SSRN-id2211962

Perceptions of Audit Service Qualityand Auditor Retentionija_457 54..74

Kym Butcher,1 Graeme Harrison2 and Philip Ross1

1University of Western Sydney, Australia2Macquarie University, Australia

Prior research has argued that perceptions of the breadth andquality of auditor-sourced services relative to rival audit firmsare of paramount importance to client management whenmaking auditor retention decisions. However, the audit qualityfactors affecting auditor retention are under-researched. Thisstudy examines the association between perceptions of auditservice quality and auditor retention in the compulsory audittendering context of local government in the Australian stateof New South Wales. This context overcomes constraints ofunlimited tenure and high costs of changing auditors in priorstudies of auditor retention in voluntary tendering contexts,and has high retention rates at tender and evidence of councilsatisfaction with audit quality. We use a questionnairesurvey of 48 audit service quality attributes drawn from theaudit service quality literature and administered to financeprofessionals and internal auditors across all New South Waleslocal councils. We hypothesize a positive association betweenperceived audit service quality and auditor retention due tocouncil satisfaction with audit quality. We generate factorscores to test the hypothesis in a logistic regression and findevidence that higher-order audit quality factors of relationship(via the expertise dimension) and service qualities (via theresponsiveness to client needs dimension) are associated withauditor retention, and are worthy of attention by audit firms inorder to enhance client commitment and their likelihood ofbeing retained as an incumbent auditor.

Key words: Audit service quality, auditor retention, compulsoryaudit tendering, local government audit, relationshipcommitment in professional services

1. INTRODUCTION

Perceptions of the breadth and quality ofauditor-sourced services relative to rival audit firmsare of paramount importance to client management

when making auditor retention decisions(Hackenbrack & Hogan, 2005: 7). Duff (2009: 401)argues that current issues of ‘the globalization ofbusiness, commercialization of practice andstakeholder dissatisfaction with the level ofaudit quality . . . are focusing auditors’ minds onimproving the quality of service they offer to theirclients’. Morton and Scott (2007: 18) argue that

Correspondence to: Kym Butcher, School of Accounting,University of Western Sydney, Sydney, Australia. Email:[email protected]

International Journal of Auditing doi:10.1111/j.1099-1123.2012.00457.xInt. J. Audit. 17: 54–74 (2013)

ISSN 1090-6738© 2012 Blackwell Publishing Ltd

clients’ perceptions of service quality are associatedwith intentions or decisions to continue topurchase services from the same provider.Consequently, to improve their likelihood of beingretained, audit firms need to be concerned withboth the quality of services offered and clients’perceptions of the quality of those services (Guy,Harris & Williams, 1979: 17).

There is a considerable body of research onperceptions of audit quality attributes (e.g.,Schroeder et al., 1986; Carcello et al., 1992; Aldhizer,Miller & Moraglio, 1995; Davis, 1995; Behn et al.,1997; Chen, Shome & Su, 2001; Kilgore, 2010). Therehave also been many studies that have examinedclient perceptions of audit quality attributesassociated with auditor rotation and change(e.g., Healy & Lys, 1986; Williams, 1988; Haskins &Williams, 1990; Johnson & Lys, 1990; Woo & Koh,2001), and auditor selection and appointment (e.g.,George & Solomon, 1980; Addams & Davis, 1994;Abbott & Parker, 2000; Velury, Reisch & O’Reilly,2003; Godfrey & Hamilton, 2005). The consensus ofthis literature is that dissatisfaction with the qualityof the incumbent auditor is the main reason forauditor displacement (e.g., Burton & Roberts, 1967;Bedingfield & Loeb, 1974; Williams, 1988; Beattie &Fearnley, 1995; Behn et al., 1997).

The corollary to this finding is that if clients aresatisfied with, or have a favourable perception of,certain audit quality attributes of their incumbentauditor, they will remain with the incumbent(Pandit, 1999). However, there is little empiricalresearch directly examining the audit qualityattributes associated with auditor retentiondecisions. Apart from a small number ofpractitioner studies (e.g., Stanny, Anderson &Nowak, 2000; Rummel, Davidson & Action, 1999;Gabhart & Miller, 1984), only Pandit (1999) andMorton and Scott (2007) have examined directly theassociation between client perceptions of auditservice quality attributes and auditor retention.

Pandit (1999) examined the association betweenfive dimensions of audit quality (the audit firm’sresponsiveness to client needs; industry expertiseof the audit firm; the audit firm’s executiveinvolvement in the audit; conduct of the auditfieldwork; and quality of the audit staff) and clientintentions to remain loyal to, and retain, theirincumbent auditor. The five dimensions wereselected from the 12 factors identified by Carcelloet al. (1992) from their list of 41 attributes affectingperceptions of audit quality. Pandit (1999) foundthat two of the five dimensions (the audit firm’s

executive involvement and responsiveness to clientneeds) were associated with the intention to retainan incumbent auditor. Although hypothesized,no association was found between the industryexpertise of the audit firm or the conduct of theaudit fieldwork and intention to retain theincumbent auditor. The result for industryexpertise was acknowledged as contrary to priorresearch (e.g., Shockley & Holt, 1983; Beattie &Fearnley, 1995). It was not possible to test thehypothesis for the quality of the audit staff becauseof low factor loadings for this dimension.

Morton and Scott (2007) developed a 28-itemmeasure of audit service quality based on thebehavioural audit survey literature, exploratoryresearch and the SERVQUAL scale of Parasuraman,Zeithaml and Berry (1985). Using a sample of 136chief financial officers of Australian companies,Morton and Scott (2007) found only a weakassociation between perceived audit service qualityand retention of the auditor. They argued that thisresult might be because there was no legislativelimit on auditor tenure and because the cost ofchanging auditor is high.

The purpose of our study is to examine theassociation between perceptions of audit servicequality attributes and auditor retention in a contextthat comprises a high auditor retention rate andclient satisfaction with audit service quality, andthat also overcomes the limitations of Pandit (1999)and Morton and Scott (2007). The context is that ofcompulsory audit tendering (CAT) in New SouthWales (NSW) local government. In this context,legislation, specifically the NSW Local GovernmentAct 1993, mandates tenders for audit services becalled by local councils every six years irrespectiveof whether the council is satisfied or dissatisfiedwith its incumbent auditor, or wants or intends tochange auditors (NSW Government, 1993, Sec. 423;Butcher et al., 2011). The typical outcome of audittendering is auditor rotation (Butterworth &Houghton, 1995), with the voluntary audittendering studies of Beattie and Fearnley (1998a,1998b) and Johnson (1993) reporting rotation ratesof 82 per cent and 73 per cent, respectively.However, a high rate of auditor retention existsin the CAT context of NSW local governmentwith empirical research providing evidence thatdespite the (compulsory) opportunity to rotate,an increasing number of NSW local councils havechosen to retain their audit firm, with the auditorretention rate increasing from 59 per cent at thetime of the first compulsory tender in 1995 to 86 per

Perceptions of Audit Service Quality and Auditor Retention 55

Int. J. Audit. 17: 54–74 (2013)© 2012 Blackwell Publishing Ltd

cent following the third (in 2007) (Butcher et al.,2011). Further, Boon, McKinnon and Ross (2008)found that NSW local councils reported high levelsof satisfaction with their audit service quality.

Additionally, the CAT context does not suffer theconstraints of no legislative limit on auditor tenureand the high cost of changing auditor that Mortonand Scott (2007) argued might have confoundedtheir results and caused the weak association theyfound between audit service quality and auditorretention. First, CAT legislates a limit on auditortenure of six years. Second, as councils have tocall tenders every six years, the costs of tenderingand auditor bid evaluation and selection have tobe incurred irrespective of whether the councilreappoints its incumbent auditor or appoints a newauditor. Our study also overcomes limitations ofPandit (1999). As noted above, Pandit (1999) drewon the 12 audit service quality factors of Carcelloet al. (1992), but selected only five for study. One ofthe five (quality of the audit staff) could not betested because of low factor loadings and another(industry expertise) produced results contrary toprediction and prior research. We use the completelist of attributes and factors from Carcello et al.(1992). This allows a comprehensive examination ofthe association between audit service quality andauditor retention.

