Auditor-client relationship: thecase of audit tenure and auditor

switching in MalaysiaAbu Thahir Abdul Nasser and Emelin Abdul Wahid

Faculty of Accountancy, University Technology Mara, Johor, Malaysia

Sharifah Nazatul Faiza Syed Mustapha NazriFaculty of Accountancy, University Technology Mara, Selangor, Malaysia, and

Mohammad HudaibDepartment of Accounting and Finance, Bradford University School of

Management, Bradford, UK

Abstract

Purpose – The main purpose of this paper is to examine one aspect of auditor-client relationship,namely audit tenure and switching behaviour, and factors affecting it. Lengthy audit tenure with thesame client has been cited as one of the threats to auditor independence. Given the importance of thisissue, this research attempts to shed some light on the effect of audit tenure and switching behaviouron auditor independence in Malaysia.

Design/methodology/approach – This study evaluates the effects of various independentvariables on switching behaviour and audit tenure using logistic regression analysis.

Findings – An examination of 297 companies listed on the Kuala Lumpur Stock Exchange over aperiod of 11 years reveals audit firm switching to be significantly associated with distressed largeclients and that the length and direction of switch depend upon the type of audit firm.

Research limitations/implications – A number of important variables such as corporategovernance characteristics, audit and non-audit fees and types of audit opinion that could enhance ourunderstanding of audit tenure and auditor switching in Malaysia, were not incorporated into ourregression models. Hence, future studies may consider such variables.

Originality/value – This study is the first conducted using Malaysian data where audit tenure andswitching are used as dependent variables. The results have important implications on the auditingprofession and regulators in Malaysia.

Keywords Auditors, Auditing, Customer relations, Malaysia

Paper type Research paper

1. IntroductionAuditor independence is the cornerstone of the auditing profession. In general, auditorindependence can be of two forms: “independence in fact” and “independence inappearance”. The former requires auditors to form and express an opinion in the auditreport as a disinterested and expert observer, uninfluenced by personal bias, while thelatter expects auditors to avoid situations that might cause others to conclude that theyare not maintaining an unbiased objective attitude of mind (Porter et al., 2003).

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/0268-6902.htm

The authors acknowledge the research funding from IRDC of University Teknologi Mara,Malaysia in conducting this research.

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Managerial Auditing JournalVol. 21 No. 7, 2006pp. 724-737q Emerald Group Publishing Limited0268-6902DOI 10.1108/02686900610680512

Flint (1988) argued that independence will be lost if the auditor is involved in apersonal relationship with the client, as this may influence their mental attitude andopinion. One of such threats is lengthy tenure. He contends that lengthy tenure in officemay cause the auditors to develop “over-cosy relationships” as well as strong loyalty oremotional relationships with their clients, which could reach a stage where auditorindependence is threatened. Lengthy tenure also results in “over familiarity” andconsequently, the quality and competence of auditors’ work may decline when they startto make unjustified assumptions instead of objective evaluation of current evidence.

The GPES 1.201 (para 2.5) of the ICAEW (2001) recognised that this problem maybe perceived as a threat to auditor independence and recommends that auditors avoidsituations that may lead them to become over-influenced or to be too trusting of theclient’s directors and key personnel which could consequently lead to audit staff beingtoo sympathetic to the client interest. Since, the relationship between the auditor andhis client can be close in one way or another regardless of the number of years in office,there is little the profession can do with regard to this matter (Dunn, 1996). In otherwords, the profession does not object to auditors serving their clients for a long periodof time, but the objection seems to be over the worry that long period of service maylead to “cosy relationships” that may threaten auditor independence.

