JMAA_2014_1

Journal of
Modern Accounting and Auditing
Volume 10, Number 1, January 2014 (Serial Number 104)
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Jour na l of M ode r n
Ac c ount ing a nd Audit ing
Volume 10, Number 1, January 2014 (Serial Number 104)
Contents
Accounting
A Possible Narrative Section Harmonisation? The Role of the Practice Statement

Management Commentary 1
C. Carini, M. Veneziani, G. Bendotti, C. Teodori
Cost Accounting, Ethical Accountability, and Accounting Principles 20

Hossein Pashang, Urban Österlund, Kjell Johansson
From Consolidation to Segment Reporting in Local Government: Accountability Needs,

Accounting Standards, and the Effect on Decision-Makers 32
Giuseppe Grossi, Elisa Mori, Federica Bardelli
A Study of the Factors Affecting Choice of the Accounting Profession 47

Semra Aksoylu
Linear Programs in Cost Accounting: A Linear Cost Model 55

Gurhan Uysal
Auditing
Measuring Audit Firms’ Intellectual Capital as a Determinant of Audit Quality:

A Suggested Model 59
Amr N. Abdelrhman, Khaled Z. Labib, Ahmed F. Elbayoumi
Does an Auditor’s Within-Industry Market Share Still Capture Auditor Industry

Expertise in a Mandatory Audit Partner Rotation Regime? 80
Chi Wuchun, Liao Hsiumei, Xie Hong
Finance
Monetary Model of Exchange Rate Determination: Evidence From the Czech Republic,
Hungary, and Poland 97
Victor Shevchuk
An Evaluation of the Effect of Credit Risk Management (CRM) on the Profitability of

Nigerian Banks 104
Junaidu Muhammad Kurawa, Sunusi Garba
Corporate Governance
International Supply Chain Management (ISCM): An Emergent Perspective on

Internationalization Driven by Information and Communications Technology (ICT) 116
Thomas Borghoff
Analysis of Leader Intelligence in Telecommunication Industry in Indonesia 125

Ratri Wahyuningtyas
Journal of Modern Accounting and Auditing, ISSN 1548-6583
January 2014, Vol. 10, No. 1, 1-19
D DAVID PUBLISHING
A Possible Narrative Section Harmonisation? The Role of the

Practice Statement Management Commentary∗
C. Carini, M. Veneziani, G. Bendotti, C. Teodori

University of Brescia, Brescia, Italy
The Practice Statement provides a flexible approach to preparation of the management commentary, generating
more meaningful disclosure and discussing those matters that are more relevant to the company’s individual
circumstances. In this direction, the International Accounting Standards Board (IASB) has highlighted some
content elements recognised as being fundamental for guaranteeing the usefulness of the management commentary.
With reference to these elements, it is interesting to analyse the level of disclosure of the financial reporting. These
analyses aim to identify the themes dealt with most extensively by the companies and those that require greater
attention so that the narrative section of the financial statement is, on the one hand, at least consistent with the
suggestions of the guideline and, on the other hand, contains information that is useful for the users. Lastly, in the
light of the relevant European Union (EU) directives, the results of the analysis will help to formulate
considerations on the ability of the IASB guideline to improve the completeness of the narrative section. All this is
examined in a cross-country dimension: Financial reports in Italy and the United Kingdom (UK) are examined. The
content analysis methodology is applied. Within the financial reporting, the management discussion is examined in
particular. The analysis is performed considering 2008. This qualitative paper will contribute to the studies on
disclosure and usefulness of the information provided.
Keywords: management commentary, content analysis, disclosure
The Aim and the Research Questions

The aim of this paper is to analyse the level of disclosure of the financial reporting with reference to the
indication of the International Accounting Standards Board (IASB) Practice Statement management
commentary (IASB, 2010). Although the Practice Statement provides a flexible approach to preparation of the
management commentary, the IASB has highlighted some content elements recognised as being fundamental
for guaranteeing the usefulness of the management commentary. With reference to these elements, the
empirical analysis is performed.
∗
Acknowledgments: The study is part of a wider research project, co-financed by the Ministry of Education, University, and
Research, which involves, in addition to Brescia, four other Italian universities: Genoa, Naples, Parma, and Pisa.
C. Carini, Ph.D., honorary fellow, Department of Economics and Management, University of Brescia.
M. Veneziani, associate professor, Department of Economics and Management, University of Brescia.
G. Bendotti, honorary fellow, Department of Economics and Management, University of Brescia.
C. Teodori, Ph.D., full professor, Department of Economics and Management, University of Brescia.
Correspondence concerning this article should be addressed to C. Carini, Department of Economics and Management,
University of Brescia, Contrada Santa Chiara, n. 50, 25122, Brescia, Italy. Phone: +39.030.2988554; Fax: +39.030.295814. Email:
[email protected].
2 THE ROLE OF THE PRACTICE STATEMENT MANAGEMENT COMMENTARY
More specifically, the following research questions will be addressed:

(1) Which themes are dealt with most extensively by the companies and which require greater attention to
ensure that the narrative section of the financial statement is at least consistent with the suggestions of the
Practice Statement?
(2) What is the usefulness of the Practice Statement for the European companies in the presence of more
incisive forms of regulation (i.e., European Union (EU) directives) and in the light of the companies’ behaviour
prior to introduction of the guideline?
All this is examined in a cross-country dimension: Financial reports in Italy and the United Kingdom (UK)
are examined. We compared a sample of Italian and UK listed companies in view of the profound differences
existing at the level of economic environment. There are numerous works in literature that study the
environmental factors characterising the socio-economic fabric of various countries (Alexander & Nobes, 1994;
Onesti, 1995; Zambon, 1996, 2002; Rusconi, 1999; Di Pietra, 2002; Nobes & Parker, 2002; Choi & Meek,
2005) and provide a comparison of national accounting systems (Mezzabotta, 1995; Provasoli & Viganò, 1995;
Di Pietra & Riccaboni, 2003). These studies illustrate the numerous differences (see Table 1) existing between
the Italian and UK economic environments, a summary of which is provided (Dunne, Fifield, Finningham, Fox,
Hannah, Helliar, Power, & Veneziani, 2008).
Table 1
The Socio-economic Characteristics of Italy and UK
Subject Italy UK
Company law
Company law
Accounting standards
Accounting standards
Major sources of regulation Stock exchange requirements
Stock exchange requirements
Special laws for banks and insurance
Financial Services Authority
companies
Legal system Civil law Common law
Main users of annual reports Creditors Investors
Basis of accounting Prudence concept dominates Accruals concept dominates
Large economy Large open economy
Economy and market structure Small stock exchange Well-developed capital market
Family-owned companies Public companies
Following the guidelines provided by the stakeholder theory (Freeman, 1984), this study follows the line
of thinking that an organisation’s management is not only expected to take on activities expected by its
stakeholders, but also to report on those activities to the stakeholders (Boesso & Kumar, 2007). Such an
approach is also closely linked to the institutional theory, which posits that institutional environment is
characterised by a range of different authorities, organisations, social practices, and economic and market
organisations each with their own expectations concerning appropriate ways to operate and how to
communicate the results obtained. The multiple and often conflicting expectations affecting an entity suggest
that companies are not passive in their choices of work and communication practices (Hoque, 2006).
The content analysis methodology is applied. Disclosure is studied in particular since, according to a
widely-held opinion, financial communication does not represent a neutral process but affects the behaviour of
the recipients and consequently that of the preparers. In this study, the differences between mandatory and
voluntary disclosure are not relevant and therefore are not taken into consideration.
THE ROLE OF THE PRACTICE STATEMENT MANAGEMENT COMMENTARY 3
Within the financial reporting, the management discussion is examined in particular. This choice stems
from the debate on improvement of the financial reporting model via the introduction of narrative reporting
which is particularly topical at the international level.
The annual financial report is considered, because it is the most complete mandatory accounting document
published by the companies.
The companies (40) were selected among the population of non-financial companies listed as of
December 31, 2008.
The analysis is performed considering 2008, the year prior to publication of the Practice Statement
exposure draft. The year of 2008 was chosen in order to take account of application of the EU directives, one of
the main environmental events that influenced the behaviour of the listed companies in preparing the narrative
section. Secondly, analysing the year before publication of the exposure draft may avoid bias due to adaptation
of the information to the guideline indications. Lastly, content analysis of the 2008 narrative section may help
to evaluate the usefulness of the project in terms of meeting users’ information needs. Confirmation that the
content of the 2008 narrative section is already aligned with the suggestions of the guideline would result in
substantial reappraisal of the scope of the Practice Statement from the user’s perspective. Finally, it is hoped
that the research will contribute to a better understanding of the role of the Practice Statement in the light of the
harmonisation process of the narrative section already initiated by the EU and the planned financial reporting
simplification process.
This qualitative paper will contribute to the studies on disclosure and usefulness of the information
provided.
The remainder of the paper is organised as follow: Section 2 outlines the literature review and background;
Sections 3 and 4 summarise the IASB Practice Statement project and the evolution of the management
discussion regulation in the EU directives; Section 5 discusses the research method; Section 6 presents the
empirical results and discussion; and Sections 7 and 8 summarise and conclude.
Literature Review
In recent years, the nature of business has changed fundamentally and likewise the information
requirements of the stakeholders. These changes obviously depend on the alterations that have taken place in
the socio-economic environment in which the companies operate. In this context, numerous articles propose
models of disclosure1. Of particular note is the report published by the American Institute of Certified Public
Accountants (AICPA, 1994) which has become extremely influential (the Jenkins Report): This set out to
improve business reporting by adopting a customer focus. The report proposed a comprehensive model of
business reporting, composed of eight main topics, which embraced a broader integrated range of information.
The eight topics are: financial data, operating data, management analysis, forward-looking information,
information on management and shareholders, objectives and strategy, description of business, and industry
structure. In 2001, the Financial Accounting Standards Board (FASB) set up a business reporting research
project to consider the types of information that companies are voluntarily providing and the means for
delivering it. The objective of this report is to help companies improve their business reporting by providing
evidence that many leading companies are making extensive voluntary disclosures and by listing examples of
1
For a complete review of the main models presented in the nineties, see the review article by Beattie (2000) which contains a
synthesis and a review of the key reports on the future of corporate reporting.
these disclosures. The examples in the report serve to provide companies with helpful ideas on how to describe
and explain their investment potential to investors. The FASB model is composed of six main topics: business
data, management analysis, forward-looking information, information on management and shareholders,
company background, and information on intangible assets. In 2003, the Institute of Chartered Accountants in
England and Wales (ICAEW, 2003) published the New Reporting Models for Business. It identified six
underlying issues (stakeholders, investment and information, theory of accounting regulation, intangibles,
conceptual framework, and transparency in reporting) on which a consensus needs to be formed if significant
progress is to be made towards an agreement either on an appropriate reporting model for business or on how
such a model should be adopted.
Meanwhile, accounting researchers have increasingly focused their efforts on investigating disclosure. A
number of theories have been put forward to explain why companies disclose information, especially of the
voluntary type (Healy & Palepu, 2001; Patelli & Prencipe, 2007). Companies that have high levels of
disclosure often have a lower cost of capital, a higher share value, and a higher market-to-book ratio, because
they are seen to be less risky than their non-disclosing counterparts by investors; thus, it may be in companies’
interests to disclose information (Verrecchia, 1999; Aggarwal & Simkins, 2004). This argument is consistent
with both agency theory and a decision-usefulness approach where managers and owners have to weigh up the
relative costs and benefits of increased disclosure. The costs of disclosure relate to the expense of collating,
interpreting, and disclosing information. Such information is value-reducing for informed traders, as they
already have the information that is not known to the markets generally. They may be able to trade on this
information and exploit their advantages. Furthermore, insiders have an incentive not to disclose if they
think that they will be providing strategic information to competitors (Marshall & Weetman, 2002). However,
one benefit from reporting such information is that it will reduce any information asymmetry among
shareholders and improve the liquidity in the market for that company’s shares, lowering bid-ask spreads and
increasing the volume of transactions that take place (Cornell & Sirri, 1992). Several studies have addressed
the impact of corporate characteristics on the level of disclosure (Belkaoui & Kahl, 1978; McNally, Eng, &
Hasseldine, 1982; Cooke, 1991, 1992; Wallace & Naser, 1995). These characteristics include size, listing
status, leverage, profitability, industry, type of auditor, dispersion of stock ownership, and country of origin.
Overall, these studies indicate that size and listing status are significantly associated with the level of
disclosure.
From the studies cited, it emerges that the contents of the management discussion have been broadened by
elements which the users consider to be useful for meeting their communication needs.
This change reflects the evolution of the economic and financial environment.
Recently in December 2010, the IASB (2010) published the Practice Statement management commentary,
the objective of which is to find a synthesis point among the existing regulations concerning the “other
information”, defined as “information provided outside the financial statement that assists in the interpretation
of a complete set of financial statements or improves users’ ability to make efficient economic decisions”
(p. 26). As is known, the proposal, presented in the management commentary exposure draft (June 2009)
subsequently approved, will not result in International Financial Reporting Standards (IFRS), but it aims to
offer a non-binding framework which could be adapted to the legal and economic circumstances of individual
jurisdictions (i.e., “Relazione sulla Gestione” in the case of Italy).
The publication of the document represents an important step for the IFRS adopters, as a gap has been
filled in the process of international financial reporting regulation. In the forecasts of the IASB, the Practice
Statement is therefore a further element of support for users interested in obtaining important information from
the financial report.
Although the flexible approach adopted represents one of the most important points of interest, for the
European firms, a basic criticality is highlighted connected with the mode of coordination with the current
narrative section regulation which presents a much more clearly defined disclosure requirement, the evolution
of which is discussed below.
The Practice Statement, Objective, and Structure

The statement identifies the framework and some content elements which make the narrative section a tool
for containing information useful for the IFRS financial report users, mainly investors.
In relation to the framework, the statement discusses objective, principles, and modes of presentation of
the management commentary.
The objective of the management commentary is to provide a set of reference information useful for the
users. In this sense, emphasis is placed on the information on performance, on the current situation and future
prospects of the firm, on the company strategy, and on the modes of implementation. A central aspect is
highlighting of the possible trends of the company results and the key factors that contribute to influencing
them. Since the forward-looking information contained in the narrative section is based on the observation
point of the management, great importance is also attributed to the assumptions used in formulation of the
forecasts.
The IASB, recognising that the management commentary is an integral part of the other financial reporting
and with a view to integration and complementarity among the documents that identify the IFRS financial
report, recalls some quality characteristics already referred to in the conceptual framework: relevance and
faithful representation. Furthermore, the usefulness of the information included in the management commentary
is increased by ensuring comparability, verifiability, timeliness, and understandability. Lastly, materiality is
recalled, very important in the context of the flexible approach promoted in the Practice Statement. Materiality
is recognised as entity-specific, i.e., depending on the characteristics of the firm. The job of identifying the
information useful for the users is, in other words, assigned to the management which in relation to the business
complexity and the economic context in which the company operates, is required to provide the information via
the management commentary.
Lastly, as regards the modes of presentation, it is suggested that the management commentary should be
complete, clear, coherent with the financial statement, and in the broadest financial reporting communication
strategy, must limit redundancy and duplication of information.
With reference to the content elements, the second central aspect of the Practice Statement, the IASB
assumes that the narrative section must be coherent with the specific characteristics of the firm; however, even
in this entity-specific context, some information elements are recognised as essential and generalisable to firms
as a whole. They are connected with:
(1) The nature of the business;
(2) The objectives and strategies;
(3) The resources, risks, and relationships;
(4) The results and prospects;

(5) The performance measures and indicators used by the management to evaluate the company
performances and the objectives achieved.
In relation to the nature of the business, attention is focused on the economic activity carried out, on the
environment in which the firm operates, namely the sector, the reference markets, the competitive positioning,
the rules and regulations, the macro-economic conditions, the products, services, distribution processes and
channels, the company structure, and the modes of creating value.
With reference to the objectives and strategies pursued, the information contained in the narrative section
must favour identification of the company priorities and the connected modes of achieving the objectives.
Emphasis should be placed on monitoring achievement of the strategies decided and on any actions taken to
intervene in the pre-set objectives.
Concerning the resources, risks, and relationships, the management commentary should identify the main
resources, financial and non-financial, available or necessary to pursue the company strategies. Furthermore,
attention should be paid to the most significant risks to which the firm is exposed, highlighting the changes in
them and the actions taken or planned to control them. Lastly, the main relations of the company with the
stakeholders and the ways in which these relations are managed should be presented.
With regard to results and prospects, priority should be given to analysis of the non-financial performances
and the financial results achieved.
Lastly, the performance measures and the business management indicators play a very critical role in the
process of communication via the financial report. On the one hand, they are particularly significant for the
readers, as they aid understanding of the tools used in management of the firm but on the other hand, since they
are communicated outside the firm, they require particular attention. A first critical aspect concerns spatial
comparability. Since they are entity-specific, performance measures and indicators can be an obstacle to
comparison of information from an inter-company perspective. A second critical aspect concerns consistency,
or the temporal coherence and comparability guaranteed by the constant disclosure of this information: If the
management decides to modify the performance measures or the modes of representation, it must provide
adequate communication of this change.
In short, via the Practice Statement, the IASB fills a gap in the regulation process of the IFRS financial
report. By promoting a flexible approach, the board allows the firms to use their discretion in adapting the
content of the narrative section to the peculiarities and specific characteristics of the firms. It is particularly
worth highlighting that this flexibility refers mainly to the elements that identify the specific content of the
document.
The potential of the statement can therefore emerge when accompanied by a business culture that pays
sufficient attention to the information expectations of the users.
The Evolution of the Management Discussion Regulation in the EU Directives

Worldwide narrative communication in annual reports is viewed as the crucial element in achieving the
desired step-change in the quality of financial reports (Core, 2001; Beattie, McInnes, & Fearnley, 2004; Beattie
& Thomson, 2005; Beattie & McInnes, 2006; Beattie, McInnes, & Pierpoint, 2008). In particular, regulators are
focusing on the management discussion and analysis (MD&A) statement. In some jurisdictions, guidelines are
being extended and revised, while in others, disclosures are mandatory. In Canada, the Canadian Institute of
Chartered Accountants (CICA) issued more detailed MD&A guidelines that set out six disclosure principles
and developed a 5-part integrated disclosure framework that covers strategy, key performance drivers,
capabilities, results, and risks (CICA, 2009). In Australia, the G100 strongly encourages directors to include the
Operating and Financial Review (OFR) in the annual report.
In Europe, the management discussion section was introduced into the community regulations and then
also into Italy and the UK under Directive 1978/660/EC and Directive 1983/349/EC, better known as
IV Directive (annual accounts) and VII Directive (consolidated accounts). In the provisions of the above
directives (Art. 46), geared to incentivising a comparable minimum level of information among the companies
belonging to the EU member states, the management discussion section must include at least a fair review of
the development of the company’s business and its position. The report shall also give an indication of any
important events that have occurred since the end of the financial year, the company’s likely future
development, activities in the field of research and development, and information concerning acquisitions of
own shares.
While some information characteristics have not altered, in recent years, the information content of the
management discussion section has undergone profound changes as a result of the evolution of the community
and national regulations.
The first and significant step in this sense should be attributed to the Directive 2001/65/EC which allows
the EU member states to introduce fair value into the evaluation of some financial instruments, also modifying
the disclosure to be provided in the management discussion section. This directive establishes that the
management discussion section must indicate, in relation to use of the financial instruments and if relevant, the
company’s financial risk management objectives and policies, including its policy for hedging each major type
of forecasted transaction for which hedge accounting is used, and the company’s exposure to price risk, credit
risk, liquidity risk, and cash flow risk.
The Directive 2003/51/EC, which modifies the previous IV and VII Directives, significantly widening the
information content of the management discussion section, has a more incisive effect on the regulations. With
the adoption of this directive, the management discussion section includes a fair and thorough review of the
development and performance of the company’s business and its position, together with a description of the
principal risks and uncertainties that it faces. The review shall be a balanced and comprehensive analysis of the
development and performance of the company’s business and its position, consistent with the size and
complexity of the business. To the extent necessary for an understanding of the company’s development,
performance, or position, the analysis shall include both financial and, where appropriate, non-financial key
performance indicators relevant to the particular business, including information relating to environmental and
employee matters.
Lastly, for the listed companies, an important role is also played by the Committee of European
Securities Regulators (CESR) in Recommendation No. 178b/2005, which requires more detailed disclosure
with reference to financial and non-financial key performance indicators called “Alternative Performance
Measures”. It was observed that in their financial reporting to markets, European listed companies widely use
diverging financial data that are not as such extracted from the issuer’s audited financial statements. These
additional data are usually based on the financial statements prepared in accordance with the applicable
financial reporting framework (i.e., operating earnings, cash earnings, earnings before one-time charges,
earnings before interest, taxes, depreciation, and amortization (EBITDA)), or can also be based on other
sources or alternative methodology to conventional accounting (i.e., performance indicators reflecting

business activity, production or activity levels, projection of future cash flows, forward-looking indicators). As
such, alternative performance measures can provide investors with appropriate additional information if
properly used and presented. In such cases, these measures can assist investors in gaining a better
understanding of a company’s financial performance and strategy. So CESR indicated that issuers should
define the terminology used and the basis of calculation adopted; where applicable, the disclosure of the basis
of calculation should include indications on hypothesis or assumptions used. If the company chooses to
present alternative performance measures, it should provide comparable information for other periods as well:
The definition of the measures should be consistent over time to avoid investors’ decisions being taken on
wrong assumptions.
As can be seen by observing the progressive extension of the disclosure obligations, the need is felt firstly
to fill the information gap as regards risks, financial first and foremost but more generally connected with the
structure and organisation of the risk management functions, the covering strategies, the processes for
monitoring the effectiveness of these strategies, and the policies for avoiding or limiting excessive risk
concentrations.
Secondly, increasing attention is dedicated to the performance measures which, compatibly with the
company’s complexity, are related to business and industry. These performance measures are not limited to
financial variables but require further non-financial measures; they can be based both on historical data and on
forward-looking projections and do not necessarily have to be based on quantitative-monetary values but can be
expressed qualitatively or via quantitative non-monetary measures. The widening of disclosure in this sense is
reflected in the predicted inclusion of information categories far-removed from the mere financial aspect, such
as the requirement to provide, where significant, information on personnel and the environment.
Looking at the specificity of the financial communication process of the countries analysed in this paper,
the introduction and revision of Directives IV and VII are obviously the most important elements affecting
narrative disclosure in both Italy and the UK, but if we look at the two countries more closely, the situation is
differentiated. In both the UK and Italy, narrative disclosure is under the influence of many regulators who
provide authority or offer guidance on a particular subject area (i.e., corporate governance, environmental
reporting, corporate social reporting, directors’ remuneration). Apart from specific requests, the paragraph
focuses on a more all-embracing report, the “Relazione sulla Gestione” for Italian companies and the “OFR” or
“business review” for the UK.
As regards the Italian situation, there are two significant innovations in the narrative section. The first one
refers to the Directive 2001/65/EC and the Legislative Decree No. 394/2003, the first effects of which start
from the 2005 annual reports. The second one is connected with the Directive 2003/51/EC which came into
force with the Legislative Decree No. 32/2007 which adopts the above directive and which is effective as from
the 2008 annual reports.
With reference to the UK (Weetman, 2009), the Accounting Standards Board (ASB) issued the “Statement
of OFR” in late 1993, subsequently revised in 2003. The statement was built on the foundations of the best
practice and provided a framework within which companies could discuss the main factors underlying
performance and financial position. Following a recommendation in the final report of the Sterring Group
Company Law Review (CLR 2001), the government decided to require listed companies to prepare and publish
a statutory OFR, the first effects of which were seen in the 2005 financial report. The government then gave the
ASB the power to make reporting standards for the OFR and in May 2005, the Reporting Standard No. 1 was
issued. The OFR must provide a balanced and comprehensive analysis, consistent with the size and complexity
of the business, of: the business’s development and performance during the financial year; the company’s
position at the end of the year; the main trends and factors underlying the development, performance and
position of the company, and which are likely to affect it in the future. However, introduction of Directive
2003/51/EC, applicable as from January 1, 2005, induced the same government to remove statutory application
of the OFR: Repeal of mandatory adoption of the OFR, applicable from January 2006, resulted in UK
companies subsequently drawing up only the Business Review, coherent with the EU directive. This directive
requires less information than the OFR. The OFR (which in effect was mandatory only in 2005) nowadays
remains a guideline and the Business Review is modelled on the EU directive.
To conclude, given the relative albeit not complete overlap between the information requirements
contained in the EU law and the suggestions contained in the Practice Statement, it is interesting to perform an
empirical analysis of the contents of the narrative section on the 2008 financial report. Analysing the year
before publication of the exposure draft may avoid bias due to adaptation of the information to the guideline
indications. In addition, content analysis of the 2008 narrative section may help to evaluate the usefulness of
the project in terms of meeting users’ information needs. Confirmation that the content of the 2008 narrative
section is already aligned with the suggestions of the guideline would result in substantial reappraisal of the
scope of the Practice Statement from the user’s perspective.
The Methodology Applied

Content Analysis
Management discussion in corporate reporting has been analysed using the content analysis methodology.
This technique has been used extensively in the accounting literature (Gray, Kouhy, & Lavers, 1995a, 1995b;
Beretta & Bozzolan, 2004; Beattie et al., 2004; Dunne et al., 2008; Beck, Campbell, & Shrives, 2010).
Krippendorff (1980, p. 21) defined content analysis as “a research technique for making replicable and valid
inferences from data according to their context”. Thus, content analysis is a method of codifying the text (or
content) of a piece of writing into various groups (or categories) depending on selected criteria (Weber, 1985).
In order to act as an effective research tool, content analysis must encompass certain key characteristics: The
process must be reliable and valid (Holsti, 1969; Krippendorff, 1980, 2004; Andrén, 1981; Weber, 1985;
McTavish & Pirro, 1990). Reliability or reproducibility is one of the distinguishing characteristics of the
content analysis, in contrast to other techniques that are often used when describing the content of
communication (Kassarjian, 1977; Krippendorff, 2004). Krippendorff (2004) identified three types of reliability
for content analysis: stability, reproducibility, and accuracy. Stability refers to the ability of a judge to code data
the same way over time (Milne & Adler, 1999; Krippendorff, 2004). The aim of reproducibility is to measure
the extent to which coding is the same when multiple coders are involved (Kassarjian, 1977; Weber, 1985;
Milne & Adler, 1999; Krippendorff, 2004). Intercoder reliability is the percentage of agreement among several
judges processing the same communications material (Holsti, 1969; Andrén, 1981; Kassarjian, 1977; Weber,
1985; Gray et al., 1995b; Milne & Adler, 1999; Krippendorff, 2004). The accuracy measure of reliability
involves assessing coding performance against a pre-determined standard, or against previous studies. There is
a need for explicitly formulated rules and procedures to minimise the possibility that findings reflect the coder’s
subjective predispositions rather than the content of the documents under analysis (Kassarjian, 1977;
Krippendorff, 2004). Validity relates to how well the results of a study mirror reality (Jones & Shoemaker,
1994). To improve validity, a coding scheme needs to be developed that guides coders in the analysis of content
(Krippendorff, 1980, 2004; Potter & Levine-Donnerstein, 1999). The coding scheme is an effort to make the
coding process uniform across all coders so that the coding can be regarded as systematic (Krippendorff, 1980,
2004; Potter & Levine-Donnerstein, 1999). This process helps to eliminate partial or biased analysis and
ensures that data relevant to a problem or hypothesis are secured and the findings have theoretical relevance
and are generalisable (Kassarjian, 1977; Krippendorff, 1980). To be characterised as content analysis, the data
collated must be quantitative and thus amenable to statistical methods for summary purposes, as well as for
interpretation and inference (Kassarjian, 1977; Krippendorff, 1980, 2004).
The present content analysis initially requires the development of an appropriate coding scheme. The next
stage involves the selection of companies to be included in the investigation. The central part of the research
involves analysing management discussion in corporate reporting. First statistical elaborations are used to
enable some explanations of the dataset.
More specifically, the research method we applied consisted of the following phases:
(1) Analysis of the content element suggested in the Practice Statement and the definition of categories
information;
(2) Analysis of pre-samples of management discussion in Italian and UK corporate reporting which are
employed in content analysis in order to be confident with the set of information category to be used in the
analysis of the main sample (Krippendorff, 2004);
(3) Definition of the coding unit and the measuring unit;
(4) Construction of the coding scheme which is a sort of guide composed of detailed rules to make the
coding process uniform across all coders;
(5) Construction of the electronic disclosure sheet in order to collect data in a systematic way;
(6) Application of the investigation technique by four researchers on the same sample of financial reports,
highlighting any differences in the findings. In this pre-analysis phase, in order to make the behaviour
of the researchers as uniform as possible, some modifications had to be made to the basic scheme, and
only after achieving 90% identity among the results did we begin analysis of the documents pertaining to the
study;
(7) Analysis of the documents and application of the detailed rules defined in the pre-analysis phase to the
parts of the financial report significant for the research (in particular the management discussion);
(8) Identification of the data and subsequent processing of the results.
Looking at the Practice Statement, the disclosures were divided into six principal categories: nature of the
business; objectives and strategies; resources, risks, and relationships; results and prospects; performance
measures; and performance indicators. The last category (other) is residual and is referred to photos, pictures,
and graphs not included in any other categories. For each category, a number of sub-categories were also
identified (totalling 11) (see Table 2).
As regards the unit of coding and measurement, in accordance with Milne and Adler (1999),
the sentence was chosen as the coding unit for a better understanding of the message and the line was chosen
as the measuring unit in order to quantify the space dedicated to each piece of information. In addition to the
text, the analysis also considers tables, graphs, and photographs. The space occupied by them is translated into
number of lines obtained by overlaying a piece of tracing paper representing a page of the financial
report completely occupied by lines of text. The blank lines were not attributed to any category. In
the analysis phase, the dominance principle was applied. The analysis was performed without the use of
software.
During gathering of the data, the overall number of pages of the financial report and the number of pages
of the section analysed were noted. Examples and notes were isolated during the research.
Table 2
The Categories and Sub-categories
Performance
Nature of the Objective and Resource, risk, and
Result and prospect measure and Other
business strategy relationship
indicator
Product, services, Historical
Financial resources
and processes perspective
Non-financial
Legal and regulatory Forward-looking
resources:
environment* perspective
intangibles
Non-financial
Macro-economic
resources: human
environment
and intellectual
Industries, main
markets, competitive
Risks
position, and entity
structure
Relationships
Note. *: Including information on corporate governance.
Research Sample and Documents Analysed