In summary, given the CAT context in NSW localgovernment of high auditor retention rates andcouncil satisfaction with audit quality, we use thiscontext to examine the association between auditservice quality and auditor retention. We use aquestionnaire survey of 48 audit service qualityattributes drawn from the literature andadministered to finance professionals and internalauditors across all NSW local councils. Weformulate a hypothesis based on theory drawnfrom the marketing model used by Ismail et al.(2006) and on Duff’s (2009) AUDITQUAL measureof audit quality. We find that audit firm expertiseand responsiveness to client needs are associatedwith auditor retention and are, therefore,important attributes for audit firms to focus on toenhance the likelihood of being retained as theincumbent auditor.

The paper is organized as follows. Section 2provides background information on the CATcontext of NSW local government. Section 3 drawson the audit service quality and marketingliteratures to formulate a hypothesis about theassociation between audit quality attributes andauditor retention. Sub-hypotheses are formulated

based on Duff’s (2009) AUDITQUAL model ofaudit quality. Section 4 discusses the method,including variable identification, survey designand administration, sample selection, method ofanalysis and specification of the model to test thehypothesis. Section 5 presents the results of testingthe hypothesis using AUDITQUAL. Section 6presents the results of sensitivity analysis usingCarcello et al.’s (1992) audit quality attributecategories as adapted by Behn et al. (1997), andSchroeder et al.’s (1986) audit team and auditfirm attribute categories. Section 7 presents theconclusions, limitations and suggestions for futureresearch.

2. BACKGROUND

This section provides demographic and descriptiveinformation on NSW local government, anddiscusses the context of, and legislativerequirements for, local government auditing inNSW.

New South Wales (NSW) is the most populousof the eight states and territories in Australia,having approximately one-third (7.24 million) ofthe Australian population of 22.5 million. Althoughthe area of NSW is 800,000 km2, the populationdensity is just 8.44 per km2, with 63 per cent ofthe population living in the state capital, Sydney,and an urbanization rate of almost 80 per cent(Wikipedia, 2011). There are 152 local councils inNSW. Local councils are the third tier ofgovernment in Australia, the first and secondbeing the federal and state/territory governments,respectively. Councils are subject to stategovernment legislation; in the case of NSW by theNSW Local Government Act 1993 administered bythe Division of Local Government, Department ofPremier and Cabinet.

Because of the demographics of the state, localcouncil populations and areas differ greatly withan inverse ratio of population to area betweenmetropolitan (particularly Sydney) and ruralcouncils. The council with the highest residentpopulation of 300,000 (Blacktown City Councilwithin the Sydney metropolitan area) covers anarea of just 240 km2 (a population density of 1,250per km2), while the rural council of Urana has apopulation of just 1,300 but an area of 3,357 km2

(a population density of 0.38 per km2). The meanpopulations are 47,000 for all councils, 106,700for Sydney councils and 27,500 for non-Sydneycouncils, Revenues correlate positively with

56 K. Butcher et al.


population and population density, with aminimum of $5.9 million per annum (Urana), amaximum of $457.8 million (Sydney City) anda mean (median) of $61.6 million ($38 million)(NSW Government, 2011).

Local councils are funded by their residentialand commercial constituents (the community)through rates, user charges and fees (amountingto about two-thirds of income from all sources),and by the state government through general andspecific purpose grants (amounting to about17 per cent of total income) (NSW Government,2011). The community and government delegatedecision-making authority and responsibility tocouncil managers and directors (councillors)for service provision within their areas andconstituencies, typically road and infrastructuremaintenance, community facilities (recreational,parks, libraries), town planning and developmentapplications, and waste collection.

The Local Government Act 1993 provides anumber of mechanisms to monitor theaccountability of councils to their government andcommunity stakeholders. A major accountabilitymechanism is the annual report and the associatedauditor’s report. Section 428 of the LocalGovernment Act requires councils to prepareannual reports which include audited financialstatements. The Act requires that the council’sannual report and audit report be submitted to theMinister for Local Government and the Executiveof the Division of Local Government. Councils arealso required to present their audited financialstatements at a public council meeting no later thanfive weeks after receipt of the audit report.

The legislative requirements for local councilauditing in NSW changed significantly in 1993with the introduction of CAT under the NSWLocal Government Act of 1993, Section 422, andfollowing the recommendations of the 1991 Reporton the Audit of Local Government conducted bythe Public Accounts Committee (Parliament ofNSW, 1991). The Act (Section 424) described CAT asthe process whereby an open tender for auditservices is sought from qualified auditors everysix years, with the incumbent auditor eligible toreapply. CAT was introduced to increase localgovernment accountability, and to increase thecompetitiveness of the local government auditmarket in order that councils could obtain the bestpossible audit services in terms of costs and quality(NSW Government, 1992: 8, 36). Prior to 1993, onlyauditors holding a Local Government Auditing

Certificate were eligible to audit local councils. Inhis submission to the 1991 Public AccountsCommittee, the NSW Auditor-General describedthe existing process of auditor appointment asbeing ‘far too narrow and restrictive’.

In essence, it has created a ‘closed shop’environment. Only auditors holding a LocalGovernment Auditing Certificate are eligiblefor appointment and once appointed it isvery difficult to remove them, even where aCouncil is dissatisfied with the service provided(Parliament of NSW, 1991: 68).

CAT in the context of NSW local council auditoperationalizes the six criteria argued by the USGeneral Accounting Office (GAO) (1987) to bedesirable in audit procurement: competition,solicitation, technical evaluation, a writtenagreement, multi-year agreements, and specializedfinance professionals. CAT requires that audits areput to competitive and open tender every six years;tenderers are provided with a tender specification;tender specifications state that councils are notrequired to take the lowest bid and that both priceand service-based quality factors will be taken intoaccount; the tender specifications and engagementletter form the basis of the audit contract;appointment is for a mandated tenure period of sixyears; and appointment decisions are made by atender committee comprising finance professionalswith extensive local government knowledge.

3. THEORETICAL FRAMEWORK ANDHYPOTHESIS DEVELOPMENT

3.1 Audit quality and audit service quality

Duff (2009: 401) notes that the literature doesnot provide a consistent definition oroperationalization of audit quality. Perhaps themost agreed upon definition is that of DeAngelo(1981) who defines audit quality as the probabilitythat the auditor will both discover irregularitiesand breaches (due to the auditor’s technicalcompetence) and report the irregularities andbreaches (due to the auditor’s independence).There are various models used in the literature tooperationalize, or measure, audit quality (seeFrancis, 2004 and Kilgore, 2007 for reviews of auditquality research), including those that focus on theservice quality dimensions of audit quality.

As for audit quality, there is no consensus onthe conceptualization or operationalization of audit



service quality, as different researchers focus ondifferent models of service quality (Cronin & Taylor1992; Ismail et al., 2006). Duff (2009: 401) states that‘service quality can be thought of as a sustainablemeans of providing clients . . . with what they wantor need, better, and more effectively’. Prominentexamples of models of service quality usedin the auditing literature include SERVQUAL(Parasuraman, Zeithaml & Berry, 1991),AUDITQUAL (Duff, 2004, 2009), and models usingaudit quality attributes, the three most significantof which, according to Kilgore (2010), areSchroeder et al. (1986), Carcello et al. (1992) andWarming-Rasmussen and Jensen (1998).

Duff (2009) notes that although prior modelsusing audit quality attributes (such asSchroeder et al., 1986; Carcello et al., 1992 andWarming-Rasmussen & Jensen, 1998) containsimilar attributes, these models have beendeveloped and used in isolation from eachother. By contrast, Duff’s (2004, 2009) model,AUDITQUAL, integrates the attributes fromthe prior audit quality literature into amultidimensional, structured model that has beentested for its psychometric properties over differenttime periods and samples, and has been foundto demonstrate both construct validity andmeasurement equivalence as a measure of auditquality. AUDITQUAL consists of nine dimensionswithin four higher-order factors of competence,independence, relationship and service qualities.The competence factor relates to perceptions ofthe auditor to detect errors and comprises threedimensions of reputation, capability and assurance.The independence factor is uni-dimensional, whilethe relationship factor reflects the technicalqualities of the auditor and is two-dimensional,comprising experience and expertise. Thefourth factor, service qualities, reflects the‘often-unobserved nature’ of the auditor–clientrelationship and comprises the three dimensions ofresponsiveness, empathy and non-audit services(Duff, 2009: 404).

