Audit Quality: A Cross-National Comparison of Audit Regulatory Regimes

ByGary Kleinman, Ph.D.Betsy Beixin Lin, Ph.D.Department of Accounting, Law & TaxationMontclair State UniversityAudit Quality in an International Setting: Testing the Impact of Religion, Culture, Income and Legal Code on National Regulatory Efforts

MotivationsThe importance of fostering more accurate audits in order for audits to serve the public interest has been heightened by a series of high-profile accounting scandals at the beginning of the millennium. These scandals prompted the legislating of more stringent regulations over corporate governance and financial reporting since 2002. It also led to the setting up of such audit oversight bodies as the Public Accounting Oversight Board (PCAOB) in the U.S. and the Public Oversight Board (POB) in the UK. In parallel, the growing globalization of business has brought forth the globalization of capital markets. The creation of operations abroad, entrance into joint ventures, and the growth in the number of firms that seek to list on foreign stock exchanges, calls for new attention to how audit regulation is undertaken. The drumbeat of audit failures and scandals, most notably exemplified by the Enron and Worldcom debacles in the Unites States; the Ahold and Parmalat failures in Europe; the Resona bank audit failure in Japan and the HIH insurance company failure in Australia, has heightened public and regulatory concern over both the quality and integrity of public company audits across the globe. 2MotivationsSeveral potential determinants of the strength of audit regulation and enforcement efforts were postulated in Kleinman, Lin and Palmon (2014). The postulated determinants include national culture, religion, source of auditing and accounting standards, and legal code origin. The authors, however, did not test the relationship of the postulated determinants to auditing enforcement efforts. This study undertakes the task of investigating these postulated determinants, using the Brown, Preiato and Tarca (2014) measures of auditing enforcement efforts. National Audit Regulatory Regimes (KLP 2014)We identify the following questions as valuable to answer:What standards does each national regulator use: IAS? PCAOB (here)? Other?Does the extant literature say these are principles or rule-based?Legal framework used in nation?Who is the national regulator?How is regulation enacted?Regulator inspections?Non-regulator inspections that count (e.g., peer review)?How often are the inspections conducted?What are the consequences of found problems? Fines? Disciplinary actions?What public reports, if any, are made available--allowing potential clients to see 'auditor quality'?Are there cross-national agreements? And what criteria govern the willingness of country As willingness to accept audit inspections conducted by country B?

Standards are useless unless their use is enforced. Accordingly, next we describe the national regulatory systems to shed light on the existence of potential pressures on auditors to resist the calls of avarice and lassitude, and therefore to expend the necessary effort to accomplish their work well.

4Brown, Preiato,Tarca (2014) Audit and Accounting Enforcement IndicesMost previous studies do not consider specific enforcement measurements of accounting and auditing standards and the activities of auditors and enforcement bodies in the construction of enforcement measurement.Brown, Preiato and Tarca (2014) construct the auditing and accounting enforcement indices including the specific elements mentioned above that are likely to affect the quality of information available in capital markets and thus to be important for investor decision making in each country. (Table 2 & 3 in Brown et al.s paper)Main source of the information is IFAC surveys of professional accounting bodies. Others include FEE, CESR, annual reports of securities and market regulators, and World Banks ROSC. As noted above, we focus on financial reporting enforcement, not the broader enforcement of securities market law and regulations.

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Research ObjectiveGordon, Greiner, Kohlbeck, Lin and Skaife (2013) who note that non-US audit markets can differ from the US markets in that the objective of the audit function varies (p. 143.) They specifically note that audits conducted outside the US may differ, even when the audits are conducted using the same Big N name. The authors argue, therefore, for the adequate characterization of local audit markets, with respect to the relationship between auditing and financial reporting quality.Therefore, the objective of this study understand the relationship between national cultures, religious affiliation, religious importance, legal systems, economic and capital market factors and audit enforcement regimes. It is the first cross-national study of such.

Religion-1 Gottschall (2012), citing Durkheim defines a group as a group by providing group members with a unified system of beliefs and practices. coordinates behavior within a group, setting up rules and norms, punishments and rewards. provides a powerful incentive system that promotes group cooperation and suppresses selfishness.Guiso et al. (2003)religious people, among others, are less willing to break the law, believe more in the fairness of the market and have less progressive attitudes towards working womenReligion-2However, large deviations often exist during the translation of values and beliefs into concrete actions and behavior. Social pressures may affect the relationship between religion and concrete actions and behavior (Klaubert 2010).Religionsdiffer [with respect to] their enforcement mechanisms, [and] with respect to the strictness of the enforcement of the norms and rules (Klaubert 2010). La Porta et al. (1999) present evidence that countries having high proportions of Catholics or Muslims exhibit poorer government performance. Stulz and Williamson (2003) finds that religion is a better predictor for creditor rights and the enforcement of rights and accounting standards than other predictors such as a countrys natural openness to international trade, its language, its income per capita, or the origin of its legal system. Religion-3Mensah (2014) examined the relationship of culture and religion to perceived levels of corruption. He uses the Protestant religion as his benchmark in his evaluation of the impact of religion on corruption, because prior literature found Protestantism is negatively associated with corruption. Mensah (2014) finds that the Protestant, Buddhist and Hindu adherent percentages were associated with reduced corruption, while other Christian religions, Islam and other religions or no religion percentage of followership in his sample countries were associated with greater corruption. Hypothesis 1Do, therefore, strong injunctions against bad behavior also lend themselves to strong support for institutions to protect against the occurrence of such behavior? Or does the presence of strong normative (religious-based, here) injunctions against bad behavior lead to a perception that such strong institutional controls on bad behavior are not needed, with the result that they are not put into place?