The companies were selected from the population of Italian and UK companies listed as of December 31,
2008, using the following criteria: (1) continuous listing throughout the transition to IFRS; (2) listing on
markets other than the United States; (3) drawing up of the financial statement according to the national
regulations prior to the community obligation which introduced the IFRS; and (4) membership of the category
of non-finance companies. These criteria were selected in order to focus attention on companies that are
comparable in terms of macro-sector of activity (non-finance companies), operating continuously on the
financial markets (at least six years), which have not anticipated the potential information and communication
change introduced by the IFRS with respect to the timescale for European harmonisation, either voluntarily or
in connection with listing on the New York market.
The sample is formed of 20 Italian companies and 20 UK companies belonging to different manufacturing
sectors (see Table 3). The companies were selected by matching two criteria: dimension (capitalisation) and
industry.
With reference to the documentation analysed, the consolidated financial reports for the periods 2008 were
collected. In all, therefore, 40 documents were analysed. Although the content analysis methodology is a source
of rich data, it is a labour-intensive and time-consuming methodology. As such, it is fairly common to find a
relatively small sample size in studies using this methodology (Hooks, Coy, & Howard, 2002; Bozzolan,
Favotto, & Ricceri, 2003; Beattie et al., 2004).
Analysis of the disclosure concentrated mainly on the section dedicated to management discussion in
corporate reporting. To be more precise, all the parts of the financial report were analysed excluding the balance
sheet and income statement, notes, audit report, financial report cover, and table of contents. In the text, the
term “management discussion” is used as it constitutes the main element of the parts of the financial report
considered.
Table 3
Companies Selected
Cap. average
No. Company Country Sector of activity Cap. 2008
2003-2008
1 Statpro Group UK Software & computer services 22,598 28,025
2 Microgen UK Software & computer services 38,205 53,641
3 Gefran Italy Electronic & electrical equipment 42,529 61,776
4 Trafficmaster UK Technology hardware & equipment 25,277 63,385
5 Autologic UK Industrial transportation 5,899 64,101
6 Clarke (T) UK Construction & materials 44,742 73,25
7 CDC Italy Technology hardware & equipment 11,872 81,713
8 Tanfield Group UK Support services 17,598 124,773
9 Beghelli Italy Electronic & electrical equipment 101,599 127,772
10 Bastogi Italy Support services 26,308 135,177
11 Delta UK Industrial engineering 128,008 165,043
12 Dada Italy Software & computer services 108,977 168,04
13 Development Securities UK Real estate investment & services 109,426 172,846
14 Pininfarina Italy Automobiles & parts 35,251 174,828
15 Camellia UK Financial services (sector) 139,67 181,072
16 Biesse Italy Industrial engineering 105,669 197,885
17 Alerion Industries Italy Financial services (sector) 177,365 207,311
18 Sabaf Italy Industrial engineering 173,002 216,751
19 Restaurant Group UK Travel & leisure 220,839 316,812
20 CLS Holdings UK Real estate investment & services 190,794 321,013
21 Morgan Sindall UK Construction & materials 234,802 337,109
22 Headlam Group UK Household goods & home construction 174,957 348,178
23 Mariella Burani Italy Personal goods 303,865 385,633
24 Rathbone Brothers UK Financial services (sector) 357,223 395,357
25 De Longhi Italy Household goods & home construction 215,28 463,948
26 Caltagirone Editore Italy Construction & materials 293,693 635,205
27 Indesit Company Italy Household goods & home construction 440,115 1,079,605
28 Aegis Group UK Media 869,101 1,241,986
29 Trinity Mirror UK Media 130,133 1,290,425
30 Tod’s Italy General retailers 917,171 1,342,400
31 Gruppo Editoriale L’Espresso Italy Media 466,207 1,565,837
32 Balfour Beatty UK Construction & materials 1,583,375 1,570,514
33 Mondadori Editore Italy Media 833,475 1,624,849
34 United Business Media UK Media 1,230,181 1,631,099
35 Acea Italy Electricity 2,047,899 2,120,745
36 Autogrill Italy Travel & leisure 1,366,128 2,804,760
37 International Power UK Electricity 3,660,110 3,887,536
38 Saipem Italy Oil equipment & services 5,142,447 6,404,349
39 Mediaset Italy Media 4,605,269 9,154,294
40 BAE Systems UK Aerospace & defence 13,243,740 11,486,188
Presentation of Results
In the study, the results will be presented in a qualitative and comparative way, discussing jointly results
for Italian and UK companies. In relation to the method of processing the data collected, the study uses the
mean on aggregated values; the coefficient of variation is used as the main measure of variability of the results
among the firms in the two countries.
Empirical Evidence and Discussion

Introduction
Overall, the results of the empirical research highlight that the narrative section of the financial reports
examined contains only partly the content elements recalled by the Practice Statement and considered useful for
the readers. In particular, the aspects least dealt with are linked to two central themes in the same Practice
Statement: objectives and strategies and performance measures. In addition, for some information categories and
sub-categories, the decisive role of the European directives and in particular of the Directive 2003/51/EC emerges.
Comparing the data referring to the two countries (see Table 4), although the overall results in terms of
percentage of content with respect to blank spaces and the overall dispersion are similar, some significant
differences emerge.
Table 4
The Overall Results
Italy UK
Mean Median S.D. C.V. Min. Max. Mean Median S.D. C.V. Min. Max.
Nature of the business (a) 33.33 31.78 12.07 0.36 15.61 61.79 38.15 36.17 10.26 0.27 21.47 61.94
Legal and regulatory 14.40 10.88 11.07 0.77 1.55 41.08 21.62 22.95 8.53 0.39 9.61 44.77
environment
Product, services, and 15.06 12.41 10.24 0.68 3.01 40.21 14.62 12.04 6.39 0.44 5.10 34.51
processes
Macro-economic 2.22 1.95 1.60 0.72 0.13 5.91 0.50 0.34 0.63 1.25 0.00 2.08
environment
Main markets and 1.65 0.93 1.43 0.86 0.00 4.61 1.42 0.26 2.90 2.05 0.00 12.86
competitive position
Objectives and strategies (b) 0.71 0.47 0.82 1.15 0.00 2.66 1.18 0.62 1.04 0.88 0.00 3.49
Resources, risks, and 11.95 11.10 5.69 0.48 2.17 21.47 13.11 13.13 4.02 0.31 3.64 19.16
relationships (c)
Non-financial resources: 0.34 0.00 0.72 2.09 0.00 2.90 3.04 3.27 1.66 0.55 0.58 7.29
human and intellectual
Financial resources 0.69 0.53 0.78 1.13 0.00 3.49 0.64 0.64 1.21 1.89 0.00 5.46
intangibles
relationships
Risks 4.94 5.30 3.60 0.73 0.00 14.07 3.41 2.48 2.69 0.79 0.00 11.30
Results and prospects (d) 18.78 19.11 7.99 0.43 8.37 34.53 12.25 10.78 7.56 0.62 4.94 41.19
Performance measures and 0.57 0.00 0.93 1.64 0.00 3.15 0.86 0.44 1.15 1.34 0.00 3.29
indicators (e)
Historical 0.30 0.00 0.67 2.23 0.00 1.96 0.74 0.08 1.16 1.56 0.00 3.29
Forward-looking 0.27 0.00 0.71 2.61 0.00 3.15 0.12 0.00 0.28 2.29 0.00 0.99
Other (f) 4.76 0.53 8.37 1.76 0.00 28.45 5.53 2.08 5.00 0.90 0.17 18.57
Total contents 70.04 73.62 10.28 0.15 49.93 85.44 70.44 72.31 12.56 0.18 44.31 98.33
Blank 29.89 26.38 10.28 0.34 14.56 50.07 28.91 27.69 12.56 0.43 1.67 55.69
Note. a, b, c, d, e, and f are elements of management commentary that are essential and generalisable to firms as a whole (IASB, 2010).
Nature of Business
With reference to the comparison between countries, Italian firms concentrate mainly on the nature of
business (33.3%), focusing on the core business, on analysis of the economic activity carried out, and on the
products and processes. Plenty of information is also provided on the normative and regulatory system.
Also for the UK firms, most space is dedicated to the nature of the business (38.2%). In addition to
providing a description of the economic system in which the firm operates, broad and detailed references are
provided on the regulatory and normative system.
The large amount of information on the nature of the business and the significant difference in terms of
space occupied with respect to other information categories must be evaluated in the light of the characteristics
of the management discussion, a document which gives considerable space (by law) to presentation of the
context in which the company operates and the characteristics of its business.
Another important aspect highlighted by the results refers to the sub-category legal and regulatory
environment. The bulk of the contents consist of information on corporate governance. The results achieved in
the two countries and the respective differences can be explained by looking at the institutional theory and
studies on the socio-economic and environmental factors characterising the two countries. In the case of the UK
firms, the high results achieved could be influenced by the presence of an effective capital market and the
consequent multiple expectations of the shareholder. In terms of operation and consequent communication of
the system of corporate governance, the UK favours recourse to codes of conduct which support, without being
prescriptive, the management in the adoption of the best practices (i.e., UK Corporate Governance Code 2005,
2007, 2010). In the case of Italian companies, the result seems to be explained by a civil law system which
induces firms to adopt a communication behaviour aimed at complying with the provisions of law rather than
prioritising their usefulness for the purpose of users’ information needs. On the contrary to the UK, for Italian
companies, a lot of laws and rules are applicable on the corporate governance (i.e., Consob, Italian Stock
Exchange, Bank of Italy, Unified Finance Code, Civil Code).
Two examples selected from two Italian and UK companies belonging to the same industry and with
similar capitalisation could explain the different behaviours:
On 27 March, 2006, the board of directors adopted internal regulations for internal dealing, which govern information
flows from persons subject to Article 114, para. 7, of the TUF (Unified Financial Legislation) and those recognised as
“relevant” by the rules of the Company, Consob, and the Market. This applies to all transactions carried out on and after
1 April, 2006. (Biesse, Annual Report, 2008, p. 39)
The obligation of transparency applies to all the aforementioned transactions which, when totalled, have a value of
Euro 5,000.00 or more in a single year, even when carried out by persons closely connected to the relevant persons. Biesse
has already made provision to adopt the black-out period restrictions, in Consob deliberation n. 15786 of 27 February,
2007 for those wishing to remain in the STAR sector, under which it is forbidden for relevant persons and those closely
connected to them to carry out any transactions in the following periods:… (Biesse, Annual Report, 2008, p. 39)
The board is committed to high standards of corporate governance which it considers are critical to business integrity
and to maintaining investors’ trust in the company. This statement, together with the Directors’ Remuneration Report,
seeks to demonstrate how the principles of good governance, advocated by the Combined Code on Corporate Governance
(2006) (“Code”) have been applied. (Delta, Annual Report, 2008, p. 20)
The considerations on the results obtained in the subcategory legal and regulatory environment are further
strengthened if we look at the results obtained in terms of variability among the firms of the group. In fact,
although the category nature of business in overall terms presents a relatively limited variability in the groups
(0.36 for Italian companies and 0.27 for the UK, in terms of coefficient of variation), there is a greater
variability for the subcategory legal and regulatory environment for the Italian firms (0.77) compared to the UK
firms (0.39). These results underline in the Italian firms a coexistence of virtuous behaviour alongside other less
communicative modes of behaviour. The UK firms, on the other hand, present on average more uniform
behaviour in terms of communication.
Results and Prospects
In terms of space dedicated, results and prospects is the second information category most discussed. In
comparative terms, the Italian firms dedicate more space (18.8%) than the UK firms (12.3%). Here again, the
high results and limited variability, as already observed for the category nature of business, must be related to
the characteristics of the document examined.
Resources, Risks, and Relationships
The results obtained for the category resources, risks, and relationships are of particular interest. This
category is particularly emphasised in the Practice Statement due to its value in offering the readers information
useful for better understanding the economic-financial results achieved and, above all, the future potential.
In comparative terms, the UK firms dedicate greater space to the category (13.1%) than the Italian firms
(12.0%). The variability in behaviour among the firms, furthermore, highlights limited results in both groups,
although the dispersion is lower for the UK firms (0.31) compared to the Italian firms (0.48).
As the category is variegated, a more effective examination can be performed by breaking it down into
three sub-categories: resources, risks, and relationships.
In relation to the first sub-category (resources, financial, and non-financial), it emerges that the UK firms
concentrate mainly on the human non-financial resources (3.0%). The same information offered by the Italian
firms is limited (0.3%). In both countries, the sub-category human non-financial resources is expressed mainly
via information on the management. Looking at the studies on the environmental factors, these results are
coherent with the characteristics of the Italian socio-economic environment: The companies, although listed,
often have a stable shareholding structure, with close links to the entrepreneur or the family and managers
appointed by the entrepreneur. The situation is different in the UK, where the financial market consists of
public companies characterised by a diversified shareholding structure and by a management system
independent of a specific shareholding structure. Dispersion supports this conclusion. In fact, while the
variability is limited (0.55) for the UK firms, for the Italian firms, the dispersion of the results in the group
(2.09) highlights situations of satisfactory disclosure alongside other cases in which little information is
provided.
Again with reference to the non-financial resources, the Italian firms (1.5%) provide more information
than the UK firms on the intangibles (0.2%). Italian companies provide on average more information related to
research and development activities. The amount of space occupied in these cases is undoubtedly influenced by
the type of business carried out by the company analysed. The results are not distinguished by a high mean
variability (1.13 for Italy; 1.38 for UK).
With reference to the second sub-category, the Italian firms dedicate greater space to description of the
risks (4.9%) compared to the UK firms (3.4%). The theme has been regulated by many legal provisions
including the Directive 2003/51/EC which could have had a positive effect in both countries: In fact, the mean
variability is limited (0.73 for Italy; 0.79 for UK).

Lastly, greater attention is paid to the sub-category relationships by the UK firms (5.9%) than the Italian
firms (4.5%). For both countries, the aspects referred to in greatest detail are corporate social disclosure and in
particular social information. Here again, as already observed for other types of information, assimilation of the
Directive 2003/51/EC could have had a positive effect on the overall results. This consideration is supported by
the coefficient of variation which highlights a limited variability on average within the groups (0.84 for Italy;
0.56 for UK).
Objectives and Strategies and Performance Measures and Indicators
The results of the categories objectives and strategies and performance measures represent one of the most
deficient aspects. Both categories are dealt with to a minimum extent by both the Italian and UK firms.
In relation to the objectives and strategies, the UK firms dedicate slightly more space (1.2%) than the
Italian firms (0.7%).
The marginal role of the category objectives and strategies may derive from several factors. Firstly, the
crisis of the financial market in 2008 makes it difficult to formulate long-term strategies. Secondly, a full
understanding of the theme requires a joint analysis of the management discussion section with other company
documents (i.e., analyst presentation) not forming part of the financial report. Lastly, the disclosure of this
information may be limited by the need to safeguard the competitive advantage accumulated.
Furthermore, the results obtained with reference to the variability in behaviour in the groups, with a
greater heterogeneity in the Italian firms (1.15) compared to the UK firms (0.88), can be interpreted in the light
of the different cultural characteristics of the two countries. As is known (Dunne et al., 2008; Choi & Meek,
2005; Nobes & Parker, 2012), studies on environmental and cultural characteristics of the two countries suggest
that different legal systems could affect the results. The common law system characterising the UK gives
considerable relevance at the codes of conduct: OFR, in this case, stimulates diffusion of the strategic
information. On the contrary, in the civil law legal system, greater space is given to the mandatory disclosure:
Legislative Decree No. 32/2007, which adopts the Directive 2003/51/EC, gives only an indirect stimulus to the
strategic information.
The results are fairly limited for the category performance measures: 0.9% for UK and 0.6% for Italy. In
both countries, very mixed modes of communication coexist. Alongside firms with a good level of
communication, with Italian firms dedicating 3.15% of the space in the narrative section and 3.29% dedicated
by the UK firms, there are firms which omit this type of information.
The results of the category are surprising, as the theme is explicitly recalled also by the Directive
2003/51/EC. Although the firms examined provide detailed information on the financial and non-financial
results achieved, the performance measures and indicators used in the company management are explicitly
illustrated only in limited cases. The references to the performance measures used in pursuit of the company
strategies are practically absent.
Conclusions
In the Practice Statement, the IASB has highlighted the complementarity between the narrative section and
the financial reporting, emphasising the role of the management commentary in providing the readers of the
financial reports with information useful for interpreting the economic dynamics of the firm.
The results emerged from the research have highlighted with reference to research question No. 1 that
among the content elements suggested by the Practice Statement, there is a modest communication of the most
interesting and innovative information categories: Strategies, company objectives, and performance measures
are all present to a minor extent. With reference to the latter type of information, the comparative analysis
between the two countries did not highlight significant differences in behaviour attributable to their particular
economic-social systems. Although this result should be evaluated in the light of the current economic situation
analysed, since the crisis of the financial market in 2008 could make it difficult to formulate long-term
strategies and, secondly, a complete vision of the company strategies and tools used in management requires a
joint reading of the annual reports and other company documents (i.e., analyst presentation), it is possible to
identify in these themes aspects that present considerable potential for improvement and more detailed analysis.
For the remaining information categories, the results of the empirical analysis confirm that the content
elements presented to the greatest extent are mainly connected with the nature of the business and description
of the results achieved, elements which traditionally represent the central part of the narrative section and
which have been widely regulated. The results connected with risks and social and environmental disclosures
are also positive. For them, Directive No. 2003/51/EC and Directive 2001/65/EC could have had a decisive role
in guaranteeing greater information and in ensuring a satisfactory mean quality.
The reference to the directives brings us to research question No. 2. The qualitative analysis of the
regulatory provisions concerning management commentary has highlighted a relative overlap between the
content elements emphasised in the Practice Statement and those required by the European directives.
Therefore, at least for the firms subjected to these directives, the Practice Statement should be evaluated as
a further stimulus towards those aspects (i.e., objectives, strategies, performance measures, non-financial
resources, intangibles) which are central for ensuring an adequate understanding of the company dynamics and
future potential and in the wider strategy of effective communication towards the users of the financial report.
For the information categories already adequately represented in the narrative section, in the light of the
mixture of behaviour identified, the Practice Statement could take on a central role in limiting the variability of
behaviour and raising the mean quality of disclosure.
In a significant evolution with respect to its traditional role, the IASB has interpreted the Practice
Statement not as an IFRS standard but as a guideline: An IFRS-adopting firm can apply the Practice Statement
in preparation of the management commentary, while mandatory adoption of the guideline is left to the
legislation of the countries that permit or impose use of the international accounting standards.
Evaluating jointly the aspects discussed, it can be concluded that the strength of the Practice Statement lies
in the flexible approach proposed, which allows firms to adapt and model the narrative section of the financial
report to their specific characteristics. The publication of a guideline adapts well to the entity-specific approach
promoted.
The aspects of flexibility and, in certain respects, innovation in content require the management to pay
adequate attention to the information needs of the recipients of the financial report.
In this regard, since it has emerged from the empirical analysis that the narrative section dedicates most
space to information to some extent required by regulatory provisions, it would be interesting to analyse and
evaluate the ability of the firms in a context of civil law to assimilate and pro-actively exploit the flexible
approach proposed by the Practice Statement.
Limitations and Future Research

This qualitative paper represents a preliminary study on the Practice Statement, and it is the result of a first
application of the method chosen for analysis of disclosure. Some of the findings are affected by the specific
sector in which the company selected operates. Furthermore, the results suffer from the limitation inherent in
content analysis, i.e., the relatively limited number of companies considered and therefore the consequent
impossibility of generalising the conclusions of the study performed.
Future development of this research could be extension of the observation period to the years of
2010-2011 in order to evaluate whether introduction of the statement may have influenced the contents of the
management commentary with reference to the less frequent information categories. A second thread for
further study relates to extension of the analysis to non-EU countries, in order to compare the results obtained
with those of firms not subjected to application of the EU directives.
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January 2014, Vol. 10, No. 1, 20-31
D DAVID PUBLISHING
Cost Accounting, Ethical Accountability, and Accounting

Principles
Hossein Pashang, Urban Österlund, Kjell Johansson

University of Borås, Borås, Sweden
This essay explains why cost accounting, ethical accountability, and accounting principles are interrelated concepts.
During the past two decades, the relationship between accounting systems and discharge of accountability has
increasingly drawn the attention of researchers. However, researchers have shown a marginal interest in the
inclusion and examination of the theme of cost accounting, and in particular, no interest has been oriented to
explore the potential role of cost accounting in serving presentation of the trustful cost information as regards the
discharge of accountability. In this essay, we will reason that the traditional discourse of cost accounting is
fundamentally different from the managerial discourse of cost accounting. The traditional cost accounting is built
upon the ethical, legal, professional, and principle-based discourses. By exploring the differences between the two
cost accounting discourses, this essay will reduce the effect of current skeptical views with which quality of our
academic education, relevance of our research, and our understanding of the potential role of cost accounting in
serving the provision and presentation of trustful information have been seriously undermined.
Keywords: accountability deficit, principle of invested cost, ethical accountability
Perspectives and Problems of the Essay