Hence, to maintain public confidence in the audit function and to protect auditors’objectivity, the profession through a series of clauses proscribes auditors from havingpersonal relationships with their clients that may give rise to a potential conflict ofinterests. One of the proposals is to have mandatory auditor rotation (AICPA, 1978a, b)as it may increase auditors’ ability in protecting the public via the increase in alertnessto any possible improprieties, increase in quality service and prevent closerrelationship with client (Mautz, 1974; Winters, 1976; Hoyle, 1978; Brody and Moscove,1998). However, some are against the idea because they believe that the costs outweighthe benefits. Frequent rotation and switching would result in increased audit fees asthe benefits to be gained from subsequent lower cost after the initial years of any auditwould not be fully realised. Another disadvantage is that the knowledge gained overtime in improving quality of audit work would be wasted with the appointment of anew auditor (AICPA, 1992). Nevertheless, in 1994, the professional bodies in the UKintroduced a seven year rotation policy for the audit engagement partners auditingpublic listed companies (Porter et al., 2003). A similar rotation policy was alsointroduced for audit engagement partners involved in auditing SEC registeredcompanies (Wood and Sommer, 1985; Brody and Moscove, 1998).

In Malaysia, the issue of audit tenure and interval rotation of audit firms or auditpartners were not explicitly addressed in any of the relevant Malaysian officialdocuments such as the Companies Act 1965, the Security Commission regulations,approved auditing standards, etc. Lack of official pronouncements on this issue couldbe due to the rejection of such rotation idea by the business community. Jaffar andAlias (2002) found only 35 per cent of the audit firms’ partners and only 32.4 per cent ofthe chief finance officers surveyed favoured audit firm rotation every three years ofengagement. However, in light of the Enron case, the Chairman of the MalaysianAccounting Standard Board announced the intention of the board to make itmandatory to rotate the audit firm once every five years (The Edge, 2002). While somecountries are either considering or have already imposed the five-year restriction torotate the audit firms, the length of audit tenure and the possible effect of switching on

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auditor independence in Malaysia is still unclear. Hence, the results would highlight ifaudit tenure and switching should be of concerned before any rotation length isimposed. This is our main contribution to the literature.

Our analysis involves an examination of 297 Malaysian listed companies between1990 and 2000 using logistic regression. Results indicate the probability of switchingthe audit firm is greatest for distressed large client and that the direction of switch andlength of tenure are dependent on type of audit firm. This implies that auditors in suchenvironment fear losing their tenure and being switched, hence their independence andobjectivity may be impaired. As such, we assert that rotation policy should be partiallyimposed on distressed clients as a first step forward in protecting auditor independencein the country. The paper proceeds as follows. The next section discusses the literaturereview and the development of the hypotheses. Sections 3 and 4 present the researchmethod and results, respectively. Section 5 presents the summary and conclusions.

2. Literature review and development of hypothesesIt has been suggested in the literature that larger audit firms (Big 4) are usuallyperceived as more capable of maintaining an adequate degree of independence thantheir smaller counterparts because they usually provide a range of services to a largenumber of clients, hence reducing their dependence on certain clients (Dopuch, 1984;Wilson and Grimlund, 1990). In addition, larger audit firms are generally perceived asthe provider of high audit quality and enjoy a high reputation in the businessenvironment and as such, would strive to maintain their independence to keep up theirimage (DeAngelo, 1981; Dopuch, 1984; Wilson and Grimlund, 1990). Furthermore,larger audit firms are also perceived to be more independent than their smallercounterparts in withstanding management’s pressure in the event of disputes as theynormally have more clients and can afford to give up some of their more “difficult”clients (Chow and Rice, 1982).

In Malaysia, high dependence on a few clients has been found to affect perception ofindependence (Teoh and Lim, 1996). This is not surprising as the market for auditservices for public companies in Malaysia is dominated by the international Big 4(previously the Big 6) audit firms. In fact, Che-Ahmad and Derashid (1996) report thatthe Big 6 (and their affiliates) audited 75.9 per cent of the Bursa Malaysia (Main Board)listed companies in 1991. Based on the above arguments, we expect the length of tenureby Big 4 audit firms to be significantly longer as their clients would be less likely toswitch them compared to their smaller counterparts. Hence, the H1 is stated as follows:

H1. The probability of switching big audit firms (Big 4) is significantly lower thanthe probability of switching smaller audit firms, ceteris paribus.

Besides the possible effect of the type of audit firms on the length of tenure, the choiceof audit firm can be related to the size of the auditee and the type of services needed.It has been argued that larger auditees, due to the complexity of their operations andthe increase in the separation between management and ownership, demand highlyindependent audit firm to reduce agency costs (Watts and Zimmerman, 1986) andauditors’ self-interest threat (Hudaib and Cooke, 2005). Furthermore, as the size of thecompanies increases, it is likely that the number of agency conflicts also increases andthis might increase the demand for quality-differentiated auditors (Palmrose, 1984),i.e. Big 4 audit firms.