3.2 The marketing model

Theoretically, we use the marketing modelemployed by Ismail et al. (2006) who examined, for500 publicly listed Malaysian companies, therelationship between audit service quality, clientsatisfaction and loyalty. The marketing modelpostulates that these three elements are distinct andthat service quality leads to client satisfaction

which, in turn, leads to client loyalty (Ismail et al.,2006: 742). Ismail et al. (2006: 739) cite Oliver’s(1980) cognitive model of the antecedents ofsatisfaction decisions in the marketing literatureto argue that client satisfaction (or dissatisfaction)‘results from experiencing a service and comparingthat experience with the kind of quality of servicethat was expected’. Ismail et al. (2006: 741) also citeAndreassen and Lindestad (1998) in the servicesliterature who argue that ‘customer satisfactionis the accumulated experience of a customer’spurchase and consumption experiences’. Rust andZahorik (1993), in the services literature, andStorbacka, Strandvik and Gronroos (1994), in themarketing literature, argue that satisfied customersare more likely than dissatisfied customers toremain loyal. Client satisfaction is seen asmediating the association between service qualityand loyalty (Ismail et al., 2006: 744).

Empirical research in the marketing literaturehas found support for this model. In reviewingthat literature, Ismail et al. (2006) cite studies thatprovide consistent evidence that customer or clientsatisfaction is affected by perceptions of servicequality (e.g., Yi, 1990), and that satisfaction ispositively associated with client loyalty (e.g., Stauss& Neuhaus, 1997). Despite these findings, theevidence concerning the association betweenservice quality and client loyalty is mixed inthe marketing literature, perhaps due to thecomplexity of the loyalty construct and thedifferent ways of measuring the construct,including cognitive, attitudinal and behaviouralmeasures (Ismail et al., 2006: 741). Studies in themarketing area have found positive (Bouldinget al., 1993; Bloemer, de Ruyter & Wetzels, 1998),negative (de Ruyter, Martin & Bloemer, 1998), andno relationship (Cronin & Taylor, 1992) betweenservice quality and loyalty.

In the auditing literature, there is considerablesupport for the model in terms of the relationshipbetween service quality and satisfaction. Attributesof audit service quality have consistently beingfound to be associated with customer satisfaction(e.g., Behn et al., 1997, 1999; Samelson, Lowensohn& Johnson, 2006; Boon et al., 2008), and servicequality (operationalized using Parasuraman et al.’s(1991) SERVQUAL model) has also been found tolead to client satisfaction (e.g., Ismail et al., 2006:743).

With the exception of Ismail et al. (2006), however,there is little research in the auditing literature onthe relationship between client satisfaction and



client loyalty. Additionally, there is little researchon the relationship between audit service qualityattributes and client loyalty expressed as auditorretention. The research that exists shows mixedresults. Three practitioner studies (Gabhart &Miller, 1984; Rummel et al., 1999; Stanny et al., 2000)provide no common attributes. Rather, these studiesfind a range of attributes associated with experiencewith the incumbent auditor to be important,including data processing capabilities and theability of the audit partner to communicateeffectively (Gabhart & Miller, 1984), staffpersonalities and meeting deadlines (Rummel et al.,1999) and overall quality of services (Stanny et al.,2000).And, as noted in the introduction to the paper,the two academic studies of Pandit (1999) andMorton and Scott (2007) that have examined therelationship between audit service quality andretention also provide mixed results.

Ismail et al. (2006) examined the relationshipbetween audit service quality, client satisfactionand client loyalty. They hypothesized positiverelationships between service quality andsatisfaction and between satisfaction and loyalty,arguing that clients who were satisfied with theirauditor would retain that auditor’s services for alonger period and would buy additional non-auditservices from the auditor. Ismail et al. (2006) usedthe five-dimensional marketing model SERVQUAL(Parasuraman et al., 1991) to measure audit servicequality, with the five dimensions being tangibility,reliability, responsiveness, assurance and empathy.They used hierarchical regression to examinethe mediating effect of client satisfaction on theassociation between audit service quality andloyalty. They found that the service quality factorsof tangibility, reliability and empathy wereassociated with satisfaction, satisfaction wasassociated with client loyalty, and that satisfactionpartially mediated the relationship between auditservice quality and client loyalty via the reliabilitydimension of the five-dimensional model (Ismailet al., 2006: 750). Their finding supported theconjecture that client satisfaction is a mediator ‘tothe extent that it carries the influences of auditservice quality to client loyalty’ (Ismail et al., 2006:749).

3.3 Hypothesis

Based on the foregoing theory drawn from themarketing model that service quality is associatedwith client satisfaction and that satisfaction with

audit quality is associated with client loyalty (Ismailet al., 2006), we expect a positive and significantrelationship between perceptions of audit servicequality and auditor retention in our context ofcompulsory audit tendering (CAT) in NSW localcouncils. This context has been demonstrated to beone in which clients, local councils, are satisfiedwith audit service quality (Boon et al., 2008), andone in which the CAT regime is associated withaudit quality. CAT has been proposed as a means ofenhancing audit quality and auditor independenceby improving the information set available duringthe auditor appointment process, and altering thesupply of audit firms available to an organizationfrom which to appoint an auditor (Jensen & Payne,2005a, 2005b).

The six-year mandatory tenure period in theNSW local council context is also associatedwith audit quality because, while it means theincumbent auditor should face no dismissal riskfor the period, at the end of the period the councilmight not reappoint (retain) the incumbent, butmight change auditors, meaning that the qualityof the predecessor’s audit will be subject toscrutiny (Vanstraelen, 2000). This scrutiny is likelyto be intense because new auditors have anincentive to provide superior audit service in theinitial years of engagement to demonstrate theirability to deliver a quality audit (Craswell, Francis& Taylor, 1995).

Our study employs the Duff (2009) model ofAUDITQUAL to hypothesize and measureaudit quality. We use AUDITQUAL becauseof its theoretical properties as an integratedmultidimensional model of audit quality andits psychometric properties of construct validityand measurement equivalence. As noted earlier,AUDITQUAL consists of nine dimensionswithin four higher-order factors of competence,independence, relationship and service qualities.Our study also employs 48 individual audit qualityattributes drawn from the audit service qualityliterature. The attributes allow us to hypothesizeand measure seven of the nine dimensions inAUDITQUAL, including the three dimensions ofthe competence factor (reputation, capability andassurance), independence, the two dimensions ofthe relationship factor (experience and expertise)and one dimension of the service qualities factor(responsiveness). The other two dimensions of thisfactor (empathy and non-audit services) are notmeasured within the 48 attributes and are nothypothesized. We hypothesize as follows:



H1 There is a significant and positiverelationship between perceptions of audit servicequality and auditor retention.

This overall hypothesis is stated as sevensub-hypotheses using seven dimensions of Duff’s(2009) four-factor model of audit service quality.The sub-hypotheses are as follows:

H1a There is a significant and positiverelationship between reputation and auditorretention.

H1b There is a significant and positiverelationship between capability and auditorretention.

H1c There is a significant and positiverelationship between assurance and auditorretention.

H1d There is a significant and positiverelationship between independence and auditorretention.

H1e There is a significant and positiverelationship between experience and auditorretention.

H1f There is a significant and positiverelationship between expertise and auditorretention.

H1g There is a significant and positiverelationship between responsiveness and auditorretention.

4. METHOD

4.1 Variable identification

Figure 1 provides a comprehensive list of 48attributes drawn from the audit service qualityliterature. The attributes are shown in Column 2and the literature sources in Column 3. Figure 2uses AUDITQUAL (Duff, 2009) to classify the48 attributes into four higher-order categoriesand seven sub-categories: (i) competence(sub-categories of reputation, capability andassurance), (ii) independence (sub-category ofindependence), (iii) relationship (sub-categories ofexpertise and experience) and (iv) service qualities(sub-category of responsiveness).

