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1.1        Background to the Study

The monitoring role of external auditor is critical in promoting the quality of financial statements prepared by management. By providing independent verification of financial statements, auditors lend credibility to accounting information and enhance its integrity. Watts and Zimmerman (1986) argued that financial statements audit is a monitoring mechanism that minimizes information asymmetry and protect the interest of the principals as well as existing and potential stakeholders, by providing reasonable assurance that the financial statements (prepared by management) are free from material misstatements. As such, external audit helps reduce agency costs between managers and external parties. However, these external parties cannot be expected to trust reported financial information without confidence in the Auditors‟ Independence. Recently, there is an increasing concern by regulators, investors and the general public regarding the quality and reliability of audited financial statements, because auditors compromise independence and thus diminish the quality of earnings reported, by either providing non-audit services to clients or collecting abnormal audit fees from the clients (Romano, 2004).


In Nigeria, Semiu and Kehinde (2011) and Semiu and Johnson (2012) empirically examine the perception of auditor independence in Nigeria and reported that the size of audit fee is the most influencing factor capable of deterring auditor independence in Nigeria. Similarly, they reported that, joint provision of audit and non-audit services affects auditor independence adversely. On the contrary, an investigation of stakeholders‟ perception of non-audit services provision vis-à-vis auditor independence in Nigeria by Umar (2012) reveals that non-audit services do not impair auditor independence. However, his findings reveal that there are a number of threats to auditor independence and one of which is familiarity, which comes as a results of long-term audit firm-client relationship.


The regulators‟ concern over the increase in the provision of management consultancy services impair audit firm independence is based on the premise that the provision of nonaudit services increases the fees paid to the audit firm thereby increasing the economic dependence of the audit firm on the client (Ashbaugh, Lafond & Mayhew, 2003). Similarly, DeAngelo (1981) and Magee and Tseng (1990) opined that non-audit services impair auditors‟ independence because of the presence of client‟s future quasi-rents (non-audit fee) provided to the auditors. They further stressed that it is the strength of the economic bond between the audit firm and its client that reduces auditor independence. This proposition holds true in some corporate collapse in USA and has forced regulators to ban certain kinds of non-audit services with the view that the financial reporting quality and investor confidence will increase. It is in light of this proposition that excessive audit fee (abnormal fees) is related to auditor‟s incentive to compromise independence. That is because of economic bond between client and auditor; the auditor with the possible loss of revenue is more likely to comply with client‟s wishes to manage earnings. However, Simunic (1984) and Chung and Kallapur (2003) were of the view that costs related to the loss of reputation and litigation minimize the incentives for auditors to compromise their independence. They further lamented that auditors care much about their reputation and if the auditor complies with the client and damages the reputation may potentially lose fees from current and future clients.


For any country to achieve economic growth and development a sound and efficient banking system is necessary to mobilize funds from the surplus units to the deficit units of the economy for productive activities. In Nigeria, banking industry witnessed different factors that slow the desired level of economic growth and development, which according to Soludo

(2004) include weak internal audit, high incidence of fraud and poor corporate governance.

Similarly, the Central Bank of Nigeria (CBN) Code of Corporate Governance for Banks in Nigeria Post Consolidation of 2006 identified weak internal controls, non-compliance with laid-down internal controls and operations procedures; poor risk management practices resulting in large quantum of nonperforming credits including insider-related credits, and abuses in lending, as problems of the Nigerian banking sector. Historical trend in the Nigerian banking industry shows that 59 banks have failed between 1994 and 2007, and four chief executives were sacked in 2009 in connection with unethical practices with respect to loans and advances. Similarly, the CBN in 2011 had revoked the license of four banks in connection with financial regulatory cases. These have questioned the integrity and quality of audited financial statements of Nigerian banks as well as the independence of external auditors on whether they are independent of management influence via audit fees and auditor tenure.


Auditor independence is critical to the reliability of financial statements as well as investors‟ confidence due to the psychological belief in the auditors‟ role. This together with public expectations of the audit work is critical to regulatory agencies. It is in this context that

Abdelkhalik (2002) states that the value of an audit depends on independence (objectivity).

The codes of Ethics of the International Federation of Accountants (IFAC, 2000) and the Institute of Chartered Accountants‟ of Nigeria (ICAN, 2010) define independence as a state of not being controlled by other people or things, such as financial benefits. The code further states that an auditor needs to be objective in the course of performing his duties.

Independence is divided into two according to the code; independence of mind and independence in appearance which are to be observed by an auditor in passing his professional opinion.


