The impact of audit quality on firm performance empirical evidence in vietnam

UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY VIETNAM

THE HAGUETHE NETHERLANDS

VIETNAM – NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF AUDIT QUALITY ON FIRM PERFORMANCE:
EMPIRICAL EVIDENCE IN VIETNAM

A thesis submitted in partial fulfillment of the requirements for the degree of
MASTER OF ART IN DEVELOPMENT ECONOMICS
By
LÊ THỊ ANH THƯ

Academic Supervision
Dr. LÊ HỒ AN CHÂU

HO CHI MINH CITY, November, 2016


DECLARATION

“I certify the content of this thesis entitled “The impact of audit quality on firm
performance: empirical evidence in Vietnam” has not already been submitted for any
degree and is not being currently submitted for any other degrees
I certify that, to be the best of my knowledge, any help received in preparing this

thesis and all sources used, have been acknowledged in this dissertation”

Signature

Lê Thị Anh Thư
Date: November ……., 2016

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ACKNOWLEDGEMENT
First and foremost, I would like to express my gratefulness and my dearest thank to
my supervisor, Dr. Lê Hồ An Châu for her guidance and support during my thesis
completion.
In additional, I would like to thank Dr. Trương Đăng Thụy, who also gave me the
useful help for my research. More special thanks for all lecturers and staffs at VietnamNetherlands Program and my VNP 21 classmates.
Furthermore, thanks to the support from my colleagues at Gia Cat Consulting and
Auditing Co., Ltd who create more conditions for me to complete this thesis.
Last but not least, I would like to express my many thanks to my family and my
friends, who encourage and support to me in both mental and physical during the thesis
process.

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ABBREVIATIONS
CSMAR:

China Stock Market Accounting Research

ICAEW:

Institution of Chartered Accountants in England and Wales

IPO:

Initial Public Offering

ISA:

International Standards Auditing

IFAC:

International Federation of Accountants.

GAO:

Government Accountability Office

GMM:

Generalized Method of Moments

HOSE:

Hochiminh Stock Exchange

NSE:

Nigeria Stock Exchange

OLS:

Ordinary Least Squares

PCAOB:

Protecting Investors through Audit Oversight

TPP:

Trans-Pacific Strategy Economic Partnership Agreement

UKFRC:

United Kingdom Financial Reporting Council

VACPA:

Vietnam Association of Certified Public Accountants

VSA:

Vietnam Standards of Auditing

WTO:

World Trade Organization

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ABSTRACT
This study empirically examines the impact of audit quality on firm performance in
Vietnam. Audit quality is considered as an external monitoring factor which objectively
affects firm performance. In this thesis, audit quality is measured by three variables
including audit rotation, audit reputation and audit experience whereas firm performance is
proxied by accounting profits (ROA), market value (Tobin’s Q) and risk of bankruptcy (Zscore). The dataset includes 268 listed non-financial companies in Vietnam over the period
from 2010 to 2015. The results show that there is no relationship between audit rotation,
audit reputation and audit experience on Tobin’s Q and Z-score. However, audit reputation
and audit experience are insignificantly correlated with firm profitability. The effect of
audit rotation on ROA is positive, suggesting that companies which have audit rotation are
more likely to have higher profits. This implies that the change of audit firm increases the
independence of auditors as well as enhances audit quality and hence positively affects
firm performance.

Key words: audit quality, audit rotation, audit reputation, audit firm experience, firm
performance, listed companies, Vietnam.

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TABLE OF CONTENTS
CHAPTER 1:INTODUCTION .......................................................................................... 1
1.1. PROBLEM STATEMENT .................................................................................................. 1
1.2. RESEARCH OBJECTIVES AND RESEARCH QUESTIONS ..................................................... 3
1.3. RESEARCH METHODOLOGY AND DATA ......................................................................... 3
1.4. RESEARCH CONTRIBUTION .......................................................................................... 4
1.5. THESIS STRUCTURE: ..................................................................................................... 4