Columns 1, 2 and 3 of Figure 2 show the categoryname, sub-category number and sub-categoryname, respectively. Column 5 shows the individualattributes that are used in the survey questionnaire,

classified into the seven sub-categories and fourcategories. Column 4 shows the numbering of theattributes in the questionnaire. The numbers inColumn 4 are not sequential as the attributes wererandomly distributed in the questionnaire.

4.2 Survey design

The survey questionnaire (designed followingDillman’s (2000) Tailored Design Method)consisted of two sections. The first sectionprovided respondents with the list of 48attributes. Respondents were requested to:‘Assume that you have been asked to evaluate thequality of audit services provided by yourincumbent auditor. Please indicate . . . the extentto which you agree or disagree that each attributewill impact on your evaluation of the quality ofaudit services provided by your incumbentauditor’. Consistent with Butcher et al. (2011) andBeattie and Fearnley (1995), the request wasframed as a generic task in order that respondentswere not primed about the dependent variable ofthe study (intention to retain the incumbentauditor), and thus to avoid measurementinvariance (Brown, 2006) that might confound theresults of the study. A seven-point Likert-typescale was used ranging from -3 (strongly disagreethat the attribute would impact their perceptionsof audit service quality) to +3 (strongly agree). Theorder of the 48 attributes was randomized toavoid any potential bias resulting from demandcharacteristics or halo effect.

The second section of the questionnairecontained demographic questions about therespondent (e.g., extent of experience) and therespondent’s council (e.g., size and location).The final question asked respondents: ‘If yourcouncil had to make an auditor appointmentdecision now, would it prefer to (i) retain theincumbent audit firm or (ii) appoint a new auditfirm?’. Responses to this question formed thedependent variable of auditor retention.

We used preferred intention to retain or rotatethe incumbent auditor as the dependent variableto reflect the dichotomous nature of the decision.The demand-side studies of auditor selection alsouse this dichotomy (e.g., Woo & Koh, 2001). Ameasure of preferred outcome follows Pandit(1999), and is based on research that showspreference follows attitude and precedesbehaviour, and is a commonly used approach inthe broader behavioural literatures to measure the



Attribute (survey item)

no.

Audit service quality attribute description Literature source

1 The audit firm has been performing the audit for at least 2–3 years Carcello et al. (1992), Chen et al. (2001) 2 The audit firm is considered to be a specialist in local government

audit Carcello et al. (1992), Pandit (1999), Chen et al. (2001)

3 The audit engagement partner has been on the audit for at least 2–3 years

Carcello et al. (1992)

4 The partner assigned to the audit engagement is very knowledgeable about the industry

Carcello et al (1992), Behn et al. (1999), Pandit (1999), Chen et al. (2001)

5 The audit firm participates in the peer review process, and its most recent peer review report was a clean one

Schroeder et al. (1986), Carcello et al. (1992), Aldhizer et al.(1995)

6 The audit firm actively encourages staff members to take courses and attend seminars in fields where the firm has major clients

Schroeder et al. (1986), Carcello et al. (1992)

7 The audit firm that is conducting the audit provides no consulting services for the client

Carcello et al. (1992), Chen et al. (2001)

8 The audit firm is skillful in devising acceptable accounting treatments for transactions that generate results that council management wants

Carcello et al. (1992), Pandit (1999), Chen et al. (2001)

9 The audit firm has a policy on the maximum number of hours per day and per week that its staff can work


10 The audit firm develops stringent time budgets for each audit area and expects its people to meet them


11 The audit firm has a high audit staff turnover rate Chen et al. (2001) 12 The audit firm conducts a thorough study of the client’s system of

internal control Carcello et al. (1992), Davis (1995), Pandit (1999), Chen etal. (2001)

13 The audit firm makes extensive use of computers in conducting the audit


14 The audit firm’s attitude is one of a sceptic, not one of a client advocate

Carcello et al. (1992), Behn et al. (1999), Pandit (1999), Chen et al. (2001)

15 The audit firm is agreeable to completing the audit by a date the client has set

Schroeder et al. (1986), Carcello et al. (1992), Davis (1995), Pandit (1999)

16 The auditors assigned to the engagement are very knowledgeable about accounting and auditing standards

Carcello et al. (1992), Davis (1995), Behn et al. (1999), Pandit (1999)

17 The audit team members as a group always exercised due care throughout the engagement

Behn et al. (1999)

18 The audit staff assigned to the engagement have very high ethical standards

Carcello et al. (1992), Davis (1995), Behn et al. (1999), Pandit (1999), Chen et al. (2001)

19 There is frequent communication between the audit team and the council’s audit committee

Schroeder et al. (1986), Carcello et al. (1992), Behn et al.(1999)

20 The audit firm conducting the audit has other local council audit clients

Carcello et al. (1992), Aldhizer et al. (1995), Pandit (1999), Chen et al. (2001)

21 Audit team members are rotated off the audit periodically Schroeder et al. (1986), Carcello et al. (1992), Chen et al.(2001)

22 There is frequent communication between the audit team and council management

Schroeder et al. (1986), Carcello et al. (1992), Davis (1995), Pandit (1999), Chen et al. (2001)

23 The audit firm keeps council management informed during the year about accounting and financial reporting developments that affect the council

Carcello et al. (1992), Davis (1995), Chen et al. (2001)

24 The audit engagement partner and manager make frequent visits to the council during the conduct of the audit

Carcello et al. (1992), Davis (1995), Pandit (1999)

25 The percentage that the council audit fee represents to the total audit fee revenue of the audit firm is not material

Schroeder et al. (1986), Carcello et al. (1992), Chen et al.(2001)

26 The personnel on the engagement below manager level have passed the professional bodies’ exams


27 The audit partner on the engagement is a CA/CPA Carcello et al. (1992), Aldhizer et al. (1995) 28 Before accepting a new client, the CPA firm conducts a pre-

engagement investigation and goes through risk control procedures including the conduct of a background search on senior management of the prospective client


29 The audit firm reports internal control deficiencies and the auditors’ recommendations on internal control are useful

Davis (1995)

30 The audit firm tends to have decentralized offices rather than centralized offices

Carcello et al. (1992)

31 The overall reputation of the audit firm is positive Schroeder et al. (1986), Carcello et al. (1992), Chen et al.(2001)

32 The work performed by inexperienced members of the audit team is supervised by the audit team manager

Davis (1995)



likelihood of action (Pandit, 1999: 176). Thedependent variable is referred to as auditorretention hereafter.

4.3 Sample selection and surveyadministration

The survey was administered to the sample of 235finance professionals who attended the NationalLocal Government Finance Professionals’ BiennialConference held in NSW in May 2006, and via mailto the population of 35 NSW council internalauditors. These two groups were identified bythe NSW Division of Local Government as themost appropriate respondents for the study as theyliaise closely with the external auditors during theaudit of the council’s financial statements and areinvolved in providing recommendations forthe auditor appointment decision. The financeprofessionals are all senior accountants from ChiefFinancial Officer down to senior supervisors incharge of an area of finance. Finance professionalswork with the auditors during the audit and areinvolved in the auditor appointment process

as members of the tender committee thatrecommends appointment to Council. Manycouncils do not have an internal audit function(hence the small number in the sample). However,when they do, the internal auditors are alsomembers of the tender committee. Council financeprofessionals and internal auditors have equivalentaccounting qualifications, comparable familiarityand liaison with the external auditors during theaudit, and involvement in the auditor appointmentdecision. Hence, the two groups are combined inthe analysis. The analysis was also conductedexcluding the responses from internal auditors. Theresults were unchanged.

The time of data collection (May 2006) wastowards the end of the second compulsory tenderperiod. The first tender period since theintroduction of CAT was 1 July 1995 to 30 June2001, and the second from 1 July 2001 to 30 June2007. Hence, data collection occurred at thebeginning of the final year of the second, six-yearmandatory tenure period. The respondents,therefore, had at least five years’ experience withtheir incumbent auditors.

33 In all your dealings with the audit firm and individual audit team members, the audit firm and audit team members never engaged in any actions that would compromise its/their independence, either in fact or in appearance

Behn et al. (1999)

34 The audit firm has strict guidelines on the procedures that must be completed before signing the audit report

Schroeder et al. (1986), Chen et al. (2001)

35 The cost to the audit firm of different audit procedures in terms of Carcello et al. (1992), Pandit (1999), Chen et al. (2001) time expended is the major criterion as to whether a procedure is used.