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Based on the above arguments, we expect the length of tenure of auditors of largeclients to be longer than that of auditors of smaller clients in Malaysia. In other words,we expect the propensity to switch auditors to be lower for large clients than theirsmaller counterparts. This leads us to the following hypothesis:

H2. The probability of large clients switching audit firms is significantly lowerthan the probability of small clients switching audit firms, ceteris paribus.

When businesses continue to grow, the demand for the highly independent andqualified audit firm to reduce agency costs and to provide non-audit services neededfor the expansion of the firm increases. Therefore, growing businesses are expected tobe more likely to retain their audit firms than their lower growth counterparts. Sinasonet al. (2001) examined 16,976 COMPUSTAT companies in the US over a period of20 years and found that audit tenure is significantly affected by client’s growth rate.

Since, the literature indicates that audit tenure is affected by the client’s growth rate,we hypothesised the length of tenure of auditors of high growth clients in Malaysia tobe longer than low growth clients. In other words, high growth clients are less likelyto switch their auditors. As such, our next hypothesis is:

H3. The probability of high growth clients switching audit firms is significantlylower than the probability of low growth clients switching audit firms, ceterisparibus.

The financial position of auditees may have important implications on decisions inretaining the audit firm. Auditees who are insolvent (have high gearing ratios) and areexperiencing an unhealthy financial position are more likely to engage auditors havinghigh independence to boost the confidence of shareholders and creditors as well as toreduce the risk of litigation (Francis and Wilson, 1988). In addition, financially stressedclients are more likely to replace their audit firms compared to their healthiercounterparts (Schwartz and Menon, 1985; Hudaib and Cooke, 2005).

As such, we expect auditors of distressed clients to have shorter tenure compared totheir counterparts auditing healthier clients and will in turn be less likely to beswitched. The next hypothesis is stated as follows:

H4. The probability of distressed clients switching audit firms is significantlyhigher than the probability of healthier clients switching audit firms, ceterisparibus.

Sinason et al. (2001) found the length of audit tenure to be positively affected by thetype of audit firm. In other words, smaller audit firms experience shorter tenurecompared to their larger counterparts who often enjoy lengthy tenure. Differences inthe length of tenure between the two types of audit firms could impair independencebecause in the long run, small audit firms will find it difficult to keep their existingclients and at the same time maintain a high degree of independence and objectivitydue to increased competition and size mismatch. Ideally, the size of audit firm shouldmatch the size of auditee. A size mismatch between large auditees audited by smallaudit firms could cause termination of the audit engagement (Hudaib and Cooke, 2005),i.e. a switch of auditor.

Since, there are four possibilities of switching auditors, viz. switch from non-Big 4 tonon-Big 4, from non-Big 4 to Big 4, from Big 4 to non-Big 4 and from Big 4 to Big 4,

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we expect the lengths of tenure for the four types of switches to be significantlydifferent. Specifically, we hypothesise that:

H5. The length of audit tenure for non-Big 4 replaced by Big 4 (m2) is significantlyshorter than the length of audit tenure for non-Big 4 replaced by anothernon-Big 4 (m1). Hence, m1 – m2 – m3 – m4.

where, m1, switched from non-Big 4 to non-Big 4; m2, switched from non-Big 4 to Big 4;m3, switched from Big 4 to non-Big 4; m4, switched from Big 4 to Big 4.

3. Research method3.1 Data sourcesThere were 810 listed companies on both the main and second board of the KualaLumpur Stock Exchange (KLSE) or Bursa Malaysia as at 10 June 2002. The sample ofthis study consists of 297 randomly selected companies listed on both boards. Based onthe sample error formula (Burns and Bush, 2003), a sample size of 297 is deemedappropriate. The relevant data had been collected from KLSE Research InstituteDatabase for a period of 11 years from 1990 to 2000. Besides the relevant financialstatements, the relevant audit reports of the sample firms available at KLSE were alsoused in this research.