CHAPTER 2:THEORETICAL FRAMEWORK AND EMPIRICAL EVIDENCE OF
AUDIT QUALITY AND FIRM PERFORMANCE ......................................................... 5
2.1 THEORETICAL LITERATURE OF AUDIT QUALITY AND FIRM PERFORMANCE .................... 5
2.1.1. Audit quality definition and relevant theoretical framework............................... 5
2.1.1.1. Agency Theory ............................................................................................. 6
2.1.1.2. The stakeholder theory.................................................................................. 7
2.1.1.3. Theory of Asymmetric Information .............................................................. 9
2.1.2. Definition and measure of firm performance .................................................... 10
2.2. EMPIRICAL EVIDENCE ABOUT THE IMPACT OF AUDIT QUALITY ON FIRM PERFORMANCE
......................................................................................................................................... 11
2.2.1. The impact of audit rotation on firm performance ............................................ 12
2.2.2. The impact of audit reputation on firm performance ........................................ 16
2.2.3. The impact of audit firm experience on firm performance ................................ 17
2.2.4. The effect of Vietnamese Auditing Standards (VSA 220) on “Quality control of
financial statements audit activities” on firm performance ........................................ 18
2.3. THE CONCEPTUAL FRAMEWORK ................................................................................. 19
CHAPTER 3:RESEARCH METHODOLOGY AND DATA ....................................... 20
3.1. DATA COLLECTION ..................................................................................................... 20
3.2. METHODOLOGY ......................................................................................................... 20
CHAPTER 4:DATA ANALYSIS AND EMPIRICAL RESULTS ................................ 27
4.1. DESCRIPTIVE STATISTICS AND BASIC ESTIMATION ..................................................... 27
4.1.1. Descriptive Statistics.......................................................................................... 27
4.1.2. The correlation matrix of variables ................................................................... 32
4.1.3. Heteroskedasticity .............................................................................................. 34
4.1.4. Identification of Endogeneity Problem .............................................................. 34
4.2. REGRESSION RESULTS AND DISCUSSION .................................................................... 35
4.2.1. Audit quality and firm performance measured by ROA: ................................... 35
4.2.2: Audit quality and firm performance measured by Tobin’s Q: .......................... 38
4.2.3: Audit quality and firm performance measured by Z-Score ............................... 39
4.2.4: Changing Policy and Firm Performance .......................................................... 40

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CHAPTER 5:CONCLUSIONS AND POLICY IMPLICATIONS ............................... 41
5.1. MAIN FINDINGS ......................................................................................................... 41
5.2. POLICY IMPLICATION ................................................................................................. 42
5.3. LIMITATION AND FURTHER RESEARCH ....................................................................... 43
REFERENCES................................................................................................................... 44
APPENDIX ......................................................................................................................... 50

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LIST OF TABLES
Table 1: Rules on mandatory audit firm rotation and mandatory auditor rotation for
listed companies. .........................................................................................................49
Table 2: The Z-Score level.......................................................................................... 23
Table 3: Summary of variables and predicted sign of coefficient .............................. 26
Table 4: Categorized business fields ...........................................................................27
Table 5: Descriptive Statistic ......................................................................................28
Table 6: Correlation matrix ......................................................................................... 33
Table 7: Heteroskedasticity test ..................................................................................34
Table 8: Endogeneity test ............................................................................................ 35
Table 9: System GMM estimation of firm performance measured by ROA ..............36
Table 10: System GMM estimation of firm performance measured by Tobin’s Q ....38
Table 11: System GMM estimation of firm performance measured by Z-Score .......39
Table 12: Companies in year of establishment ........................................................... 52

VII

LIST OF FIGURES
Figure 2.1: The Agency Theory ........................................................................................ 7
Figure 2.2: The Stakeholder model of the corporation ..................................................... 8
Figure 2.3: The Asymmetric Information Theory ............................................................ 10
Figure 2.4: The Analytical Framework ............................................................................. 20
Figure 4.1: The prediction of relationship between audit firm experience and ROA....... 30
Figure 4.2: The prediction of relationship between
audit firm experience and Tobin’s Q ................................................................................ 31
Figure 4.3: The prediction of relationship between audit firm experience and Z-Score .. 32

VIII


CHAPTER 1:
INTRODUCTION
1.1. Problem statement
From the agency theory’s perspective, the separation of function between
ownership and management in corporation leads to information asymmetry problem and
conflict of interest between managers and shareholders. The role of third party who gives
the opinion related to financial information disclosure is very important and audit quality is
considered as an external monitoring factor which has a significant effect on firm
performance. There are some previous studies which investigate the role of audit quality in
terms of its effect on firm performance. However, they use the different measures of audit
quality and conduct in different markets, so the empirical results are inconsistent. Some
studies point out that the impact of audit quality on firm performance is positive whereas
other studies find negative or insignificant effects on firm performance.
However, the role of audit quality as a key driver of firm performance has not yet
attracted sufficient attention from researchers and policy makers in Vietnam. This may
result in the fact that investors lack the proper consideration about audit quality which