36 The audit firm has rarely been found negligent in lawsuits brought against it (alleging inadequate audit performance)

Schroeder et al. (1986), Carcello et al. (1992), Chen et al.(2001)

37 The audit team members as a group have an adequate understanding of the operations of the council

Aldhizer et al. (1995), Sucher et al. (1998), Chen et al.(2001)

38 The audit team members conducted the audit fieldwork in an appropriate manner

Behn et al. (1999)

39 The audit firm makes extensive use of statistical techniques in conducting the audit


40 The audit report and work papers receive a second partner review Aldhizer et al. (1995) 41 The auditor adds value to the entity in terms of generating useful

ideas for improvement Davis (1995), Sucher et al. (1998)

42 The size of the audit firm in terms of its total revenue and number of auditors is much larger than the average size in the region

Chen et al. (2001)

43 The audit manager has been on the audit for at least 2–3 years Carcello et al (1992), Chen et al. (2001) 44 The audit supervisor has been on the audit for at least 2–3 years Carcello et al (1992), Chen et al. (2001) 45 The audit manager and supervisor assigned to the engagement are

very knowledgeable about the industry Carcello et al. (1992), Behn et al. (1999), Pandit (1999),

46 The auditors are mindful of how busy the council’s key finance staff are and contact these individuals only to the extent necessary


47 The external auditors co-operate with the internal auditors Davis (1995) 48 The number of hours spent by the audit team to complete the audit

(from the beginning of fieldwork to the audit report date) is commensurate with a quality audit.

Aldhizer et al. (1995)

Figure 1: Literature review – Audit service quality attributes.



Category name Sub-categorynumber

Sub-categoryname

Surveyattribute

no.303136

1 Reputation

421012131726272935

373839

2 Capability

48

569112128

3234

Competence

3 Assurance

4078

141825

Independence 4 Independence

33

24

Relationship 5 Expertise

1620451343

6 Experience

4415192223

244146

Service qualities 7 Responsiveness

47

Figure 2: Audit service quality taxonomy as per Duff (2009).



Survey item

The audit firm tends to have decentralized offices rather than centralized offices The overall reputation of the audit firm is positive The audit firm has rarely been found negligent in lawsuits brought against it (alleging inadequate audit performance) The size of the audit firm in terms of its total revenue and number of auditors is much larger than the average size in the region The audit firm develops stringent time budgets for each audit area and expects its people to meet them The audit firm conducts a thorough study of the client’s system of internal control The audit firm makes extensive use of computers in conducting the audit The audit team members as a group always exercised due care throughout the engagement The personnel on the engagement below manager level have passed the professional bodies’ exams The audit partner on the engagement is a CA/CPA The audit firm reports internal control deficiencies and the auditors’ recommendations on internal control are useful The cost to the audit firm of different audit procedures, in terms of time expended, is the major criterion as to whether a procedure is used The audit team members as a group have an adequate understanding of the operations of the council The audit team members conducted the audit fieldwork in an appropriate manner The audit firm makes extensive use of statistical techniques in conducting the audit The number of hours spent by the audit team to complete the audit (from the beginning of fieldwork to the audit report date) is commensurate with a quality audit. The audit firm participates in the peer review process, and its most recent peer review report was a clean one The audit firm actively encourages staff members to take courses and attend seminars in fields where the firm has major clients The audit firm has a policy on the maximum number of hours per day and per week that its staff can work The audit firm has a high audit staff turnover rate Audit team members are rotated off the audit periodically Before accepting a new client, the CPA firm conducts a pre-engagement investigation and goes through risk control procedures including the conduct of a background search on senior management of the prospective client The work performed by inexperienced members of the audit team is supervised by the audit team manager The audit firm has strict guidelines on the procedures that must be completed before signing the audit report The audit report and work papers receive a second partner review The audit firm that is conducting the audit provides no consulting services for the client The audit firm is skillful in devising acceptable accounting treatments for transactions that generate results that council management wants The audit firm’s attitude is one of a sceptic, not one of a client advocate The audit staff assigned to the engagement have very high ethical standards The percentage that the council audit fee represents to the total audit fee revenue of the audit firm is not material In all your dealings with the audit firm and individual audit team members, the audit firm and audit team members never engaged in any actions that would compromise its/their independence, either in fact or in appearance The audit firm is considered to be a specialist in local government audit The partner assigned to the audit engagement is very knowledgeable about the industry The auditors assigned to the engagement are very knowledgeable about accounting and auditing standards The audit firm conducting the audit has other local council audit clients The audit manager and supervisor assigned to the engagement are very knowledgeable about the industry The audit firm has been performing the audit for at least 2–3 years The audit engagement partner has been on the audit for at least 2–3 years The audit manager has been on the audit for at least 2–3 years The audit supervisor has been on the audit for at least 2–3 years The audit firm is agreeable to completing the audit by a date the client has set There is frequent communication between the audit team and the council’s audit committee There is frequent communication between the audit team and council management The audit firm keeps council management informed during the year about accounting and financial reporting developments that affect the council The audit engagement partner and manager make frequent visits to the council during the conduct of the audit The auditor adds value to the entity in terms of generating useful ideas for improvement The auditors are mindful of how busy the council’s key finance staff are and contact these individuals only to the extent necessary The external auditors co-operate with the internal auditors

Figure 2: Continued



4.4 Response rate

Of the 235 finance professionals attending theconference, 207 responded. Of the 207, 22 wereexcluded because they were from states other thanNSW, resulting in 185 responses from financeprofessionals in NSW local councils. Of the 35NSW internal auditors, 28 responded. Overall, 213responses were received for a response rateof 86 per cent. Given the high response rate,non-response bias was not considered a threat tothe validity of the results.

In some cases, more than one financeprofessional from the same council attended theconference and completed the questionnaire. Thisis not a concern for the results as the focus ofthe study is at the individual level, specificallythe perceptions of finance professionals withincouncils, not the council level. Also the financeprofessionals were from different functions (e.g.,Revenue Accountants, Expenditure Accountants,Tax Accountants) and likely to have differentinteractions with the external auditors and, hence,different perceptions of audit service quality andattributes affecting audit service quality. Of thepopulation of 152 NSW local councils, 88 (58%)were represented at the conference.

4.5 Method of analysis

The data were analysed using two approaches.First, a forced confirmatory factor analysis wasconducted for each of the attribute categoriesshown in Column 3 of Figure 2 (i.e., the Duff (2009)taxonomy). Principal components extraction withVarimax (Kaiser Normalization) rotation was usedand the factor loading cut-off was 0.30. Each factorwas converted into a single factor score (followingField, 2000). The factor scores were then used in alogistic regression as predictor variables explainingintention to retain or rotate the incumbent auditor.Forced confirmatory factor analysis was usedas it provides factors coterminous with theattribute taxonomy and allows testing of thehypotheses. Confirmatory factor analysis removeswithin-attribute collinearity, although not between-attribute collinearity. Its purpose is to reducepredictor variables to a subset of uncorrelatedfactors (Field, 2000: 431–2).

Second, exploratory factor analysis wasperformed on all 48 items. This approach identifiesa parsimonious list of uncorrelated factors basedupon a principal components analysis of all items.

Exploratory factor analysis achieves parsimony byexplaining the maximum amount of commonvariance in a correlation matrix using the smallestnumber of explanatory concepts (factors) (Field,2000: 423). These factors are then included in alogistic regression explaining rotation/retention.

Exploratory factor analysis was performed usingthe principal components extraction method withVarimax (Kaiser Normalization) rotation. Sixfactors were extracted based on (i) scree plotanalysis and (ii) an absolute value coefficient cut-offof 0.50. (The cut-off point for selecting the numberof factors is based on the point of inflexion of thescree plot, which graphs the value of eacheigenvalue against the factor with which it isassociated; Field, 2000: 436.) The six-factor solutionexplains 45.52 per cent of the variance amongthe items. Figure 3 summarizes these six factors,providing a subjective factor (or attribute) labelbased on each factor’s constituent items. Thoseconstituent items with factor loadings greater than0.50 are shown in Figure 3, together with the factorloadings for each item.