This essay is concerned with a set of problems related to the accountability of the accounting
communication of the invested costs. Firms invest in certain areas, and in many occasions, avoid investing in
areas which may be vital for the survival of business life in society. The accounting systems of the firms do not
communicate the invested costs and do not inform the users of accounts about the circumstances in which cost
investments were avoided. The accountability gap between firms’ investments of resources and communication
of the invested resources by cost accounting is widening. We view this gap as a serious accountability deficit
and try to make a systematic assessment of the conceptual cost categories by which accountability of the
invested costs can be improved.
To the point is the notion that language of cost accounting is considered being central in the establishment
of accountability for investments. The users of accounts need information about the invested resources and the
givers of accounts are accountable to inform the users of the nature of their investments. By reflecting on the
symbolic capability of cost accounting, we will attempt to improve costing-based accountability
communication.
Hossein Pashang, assistant professor, Department of Accounting, University of Borås. Email: [email protected].
Urban Österlund, assistant professor, Department of Accounting, University of Borås.
Kjell Johansson, assistant professor, Department of Accounting, University of Borås.
COST ACCOUNTING, ETHICAL ACCOUNTABILITY, AND ACCOUNTING PRINCIPLES 21
In this essay, we are concerned with the analysis of cost accounting as an independent subject that can
serve communication of the ethical accountability in a more trustful way. We will argue that academic research
interest for decision-making-based models of costs together with the wide-ranging critics of the technical
aspects of cost accounting (Kaplan, 1984, 1988) had the consequence of neglecting the institutional, ethical,
and potential role of cost accounting in the provisions of accounts upon the firms’ vital events. The ascendance
of behavioral costs models, such as activity-based costing (ABC) as the dominant paradigm, has blurred our
ability to judge that traditional cost accounting can be independently applied to solve accountability deficits
attached to the current field of accounting communication.
We try to get to grips with accountability deficits by addressing three main questions. The first question is
of a conceptual nature. We will argue that misunderstanding of the conceptual and technical features of cost
accounting is one of the problems that caused accountability deficits. Cost accounting is guided by accounting
principles and that paradigm of cost accounting is not detached from the paradigm of financial accounting. Few
people can dispute the notion that cost accounting is an expansion of financial accounting (Littleton, 1958). The
task of financial accounting is said to provide a few categories of the aggregated data upon the entities’
achievements. The task of cost accounting is disaggregation of the financial accounting data with the purpose
of increasing the informative content of accounting communication. The conceptual perspective which we will
develop in the following pages is thus embarked upon a wider view of the role of cost accounting beyond its
traditional function. We are going to argue that the detailing measures of cost accounting data significantly
increase the usefulness of accounting information.
The second question is related to the notion of accountability deficits. Those who invest costs and put to
use the firms resources are also accountable for reporting how these resources are used. Cost accounting and
cost accountability are not separable and the separation and misconception of the two are causes of the
accountability deficits. Relevant to the points, which will be gradually developed in this essay, is the notion that
accounting of the invested costs is the most informative and challenging subject of consideration.
Understanding of the gap between firms’ invested costs and communication of the invested costs is essential for
the understanding of accountability deficits. The concept of accountability deficits, evoked in this essay, is
judged on the basis of empirical perceptions as well as theoretical propositions. On the one side, cost
information can reveal fundamental cores of the firms’ accountability as regards strategic and operational
decisions. On the other side, firms show a persistent tendency to suppress cost accounting with regard to the
problem of producing full information about the invested costs.
The third question is of evaluative or analytical type. What is the potential capacity of cost accounting to
serve a broader requirement with regard to accountability explanation? As has been mentioned, cost accounting
can provide useful information about the discharge of accountability. To be more concrete on this point,
accounting of the invested costs, for example, on products/services, on assets, on personnel, on control tools, on
education, on sustainability and social activities, etc., provides an interpretive scheme for the users of
accounting to assess management accountability.
Thus, this essay pursues to provide some reasons and aspirations for the understanding of cost accounting
as the main subject of accounting scholarship. One objective is to bring forward the potential role and
usefulness of cost accounting in serving ethical accountability. Another objective is to contribute with the
consideration that paradigm of cost accounting is essentially independent and conceptually different from the
paradigm of behavioral cost models.
22 COST ACCOUNTING, ETHICAL ACCOUNTABILITY, AND ACCOUNTING PRINCIPLES
To the point is the notion that the overall purpose of this essay should not be searched in the descriptions
of the advantages of the traditional cost accounting. The advantages of cost accounting, in our view, should be
drawn from its broader potential roles, or its symbolic capacity, in solving the current problem of accountability
deficits. The principal focus of this essay is thus to highlight this hidden and often purposely suppressed
potential.
This essay is arranged in five sections. It begins with a review of literature and follows with the
paradigmatic definition of cost accounting with an emphasis on its professional and objectivity nature. In the
third section, the legal connotation of cost accounting will be highlighted. In the forth section, the history of the
origin of cost accounting will be presented. In the final sections, the potential role of cost accounting in serving
ethical accountability will be brought forward. The essay suggests three new principles that can aid the
guidance of cost accounting towards the ethical accountability.
Literature Review
In textbooks of business education, cost accounting is almost a neglected topic (Drury, 2007; Horngren,
Foster, & Datar, 1994; Anderson, Needles, & Caldwell, 1996). The dominant theme of education is managerial
models of costs with an exclusive focus on decision-making and control. The T-account perspective of cost
accounting is totally eliminated from the textbooks, which means that cost information is not disclosed for the
purpose of independent examinations. The adopted managerial emphasis provides limited space for the
detailing of cost accounting and no space for the significance of the topic with regard to accountability
communication. The aspiration for the teaching of managerial emphasis and behavioral modeling of costs,
however, turned into the negligence of the important theme of cost accounting. In fact, the managerial emphasis
has left the educational value of cost accounting in shambles. Students had limited possibilities to learn and
inquire into the subject of cost accounting, its origin, its legal connotation, and its potential role in arrangement
of accountability.
In some of the management accounting textbooks, cost accounting appears as a coherent paradigm of
“managerial accounting”. Such interpretation was boosted by the so-called gurus of the cost accounting, such as
Kaplan (1984) who defined cost accounting as a useless model among several other managerial cost models.
For example, Kaplan stressed that return on investment (ROI) is the only useful and widespread cost
accounting upon which a firm’s incentive-based payment is modeled. Firstly, it should be said that ROI is not a
cost accounting; it is calculated on the basis of cost accounting. Secondly, the underpinning structure of ROI is
an arithmetical approach for presentation of material gain, while the underpinning structure of cost accounting
is association of practical with accounting principles. Thirdly, cost accounting is normally a large system of
interrelated and to some extent complicated accounts, items, and categories, and ROI is just a simple key ratio
with a limited usage.
As a result of this type of misconceptions and definitional ambiguity (see March (1987) for further
remarks), cost accounting was repeatedly presented in articles and other textbooks as static and timeless
inscriptions with recurring format as if it is similar with managerial accounting. It is constantly equated with
diverse cost models and key ratios which their scope does not expand beyond a simple equation and timeless
presentation of facts. Cost accounting, as it is treated in the current textbooks, is partial in its understanding of
its potential role and possibility of invoking accountability as a trustful, context dependent, time-bounded, and
dynamic phenomenon.
The theme of cost accounting is also neglected in research. The unjustified critical views of cost
accounting, which were formed by references into the narrowly understood managerial decision-making
discourse, resulted in the abandonment of cost accounting as an object of research. For example, a number of
influential writers, such as Horngren, Drury, Johansson, and Kaplan, provoked and intensively boosted the idea
that cost accounting is not relevant for decision-making. This type of authoritative proposition was formed with
regard to a technical point of view (often as regards the problem of overheads). As such, it failed to interpret
cost accounting as practical, legal, historical, and institutional phenomena. According to Drury and Tayles’
(2000) survey of 187 United Kingdom (UK) companies, 91% of these organizations provide their costs
information on the basis of the traditional cost accounting rules and procedures. Only 9% have dual systems in
which the traditional cost accounting appears with additional cost models (dual systems). To increase the
scientific rigor of the cost information by means of the non-practical and imaginary cost models, a group of
unsophisticated researchers turned away their focus from the professional and traditional cost accounting.
Instead, they put their energy on research about some of the cost ideas and reporting models that have never
worked when they were put into operation.
In the dominant and authoritative cost accounting literature, it is repeatedly recommended that the theme
of cost accounting to be conceived either as irrelevant (Johnson & Kaplan, 1987) or as subservience of
managerial decision-making and profit maximization (Horngren et al., 1994; Drury, 2007). In particular, the
notion of “irrelevant”, repeatedly emphasized in the literature, had some practical bearing. A philosophical
statement stressed by James (2000) may contribute to interpreting the practical bearing of the concept of
“irrelevance”.
According to James (2000), “our conceptions of things are no more than our idea of their sensible effects”
(p. xv). That is to say that the “sensible effects” of the recommended proposition of the “relevant lost”
repeatedly promoted by gurus of cost accounting, were nothing more than: (1) to increase the accountability
deficit of reporting upon the invested costs; and (2) to help establish a new rule of the game for cost reporting.
The remodelling of cost accounting as new rules of the game emerged under the headline of ABC system.
In terms of this transformation, it is thought that practical reasoning, practical experience, and objectivity of
cost information should be replaced by behavioral assumptions. James (2000) further argued that conceptions
of things have “conceivable bearing upon the conduct of experience” (p. xv). There is no doubt that ABC
system is a product of the conceptual experiment for the purpose of conducting human experiences at the
operational levels. That is to say that the purpose of ABC system is to conduct operational experiences more
adoptive to scientific requirements of perceiving costs, rather than serving communication of the accountability
for the invested costs. In fact, ABC system is thought to stand up for laboratory conditions of exactitude,
consistency, and logical/empirical relationships between cost object (activities) and decision-making. The
interpretation is that the ABC system is a special design, applicable to individuals’ conduct, not through the
selection of facts as it is experienced by individuals themselves, but by scientifically determined form of
conducting the selection of the facts. Perhaps, the problem of fact selections resulted in the consequence that
made ABC to become practically and communicatively irrelevant.
Review of the literature, presented so far, has contributed with two points. Efforts for the elimination of
cost accounting stopped the research for improving the cost accounting. The behavioral cost models cannot
serve accountability of the invested costs. Problem of “fact selections” makes these models irrelevant for the
communication of ethical accountability.
Defining and Distinguishing the Paradigm of Cost Accounting

We start this section by addressing this question: What is the meaning of cost? The term cost is unspecified.
Concerning cost accounting, cost is always used with a modifier, for example, direct costs, indirect cost, selling
cost, conversion cost, overheads costs, etc.. We use these terms in order to avoid confusion and
misunderstanding. In cost accounting, these cost terms are used in relation to their representations or “money
accounts” rather than in relation to the arithmetic result of calculation. And finally, in cost accounting, these costs
are used by consideration of the principle of objectivity. It is also expected that categorization of costs to be
carried out by consideration of the principle of materiality. The two principles are not sufficient for the
conduction of cost accounting in a broader view. The principle of the invested costs should be called upon to
control the processes of cost accounting preparation and communication (Littleton, 1958). In cost accounting,
only verifiable and intelligible costs are accepted, because cost information should be constructed on the basis of
judgement and principally agreed rules. The tax authorities all over the world do not accept the cost statements
that do not follow the agreed principles. For example, the variable costing systems, which are based on
non-verifiable categories such as fixed respectively variable costs, are not accepted by tax authorities and
accountants as a basis for accountability communication. Since “behaviors” of fixed and variable costs cannot be
objectively verified (and the categorizations of which may serve accounting manipulation), tax authorities refuse
to accept the cost statements which are based on the non-verifiable foundations, such as “time value of money”
or fixed and variable categorizations. The paradigmatic differences between the two groups of costs should be
related to the point that elimination of the first category (direct and indirect) will lead to accountability deficit,
and the emphasis of the second category will lead to mistrust, confusion, and impracticality of the accounting
systems.
Like the concept of cost, the definition of cost accounting is also confusing. In some jurisdictions, the term
“internal accounting” is used in place of cost accounting. The point we will emphasize here is that the theme of
cost accounting is much larger than the theme of internal accounting and that the key purpose of cost
accounting is (was) not to serve decision-making. The traditional cost accounting has emerged during the
course of time to serve the purpose of external accounting in a simplified way. As such, interchanging the
internal accounting with cost accounting is fundamentally misleading. In order to reduce this confusion and
misconception, an attempt is made here to define and distinguish cost accounting from other diversified themes
of accounting by references for their respective purposes.
Generally speaking, there are four different branches of accounting that help provide some kind of cost
information for different purposes. As shown in Table 1, these are financial management accounting,
management or managerial accounting, cost accounting, and financial or external accounting. Financial
management accounting deals with giving cost information about the supply of resources. Managerial
accounting deals with giving control cost information upon the activities that use the resources. Cost accounting
provides information about the uses of the resources. Finally, financial accounting deals with giving
information upon the result of using the resources. An accounting system may include all these four branches of
accounting. Meanwhile, the current available studies indicate that traditional cost accounting is the only source
of cost information considering the knowledge-intensive firms (Sveiby & Lloyd, 1987; Segelod, 2000;
Alvesson, 1995). The study done by Ryan, Scapens, and Theobald (2003) showed that almost all accounting
systems are based on the idea of financial accounting.
Table 1 shows the conceptual distinctions of the four themes of accounting in terms of their purposes.
Table 1
Illustration of the Different Branches of Accounting in Terms of Their Purposes
Branch of accounting Practical purpose
Financial management accounting Information about supply of the resources
Management accounting Information about control of the activities
Cost accounting Information about uses of the resources
Financial accounting Information about results of using the resources
We argue that the teleological concept of purpose is useful for making a type of paradigmatic distinction
among the different branches of accounting. We add this standpoint that it is the task of cost accounting to
communicate the uses of resources. Firms are ethically accountable for using their resources in areas which are
vital, legitimate, and significant for the survival of business life.
The Legal Connotation of Cost Accounting

The paradigm of cost accounting can be distinguished from managerial accounting in terms of the legal
connotation. According to Maurice (1974), in the United States, politicians had the intention to regulate cost
accounting before the regulation of the financial accounting. The current scandals led to the issuance of the
Sarbanes Oxley Act (SOX) which is heavily focused on the topic of cost accounting and the belief that how legal
conduction of cost accounting will lead to unbiased accounting systems. Additionally, the international standard
setters attempted to guide the cost accounting by means of the rules prescribed in connection with inventory
valuation (International Accounting Standard (IAS) 2), accounting of generated assets (IAS 16), and regulation of
transfer pricing. However, in standard regulation of cost accounting, the rules-based discussion was applied. In
major parts, conduction of cost accounting is left to the professionally understood concept of the generally
accepted accounting principles (GAAP). Thus, there is no principle-based discussion by which presentations of
accounts by cost accounting can be judged. In cost accounting textbooks, the term causality is often used to denote
that cost accounting has a principle-based discipline. This interpretation is misleading, in the sense that causality is
not a judgemental or accounting principle (Kant, 1965). Further, the classical accounting writers (Paton, 1922;
Littleton, 1985; Most, 1977; Maurice, 1974) avoided to adopt causality as an accounting principle.
IAS 2 requires a list of disclosures which covers eight different accounting items and situations. Two of
these disclosure requirements directly guide categorization of the cost accounting to serve financial accounting.
The tax offices often require the similar disclosure specifications with regard to the cost accounting systems of
the companies. The list of disclosures appears in the following ways:
(1) The accounting policies and the cost formula used in inventory valuation (IAS 2, paragraph 36);
(2) The total carrying amount and the breakdown of the carrying amount by appropriate sub-classifications,
such as merchandise, productions supplies, work in progress, and finished goods (IAS 2, paragraph 36 (b));
(3) The carrying amount of inventories at fair value less cost to sell (IAS 2, paragraph 36 (c));
(4) The carrying amount of inventories pledged as securities (IAS 2, paragraph 36 (h));
(5) The amount of any reversal of any write-down that is recognized as a reduction in the amount of
inventories recognized as expense in the period in accordance with paragraph 34 (IAS 2, paragraph 36 (f));
(6) The financial statement shall disclose the amount of inventory as expense during the period (IAS 2,
paragraph 36 (d));
(7) The carrying amounts, the amount of write down, the amount of losses... should be recognized as an
expense of the period (matching principles) (IAS 2, paragraph 36 (d));
26 CO
OST ACCOU
UNTING, ETH
HICAL ACCOUNTABILIITY, AND AC
CCOUNTING
G PRINCIPL
LES
(8) Thhe amount off write-down and the circuumstances orr events that led to the revversal of the write-down
should be disclosed
d in accordance
a w the IAS 2 (paragraph 36
with 3 (e) and (g))).
The reading
r of disclosure
d reqquirements reveals
r that there is no discussion aabout the prrinciples or
principle-bbased rules byy which cost accounting shhould be desiigned or obseervations of tthe invested costs
c should
be compreehended and categorized. According to t the abovee-stated paraggraphs, the leegal conducttion of cost
accountingg is shaped byb “value theory of accouunting” in thaat concern foor the presenttation of accounting net
income is pursuant.
p We will return too the problem
m of value theeory in the finnal section off this essay.
History of Cost Accounting

Additiionally, the paradigm
p of cost
c accountinng can be difffered from management
m accounting by
b historical
references. In contrast to t managemeent accountingg, cost accou unting has a loong historicaal tradition. Although
A the
theme of cost
c accountinng is assumed being closeely related to o the theme of o financial aaccounting (A Arora, 2011;
Littleton, 1958),
1 the hisstories of the origins of thhe two themees are not recorded in a siimilar way. The T study of
accountingg literature inndicates that the history of o cost accou unting is nott as long as the history of o financial
accountingg. According to Riahi-Belkkaoui (2004),, the history of o financial accounting
a shhould be relatted to 3,000
years BC. However,
H thee history of coost accountingg is somewhaat confusing. One O interprettation is that the
t origin of
cost accounnting should be b regarded asa old as the history
h of finaancial accounnting (Garner, 1954). On th he other side,
the majoritty of the costt accounting and financiall accounting writers w (for example,
e Littlleton, 1958) believe that
cost accounnting emergeed from the context c of inddustrial revollution of the 1800 centuryy. This claim is severely
opposed byy Garner (19954) who throough a docum ment study showed
s t principle of cost acco
that the ounting was
developed in the 15th ceentury with reegard to the textilet industrry. It seems thhat disagreem
ments about th he history of
cost accounnting are relaated to the prroblem of disstinctions (confusion) betw ween cost acccounting as ana industrial
practice annd the costingg systems whhich are desiggned rationallly to serve ecconomic deciision-making.. While this
latter has itts root in the period
p of induustrial revoluution, the formmer has a histoory long befoore the industrrialization.
Accorrding to Garnner (1954), acccounting of the Medici Family F (in Floorence) offers an interesting example
not only off financial accounting but also of cost accounting. In I the 15th annd 16th centuuries, the Meedici Family
was engagged in the prooduction of silk s and wool through a partnership
p m
model of busiiness. Besidees this, they
produced thhe highly quaalified clothes and distribuuted them witthin the Euroopean countriees. The exerccise of these
activities requires
r a knnowledge of bothb financiaal and cost acccounting. The followingg illustration shows how
bookkeepinng is used to generate the system of cost accounting g.
Figuure 1. Illustratioon of cost accouunting within teextile of the 16tth century Meddici Family. Souurce: Garner (19
954).
As it is illustrated in Figure 1, the Medici Family kept a general and a wage ledger. These legers were
linked with other subsidiary journals, such as waste book, book of income and outgo, book of spinners, book of
weavers, and book of dyers and other workmen. These bookkeeping-based subsidiary accounts worked as a
cost accounting system providing cost information about different work processes, products, and events which
were meaningful for its period and for organizational participants of the textile industry. There was no ledger
account for the environmental accounting and there was no ledger account for the depreciations and treatments
of the rate of interests, simply because such events were not observable or relevant for the conduction of the
textile production and divisions of responsibilities. There was a particular waste book by means of which waste
could be assessed. The revenue and cost of each process could be calculated and the relevant profit could be
shared between the Medici Family (who was the owner of the general ledger) and other small businesses
(spinners, weavers, and dyers) who worked for the family as the independent and self-governed businesses.
Thus, cost accounting emerged as the extension of the financial accounting and adopted all principles which
conducted the rules of bookkeeping. The objective of cost accounting was to provide, in an intelligible and
sensible way, information about the costs of relevant events (waste) and units (M. Pashang, 2012). The adopted
model of cost accounting served the fair distribution of resources and the trusted distribution of information
based on verifiable cost items. Costs were both aggregated (in the general ledger) and disaggregated (by
subsidiary ledgers) to serve the informational needs of all parts engaged in businesses. The cost accounting
system reflected the work flow of the small business and interaction among these businesses by means of
extending the bookkeeping system.
The second phase of the development in the area of cost accounting should be related to the European
culture and the revolutionary periods of industrialisation. According to Garner (1954), there are abundant
materials left from this period. The major problem was how to treat the overhead costs and categorize the
owners’ claim for the rate of interest. Further, the industrial production required that the cost of machines and
building to be proportioned among the products, and this needed an agreement about the method of
proportioning. The ownership and the operative parts of the business could not reach an agreement about the
proportioning of the costs and revenues. One key problem of disagreement was how to apply the rate of interest
(often required by owners of the businesses) and how the depreciations should be calculated. Garner (1954)
argued that the agreement could not be reached in Europe, and thus, cost accounting was completed in the
United States of America (USA) during the years of 1900-1930 in particular when the relevance of the
ownership accounting was questioned (Paton, 1922).
Garner’s (1954) study of historical accounts indicates that problem of relating the rate of interest and other
capital charges to the operational costs raised a debate that finally led to the agreement on how cost accounting
should be outlined. The current industrial cost accounting practice is majorly emerged from the textile
industries and completed later on with regard to other branches of industries.
The first systematic discussion of cost accounting can be seen in the works of Paton (1922), Littleton
(1958), and with regard to the principle of matching. In a book called An Introduction to Corporate Accounting
Standards written by Paton and Littleton (1950), we can read the most fundamental statements about how cost
accounting should be organized independent from ownership and managerial appraisals.
In this book, the concepts of assignable and non-assignable costs are defined and reasoned. It is pointed
out that:
Accounting for costs involves three stages: (1) ascertaining and recording costs as incurred, appropriately classified;
(2) tracing and reclassifying costs in terms of operating activity; (3) assigning costs to revenue... The revenues of a
particular period should be charged with the costs which are reasonably associated with the product represented by such
revenues. (Paton & Littleton, 1950, p. 69)
The underlying assumptions employed to theorize cost accounting were based on interplay among
accounting principles, principle-related standards, and observation of cost on a basis of objectivity and
materiality.
Littleton (1958), one of the classical writers in the area of accounting, presented a range of concepts and
rules to introduce cost accounting as an independent system of accounts. Terms like judgement, statistical
categories, double entry perspective, direct costs, overhead costs, etc. are repeatedly defined and redefined.
The experience of stock market crash of the 1930s provided sufficient information that cost accounting
should be professionalized and coordinated by norms. The concept of controller was invented in the USA for
the administration of cost accounting independent from the influence of managers. The main objective was to
prevent misconceptions of costs and conduction of cost accounting by ethical code.
Accounting Principles and Cost Accounting

Besides historical and legal distinctions presented in previous sections, the paradigmatic differences of
cost accounting and management accounting should be related to the theoretical propositions of principles. The
use of cost accounting principles combined with legal sanctions can, in our view, substantially improve the
operation of ethical accountability. This section will scrutinize this purpose.
Although the discourse of cost accounting has sporadically appeared with regard to its legal and historical
connotation, it has never appeared with regard to judgemental principles. According to Kant (1965), principles
help a priori schematize certain concepts for making the experiential judgement possible. The use of principles
can also facilitate judgements about the mood of presentation of costs in categorical understanding. Here, our
concern is exclusively oriented to the mood of presentation. We mean that accountability deficit is primarily
related to the mood of presentation of costs for the purpose of categorical understanding. Our standpoint is that
considerations of a set of principles will contribute to presentation of cost accounting, independent from
influence of interest, and in line with the ethical discourse.
In so doing, we shift between inductive and deductive frame of judgement (see H. Pashang (2012) for the
definition of judgement). The use of inductive judgement aids in showing how observation of accountability
deficit can be reasonably comprehended. The use of deductive judgement can aid schematization of
accountability deficit, calling for the need of a set of a priori principles for the elimination of accountability
deficit. First, we start with the inductive reasoning. The following three statements can be easily drawn from
the empirical study of a typical accounting system:
(1) We can observe certain areas that the invested costs are accounted by means of the disaggregation of
data. Cost of the products/services produced is an example that points out this observation (Our research has
however disclosed that many small firms have not developed their cost accounting to respond to this legal
requirement);
(2) We can observe areas that the invested costs are not reported. Costs of product innovation, employees,
maintenance, and management control instruments are four examples of the invested costs that are not reported
according to the rules of cost accounting. The communicative gap, or accountability deficits, between the
invested costs and communication of the invested costs emerges with regard to this area;
(3) There are areas in which a firm does not invest costs (not empirically observed) or the invested costs
are not systematically reported by rules of cost accounting. Sustainability and social activities are two main
areas that a firm may not invest or the invested costs may not be systematically reported by the integrated cost
accounting system. This area causes the major accountability deficits.
Our inductive experience can be developed one step further, if we include the T-account perspective of the
cost accounting in our inductive reasoning. Namely, the credit sides of the cash accounts, material accounts,
different overheads accounts, and employees’ accounts are money representation of the invested costs. Using
the logic of double-bookkeeping, these invested costs need to be entered into the debit sides of a set of accounts
that can communicate the invested costs in understandable categories. The expansion of T-accounts can
usefully serve provisions of the detailing information upon the invested costs.
As we all know, there is not any principle that can guide the mood of presentation in understandable
categories. That is to say that the cost accounting system needs some principles for the normative guidance of
the accounts towards the ethical accountability.
Thus, we shift our attention to the deductive reasoning with the aim of interconnecting our mechanical
explanation of the work of T-account with principle of categorical judgement. We deduct the technical features
of the cost accounting (discussed above) in connection with the mood of presenting these costs. Mood of
presentation in categorical understanding can be drawn from the canon (objectives) of the principle of the
invested costs. That is to say, establishments of the rules, classifications, and standards of cost accounting are
assumed to be deducted from the objectives of the principle of invested costs. According to Littleton (1958), the
theme of cost accounting is mainly related to the principle of invested costs. So far, various regimes of
accounting have refused to adopt the principle of invested costs to prescribe cost accounting. The reason for the
avoidance should be partly related to the adoption of value theory of accounting and partly to the emphasis on
managerial discretion as the basis of valuation. For example, determination of the initial value of goodwill is
not decided on the basis of a sound and independent accounting principle. Instead, it is based on managerial
intention (Pashang & Fihn, 2011). The current discourse of value theory adopts only those categories that
present the costs of some physical objects, such as products or unit of production. The value theory approach
does not allow recognitions of the invested costs on pollution, innovation, quality development, and
maintenance.
The second principle viewed as being useful for the conduction of cost accounting is the principle of event.
According to Sorter (1969), an event approach to accounting theory is superior to the value theory. The event
approach conducts presentation of accounting information with regard to the significance of “events” rather than
their “values”. Sustainability improvement, quality development, maintenance, and innovation are essential
events. Various investments in these events require an increase in invested costs. Users of the accounts will
receive a great benefit of cost information about the essential events. Disclosures of the invested costs on events
will help the users of accounts to judge about the quality of discharging accountability. Accounting of the
material and essential events helps the users of cost accounting information to appraise accountability deficits of
the firms.
The last principle that we intend to suggest is the principle of place. The entities’ resources may be used
(debited) for the activities, events, and purposes which may not be encompassed within the limit of current
accounting regulations. The disclosure of cash payments and other invested costs increases trust between the
account givers and users of the account. Principle of place, together with legal sanction, can substantially
develop accounting disclosure.
Conclusion and Implications

Our study led to a limited contribution to the improvement of accounting disclosure by means of cost
accounting. Our empirical reflection showed that there is a large gap between the invested costs and accounting
for the invested costs. We termed this gap as accountability deficit. We reasoned that accountability deficit
arises from the misconception and misinterpretation of cost accounting. We examined the paradigm of cost
accounting and its relationship with the principle of invested costs. We suggested that an outline of cost
accounting needs to be carried out by means of a set of new principles and consideration of ethical
accountability.
In the final section, we directed our attention towards the inductive/deductive reasoning upon the current
circumstances of cost accounting and highlighted the problem related to the mood of presentation of cost
accounting in categorical understanding. Our mechanical (T-accounts) analysis resulted in suggestion that cost
accounting needs to be shifted from the basis of value theory towards the basis of event theory. The invested
costs need to be disaggregated by categories of accounts to demonstrate firms’ investment in vital events. In
order to bring ethical accountability inside the firms, we presented three principles: principle of invested cost,
principle of event, and principle of place. We concluded that the use of these principles, together with legal
sanctions, can eliminate accountability deficits caused by mistreatment of the categorical presentation of cost
accounting.
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January 2014, Vol. 10, No. 1, 32-46
D DAVID PUBLISHING
From Consolidation to Segment Reporting in Local Government:

Accountability Needs, Accounting Standards, and
the Effect on Decision-Makers
Giuseppe Grossi
Kristianstad University, Kristianstad, Sweden
Elisa Mori
University of Modena & Reggio Emilia, Modena, Italy
Federica Bardelli
Kibernetes s.r.l., Siena, Italy
Consolidated Financial Statements (CFSs) in the public sector represent useful financial tools to improve
transparency and accountability toward internal and external users. This aggregate view is only a part of the
information needed in order to give politicians, managers, employees, financial institutions, rating agencies, and
citizens a whole view of a local government’s financial performance. It emerges the need to have segment
information, covering specific policy areas for which it is appropriate to separately report financial and
non-financial information. This paper, after having discussed the need for accountability and decision-making in a
theoretical framework, gives account of a pilot project realized by the municipality of Reggio Emilia, which
introduced CFSs and segment reporting. The empirical study is based on an action research as a methodological
approach to solving practical problems. Finally, the paper also offers some practical suggestions to contribute to the
applicability of the segment reporting in the public sector.
Keywords: Consolidated Financial Statements (CFSs), segment reporting, International Public Sector Accounting
Standards (IPSAS), local government, action research
Introduction
Consolidated Financial Statements (CFSs) have been an area of growing interest for scholars and
practitioners in the public sector during the last years. CFSs have been successfully introduced in a number of
countries like the United Kingdom (UK), Canada, the United States of America (USA), Australia, New Zealand,
and Sweden both at the central and local levels of government (Newberry & Pont-Newby, 2009; Heald &
Georgiou, 2009; Grossi & Pepe, 2009).
In the public sector, the CFS is a useful instrument for governments that deal with a large number of
Giuseppe Grossi, professor of Public Management and Accounting, School of Health and Society, Kristianstad University.
Email: [email protected].
Elisa Mori, Ph.D., adjunct professor of Business Management, Department of Economics “M. Biagi”, University of Modena &
Reggio Emilia.
Federica Bardelli, consultant as Public Sector Accounting Area Responsible, Kibernetes s.r.l..
FROM CONSOLIDATION TO SEGMENT REPORTING IN LOCAL GOVERNMENT 33
publicly-owned companies, because it presents a clear picture of the current economic status of the public
corporate group (Lande, 1998; Grossi, 2004; Wise, 2004, 2006).
This aggregate view is only a part of the information needed in order to offer the citizens and other
stakeholders a clear view of a local government’s impact. In particular, it does not allow to have segment
information, covering specific areas and policies of intervention for which it is appropriate to separately report
financial information (International Public Sector Accounting Standards (IPSAS) 18; International Public
Sector Accounting Standards Board [IPSASB], 2000, § 9).
This is even more important for local governments which tend to delegate a big part of their service
production to decentralized entities, such as corporations, private contractors, and public and private partnerships
(Pina & Torres, 2002; Grossi & Reichard, 2008; Crediop, 2004). These entities, by managing and offering
services, interact with the municipality in order to realize local policies and programs (Laughlin, 2008). As a
result, it becomes quite difficult to determine the objectives and performances of a public local group and to find
out effective measures and reporting instruments. All this requires a more comprehensive accounting and
reporting system for financial and political accountability (Chan, 2003; Broadbent & Guthrie, 2008; Almqvist,
Grossi, van Helden, & Reichard, 2013).
This paper is based on a literature review concerning information and accounting systems for
decision-making in the public sector. It investigates the changes of informative needs for local authorities when
decentralizing a number of public services. The research topic explores needs and expectations of managers and
politicians in order to improve their ability to take decisions and gives account of a pilot project realized in a
town with more than 150,000 inhabitants in Northern Italy, Reggio Emilia, which has implemented the CFS
since 2009, and it is now introducing a consolidated segment reporting system.
The empirical study is based on an action research as a methodological approach to solving real problems
(Reason & Bradbury, 2001; Coghlan, 2003). This approach has been chosen, because it allows a greater level of
flexibility and an active involvement of both academics and decision-makers. The researchers worked within
organizations as consultants. The decisions about the direction of the research have been collective and have
been concerned with the identification of decision-makers’ needs and expectations and the deployment and
subsequent stabilization of a segment reporting system.
Theoretical Framework
Accountability and the Decision-Making Approach in the Public Sector
Scholars have highlighted the importance of accounting and financial reforms to new public management
(NPM) change in order to increase both performance measurement and evaluation and performance
accountability about the efficiency and the effectiveness by which politicians and managers use public
resources (Mack & Ryan, 2006; Olson, Guthrie, & Humphrey, 1998; Broadbent & Laughlin, 2002).
In recent years, there has been a great deal of accounting innovation in the public sector depending on the
historical and geographical localization of various lines of force (Miller & Napier, 1993). These changes are an
integral part of the new public financial management (NPFM) and represent an improvement for the
decision-making and the management of public institutions (Guthrie, Humphrey, & Olson, 1999). In particular,
there is a large consensus on the implementation of accrual accounting as a means for making institutions more
cost- and value-conscious and for leading significant improvements in their performance and accountability
(Jarrar & Schiuma, 2007; Mack & Ryan, 2006).
34 FROM CONSOLIDATION TO SEGMENT REPORTING IN LOCAL GOVERNMENT
The international literature (Schedler, 2006; Pallot, 1994; Chan, 2003) observed that accrual accounting is
often seen as a prerequisite for the most important performance indicators (Bergmann, 2012) and provides more
useful information for long-term assessment of public policies’ financial sustainability (Grossi & Soverchia,
2011). It provides useful information in terms of decision-making, transparency, accountability, and public
policy financial sustainability, both for internal and external use (Caperchione, 2006). Accrual-based financial
statements provide also better measures of organizational efficiency and effectiveness (Athukorala & Reid,
2003).
Public sector provides services that are not generally offered in a market, and there is an emerging
consensus that public organizations should be financially accountable and satisfy a number of different
stakeholders. It appears the linkage between accounting systems and accountability and the consequent
necessity to identify users’ information needs (Lapsley, 1999). For example, Laughlin (2008) remarked the
distinction between “entity accountability” and “decision usefulness” information. “Entity accountability” is
interpreted as the reporting about the activities of the entity to inform all users, while “decision usefulness” is
concerned with the reporting for particular decision purposes to particular stakeholders. He also stated that the
two terms can represent the basis of a unified conceptual framework to fulfill the decision usefulness and
decision needs of the different stakeholders involved.
Day and Klein (1987) identified political accountability as “the delegated authority and their actions to
people” (p. 26); on the contrary, managerial accountability is about “making authority answerable for tasks
according to defined performance criteria” (p. 27).
Stewart (1984) thought that public entity accountability can be developed in more levels, and one of these
involves raising more detailed information and exposing policies and programs, in relation to time. For this
reason, when implementing an accounting system, it is important to clarify purposes (internal and external) and
expectations of managers and politicians and take into account their information needs.
The shift from financial accounting to public accountability and from traditional financial control to a
more “value for money auditing” is registered, even if with different scopes and speed, in many OECD
(Organization for Economic Cooperation and Development) countries (Pollitt, Girre, Lonsdale, Mul, Summa,
& Waerness, 1999).
CFS: Benefits and Limits
The growing development of municipal corporations has led to the fact that the traditional annual reports
of local governments disclose only a partial view of their economic and financial activities, because the
financial consequences of subsidiaries, joint ventures, and associates are not necessarily considered (Tagesson,
2009). Thus, the corporatization and decentralization process has led to a great lack of information (Walsh,
1995). Hence, the annual accounts of local governments do not give a true and fair view of the whole of local
government (Rhodes, 2000; Osborne & Brown, 2005; Bundred, 2006).
Thus, CFS is recognized and promoted as essential to support decision-making processes and to ensure
public accountability (IPSASB, 2011). As a result, accountability and decision usefulness are not guaranteed by
the traditional annual reports of local governments anymore. Internal (e.g., politicians, managers, auditors, and
employees) and external users (e.g., citizens, voters, taxpayers, suppliers, other public administrations, banks,
and rating companies) of financial information are not able to base their decisions on reliable and relevant
information about the financial position, financial performance, and cash flows of the whole of local government
(Grossi, 2009). The use of CFS in public sector has actually also been accompanied by some critiques about:
(1) The private sector accounting standards are often translated into public sector without due attention to
the public sector peculiarities in terms of objective (provision of goods and services), organization (politicians
and managers), finance (grants, taxes, etc.), the importance of the budget, responsibility for heritage assets, and
longevity of public sector entities and programs (Heald & Georgiou, 2000; Grossi & Steccolini, 2008; Grossi &
Newberry, 2009; IPSASB, 2010);
(2) Lack sufficient details about controlled entities that operate across several services, and the
aggregation of dissimilar data makes complex the consolidation process especially in the public sector where
governments and related government entities (such as agencies, boards, commissions, and state-owned
enterprises) use different accounting standards;
(3) Governments and its controlled entities, indeed, according to Clarke and Dean (1993), are a fictitious
structure, without legal power to exercise rights or incur physical or financial damage. Finally, Clarke and Dean
(1993) claimed that it is curious that aggregated data are considered, with consolidation, more informative than
disaggregated data, which virtually everywhere are deemed to enlighten complex situations.
Advantages of Segment Reporting in Public Sector Organizations
On the wave of private sector accounting standards, in 2000, the International Public Sector Accounting
Board issued the IPSAS 18 Segment Reporting. As defined in the IPSAS 18, a segment is represented by:
A distinguishable activity or group of activities of an entity for which it’s appropriate to separately report financial
information for the purpose of evaluating the entity’s past performance in achieving its objectives and for making
decisions about the future allocation of resources. (IPSASB, 2000, pp. 452-453)
Segment is identified as a strategically relevant sub-system disclosing issues that are similar to central
administration ones, characterized by organizational management (Lombardi Stocchetti, 2007).
Information provided by segment reports can be seen as an alternative indicator of the total group
performance, but they also provide details about the performance of each segment of activity of the group
(Emmanuel & Garrod, 2002). The need to adequately reply to growing citizens’ needs, in terms of policies and
services quality, having scarce resources available, forces governments to deeply understand financial and
organizational performances and to find ways to measure the degree of accomplishment of strategic and
political objectives, assuring both services quality and effectiveness. Because of that, more transparency in
using public resources and in reaching results is required toward decision-makers, citizens, and other
stakeholders. Segment reporting allows politicians and public managers involved in the planning process to use
aggregated data in a different way and to easily obtain accessible information in order to take decisions and
allocate resources, improve internal communication, and perform accounting duties (Rolando, 2004).
Secondly, segment reporting is relevant also for external stakeholders who are differently interested in an
entity’s activities (for example, citizens who are users of public services and tax payers, financial institutions,
subsidiaries, creditors, donors, and also financial analysts and rating companies who have to certificate
government “credibility”).
Segment reporting presents external advantages for public administration, since it allows demonstrating
and documenting an entity’s activity to citizen users and other stakeholders, by underlining resources
allocation, not only in terms of accounting regularity, but especially in terms of management efficiency,
effectiveness, and economy (Staderini, 2002). It permits to have a global view of the allocative method and of
revenues distribution, which allows better supporting and justifying responsible choices, by rationalizing and
coordinating each action toward shared objectives and by avoiding revenues wastes or allocative
inefficiencies.
Segmentation mainly answers to political-economic objectives, rather than financial ones, and there is no
universally acceptable prescriptive means of identifying reportable segments (Emmanuel & Garrod, 2002).
That is the reason why activities’ attribution to different segments of activity should reflect logical operations
(such as economic classifications, the areas of responsibility, the main political and social areas of activity, or
other particular segmentations required by administrators) (IPSASB, 2000). However, there are some limits in
terms of relevance and comparability of segments depending on the method by which they are identified
(Emmanuel & Garrod, 2002) and by the degree of political and managerial discretion (Accounting Standards
Committee, 1990).
Case Method
Reggio Emilia Network and Whole of Government Strategy
The municipality of Reggio Emilia is one of the capital cities located in the Emilia Romagna region. It
counts 167,000 inhabitants, 1,091 employees in core administration, and a budget volume of around €174
millions (year 2010). By the end of 2010, the municipality of Reggio Emilia has shares in 26 corporations
which have different legal forms (public or private) and different ownership structures (totally public or mixed
public-private) and are responsible for providing different public services, such as pharmacies, schools and
nurseries, water, gas, waste, and housing. The municipality of Reggio Emilia has also established contractual
relationships with several entities mainly in charge of social services delivery.
The municipality of Reggio Emilia, in the role of owner, defines the group strategies, coordinates the
activities of the owned corporations, and controls their performance. The group strategies are defined within the
strategic plan of the municipality, which is useful to steer the activities to be performed in the medium to long
term (five years).
In the strategic plan, programmes and strategic objectives, to be realized by the internal unit of the
municipality and its corporations, related to the 5-year electoral mandate, are defined in line with political
guidelines. For the year 2011, seven programmes were defined, and for each programme, 24 strategic
objectives and a system of indicators to measure their achievement were also defined.
The corporations’ interim reports allow the municipality to monitor business risks and to timely and
effectively control the achievement of individual corporate targets defined by the municipality. For this purpose,
the municipality of Reggio Emilia requires each corporation to compile the following reports which are helpful
to monitor the economic and financial equilibrium:
(1) Quarterly reports concerning the corporate activities, with an income statement divided by cost centers
and performance indicators of effectiveness and efficiency;
(2) Annual reporting of the overall financial results of each service provider and all financial intra-group
relations between the municipality and its corporations.
In 2008, in order to have a better control of its corporations, the municipality of Reggio Emilia compiled
and published its first CFS according to IPSAS 6, 7, and 8. The area of consolidation was made up of several
decentralized entities (12 controlled entities, 13 associated entities, and five joint ventures), with private
organizational forms and public organizational forms. In order to control the non-financial performance of
municipal corporations and other external service providers, tied to the municipality of Reggio Emilia only by
contractual relationships, the following tools are used: customer satisfaction analysis, service contracts, and
citizens’ charter of public service providers. Considering the 2010 financial year, the municipality of Reggio
Emilia implemented a consolidated and segment reporting system. This experimental reporting system is based
on the identification of 10 segments and a plurality of sub-segments.
The Action-Based Research: Methodology and Interviews
The present paper draws on the application of IPSAS 18 (IPSASB, 2000) in order to integrate traditional
annual reporting with segment information about the policies and activities pursued by the city, by municipal
corporations, and also by external providers. The aim of the researchers has not only been to build and
implement an integrated segment reporting system for the municipality of Reggio Emilia, but also to test a model
that could be extended to other public organizations. The study is based on an action-oriented based approach,
traditionally defined as an approach to research based on a collaborative problem-solving relationship between
researchers and practitioners, aimed at solving a problem and generating new knowledge (Coghlan, 2003).
Action research combines theory with researcher intervention to solve immediate problems or realize
experimental studies, linking theory with practice and studying with doing (Baburoglu & Ravn, 1992;
Baskerville & Wood-Harper, 1998; Susman, 1983). In this way, research informs practice and practice informs
research synergistically (Avison, Lau, Myers, & Nielsen, 1999). The dual purpose (and the subsequent dual
outcome) of action-based research is to contribute both to the practical concerns of an organization and to the
research (Coughlan & Coghlan, 2002).
It involves a cyclical process of diagnosing a changed situation or a problem, planning, gathering data,
taking action, and then fact-finding about the results of that action in order to plan and take further actions
(Lewin, 1946; Baskerville & Wood-Harper, 1996). Referring to the present research, action research used a
scientific approach to study managerial and accounting issues together with public managers who experience
these issues directly. We have covered several roles: We have worked as trainer, observer, consultant,
collaborator, and designer of the project (O’Brien, 2001).
As recommended also by IPSAS 18 (IPSASB, 2000), in the first step of the research, we had an
exploratory meeting and made some non-structured and informal face-to-face interviews to consider the
“expectations of politicians and management regarding the key activities of the entity and qualitative
characteristics of financial reporting” when defining segments. By selecting managers and politicians to interact
with, we wished to identify subjects that are actively involved in the design and use of segment information.
We interacted with the Head of the Planning and Controlling Office (HP&CO), and we made interviews with
the Councilor for Finance (CF) and the Head of the Welfare Office (HWO).
Then, we worked jointly with the HP&CO and its staff to realize the segment report. The whole project
has been developed throughout the year 2011 and considers 2010 financial statements of the municipal
corporate group.
The Approach to Consolidation
The municipality of Reggio Emilia has opted for the implementation of integrated information and
accounting system based on both cash and accrual accounts. In fact, as stated by the HP&CO:
Since 2008, the planning and controlling system has been conceived to drive decisions over single projects and
policies. Budgeting and reporting documents of the local authority are structured according to policies. Moreover,
regarding some specific policies, an observatory has been instituted together with a methodology of analysis about related
context, demand, delivered services, and costs.
At the same time, the municipality implemented cost accounting and management control over its
activities and municipal corporations. Concerning this, the HP&CO stated that:
Up today to controlled entities are assigned targets as well as to the Local Authority Services. A series of performance
indicators (about efficiency, effectiveness, and quality of services) have also been set up and entities must periodically
monitor and account for them. In fact, Reggio Emilia’s controlled entities send their budgets and financial statements to the
municipality together with financial quarterly reports and quarterly reports concerning the corporate activities to support
the decision process of the municipality.
This has also permitted the municipality to compile its CFS.

In 2010, according to IPSAS 6, 7, and 8, the area of consolidation has been determined and was made up of:
(1) Sixteen controlled entities (mostly foundations, limited companies, special undertakings, consortiums,
and institutions);
(2) Ten associates (not only joint stock companies but also limited companies and foundations).
Data have been standardized by adjusting and reclassifying them, gathering the conditions for individual
financial statements from the various entities to be compared. Standardization concerned time-span
standardization and value standardization. The latter has been particularly significant so that all statements are
classified according to the same valuation criteria as the controlling entity. To date, an ongoing review of the area
and the principles of consolidation has been undertaken in order to adapt the CFS to recent national accounting
standards, issued as a result of Italian accounting reforms in 2011.
In order to examine these critical aspects and to understand usefulness and limits of the CFS for
decision-making, we interviewed the HP&CO, the CF, and the HWO of the municipality.
The HP&CO revealed that:
CFS and all other accounting instruments have the aim to support the decision-making process, and this is also the
reason why CFS is compiled by the Office for Planning and Control instead of the Office for Financial Reporting.
Consolidated information are considered useful, because they refer to the municipal corporate group as a whole,
considering it as a unitary system. In fact, CFS offers an aggregate overview about the financial and economic situation,
amount of assets and solidity of the group, cost and management of human resources. It is also very useful, for example,
for the control and the choice of debt level. However, CFS does not highlight possible inefficiencies or diseconomies that
may occur in specific corporate areas, as the consolidation process tends to balance out results into a synthetic one. The
consequence of a lack of information about specific areas of activity is that an activity could be continued without knowing
its contribution to the increase of spending and to the value creation for the community.
The overall impression from the interviews is that the General Manager (GM) and the HP&CO have taken
on a leading role in improving an extended performance measurement and control systems, but the above
mentioned kind of financial reporting appeared not to be enough to have a complete picture.
Regarding the kind of information, both the HP&CO and the CF agreed that, “First of all, the municipality
needs to improve the governance of the group and effectively monitor and control activities of the controlled
entities, taking consideration of the autonomy of each entity involved in the network”.
The CF also stated that:
Starting from the demand of a service, the local authority intends to be able to make consideration on policies adopted
or to renew and modify them. The innovation of accounting techniques must be driven by the need to report costs at
different levels. Detailed costing of procedures, especially functional costs, is all required.
The CF added that:

In detail, managers and politicians mostly look for information about services, activities, and their costs. This is even
necessary for the big part of jointly delivered or externalized services. It is therefore necessary to oversee the overall
amount of what is allocated and spent by controlled entities.
According to the HP&CO, information about specific segments of activity could be useful to “make
managerial choices (for example externalization, creation of synergies like centralized storages), to assign
budgets and allocating contributions, to control investments per area of activity and save costs and connect
expenses to the rate of response to collective needs”.
Regarding the previous issues, both the HP&CO and the CF stressed that, “Top managers and politicians
need a new reporting system based on policies. It is also important that these segments are stable and
comparable over time”.
A segment has been suggested for a pilot implementation: the “welfare policies”. According to the CF:
This choice is due to the strategic relevance of the segment in light of the economic crisis and the scarcity of available
resources during this period of time, but also to the fact that the Observatory of Welfare Policies represents the main area
of analysis for the Municipal Observatory.
In order to understand the complexity of the policy, the delivered services, and the information available,
we interviewed the HWO who stated that:
The municipality provides services to elderly people, minors, disabled people, and other services to people with
different frailties. Most of them are delivered through some of the municipal subsidiaries. If we want to consider all
welfare costs and investments that the municipality does, we must include the financial statements of subsidiaries
operating in that sector.
The HWO argued that:

The Observatory of Welfare Policies collects and analyses a large amount of qualitative and quantitative data,
performance indicators, and accounting reports about controlled entities. Therefore, a segment reporting based on
accounting information would make possible the connection between data about context, demand, and delivered services
with the whole cost (and other accounting information) of the sector. In fact, accounting and non-accounting information
need to be put in relationship to take the right decisions.
The HWO also suggested that, “Consciousness about costs of a segment would be useful in order to assign
budgets to different welfare districts and improve governance among entities, as well as to the monitoring of
activities”.
Considering what have been exposed above, we asked interviewees about the potential usefulness of
segment reporting. The HP&CO emphasized that:
Segment reporting must answer primarily to internal decision-making. It would permit the disaggregation of
consolidated financial and economic performance per sector of activity and the connection, for example, with information
about the demand of a service, to address policies and analyze cost of interventions.
According to the CF, segment reporting could also be used to external communication:
… external needs for accountability often coincide with the internal ones, because the organizational structure and the
strategic documents are structured according to policies addressed to the community. At the same way, programs realized
by managers must be previously approved by institutional bodies of the municipality, so information that politician and
managers seek for are closer.
Accordingly, there were suggestions that a consolidated segment reporting could also improve disclosure of
existing external document (of which CFS is already an essential part) and the transparency of the local authority
toward its stakeholders. The CF stated that, “From the communication point of view, the segment reporting can
represent a turning point of accountability, if strategic documents are structured according to policies”.
The Approach to Segment Reporting
Starting from the CFS, a series of segments have been identified and the pilot segment “welfare policies”
have been chosen to draw up a segment report with consolidated data.
The concept of segment that has been considered in this case refers to “service segment” instead of
“geographical segment”. Segments identified for the Reggio Emilia’s local public group refer to “distinguishable
components of the group that is engaged in providing related outputs or achieving particular operating objectives
consistent with the overall mission of each entity” (IPSAS 18; IPSASB, 2000, par. 17, p. 455).
Starting points for the identification of segments have been the programs, the strategic objectives, and the
actions specified in the strategic documents of the municipality.
Ten segments have been identified, according to the strategic policies prescribed into the planning
documents of the city: welfare, culture, sport, education, mobility, social security and integration, urban
regeneration of the landscape, local economy, care of the city, and public organization. The identification of
segments has been done by re-allocating strategic objectives and actions on the basis of (IPSAS 18; IPSASB,
2000, par. 19):
(1) Primary operating objectives of the entity and the goods, services, and activities that relate to the
achievement of each of those objectives;
(2) Nature of the services provided or activities undertaken;
(3) Nature of the production processes;
(4) Type or class of customer for their services;
(5) Way in which the entity is managed and financial information is planned and reported to senior
management and the governing board.
Figure 1 shows an example of the attribution of programs, strategic objectives, and actions to segments.
Consistent with IPSAS 18 (IPSASB, 2000), the approach that has been followed is based on the way
managers organize the segments within the public entity in order to make operational decisions and assess
performance. The implementation of the welfare policy segment report required the identification of five
sub-segments so as to make information more useful for decision-making and to monitor specific areas of
activity: elderly people, disabled people, minors in difficulty, home care, and people with frailties.
The portfolio of entities involved in the provision of welfare services has been identified:
(1) “Azienda di Servizi alla Persona (ASP) Rete” and the municipal pharmacy “Farmacie Comunali
Riunite (FCR)”, which are two public undertakings providing services and assistance to elderly people
(sub-segment “elderly people”);
(2) “Azienda di Servizi alla Persona (ASP) Osea”, which is a public undertaking offering services and
assistance to minors (sub-segment “minors in difficulty”);
(3) “Azienda di Servizi alla Persona (ASP) SS. Pietro e Matteo”, which is a public undertaking offering
services and assistance to disabled people (sub-segment “disabled people”);
(4) “Azienda per la Casa Emilia Romagna (ACER)”, which is a public undertaking active in the
management of social housing (sub-segment “home care”).
On the opposite, the sub-segment “people with frailties” included only direct activities of the municipality.
The identification of the report’s contents consisted of the selection of centers of cost allocated to segments,
sub-segments, and those that had to be excluded. Figure 2 shows an example of attribution of centers of cost to
segments and to sub-segments.
Home services for

elderly and
disabled people
Carer’s allowance
Daily care centers

Strengthen the
home care Action n. 1.1.4
Action n. 1.1.5 Segment 1
Action n. 1.1.6
Action 1.2.1
Program 1: Action 1.2.2
Protect
Living a good
frailties
life Action 1.2.3
Increase the
degree of
integration Segment 2
of the
community
Strategic
objective Segment 3
2.1
Program 2:
Having a good Strategic
education and objective Segment 4
culture 2.2
Segment 5
Strategic Segment 1
objective
2.3
Segment 5
Figure 1. Example of attribution of programs, strategic objectives, and actions to segments.

Segment: Welfare Municipality of Reggio Emilia
Sub-segments Cost centers
Cost center n. 128

Elderly people Residential home care for
elderly people
Cost center n. 131

Disabled people Residential care to young
adults
Cost center n. 139

Minors in difficulty Services for the
free time
Cost center n. 144

People with frailties Woman’s safe
house
Home care
Figure 2. Exemplification of attribution of centers of cost to sub-segments for the municipality of Reggio Emilia.
Data are consistent with the accounting policies adopted for preparing and presenting the CFS. As stated in
IPSAS 18 (IPSASB, 2000), for each segment, we allocated revenues, expenses, operating assets, and liabilities
that are directly attributable to a segment and the relevant portion that can be allocated on a reasonable basis to
the segment (IPSAS 18; IPSASB, 2000, par. 27).
According to IPSAS 18 (IPSASB, 2000), transversal centers of cost to more than one activity, as well as
centers of cost for general and administrative expenses (referring to the whole organization) have been
excluded from the pilot segment report and will be reported apart when realizing the whole segment report. On
the contrary, extraordinary items, interest, gains or losses, and other indirect revenues or expenses primarily
attributed to the centers of cost included here have been considered in the segmentation process.
Segment revenue, segment expense, segment assets, and segment liabilities are determined by eliminating
balances and transactions among entities comprised into a single segment. Also, the carrying amount of the
controlling entity’s investment in each controlled entity (and the controlling entity’s portion of net assets/equity
of each controlled entity) has been eliminated, together with the net surplus or deficit attributable to the owners of
the controlling entity. The report for each sub-segment is composed by a Statement of Financial Position, a
Statement of Financial Activities, Guideline, and Explanatory Notes to a consolidated segment.
Discussion and Conclusions

The importance for politicians and managers to monitor the correct allocation of resources and consider
the costing of services when deciding policies (and how to realize them) has been underlined. However, the
accounting and reporting system of Italian municipalities usually does not provide public managers with the
information needed for outsourcing choices or for financial and strategic control over subsidiaries. In addition,
the accounts of municipalities do not allow managers and citizens to see the overall amount of public
expenditures for the provision of public services considering that the big part of services has been externalized.
The adoption of the consolidated and segment reporting can overcome these limits. These instruments
allow one to have both an overall view of the financial and economic performance of a public group seen as a
whole, and an analytical view in order to make appropriate strategic and operational decisions. In particular,
segment reporting disaggregates consolidated information over economic sub-units, called segments, which are
transversal to services and give a complete picture of the functions of the local authority. Disaggregated
information could help the determination of factors influencing performance and the evaluation of the
sustainability of the group in the medium-long term. As derived both by IPSAS 18 (IPSASB, 2000), the
identification of segments to report for requires judgment, in accordance with the way in which management
reports for internal use. The consolidated segment reporting would allow providing internal and external users
with better information about the group’s performance and allocating resources, increasing transparency of
financial reporting and accountability, and evaluating the nature and financial effects of the business activities.
This pilot implementation does not lack some critical aspect and limitation, for example, the impossibility
to disaggregate data of the municipality’s financial position but also communication and governance problems.
Possible developments of the project are also connected with the development of a segment budgetary system
making it possible to consider the relationship between programs funding and expected results.
Public accounting schemes and tools adopted by Italian municipalities for internal and external reporting
activities show a lack of information for public management in order to exercise strategic control over
subsidiaries. The introduction of CFSs, characterized by heterogeneous activities but with low interdependence
among sectors, may not be so significant, because they tend to compensate surpluses and deficits of different
areas of activity, so segment information are essential.
The segment reporting offers an alternative approach of consolidated reporting which, instead of focusing
on accounting information as a whole, focuses on accounting information useful to the decision-making
purposes.
Some of the advantages of segmentation could be identified in: (1) an enhancement of comparability
between similar-sized municipal bodies on a national basis (benchmarking); and (2) the enablement for users of
financial statements to make more accurate assessments of risks and added value of different areas of activity. It
also offers new accounting information tools to answer to the changed roles and responsibilities of managers by
managing services.
In preparing segment reporting, new accounting methods and performance measurement systems need to
be introduced into public management also by fulfilling politicians’ expectations. Furthermore, we can state
that accrual accounting on its own does not lead to useful information, but needs further identification of key
performance indicators and relies on the use of accounting-based techniques like open-booking accounting,
integrated information systems, target costing, and inter-organizational cost management (Behn, 2005; Kraus &
Lind, 2007). Technical procedures also depend both by values and by policies. Considering external
communication, both CFS and segment reporting allow the community to see the amount of resources spent by
the municipality to provide services directly and indirectly.
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January 2014, Vol. 10, No. 1, 47-54
D DAVID PUBLISHING
A Study of the Factors Affecting Choice of the Accounting