might affect the financial disclosure and useful information for investors’ decision-making.
In the process of integration and development, Vietnam has more opportunities to
approach and take part in the global organization such as WTO, TPP etc. One of the
difficulties in the foreseen future isto guarantee the reliance and the transparency of
declared financial information to attract foreign investment and create the fair competitive
environment. The collapse of Arthur Andersen, one of the five biggest audit firms (Big 5)
in 2002, the scandal and infringement related to audit quality recently and the integrity of
firms’ financial statements force to enhance the investors’ perception about the audit
quality and even the pressure to improve the audit quality of external parties. In Vietnam,
there is also a rising concern about this issue after a serial of scandal of listed companies in
the stock exchange such as the evaporated inventories of Truong Thanh Corp (TTF),
NTACO Corp (ATA) and bad debt from Ocean Group (OGC) which led to sharp
deterioration in stock market and investor’s belief.

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Audit quality is a controversial issue between the legislators and a key
consideration for auditors. The audit quality framework of United Kingdom Financial
Reporting Council (UKFRC) public in 2008 identifies key determinants of audit quality
including culture within audit firm, skills and quality of auditors, the effectiveness of audit
process, reliability and usefulness of audit reporting and outside factors. According to
DeAngelo(1981) and PCAOB (2011), audit quality is identified as the probability of
detecting errors or omissions which affect the financial statements in material aspects.
IFAC (International Federation of Accountants) states that audit quality is the most
fundamental characteristic of international auditing standards, it should be capable of
consistent interpretation, unambiguous translation, enforceable and designed to achieve a
high quality of audit. In Vietnamese Standards Auditing 220 (VSA 220) about Quality of
auditing activities, audit quality refers to the degree of satisfaction of users of the audit
results as the objectivity and reliability of the opinion expressed, and of the entity under

audit as to the auditor’s recommendations with the view to improve the business efficiency
of the entity within a time limit and at a reasonable price.
There is no consensus among researchers about the method to measure audit
quality. Previous studies use indirect measurement such as audit rotation and audit fees
(Sayyar et al., 2015),audit firm size, litigation, auditor tenure, non-audit services, industry
experience and peer review (Hussein & Hanefah, 2013). According to Sori et al., (2006),
size of audit firm is a good proxy for audit quality because the large audit firm with better
reputation, experienced practitioners, superior technology and abundant financial resources
will give assurance of audit opinion about the financial status of audited companies.
Moreover, the large audit firm size might not be pressured by revenue from big clients that
affect its independence and objectivity when expressing audit opinion.
The initial auditing institution appeared early in 1942, which is the institute of
Internal Auditors in the United States of America. In Vietnam, the independent auditing
firms started later in 1991. To maintain the audit quality, the audit firms and auditors have
to comply with the audit standards that have been set by Ministry of Finance and Vietnam
Association of Certified Public Accountants (VACPA). Moreover, auditors also conform
to the Ethical Standards including the basic principles: integrity, independence, prudence
and professional competence. The main motivation of principles is to maintain both

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independence of mind and independence of appearance (ISA 200, 2009) and audit rotation
is considered a representative variable for audit independence.
In an attempt to enforce and improve audit quality in Vietnam, on 6th December
2012, Ministry of Finance announced the composition of 37 new auditing standards. These
standards are applied and effective from January 1st, 2014. One of which specially focuses
on “Quality control of financial statements audit activities” – VSA 220. This standard aims
to give more requirements and increase the audit control activities to enhance the quality of
independent audit activities in Vietnam.

1.2. Research objectives and research questions
The main objective of this study is to examine the impact of audit quality on firm
performance of listed companies in Vietnam. Specifically, it aims to give the deep insight
into the impact of three proxies for audit quality (audit rotation, audit reputation and audit
firm experience) on firm performance measured by firm profitability, market value and
risk of bankruptcy. Moreover, this thesis will also test the effect of the promulgation of
VSA 220 which is considered as an important legal framework to improve audit quality in
Vietnam on firm performance.
In order to achieve those objectives, we conduct an empirical analysis on the firm
level data in Vietnam to seek convincing answers for the following two research questions:
- Does audit quality proxied by audit rotation, audit reputation and audit firm
experience have any effect on firm profitability (ROA), market value (Tobin’s Q)
and risk of bankruptcy (Z-Score) of listed companies in Vietnam? If so, the effects
are positive or negative and why?
- Does the promulgation of VSA 220 in 2014 have any effect on firm profitability,
market value and risk of bankruptcy of listed companies in Vietnam?
1.3. Research methodology and data
This study uses the panel data of 268 listed companies on Ho Chi Minh Stock
Exchange from 2010 to 2015. Financial institutions and insurance companies are excluded
from this dataset given their different financial structure and performance measurement.
Generalized method of moments (GMM) estimation is applied to examine the impact of