4.6 Model specification

The auditor choice models to be estimated are asfollows:

Intention to retain ReputationCapability Assuran

= + ++

β ββ β

0 1

2 3 cce IndependenceExpertise Experience Responsivene

+ ++ +

ββ β β

4

5 6 7 sss e+[1]

where: Intention to retain = categorical dependentvariable, coded 1 for intention to retain, 0 otherwise,and the independent variables are continuousindependent variables; factor scores derived fromfactor analysing attributes comprising thecorresponding audit quality categories of Duff(2009) shown in Figure 2, Column 3.

Intention to retainExpertise and responsivenessAs

= ++

βββ

0

1

2 ssurance Quality control policiesIndependence and reput

/ +β3 aation Experience

Expertise Communication e+ +

+ +β

β β4

5 6 [2]

where: Intention to retain = categorical dependentvariable, coded 1 for intention to retain, 0otherwise, and the independent variables arecontinuous independent variables; factor scores



An exploratory factor analysis was conducted on all 48 items. A scree plot revealed a six-factor score solution. The extraction method is principal components analysis. The orthogonal rotation method used is Varimax with Kaiser Normalization. The numbers in parentheses after the attribute descriptions are the factor loadings from the pooled factor analysis. Factor loadings were suppressed at 0.50.

Expertise and responsiveness (15.16%)Attribute no. Attribute description

37 The audit team members as a group have an adequate understanding of the operations of the council (0.808) 41 The auditor adds value to the entity in terms of generating useful ideas for improvement(0.785)

45 The audit manager and supervisor assigned to the engagement are very knowledgeable about the industry (0.766)

29 The audit firm reports internal control deficiencies and the auditor’s recommendations on internal control are useful (0.765) 38 The audit team members conducted the audit fieldwork in an appropriate manner (0.732) 16 The auditors assigned to the engagement are very knowledgeable about accounting and auditing standards (0.683) 23 The audit firm keeps council management informed during the year about accounting and financial reporting developments that affect the council 22 There is frequent communication between the audit team and council management(0.604)

12 The audit firm conducts a thorough study of the client’s system of internal control (0.531)

32 The work performed by inexperienced members of the audit team is supervised by the audit team manager (0.523)

15 The audit firm is agreeable to completing the audit by a date the client has set (0.510)

Kaiser-Meyer-Olkin Measure of Sampling Adequacy = 0.704 Bartlett’s test of Sphericity: Approx Chi-square = 609.042 (Sig = 0.000)

Independence and reputation (6.98%) Attribute no. Attribute description

33 In all your dealings with the audit firm and individual team members, the audit firm and audit team members never engaged in any actions that would compromise its/their independence either in fact or in appearance (0.683) 18 The audit staff assigned to the engagement have very high ethical standards (0.619)

36 The audit firm has rarely been found negligent in lawsuits brought against it (alleging inadequate audit performance) (0.573)

17 The audit team members as a group always exercised due care throughout the engagement (0.560)

31 The overall reputation of the audit team is positive (0.542)

34 The audit firm has strict guidelines on the procedures that must be completed before signing the audit report (0.534)


Experience (6.44%) Attribute no. Attribute description

43 The audit manager has been on the audit for at least 2–3years (0.821)

44 The audit supervisor has been on the audit for at least 2–3years (0.728)

3 The audit engagement partner has been on the audit for at least 2–3years (0.506)

1 The audit firm has been performing the audit for at least 2–3years (0.506)


Expertise (5.23%) Attribute no. Attribute description

4 The partner assigned to the audit engagement is very knowledgeable about the industry(0.612)

2 The audit firm is considered to be a specialist in local government audit (0.599)

20 The audit firm conducting the audit has other local council audit clients (0.546)


Communication (4.25%) Attribute no. Attribute description

19 There is frequent communication between the audit team and the council’s audit committee (0.560)


Assurance/Quality control policies (7.46%)Attribute no. Attribute description

9 The audit firm has a policy on the maximum number of hours per day and per week that its staff can work (0.697)

10 The audit firm develops stringent time budgets for each audit area and expects its people to meet them (0.556) 35 The cost to the audit firm of different audit procedures in terms of time expended is a major criterion as to whether a procedure is used (0.537) 21 Audit team members are rotated off the audit periodically(0.508) 5 The audit firm participates in the peer review process and its most recent peer review report was a clean one (0.501)


Figure 3: Audit service quality attribute categories based on exploratory factor analysis.



derived from performing an exploratory factoranalysis as shown in Figure 3.

5. RESULTS

Panel A of Table 1 presents the results ofindependent t-tests of differences in perceptionsof audit service quality of each of the sevenattribute sub-categories of Duff (2009) betweenrespondents preferring to retain their incumbentauditor (retainers) and those preferring torotate (rotators). Panel B of Table 1 presentscorresponding results for the six attribute

categories produced by the exploratory factoranalysis. Panel A of Table 1 shows that thet-statistics (two-tailed) for Capability (t = 4.437,p = 0.000), Expertise (t = 4.452, p = 0.000) andResponsiveness (t = 6.191, p = 0.000) are positiveand significant, indicating that these attributecategories had a greater impact on perceptions ofaudit service quality for retainers compared torotators. Panel B of Table 1 shows similar resultswith t-statistics (two-tailed) for Expertise andResponsiveness (t = 5.373, p = 0.000), Expertise(t = 2.782, p = 0.006), and Communication (t =3.106, p = 0.002) being positive and significant.

Table 1: Results of t-tests of mean differences between potential retainers and rotators

Panel A

Factor scoresa Mean value of factor scoresa t-statistic Significance(2-tailed)b,c

Potential retainers[Coded 1] (n = 164)

Potential rotators[Coded 0] (n = 37)

Reputation 0.089 -0.389 2.662 0.008Capability 0.142 -0.630 4.437 0.000*Assurance 0.055 -0.246 1.661 0.098Independence 0.084 -0.373 2.549 0.012Expertise 0.143 -0.632 4.452 0.000*Experience 0.041 -0.180 1.212 0.227Responsiveness 0.190 -0.844 6.191 0.000*

aEach of the attributes comprising the categories reported in Figure 2, Column 3, were forced into one factor. Thecategories were based on Duff’s (2009) audit service quality taxonomy. The orthogonal rotation method used isVarimax with Kaiser Normalization.bBonferroni corrections were made for the seven multiple comparisons, thus factors scores are significant atp < 0.007, two-tailed. Significant differences are marked with an asterisk.cA positive (negative) t-statistic that is significant (p < 0.007, two-tailed) indicates that the variable has a greaterimpact on perceptions of audit quality for retainers (rotators).

Panel B

Factor scoresa Mean value of factor scoresa t-statistic Significance(2-tailed)b,c

Potential retainers[Coded 1] (n = 164)

Potential rotators[Coded 0] (n = 37)

Expertise and responsiveness 0.169 -0.747 5.373 (0.000)*Assurance/Quality control policies -0.038 0.170 -1.148 (0.252)Independence and reputation 0.001 -0.002 0.016 (0.987)Experience 0.011 -0.051 0.342 (0.733)Expertise 0.092 -0.406 2.782 (0.006)*Communication 0.102 -0.452 3.106 (0.002)*

aAn exploratory factor analysis was conducted on all 48 items. A scree plot revealed a six-factor score solution.Results of the exploratory factor analysis are shown in Figure 3. The extraction method is principal componentsanalysis. The orthogonal rotation method used is Varimax with Kaiser Normalization.bThe Bonferroni correction for the six multiple comparisons was performed with factor scores being significantat p < 0.008, two-tailed. Significant comparisons are marked with an asterisk.cA positive (negative) t-statistic that is significant (p < 0.008, two-tailed) indicates that the variable has a greaterimpact on perceptions of audit quality for retainers (rotators).



To test the hypothesis, the factor scores for theseven attribute sub-categories (Duff, 2009) wereincluded in a logistic regression explaining auditorretention/rotation. The results are presented inPanel A of Table 2. The logistic regression issignificant overall (Chi-squared statistic = 32.931,prob < 0.000) and the Nagelkerke R2 is 24.6%.Panel A of Table 2 shows that the coefficientsfor Expertise (Wald = 3.098, p = 0.078) andResponsiveness (Wald = 11.576, p = 0.001) arepositive and significant, indicating that theseattribute sub-categories had a greater impact onperceptions of audit service quality for retainerscompared to rotators.