Profession
Semra Aksoylu
Erciyes University, Kayseri, Turkey
An accounting professional is called a “Certified Public Accountant Financial Advisor (CPAFA)” in Turkey and
the profession has a notable status in the country. Individuals choosing this profession have to complete a minimum
3-year internship program before becoming members of this profession. They have to pass an exam both to start
and finish the internship program. The profession and the reasons for choosing it are highly significant issues.
Therefore, the present study was conducted to investigate the factors directing the professional choices of
prospective individuals who wish to be CPAFAs and the significance of such factors. Along with these objectives,
a nation-wide study was conducted on candidates who took the CPAFA internship exam in periods of 2012-3,
2013-1, and 2013-2 (three periods). The factors affecting candidates’ choices to be an accountant professional were
gathered under five groups. The factors “influence of immediate surroundings”, “prestigious social status of the
profession”, “high life-long income potential”, “flexible working hours”, and “future guarantee of the profession”
had higher factor loadings than other factors.
Keywords: choice of profession, accounting profession, factor analysis, Certified Public Accountant Financial
Advisor (CPAFA)
Introduction
Individuals make choices or select certain things throughout their lives, regardless of age. Undoubtedly,
the choice of profession is among the most important decisions we have to make in our lives. The decision we
make in our choice of profession will have a marked effect on us throughout our lives. Therefore, we need to
make the best choice in this issue. The right choice will result in success most of the time. A successful working
life will then bring out various life expectations in individuals.
An individual should know him/herself well to make the proper choice of profession. In addition to this,
an individual should decide on a profession with which he/she will be happy and successful. Compliance
should be ensured between personal qualifications—desires and the qualifications—demands of the profession.
The secret of a happy working life lies in choosing a profession which complies with one’s personal strengths,
properly determining the skills and characteristics so as to be able to provide more comfort in one’s working
life, and exerting effort towards developing those skills and characteristics.
Certain professions require specific characteristics and skills. For instance, the individuals with higher
analytical ability may prefer professions like accounting which requires mathematical ability. However,
Semra Aksoylu, Ph.D., assistant professor, Social Sciences Vocational School, Erciyes University. Email:
[email protected].
48 FACTORS AFFECTING CHOICE OF THE ACCOUNTING PROFESSION
analytical ability alone is not a sufficient reason to choose the profession of accounting. Evidently, as is so in
certain other professions, there are several other individual, environmental, and profession-specific factors
which affect the choice of the accounting profession. All these factors should be analyzed carefully by taking
their significance and priorities into consideration.
The accounting profession gained a legal status with the Certified Public Accountant (CPA), Certified
Public Accountant Financial Advisor (CPAFA), and Sworn-in CPA Law (Number 35681) which was published
in the Official Gazette dated June 13, 1989 and numbered 20194. Some articles of the law were revised and
updated with the amendment law on CPA, CPAFA, and Sworn-in CPA Law (Number 57862) which was
published in the Official Gazette dated July 26, 2008 and numbered 26948.
The general requirements to be an accounting professional are specified in Article 4 of the 3568-numbered
law as follows:
(1) To be a Turkish citizen;
(2) To have the legal capacity to use civil rights;
(3) Not to be banned from public rights;
(4) Regardless of the durations specified in the Turkish Penal Code, not to be sentenced for more than one
year for offenses against public safety, constitutional order or the operation of this order, national defense, state
secrets and offenses of espionage, embezzlement, impropriety, bribery, larceny, falsum, falsification, abuse of
confidence, fraudulent bankruptcy, bid rigging, acquisition rigging, laundering illegal property, and smuggling;
(5) Not to be removed from public offices because of penal prosecution or disciplinary proceeding;
(6) Not to hold positions inappropriate to the prestige and honor of the profession.
Besides the above specified general clauses, specific clauses with regard to accounting professionals are
specified in Article 5 of the 3568-numbered law as follows:
(1) To have a bachelor’s degree from faculties such as law, economy, finance, business, banking, and
political sciences or a recognized equivalent from other faculties or to have a graduate degree from one of the
above specified faculties for those with a bachelor’s degree from faculties other than those specified above;
(2) To complete a minimum 3-year internship program;
(3) To pass the CPAFA exam;
(4) To have the CPAFA license.
Among the specific requirements, candidates need to pass an exam to start the 3-year internship program.
This exam is held by TESMER (Center for Basic Education and Internship). The exam is composed of sections
on general culture and skills, financial accounting, cost accounting, financial statement analysis, inspection,
accounting standards, tax law, commercial law, and obligations law sections. Candidates who passed this exam
are required to successfully complete the training and education curriculum specified by TESMER. Then,
candidates who completed the 3-year internship program need to pass the CPAFA exam held by TÜRMOB
(Turkish Union of Chambers of CPA and Sworn-in CPA) within two years. The exam on completion of
internship is composed of sections on financial accounting, cost accounting, financial statement analysis,
1
3568 Turkish Law (1989). Serbest Muhasebeci, Serbest Muhasebeci Mali Müşavirlik ve yeminli Mali Müşavirlik Kanunu
(Independent accounting, certified public accountant financial advisors, chartered accountant law), No. 20194, Turkey.
2
5786 Turkish Law (2008). Serbest Muhasebeci, Serbest Muhasebeci Mali Müşavirlik ve yeminli Mali Müşavirlik Kanunu’nda
Değişiklik Yapılması Hakkındaki Kanun (Independent accounting, certified public accountant financial advisors, chartered
accountant of the law on the amendment of the law), No. 26948, Turkey.
FACTORS AFFECTING CHOICE OF THE ACCOUNTING PROFESSION 49
inspection, law, and tax legislation and implementations. Candidates who pass the exam gain the right to hold
the CPAFA license.
The present study was conducted nation-wide on candidates who took the internship exam to determine
the factors encouraging them to take the internship program to become a CPAFA.
A profession is a means of using one’s skills, realizing and developing oneself and a combination of
activities implemented to make a living, activities whose rules are specified by society, and activities which are
based on the knowledge and skills gained from a certain kind of education and training. Since the term
“profession” is defined as “job or activity area in which an individual constantly works” or “the job performed
to make a living or live off”, it is not only a means of income (Razon, 2013, p. 1).
Choice of profession is the most critical milestone in one’s life. An individual chooses a certain work or life
style for him/herself while choosing a profession and tries to prove him/herself in accordance with this path. An
individual becomes successful, productive, and happy as long as he/she chooses a profession which complies
with his/her individual skills, interests, and desires. Otherwise, an individual will be unsuccessful, unproductive,
and unhappy if he/she randomly selects a profession without taking individual characteristics into consideration.
Therefore, care must be taken to ensure compliance between the characteristics of an individual and the
characteristics of the profession to be selected when choosing a profession (Sarıkaya & Khorshid, 2009).
Various factors are effective when choosing a profession, such as skills, abilities, close surroundings and
family, gender, values of the profession, income, and psychological needs3. All these factors should be taken
into consideration while choosing a profession. However, studies on this issue reveal that the number of
individuals who selected a profession complying with their individual skills, abilities, interests, and ideals was
significantly low and the number of individuals complaining about their profession was significantly high.
The priority quality of a profession that makes it valuable is the principle of service to humanity. While
rapid social developments and changes have resulted in the emergence of different professions, such changes
and developments have diminished the social status and economic opportunities of some other professions.
This creates a significant problem for individuals about to choose a profession. Professions should bear certain
responsibilities towards the changes and developments in society. Each society assigns a status and privilege to
each profession (Sarıkaya & Khorshid, 2009).
The accounting profession embodies several challenges and difficulties and requires expertise. Choice of
the accounting profession is also affected by several individual, social, characteristic, and profession-specific
factors. The accounting profession requires certain ethical values in addition to knowledge and qualifications. It
is a profession which provides the implementation of both private and public accounting and financial
inspections in accordance with the relevant laws, regulations, rules, principles, standards, and methods in an
objective, fair, neutral, confidential, and trustworthy fashion. Accounting professionals are responsible for the
reliable operation and recording of the financial activities and processes of businesses, for the inspection and
evaluation of such activity and process outcomes, and for providing the actual current state of the business to
relevant personnel. They abide by professional standards, have a feeling of social responsibility, and uphold the
general and specific requirements of the profession (Gökgöz & Zeytin, 2012).
3
Retrieved from http://mesbil.meb.gov.tr/.
The accounting profession has gained ever-increasing value together with the developments in economic,
social, financial, and technological areas and presently holds a highly significant position in social and
commercial life. Such status and prestige gained over the years have become significant factors affecting the
choice of this profession.
Literature Review
There are limited studies about the factors affecting the choice of accounting profession. Ahmadi, Helms,
and Nodoushani (1995) carried out a study titled A Factor-Analytic Approach Profiling Job Selection
Differences of Male and Female Accountants on 500 accountants in the United States of America (USA) and
determined the significant factors affecting the choice of profession as “income of the profession”, “flexibility
in working hours”, “possible travel opportunities”, and “ability to spare time for family members” (pp. 17-24).
Ömürbek and Usul (2008) carried out a study titled Factor Analysis on Factors Effective in Choice of
Accounting Profession and investigated the reasons for selecting the accounting profession in 300 accounting
professionals in the Mediterranean, Aegean, Marmara, and Central Anatolia regions of Turkey. The researchers
indicated the primary reasons for selecting the accounting profession as “finding a job all the time in the
profession”, “prestige of the profession”, “independent working opportunity”, “future opportunities of the
profession”, “flexible working hours”, and “good working conditions” (pp. 164-173).
Can, Karaca, and Gökgöz (2010) performed a study titled A Study on Choice of Accounting Profession in
Accounting Professionals of Balkan Origin: Case of Sakarya Province which investigated the reasons for
choosing the accounting profession in accountants of Balkan origin living in Sakarya province. The researchers
reported the factors affecting the choice of accounting profession as “accounting professional role models”,
“proper education and training for the profession”, “independent working opportunities of the profession”,
“knowledge and experience-depended fashion of the profession”, “promotion opportunities of the profession”,
and “future significance guarantee of the profession” (pp. 877-890).
Küçük (2011) carried out a study titled Analysis of the Factors Beneath the Intention to Be a Certified
Public Accountant Financial Advisor Within the Framework of Planned Behavior Theory which tried to put
forth the factors directing students at Erciyes University’s Faculty of Economics and Administrative Sciences
towards becoming CPAFAs. The researchers indicated the factors for choosing the accounting profession as
“independent working opportunity”, “public title of the profession”, “opportunity to be employed in prestigious
companies”, “high life-long income potential”, and “high career opportunities of the profession” (pp. 145-162).
Gökgöz and Zeytin (2012) implemented a study titled The Factors Affecting the Choice of Accounting
Profession: Case of Yalova and Bilecik Provinces which investigated the reasons for selecting the accounting
profession in those provinces. The researchers reported the primary factors affecting the choice of accounting
profession as “prestigious social status of the profession”, “being a desk (office) job”, and “future significance
of the profession” (pp. 67-85).
Research Methodology
The primary objective of the present study was to determine the reasons encouraging candidates to take
the internship for CPAFA.
The research universe was composed of nation-wide candidates who took the CPAFA internship exam in
periods of 2012-3, 2013-1, and 2013-2. The number of candidates in all three periods was around 15,000.
Internship in the accounting profession is a period during which the candidate gains the professional
knowledge and skills to be used in his/her professional life. The initial requirement for the internship is to pass
the entrance exam. Therefore, the initial step in the accounting profession is to prepare for the internship exam.
An individual chooses the profession during this preparation period.
Questionnaire forms were prepared to gather data (see Appendix A) and responses were received from 291
internship exam candidates.
For better outcomes, the questionnaire forms were filled by means of direct face-to-face meetings between
the researcher and internship exam candidates. Data were statistically analyzed by using Statistical Package for
Social Sciences (SPSS) software. Kaiser-Meyer-Olkin (KMO) and Bartlett tests were used to check the
availability of the data for factor analysis. The KMO test is preferred, as it gives consistency of variables,
which is required for the implementation of factor analysis. Data were found to be available for factor analysis
and therefore were subjected to analysis.
Results
The demographic characteristics of internship exam participants are provided in Tables 1, 2, and 3.
Table 1
Genders of Exam Participants
Gender Frequency Percentage (%) Valid percentage (%) Cumulative percentage (%)
Male 188 2.0 67.4 67.4
Female 91 0.9 32.6 100.0
Total 279 2.9 100.0
Exam candidates were composed of 67.4% males and 32.6% females (see Table 1).
Table 2
Graduation of Exam Candidates
Education Frequency Percentage (%) Valid percentage (%) Cumulative percentage (%)
Formal education 92 0.9 32.5 32.5
Open University 191 2.0 67.5 100.0
Total 283 2.9 100.0
About 32.5% of the candidates taking the internship exam graduated from formal education programs and
67.5% graduated from Open University (distance learning) programs.
Table 3
Monthly Family Incomes of Exam Candidates
Income Frequency Percentage (%) Valid percentage (%) Cumulative percentage (%)
< 600 TL 5 0.1 1.8 1.8
601-1,200 TL 47 0.5 17.1 18.9
1,201-1,800 TL 82 0.8 29.8 48.7
1,801-2,400 TL 61 0.6 22.2 70.9
> 2,401 TL 80 0.8 29.1 100.0
Total 275 2.8 100.0
With regard to the monthly family incomes of exam candidates, 1.8% had incomes below 600 TL, 17.1% had
incomes between 601 and 1,200 TL, 29.8% between 1,201 and 1,800 TL, 22.2% between 1,801 and 2,400 TL,
and 29.1% had incomes above 2,401 TL.
Demographic characteristics revealed that the accounting profession was mostly preferred by male
candidates who graduated from Open University programs. In general, exam candidates have monthly family
incomes above 1,200 TL.
The differences between demographic characteristics and the factors effective in choice of the accounting
profession were tested by t-test and analysis of variance (ANOVA) test; significant differences were not
observed in variables with regard to demographic characteristics.
Data availability should be checked before factor analysis. The KMO test was carried out in this study to
check the availability of data for factor analysis, and the KMO value was found to be 0.794. This value is
higher than the minimum required value (0.50) indicating the availability of the data for factor analysis. The
significance value was 0. Therefore, factor analysis could be performed on the data.
Table 4
KMO and Bartlett Test Results
KMO and Bartlett test Result
KMO sample sufficiency test 0.794
Chi-square 1,636.891
Bartlett test Standard deviation 210
Significance 0.000
Table 5
Total Variance Representation Rates
Initial eigenvalue Factor total load
Factor Variance Cumulative Variance Cumulative
Total Total
percentage (%) percentage (%) percentage (%) percentage (%)
1 5.423 25.824 25.824 5.423 25.824 25.824
2 2.612 12.438 38.261 2.612 12.438 38.261
3 1.573 7.489 45.750 1.573 7.489 45.750
4 1.457 6.939 52.690 1.457 6.939 52.690
5 1.198 5.705 58.395 1.198 5.705 58.395
6 0.986 4.694 63.089
7 0.868 4.135 67.224
8 0.851 4.055 71.279
9 0.777 3.699 74.978
10 0.711 3.384 78.362
11 0.681 3.241 81.602
12 0.640 3.046 84.648
13 0.545 2.595 87.243
14 0.481 2.290 89.533
15 0.449 2.137 91.671
16 0.395 1.880 93.551
17 0.376 1.791 95.341
18 0.354 1.686 97.027
19 0.314 1.496 98.524
20 0.164 0.782 99.305
21 0.146 0.695 100.000
As seen in Table 5, which provides the results of factor analysis, the factors affecting the choice of
accounting profession were gathered under five groups and these factors were able to represent 58.3% of total
variation.
Table 6 revealed that the first group with the best representation rate was composed of “influence of
family friends”, “influence of close friends”, “influence of close relatives”, “influence of classmates”,
“influence of spouses”, “influence of faculty members”, “influence of CPAFA in close surroundings”, and
“influence of business world”. The second group was composed of “pleasant nature of the profession”, “vision
of the profession as the best profession for them”, “vision of accounting professionals as knowledgeable
individuals who are needed in society”, and “vision of the profession as a desk job”. The third group was
composed of “high life-long income potential of the profession”, “a serious need for the profession in the close
vicinity”, and “easy internship program”. The fourth group was composed of “opportunity to spare time for
family members”, “opportunity for independent work”, and “decent working atmosphere”. Finally, the fifth
group was composed of “official title of the profession” and “low unemployment levels of the profession”.
Table 6
Matrix Components
Factor
Question
Surrounding Status Income Flexibility Guaranteed employment
S24 0.852
S26 0.832
S23 0.814
S25 0.808
S22 0.690
S27 0.689
S20 0.623
S28 0.509
S9 0.815
S11 0.695
S10 0.556
S8 0.444
S2 0.808
S1 0.743
S18 0.482
S14 0.432
S5 0.829
S4 0.644
S7 0.583
S13 0.784
S17 0.694
Conclusions
The choice of profession is the most critical milestone in the lives of individuals, because they shape their
lives according to such choices. Individuals selecting a profession complying with their skills and desires are
usually happy and successful. Therefore, while selecting a profession, individuals should be conscious and
answer any questions in their minds about whether or not a certain profession is suitable for them or whether
they really want to choose this profession. Young individuals should always keep in mind that choice of
profession is an irreversible process.
There are several factors which affect individuals in their choices of profession, and such factors have
different impacts on each one of them. These factors include family, close friends, education, family
socio-economic level, sociological factors, psychological needs, general and specific skills, characteristics, and
employment opportunities of the region.
As is so in other professions, there are several factors which are effective in choosing the accounting
profession. In the present study, questionnaires were performed on candidates of the CPAFA internship exam
and 28 statements were identified as the factors affecting the choice of the accounting profession.
The KMO test was performed to check the availability of data for factor analysis and data were found to
be available for the factor analysis. Following the analysis, 28 statements were gathered under five factor
groups. In general, the factors “influence of immediate surroundings” in the first group, “prestigious social
status of the profession” in the second group, “high life-long income potential” in the third group, “flexible
working hours” in the fourth group, and “future guarantee of the profession” in the fifth group had higher factor
loadings than other factors.
Similar studies may be carried out with different research universes. In this way, the results of the present
study may be better understood. Further studies could also be carried out on individuals who have newly
entered the accounting profession to determine the differences between the perceptions of candidates and
newcomers to the profession.
References
Ahmadi, M., Helms, M. M., & Nodoushani, P. (1995). A factor-analytic approach profiling job selection differences of male and
female accountants. Managerial Auditing Journal, 10(7), 17-24.
Can, A. V., Karaca, N., & Gökgöz, A. (2010). Balkan Kökenli Muhasebecilerin Muhasebe Mesleğini Seçme Nedenleri Üzerine
Bir Araştırma: Sakarya İli Örneği (A study on choice of accounting profession in accounting professionals of Balkan origin:
Case of Sakarya province) (pp. 877-890). Uluslararası Balkanlarda Sosyal Bilimler Kongresi (International Balkan Congress
of the Social Sciences). Kosovo: Prizen.
Gökgöz, A., & Zeytin, M. (2012). Muhasebe Mesleğinin Seçilmesini Etkileyen Faktörlerin İncelenmesi: Yalova ve Bilecik İlleri
Örneği (The factors affecting the choice of accounting profession: Case of Yalova and Bilecik provinces). Uluslararası
İktisadi ve İdari İncelemeler Dergisi (International Journal of Economic and Administrative Studies), 4(8), 67-85.
Küçük, E. (2011). Planlanmış Davranış Teorisi Çerçevesinde Mali Müşavir (SMMM) Olma Niyetinin Altında Yatan Faktörlerin
Analizi (Analysis of the factors beneath the intention to be a certified public accountant financial advisor within the
framework of planned behavior theory). ZKÜ Sosyal Bilimler Dergisi (ZKÜ Journal of Social Sciences), 7(14), 145-162.
Ömürbek, V., & Usul, H. (2008). Muhasebe Mesleğinin Seçilmesinde Etkin Olan Etkenlerin Faktör Analiziyle İncelenmesi
(Factor analysis on factors effective in choice of accounting profession). Muhasebe ve Finansman Dergisi (Journal of
Accounting and Finance), 37, 164-173.
Razon, N. (2013). Gencin Meslek Seçimini Etkileyen Faktörler (Factors affecting selection of young profession). Retrieved from
http://www.ekipnormarazon.com
Sarıkaya, T., & Khorshid, L. (2009). Üniversite Öğrencilerinin Meslek Seçimini Etkileyen Etmenlerin İncelenmesi: Üniversite
Öğrencilerinin Meslek Seçimi (University students’ examination of factors affecting job selection: Selection of university
students’ occupation). Türk Eğitim Bilimleri Dergisi (Journal of Turkish Educational Sciences), 7(2), 393-423.
January 2014, Vol. 10, No. 1, 55-58
D DAVID PUBLISHING
Linear Programs in Cost Accounting: A Linear Cost Model∗
Gurhan Uysal
Ondokuz Mayıs University, Samsun, Turkey
This paper aims to find unit cost of a product for firms. It establishes a linear cost model to find unit cost. Linear goal
programs assume a direct relationship between independent variable and dependent variable. Dependent variable of
linear model is unit cost. Independent variables are cost accounting variables. They are supply cost, labor cost, and
administration cost. This study assumes a direct relationship between supply-labor-administration costs and unit cost.
Therefore, it establishes a linear cost model. The major research question of this study is to apply linear goal
programming to cost accounting. The goal of this linear program is to find unit cost of product. This study uses
quantitative method and human capital method. The main research result is linear costing model itself.
Keywords: linear programs, cost accounting, unit cost, linear cost model
Introduction
This study aims to present a new costing model for firms to determine unit cost of a product. There are
traditionally three costing methods for firms: average cost model, activity-based costing, and cost accounting.
This paper presents a fourth model of cost accounting. Therefore, this paper aims to apply a quantitative
method to cost accounting. It is the linear programs. It is assumed that linear costing model helps firms to make
effective pricing decisions.
This study sets linear goal programming to calculate unit cost. The goal of the program is to find unit cost,
and the program uses cost variables of cost accounting to establish a linear model such as supply cost, labor
cost, and administration cost, because cost accounting accounts for three costs: supply cost, labor cost, and
administration cost.
Linear programs assume a direct relationship between dependent variable and independent variable.
Dependent variable of this linear model is unit cost of product. Independent variables are supply cost, labor cost,
and administration cost. Beta in the cost model represents impact share of each independent cost variable on unit
cost. Therefore, managers have to predict beta coefficients of the linear model to thoroughly calculate unit cost.
This prediction must be based on management’s experience and expertise. Such experience and expertise of
managers are called as “human capital” in modern management theory.
Theoretical: Cost Accounting

Cost accounting establishes unit cost of a product. There are three costs in cost accounting: supply cost,
labor cost, and administration cost.
∗
This paper is presented at the 3rd Annual Conference of European Decision Sciences Institute on June 24-27, 2012 held by
Istanbul Kemerburgaz University, Istanbul, Turkey.
Gurhan Uysal, associate professor, School of Business, Ondokuz Mayıs University. Email: [email protected];
[email protected].
56 LINEAR PROGRAMS IN COST ACCOUNTING
Linear programs assume a direct relationship between independent variable and dependent variable.
In linear costing model, dependent variable is “unit cost”. Independent variables are “supply cost, labor cost,
and administration cost”. Therefore, this study assumes a linear relationship (direct) between
supply-labor-administration costs and unit cost.
Cost accounting distributes and uploads the share of each cost unit to unit cost: How many percentage of
labor cost affect unit cost? How many percentage of supply cost affect unit cost? How many percentage of
administration cost affect unit cost? These percentages are represented by impact factor (beta) in the linear
model.
Theoretical representation of this linear model is shown in Figure 1.
Supply cost
(X1)
aX1
Labor cost bX2 Unit cost

(X2) (Y)
cX3
Administration cost
(X3)
Figure 1. Cost accounting model.
Research Question
The research question of this study is to apply linear goal programming to cost accounting. The goal of
this linear program is to find unit cost of a product. Therefore, this study establishes a linear cost model to find
unit cost.
Research Methodology
This study uses quantitative research method. It simplifies a linear cost model. Basic proposition of this
linear model is to thoroughly find unit cost.
This study has human capital approach from management theory, because there are beta coefficients in the
linear model. Firm managers predict beta coefficients to replace in cost model. This prediction requires human
capital ability of managers. Human capital can be defined as “experience” of managers accumulated during
their careers in management of business.
Research Results: Linear Cost Model

This study establishes a linear cost model to calculate unit cost for firms. This model is the basic research
result of this study. Linear cost model of study is as follows:
Y = aX 1 + bX 2 + cX 3
LINEAR PROGRAMS IN COST ACCOUNTING 57
where:
Y is unit cost of a product;
X1 is supply cost;
X2 is labor cost;
X3 is administration cost;
a is coefficient: impact factor (share of supply cost inside unit cost);
b is coefficient: impact factor (share of labor cost inside unit cost);
c is coefficient: impact factor (share of administration cost inside unit cost).
In practice, firms calculate unit cost through dividing total cost into quantity of production. This study
accounts unit supply cost, unit labor cost, and unit administration cost with the same method. Therefore:
X1 = Total supply cost/quantity;
X2 = Total labor cost/quantity;
X3 = Total administration cost/quantity.
For example, the amount of production (quantity) is 10,000. Total supply cost is 10,000 euro, total labor
cost is 20,000 euro, and total administration cost is 30,000 euro. Firm predicts coefficients (impacts) as:
a = 0.7, b = 0.2, and c = 0.1
X1 = 10,000 euro/10,000 unit, therefore, X1 = 1 €;

X2 = 20,000 euro/10,000 unit, therefore, X2 = 2 €;
X3 = 30,000 euro/10,000 unit, therefore, X3 = 3 €.
When those values are put into model, then:
Y = 0.7 ×1 + 0.2 × 2 + 0.1× 3

Y = 0.7 + 0.4 + 0.3
Y = 1.4 euro
Therefore, unit cost of product in this firm is 1.4 euro. In addition, “cost + profit” determines the sales
price of product.
Limitations
In addition, there are also limitations in this model in cost accounting.
Production Planning
The first limitation is production planning, because labor demand, supply demand, and material demand
depend on production planning and because with production planning, companies determine a predictive
amount of production beforehand.
Wage
The second limitation is labor wage. Businesses cannot exceed company budget for recruitment of labor.
This determines labor cost.
Efficiency
The third limitation is efficiency, because efficiency decreases production costs and material requirements
such as stock expenses, energy expenses, and material expenses.
58 LINEAR PROGRAMS IN COST ACCOUNTING
Conclusion
This cost model can be turned into software program for firms to calculate cost of products to make
effective pricing decisions.
Linear programs assume a direct relationship between independent variable and dependent variable.
Dependent variable of linear cost model in this study is “unit cost”. Independent variables are supply cost, labor
cost, and administration cost, meaning that, supply-labor-administration costs have an impact on the cost of a
product.
Linear model assumes a direct relationship between supply-labor-administration costs and unit cost. This
relationship sets the cost model in this study.
This paper aims to apply a quantitative method to cost accounting to determine sales price. This method is
linear programming. This study combines linear programming and cost accounting; so, linear cost model
appears to determine sales price of products.
It is believed that linear costing model is a new method for firms to calculate the costs of products and to
determine the sales prices of their products.
January 2014, Vol. 10, No. 1, 59-79
D DAVID PUBLISHING
Measuring Audit Firms’ Intellectual Capital as a Determinant of