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audit quality on firm performance. This study is also to examine the correlation,
heteroskedasticity and the fit of instrumental variable by Hansen and Sargan test. The
impact of three proxies of audit quality on firm performance have been tested individually
and simultaneously.
1.4. Research Contribution

Until now, there is limited empirical evidence about the impact of audit quality on
firm performance of listed companies in Vietnam whereas previous studies across
countries provide inconsistent results about this effect. Therefore, this study is the modest
attempt. Moreover, what makes this work different from the contemporary literature is that
different measurements of firm performance were analyzed, from accounting perspective
(ROA) to market value (Tobin’s Q) and risk of bankruptcy (Z-Score). Testing the effect of
auditing legal framework in Vietnam via the promulgation of VSA 220 on the audit quality
is another contribution that this thesis provides from the empirical evidence. Therefore, the
findings from this research will suggest important policy implication for investors in their
investment decision – making and for policy makers to improve the transparency of
business environment in Vietnam.
1.5. Thesis structure
The remainder of this thesis is organized as follows: the second section is the
review of theoretical framework and empirical evidence about the effect of audit quality on
firm performance. The third section will discuss the research methodology and data. The
empirical results will presented in the fourth section and the last section will conclude and
suggest policy implication.

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CHAPTER 2:
THEORETICAL FRAMEWORK AND EMPIRICAL
EVIDENCE OF AUDIT QUALITY AND FRIM
PERFORMANCE
Some theories have been presented in this section relative to the role of audit
quality as the external monitoring factor in firm financial performance including Agency
theory, stakeholder theory and Information Asymmetric theory. In addition, evidence of
the impact of audit quality on firm performance from previous empirical studies will also
be reviewed. From the theoretical framework and empirical evidence, the research

hypotheses and empirical strategy will be developed.
2.1 Theoretical literature of audit quality and firm performance
2.1.1. Audit quality definition and relevant theoretical framework
Audit quality is a vague term. According to DeAngelo (1981) and PCAOB (2011),
audit quality is the probability of misstatements and errors of annual audited financial
statements in material aspects which are detected by using the appropriate audit
procedures. Eilifsen and Wilekens (2008) identify that audit quality is an aggregation of
independence and competence of auditors to find out the material misstatements and
express the appropriate audit opinion based on the audit evidence and applied audit
procedures. International Federation of Accountants (IFAC) argues that audit quality is the
most fundamental characteristic of international auditing standards and it should be
consistent interpretation, unambiguous translation, enforceable and designed to achieve a
high audit quality. In Vietnam Standards Auditing 220 (VSA 220) the concept of the
quality of audit activities refers to the level of satisfaction of users about the auditing
results as the objectivity and reliability of the opinion expressed, and of the entity under
audit as to the auditor’s recommendations with the view to improve the business efficiency
of the entity within a time limit and at a reasonable price.
The role of third party who gives the opinion related to financial information
disclosure is very important. Audit quality is considered as an external monitoring factor

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which has a significant effect on firm performance. This was explained from many relevant
theories such as agency theory, stakeholder theory and theory of information asymmetric.
2.1.1.1. Agency Theory
The agency theory is developed by Jensen and Meckling (1976). This theory
investigates the relationship between the shareholders and the managers as the agents who
are hired for running the firm’s operation to maximize the return for investors. Agency
theory is also concerned about solving problems which exist in agency relationships

because of inconsistent benefits, the disparity of approached strategies and level of risk.
The problem relating to the separation between the ownership and management in
large corporations is initially discussed by Adam Smith (1776), Berle and Means (1932).
However, Jensen and Meckling (1976) restate this problem and emphasize the moral
hazard problem. Managers may ignore the interests of the owners and hide the inefficient
operation in order to get the personal benefits. The managers also can use the accounting
tricks while preparing financial statements to show the good financial status for selfinterest purposes. The conflict of interest between directors and shareholders is also
demonstrated by the diagram in Soltani (2007)’s research.
Figure 2.1. The Agency theory

Attributes:

Solutions:

Nexus of contracts

Intensive

Internal and External
Audit

Monitoring

Performance
Agency
Theory

Profitability
Market Value
Corporate Bankruptcy

Conflict of interest

Source: Jensen (1983), Zahra and Pearce (1989)