Panel B of Table 2 presents corresponding resultsfor the six attribute categories produced by theexploratory factor analysis. The logistic regressionis significant overall (Chi-squared statistic = 42.022,prob < 0.000) and the Nagelkerke R2 is 30.7%.Panel B of Table 2 shows similar results to thosein Panel A with the coefficients for Expertiseand Responsiveness (Wald = 19.645, p = 0.000),Expertise (Wald = 8.126, p = 0.004) andCommunication (Wald = 9.804, p = 0.002) beingpositive and significant.

The results provide support for two of the sevensub-hypotheses. The results show that industryexpertise of the audit firm and audit firmresponsiveness to the client were importantconsiderations in intended auditor retentiondecisions. These attribute categories weresignificant in both the analysis based on the auditservice quality taxonomy of Duff (2009) and theanalysis based on the factor structure from theexploratory factor analysis.

6. SENSITIVITY ANALYSIS

Sensitivity analysis was conducted using twoalternative measures of audit service quality: (i)the 12 factors (attribute categories) of Carcelloet al. (1992), as adapted by Behn et al. (1997) andoperationalized by Boon et al. (2008) (hereafterreferred to as Carcello et al., 1992), and (ii) the15 audit quality attributes identified by Schroederet al. (1986). Kilgore (2010: 29) notes that theseare two of the most prominent taxonomies ofaudit quality in the literature.

Forced confirmatory factor analyses wereconducted for each of the taxonomies (principalcomponents extraction with Varimax (KaiserNormalization) rotation and a factor loadingcut-off of 0.50). Factors were converted into

factor scores which were then used in logisticregressions as predictor variables explainingintention to retain or rotate the incumbentauditor. In cases where an attribute categorycontained a single attribute, the attributemean score was used in the logistic regressionmodels.

Two auditor choice models were estimated.Model 3 is based on the Carcello et al. (1992)taxonomy, and Model 4 is based on the Schroederet al. (1986) taxonomy. The auditor choice modelsestimated were as follows:

Intention to retain Client experienceIndustry expe

= + +β ββ

0 1

2 rrtise ResponsivenessTechnical competence Independe

+ ++

ββ β

3

4 5 nnceDue care Quality commitmentExecutive involveme

++ +β β

β6 7

8 nnt Fieldwork conductAudit committee Ethical stan

+ ++

ββ β

9

10 11 ddardsScepticism Freshness of perspectiveDegree

++ +β β

β12 13

14 of individual responsibility e+ [3]

where: Intention to retain = categorical dependentvariable, coded 1 for intention to retain, 0otherwise, and the independent variables arecontinuous independent variables; factor scoresderived from factor analysing attributescomprising the corresponding attribute categories,or attribute mean scores where the attributecategory contained a single attribute. Singleattribute categories are Due care, Executiveinvolvement and Audit committee.

Intention to retainProvision for team rotationSki

= ++

βββ

0

1

2 llls and experienceCommunication team and management

++β

β3

4AAudit planning and conductQuality control Location a

++β β5 6 nnd size

Litigation Professional developmentSignifi

++ +β β

β7 8

9 ccance of fees Peer reviewCommunication team and au

+ +ββ

10

11 ddit committeePartner and manager attentionExperti

++β

β12

13 sse IndependenceReputation e

+ ++β

β14

15 [4]

where: Intention to retain = categorical dependentvariable, coded 1 for intention to retain, 0otherwise, and the independent variables are



Table 2: Logit model relating audit service quality attributes to intention to retain the incumbent auditor(categorical dependent variable, that is intention to retain the incumbent audit firm, coded 1, versusintention to rotate audit firm, coded 0)

Panel A

Factor scoresa Coefficient Wald statistic Significance (2-tailed)b,c

Reputation 0.190 0.654 0.419Capability -0.309 0.853 0.356Independence -0.077 0.099 0.753Expertise 0.409 3.098 0.078*Experience 0.000 0.000 0.998Responsiveness 1.003 11.576 0.001***Constant 1.768 63.149 0.000

aEach of the attributes comprising the categories reported in Figure 2, Column 3, were forced into one factor. Thecategories were based on Duff’s (2009) audit service quality taxonomy. The orthogonal rotation method used isVarimax with Kaiser Normalization. The category Assurance was removed from the logistic regression due tomulticollinearity concerns.b*Significant at the 10% level, **Significant at the 5% level, ***Significant at the 1% level.Sample size: 201Correct classification: 81.6%Chi-squared statistic = 32.931; prob < 0.000Nagelkerke R2: 24.6%where: Intention to retain = Categorical dependent variable, coded 1 for intention to retain, 0 otherwise, andIndependent variables = Continuous independent variables; factor scores derived from factor analysingattributes comprising the Duff (2009) categories.cA positive (negative) coefficient that is significant (p < 0.10, two-tailed) indicates that the variable has a greaterimpact on perceptions of audit quality for retainers (rotators).

Panel B

Factor scoresa Coefficient Wald statistic Significance (2-tailed)b,c

Expertise and responsiveness 0.875 19.645 0.000***Assurance/Quality control policies -0.305 2.210 0.137Independence and reputation 0.022 0.012 0.912Experience 0.107 0.273 0.601Expertise 0.564 8.126 0.004**Communication 0.670 9.804 0.002**Constant 1.882 61.207 0.000

aAn exploratory factor analysis was conducted on all 48 items. Results are shown in Figure 3. The extractionmethod is principal components analysis. The orthogonal rotation method used is Varimax with KaiserNormalization.b*Significant at the 10% level, **Significant at the 5% level, ***Significant at the 1% level.Sample size: 201Correct classification: 81.6%Chi-squared statistic = 42.022; prob < 0.000Nagelkerke R2: 30.7%where: Intention to retain = Categorical dependent variable, coded one for intention to retain, zero otherwise,and Independent variables = Continuous independent variables; factor scores derived from factor analysingattributes as shown in Figure 3.cA positive (negative) coefficient that is significant (p < 0.10, two-tailed) indicates that the variable has a greaterimpact on perceptions of audit quality for retainers (rotators).



continuous independent variables; factor scoresderived from factor analysing attributescomprising the corresponding attribute categories,or attribute mean scores where the attributecategory contained a single attribute. Singleattribute categories are Litigation, Professionaldevelopment, Significance of fees, Peer review,Communication team and audit committee, Partnerand manager attention, and Reputation.

For purposes of exposition, figures and tablesdetailing the classification of the 48 items and thet-test and logistic regression results for the twoalternative taxonomies are not shown here. Insummary, the results of the two sensitivity analysessupport those from the main analyses. Using thetaxonomy of Carcello et al. (1992), the attributecategories of Industry expertise (Wald = 6.678,p = 0.010) and Responsiveness (Wald = 11.594,p = 0.001) were positive and significant, indicatingthat these attribute categories had a greater impacton perceptions of audit service quality for retainerscompared to rotators. Additionally, the attributecategory Independence was also positive andsignificant (Wald = 5.095, p = 0.024). The logisticregression model was significant overall(Chi-squared statistic = 56.927, prob < 0.000) andthe Nagelkerke R2 was 38.8%.

Using the 15 attributes of Schroeder et al.(1986), the attributes of Expertise (Wald = 3.624,p = 0.057), Communication (between) audit teamand management (Wald = 7.065, p = 0.008), Auditplanning and control (Wald = 8.525, p = 0.004) andSignificance of fees (Wald = 9.471, p = 0.002) werepositive and significant, indicating greater impacton perceptions of audit service quality for retainerscompared to rotators. While Significance of feeswas positive and significant, the attribute was ‘thepercentage that the council audit fee represents tothe total audit fee revenue of the audit firm’. Thisattribute relates to the dependence of the auditor onthe council for total fee revenue. Hence, thesignificance of this attribute supports the findingfor Independence in the analysis based on Carcelloet al. (1992). The logistic regression model wassignificant overall (Chi-squared statistic = 59.964,prob < 0.000) and the Nagelkerke R2 was 41.9%.