H1: Religion will not be associated with greater auditing regulatory enforcement.

Religious Importance -1Wilson (1993), citing Ginsberg (1947), notes that religious doctrines, whether drawn from Buddhism, Christianity, Judaism, Islam or Confucianism, have much in common. He notes that a list of virtues or duties drawn up by any of these would not differ greatly from a list drawn up by any other of these religions.On the other hand, the importance of religion, any religion, may vary from piddling to very important, an idea addressed in Hess (2012) and Durant and Durant (1968).Religious Importance -2Hess (2012) studied the relationship between high religious norms and levels of credit card debt, foreclosures, and bankruptcies.Hilary and Hui (2009) find that firms located in U.S. counties with high religiosity level are associated with lower risk exposure measured as the variance in equity return and in ROA. McGuire et al. (2012) was among the first that examines directly the impact of religion on financial reporting behavior using U.S. firms. They find that firms headquartered in areas with strong religious social norms generally have fewer cases of financial reporting irregularities and are associated with lower accounting risk.

Hypothesis 2If stronger felt importance of religion is associated with higher ethics, perhaps there will be a perception that more money need not be spent on regulatory activity, i.e., that individuals and organizations will self-police? Or a country of a certain predominant faith might perhaps be considered to be more likely to employ stronger regulatory enforcement since such behavior would enhance the preference for low corruption in the financial reporting environment.H2: The importance ascribed to religion by individuals will not be associated with the level of regulatory enforcement.Culture-1These issues are further compounded by the inevitable embedding of audit practices in different national cultures, with the resultant impact on behaviors within a culture resulting in differences in auditor perceptions and behaviors across cultures (e.g., Sarens and Abdolmohammadi, 2009; Doupnik, 2008; Endrawes and Monroe, 2012; Wingate, 1997; Gray 1988). Gray (1988)s theoretical framework postulates the effect of national cultural values as defined by Hofstede (1980) on such accounting values as professionalism, uniformity, conservatism, and transparency. Many researchers have since tested Grays (1988) hypotheses in their empirical studies (see the literature review by Doupnik and Tsakumis, 2004). Culture-2Sarens and Abdolmohammadi (2009) found that the degree of professionalism in internal auditing is higher in countries with lower level of uncertainty avoidance, collectivism and assertiveness using a sample of 45 countries and the degree of uniformity in internal auditing is higher in countries with lower level of power distance and collectivism using a sample of 32 countries. Culture-3Employing an experimental study approach, Endrawes and Monroe (2012) examine the effect of culture on auditors professional skepticism by comparing auditors from two cultures that are sharply different Egypt and Australia. Both groups of auditors work in the same Big Four audit firms. Using culture dimensions of individualism/ collectivism and power distance developed by Hofstede (1980), the culture of Egypt is characterized as high power distance and collectivist whilst Australia is characterized as a low power distance and individualistic society. As Endrawes and Monroe (2012, p. 11) pointed out, The similarity of judgment between auditors in a collectivist culture is likely to be higher than auditors in an individualism/autonomy culture, where they are more flexible and independent and have the right to pursue their own intellectual directions and decisions. In a collectivistic society, such as Egypt and China, individuals lose face by not meeting the social needs of the group. This suggests that auditors judgment is a function of individualism/collectivism.

Culture -4We focus here on Uncertainty Avoidance and Individualism/Collectivism because Grays (1988) theoretical framework argues that these two cultural dimensions are the most important societal values that affect the accounting subculture and are most germane to the choice of regulatory structure.Uncertain Avoidance (UA): Increased or stronger regulation should decrease the level of uncertainty individuals feel when contemplating the quality of market investments. It would seem, then, that uncertainty avoidance should be positively related to seeking additional regulation. Of course, giving greater power to the state may result in greater uncertainty for individuals within the state, facing the power of the state. Nations may differ with respect to how they evaluate the tradeoff. Countries with a tolerance for uncertainty will react differently to problem solvingthan those whose culture has an aversion to uncertainty. Specifically, professionalswith a greater cultural tolerance for uncertainty may be comfortableexercising judgment in a principles-based environment, whereas professionals withless cultural tolerance for uncertainty may be less comfortable making judgments inthe absence of detailed rules.