Audit Quality: A Suggested Model
Amr N. Abdelrhman, Khaled Z. Labib

Cairo University, Cairo, Egypt
Ahmed F. Elbayoumi
Cairo University, Cairo, Egypt
The American University in Cairo, Cairo, Egypt
The intellectual capital is a main source of competing advantage. Many studies developed measure(s) of intellectual
capital of industrial and service firms. Few studies have tried to develop a reliable measure of intellectual capital in
audit firms. This study extends the current models to provide more insight into the role of intellectual capital in
audit firms. The aim of this study is to develop a quantitative model to measure audit firms’ intellectual capital. The
suggested model can be used to explore the relationship between the intellectual capital in audit firms and audit
quality. The model combines the main components of intellectual capital (human capital, structural capital, and
relational capital). The suggested model provides a tool that may help to better manage the intellectual capital in
audit firms. As this is a theoretical study, a number of hypotheses are presented for testing in the future.
Keywords: intellectual capital, human capital, structural capital, relational capital, audit quality, audit firms
Introduction
Over the past decade, many companies were exposed to bankruptcy and collapse. At the same time, courts
witnessed many cases against audit firms. In these cases, the auditors of the collapsed companies were accused
of negligence. The rationale behind this accusation was that the auditors failed to refer, explicitly or implicitly,
in their reports that the future of those companies is at risk. Among the most famous cases in this regard are the
bankruptcy and the collapse of a number of giant companies, such as Enron and WorldCom. One result of such
scandals was the negative impact on the reputation of the audit firms, which had audited the financial
statements of those companies. For example, the name of Arthur Anderson has been vanished from the audit
market (Tuwaijri & Nafabi, 2008; Hassanein & Kotb, 2003).
With the growing criticism of the audit profession, there is an urgent need to draw attention to issues
related to the quality of professional performance of the auditors. Improving audit quality can be regarded as a
strategic tool to achieve competitive advantages to the auditors in the financial service market. Professionals
and users of financial information are seeking for audit quality (Alodimi, 2006). The increased attention to the
Amr N. Abdelrhman, assistant lecturer, Department of Accounting, Faculty of Commerce, Cairo University. Email:
[email protected].
Khaled Z. Labib, professor of accounting, Department of Accounting, Faculty of Commerce, Cairo University.
Ahmed F. Elbayoumi, lecturer of accounting, Department of Accounting, Faculty of Commerce, Cairo University; Department
of Accounting, School of Business, the American University in Cairo.
60 INTELLECTUAL CAPITAL AS A DETERMINANT OF AUDIT QUALITY
audit quality requires a corresponding increase in studying the factors that may affect the audit quality. The
different levels of quality among audit firms may be attributed to some or all of these factors. One of these
factors is the intellectual capital in the audit firms.
Among many external and internal factors affecting the firm’s value, the significance of the intellectual
capital began to grow. The intellectual capital concept began to gain a great interest among academics and
practitioners. Some believe that the intellectual capital is a major factor that may affect the success or failure of
companies to achieve its objectives, especially when a great economic competition and a constant seeking for
improvement and development are observed (Mouritsen, 2001). Thus, the intellectual capital can effectively
contribute to improving the performance of different types of firms (Kianto, Hurmelinna-Laukkanen, & Ritala,
2010). Among these firms are the audit firms.
Despite the growing interest in studying the role of intellectual capital in improving the performance of
different types of firms, there is still no generally accepted measure of intellectual capital (Joshi, Cahill, &
Sidhu, 2010). It could be said that the concept of intellectual capital within audit firms is surrounded by some
kind of ambiguity. This ambiguity may be due in part to the lack of a clear and specific measure of the
intellectual capital in these firms. The lack of a clear and specific measure of the intellectual capital, in turn,
leads to a lack of clarity regarding the nature of the relationship between the intellectual capital of the audit
firms and the audit quality. This study aims to develop a quantitative model for measuring intellectual capital in
audit firms as a determinant of audit quality.
In achieving this objective, this study is organized as follows: First, the concept of audit quality will be
discussed. After that, the concept of the intellectual capital will be investigated. Then, previous literature
related to measuring intellectual capital in different types of firms, and previous literature that focused on the
relationship between intellectual capital in audit firms and the quality of their audits will be reviewed. In the
light of the previous studies, a quantitative model for measuring intellectual capital in audit firms as a
determinant of audit quality will be developed. The last section of the study will be devoted to the conclusions
of the study.
Audit Quality
Despite the growing interest in audit quality, there is no clear and specific definition of it (Kilgore, 2007).
Research regarding the concept of audit quality discusses different aspects of that quality such as: adherence to
professional standards (Carcello, Hermanson, & McGrath, 1992; Copley & Doucet, 1993; Brown &
Raghunandan, 1995), the operational aspect of the audit process (Hassanein & Kotb, 2003), errors and fraud
detection (DeAngelo, 1981; Palmrose, 1988), reducing audit risk (Ibrahim, 2008), the credibility of financial
reports (Teoh & Wong, 1993; Kilgore, 2007), and achieving the goals of all parties involved in the audit
process (Hassan, 1998). Although these aspects were discussed individually, it is believed that they may be
integrated together to shape the concept of audit quality.
Following the professional standards (the first aspect), auditors are required to develop plans, detailed
programs, and budgets. These requirements justify the time spent and financial resources allocated to perform
the audit process. They also emphasize the importance of supervision and performing the audit with the
professional due care (the second aspect). The professional due care increases the auditor’s ability to detect and
report errors and fraud that may exist in the financial statements (the third aspect). Auditor’s ability to detect
and report errors and fraud can help in reducing the audit risk (the fourth aspect) and increasing the credibility
INTELLECTUAL CAPITAL AS A DETERMINANT OF AUDIT QUALITY 61
of the audited financial reports (the fifth aspect), eventually leading to satisfying the objectives of all parties
involved in the audit process (the sixth aspect).
Due to different aspects of audit quality discussed in the literature, many measurement approaches of audit
quality were utilized. In general, there are two approaches that can be followed when measuring audit quality:
the direct measurement and the indirect measurement (Kilgore, 2007).
The direct measurement approach focuses on the outcomes of the audit process. So, this approach looks at
the audit quality from an ex-post perspective. According to this approach, some studies depend on the results of
a peer review program in measuring audit quality (Brown & Raghunandan, 1995; Casterella, Jensen, &
Knechel, 2009). While some other studies depend on whether the auditor has issued a qualification regarding
going-concern in the previous year to declare the bankruptcy of the companies (Geiger & Raghunandan, 2002).
Many other studies depend on observing abnormal accruals (Francis & Yu, 2009; Choi, C. Kim, J. B. Kim, &
Zang, 2010). Finally, some studies depend on assessing the level of commitment to generally accepted auditing
standards (Copley & Doucet, 1993; Krishnan & Schauer, 2000).
The indirect measurement approach looks at the audit quality from an ex-ante perspective. This approach
involves two different methods of assessing audit quality. The first method involves using proxies to audit
quality. These proxies include: industrial specialization (Rusmin, 2010), audit tenure (Ghosh & Moon, 2005),
number of litigation cases (Palmrose, 1988), and audit firm size (DeAngelo, 1981; Khurana & Raman, 2004;
Zureigat, 2011). Most of the studies that used proxies to the audit quality focus on examining the characteristics
of audit firm only. Some of these studies examine an individual characteristic of the audit firm.
The second method utilizes the behavioral perspective of audit quality. This is done by examining the
factors and characteristics associated with audit quality perceived by the stakeholders involved or affected by
the audit process and audit reports. Stakeholders may include auditors (Sutton, 1993; Tuwaijri & Nafabi, 2008),
preparers of the financial reports (Manita & Elommal, 2010), users of the financial reports (Kilgore, Radich, &
Harrison, 2011), or mixture of them (Carcello et al., 1992; Sobahi, 1997; Radi, 1998). It could be noticed that
most of the behavioral studies focused on examining the characteristics of both audit firms and audit teams.
Also, some of these studies examined a range of audit quality characteristics.
Intellectual Capital
Despite the large number of previous research related to intellectual capital, there is no uniform definition
of intellectual capital that has a general acceptance (Fouda, 2008). This notion was emphasized by The Third
Conference of the Intellectual Capital Management, which was held in Canada in 1999 with the participation of
about 80 experts from all over the world. The conference concluded that it is too early to talk about a uniform
definition of intellectual capital, as much about the nature of intellectual capital is still unknown, so it is
difficult to express it in clear terms (Seetharaman, Sooria, & Saravanan, 2002).
Some definitions of intellectual capital focused on measuring the value of intellectual capital (Dzinkowski,
2000b). While some other definitions focused on the components of the intellectual capital, whether in total
(Petrash, 1996; Guthrie, 2001; Choudhury, 2010) or in detail (Tome, 2008; Huang, Tayles, & Luther, 2010).
While others attempted to make a link between the components of intellectual capital and the benefits that can
be realized to the company through that intellectual capital. These benefits may include: supporting the
competitive position of the company (Edvinsson, 1997; Huang & Wu, 2010), increasing the wealth of the
company (McDougall & Hurst, 2005), or creating value (Zeghal & Maaloul, 2010).
Intellectual capital can be defined as a group of intangible resources, including human, organizational, and
relationship resources that are not associated with a specific administrative level but if it is managed effectively,
several benefits may be achieved to the firm, including strengthening the competitive ability in the market,
generation and development of wealth, and creation of added value.
Although there is no uniform definition of intellectual capital, there is a general agreement about its
importance. A study of Harrison and Sullivan (2000) pointed out that the importance of intellectual capital
stems from its ability to play a number of defensive and offensive roles. Some other studies attributed the
importance of the intellectual capital to the large increase in the ratio of market value to book value
(Seetharaman et al., 2002). A group of studies used surveys to assess the perception of executive managers
about the importance of the intellectual capital. These studies provide empirical evidence about the importance
of the intellectual capital (Dzinkowski, 2000a; Litschka, Markom, & Schunder, 2006).
The disagreement regarding the definition of the intellectual capital has led to another disagreement about
the components of the intellectual capital. A group of studies pointed out that intellectual capital consists of two
components (Edvinsson, 1997; Guthrie, 2001; Diez, Ochoa, Prieto, & Santidrian, 2010), a second group of
studies pointed out that it consists of three components (Petrash, 1996; Sveiby, 1997; Bontis, 1998; Lynn, 1998;
Roos, Bainbridge, & Jacobsen, 2001; Palacios-Marques & Garrigos-Simon, 2003; Seetharaman, Low, &
Saravanan, 2004; Ting & Lean, 2009; Joshi et al., 2010; Ahmadi, Habibi, & Khodamoradi, 2011), while a third
group of studies pointed out that it consists of four components (Brooking, 1997; Maditinos, Sevic, & Tsairidis,
2010).
Most of the previous studies pointed out that the intellectual capital generally consists of three main
components, namely, the human capital, the structural capital, and the relational capital. The following is an
explanation of each one of these components in detail.
Human Capital
Human capital is the largest and most important intangible asset in the organization (Ghosh & Mondal,
2009). So, it has gained a great deal of interest in previous studies, in an attempt to clarify it, to determine its
aspects, and to emphasize its importance as one of the key components of the intellectual capital (Abdelaal,
2009).
With regard to the meaning of human capital, Bontis (1998) mentioned that the human capital is the
knowledge of the human mind. Palacios-Marques and Garrigos-Simon (2003) believed that human capital is all
knowledge assets (implicit or explicit) possessed by individuals, while Seetharaman et al. (2004) thought that
human capital is the staff’s ability to act in various situations to create both tangible and intangible assets.
Lynn (1998) noticed that the human capital is the stock of knowledge, the skills, and the abilities possessed
by the individuals within an organization. Roos et al. (2001) concluded that human capital is composed of
abilities, skills, and intellectual flexibility of the employees. Ting and Lean (2009) thought that the human capital
is the capacity for innovation, the flexibility of employees, the creativity, the right knowledge, past experience,
efficiency of team work, motivation, satisfaction, learning ability, loyalty, and training.
In this regard, it must be noted that the human capital not only takes into account the knowledge and skills
acquired by a certain group of employees, but it also takes into account its relationship with other employees
when creating team works within the organization (Palacios-Marques & Garrigos-Simon, 2003). Thus, human
capital within an organization can be observed in two levels. The first level is the micro level, such as personal
attributes, professionalism, and creativity. The second level is the macro level, such as team works (Joshi et al.,
2010). Human capital is beyond the control of the organization. The organization may lose the ability to retain
its human capital in the long run. In some cases, knowledgeable and skilled employees may leave to other
organizations seeking for more value and benefits or greater appreciation (Lynn, 1998).
Human capital plays an important role in value creation through increasing efficiency. When the company
has a highly-skilled team compared to other competing companies, its performance is more likely to improve
positively. A highly-skilled team may adopt certain strategies, such as new methods of production, which may
lead to reduction of production costs. Consequently, the company can become more efficient compared to other
companies and, hence, gain a competitive advantage (El-Bannany, 2008). Human element is a basic factor that
can help increase the efficiency and improve the performance of any organization. As a result, the management
of any organization should adopt a strategy that provides an ongoing support for the development of the explicit
and implicit knowledge (Noi, 2006). Hsu and Wang (2012) believed that the importance of human capital stems
from the fact that the quality of human capital determines the quality of structural capital. Also, human capital
could affect the composition of relational capital and maintain it. Thus, human capital may be considered as the
most important and the most significant component of intellectual capital. In other words, human capital is
believed to be the heartbeat of the intellectual capital of any organization.
Structural Capital
Anything that remains in the company after employees and workers go home represents the structural
capital (Edvinsson & Sullivan, 1996). Structural capital is the knowledge related to the regulatory action and
procedures (Bontis, 1998). Also, it may be considered as the knowledge organized by and located within the
organization (Palacios-Marques & Garrigos-Simon, 2003). Some believe that the structural capital is the
knowledge that has been converted to something owned by the company (Hsu & Wang, 2012). Finally, it may
refer to the infrastructure that is prepared by an organization for its human capital (Abdelaal, 2009).
Lynn (1998) stated that the structural capital includes the organization’s operating systems, organizational
culture, and all forms of intellectual property owned by the organization, such as trademarks and patents. Roos
et al. (2001) believed that the structural capital includes the processes, systems, structures, intellectual property,
and other intangible assets owned by the organization but do not appear in its balance sheet. Joshi et al. (2010)
argued that the structural capital includes organizational structures, procedures, systems, machinery,
organizational culture, databases, inventions, processes, copyrights, patents, technology, and strategy.
The most important characteristic of the structural capital is that it can be controlled by the organization.
Besides, it may be characterized by the feature of continuity. So, the main challenge the management faces
regarding the intellectual capital is the conversion of the human capital and relational capital into structural
capital that has the features of continuity and sustainable development over time (Lynn, 1998).
Relational Capital
Relational capital refers to the nature of the relationships of an organization with relevant individuals
outside it (Elsayed, 2008). Palacios-Marques and Garrigos-Simon (2003) suggested that relational capital
includes knowledge assets accumulated by the organization as a result of its relationships with other parties in
the same environment. Elmelegy (2005) argued that relational capital includes knowledge and skills that will
help accounting units build excellent relationships with customers and suppliers. Lynn (1998) believed that the
relational capital is the value realized to the organization as a result of the quality of the relationship between
the firm and both customers and suppliers. Finally, Roos et al. (2001) thought that relational capital represents
all valuable relationships with customers, suppliers, and other relevant stakeholders.
Regarding the components of the relational capital, Seetharaman et al. (2004) suggested that relational
capital includes reputation, strategic alliances, relationships with customers and suppliers, and external
networks. While Ting and Lean (2009) suggested that relational capital includes loyalty and customer
satisfaction, relationship with suppliers, mental image, commercial power, and environmental activities.
It is not enough to create relational capital. It is very important to maintain and develop it. The most
important feature of human capital is that it cannot be controlled; it is beyond the control of the organization.
Customers may turn to other organizations that provide them with greater value and more satisfaction (Lynn,
1998).
Based on the previous discussion, it could be proposed that the intellectual capital in audit firms consists
of three main components:
(1) Human capital: referring to the knowledge and skills possessed by auditors in the audit firms;
(2) Structural capital: denoting to all infrastructures that remain in the audit firms when the auditors leave
to their homes;
(3) Relational capital: representing the relationship between audit firm and all outside parties, such as
customers and competitors.
The identification of the intellectual capital components in audit firms is the first and the basic step to
measure the intellectual capital. It is not easy to measure the intellectual capital in the audit firms without a
good knowledge of these components.
In general, methods of measuring the intellectual capital vary between financial and non-financial
measurement methods. Financial measurement methods rely on finding a financial value of intellectual capital.
That value could be assigned to the intellectual capital as a unit, or it could be assigned to each one of its
components. Among the most important methods of measuring the intellectual capital are: market or value-based
approach (Starovic & Marr, 2003), Tobin’s q (Starovic & Marr, 2003), discounted cash flow (Abdelaziz, 2003),
calculated intangible value (Stewart, 1998), and value-added intellectual capital (Pulic, 2004). On the other hand,
the non-financial measurement methods rely on a set of financial and non-financial indicators to measure the
components of the intellectual capital and report it. The indicators can be formulated in the form of specific
model(s) or graph(s). Among the most important methods are: balanced score cards (Kaplan & Norton, 1992),
Skandia Navigator (Edvinsson, 1997), and the intangible assets monitor (Sveiby, 1997).
Literature Review
Previous studies related to the intellectual capital can be divided into four groups. The first group aimed at
measuring the intellectual capital. Studies of the second group discussed the relationship between the components
of human capital in audit firms and audit quality. Studies of the third group investigated the relationship between
the components of structural capital in audit firms and audit quality. Studies of the fourth group emphasized the
relationship between the components of the relational capital in audit firms and audit quality.
Regarding measuring the intellectual capital (the first group), the objective of Shaheen (2003) was to
provide a proposed approach for the accounting measurement of intellectual assets in pharmaceutical
companies in Egypt. The study used data extracted from the financial statements of the Nile Company for
pharmaceutical and chemical industries from 1997/1998 to 2001/2002. The most significant result of the study
is the possibility of achieving an objective accounting measurement for intellectual assets using the rate of
return on invested capital approach. Then, the total value of the intellectual assets was allocated into
sub-components using selected weights of intellectual assets components through direct and indirect
expenditures associated with those components.
Using a questionnaire to collect data from managers of 222 biotechnology and telecommunication firms in
Spain, from December 2001 to March 2002, the study of Palacios-Marques and Garrigos-Simon (2003) aimed
to specify how to construct and validate an intellectual capital measurement scale based on management
perceptions. The findings of the study introduce a model that can easily measure the intellectual capital. The
model depends mainly on dividing the intellectual capital into three key dimensions: human capital, structural
capital, and relational capital. Then, each key dimension was divided into a range of sub-dimensions.
The purpose of the study of Chen, Zhu, and Xie (2004) is to design a measurement model and qualitative
index system of intellectual capital, so as to provide a good tool for enterprises to manage their intellectual
capital. The data were collected using a questionnaire from 60 subjects (the owners, the general managers, and
the top executives of the corporations in high-tech enterprises in China). The study suggested a model to
measure intellectual capital, depending on the measurement of its elements including human capital, structural
capital, innovation capital, and customer capital through a combination of non-quantitative indicators. That
study also found a relationship among the four components of intellectual capital. It also found a relationship
between indicators of intellectual capital elements of the firm and its performance.
In an attempt to participate in the development of a theory of intellectual capital, the study of Seleim,
Ashour, and Boints (2004) aimed to build a measurement system within the unique context in software firms.
The sample of the study consisted of chief executive officers (CEOs) of 38 software firms in Egypt. The data
were collected using a questionnaire and personal interviews. The study suggested a system to measure
intellectual capital depending on providing a set of indicators to measure each component of the intellectual
capital (human capital, structural capital, and relational capital).
Depending on the financial reports of the three major telecommunication companies in Egypt (for 2003
and 2004), the study of Elmelegy (2005) aimed to build an accounting model for measuring intellectual capital
in the telecommunication companies. The study suggested a model to measure intellectual capital in total,
based on the net assets approach. The model distinguishes between the increases in net assets attributable to
changes in price levels and those that are due to the presence of intellectual assets.
In Taiwan, the study of Chen (2009) aimed to identify and rank the measures of intellectual capital of
e-learning service companies that ultimately influence firms’ competitive advantages. The study used
interviews as a method to collect data from 12 experts of three e-learning service companies. The study
identified five dimensions (human capital, structural capital, service capital, relational capital, ad innovative
capital) and 15 indicators to measure the intellectual capital. The findings of the study can help the e-learning
companies understand the critical success factors that facilitate gaining their competitive advantages.
Jalal (2009) aimed to highlight the expected benefits of compiling a list of the intellectual capital
components of the Egyptian universities. The data were collected using a questionnaire from a sample of 318
faculty members and their assistants at the Suez Canal University, in addition to 340 administrative staff at the
same university. The study proposed a list of intellectual capital elements for the Suez Canal University. The
list was based on the key components of intellectual capital. The components in the study were human capital,
structural capital, and relational capital. The study also introduced financial and non-financial measures. The
study also found that the most important advantages of measuring and reporting the intellectual capital
elements in the Suez Canal University are achieving the university’s budget goals, developing the competitive
abilities of the university, and supporting the link between the university and industry.
After reviewing previous literature regarding measuring the intellectual capital and its components, it
could be noticed that the previous studies were applied to a variety of industries. Studies were applied to
pharmaceutical companies (Shaheen, 2003), telecommunication companies (Elmelegy, 2005), universities
(Jalal, 2009), e-learning service companies (Chen, 2009), high-tech companies (Chen et al., 2004), software
companies (Seleim et al., 2004), and biotechnology and telecommunication companies (Palacios-Marques &
Garrigos-Simon, 2003). Also, there is diversity in the implementation environment, such as Egypt (Shaheen,
2003; Seleim et al., 2004; Elmelegy, 2005; Jalal, 2009), Spain (Palacios-Marques & Garrigos-Simon, 2003),
China (Chen et al., 2004), and Taiwan (Chen, 2009). Regarding data collection, some studies relied on primary
data via a questionnaire (Jalal, 2009; Palacios-Marques & Garrigos-Simon, 2003; Chen et al., 2004), interviews
(Chen, 2009), or both a questionnaire and interviews (Seleim et al., 2004). While other studies relied on
secondary data extracted from published financial reports (Shaheen, 2003; Elmelegy, 2005).
Regarding the results of these studies, some studies suggested a proposed model for the measurement
depending on the financial measuring of the sum of the intellectual capital (Elmelegy, 2005) or the detailed
components of intellectual capital (Shaheen, 2003). Other studies suggested a proposed model depending on the
non-financial measuring of intellectual capital (Palacios-Marques & Garrigos-Simon, 2003; Chen et al., 2004;
Seleim et al., 2004; Jalal, 2009; Chen, 2009).
So, it is clear that this group of studies has tried to measure intellectual capital in various firms, but it did
not attempt to measure it in audit firms, especially in Egypt.
With regard to studies that addressed the relationship between the components of human capital in the
audit firms and audit quality (the second group), some of these studies assessed the relationship between more
than one component of human capital in the audit firms and the audit quality, while some other studies assessed
the relationship between only one component of human capital in these firms and the audit quality.
Many studies tried to examine the relationship between more than one component of human capital in the
audit firms and audit quality. For example, Khadr (2004) examined the relationship between auditor’s expertise
and auditor’s assessment of internal control risks within an electronic operating environment. The study used a
sample of 50 auditors working in audit firms in Egypt. The data were collected using a questionnaire. The study
concluded that there is a strong influence of auditor’s expertise when assessing the risk of internal control.
Brocheler, Maijoor, and Witteloostuijn (2004) analyzed data of 1,693 firms that entered into the Dutch
audit market in the period of 1930-1992 to examine the relationship between auditor’s human capital and audit
firm survival as a measure of the audit firm performance. The study concluded that a higher level of auditors’
education generally increases the chances of audit firm’s survival. But high levels of experience increase the
chances of survival at founding, while weakening the chances of survival during the lifetime of an audit firm.
Fouda (2008) used a questionnaire to collect data from 150 auditors in the Egyptian business environment.
The study aimed to examine the effect of auditor’s expertise on improving the quality of professional judgment.
The study found that auditor’s going-concern opinions not only depend on years of experience but also depend
on the auditor’s level of education.
Applied to the business environment of Taiwan, Cheng, Liu, and Chien (2009) aimed to investigate if
there is a positive association between human capital and auditor quality in public accounting firms, and if the
extent of the association varies among accounting firms. Using 4,865 firm-year observations over the period
from 1989 to 2004, the study found that higher investments in human capital correspond to a higher level of
audit quality. Furthermore, the influence of human capital on auditor quality has a significant difference
between public and non-public audit market firms.
Regarding previous studies that examined the relationship between more than one component of human
capital in audit firms and audit quality, Khadr (2004) used experience, specialization, number of audits, size of
audit process, and the number of times the auditor acted as the head of a working group as components of human
capital. Brocheler et al. (2004) suggested that the human capital consists of level of education and experience.
Fouda (2008) noted that experience, education, and abilities represent components of human capital. Finally,
Cheng et al. (2009) referred that human capital consists of the educational level, experience, professional
qualification level, and continuous professional development. The implementation environment varied among
Egypt (Khadr, 2004; Fouda, 2008), Taiwan (Cheng et al., 2009), and Holland (Brocheler et al., 2004). Regarding
the data, some studies relied on primary data via a questionnaire (Khadr, 2004; Fouda, 2008), while others relied
on secondary data available in published reports (Brocheler et al., 2004; Cheng et al., 2009).
Most of these studies supported the existence of a positive impact of the components of human capital in
the audit firms (either collectively or individually) on audit quality. Some of these studies referred that these
components increase the audit quality in general (Cheng et al., 2009). Some other studies concluded that there
is a positive impact of these components on auditor’s going-concern opinions (Fouda, 2008). Other studies
referred to the existence of a positive impact of these components on the assessment of internal control risks
(Khadr, 2004). Despite Brocheler et al. (2004) agreed that there is a positive impact of the components of
human capital (collectively) in the audit firms on audit quality, they pointed out that experience (individually)
increases the chance of survival at the early life of audit firms, while weakening that chance during the lifetime
of the audit firm due to the high rate of auditors’ rotation.
On the other hand, some studies examined the relationship between only one component of the human
capital in audit firms and audit quality. For example, Lutfi (1995) aimed to examine the impact of general
experience on the efficiency and effectiveness of auditors’ decisions. The study sample consisted of 20
managers, 100 team work auditors, and 50 novice auditors in Egypt. The study utilized an experiment to test its
hypotheses. The study concluded that the most experienced auditors will produce more appropriate and credible
explanations and less ambiguous, and they have a more accurate understanding of the frequency of errors in the
financial statements.
In another experiment, Shelton (1999) aimed to examine the effect of irrelevant information on the
going-concern judgments of less-experienced auditors compared to more experienced auditors. The data have
been collected from 56 partners and managers and 31 audit seniors from four of the Big 6 accounting firms.
The study found that irrelevant information has a significant effect on the judgments of audit seniors, but does
not have a significant effect on the judgments of audit managers and partners.
Applied to the Australian business environment, Chung and Monroe (2000) utilized an experiment to
examine the effect of audit experience and task difficulty on the degree of precision and confidence in auditor’s
control risk evaluation. The study sample consisted of 98 auditors. They concluded that judgment confidence
increases with audit experience and that judgment confidence decreases as the perceived task difficulty
increases. However, they found no relationship between audit experience and judgment accuracy or between
perceived task difficulty and judgment accuracy.
Krishnan (2003) aimed to examine the association between auditor’s industry expertise and client’s level of
absolute discretionary accruals (a common proxy of earnings management). The study sample consisted of 24,114
firm-year observations representing 4,422 firms for the period of 1989-1998. He found that clients of
non-specialist auditor report higher absolute discretionary accruals compared to the clients of specialized auditors.
In the same direction, Low (2004) aimed to investigate the effects of industry specialization on auditors’
risk assessments and audit-planning decisions, in the American business environment. In doing so, the study
relied on an experiment to collect data from 98 audit seniors, 36 of which are classified as industry-matched
auditors and the remaining as industry-mismatched auditors. The study concluded that the auditors’ knowledge
of clients’ industry improves their audit risk assessments and directly influences the nature and the perceived
quality of their audit-planning decisions.
In another direction, Chen, Chang, and Lee (2008a) aimed to investigate the effects of professional
training and manpower on performance of audit firms under different organization types. The study sample
consisted of 502 big-sized, 889 medium-sized, and 2,088 small-sized firms in Taiwan during the period from
1989 to 2002. The study concluded that professional training and manpower make a positive contribution to the
operation of audit firms.
Also, Chen, Chang, and Lee (2008b) aimed to examine the relationship between professional training and
financial performance of public accounting firms. The sample consisted of 149 big-sized, 241 medium-sized,
and 414 small-sized firms in Taiwan during the period from 1992 to 1995. The study found that professional
training for partners or assistants, internally or externally, linked positively to financial performance in public
accounting firms.
Based on 502 firm-year observations from 2004 to 2008 of companies listed on the New Zealand Stock
Exchange, Habib and Bhuiyan (2011) aimed to document the association between audit firm industry
specialization and the audit report lag. They concluded that the audit report lag is shorter for firms audited by
industry specialist auditors.
In the same direction, the objective of Nagy (2012) was to examine the effects of auditor specialization on
audit quality within a developed market. Using the data of 229 American companies, the study found a negative
relationship between specialization and abnormal accruals.
Also, Chiang and Lin (2012) analyzed the data of 4,372 publicly quoted entities in Taiwan from 2006 to
2009, to examine the effect of auditor’s industry specialization on disclosure quality. The study concluded that
the financial statements that are audited by specialized auditors are associated with a higher level of
information quality.
Reviewing previous studies that examined the relationship between one component of human capital in the
audit firms and audit quality highlights some relevant conclusions. Some of these studies addressed the
relationship between experience and audit quality (Lutfi, 1995; Shelton, 1999; Chung & Monroe, 2000). Other
studies addressed the relationship between professional training and audit quality (Chen et al., 2008a, 2008b).
Finally, some studies addressed the relationship between specialization and audit quality (Krishnan, 2003; Nagy,
2012; Chiang & Lin, 2012; Low, 2004; Habib & Bhuiyan, 2011). These studies were applied to different
business environments. Among these environments are: Egypt (Lutfi, 1995), United States of America (USA)
(Shelton, 1999; Low, 2004; Krishnan, 2003; Nagy, 2012), Taiwan (Chen et al., 2008a, 2008b; Chiang & Lin,
2012), Australia (Chung & Monroe, 2000), and New Zealand (Habib & Bhuiyan, 2011). A wide range of data
collection techniques were applied. Some studies relied on the experimental method in collecting the data (Lutfi,
1995; Shelton, 1999; Chung & Monroe, 2000; Low, 2004), while others relied on secondary data represented in
published reports (Krishnan, 2003; Chen et al., 2008a, 2008b; Habib & Bhuiyan, 2011; Nagy, 2012; Chiang &
Lin, 2012).
Regarding the results of studies on the relationship between experience and audit quality, some studies
pointed out that experience has a positive impact on audit quality, as it increases the ability of the auditor to
identify mistakes and to provide more convenient and convincing explanations than non-experienced auditors
(Lutfi, 1995). It also decreases the effect of irrelevant information on auditor’s going-concern judgments
(Shelton, 1999). Other studies concluded that there is no relationship between audit experience and judgment
accuracy (Chung & Monroe, 2000). The studies that examined the relationship between professional training
and audit quality referred to the existence of a positive relationship between professional training and audit
quality. Finally, studies that examined the relationship between industry specialization and audit quality
referred to a positive correlation between specialization and audit quality. Among the conclusions of these
studies, it was found that specialization improves the quality of disclosure (Chiang & Lin, 2012) and limits the
process of earnings management (Krishnan, 2003; Nagy, 2012). The studies also suggested that industry
specialization reduces the period of audit report lag (Habib & Bhuiyan, 2011). Finally, it was concluded that
industry specialization increases the accuracy of the audit risk assessments and audit-planning decisions and
helps to narrow the expectation gap by increasing the ability to detect and respond to cases of fraud and
financial fraud (Low, 2004).
In the light of this group of previous studies, it can be said that these studies have tried to examine the
relationship between only one main component of intellectual capital in audit firms which is human capital and
the quality of their audits.
With regard to studies that addressed the relationship between the components of structural capital in the
audit firms and audit quality (the third group), Banker, Chang, and Kao (2002) aimed to examine the effect of
using information technology in public accounting firms on the productivity of these firms. They collected a
panel of data for 24 monthly observations from January 1997 to December 1997 and from January 1999 to
December 1999. Data were collected from the monthly income statements for each of the five offices of the
firm. The study found that there is a significant improvement in performance after the application of
information technology.
Also, for the purpose of measuring the impact of information technology in managing the audit process on
the productivity of the accounting and auditing firms, Tolba (2003) depended on a questionnaire to collect data
from 22 auditors in large and medium-sized audit firms in Egypt. The study concluded that the benefits of using
computers in managing the audit process increase the quality of the audit and increase the productivity of the
audit team work.
On the other hand, Geneidi (2006) studied and analyzed the expected impacts of building and
strengthening the organizational culture of the audit firms and its effect on the reports and qualification of the
auditor. The study sample consisted of 40 auditors and 40 members in the departments of accounting and
auditing in the faculties of commerce and 40 of the financial analysts, managers of credit, and investment funds
in banks. The study used a questionnaire and interviews to collect data. The most important result of the study
is that the organizational culture of audit firms plays an important role in the activation of the informational
content of audit reports in general and qualification audit reports in particular. Also, the study concluded that
the organizational culture of audit firms reduces the time of announcement of the qualified audit reports.
Applied to the Jordanian business environment, M. Alshrairi and G. Alshrairi (2007) aimed to assess the
impact of using computers on audit procedures development. The data were collected from 50 auditors working
in Amman, using a questionnaire. The study found that information technology helps in improving the
efficiency and effectiveness of the audit process through increasing the possibility of detecting errors, reducing
procedures costs, and improving internal control systems.
Using a questionnaire, Hamdouna and Hamdan (2008) aimed to study the use of information technology in
various fields and activities of auditing, planning, controlling, and documenting. Also, the study aimed to
evaluate the impact of using information technology on the quality of audit evidence. To achieve these
objectives, the data were collected from 40 audit firms in Palestine. The study found that auditors’ use of
information technology in planning, controlling, and documenting was below average. It also found an average
effect of the use of information technology in the audit process on improving the quality of audit evidence.
Morris (2009) examined the relationship between one measure of audit quality (dysfunctional auditor
behavior) and in-charge auditors’ perceptions of their firms’ ethical culture and authentic leadership on their
firms, with the application to the American business environment. The study sample consisted of 120 in-charge
auditors covering the period from August 2008 to November 2008. The data were collected using a
questionnaire. The study concluded that there is a negative correlation among these variables.
Finally, Krambia-Kapardis, Christodoulou, and Agathocleous (2010) aimed to assess the use of artificial
neural networks (ANNs) as a tool of fraud detection. The sample included 200 auditors who attended a seminar
on fraud detection and prevention in Cyprus. A questionnaire was used to collect the data. The study showed
that ANNs can be used by auditors to identify companies exposed to fraud.
Reviewing previous literature that investigated the relationship between the components of structural
capital in audit firms and audit quality reveals that these studies aimed to study the relationship between only
one component of structural capital in audit firms and audit quality. Some studies assessed the relationship
between the use of technology in audit firms and audit quality (Banker et al., 2002; Tolba, 2003; M. Alshrairi &
G. Alshrairi, 2007; Hamdouna & Hamdan, 2008; Krambia-Kapardis et al., 2010). Other studies investigated the
relationship between organizational culture in audit firms and audit quality (Geneidi, 2006; Morris, 2009).
These studies were applied to different business environments. The studies were applied to Egypt (Tolba, 2003;
Geneidi, 2006), Jordon (M. Alshrairi & G. Alshrairi, 2007), Palestine (Hamdouna & Hamdan, 2008), Cyprus
(Krambia-Kapardis et al., 2010), and USA (Banker et al., 2002; Morris, 2009). Some studies relied on primary
data via a questionnaire (Tolba, 2003; M. Alshrairi & G. Alshrairi, 2007; Hamdouna & Hamdan, 2008; Morris,
2009; Krambia-Kapardis et al., 2010) or both a questionnaire and interviews (Geneidi, 2006). Other studies
relied on secondary data reported in published reports (Banker et al., 2002).
The results of the studies that addressed the relationship between the use of technology in audit firms and
audit quality were not identical. Most of these studies referred to the existence of a significant impact of using
technology in audit firms on the quality of all stages of the audit process. Some studies indicated that the use of
technology in audit firms is effective in fraud detection (M. Alshrairi & G. Alshrairi, 2007; Krambia-Kapardis
et al., 2010), reducing the costs of procedures and improving the internal control systems (M. Alshrairi &
G. Alshrairi, 2007), increasing the productivity of the audit work group (Tolba, 2003), and improving the
revenue generation rate (Banker et al., 2002). On the other hand, some studies pointed to the existence of an
average impact of the use of information technology in audit firms on audit quality (Hamdouna & Hamdan,
2008). The studies on the relationship between organizational culture in the audit firms and audit quality
indicated that the organizational culture in audit firms has a positive effect on audit quality. These studies argue
that the organizational culture plays an important role in activating the informational content of audit reports,
especially qualified ones (Geneidi, 2006), and the studies also indicated that the organizational culture
decreases the chances of dysfunctional auditor behavior (Morris, 2009).
Therefore, this group of studies have tried to examine the relationship between only one main component
of intellectual capital in audit firms which is structural capital and the quality of their audits.
The fourth group of studies dealt with the relationship between the components of relational capital in
audit firms and audit quality. For example, Sobahi (1997) aimed to determine the characteristics of audit quality
in Egypt from the perspective of parties involved or affected by the audit process. One of these characteristics
is the existence of a link between the audit firm and one of the global audit firms. The study collected the data
using a questionnaire. The sample consisted of 100 auditors, 80 financial department managers, and 70 users of
the audit reports. One of the results of the study is that the link between audit firm and one of the global audit
firms increases the audit quality. The same conclusion was reached by Radi (1998) who surveyed 60 auditors,
60 preparers of financial statements, and 60 users of audit service to assess their perceptions of factors affecting
audit quality.
On the other hand, Johnson, Khurana, and Reynolds (2002) aimed to examine whether the length of the
relationship between a company and an audit firm is associated with financial reporting quality. The study
sample consisted of 2,463 firm-year observations in USA from 1986 to 1995. The study found that medium
audit firm tenures (4-8 years) and short audit firm tenures (2-3 years) are associated with lower-quality
financial reports. In contrast, no evidence of reduced financial reporting quality was found for longer audit firm
tenures (nine and more years).
Also, J. Myers, L. Myers, and Omer (2003) depended on 42,302 firm-year observations in USA from 1988
to 2000, to examine the relationship between auditor tenure and earnings quality. They concluded that higher
earnings quality is associated with longer auditor tenure.
Depending on the data of 208 USA companies from 1990 to 2001, Carcello and Nagy (2004) aimed to
examine the relationship between audit firm tenure and fraudulent financial reporting. The study found that
fraudulent financial reporting is more likely to occur in the first three years of the auditor-client relationship.
The study failed to find any evidence that fraudulent financial reporting is more likely associated with long
auditor tenure.
In order to analyze whether investors’ perceptions of earnings quality could be affected by auditor tenure
in USA, Ghosh and Moon (2005) depended on 35,826 firm-year observations from 1990 to 2000. The study
concluded that there is a positive association between investors’ perceptions of earnings quality and auditor
tenure.
Knechel and Vanstraelen (2007) aimed to examine the effect of auditor tenure on audit quality. The study
sample consisted of 618 audit reports from Belgian companies divided equally between stressed companies that
went bankrupt and stressed companies that survived from 1992 to 1996. The results of the study showed that
the decision of auditor to issue a going-concern opinion is not affected by tenure in bankrupt sample. In the
non-bankrupt sample, they found some evidence of a negative association between auditor tenure and the
issuance of a going-concern opinion.
In the same direction, Meyer, Rigsby, and Boone (2007) examined whether auditor-client relationships
have an effect on an auditor’s decision to remove an audit qualification related to a going-concern opinion. The
study selected a sample of 337 USA companies from 1983 to 1987. The study found that interpersonal and
inter-organizational attachment has a significant impact on those opinion decisions that require more auditor
judgment.
In Jordon, Al-Thuneibat, Al-Issa, and Baker (2011) analyzed the effects of the length of the audit
firm-client relationship and the size of the audit firm on audit quality. The sample of the study included any
firm whose stock is publicly traded on the Amman Stock Exchange throughout the years of 2002-2006. The
statistical analysis showed that the length of the audit firm-client relationship negatively affects the audit
quality, as a result of the growth of the size of abnormal accruals. There was no material impact of the size of
audit firm on the relationship between the length of the audit firm-client relationship and the audit quality.
Using data of 190 manufacturing and 99 service companies listed in the Amman Stock Exchange during
the period of 2002-2005, Baker and Al-Thuneibat (2011) aimed to investigate the relationship between audit
firm tenure and the perceived audit quality measured by the client-specific equity risk premium. The study
found that the relationship between audit firm tenure and equity risk premium is positive; the equity risk
premium increases with tenure as a result of the reduced audit quality.
In order to test the relationship between auditor tenure and the market’s perception of discretionary
accruals quality in periods before and after the Sarbanes-Oxley Act (SOX), Jenkins and Velury (2012) used
data of 65,514 firm-year observations including 48,441 in the pre-SOX period (1991-2001) and 17,073 in the
post-SOX period (2002-2006). The study found that in the post-SOX period, there is no significant relationship
between auditor tenure and the pricing of discretionary accruals.
Finally, the study of Yu and Lenard (2013) aimed to explore the relationship between auditor tenure and
financial reporting quality of Chinese firms. The study sample consisted of 3,854 firm-year observations from
1997 to 2007. The study has concluded that the least important clients employ more conservative accounting
techniques as auditor tenure increases. For the most important clients, there is less conservatism, compared to
the least important clients, in the early years of the auditor tenure.
Reviewing previous studies on the relationship between the components of relational capital in audit firms
and audit quality provides many indicators. It is clear that these studies aimed to study the relationship between
only one of the components of relational capital in audit firms and audit quality. Some studies dealt with the
relationship between the existence of a link between audit firm and one of the global audit firms and audit
quality in these firms (Sobahi, 1997; Radi, 1998). Some other studies dealt with the relationship between
auditor tenure and audit quality (Johnson et al., 2002; Myers et al., 2003; Carcello & Nagy, 2004; Ghosh &
Moon, 2005; Knechel & Vanstraelen, 2007; Jenkins & Velury, 2012; Yu & Lenard, 2013; Meyer et al., 2007;
Al-Thuneibat et al., 2011; Baker & Al-Thuneibat, 2011). The studies were applied to different business
environments. Examples of these business environments include USA (Johnson et al., 2002; Myers et al., 2003;
Carcello & Nagy, 2004; Ghosh & Moon, 2005; Meyer et al., 2007; Jenkins & Velury, 2012), Belgium (Knechel
& Vanstraelen, 2007), Jordon (Al-Thuneibat et al., 2011; Baker & Al-Thuneibat, 2011), and China (Yu &
Lenard, 2013). All of the reviewed studies relied on secondary data reported in published reports.
Studies on the relationship between the presence of a link between audit firm and one of the global audit
firms and audit quality concluded that there is a positive relationship between the two variables. Studies that
investigated the relationship between auditor tenure and audit quality showed diverse results. Some studies
indicated that there is a negative correlation among these variables, led by the growth of the size of abnormal
INTEL
LLECTUAL CAPITAL AS
S A DETERM
MINANT OF
F AUDIT QUA
ALITY 73
accruals (AAl-Thuneibat et al., 2011). Some other studies

