Internal Control Quality, Egyptian Standards on Auditing and External Audit Delays: Evidence from the Egyptian Stock Exchange

• Published date: 01 July 2014
• Author: Hichem Khlif,Khaled Samaha
• Date: 01 July 2014
• DOI: http://doi.org/10.1111/ijau.12018

Internal Control Quality, Egyptian Standards on Auditing and External Audit

Delays: Evidence from the Egyptian Stock Exchange

Hichem Khlif1and Khaled Samaha2

1University of Monastir,Tunisia

2The American University in Cairo,Egypt

This paper examines the impact of internal control quality (ICQ) on external audit delays as proxied by the auditor

component of audit report lag (A-ARL) and the effect of the adoption of the Egyptian Standards on Auditing (ESA)

on this relationship in the Egyptian context. Using a balanced panel data of 344 firm-year observations spanning

from 2007 to 2010, we hypothesise and empirically find the following. First, ICQ represents a key determinant of

timely disclosure, as it contributes significantly to the reduction of A-ARL. Second, the adoption of the ESA has

significantly contributed to the improvementof audit practices by reducing A-ARL. Third,the adoption of ESA has

also strengthened the relationship between A-ARL and ICQ for the post-adoption period of these standards.

Additional analysis is conducted to examine the impact of industry characteristicson the relationship between ICQ

and A-ARL and the association remains significant regardless of the sector considered. In order to make a more

informative analysis, we examine the effect of ICQ on the management component of audit report lag(M-ARL) and

we document a positive association between both variables. The results contribute to the literaturedealing with the

relation between A-ARL and ICQ by shedding light on the importance of ICQ in audit practices in an emerging

country characterised by weak legal enforcement and a high level of secrecy. Findings also have policy

implications for Egyptian standard-setters with respect to the development of internal auditing standards.

Key words: Audit practice, external audit delays, internal control quality, Egyptian Standards on Auditing (ESA),

Egypt

1. INTRODUCTION

Audited financial statements represent an important

source of information for investors to evaluate firms’

financial reporting credibility before making decisions

about their resource allocations. Independent and quality

audit plays a pivotal role in enhancing transparency in

financial reporting practices and establishing confidence

in any capital market. However, it remains essential for

audit firms to provide the investment community with

a timely audit report to allow investors to allocate

their resources in a more rational way (Dahawy &

Samaha, 2010). Any delay in the disclosure of the

auditor’s opinion on the true and fair view of financial

information elaborated by the firm’s management

exacerbates information asymmetry between managers

and shareholders and adversely affects financial system

efficiency (Mohamad-Nor, Shafie & Wan-Hussin, 2010).

According to Habib and Bhuiyan (2011), an audit report

contains the auditor’s opinion which informs investors

about the credibility of financial statements and allows

them to adjust accordingly their investment preferences.

Furthermore, Knechel and Payne (2001) state that longer

audit delays reduce information quality.

Given the importance of disclosure timeliness to the

investment community in general, audit report lag (ARL)

and its determinants have become an important topic in

the accounting literature. The conventional overall ARL

(O-ARL) is generally defined as ‘the number of daysfrom

fiscal year end to audit report date’ (Mohamad-Nor et al.,

2010, p. 57). However, such a classic definition of ARL

represents a biased proxy for the auditor component of

ARL (A-ARL) especially in emerging economies where

management may play a critical role in increasing the

O-ARL by exerting discretion over the timeliness of

reporting (Afify, 2009). Therefore, the use of A-ARL as a

refined proxy for ARL by subtracting the management

component of ARL (M-ARL) from the O-ARL represents

a more accurate measure of A-ARL in emerging markets.

Initially, the audit and accounting literature has

focused on the effect of corporate characteristics,

including audit firm size, corporate performance and

audit fees on A-ARL (Ettredge, Li & Sun, 2006).

Nevertheless, after the financial scandals involving audit

firms on both sides of the Atlantic, corporate governance

attributes have become important factors employed to

explain A-ARL (Afify, 2009; Mohamad-Nor et al.,

2010). Such a topic has attracted a great deal of attention

among accounting researchers, especially in emerging

and newly developed markets where the audited

financial statements in the annual report represent a

unique, reliable source of information for investors.

According to Afify (2009, p. 57) ‘timely reporting in

emerging markets, as Egypt, is very crucial, since

information in these markets is relativelylimited and has

a longer time lag’. As a result, the reduction of the gap

between the end of financial year and the publication of

audited financial statements orients investors towards a

better choice in terms of their resource allocations and

hence improves market efficiency.

Egypt has recently been a fertile ground for regulatory

reforms, including the Egyptian Accounting Standards

(EAS) in 2006, new corporate governance law in 2005

and the Egyptian Standards on Auditing (ESA) which

were introduced in early 2009. Accordingly, it becomes

important to understand the determinants of A-ARL

following these reforms. In this regard, Afify (2009) has

examined the relationship between O-ARL1and several

corporate characteristics and corporate governance

attributes. He suggests that future research may consider

Correspondence to: Hichem Khlif, Department of Management,

University of Economic Sciences and Management of Mahdia,

University of Monastir, Sidi Messaoud, Mahdia 5100, Tunisia. Email:

hichemkhlif@gmail.com

International Journal of Auditing doi:10.1111/ijau.12018

Int. J. Audit. 18: 139–154 (2014)

© 2013 John Wiley & Sons Ltd ISSN 1090-6738

the effect of the quality of a company’s internal control

system on A-ARL. In addition, he recommends also that

the examination of the delay types (A-ARL and M-ARL)

could lead to more informative analysis.