The dependent variables are auditor switching (SWITCHt) and the four directions ofswitch (mxt) which are noted from the audit reports during the study period. Theindependent variables consist of book value of equity (BVE) and market value ofequity (MVE), client size (CLI.SIZE), changes in total assets (LnDTA), changes in sales(LnDS), type of audit firm (AUDIT), changes in income from continuing operations inthe two years preceding the audit change (LnDRt22), financial distress of the clientcompany (LnDZ),[1] interactive effects of length of tenure held by Big 4 and non-Big 4before being switched (TENU*AUDITxt) and the interactive effects of length of tenurebefore the first switch (TENU*B1.SWI).

3.2 Data analysisLogistic regression was adopted to assess the relationships since the dependent variablesare dichotomous. The model parameters are estimated using the maximum-likelihoodmethod whereby the coefficients that make the observed results most “likely” are selectedon the basis of an iterative algorithm. Furthermore, the maximum-likelihood method hasalso the advantage of asymptotic normality (Hudaib and Cooke, 2005). Model 1 has thedependent variable as switching/non-switching (SWITCHt) and Model 2, direction ofswitching/otherwise (mxt). Model 1 provides answers to the research hypothesesassociated with audit tenure and switching while Model 2 investigates the impact ofindependent variables on the directions of auditor switching.

3.3 Model specification3.3.1 Model 1. We use the following logistic regression model to test for therelationships between auditor switching (SWITCHt) and type of audit firm (AUDIT),client size (CLI.SIZE), client growth (LnDS), client financial risk (Ln Z), the interactiveeffects of length of tenure of remaining in the office before being switched(TENU*AUDITxt), the change in operating income (LnDRt22), change in market valueof equity (LnDMVE) as well as change in total assets (LnDTA):

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SWITCHt ¼a0 þb1AUDITþb2CLI:SIZEþb3LnDSþb4LnZþ

X2

i¼1

dixtTENU*AUDITxt þb7LnDRt22 þb8LnDMVEþb9LnDTAþ 1

SWITCHt is a binary variable indicating whether or not the audit firm was switched ornot switched. The other independent variables are as summarised in Table I.

3.3.2 Model 2. To further explain the impact of independent variables on theswitched directions of audit firms (mxt), the following logistic regression model wasadopted to test the association between auditor switching from one type of audit firmto another and the nine independent variables, viz. type of audit firm (AUDIT), clientsize (CLI.SIZE), client growth (LnDS), financial risk (Ln Z), change in operating income(LnDRt22), change in market value of equity (LnDMVE), the change in total assets(LnDTA), the interactive effects of length of tenure before the first switching(TENU*B1.SWI) and the interactive effects of length of tenure of a large audit firm(Big 4) remaining in the office before being switched (TENU*AUDITB4):

a0 InterceptSWITCH A dummy variable, 1 if the audit firm is switched at time t, and 0 otherwisemxt Four propositions of switch directions

1. m1 ¼ from non-Big 4 to non-Big 42. m2 ¼ from non-Big 4 to Big 43. m3 ¼ from Big 4 to non-Big 44. m4 ¼ from Big 4 to Big 4

AUDIT A dummy variable, 1 if the firm is a Big4 audit firm, and 0 otherwiseCLI.SIZE A dummy variable, 1 if the client’s TA is large (ln TA . the mean), and

0 otherwiseLnDS The natural logarithm of squared changes in sales scaled by ln TA

½lnððDS=ln TAÞ2Þ�;Ln Z The natural logarithm of company’s financial risk: cash flow from operations

over long-term debt [ln(Z)2]SQ ln BVE The square root of natural logarithm of BVE ½

ffiffiffi2lnðBEÞ2

p�;

ln TA The natural logarithm of the client’s assets [ln TA]LnDTA The natural logarithm of squared changes in of total assets ½lnðDTAÞ2�;ln MVE MVE [ln MVE]LnDMVE The natural logarithm of squared changes in MVE ½lnðDMVEÞ2�;LnDRt22 The natural logarithm of squared changes in operating income two years

(yeart22) before switching in yeart20 ½lnðDRt22Þ2�;

