THE EFFECT OF AUDIT QUALITY ON FINANCIAL PERFORMANCE OF NIGERIA DEPOSIT BANKS

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The financial distress, which has affected most of the Nigerian banks prior to the 2004/2005 bank consolidation exercise, has pushed up the demand for high quality corporate governance. Adeyemi (2006) pointed out that the need for a strong, reliable, and viable banking system is underscored by the fact that the industry is one of the few sectors in which the shareholders fund is only a small proportion of the liabilities of an enterprise. It is, therefore, not surprising that the banking sector is one of the most regulated sectors in any economy as is the case in Nigeria. Banking reforms have been an ongoing phenomenon around the world right from the 1980s, but it was more intensified in recent time because of the impact of globalization, which is precipitated by continuous integration of the world market and economies (Adegbagu & Olokoye 2008). Banking reforms involve several elements that are unique to each country based on historical, economic, and institutional imperatives.

In Nigeria, the reforms in the banking sector preceded against the backdrop of banking crisis due to highly undercapitalization of deposit taking banks; weakness in the regulatory and supervisory framework; weak management practices; and the tolerance of deficiencies in the corporate governance behaviour of banks (Uchendu 2005). Banking sector reforms and recapitalization have resulted from deliberate policy response to correct perceived or impending banking sector crisis and subsequent failures. A banking crisis can be triggered by weakness in banking system characterized by persistent illiquidity, insolvency, undercapitalization, high level of non-performing loans and weak corporate governance, among others. Similarly, highly open economies like Nigeria, with weak financial infrastructure, can be vulnerable to banking crises emanating from other countries through infectivity (Adegbagu & Olokoye 2008). Banking sector reforms in Nigeria are driven by the need to deepen the financial sector and reposition the Nigeria economy for growth; to become integrated into the global financial structural design and evolve a banking sector that is consistent with regional integration requirements and international best practices. It also aimed at addressing issues such as governance, risk management and operational inefficiencies, the centre of the reforms is around firming up capitalization (Ajayi 2005).

Capitalization has been an important component of reforms in the Nigerian banking industry, owing to the view that a bank with a strong capital base has the ability to absolve losses arising from non performing liabilities, improve its revenue, and attain costefficiency. Attaining capitalization requirements may be achieved through consolidation of existing banks or raising additional funds through the capital market. An early view of bank consolidation was that it makes banking more cost efficient because larger banks can eliminate excess capacity in areas like data processing, personnel, marketing, or overlapping branch networks (Somoye 2008). Consolidation is viewed as the reduction in the number of banks and other deposit taking institutions with a simultaneous increase in size and concentration of the consolidated entities in the sector (Bank of International Settlement, 2001). Irrespective of the cause, however, bank consolidation is implemented to strengthen the banking system, embrace globalization, improve healthy competition, exploit economies of scale, adopt advanced technologies, raise efficiency, and improve profitability (Adegbagu & Olokoye 2008). Ultimately, the goal is to strengthen the intermediation role of banks and to ensure that they are able to perform their developmental role of enhancing economic growth, which subsequently leads to improved overall economic performance and societal welfare they conclude. The government policypromoted bank consolidation rather than market mechanism has been the process adopted by most developing or emerging economies and the time lag of the bank consolidation varies from nation to nation (Somoye, 2008). For example, what was termed “government guided” merger was a unique banking sector reform implemented in 2002 by the Central Bank of Malaysia BNM (Bank Negara Malaysia) guiding 54 depository institutions to form 10 large banks (Rubi, Mohamed & Michael, 2007). This was partly a response to the banking crises perpetrated by the 1997-1998 Asian financial crises, they noted. Bank of International Settlement (2001) also noted that in Japan during the banking crises of the 1990’s, government funds were deployed to support reconstruction and consolidation in the banking sector.

Soludo (2004) announced a 13-point reform program for the Nigerian Banks. The primary objective of the reforms is to guarantee an efficient and sound financial system. The reforms are designed to enable the banking system to efficiently, perform its functions as the pivot of financial intermediation (Lemo, 2005). Thus, the reforms were to ensure a diversified, strong, and reliable banking industry where there is safety of depositors’ money. However, the Central Bank of Nigeria went further beyond bank recapitalization and consolidation and in 2006 enacted a mandatory code of corporate governance for banks in Nigeria. The Central Bank of Nigeria (2006) noted that for the financial industry, the retention of public confidence through the enthronement of good corporate governance remains of utmost importance given the role of the industry in the mobilization of funds, the allocation of credit to the needy sectors of the economy, the payment and settlement system and the implementation of monetary policy. The Central Bank of Nigeria (2006) pointed out that a survey, by the Securities and Exchange Commission (SEC) reported in a publication in April 2003, showed that corporate governance was at a rudimentary stage, as only about 40% of quoted companies, including banks, had recognized codes of corporate governance in place. Specifically for the financial sector, poor corporate governance was identified as one of the major factors in virtually all known instances of a financial institution’s distress in the country. The Central bank of Nigeria (2006) also pointed out that the on-going industry consolidation is likely to pose additional corporate governance challenges arising from integration of processes, IT, and culture. Research had shown that two-thirds of mergers, worldwide, fail due to inability to integrate personnel and systems as well as due to irreconcilable differences in corporate culture and management, resulting in Board and Management squabbles (The Central bank of Nigeria, 2006). In addition, the emergence of mega banks in the post-consolidation era is bound to task the skills and competencies of Boards and Managements in improving shareholder values and balance same against other stakeholder interests in a competitive environment.