In an effort to ensure independence of mind and in appearance, the International Standard on

Auditing (ISA) No. 200 (objective and general principles of audit) states that “in the conduct of any audit of financial statements, auditors should comply with the ethical guidance issued by their relevant professional bodies”. These ethical rules govern auditors‟ responsibilities and guide the audit and non-audit functions performed by auditors. In this regard, the auditors‟ code, published by Auditing Practice Board (APB), titled fundamental principles of independent auditing state that auditors should be seen to be objective in all other dealings with their clients, and their opinions should be independent of its directors. Similarly, in

Nigeria, ICAN‟s rules of professional conduct for members‟ regard objectivity as independence of mind, and require auditors‟ objectivity to be beyond question when conducting an audit. The code makes it mandatory for both accountants in business and in public practice with special emphasis on all professional persons to exercise professional judgement. Hence, the ICAN‟s ethical principles out rightly prohibits misconduct and ignorance of misconduct in the audit of financial statements and thus, defined misconduct as any act or default which is likely to bring disrepute to auditor, his fellow accountant, and the profession of accounting in general (ICAN, 1999).


Consequently, non-compliance with ethical code of professional conduct by auditors make auditors allows managers to manipulate financial statements figures and thus erode the quality of earnings. Earnings management according to Bello (2010), is any attempt to cook/doctor or tailor financial accounting reports to a given desired level. He regarded earnings management as ethical misconduct of accountants and relates it to the recent times corporate failures and loss of investors‟ confidence on both financial reports and auditors. One of the major incentives to manage earnings by managers is their compensation that is based on reported earnings, and hence, they can use abnormal audit fees from non-audit services to make auditors compromise their independence and allow managers to manipulate earnings, and thus impair the quality of earnings. Hence, high auditor independence should be more likely to detect and prevent earnings management. Therefore, higher level of independence is associated with lower levels of earnings management and higher quality earnings.


Abnormal audit fees and the length of client-audit relationship are seen as the major factor behind the lack of auditors‟ independence to objectively carry out their statutory audit function. This resulted in regulatory agencies placing restriction on auditor‟s non-audit services (Hope and Langli, 2007). In contrast to the regulators decision, Defond et al., (2002) argue that regulators ignore the possibility that non-audit services may actually improve audit quality. This has prompted researches on the effect of audit fees, audit firm tenure on the quality of earnings. Also, there are none or fewer studies on auditor independence and earnings management in a developing economy like Nigeria, therefore, this study examines the effect of auditor independence on earnings quality in the Nigerian banking sector.


1.2        Statement of the Problem

With the emergence of stewardship accounting, directors and managers are conferred with the responsibility of preparing financial statements. The essence of the statements is to communicate to users the effect of operating activities during a specified time period and the financial position at the end of the period for a specific business. In an effort to ensure that the major objective of preparing the financial statements is accomplished, external auditor is appointed based on statutory regulations. The auditor‟s responsibility is to conduct an independent examination of an organization‟s financial statements, supporting documents, and records in order to give an opinion about the fairness and general reliability of the financial statements (ICAN, 2010). While this can be considered as a good control measure for ensuring that established procedures and policies are being followed, there is however a great concern by the regulatory authorities and other stakeholders as regard the relevancy and effectiveness of this control measure. This is largely due to the fact that the control measure is not producing the desired outcome. The problem is more prominent in the sector in which most of the banks‟ failures are not reported by the auditors but rather by the CBN. Could it be that the auditors lack professional skills and talents to unveil failure problems or are there some underlining factors that prevent them from discharging their functions effectively? This situations warrant the need to have full investigation/failure of the cause.

Despite the economic importance of the banking industry to the economy, accounting researchers have done little to investigate the relationship between earnings management and auditor independence particularly in Nigeria. Kanagaretnam, Krishnan and Lobo (2008) consider banking industry as the most suitable for studying earnings management because Loan Loss Provision (LLP) is by far the largest and most important accrual for banks. This was also the view of Wahlen (1994) and Kanagaretnam et al. (2003 &2004), where they indicate that banks use LLP to manage earnings. Kanagaretnam et al. (2008) further state that this is to the extent that banks can leverage fee dependence to influence their auditors to accept abnormal LLP which can be determined by studying the relation between abnormal LLP and auditor fees.

Although series of arguments (such as the audit firm characteristics and client firm characteristics) are found in the literature as to the causes of the problem, some of the arguments are conflicting and are mostly based on studies conducted in advanced countries in which the financial systems are more matured compared to the developing countries. This therefore stimulates the need to investigate factors that are responsible by taking into consideration peculiarities of specific area.


Given the fact that the Nigerian banking sector has undergone a series of transformations in order to have a strong and reliable banking sector, the transformations are based on research outputs in which the sector is identified to possess inadequate capital, inept management, and improper risk analysis amongst others. One vital factor that needs thorough investigation in order to have more solutions to the Nigerian banking sector is to empirically study the real relationship and effects between external auditors‟ independence (through Fees, Tenure and the use of large reputable audit firm) and managerial manipulations in the financial statements they audit. This has become essential due to assertions that managements of banks take advantages of the huge audit fees paid to auditors, audit firm tenure and generally accounting principles‟ shortfall and embark on earnings management which is only beneficial to the management but a threat to the survival of banks.