TOT.TENU Total length of tenure (years) for the periodTENU*B1.SWI The interactive effects of length of tenure before the first switch, company j is

coded 1 up to 11 depending of the length of tenure before the first switch inperiodtx

TENU*AUDITxt Two propositions of the interactive effects of tenure length before switching1. TENU.AUDITB4 ¼ number of years the incumbent Big4 held office before

being replaced divided by TOT.TENU2. TENU.AUDITnB4 ¼ number of years the incumbent non-Big4 held office

before being replaced divided by TOT.TENU1 Error term

Table I.Variables in the logistic

regression models

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mt ¼ a0 þ b1AUDIT þ b2CLI:SIZE þ b3LnDS þ b4Ln Z þ b5LnDRt22

þ b6LnDMVEb7LnDTA þ b8TENU*B1:SWI þ b9TENU*AUDITB4 þ 1

The model is run four times to cover all switch directions taken by clients to appointtheir new audit firms after terminating the services of their incumbent audit firms.

4. Empirical results4.1 Descriptive statisticsTable II (Panel A) presents descriptive statistics for the experimental, control anddependent variables. The mean size of clients is RM 1.5 billion. The negative signs in

Minimum Maximum Sum Mean SD

Panel A (Continuous)TA 35,251 51,453,100,000 1546788049.45 4855264576.1LnDTA 215.2018 1.1077 25.106514 2.6BE 21,882,020,548 14,518,600,000 449149349.93 1182242201.7SQ ln BVE 5.22 6.84 6.1446 0.2MVE 350 17,432,850 404402.64 1614674.7LnDMVE 29.6318 12.9503 20.753392 2.1LnDS 213.6249 9.5961 23.629986 3.3LnDRt22 218.4207 10.1909 21.388829 3.2Risk (Z) 20.0300 1835.8700 24.510732 172.1Ln Z 220.8286 15.0305 20.525179 4.2TENU*B1.SWI 1 11 6.10 3.5TENU*AUDITB4 0.00 1.00 0.5576 0.46640TENU*AUDITnB4 0.00 1.00 0.4424 0.46640Panel B (Dichotomous)CLI.SIZE 0 1 129 0.43 0.497AUDIT 0 1 175 0.59 0.493SWITCH 0 1 87 0.29 0.457TOT.TENU 1 11 1,987 6.69 3.619mxt 0 4 198 0.67 1.191m1 0 1 23 0.08 0.268m2 0 1 36 0.12 0.327m3 0 1 9 0.03 0.172m4 0 1 19 0.06 0.245

Notes: n – 297; TA – total assets; ln TA – the natural logarithm of total assets; LnDTA – thenatural logarithm of squared changes in total assets; SQ ln BVE – the square root of natural logarithmof BVE; LnDMVE – the natural logarithm of squared changes in MVE; LnDS – the natural logarithmof squared changes in sales scaled by ln TA; LnDRt22 – the natural logarithm of squared changes inoperating income; Ln Z – the natural logarithm of company’s financial risk; TENU*B1.SWI – theinteractive effects of length of tenure before the first switching; TENU*AUDITB4 – the interactiveeffect of years in office by Big4 before switching over total tenure period; TENU*AUDITnB4 – theinteractive effects of years in office by non-Big4 before switching over total tenure period; CLI.SIZE – adummy variable, 1 if the client’s TA is large, and 0 otherwise; AUDIT – a dummy variable, 1 if thefirm is a Big4 audit firm, and 0 otherwise; SWITCH – a dummy variable, 1 if the audit firm isswitched, and 0 otherwise; TOT.TENU – total length of tenure (years) for the period; m1 – switchedfrom non-Big4 to non-Big4; m2 – switched from non-Big4 to Big4; m3 – switched from Big4 tonon-Big4; m4 – switched from Big4 to Big4

Table II.Descriptive statistics

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the mean values indicate poor financial performance during the period of analysis.Table II (Panel B) reports the descriptive statistics of the dichotomous variables. It canbe seen from the table that the sample consisted of 43 per cent (129) large companies,60 per cent (175) Big 4 and 29 per cent (87) cases of audit termination (switching). It alsoshows that switching from small to large audit firm (i.e. from non-Big 4 to Big 4) is themost common type of auditor change (36 cases), followed by switching from smallaudit firm to small audit firm (23 cases) and switching from large audit firm to largeaudit firm (19 cases). Not surprising, the least common type of auditor switch is fromlarge audit firm to small audit firm (9 cases).

