusions. Also future study should
increase the length of the research period of the study to ensure that there is no
biasness in drawing conclusions. Perhaps by covering a longer time period, it will be
more meaningful in explaining dependent variable.
Hope this study will contribute to a better understanding of the various factors
that affect accounting conservatism in the financial statements, and the relationship of
these with the presence of audit quality. In addition, hope this work will encourage the
development of new studies on the characteristics of the financial information and
quality of auditing in Egypt.
83
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المالیة . دور التحفظ المحاسبي في الحد من الآثار السلبیة للأزمة ٣١٠٢الجارحي، ھاني عبده خلیل حسانین.
.٧٦ – ٨٥: ٠١١یة. مجلة إدارة الاعمال ، العدد العالمیة : دراسة نظر
إطار فى المالیة بالقوائم المحاسبى التحفظ قیاس نماذج وتحلیل دراسة . ٣١٠١ .محمد اھیم إبر محمد راشد،
جمهوریة على والإقتراض ) دراسة تطبیقیة بالملكیة التمویل تكلفة على أثره لتقییم المحاسبیة بالمعاییر الإلتزام
.جامعة الإسكندریة – التجارة كلیة منشورة، غیر دكتوراه العربیة (. رسالة مصر
إعداد . نموذج مقترح لقیاس وتفسیر تأثیر مستوى التحفظ المحاسبى عند ٣١٠٣سلامة، صلاح حسن على.
.٧٢٢ – ٨٣٦ :١، العدد ٠٧التقاریر المالیة على قیمة المنشأة : دراسة تطبیقیة. الفكر المحاسبي، المجلد
الفكر . مقارنة دراسة : المنشورة المالیة التقاریر في المحاسبي التحفظ قیاس . ٣١٠١ . رجب أحمد ، الملك عبد
.٠١٧ – ٦٢ : ٣ العدد ، ٠١ مجلد المحاسبي،
، " مدخل مقترح لتقییم جودة أداء المراجعة" ، المجلة العلمیة للبحوث ٣١١٠مجاھد ، إیمان أحمد أمین ،
. 103 – 171جامعة حلوان ، )العددان الثالث والرابع( ، ص : –التجاریة ، كلیة التجارة والدراسات