7. CONCLUSIONS, LIMITATIONS ANDFUTURE RESEARCH

The purpose of this study was to examine theassociation between perceived audit qualityattributes and the auditor retention decision. We

used the CAT context of NSW local governmentbecause of prior research evidence of councilsatisfaction with audit quality (Boon et al., 2008)and a high auditor retention rate (Butcher et al.,2011). We administered a survey questionnaireconsisting of 48 audit quality attributes to NSWlocal council finance professionals and internalauditors. Using the marketing model as atheoretical basis and Duff’s (2009) AUDITQUALmeasure of audit quality, we hypothesized apositive relationship between perceived auditquality and auditor retention due to perceivedsatisfaction with audit service quality.

We found that two dimensions of audit quality,i.e., expertise and responsiveness to client needs,were, as expected, positively associated withauditor retention in the main analyses using theaudit quality taxonomy of Duff (2009) and theexploratory factor structure of the 48 audit qualityattributes. We corroborated these findings in boththe sensitivity analyses using the taxonomies ofCarcello et al. (1992) and Schroeder et al. (1986). Theother five dimensions of Duff’s (2009) audit qualitydimensions; i.e., reputation, capability, assurance,independence and experience, were, contrary toexpectations, not found to be associated withauditor retention.

We provide support for prior studies. Mortonand Scott (2007) hypothesized an associationbetween audit service quality and auditorretention but found the association to be weak.Consistent with their hypothesis, we find asignificant association in our context that did notsuffer the constraints of no legislative limit onauditor tenure and the high cost of changingauditor that Morton and Scott (2007) arguedmight have confounded their results. Consistentwith Pandit (1999), we find that responsivenessto client needs is positively associated withauditor retention, implying that client-focusedattention significantly improves the likelihood ofrelationship commitment by the client and henceauditor retention. In addition, we find that theaudit quality dimension of expertise is positivelyassociated with auditor retention. Thus wefind support for the extensive audit qualityliterature advocating the importance of auditorspecialization in both providing quality audits andmaintaining client satisfaction and, thus, longtenures with audit clients.

In relation to Duff’s (2009) higher-order auditquality model, we find support for positiveassociations between two of the four higher-order



audit quality factors and auditor retention,specifically the relationship factor (via the expertisedimension) and service qualities (via theresponsiveness dimension), indicating that thesedimensions are of paramount importance to auditfirms seeking to increase their likelihood of beingretained as an incumbent auditor.

The findings of non-significant associationsbetween auditor retention and Duff’s (2009)higher-order audit quality factors of independenceand reputation may indicate that these qualityfactors are relatively more important to clients inthe initial selection of an auditor, or in a decisionto change audit firms to properly align auditor–client needs. This conjecture is supported byButcher et al.’s (2011) finding that reputation andindependence are significant considerations inthe auditor choice decision in the context ofcompulsory audit tendering.

A limitation of our study is that we used adichotomous dependent variable as a proxy forauditor retention, specifically, preferred intentionto retain the incumbent auditor or rotate to a newauditor. This is consistent with the decision that hasto be made in practice which is also a dichotomousdecision, and has literature support and precedentin prior studies. However, a dichotomous measureprecludes analysis based on strength of preferencethat may have allowed finer insights into theattributes affecting the preference. Additionally, weused preferred intention to proxy for the actualdecision. While this has support in the behaviouralliterature that shows intention follows attitude andprecedes behaviour, it remains a proxy and mayintroduce error into the measure of the dependentvariable. A further limitation is that, like priorstudies, our study is cross-sectional and relies onself-reported response data gathered by surveyquestionnaire and is, therefore, subject to thenormal limitations of self-report data. Futureresearch could use alternative theoretical modelsand measures of audit quality, and could usedifferent methods (such as client interviews). Asthere is still relatively little research in this area,future studies will be fruitful in understanding theassociation between audit service quality attributesand auditor retention.

Our results have implications for audit firmsin practice, both in the audit services market forNSW local government and more generally in localgovernment and the private sector. For firmsoperating, or seeking to operate, in the NSW localgovernment audit market, our results provide

direct evidence that council commitment to, andretention of, an audit firm is related to specificattributes of audit service quality, specifically auditfirm responsiveness to client needs and industryexpertise.

The results are also meaningful for localgovernment audit generally. As discussed inSection 2, compulsory audit tendering wasintroduced to NSW local councils in 1993 with theobjectives of increasing competitiveness in thelocal government audit market and to allowcouncils to obtain the best possible audit servicesin terms of cost and quality. Its introduction wasin response to the pre-existing system ‘of virtuallifetime appointment for Local Governmentauditors [that] had led to a “cosy” relationshipbetween auditors and management and to aprofessional cartel whose fee structure could onlybe influenced from within’ (Parliament of NSW,1991: xi).

Prior research has shown that the introductionof compulsory audit tendering achieved theobjectives of increasing competitiveness anddecreasing fees (Boon et al., 2005). However, aconcern with increased competitiveness anddownward pressure on fees is potentialcompromise of audit service quality throughdecreased audit effort and quality. Our resultssuggest that audit service quality is notcompromised in this context as we find that it isattributes associated with audit quality that havegreater impact on evaluations of audit service forclients (here, councils) intending to retain theirauditor. This adds to, and is consistent with, priorresearch in the NSW local government context thatfound that when clients (councils) were motivatedto change their auditor, the change was to appointa quality auditor proxied by competence,reputation and independence (Butcher et al., 2011).

The meaning of these findings for localgovernment audit is that compulsory audittendering appears to have been successful inachieving both the cost competitiveness and auditservice quality objectives underpinning itsintroduction in 1993. This finding is important forlocal government more generally, and for theprivate sector. At the local government level, NSWwas the only jurisdiction in Australia to introducecompulsory audit tendering as a means ofimproving audit service quality and auditorindependence. Other jurisdictions adopted othermeans. South Australia, for example, stipulated afive-year term of tenure after which the incumbent



could be reappointed (without tender), butrequired that any member of the audit team whohad been involved in the audit for the past fiveyears could take no part in the audit for a furthertwo years (South Australia Government, 1999). Inthe private sector, both Australia (CLERP 9,Commonwealth of Australia, 2004) and the US(Sarbanes-Oxley Act, 2002) also introducedcompulsory audit partner rotation to improveauditor independence and audit quality followingthe corporate collapses of the early 2000s.

However, there is growing concern about theability of audit partner rotation to provideadequate protection against loss of audit qualityand auditor independence. Evidence from the USand Australia is that quality and independenceremain potentially compromised because of thecontinuing dependence of the audit firm on theclient for fees, and the fact that rotation appliesto lead and review partners only, while theremainder of the team that conducts the auditcontinues unchanged (Durie, 2011; McKenna,2011). As such, the objective of bringing ‘fresheyes’ to scrutinize the financial statements andactivities of the client is not achieved. As aconsequence, the debate about the effectiveness ofauditor partner rotation is currently beingrevisited, with European authorities arguing for areview of audit firm rotation as an alternative topartner rotation (Durie, 2011; McKenna, 2011).

The results of our paper are, therefore, able to beextrapolated beyond the specific context of NSWlocal government and to local government moregenerally and to the private sector. Should auditpartner rotation not prove effective, as appears tobe the growing concern, the debate on alternativemechanisms needs to consider compulsory audittendering as well as audit firm rotation. Ourfindings support compulsory audit tenderingwith a mandated tenure period as a means ofauditor procurement that may prove effective inenhancing and maintaining audit and auditservice quality.

ACKNOWLEDGEMENTS

The authors acknowledge the contribution of thelate Jill McKinnon to this research. We alsoacknowledge the support provided by the NSWDivision of Local Government, Department ofPremier and Cabinet, Local Government FinanceProfessionals, NSW and the NSW LocalGovernment Internal Audit Network. We are

grateful for comments from two anonymousreviewers and participants at the University ofWestern Sydney, School of Accounting, SeminarSeries in October 2009 and participants at theAustralian National Centre for Audit Researchconference in December 2011.

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AUTHOR PROFILES

Kym Butcher is Lecturer in Accounting at theUniversity of Western Sydney.

Graeme Harrison is Professor Emeritus ofAccounting at Macquarie University.

Philip Ross is Associate Professor at the Schoolof Accounting at the University of Western Sydney.



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