Table III presents the correlation matrix for the dependent and continuous independentvariables. It indicates no multicollinearity problem, as the correlations are relativelylow except the correlation between two independent variables: type of audit firm (AUDIT)and (TENU*AUDITxt – the tenure length of Big 4 and non-Big 4). Therefore, AUDIT andTENU*AUDITnB4 are dropped when we run our regression models.

4.2 Results of the logistic regressions4.2.1 Model 1. Model 1 tests which independent variables (viz. client size, client growth,client financial risk, the length tenure in the office before being switched, the changesin operating income, market value of equity as well as the changes in total assets)explain the behaviour of ending audit firm tenure in office (i.e. audit switching). Theresults are shown in Table IV. Client size, client financial risk, the changes in totalassets and the interactive effects of the length of tenure in office before switching largeaudit firm (TENU*AUDITB4), were found to be significantly associated with auditswitching while client growth, changes in operating income and market value of equitywere found not to be significant. The results indicate that the main factors forswitching audit firm are the increase in total assets and the financial risk of thecompany. The highest log odds of CLI.SIZE [Exp(B) ¼ 1.76] indicates that client size isthe most important factor followed by financial risk in explaining switching and assuch H2 and H4 are accepted. However, the growth of company’s business, theincrease in operating income and increase in market value do not affect the length oftenure of the audit firm, thus allowing us to reject H3. The fact that the length of tenureof large audit firms (Big 4) is negatively associated with switching suggests that largeraudit firms experience fewer instances of being replaced compared to their smallercounterparts who face shorter tenure as they tend to be replaced more often and assuch, H1 is accepted.

4.2.2 Model 2. Table V shows the results of testing Model 2, i.e. the impact ofvarious independent variables on the four switching directions (mxt). As indicated bythe results, the only factor that significantly impacts switching behaviour is theinteractive effects of length of tenure before the first switch (TENU*B1.SWI), followedby changes in total assets of the client (LnDTA).

Table VI (Panel A) provides details on the pattern of switching behaviour. As can beseen, switching for similar sized audit firms, i.e. switching from a small audit firm toanother or from a large audit firm to another, often occurs after lengthy tenure.However, switching to dissimilar sized audit firms, i.e. switching from a small to alarge audit firm or from a large to a small audit firm, occurs in a relatively shorterperiod. This suggests that the propensity to switch to a large audit firm is greater forclients experiencing an increase in total assets.

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Variable m1 m2 m3 m4 SQ ln BVE

SWITCH 0.45 * * 0.58 * * 0.27 * * 0.41 * * 0.14 *

m1 1 20.11 20.05 20.08 0.05m2 1 20.07 20.10 0.02m3 1 20.05 0.05m4 1 0.14 *

SQ ln BVE 1LnDTALnDMVELnDSLnDRt22

Ln ZAUDITTOT.TENUTENU*B1.SWITENU*AUDITB4

Variable LnDTA LnDMVE LnDS LnDRt22 Ln ZSWITCH 0.06 20.03 0.08 0.10 0.08m1 20.01 0.05 0.00 0.02 0.10m2 0.04 20.09 0.12 * 20.00 0.05m3 0.09 20.03 0.04 0.15 * * 20.02m4 0.02 0.02 20.04 0.06 20.03SQ ln BVE 20.07 20.07 20.07 20.04 20.07LnDTA 1 20.02 0.21 * * 0.03 0.02LnDMVE 1 20.04 20.07 20.03LnDS 1 0.17 * * 0.12 *

LnDRt22 1 20.07Ln Z 1AUDITTOT.TENUTENU*B1.SWITENU*AUDITB4

Variable AUDIT TOT.TENU TENU*B1.SWI TENU*AUDITB4 TENU*AUDITnB4

SWITCH 0.02 0.31 * * 0.05 20.09 0.09m1 20.35 * * 0.10 0.16 * * 20.35 * * 0.35 * *

m2 0.27 * * 0.19 * * 20.15 * * 20.03 0.03m3 20.21 * * 0.13 * 20.05 0.00 20.00m4 0.22 * * 0.11 0.16 * * 0.25 * * 20.25 * *