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To minimize the consequences of agency problems, Jensen (1983) suggests some
solutions, in which he identifies the monitoring systems. These systems have to be
independent and there are no interests relative to either owners or managers. Kim and
Nofsinger (2014) also mention about setting up effective mechanisms for monitoring the
manager’s behavior to reduce agency problem. Auditor is considered a third party to
independently and objectively monitor the financial information disclosure (ICAEW,
2005).
The audit function, either internal or external attempts to address the agency
problems. The role of internal auditor typically ensures the benefits of the board of
directors and monitors the director’s behavior and decisions in accordance with company’s
policies. Therefore, the outside shareholders are not the main objective of internal auditor.
In contrast, the existence of external auditors also provides information and monitors the
director’s activities for inside parties and outside stakeholders. So the influential level and
the scope of users of external auditors’ financial information are broader than that of
internal auditors (Colbert and Jahera, 1988)
Dang and Fang (2011) provide an empirical test the relationship between the audit
quality and owner-manager agency costs using the dataset of listed companies in China.
Audit quality is considered the monitoring factor that provides an independent supervision
and checks the accounting information to reduce the agency costs. The results show that
higher audit quality reduces the owner-managers agency costs effectively, especially in
emerging market. Krishnan (2003) argues that high external audit quality declines the
manipulation of manager’s ability. Habbash and Murya (2010) investigate the

effectiveness of external audit on constraining earning managements in UK. In their study,
the external audit variable is proxied by auditor independence and audit quality. The result
illustrates that audit can moderate agency costs.
2.1.1.2. The stakeholder theory
The stakeholder theory explains how the relationship between the organization with
the outside and inside group affect or be affected by the achievement of the organization’s
strategies (Freeman, 1984). The external and internal stakeholders include employees,
customers, suppliers, government, shareholders, local community, etc. When a company’s

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financial decision is made, there are many parties to be affected. If the company has a good
and effective relationship with the stakeholder, they will have a sustainable development in
long-term and favorable good-will in public. In contrast, the company with the bad
performance will not receive the trust from stakeholder.
Figure 2.2. The stakeholder model of the corporation
Management
Owner

Local
Community

The corporation
Supplier
s

Customers
Employees
Source: Freeman(2012)

Agency theory mainly focuses on the shareholders whereas the stakeholder theory’s
scope is broader. In recent years, the organization has to concern about the economics,
society and environment aspects. The image, information disclosure and the
creditworthiness of company in public are really important. Managers have to balance the
interests and welfare between groups of stakeholders (Brusseau, 2012).The conflict of
interest might exist and the demand of transparency in corporation’s information is
necessary. The stakeholder theory also defines the business ethics in social responsibility.
According to Paydarmansh, et al., (2014) audited financial statements are essential
for dealing with the disparity between the ownership from management that has been
discussed in stakeholder theory. The given reason is that independent audit firms with
expertise in accounting and finance have full ability to identify the material risks and errors
in the financial reports. Therefore, it could increase the reliability from the stakeholders.
The relationship of objectives in Stakeholder Theory is a double-side effect. Once
stakeholders properly consider about the quality of audited financial statements, the
managers could not manipulate the company’s financial status (James and Izien, 2014).
Chiu and Wang (2014) investigate the social disclosure quality in Taiwan by applying the
stakeholder theory. They remind the disclosure information quality in stock market.
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2.1.1.3. Theory of Asymmetric Information
Asymmetric information is mentioned as one of the three factors of market’s failure
including externalities, public goods and asymmetric information. This term was first
introduced by Akerlof (1970). The asymmetric information is the situation in which some
parties possess the information about the transaction in market while other parties involved
in this transaction do not obtain the same information. Akerlof (1970) argues that the
buyers collect the information in market and apply the statistic technique to measure the
average value of this class of goods. So, the buyers just estimate the length of goods value
while the sellers have knowledge about the specific goods.

Figure 2.3: The asymmetric information theory

Source: Anderson and Lyall (2013)
The smooth exchange of information between the seller and buyer is prompting the
successful and efficient transactions. The presence of asymmetric information could
increase the agency cost and an adverse outcome (Anderson and Lyall, 2013)
Stiglitz (2000) identifies the inefficient market with the existence of asymmetric
information problem and its consequences including (1) Adverse selection, (2) Moral
hazard and (3) Monitoring cost. Keat, Young and Erfle (2013) also restate the problems
with asymmetric information and give the response of market with asymmetric information
problem such as obtaining the information from third parties, depending on the seller’s
reputation, market signaling.

