Relationship between audit quality and financial reporting quality is of great significance; higher-quality audits significantly enhance reliability and transparency of financial statements. To examine these relationships more fully, this research uses Policeman Theory as a lens through which to examine determinants of audit quality as well as any impactful fraudster activities that might affect audits.
This analysis leverages panel data and applies both OLS and GMM estimation techniques to address issues of endogeneity, as well as control variables to eliminate potential biases.
Corporate Governance
Corporate governance is a crucial topic of business management. It encompasses a set of practices designed to help companies meet their financial goals while being accountable to stakeholders. This may involve encouraging transparency and accountability by providing clear channels of communication; and encouraging diversity by cultivating an environment which values diverse viewpoints and talents. Other practices related to corporate governance could include transparent board appointments, equitable policies and impartial decision-making practices.
Scholars have traditionally investigated the link between corporate governance mechanisms and accrual quality. Auditors serve to minimize agency problems between managers and shareholders by acting as a check on firm accruals.
Recent research has cast doubt on whether institutional investors can successfully monitor corporations. This is likely due to them often being motivated by self-interest rather than looking out for minority shareholders; this lack of monitoring may especially apply for larger institutions like banks and pension funds. A strong audit committee can improve reporting quality by holding management accountable.
Audit Fees
Studies on the relationship between audit fees and quality have taken various approaches. Some researchers have attempted to separate premiums from residuals; while others have focused on client-related risk factors that can impede an audit’s quality.
Although research may vary widely depending on the subject matter and methodology employed, most prior research has concluded that higher fees correlate to greater audit quality. This finding supports the notion that firm value relies upon timely and reliable financial data which can be improved through quality audits.
Studies have also reported that firms who make use of non-audit services from their auditors tend to pay higher audit fees than firms who don’t, which goes against the assumption of economies of scale or cost savings from joint services provided by auditors and has led to some confusion over the true nature of these fees. Some research attempts at clarifying this matter by using more precise measures of audit risk and by distinguishing audit fee premiums from other residuals.
Audit Tenure
Auditor tenure is an essential determinant of audit quality. Over the course of their tenure, auditors acquire skills and develop expertise within their firms of service to increase the likelihood that they detect fraudulent activity and enhance financial reporting quality. Conversely, shorter tenure may reduce audit quality by increasing risks related to underreporting (Krishnan et al. 2007).
One reason that shorter auditor tenure may correlate to lower earnings quality is that auditors with a larger market share in an industry may be less familiar with it and therefore more likely to overlook earnings manipulation (Francis and Wilson 1988; Francis et al. 2005a; DeFond and Zhang 2014).
Studies have demonstrated that audit quality increases with auditor tenure due to the Learning Effect; conversely, shortening it can diminish audit effectiveness by diminishing its Bonding Effect. As such, regulations designed to restrict audit tenure would likely prove counter-productive for investors in countries offering robust investor protection measures.
Financial Statement Fraud
Financial statement fraud is a widespread white-collar crime that can result in significant losses for businesses and investors. Financial statement fraud involves manipulating a company’s financial figures, valuations, estimations and accounting principles to hide underlying problems within it’s finances. Financial statement fraud often takes the form of falsifying expenses; failing to mention significant events or related-party transactions; concealing accounting changes’ impact by altering them on its statements – among many other crimes committed with these means.
These fraudulent activities are often made easier due to weaknesses in corporate governance, giving individuals the ability to manipulate financial data without detection. Management plays a vital role in initiating or contributing to fraud by bypassing internal controls and collude with other employees in committing such schemes.
Studies have established a correlation between audit quality and fraudulent activities prevention, the “Policeman Theory,” and auditors acting as watchdogs to safeguard financial reporting integrity of companies. Unfortunately, most studies on this topic have focused on developed countries rather than Muslim majority countries like Indonesia.