s foundd that auditor tenure increaases equity rissk premium
(Baker & Al-Thuneibatt, 2011) and affects audiitor’s going-cconcern opinion (Meyer eet al., 2007; Knechel &
Vanstraelenn, 2007). Othher studies poointed to the existence
e of a positive rellationship bettween auditorr tenure and
audit qualiity (Myers ett al., 2003; Ghosh
G & Mooon, 2005). Some
S studiess linked that tenure positiively to the
quality of the
t financial reporting (Joohnson et al., 2002; Carceello & Nagy,, 2004; Yu & Lenard, 2013). On the
other hand, some studiees concluded that there is no n link betweeen auditor teenure and auddit quality, ass they found
that auditorr tenure is noot associated with
w the priciing of discretiionary accruaals (Jenkins & Velury, 201 12).
So, it is clear thatt this group of o studies haave tried to examine
e the relationship between only y one main
componentt of intellectuual capital in audit
a firms which
w is relatio
onal capital and
a the qualitty of their aud dits.
Revieewing the literrature revealss a great num mber of studies with regardd to measuringg the intellectual capital.
Attempts tot measure thhe intellectuaal capital aree still in an earlye stage. There
T is no general agreement on a
measuremeent approach or measurem ment theory foor intellectuall capital. Thee reason for thhat disagreemment may be
due to the fact that asseessing the inttellectual cappital is not a pure
p accountiing issue. Reesearchers fro om different
research areas
a other thhan accountiing are also interested in n that issue.. Human ressources reseaarchers and
psychologyy researcherss besides manny other reseearchers havee the same interest in meeasuring the intellectual
capital (Naazari & Herreemans, 2007)..
Last but
b not least, in the light of the previoous discussio on, it is clear that in spitee of the largee number of
studies thaat tried to meaasure intellecctual capital in
i various firrms, there is a lack of studdies that aim to measure
intellectuall capital in audit
a firms. On
O the other hand, some studiess tried to measure tthe main com mponents of
intellectuall capital in thhe audit firmss (human cappital, structurral capital, annd relational ccapital) indiv
vidually and
to assess thheir relationship to audit quality.
q Somee of these stuudies addresseed one sub-component off these main
componentts and its relationship to audit qualityy in audit firm ms. It could be concludedd that there is i a lack of
studies thaat have tried to measure intellectual
i c
capital as a whole
w in audit firms and its relationsh hip to audit
quality. Thhus, there is a research gap g that needds more reseaarch and studdy. As a firsst step of meeasuring the
intellectuall capital in auudit firms and in the lightt of previous studies, Figuure 1 shows tthe main com mponents of
intellectuall capital in auudit firms andd the sub-commponents of each main com mponent.
E
Education
Exxperience
Human n
capital in
i Speecialization
audit firm
ms
Coontinuous
professiional educationn
Coontinuous
professsional training
Intellectuall
Audit
capital in Structurral Organizational culturee
quality
audit firms capital in
i
audit firm
ms Teechnology
Tenure
Relationnal
capital in
i Link between
b audit
audit firm
ms firm annd other global
auudit firms
Figuree 1. Componentts of intellectuall capital in audiit firms.

The Suggested Model

In an attempt to fill the gap in the literature and depending on previous studies and measures used to
measure intellectual capital’s variables, this paper suggests a quantitative model to measure intellectual capital
in audit firms. The model is based on a set of non-financial measures. Financial measures are not used here due
to the difficulty associated with obtaining published financial statements for the audit firms. The model is
discussed in the following lines.
Model (1) examines the relationship between overall intellectual capital and audit quality:
AQ = α + β1 IC + ε (1)
where:
AQ = Number of litigation cases/number of clients;
IC = The sum of human capital, structural capital, and relational capital.
Model (2) examines the relationship between the main components of intellectual capital and audit quality:
AQ = α + β1 HC + β 2 SC + β 3 RC + ε (2)
where:
HC = The sum of education level, experience, specialization, continuing professional education, and
continuing professional training;
SC = The sum of organizational culture and technology;
RC = The sum of tenure, link between audit firm and other global audit firms.
AQ = α + β1 HC + ε
Model (3) examines the relationship between overall human capital and audit quality:
(3)
Model (4) examines the relationship between the sub-components of human capital and audit quality:
AQ = α + β1 EDU + β 2 EXP + β 3 SPEC + β 4CPE + β 5CPT + ε (4)
where:
EDU = {(number of auditors with doctorates ൈ 23) + (number of auditors with master’s degrees or
postgraduate diploma ൈ 18) + (number of auditors with bachelor’s degrees ൈ 16)}/total number of auditors;
EXP = Average years of experience;
SPEC = One if the audit firm is specialized, and zero if otherwise;
CPE = Number of auditors who have membership in professional organizations (American Institute of
Certified Public Accountants (AICPA) for example) require continuing professional education as a condition
for the continuation of the membership/total number of auditors;
CPT = One if the audit firm has a department for professional training, and zero if otherwise.
Model (5) examines the relationship between overall structural capital and audit quality:
AQ = α + β1SC + ε (5)
Model (6) examines the relationship between the sub-components of structural capital and audit quality:
AQ = α + β1OC + β 2TEC + ε (6)

where:
OC = One if the audit firm has an organizational structure, and zero if otherwise;
TEC = One if the audit firm uses technology in the audit process, and zero if otherwise.
Model (7) examines the relationship between overall relational capital and audit quality:
AQ = α + β1 RC + ε (7)
Model (8) examines the relationship between the sub-components of relational capital and audit quality:
AQ = α + β1TENURE + β 2GLOBAL + ε (8)
where:
TENURE = Average years of the relationship between the audit firm and its clients;
GLOBAL = One if the audit firm links with one of the global audit firms, and zero if otherwise.
Concluding Remarks
Despite the growing importance of the intellectual capital in recent years, more research is needed to
recognize and measure the intellectual capital in audit firms. Recognizing the most significant components of
intellectual capital on audit quality would help audit firms to gain a better understanding of their competing
advantages. This study provides a suggested quantitative model for measuring intellectual capital in audit firms
as a determinant of audit quality.
The suggested model builds on several intellectual capital models that have not been well-connected to the
audit profession. The model depends on measuring the main components of the intellectual capital, which are
human capital, structural capital, and relational capital. In the suggested model, human capital consists of
education, experience, specialization, continuous professional education, and continuous professional training.
Structural capital consists of technology and organizational culture. Finally, relational capital consists of tenure
(relationship to customers) and link between audit firm and other global audit firms (relationship to
competitors).
The model attempts to measure intellectual capital within audit firms based on the data that are not
publicly available. Data unavailability imposes measurement difficulties that may be considered as a research
limitation.
The study provides a theoretical discussion designed to promote a more precise and inclusive
measurement of intellectual capital in audit firms. Further research is needed to indicate the feasibility of this
study. A cross-sectional analysis using a large sample of Egyptian auditing firms is under investigation by the
researchers. Future researches are encouraged to apply the suggested model in different settings.
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January 2014, Vol. 10, No. 1, 80-96
D DAVID PUBLISHING
Does an Auditor’s Within-Industry Market Share Still Capture

Auditor Industry Expertise in a Mandatory Audit
Partner Rotation Regime?
Chi Wuchun
National Chengchi University, Taipei, Taiwan
Liao Hsiumei
Ming Chuan University, Taipei, Taiwan
Xie Hong
University of Kentucky, Lexington, USA
Prior studies commonly use an auditor’s market share in an industry as a proxy for auditor industry expertise and
find that audit quality is positively related to an audit partner’s within-industry market share in a voluntary audit
partner rotation regime where the length of the client-partner relationship is not limited. Mandatory audit partner
rotation, however, limits the length of the client-partner relationship and can artificially increase or decrease the
market shares of incoming and departing partners, thus making the audit partner’s within-industry market share an
unreliable proxy for auditor industry expertise. Using a sample of banks in Taiwan, we find that audit quality is
positively related to an audit partner’s within-industry market share in the voluntary audit partner rotation regime.
However, such a positive relation disappears in the mandatory audit partner rotation regime. Thus, we conclude that
mandatory audit partner rotation decouples the link between an audit partner’s within-industry market share and
auditor industry expertise and caution researchers against using an audit partner’s within-industry market share as a
proxy for auditor industry expertise in a mandatory audit partner rotation regime.
Keywords: earnings quality, auditor expertise, mandatory partner rotation, client-specific tenure, industry-specific
market share
Introduction
Auditor industry expertise is important for the auditor to provide a high-quality audit. Prior research has
extensively examined the association between audit quality and auditor industry expertise. Since auditor
industry expertise is not directly observable, researchers typically use an auditor’s within-industry market share
(i.e., the auditor’s audit market share in an industry) as a proxy for auditor industry expertise, assuming that the
auditor who captures the largest market share in an industry is the expert auditor in that industry. Studies using
Chi Wuchun, professor, Department of Accounting, National Chengchi University. Email: [email protected].
Liao Hsiumei, assistant professor, Department of Accounting, Ming Chuan University.
Xie Hong, associate professor, Von Allmen School of Accountancy, University of Kentucky.
Correspondence concerning this article should be addressed to Liao Hsiumei, Department of Accounting, Ming Chuan
University. Email: [email protected].
AUDITOR INDUSTRY EXPERTISE IN A MANDATORY AUDIT PARTNER ROTATION REGIME 81
the United States (US) data look at auditor industry expertise at the audit firm level, because audit partner
information is not publically disclosed in the US. For example, Balsam, Krishnan, and Young (2003) and
Krishnan (2003) found a negative relation between the client’s absolute discretionary accruals, an inverse proxy
for audit or earnings quality, and an audit firm’s within-industry market share1. Reichelt and Wang (2010)
documented a negative relation between the client’s absolute discretionary accruals and an audit firm’s
within-industry market share, measured at the city, national, and a combination of both levels. These studies
thus find that audit quality is positively related to an audit firm’s market share-based proxy for industry
expertise (i.e., within-industry market shares).
Since it is audit partners who plan and implement the audit and ultimately issue the audit report, it is
important to understand how partner characteristics affect audit quality (Francis, 2011). Recent studies examine
auditor industry expertise at the audit partner level utilizing data from some audit markets outside the US that
disclose audit partner names in audit reports. For example, using audit data from Taiwan, Chin and Chi (2009)
examined whether the likelihood of accounting restatements is associated with Big 4 industry expert auditors,
proxied by within-industry market shares at the audit partner level and the audit firm level2. They found that
clients of signing auditors who are industry experts (or industry specialists), measured either at the audit partner
level alone or at the audit partner and audit firm combined level, are less likely to make accounting
restatements relative to clients of other auditors in Taiwan. Using audit data from Sweden, Zerni (2012) found
that audit fees are higher for clients audited by an audit partner who is an industry expert (proxied by
within-industry market share) or a specialist in public companies, consistent with audits by such partners being
perceived to be of higher quality. The above studies suggest that audit partners’ industry-specific knowledge
and expertise, as measured by partners’ market share in an industry, enhance audit quality or command an audit
fee premium.
However, these studies on audit partner industry expertise are conducted in a voluntary audit partner
rotation regime where the length of the client-partner relationship is not limited. Under the mandatory audit
partner rotation regime, the length of client-partner relationship is constrained. In particular, mandatory audit
partner rotation interrupts the accumulation of audit partners’ industry-specific knowledge and expertise and
tends to make a partner’s within-industry market share unstable over time. For example, assume that Partner A
held the largest market share in an industry under the voluntary audit partner rotation regime and thus was
classified as an industry expert. Partner A may fall in the rank of his market share and thus be classified as a
non-expert if being mandatorily rotated out of the industry3. On the other hand, Partner B did not hold the
largest market share in that industry and thus was not classified as the industry expert before the mandatory
rotation. If Partner B is mandatorily rotated to take more clients in that industry, Partner B can potentially hold
the largest market share and thus be classified as the industry expert in the year of mandatory rotation. But is
Partner B really an industry expert relative to Partner A in the year of mandatory rotation just because Partner B
now holds the largest market share due to mandatory rotation? Another consequence of mandatory partner
1
Prior studies have used absolute discretionary accruals as an inverse proxy for both earnings quality and audit quality (e.g.,
J. Myers, L. Myers, & Omer, 2003; Chi, Hung, Liao, & Xie, 2009). We thus use earnings quality and audit quality
interchangeably.
2
We use Big 4 to represent a Big 4 audit firm after 2001 (Deloite & Touche, Ernst & Young, Klynveld Peat Marwick Goerdeler
(KPMG), and PricewaterhouseCoopers (PwC)) or a Big 5 audit firm before 2002 (Arthur Andersen, Deloite & Touche, Ernst &
Young, KPMG, and PwC).
3
We use “he”, “him”, and “his” to indicate both male and female audit partners.
82 AUDITOR INDUSTRY EXPERTISE IN A MANDATORY AUDIT PARTNER ROTATION REGIME
rotation is that Partner B may lose the largest market share status quickly in future years, if some of Partner B’s
clients in that industry are up for rotation.
Based on the above example, we argue that an audit partner’s within-industry market share becomes a
less reliable proxy for audit partner industry expertise under the mandatory audit partner rotation regime than
under the voluntary rotation regime. Consequently, the association between audit quality and an audit
partner’s within-industry market share documented in the voluntary audit partner rotation regime (e.g., Chin &
Chi, 2009) is likely to become weaker under the mandatory rotation regime. In this study, we focus on the
banking industry in Taiwan. We empirically examine the relation between audit quality and an auditor’s
market share in the banking industry and test whether such a relation is weakened by mandatory audit partner
rotation. Our research questions are important because the two questions are unexplored in the extant
literature4.
We examine a sample of firms in the banking industry in Taiwan from 2001 to 2009. We find that as in
prior studies of other industries, audit quality is positively associated with an audit partner’s within-industry
market share coupled with his audit firm’s within-industry market share in the voluntary audit partner rotation
regime during the period of 2001-2003 in Taiwan. This suggests that the audit partner’s within-industry market
share reliably captures audit partner industry expertise in the voluntary partner rotation regime. However, after
the implementation of mandatory audit partner rotation in 2003, the positive association between audit quality
and the audit partner’s within-industry market share disappears from 2004 to 2009. This suggests that
mandatory audit partner rotation has decoupled the link between the audit partner’s within-industry market
share and audit partner industry expertise and thus the audit partner’s within-industry market share no longer
captures audit partner industry expertise after mandatory audit partner rotation.
We contribute to the auditing literature by examining the effect of mandatory audit partner rotation on the
relation between audit quality and the audit partner’s within-industry market share. We argue that mandatory
audit partner rotation decouples the link between the audit partner’s within-industry market share and audit
partner industry expertise. The justification for using the audit partner’s within-industry market share as a
proxy for industry expertise is the assumption that a free market for accounting services will allow experts to
garner greater shares of the market (Zerni, 2012). Mandatory partner rotation, however, forces changes in the
market shares of incoming and departing partners. An audit partner’s within-industry market share will no
longer flow naturally from the partner’s industry expertise. Rather, the audit partner’s within-industry market
share is artificially increased or decreased by mandatory rotation, i.e., mandatory audit partner rotation makes
the audit partner’s within-industry market share a noisy proxy for audit partner industry expertise. To our
knowledge, we are the first to raise this issue and to provide evidence that audit quality is no longer positively
associated with the audit partner’s within-industry market share. With the wide adoption of mandatory audit
partner rotation in the world, we caution researchers against using the audit partner’s market share as a proxy
for industry expertise in the mandatory partner rotation regime.
The remainder of the paper is organized as follows. Section 2 reviews the literature and discusses Taiwan’s
institutional background. Section 3 describes the research design. Section 4 presents the sample selection.
Section 5 provides regression results, and Section 6 concludes.
4
Chin and Chi (2009) and Zerni (2012) found that the audit partner’s within-industry market share is positively associated with
audit quality or audit fees in the voluntary audit partner rotation regime. Their samples, however, exclude the financial industry.
Literature Review
Market Share-Based Proxy for Auditor Industry Expertise
The role of auditor industry expertise on audit quality has attracted much research. Auditor industry
expertise is not directly observable. So, researchers typically use an auditor’s within-industry market share as a
proxy for industry expertise. Studies using the US data can only measure an auditor’s within-industry market
share at the audit firm level and, in general, show a positive association between audit quality and the auditor’s
market share-based proxy for industry expertise (i.e., the auditor’s within-industry market share). For example,
Balsam et al. (2003), Krishnan (2003), and Reichelt and Wang (2010) showed that audit quality is positively
associated with the audit firm’s within-industry market share. In addition, DeBoskey and Jiang (2012) found
that US banks use loan loss provisions (LLP) to smooth earnings and that such earnings management behavior
is significantly mitigated for banks that are audited by audit firms with larger within-industry market shares or
industry expert auditors. Moreover, many studies found that companies audited by industry expert auditors
enjoy higher valuations (Knechel, Naiker, & Pacheko, 2007) and make higher-quality disclosures (Dunn &
Mayhew, 2004). Furthermore, industry expert audit firms are more likely to issue going-concern opinions
(Reichelt & Wang, 2010) and are less likely to see their audited earnings just meet or beat analysts’ forecasts
(Payne, 2008; Reichelt & Wang, 2010), or to be involved in the Securities and Exchange Commission (SEC)
enforcement actions (Carcello & Nagy, 2004) or restatements (Romanus, Maher, & Fleming, 2008). Finally,
using audit data around the world, Kwon, Lim, and Tan (2007) found that earnings quality is higher for
companies audited by industry expert audit firms in 28 countries and regions in their sample. In addition, the
effect of auditor industry expertise on earnings quality is greater in countries and regions with weaker legal
environment, that is, weaker legal protection for investors allows industry expert audit firms to stand out from
their non-expert counterparts.
Some audit markets outside the US disclose audit partner names in audit reports, providing an opportunity
for researchers to examine auditor industry expertise at the audit partner level. Using an audit partner’s
within-industry market share as a proxy for industry expertise in Taiwan, Chin and Chi (2009) found that audit
partner industry expertise, whether alone or in conjunction with firm-level industry expertise, significantly
reduces the likelihood of accounting restatements. Using an audit partner’s within-industry market share as a
proxy for industry expertise in Sweden, Zerni (2012) found that audit fees are higher for clients audited by an
audit partner who is an industry expert or a specialist in public companies (an audit partner who audits at least
two public companies or at least 50% of whose audited assets come from public companies), consistent with
the notion that audits by such partners are perceived to be of higher quality. Importantly, Chin and Chi (2009)
and Zerni (2012) excluded the banking industry in their samples. Indeed, few studies, except for the following
notable exception, have considered the banking industry. So, the role of industry expertise on audit quality in
the banking industry remains largely unknown.
Kanagaretnam, Krishnan, and Lobo (2009) found a positive association between the discretionary part of
LLP and market return if banks are audited by an industry expert audit firm (proxied by within-industry
market share), a phenomenon which implies that the expert auditor of banks can alleviate the information
asymmetry between bank managers and investors. In addition, Kanagaretnam, Lim, and Lobo (2010), using
banks’ data from 29 countries and regions, found that an industry expert audit firm can constrain earnings
management of banks.
Accrual-Based Proxies for Audit Quality