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Healy and Palepu (2001) conclude that information asymmetric problem and
conflict of interests between the owners and managers lead to an increase in demand of
financial statements and control of disclosure information by third party. Ittonen (2010)
affirms the role of auditing in the channel of dealing with the asymmetric information
problems and increasing the credibility of financial information disclosure.
To summarize, the theoretical framework explains the role of the third party in
monitoring the firm performance and ensuring the credibility of the financial information
disclosure. The external auditing is considered as the essential mechanism to reduce the
problems of market failure and protect the rights of outside and inside parties.
2.1.2. Definition and measure of firm performance
Firm performance is one of the most important definitions of business activities. It
is also a complex term which includes many aspects. Based on the stakeholder theory, a
firm is considered as an efficient entity when it satisfies the requirements of stakeholder.
These requirements are divided into two main groups in seven different aspects including

financial performance (profitability, growth and market value) and social performance
(employee satisfaction, customer satisfaction, environmental performance and social
performance) (Santos and Brito, 2009).The term of firm performance is also identified in
paper of Venkatraman and Ramanujan (1986) who categorize corporate performance into
three different aspects: financial performance, business performance and organizational
effectiveness. This study focuses on the financial aspect of firm performance which
influences profitability, market value and growth.
There are many different methods to measure firm performance. One of the most
popular methods is that using the financial ratios to represent for firm performance. The
widely used indicator is Return on Assets (ROA) which reflects the effectiveness of assets
management to generate the profits. The disadvantages when using ROA to measure firm
performance is the historical figures because ROA represents for firm’s accounting
measurement. In order to reflect the market value on firm performance, the researcher
develops the market measurement indicator which is Tobin’s Q (Brainard and Tobin,
1968). Previous studies use two indicators in their studies to proxy for firm performance,
such as the paper of Sayyar et al., (2014), Dadashi et al., (2014), Richard et al., (2009), etc.

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Besides that, Altman (1968) initially introduces Z-Score which uses to measure
firm performance and assesses the financial health of companies. Z-Score presents the
probability of risk of bankruptcy. The higher value of Z-Score indicates good firm
performance, this firm is in the safety area and harder to bankrupt. It is a comprehensive
combination between the accounting value and market value. By overcoming the
disadvantage of Tobin’s Q and ROA, Z-Score is the good proxy to assess firm
performance (Vo H.D and Nguyen T.M, 2014). The previous studies use Z-Score to
measure firm performance in aspect of financial distress including Altman (2000), Aasen
(2011), Shahwan (2015), Vo H.D and Nguyen T.M (2014) etc.
To sum up, this study aims to combine three indicators to proxy for firm

performance including ROA represents for accounting measurement, Tobin’s Q presents
for Market measurement and Z-Score determines the risk of bankruptcy
2.2. Empirical evidence about the impact of audit quality on firm performance
The information of listed company’s financial status receives interests from the
investors, creditors, suppliers, etc… The external auditor is considered as third party which
ensures and reinforces the confidence of users of firm’s financial reporting. Therefore,
audit quality improvement is always the preoccupation of regulators and researchers.
Audit quality can be measured using direct or indirect approach. The direct
approach uses the definition of audit quality to address the measurement of audit quality,
while indirect approach bases on the surrogates of audit quality and select the suitable
variables to represent audit quality.
Regarding to the feasibility of the indirect approach, previous studies use different
proxies for audit quality. Balsam et al. (2003) show that audit quality is the unobservable
and ambiguous definition, so the best measurement is to use auditor characteristics to
surrogate audit quality. Hussein and MohdHanefah (2013) also suggest that it is better to
use the indirect method to assess audit quality. Nguyen and Ha (2014) provide empirical
evidence in Vietnam regarding to the factors affect independence characteristic of audit,
and conclude that audit rotation is one of the key drivers of auditor’s independence and
audit quality. Sayyar, et al., (2015) measure audit quality by using audit fees and audit
rotation. Al-Khaddash, Nawas and Ramadan (2013) use the set of variables such as

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internal control, audit firm size, audit fees, auditor independence, industrial specialization
and auditor competences. Ziaee (2014) examines audit tenure, audit reputation and audit
firm experience. James and Izien (2014) consider audit tenure, audit firm size, auditor
independence as the proxies of audit quality. Dadashi et al (2014) assess the audit quality
by three proxies which are audit reputation, auditor independence and auditor’s specialty.
Lu and Ma (2016) measure audit quality by audit opinion, audit reputation and audit fee.