In essence, previous studies on external audit in Nigeria did not specifically examine the effect of auditor tenure, auditor remuneration and the auditor size and expertise on the financial reporting quality using earnings management in the banking sector. This study is design to fill this gap, using methodology and techniques that are most suitable for the banking industry.


In view of the foregoing paragraphs, this study raised the following questions, how do total audit fees affect earnings management of deposit money banks in Nigeria? What is the effect of audit firm tenure on earnings management of deposit money banks in Nigeria? Are reputable audit effective in minimizing earnings management in the deposit money banks in Nigeria?


1.3        Objective of the Study

In line with the foregoing paragraphs, the main objective of this study is to examine the effect of auditors‟ independence, via fee dependence, audit firm tenure and reputable large audit firm on earnings management of deposit money banks in Nigeria. To achieve this, the following specific objectives are set forth;

  1. To assess the impact of total audit fees on earnings management of Deposit

Money Banks in Nigeria. ii.To investigate the effect of audit firm tenure on earnings management of Deposit

Money Banks in Nigeria. iii.To examine the effect of audit firm size on earnings management of Deposit

Money Banks in Nigeria.


1.4       Hypotheses of the Study

In order to draw conclusion about auditor independence on earnings management through fee dependence, tenure and reputable large audit firm, the study in line with the problem and objectives of this study formulated the following hypotheses in null form;

  1. H01: Total audit fees have no significant effect on earnings management of Deposit

Money Banks in Nigeria. ii.H02: Audit firm tenure has no significant effect on earnings management of Deposit

Money Banks in Nigeria. iii.H03: Audit firm size has no significant effect on earnings management of Deposit

Money Banks in Nigeria.

1.5        Significance of the Study

This study is motivated by the growing concern by regulators, investors and the public over the credibility and integrity of audited financial reports, and stakeholders‟ confidence in the auditors‟ independence, in the light of corporate failures and monitoring role of external auditors. This study would be significant in revealing whether the intensive regulatory oversight in the Nigerian banking industry enhances auditor independence and management practices. Therefore, this study is expected to benefit existing and potential shareholders, depositors, creditors, Managements, Regulators and professional bodies.


Shareholders, investors, creditors and depositors will find this study useful in that it will highlight whether the auditors‟ monitoring role is objectively discharged in effort to safeguard their interest in the banks. Specifically, they will be educated on whether audit fees as determined by the management are the tools of inducing auditors to compromise their independence and objectivity, so as to allow the management to manipulate financial statements information.  And, that whether or not the audit tenure causes familiarity threats to independence of auditors in the Nigerian banking sector. Hence, this study will educate the stakeholders in the Nigerian banking industry on the implication of high audit fess and audit tenure on the quality of information produced by management. This is because quality earnings are seen as the ability of a firm to service its shareholders and its debt obligation. Therefore, earnings management or poor quality earnings imply an increase risk of not meeting the shareholders, debtors and customers obligation. Thus, it is critical to investors, debtors and customers that auditors maintain their independence and provide objective assessment of client financial statements. Managers will also find this study of relevance to their operations, as it will reveal the effects of their discretions on the quality of earnings. As this could provide them with a hint on whether their action is positively or negatively affecting financial reporting.


The Central Bank of Nigeria, Securities and Exchange Commission and the Nigerian deposits insurance corporation will all benefit from the findings of this study. This is because it will examine the effect of audit fees and auditor tenure on the quality of earnings, and hence, stimulate and guide policy makers and regulators in policy formulation and regulations in order to safeguard the interests of vast stakeholders in the Nigerian banking industry. That is, the findings of this study will serve as an input to regulators.


Similarly, the accounting professional bodies will find this study critical in that it will show whether their members are complying with the ethical code of conduct set by them. Therefore, the study will provide empirical evidence on the effect of audit fees and audit tenure on the quality of earnings of the Nigerian banks.

Lastly, this study will adds value to the existing literature on auditors‟ independence in the Nigerian context with special reference to banking sector. Hence, researchers and student will benefit from this study.


1.6       Scope of the Study

This study is restricted to the Nigerian banking industry and covers the period of seven years 2006-2012. This period is informed by the fact that it is immediately after the banking sector consolidation, which is when the banking sector witnessed intensive regulations and reforms. On the other hand, it is the period that some banks suffered crises that involved management‟s unethical practices. Nigerian banking sector is selected because it offers a unique context to study earnings management and auditor independence. The study covers and considers total audit fees, audit firm tenure and large reputable audit firm as auditor‟s independence proxy, while discretionary accruals (loan loss provisions) are used to proxy earnings management.






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