Therefore, the main objective of this studyis to examine

the relationship between internal control quality (ICQ)

and A-ARL for a sample of 86 Egyptian non-financial

firms over the period 2007–10. In addition, we test the

effect of the new auditing rules on the relationship

between ICQ and A-ARL. In order to make more

informative analysis, we examine the effect of ICQ on

M-MRL and O-ARL to understand how this characteristic

affects management behaviour. Finally, an industry

analysis is conducted to investigate the effect of industry

characteristics on the relationship between ICQ and

A-ARL. By doing this, our study offers distinguishing

features with respect toAfify’s work in Egypt, as it focuses

specifically on the effect of ICQ on A-ARL and tests

whether the adoption of the new set of ESA has an effect

on audit practices in Egypt.

Our findings suggest that ICQ represents an important

variable in reducing and explaining A-ARL. The results

remain significant regardless of the period considered

or the industry investigated. Our findings add to the

existing empirical literature by focusing on an emerging

civil law market characterised by a high level of secrecy

and a lack of transparency. Accordingly, our findings

may help standard-setters and practitioners identify an

important factor that contributes to the reduction of

A-ARL and improves disclosure timeliness in Egypt.

The remainder of this paper is organised as follows.

Section 2 provides background about the financial

reporting, corporate governance and auditing reforms in

Egypt. Section 3 presents our hypotheses development.

Section 4 presents our research design. Section 5

discusses the sample selection. Section 6 presents the

empirical findings. Finally, section 7 concludes the paper.

2. FINANCIAL REPORTING, AUDITING AND

CORPORATE GOVERNANCE REFORMS

IN EGYPT

Egypt has an eventful history in the field of financial

management and accountability. During the 1960s, with

the move to an economic management based on central

planning, nationalisation, and rapid expansion of the

public sector, the Central AuditingAgency (CAA) became

the governmental agency responsible for auditing the

public sector, including state-owned companies. In the

mid-1970s, the Egyptian government introduced an

‘open-door’ policy to liberalise the national economy.

In 1991, the government launched a comprehensive

economic reform and structural adjustment programme

supported by the World Bank and the International

Monetary Fund (IMF) (Abd-Elsalam & Weetman, 2003;

Samaha, 2005; Samaha et al., 2012). Key international

donor/lending institutions such as the World Bank and

the IMF exerted pressure on developing and transitional

countries to adopt International Financial Reporting

Standards (IFRS) as a part of their reform programmes.

They argued that the application and implementation

of internationally accepted standards (e.g., auditing,

accounting) are necessary to command the confidence of

investors (Samaha & Stapleton, 2008, 2009; Samaha

et al., 2009).

Accordingly, three main reforms have recently been

undertaken by the Egyptian government, including the

adoption of: (i) EAS, (ii) the Egyptian corporate

governance code (ECGC) and (iii) ESA.

With respect to corporate disclosure requirements, a

new set of EAS was issued based on the latest IFRS

pursuant to the Decree No. 243/2006 of the Minister of

Investment, replacing the old standards issued under

the two ministerial decrees Nos. 503/1997 and 345/

2002 (www.efsa.gov.eg). These standards are applicable

to all listed companies. The new EAS have been issued

to comply with the economic changes and scientific

and technological developments either at the business

performance level of the companies or at the level of

the accounting systems that they apply. The issuance of

these standards is an important step in improving the

application of principles of good corporategovernance by

listed companies.

Regarding corporate governance practices and in

recognition of the need to enhance the level of confidence

of foreign portfolio investors in the Egyptian capital

market, the ministry of investment through the Egyptian

Institute of Directors (EIoD) (http://www.eiod.org)

introduced a corporate governance code in late 2005 for

companies listed on the Egyptian Stock Exchange (EGX)

(Samaha et al., 2012). The ECGC is initially prepared in

accordance with the Guidelines on CorporateGovernance

of State-Owned Enterprises in the Organization for

Economic Cooperation and Development (OECD).

Subsequently, a team of Egyptian experts drafted the

initial code, which was then subjected to an in-depth

examination and an extended discussion. In the end,

the code was reviewed by experts from the OECD, the

International Finance Corporation (IFC) and also the

World Bank.

Finally, the Egyptian Society of Accountants and

Auditors and the Capital Market Authority (CMA) have

prepared the ESA, including periodic reviews and

assurance services that comply in form and content with

the International Standards on Auditing (ISA) issued in

2007 (www.efsa.gov.eg). The draft was discussed among

stakeholders and the final set of standards was issued in

Arabic on 30 June 2008, and has been applicable to all

audit engagements starting from1 January 2009 (Samaha

& Hegazy, 2010). The set of standards includes: a preface,

a theoretical framework for assurance services, 32

Egyptian auditing standards, a standard for reviews, two

Egyptian standards for assurance services, two Egyptian

standards for other related services, and a guidance on

the issues that auditors must consider in their audit for

small entities.

3. ICQ AND A-ARL: HYPOTHESES

DEVELOPMENT

Several ISA state clearly that the external auditor has to

understand the firm’s internal control system and work

closely with the internal auditing department (Ho &

Hutchinson, 2010). For instance, ISA 315 ‘Identifying and

assessing the risks of material misstatement through

understanding the entity and its environment’ states that

the ‘auditor must obtaina sufficient understanding of the

entity and its environment, including its internal control

to assess the risk of material misstatementof the financial

statements whether due to error or fraud, and to design

the nature,timing, and extent of further audit procedures’

(IAASB, 2010a). In addition, ISA 330 ‘The auditor’s

procedures in response to assessed risk’ suggests that an

effective environment control allows the auditor to have

140 H. Khlif and K. Samaha

Int. J. Audit. 18: 139–154 (2014)© 2013 John Wiley & Sons Ltd