This study uses audit rotation, audit reputation and audit firm experience to proxy
for audit quality because of the highly representative and the availability of data sources.
Audit rotation presents for independent characteristic of audit quality, audit reputation and
audit firm experience presents for the brand and specialty in auditing field.
2.2.1. The impact of audit rotation on firm performance
Mandatory audit firm rotation is identified in section 207 of the Sarbanes – Oxley
(SOX) Act as the principle of a limit time of auditor tenure has conducted and
implemented the auditing procedures of one company. After the expiration of audit period,
the current audit firms will not be re-appointed during a specific period. There are many
arguments surrounding the audit rotation problem. They consider that whether audit
rotation will enhance or deteriorate the audit quality.
The primary purpose of audit is to give independent opinion to shareholders about
the true and fair view of financial statements in material aspects, whether they have
prepared in accordance with the Companies Act and Accounting standards. The benefits of
the users of financial statements (shareholders, potential investors, employers and other
sectors in business community are guaranteed (ICAEW, 2006)).The policy makers,
regulators and professors have effort to improve the audit quality through enhancing the
auditor independence. Coyle & Deirdre (2010) investigate 20 accounting firms and
interview Irish Accounting bodies, audit regulators, they find that one of the most efficient
way to improve and enhance an auditor’s independence perceptions is audit firm rotation.
Ouyang and Wan (2013), Anis (2014), Arel et al., (2005), Chi et al., (2009) also
give the empirical evidence which shows that the length of audit tenure affects to
likelihood perception of auditor independence and audit quality.

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Ouyang and Wan (2013) find that if the length of audit period is longer than ten
years, the probability of accounting fraud in company might increases. Moreover, by
utilizing the sample of listed firms in USA from 1996 to 2005, they also find that the

drawback of long audit tenure in the large companies is more serious than that of small
companies. The empirical results confirm the effect of audit rotation on audit quality and
firm performance.
Okolie (2014) examines the impact of audit quality on earning management from
discretionary accruals and economic operation manipulation of listed companies on
Nigerian Stock Exchange (NSE) during the period from 2006 to 2011. The result shows
that audit quality represented by audit rotation and audit fee has significantly negative
impact on earning management. It means that audit rotation is positively affects firm
performance through mitigating the manipulation of managers.
Rahmina and Agoes (2014) state that the failure of business is attributed to auditing
failure. So, they emphasize the role of audit quality on the credibility of users of financial
statements. Rahmina and Agoes (2014) suggest that an Institute of Public Accountants
should be established and the current mandatory auditor rotation and audit firm rotation
should follow the international regulations which require audit rotation every seven years
for listed companies in Indonesian stock market.
Ardiana (2014) investigates the role of external audit via audit rotation in enhancing
the firm performance in Indonesia. Firm performance is measured by P/E, P/B and Tobin’s
Q. By using 2,240 firm-year observations during the period from 2007 to 2013, the study
concludes that the longer audit tenure decreases the firm performance.
Khatab (2013) examines the effect of audit rotation on the firm value proxied by
Tobin’s Q in Egyptian stock market from 2005 to 2009. Using the Fixed effects model and
random effects model, the study gives evidence that audit rotation has a positive effect on
enhancing firm performance.
Mostafa and Hussien (2010) implement the self-questionnaire survey from 50
auditors who are randomly selected. They suggest that mandatory audit rotation at firm
level should be applied in Egypt rather than rotation at auditor level. Based on the client’s

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specialization industry, the audit firm will appoint auditors with extensive experience in
this field to audit the client, which will generate more benefits for both sides.
Sayyar et al., (2015) examine the impact of audit quality proxied by audit rotation
on firm performance of listed companies in Malaysia from 2003 to 2012. The empirical
evidences show that audit rotation is insignificantly correlated with firm performance
measured by ROA and Tobin’s Q. Myers et al., (2003) find that the longer auditing periods
can mitigate more extreme management decisions on firm performance.
In general, there are two primary points of view about the role of audit rotation
from the literature review. On one hand, audit rotation is considered as the long length of
audit tenure which leads to closer auditor-client relationship and reduces the auditor
independence and quality of audited financial statements. Anderson and Verma (2012),
Crabtree et al., (2004), Lu & Sivaramakrishnan (2009) find that the audit rotation is the
useful and feasible method to guarantee auditor independence and objectivity. Elder et al.,
(2015) examine the audit firm rotation and audit quality data in Florida government audit
market and suggest that rotation policies have positive relation to audit quality via audit
firm selection.
On the other hand, it is argued that the pressure of maintaining the clients and
improving the relationship with clients could cause the auditor to ignore and being
unskeptical about the accounting information of clients. Some researchers investigate the
relationship between audit rotation and audit quality and conclude that the change of
auditors after certain period could bring the fresh look and perspective to the audit process.
It also increases the probability of detection of misstatements (Siregar el at, 2012).
There are many reasons the clients have to deal with because of changing current
auditor. From the companies perspectives, the cost of audit switching and the process of
selecting new auditor is really an instrumental problem under the global competition and
the pressure of reducing company’s expense (Myers et al.,2003). Besides, frequent change
of audit firm is not always as efficient as expected, because if the financial disclosure is in
low quality, the Board of Directors have intention to change the audit firm to conceal the
accounting figures (Johnstone and Bedard, 2004). From the auditors’ aspect, some studies
show that current auditors have more experience and familiarity with the client’s business