Owing to the separation of ownership and control (and the resulting agency problems) in the modern business world, a system of corporate governance is necessary, through which management is overseen and supervised to reduce the agency costs and align the interests of management with those of the investors (Lin and Hwang, 2010). While there is no generally accepted definition, corporate governance may be defined as a system ‘consisting of all the people, processes, and activities to help ensure stewardship over an entity’s assets’ (Messier, Glover & Prawitt, 2008). A good corporate governance structure helps ensure that the management properly utilizes the enterprise’s resources in the best interest of absentee owners, and fairly reports the financial condition and operating performance of the enterprise. For corporations, the body primarily responsible for management oversight is the board of directors and its designated committees. The audit committee, consisting of members of the board, assists the board in its oversight of the financial reporting process. The role of the corporate governance structure in financial reporting is to ensure compliance with generally accepted accounting principles (GAAP) and to maintain the credibility of corporate financial statements. The corporate governance mechanisms that are the focus of recent regulations and prior studies are attributes related to the organization and functioning of the board in general and its audit committee in particular. Properly structured corporate governance mechanisms are expected to enhance audit quality which the opinion of the external auditor is one of the determining factor that provide effective monitoring of management in the financial reporting process.

Unfortunately, empirical research to date provides inconsistent evidence on the relationship between measures of corporate governance effectiveness and the audit quality as well as the financial reporting process. Often the board of directors delegates work on important tasks to its standing committees (Li and Hwang, 2010). For example, the audit committee is charged with overseeing financial reporting. The audit committee’s primary role is to help ensure high quality financial reporting by the firm. Therefore, a properly structured and functioning audit committee is expected to enhance the audit quality of a firm. The agency problems associated with the separation of ownership and control, along with information asymmetry between management and absentee owners, create the demand for external audit. External auditors are responsible for verifying that the financial statements are fairly stated in conformity with GAAP and that these statements reflect the ‘true’ economic condition and operating results of the entity. Thus, the external auditor’s verification adds credibility to the company’s financial statements. In addition, the external auditors are required by auditing standards to discuss and communicate with the audit committee about the quality, not just the acceptability, of accounting principles applied by the client company. Therefore, a quality audit is expected to constrain opportunistic earnings management as well as to reduce information risk that the financial reports contain material misstatements or omissions (Lin and Hwang, 2010). The guidelines and measures for the quality of the external auditor’s performance are set forth in generally accepted auditing standards, such as competence, independence and exercise of due professional care.

Obviously, the quality of the auditor’s performance is multi-dimensional as set forth in the auditing standards and difference in audit quality are to be expected. ‘Audit quality differences result in variation in credibility offered by the auditors, and in the earnings quality of their audit clients. Because audit quality is multidimensional, and inherently, unobservable, no single auditor characteristic can be used to proxy for it’ (Balsam, Krishnan & Yang, 2003). Since a number of factors may affect audit quality, it is not surprising that past studies have used various measures to proxy for audit quality in prior studies. For example, researchers have examined the effects of auditor brand name (auditor size) and industry specialization, auditor tenure, provision of various services by the auditor and auditor independence on a number of issues directly or indirectly related to financial reporting. Empirical evidence on these audit quality measures has been mixed. For example, while many existing studies show that the use of brand name (Big 4/5/6) auditors reduces earnings management and enhances audit quality (Becker, Defond, Jiambalvo & Subramanyam, 1998; Francis, Maydew & Sparks, 1999; Lin, Li & Yang,

2006), many others fail to report such findings (Bédard, Chtourou & Courteau, 2004; Davidson, Goodwin-Steward & Kent, 2005). Their results provide support to the SEC’s position that non-audit fees can impair auditor independence and hence audit quality. On the other hand, Chung & Kallapur (2003) find no significant relationship between discretionary accruals and audit fees or non-audit fees. Similarly, Raghunandan, Read & Whisenant (2003) find no evidence supporting the claim that non-audit fees or total fees inappropriately influence the audit of financial statements that are subsequently restated.