SQ ln BVE 0.05 0.33 * * 0.29 * * 0.08 20.08LnDTA 0.03 0.06 0.02 0.03 20.03LnDMVE 20.06 20.07 20.05 20.06 0.06LnDS 0.11 0.05 0.02 0.10 20.10LnDRt22 0.01 0.08 0.05 0.02 20.02Ln Z 20.06 20.06 20.06 20.09 0.09AUDIT 1 0.08 0.05 0.90 * * 20.90 * *

TOT.TENU 1 0.89 * * 0.09 20.09TENU*B1.SWI 1 0.14 * 20.14 *

TENU*AUDITB4 1 21.0 * *

Notes: * *Correlation is significant at the 0.01 level two-tailed; *correlation is significant at the0.05 level two-tailed

Table III.Correlation matrix

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We further extended our analysis by using ordinary least squares regression whereTENU*B1.SWI is the independent variable to test the H5. The results are reported inTable VI (Panel B). The results show that the length of tenure is longer for similar sizedswitching of audit firms and shorter for dissimilar sized switching of audit firms.Hence, based on the results, H5 is accepted.

5. Summary and conclusionsThis paper examines audit tenure and switching behaviour in the Malaysian auditenvironment for the period from 1990 to 2000. It provides evidence on the relationshipsbetween switching and five related variables, viz. the interactive effects of lengthtenure of Big 4 before being replaced (TENU*AUDITB4), client size (CLI.SIZE), clientgrowth (LnDS), client financial risk (Ln Z) and four switching directions (mxt). Theresults show that retention of audit firms depends on the size of clients based on totalassets, level of financial risk and type of audit firm but not by changes in operatingincome and market value. The likelihood of non-distressed large client audited by largeaudit firm to switch is significantly less compared with distressed small client auditedby small audit firm. Results also show that switching directions are mainly influencedby the interaction between directions of switch and type of audit firm with the length oftenure. Length of tenure before switching from a small to a large audit firm issignificantly shorter compared to the length of tenure before switching from a small toanother small audit firm. Large audit firms were found to secure longer tenure. Hence,such differences in the lengths of tenure suggest independence impairment.

Since, financially distressed clients are more likely to switch audit firms, the smallerauditors would be more reluctant to qualify their reports or show disagreement withtheir clients for fear of being dismissed and losing a client. The implication of thisfinding is that such audit-client relationship may impair auditor independence andweaken audit quality. This in turn has important implications for policy makers inMalaysia since auditor independence may be impaired due to the unhealthycompetition among the audit firms.

This study is subject to several limitations. First, corporate governancecharacteristics that would shed more light on this topic were not included in ouranalysis. Second, we have not considered the effects of audit and non-audit fees onaudit tenure and the decision to retain auditor. Third, we did not consider types of

Variables B Exp(B)

Dependent variable: switch/not switchIndependent variablesCLI.SIZE 0.566 * * * 1.761LnDS 0.061 1.063Ln Z 0.069 * * 1.071TENU*AUDITB4 20.631 * * * 0.532LnDRt22 0.042 1.043LnDMVE 20.023 0.977LnDTA 0.084 * * 1.087

Notes: x 2 51.934 ( p ¼ 0.000); number of selected cases: 297; number of switching: 87; NagelkerkeR 2 0.241; * * *1 per cent significance, * *5 per cent significance, *10 per cent significance

Table IV.Multivariate logistic

analysis: propensity toswitch (Model 1)

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Independent variables B Exp(B)