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process, hence are more likely to detect the frauds than new auditors (Ghosh& Moon,
2005; Mansi et al., 2004; GAO, 2003). Lu and Sivaramakrishnan (2009) believe that it is
not easy to have deep insight into accounting systems and understanding of the clients’
internal control. Therefore, new auditors will get troubles in the first year. Moreover, in the
final year of appointment, previous auditors will not make more efforts to guarantee the
auditing report.
Kaklar et al., (2012) examine the relationship between audit quality surrogated by
audit firm size, audit rotation and financial reporting quality. The authors expect that high
audit quality will increase the quality of financial reporting as a tool for preventing
financial distress. However, with that dataset of 91 firms listed in Tehran Stock Exchange,
the study finds no evidence about the relationship between the audit rotation and financial
quality reporting. It means that changing auditor is not a significant factor affect the
financial disclosure and the shareholders’ assessment about firm performance.
Mandatory audit rotation can be implemented via the audit firm rotation or auditor
rotation compulsorily or voluntarily. This study focuses on the audit rotation at firm level
and complies with the regulations (except for voluntary rotation at certain times).
However, the audit firm rotation has been confronted with many debates. International
Standard of Auditing (ISA) states that the appointed auditor has been changed every 7
years and come back after 2 years.
The Ministry of Finance in Vietnam required that changing the auditors and person
responsible for signing audit reports after 3 consecutive years from 2004 (Decree No.
105/2004/ND-CP). Regarding to audit firm rotation, Circular No. 39/2011/TT-NHNN was
promulgated by State Bank of Vietnam which required that financial institutions such as
banks, insurance companies have to change the audit firm after 5 continuous years. This
regulation does not apply for public companies in Vietnam. In the workshop of VACPA
discussed about the Independent Auditing Act Project, the term of auditing period was

mentioned again, but no agreements could be given to unify the appropriate period for
audit firm rotation (Auditing Magazines in March, 2011). Based on the actual situation of
each country, they require the audit tenure differently. In the case of Korea, the time for
audit rotation is 3 years and can re-appointment after 3 years. The possible acceptance of
audit tenure in China, Poland, Singapore, Turkey is every 5 years.
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Therefore, this study develops the following hypothesis
H1: Audit firm rotation has a significant impact on firm performance measured
by ROA, Tobin’s Q and Z-Score.
2.2.2. The impact of audit reputation on firm performance
The audit reputation increases the credibility of the firm’s financial reporting. Many
parties use the declared financial information but they cannot approach or observe the
source documents and assess the audit quality directly to identify the level of information
accuracy (Krishnamurthy, 2006). The shareholders have to depend on the independent
party who is the expertise in accounting and finance to express their opinion about the true
and fair view of annual financial statements. DeAngelo (1981) and Dye (1993) believe that
the presence of “auditor-reputation effects” causes the larger audit firms to protect their
brand by focusing on their audit working and assuring the quality to minimize audit errors
than smaller audit firms.
According to Jusoh et al., (2013), audit quality and firm performance are positively
and significantly related. The audit reputation is a proxy of audit quality which is measured
by a dummy variable with Big-Four and Non-Big Four Audit firms. They suggest that
higher quality of audit might reduce the agency costs and reinforce the trust in financial
information disclosure. Fooladi and Shukor (2012) consider audit quality as an external
corporate governance factor that affects firm performance and find that audit reputation has
a positive correlation with firm’s market capitalization.
Lu and Ma (2016) examine the association between audit quality and financial
bankruptcy. Data is collected from the China Stock Market Accounting Research

(CSMAR) database over the period from 2012 to 2013. Lu and Ma (2016) measure audit
quality by audit opinion, audit reputation and audit fee, while the financial distress is
calculated by Z-Score. The empirical evidence confirms that audit quality is negatively and
significantly correlated with risk of financial crisis and the findings also suggest that
external monitoring auditing is an effective mechanism to deal with risk of bankruptcy.
Dadashi et al (2014) find no relationship between the audit reputation and firm
performance in Tehran Stock Exchange between 2009 and 2013. The empirical evidence

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