The 2004/ 2005 banking consolidation exercise in Nigeria as well as the enactment of the post consolidation corporate governance codes for banks in Nigeria enhances the chances that auditors are more likely to issue going concern opinions for financially stressed banking firms in the post consolidation period. This may signal that auditors are being more watchful and that they now tend to perform their work in a highly ethical and ensure the quality of their work. Davidson and Neu (1993) noted that audit quality is viewed as one of the main factors that affect the credibility of financial information and higher audit quality results in accurate financial information reported. Audit quality adds a significant value to investors in capital markets because they often use audited financial statements as the main basis for investment decisions (Sudsomboon and Vssahawanitchakit, 2009). The use of audited financial statements by investors has been proved by many studies that noted a market reaction to the different types of audit opinions (Loudder, Khurana, Sawyers, Cordery, Johnson, Lowe & Wunderle, 1992; Chen, Su & Zhao, 2000; Zureigat, 2010; Kathleen, Vanitha and Ropert, 2007). The purpose of an audit is to provide an assurance as regards to the financial statements however; this role can be successful only if an audit opinion reflects the true findings of the audit engagement (Al-Ajmi, 2009). DeAngelo (1981) argued that audit quality depends on the joint probability of an auditor discovering and disclosing a problem in an accounting system without the interference of management. However, poor corporate governance may jeopardize the probability of an auditor discovering and disclosing a problem in an accounting system. This study thus extends recent researches that analyzed the factors affecting audit quality by focusing on the influence of variables of corporate governance (equity ownership, executive duality, and board composition, establishment of at least a minimum of credit, risk management, and audit committees) for banks in Nigeria. The justification of this study stems from the lack of similar studies of the effect of corporate governance on audit quality in Nigeria as most of the studies conducted on this area in the past focused on corporate governance and bank performance. Therefore, this study further came to cover this area and add practical details by exploring the effect of corporate governance variables on the audit quality for Nigerian banks specially when observing the existence of a mandatory code of corporate governance for compliance by Nigerian banks.

1.2 Statement of Problem

The weakness of corporate governance is perhaps the most important factor blamed for the corporate failure consequences from the economics and corporate crises. The corporate governance of banks in developing economies has been almost ignored by researchers (Caprio and Levine, 2002). The corporate governance of banks in developing economies is important for several reasons. First, banks have an overwhelmingly dominant position in developing economy financial systems, and are extremely important engines of economic growth (King and Levine, 1993). Second, banks in developing economies are typically the most important source of finance for the majority of firms. Third, banks in developing countries are the main depository for the economy’s savings and provide the means for payment. The weakness of corporate governance is perhaps the most important factor blamed for the corporate failure consequences from the economics and corporate crises. The corporate governance of banks in developing economies has been almost ignored by researchers.

Factors affecting audit quality have captured the attention of previous studies such as Carcello, et. al. (1992); Lennox (1999); Li and Lin (2005); Knechel & Vanstraelen (2007); Atoeijeri & Annafaabi (2008); Chi et al. (2009) and many others, where the institutional factors for the audited firms that might have an influence on the audit quality were more or less examined. Abdullah (2008) studied the effective component of corporate governance, board composition, and ownership by directors, ownership by financial institutions and CEO/chairman, and its relationship with the audit quality. Unlike Abdullah’s (2008) and other studies, this study focuses on the relationship between corporate governance variables notably (executive duality, ownership structure, board composition and size, and existence of at least a minimum of credit, risk management and audit committees) for banks in Nigeria and the level of audit quality. Previous research shows that there has been much debate over audit quality. However, recent empirical researchers suggest that big audit firms guarantee audit quality. The firms audited by Big 4 had lower discretionary accruals in the United States than the firms audited by Non-Big 4 (Deloitte &Touche, KPMG, PriceWater House Coopers, and Ernst & Young). In summary, audit quality is associated to the Big 4 brand name. Abdullah (2008) argued that there is little empirical research that examines the audit quality in emerging markets where equity markets are less developed and therefore the auditing environment is quite different. Most of the previous studies related to the level of corporate governance mechanism and audit quality as well as financial reporting quality concentrated in developed countries and hence this study utilizing banks specifically in a developing economy like Nigeria.

1.3 Objectives of the Study

The main objective of the study is to examine the influence of audit quality in the Nigerian banking sector with reference to 2006 code of corporate governance. To achieve the main objective, the specific objectives are to:

i. Determine the relationship between bank ownership structure, and audit quality for Nigerian banks.

ii. Examine the relationship, between CEO duality and audit quality for Nigerian banks.

iii. Ascertain the relationship between board size and audit quality for Nigerian banks.

iv. Determine the relationship between board composition and audit quality for Nigerian banks.

v. Examine the relationship between the existences of audit, credit and risk management committees and audit quality for Nigerian banks.

1.4 Research Hypotheses

Given the research questions, the following null hypotheses are specified.

i. Bank ownership concentration is not related with audit quality for Nigerian banks.

ii. Executive duality is not related with audit quality for Nigerian banks.

iii. Board size is not related with audit quality for Nigerian banks.

iv. Board composition is not related with audit quality for Nigerian banks.

v. Existences of audit, credit, and risk management committees are not related with audit quality for Nigerian banks.