(A) Dependent variable: m1 (nBig 2 nBig) [n ¼ 23]CLI.SIZE 0.227 1.255LnDS 0.096 1.101Ln Z 0.091 * 1.095LnDRt22 0.093 1.098LnDMVE 0.255 * 1.290LnDTA 0.333 * * * 1.394TENU*B1.SWI 20.118 * * 0.888TENU*AUDITB4 1.144 * * * 3.138TENU*AUDITnB4 – –x 2 203.75 ( p ¼ 0.000)Number of selected cases: 297Number of cases: 23Nagelkerke R 2 0.723(B) Dependent variable: m2 (nBig 2 Big) [n ¼ 36]CLI.SIZE 0.390 1.476LnDS 0.159 * * 1.173Ln Z 0.029 1.030LnDRt22 20.047 0.954LnDMVE 20.186 * 0.830LnDTA 0.049 1.051TENU*B1.SWI 20.274 * * * 0.760TENU*AUDITB4 – –TENU*AUDITnB4 20.115 0.892x 2 180.07 ( p ¼ 0.000)Number of selected cases: 297Number of switching from nB5 2 B2: 36Nagelkerke R 2 0.665(C) Dependent variable: m3 (Big 2 nBig) [n ¼ 9]CLI.SIZE 1.000 2.717LnDS 0.049 1.050Ln Z 0.006 1.006LnDRt22 0.200 1.221LnDMVE 20.138 0.871LnDTA 0.492 * * * 1.635TENU*B1.SWI 20.338 * * 0.713TENU*AUDITB4 20.063 0.939TENU*AUDITnB4 – –x 2 300.78 ( p ¼ 0.000)Number of selected cases: 297Number of cases: 9Nagelkerke R 2 0.912(D) Dependent variable: m4 (Big 2 Big) [n ¼ 19]CLI.SIZE 0.478 1.613LnDS 0.000 1.000Ln Z 0.004 1.004LnDRt22 0.137 * 1.147LnDMVE 0.147 1.159LnDTA 0.384 * * * 1.468TENU*B1.SWI 20.175 * * 0.839

(continued )

Table V.Multivariate logisticanalysis: propensity toswitch (Model 2)

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audit opinion and how receiving qualified opinion might affect the decision to switch orretain the audit firm. Hence, future studies should consider such variables in themodels to enhance our understanding of the Malaysian audit environment.

Note

1. Beaver (1968) used the ratio of cash flow from operations over long-term debt to diagnosefinancial risk of the company.

References

AICPA (1978a), The Commission on Auditors’ Responsibilities: Report, Conclusions andRecommendations, American Institute of Certified Public Accountants, New York, NY.

Independent variables B Exp(B)

TENU*AUDITB4 0.731 2.077TENU*AUDITnB4 – –x 2 217.60 ( p ¼ 0.000)Number of selected cases: 297Number of cases: 19Nagelkerke R 2 0.754

Notes: * * *1 per cent significance, * *5 per cent significance, *10 per cent significance Table V.

Panel A Panel B

Switched from

Regression resultsDependent variable:

TENU*B1.SWITENU*B1.SWI m1 m2 m3 m4 Estimate

1 0 8 1 0 m1 2.260 * * *

2 0 4 0 0 m2 21.397 * *

3 3 4 2 2 m3 21.7834 3 2 1 1 m4 0.9355 1 2 1 2 CLI.SIZE 2.486 * * *

6 1 4 1 2 Ln Z 0.0137 1 4 0 1 TENU*AUDITB4 5.448 * * *

8 2 4 3 0 TENU*AUDITnB4 4.431 * * *

9 1 2 0 210 1 2 0 011 10 0 0 9Total 23 36 9 19

x 2 ¼ 10.9 x 2 ¼ 46.5 * * * x 2 ¼ 19.4 * * x 2 ¼ 14.8 Adj. R 2 0.796

Notes: TENU*B1.SWI: interactive effects of length of tenure before the first switch; m1: switched fromnon-Big4 to non-Big4; m2: switched from non-Big4 to Big4; m3: switched from Big4 to non-Big4;m4: switched from Big4 to Big4; TENU*AUDITB4: interactive effects of years in office by Big4 beforebeing switched; TENU*AUDITnB4: interactive effects of years in office by non-Big4 before beingswitched; * * *1 per cent significance, * *5 per cent significance, *10 per cent significance

Table VI.Crosstabs between length

of tenure with the fourdirections and regression

results

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Corresponding authorMohammad Hudaib can be contacted at: m.hudaib@Bradford.ac.uk

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