18Culture-5Individualism: Individualism is the tendency of individuals primarily to look after themselves and their immediate families, and its inverse is the integration of people into cohesive groups. Franke et al. (1991, p. 166)Greater individualism (weaker collectivism) may lead to the adoption of a weaker enforcement apparatus since such regulatory tools may be seen to diminish individual freedom to seek ones best interest. On the other hand, greater individualism may also lead to cries for and implementation of stronger regulation if only to serve as a fence to corral self-seeking, individualistic impulses out of fear of damage to others.

Hypotheses 3 & 4H3: Uncertainty Avoidance (UA) will not be associated with greater regulatory efforts.H4: Individualism (IND) will not be associated with greater regulatory efforts.

Legal Systems-1Next we add in the impact on managerial behavior and that of controlling shareholders in nations with different legal foundations (e.g., civil code nations versus common law nations)Common law nations have stronger reputations with respect to investor protection than do civil law nations (e.g., La Porta, Lopez-de Salines, Shleifer and Vishny, 2000). Legal systems that favor investor interests may, therefore, pressure auditors and preparers to hew more closely to relevant accounting and auditing standards. However, If there is a wide variation between nations within the two respective arenas, then using the civil code/common law dichotomy may prove a distinction without difference (Lindahl and Schadewitz 2013).

Legal Systems-2Alternatively, it may be that the common law protections are alternative stressors to ward off those who would harm investor interests, perhaps obviating the need for better regulation. We offer, therefore, the following null hypothesis:H5: Legal family will not be associated with regulatory enforcement efforts.

Capital Markets-1One way to promote foreign direct investment is to reassure investors that they will be treated fairly, protected against expropriation of their assets (e.g., Chin, Chen, Lee and Kleinman, 2013). Choi and Wong (2007), for example, examined the ability of auditing to serve as a substitute governance form. They argued that FDI, operationalized as a percentage of GDP, should be positively related to the level of participation of international investors in a sample countrys equity market. This participation, they stated, should raise the demand for audit services by the Big 5 auditors. This was confirmed. We argue that stronger regulatory enforcement, other things equal, will result in greater FDI as a percentage of GDP.Capital Markets-2In addition, the importance of equity financing and maintaining market liquidity may increase the demand for high-quality audit services. Previous studies have shown that countries whose capital markets are more developed will have better regulatory apparatus and enforcement mechanism (e.g. La Porta et al., 1997; La Porta et al, 2006).Capital Markets-2H6: Greater FDI as a percentage of GDP will be associated with greater regulatory enforcement efforts.H7: More developed capital markets will be positively associated with greater regulatory enforcement efforts.H8: Markets with greater liquidity will be positively associated with greater regulatory enforcement efforts.

DataOur sample consists of 46 countries.Audit Enforcement Indices were taken from BPT (2014)Religion data, by nation, were taken from Mensahs (2014) Table 10, page 281. Mensah states that he relied on the following sources for his data on the distribution of religious faith. These sources are given as the Pew Foundation, Wikipedia.com, CIA Factbook, specific country Internet websites and general web searches. The importance of religion data were obtained from global Gallup Poll research at http://www.gallup.com/poll/142727/religiosity-highest-world-poorest-nations.aspx (Gallup.com, 8/31/2010). Hofstede culture data was drawn from Kangaretnam et al. (2014), table 2, p. 1126-1128. Kangaretnam et al. themselves draw the Hofstede culture data from Hofstede (2001). Foreign Direct Investment data (net) was downloaded from the World Bank data repository at http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD. It was deflated by Gross Domestic Product data, also downloaded from the World Bank data repository. That repository also provided Gross Domestic Product data per capita and the average total value of stocks traded as a percentage of GDP. The DEV variable, which measures whether the country was considered to have a developed capital market or not, was taken from Brown et al. (2014).

Main TestAUDIT2008=a1+b1(Individualism)+b2(Uncertainty Avoidance)+b3(Prot_Pct)+b4(Christian_Oth)+b5(Hindu_Pct)+b6(Buddh_Pct)+b7(Islam_Pct)+b8(Religion_ Important) +b9(Legal) +b10(FDI%GDP2008) +b11(Liquidity2008) + b12DEV +b13(LnGDPPC2008)+e

Audit2008Coefficientt-value(Constant)20.3432.098**IND0.1614.528***UA-0.033-1.169PROT_PCT0.0060.166CHRST_OTH0.1012.557**BUDH_PCT0.0761.548ISLM_PCT0.0641.417HINDU_PCT0.0110.207ReligionImportant-0.114-3.155***LEGAL2.6061.832*FDI%GDP2008-0.229-3.841***Liquidity20080.0202.149**DEV6.8233.362***LnGDPPC2008-1.160-1.079F19.686***Adjusted R20.844was rejected for Individualism/Collectivism (IND) but not Uncertainty Avoidance (UA). Individualism was positively related to auditing regulatory efforts at p