Researchers commonly choose a measure of accruals and then use the estimated discretionary or abnormal
portion of that measure of accruals to proxy for earnings quality or audit quality (Myers et al., 2003; Chi et al.,
2009). There are two approaches to select a measure of accruals: the portfolio approach and the representative
approach. The portfolio approach chooses a measure of all accrual components whereas the representative
approach considers only a single accrual component. As explained in the study of McNichols and Wilson
(1988), who use abnormal bad debt expenses to proxy for earnings quality, the trade-off between the two
approaches is comprehensiveness and precision 5 . Specifically, the portfolio approach offers greater
comprehensiveness, since the accrual measure includes all accrual components, but the precision in estimating
the abnormal portion of the accrual measure will suffer, because it is difficult to estimate the normal portion of
the accrual measure when it includes all accrual components. In contrast, the representative approach offers
better precision in estimating the abnormal portion of the accrual measure, since the accrual measure is only
one component of all accrual components. Obviously, the representative approach suffers from a lack of
comprehensiveness. For the banking industry, the best approach is the representative approach, because a single
account in the banking industry, LLP, makes up the majority of all accruals. We, therefore, will use abnormal
loan loss provisions (AbnLLP) as a proxy for audit quality6.
Background and Regulations in Taiwan
As we have explained, the relation between audit quality and audit partner industry expertise in the
banking industry is largely unexplored in the extant literature. More importantly, how mandatory audit partner
rotation affects such a relation is also unexplored. The unique institutional features of banks in Taiwan allow us
to examine these questions. This section introduces the institutional and regulatory background of the banking
industry in Taiwan: audit partner signatures, banking regulations, and audit partner rotation.
First and most importantly, audit reports in Taiwan contain the names of two audit partners and the name
of the audit firm. This allows us to proxy for auditor industry expertise at both the audit partner level (using the
audit partner’s within-industry market share) and the audit firm level (using the audit firm’s within-industry
market share). In addition, financial statements of both listed and unlisted banks are prepared and audited
according to the same accounting and auditing standards, so differences in standards cannot account for
differences in audit quality between listed and unlisted banks. Finally, because all financial statements are
publicly available, we can determine whether audit quality differs between listed banks and non-listed banks.
Second, in Taiwan, a 5-year audit partner rotation was made mandatory by the Taiwan Stock Exchange
Corporation (TWSE) and GreTai Securities Market (GTSM) in 2004 (Chi et al., 2009)7. The rule came into full
effect in 2004, when it was applied retroactively to auditors already in service; 2003 was a transition period,
when a listed company was allowed to have one audit partner, but not both, with audit partner tenure of five or
more years8.
5
The research sample examined by McNichols and Wilson (1988) is composed of publishers, business service providers, and
wholesalers of non-durable goods, but does not include the banking industry.
6
See Section Variable Definition below for more details about how to estimate AbnLLP.
7
TWSE and GTSM in Taiwan are analogous to the New York Stock Exchange (NYSE) and National Association of Securities
Dealers Automated Quotation (NASDAQ) in the US.
8
In our sample, only four audit partners of banks were switched in 2003 due to the mandated partner rotation. Due to the small
number of rotations, we exclude these four observations in our sample but retain the rest of the 2003 observations and classify
2003 as a voluntary rotation regime.
Third, listed banks in Taiwan are regulated by the Company Act (as are all firms) and the Securities and
Exchange Act (as are all listed firms), and they are monitored by the Financial Supervisory Commission of
Taiwan (FSC hereafter, which is similar to the SEC in the US). In addition, unlike non-banking firms, listed
banks also fall under the regulations of the Bank Act and the monitoring of the Banking Bureau (an arm of the
FSC). Moreover, banks under the control of financial holding companies are further regulated by the Financial
Holding Company Act, which requires that all financial holding companies be listed and that each hold only one
bank. After the Financial Holding Company Act was passed, many financial holding companies were set up, and
many formerly listed banks delisted and became subsidiaries of their listed financial holding companies. For
example, Hua Nan Bank was a listed company before 2001, but delisted in 2001 and became a subsidiary of
Hua Nan Bank Financial Holding.
To summarize, the above unique features of data, banking industry, and regulatory environment in Taiwan
allow us to examine the relation between audit quality and an audit partner’s within-industry market share and
whether such a relation is affected by mandatory audit partner rotation.
Research Design
This study addresses two related questions in the banking industry in Taiwan. First, what is the relation
between audit quality and the audit partner’s within-industry market share? Second, is such a relation weakened
by mandatory audit partner rotation? We first introduce definitions of key variables and then present a
regression model to test our two research questions.
Variable Definition
As discussed earlier, we choose a major component of all accruals in the banking industry, LLP, to
estimate AbnLLP as a proxy for audit quality (i.e., the representative approach). Following Kanagaretnam,
Krishnan, and Lobo (2010), we estimate Equation (1) yearly:
LLPt = α 0 + α1LLAt −1 + α 2 NPLt −1 + α 3ΔNPLt + α 4 LCOt + α 5 ΔLoant + α 6 Loant + ε t (1)
where:
LLPt: Loan loss provisions;
LLAt-1: Beginning-of-the-year loan loss allowance;
NPLt-1: Beginning-of-the-year non-performing loans;
ΔNPLt: Change in non-performing loans;
LCOt: Net loan charge-offs;
ΔLoant: Change in total loans;
Loant: Total loans outstanding.
All variables are deflated by beginning-of-the-year total assets.
Following Kanagaretnam, Krishnan, and Lobo (2010), we define AbnLLP as residuals from
Equation (1). Note that LLP is a negative accrual and so positive (negative) AbnLLP decreases (increases)
reported earnings.
We use AbnLLP as a proxy for audit quality. Following Myers et al. (2003) and many other studies, we
measure AbnLLP at three levels: absolute value (|AbnLLP|), positive value (AbnLLP+), and negative value
(AbnLLP−). Also following Myers et al.’s (2003) study and a large volume of prior studies, we define less
extreme earnings (i.e., less extremely positive if earnings are positive or less extremely negative if earnings are
negative) as higher-quality earnings and thus higher audit quality9. That is, if a company’s |AbnLLP| is not
extremely positive, or if its AbnLLP+ is not extremely positive, or if its AbnLLP− is not extremely negative, then
audit quality is high, because that company’s reported earnings are not extreme10.
Kanagaretnam, Krishnan, and Lobo (2010) deemed reported earnings that are smaller or more negative as
being of higher quality. Since an extremely positive AbnLLP makes reported earnings extremely negative,
Kanagaretnam, Krishnan, and Lobo (2010) regarded an extremely positive AbnLLP as indicating high
earnings quality. In sharp contrast, our definition and the most prior studies (e.g., Myers et al., 2003) regard
extremely negative earnings as a product of a “big bath” and thus an indicator of low earnings quality. On the
other hand, Kanagaretnam, Krishnan, and Lobo (2010) regarded an extremely negative AbnLLP (making
reported earnings extremely positive) as indicating low earnings quality, which is consistent with our
definition and the extant literature. Therefore, the critical difference between our definition of high earnings
quality and that of Kanagaretnam, Krishnan, and Lobo (2010) is that we regard extremely positive AbnLLP,
which makes reported earnings extremely negative (a “big bath”), as indicating low earnings quality, but
Kanagaretnam, Krishnan, and Lobo (2010) regarded it as indicating high earnings quality. Our definition,
along with Myers et al. (2003) and many other studies, is consistent with a “big bath” being an indication of
low earnings quality. In 1998, the chairman of the SEC Arthur Levitt criticized some companies taking a
“big bath” to create “cookie jar reserves” so as to boost future earnings (Levitt, 1998). “Big bath” was under
close scrutiny at that time and was regarded as earnings management or low earnings quality in the accounting
literature.
In this paper, we follow Myers et al.’s (2003) study and a large volume of other studies and regard
earnings that are less extreme (less extremely positive or less extremely negative) as being of high quality,
because “big bath” and “cookie jar reserves” also represent earnings management just like upward managing
earnings (Levitt, 1998). As noted earlier, we use earnings quality and audit quality interchangeably, because
high earnings quality reflects high audit quality.
Regression Model
We use the following regression model to examine our two research questions: (1) the relation between
audit quality and an auditor’s market share-based proxy for industry expertise; and (2) whether such a relation
is weakened by mandatory audit partner rotation:
Audit Quality = b0 + b1Expert Both + b2 Expert Firm-Only + b3 Expert Partner -Only

+b4 PT + b5 FT + b6 Listed + b7 Big 4 + ΣCVs + u
(2)
where Audit Quality is our proxy for audit quality, which takes the value of |AbnLLP|, AbnLLP+, and AbnLLP−,
respectively. Following Chin and Chi (2009), ExpertBoth is set to be one if both the audit firm and at least one
audit partner are leaders in the banking industry in terms of market share (the first and the second largest market
share in terms of number of clients), and zero if otherwise. ExpertFirm-Only is set to be one if only the audit firm is
9
Earnings quality and audit quality are often used interchangeably in the auditing literature, because earnings quality is jointly
determined by management and auditors. High-quality earnings reflect high audit quality.
10
Extremely positive AbnLLP+ makes reported earnings extremely negative, representing “big bath” and “cookie jar reserves” to
boost future earnings. On the other hand, extremely negative AbnLLP− makes reported earnings extremely positive.
a leader in the banking industry in terms of market share while neither of the audit partners is a leader, and zero
if otherwise. ExpertPartner-Only is set to be one if at least one audit partner is a leader in the banking industry in
terms of market share, while the audit firm is not a leader, and zero if otherwise. PT is audit partner tenure for the
partner with longer tenure, where each partner’s tenure is the number of consecutive years the client has retained
the audit partner (Chen, C. J. Lin, & Y. C. Lin, 2008). FT is audit firm tenure, which is equal to the number of
consecutive years that the client has retained the audit firm. We include PT and FT in Equation (2), because Chen
et al. (2008) showed that the two variables affect discretionary accruals (or AbnLLP in this study). Listed is a
dummy variable to indicate a listed bank. Big 4 is a dummy for a Big 4 audit firm after 2001 (Deloite & Touche,
Ernst & Young, KPMG, and PwC) or a Big 5 audit firm before 2002 (Arthur Andersen, Deloite & Touche,
Ernst & Young, KPMG, and PwC). We control for Listed (Big 4) in Equation (2), because AbnLLP between
listed banks and non-listed banks (between Big 4 auditors and non-Big 4 auditors) may differ.
Our variables of primary interest in Equation (2) are ExpertBoth, ExpertFirm-Only, and ExpertPartner-Only. As
explained earlier, we regard less extreme earnings as indicating high audit quality. Consequently, when
Audit Quality is equal to |AbnLLP| or AbnLLP+, a negative coefficient on ExpertBoth (b1 < 0), a negative
coefficient on ExpertFirm-Only (b2 < 0), or a negative coefficient on ExpertPartner-Only (b3 < 0) indicate high audit
quality, because auditors constrain managers’ extremely negative earnings management (e.g., “big bath”). On
the other hand, when Audit Quality is equal to AbnLLP−, a positive coefficient on ExpertBoth (b1 > 0), a positive
coefficient on ExpertFirm-Only (b2 > 0), or a positive coefficient on ExpertPartner-Only (b3 > 0) indicate high audit
quality, because auditors constrain managers’ extremely positive earnings management.
We also include several control variables (CV) in Equation (2): the natural log of total assets (Size)11, the
percentage of net interest revenue growth (Growth), the prior year’s LLP (LagLLP), earnings before
extraordinary items and LLP (EBEL), whether a bank reports a loss or not (Loss), capital adequacy ratio
(CADQR), and dummies of years. Size is to control for the size effect on AbnLLP (Lawrence, Minutti-Meza, &
Zhang, 2011). Growth is included, because growing banks have a greater level of extreme accruals or LLP in
this paper (Ghosh & Moon, 2005). LagLLP is added to control for the likely reversal of the previous year’s
abnormal accruals in the current year (Lim & Tan, 2008). Finally, to consider the effect on LLP of bank
performance and capital regulations, EBEL, Loss, and CADQR are also included as explanatory variables in
Equation (2) as in Kanagaretnam, Krishnan, and Lobo (2010). The appendix provides detailed definitions of all
variables.
Following Gow, Ormazabal, and Taylor (2010), we report test statistics based on the two-way
cluster-robust standard errors (cluster by firm and by year) which adjust for both cross-sectional and time-series
dependence in panel data.
Sample Selection
We obtain data from the Taiwan Economic Journal (TEJ)’s financial institution database. Our sample period
is from 2001 to 2009. Since information on LLP becomes publicly available in Taiwan in 2000, a 2001 starting
point allows this study to have lag value of LLP (LagLLP). We divide the sample period into the voluntary audit
partner rotation regime (2001-2003) and the mandatory audit partner rotation regime (2004-2009). Mandatory
11
Kanagaretnam, Krishnan, and Lobo (2010) used the natural log of market value of common equity. Since this study includes
non-listed banks, which do not have stock prices, the natural log of total assets is used.
audit partner rotation became effective in 2004, with 2003 being a transition year12. We include 2003 in the
voluntary rotation regime after deleting four observations where audit partners are mandatorily rotated13 .
Dividing the sample period into the voluntary and mandatory partner rotation regimes allows us to examine
whether the relation between audit quality and auditor industry expertise (as proxied by an auditor’s
within-industry market share) is affected by mandatory audit partner rotation.
Panel A in Table 1 reports the sample selection in the voluntary audit partner rotation regime. The last
column shows 102 company-year observations in the preliminary sample (70 listed banks and 32 non-listed
banks)14. We eliminate the four observations of listed banks where audit partners are subjected to mandatory
rotation in 2003, the transition year, and 15 (six listed and nine non-listed banks) observations because required
variables are missing. This leaves a final sample with 83 company-year observations in the voluntary rotation
regime, among which 60 observations involve listed banks and 23 observations involve non-listed banks.
Similarly, Panel B summarizes the final sample of 177 company-year observations in the mandatory audit
partner rotation regime, among which 75 (102) observations are listed (non-listed) banks.
Table 1
Sample Selection
Panel A: Voluntary audit partner rotation regime (2001-2003)
Year Listed Non-listed Total
No. of observations 2001 29 5 34
2002 25 9 34
2003 16 18 34
Preliminary sample 70 32 102
Less:
Audit partner mandatory rotation* (4) (4)
Missing variables (6) (9) (15)
Final sample 60 23 83
Panel B: Mandatory audit partner rotation regime (2004-2009)
Year Listed Non-listed Total
No. of observations 2004 16 18 34
2005 16 19 35
2006 16 19 35
2007 12 19 31
2008 11 21 32
2009 11 21 32
Preliminary sample 82 117 199
Less missing variables (7) (15) (22)
Final sample 75 102 177
Note. * This study includes 2003, a transition year for mandatory audit partner rotation, in the voluntary audit partner rotation
regime after deleting four observations where audit partners are mandatorily rotated in 2003.
12
Since 2003, the two stock exchanges in Taiwan (the TWSE and the GTSM) have required a 5-year mandatory partner rotation
(applied retroactively). However, the Taiwanese Accountants Union argued that it would be difficult for audit firms, especially
small audit firms, to rotate two partners in the same year. In response to this and other concerns, both stock exchanges postponed
the full implementation of the 5-year rule for both audit partners to 2004, with 2003 (annual audits) as a transition period when
audit firms were allowed to have one partner, but not both, auditing the same client for five or more years.
13
As explained above, 2003 was a transition year for mandatory partner rotation. We include 2003 in the voluntary audit partner
rotation regime after deleting four observations where audit partners are subjected to mandatory rotation (see Panel A in Table 1).
We cannot afford deleting 2003, because doing so would leave us only two years in the voluntary audit partner rotation regime.
14
We use banks, companies, and clients interchangeably in this paper.
Since there are three signatures in an audit report, one representing the audit firm (F) and the other two
representing audit partners (P), there are six possible combinations of auditor industry expertise: (1) All three
are experts (FPP); (2) The audit firm is an expert but only one of the audit partners is an expert (FP); (3) The
audit firm is an expert while neither of the audit partners is expert (F); (4) Both audit partners are experts but
their audit firm is not (PP); (5) Only one of the audit partners is an expert (P); and (6) None of them is an
expert (None). Table 2 shows the distribution of auditor industry expertise for the final sample in the voluntary
partner rotation regime across these six categories. Panel A in Table 2 reports that among 83 observations in
the final sample, there are zero observation in FPP, 23 observations in FP, 10 observations in F, six
observations in PP, two observations in P, and 42 observations in None. Panel B (C) in Table 2 reports a
similar distribution for listed (non-listed) banks. To make each category more descriptive, we name FP as
“Both” (corresponding to ExpertBoth = 1), F as “Firm-Only” (corresponding to ExpertFirm-Only = 1), PP and P
combined as “Partner-Only” (corresponding to ExpertPartner-Only = 1), and None as “None” (corresponding to
ExpertBoth = 0, ExpertFirm-Only = 0, and ExpertPartner-Only = 0). We do not provide a descriptive name for FPP,
because there is no observation in that category. Panel D in Table 2 shows the distribution among the above
five categories.
Table 2
Distribution of Auditor Industry Expertise in the Voluntary Audit Partner Rotation Regime
Panel A: Final sample
FPP FP F PP P None
No. 0 23 10 6 2 42
% (0.00) (27.71) (12.05) (7.23) (2.41) (50.60)
Panel B: Listed banks in the final sample
FPP FP F PP P None
No. 0 16 7 6 0 31
% (0.00) (26.67) (11.67) (10.00) (0.00) (51.67)
Panel C: Non-listed banks in the final sample
FPP FP F PP P None
No. 0 7 3 0 2 11
% (0.00) (30.43) (13.04) (0.00) (8.70) (47.83)
Panel D: Classification for Both, Firm-Only, Partner-Only, and None in Table 4
FPP FP F PP P None
Not applicable Both Firm-Only Partner-Only None
No. 0 23 10 8 42
Notes. Since there are three signatures in an audit report, one representing the audit firm (F) and the other two representing audit
partners (P), there are six possible combinations of auditor industry expertise: (1) All three are experts (FPP); (2) The audit firm is
an expert but only one of the audit partners is an expert (FP); (3) The audit firm is an expert while neither of the audit partners is
expert (F); (4) Both audit partners are experts but their audit firm is not (PP); (5) Only one of audit partners is an expert (P); and
(6) None of them is an expert (None). Panel D links Table 2 to Table 4. Both correspond to ExpertBoth = 1; Firm-Only corresponds
to ExpertFirm-Only = 1; Partner-Only corresponds to ExpertPartner-Only = 1; and None corresponds to ExpertBoth = 0, ExpertFirm-Only = 0,
and ExpertPartner-Only = 0.
Table 3 provides similar distributions of auditor industry expertise for the final sample in the mandatory
partner rotation regime.
Table 3
Distribution of Auditor Industry Expertise in the Mandatory Audit Partner Rotation Regime
Panel A: Final sample
FPP FP F PP P None
No. 0 29 46 0 14 88
% (0.00) (16.38) (25.99) (0.00) (7.91) (49.72)
Panel B: Listed banks in the final sample
FPP FP F PP P None
No. 0 14 23 0 4 34
% (0.00) (18.67) (30.67) (0.00) (5.33) (45.33)
Panel C: Non-listed banks in the final sample
FPP FP F PP P None
No. 0 15 23 0 10 54
% (0.00) (14.71) (22.55) (0.00) (9.80) (52.94)
Panel D: Classification for Both, Firm-Only, Partner-Only, and None in Table 4
FPP FP F PP P None
Not applicable Both Firm-Only Partner-Only None
No. 0 29 46 14 88
Notes. Since there are three signatures in an audit report, one representing the audit firm (F) and the other two representing audit
partners (P), there are six possible combinations of auditor industry expertise: (1) All three are experts (FPP); (2) The audit firm is
an expert but only one of the audit partners is an expert (FP); (3) The audit firm is an expert while neither of the audit partners is
expert (F); (4) Both audit partners are experts but their audit firm is not (PP); (5) Only one of audit partners is an expert (P); and
(6) None of them is an expert (None). Panel D links Table 3 to Table 4. Both correspond to ExpertBoth = 1; Firm-Only corresponds
to ExpertFirm-Only = 1; Partner-Only corresponds to ExpertPartner-Only = 1; and None corresponds to ExpertBoth = 0, ExpertFirm-Only = 0,
and ExpertPartner-Only = 0.
Empirical Results
Univariate Analysis
Panel A in Table 4 reports descriptive statistics for the sample in the voluntary audit partner rotation
regime. First, the mean and median |AbnLLP| for banks audited by auditors who are industry experts at both the
audit firm and audit partner levels (Both or ExpertBoth = 1) are 0.003 and 0.002 respectively. On the other hand,
the mean and median |AbnLLP| for banks audited by auditors who are not industry experts at either the audit
firm level or the audit partner level (None or ExpertBoth = 0, ExpertFirm-Only = 0, and ExpertPartner-Only = 0) are
0.006 and 0.004 respectively, larger than their counterparts in Both column. The difference in the mean
|AbnLLP| between Both and None columns is significantly negative at the level of 0.05. The difference in the
median |AbnLLP| between Both and None columns is also significantly negative at the level of 0.05. These
results suggest that auditors who are experts at both the firm and partner levels provide higher audit quality by
constraining extreme earnings than do auditors who are not experts. Second, the difference in mean (median)
AbnLLP+ between Both and None columns is significantly negative at the level of 0.1. However, neither the
difference in mean AbnLLP− nor that in median AbnLLP− between Both and None columns is significant. Third,
none of the differences in mean or median abnormal loan provision (|AbnLLP|, AbnLLP+, or AbnLLP−) between
Firm-Only and None columns is significant; none of the differences in mean or median abnormal loan
provision (|AbnLLP|, AbnLLP+, or AbnLLP−) between Partner-Only and None columns is significant. These
results suggest that only auditors who are experts at both the firm and the partner levels can enhance audit
quality. Finally, for many of the remaining variables, the difference in means or medians between Both and
None, between Firm-Only and None, or between Partner-Only and None columns is significant. For example,
the mean and median FT for Both column are both significantly larger than their respective counterparts in
None column.
Table 4
Basic Statistics
Panel A: Voluntary audit partner rotation regime
(1) (2) (3) (4) (5) (6) (7)
Variable Both Firm-Only Partner-Only None Both-None Firm-Only-None Partner-Only-None
Mean Median Mean Median Mean Median Mean Median Mean Median Mean Median Mean Median
|AbnLLP| 0.003 0.002 0.004 0.004 0.005 0.004 0.006 0.004 -0.003** -0.002** -0.002 0.000 -0.001 0.000
AbnLLP+ 0.003 0.002 0.005 0.005 0.007 0.007 0.006 0.004 -0.003* -0.002* -0.001 0.001 0.001 0.003
AbnLLP- -0.004 -0.003 -0.002 -0.002 -0.005 -0.004 -0.006 -0.004 0.002 0.001 0.004 0.002 0.001 0.000
PT 7.826 7.000 7.600 8.500 5.375 4.000 7.429 5.000 0.397 2.000 0.171 3.500 -2.054 -1.000
FT 11.783 11.000 11.000 12.000 5.375 4.000 8.000 6.500 3.783** 4.500*** 3.000 5.500* -2.625 -2.500
Listed 0.696 1.000 0.700 1.000 0.750 1.000 0.738 1.000 -0.042 0.000 -0.038 0.000 0.012 0.000
Big 4 1.000 1.000 1.000 1.000 1.000 1.000 0.738 1.000 0.262*** 0.000*** 0.262*** 0.000*** 0.262*** 0.000***
Size 19.670 19.202 19.211 19.145 20.073 20.078 19.326 19.155 0.344 0.047 -0.115 -0.010 0.747* 0.923**
Growth -0.102 -0.050 -0.001 -0.028 -0.112 -0.098 -0.119 -0.130 0.017 0.080 0.118** 0.102** 0.007 0.032
Loss 0.217 0.000 0.200 0.000 0.375 0.000 0.405 0.000 -0.188 0.000 -0.205 0.000 -0.030 0.000
EBEL 0.014 0.012 0.014 0.017 0.012 0.012 0.009 0.009 0.005* 0.003** 0.005* 0.008* 0.003 0.003
LagLLP 0.012 0.009 0.020 0.014 0.011 0.008 0.014 0.011 -0.002 -0.002 0.006 0.003* -0.003 -0.003
CADQR 13.920 11.010 9.896 9.600 9.476 9.435 9.830 10.310 4.09*** 0.700* 0.066 -0.710 -0.354 -0.875
Panel B: Mandatory audit partner rotation regime
(1) (2) (3) (4) (5) (6) (7)
Variable Both Firm-Only Partner-Only None Both-None Firm-Only-None Partner-Only-None
Mean Median Mean Median Mean Median Mean Median Mean Median Mean Median Mean Median
|AbnLLP| 0.002 0.002 0.003 0.001 0.003 0.002 0.002 0.001 0.000 0.001 0.001 0.000 0.001 0.001
AbnLLP+ 0.002 0.001 0.003 0.002 0.004 0.002 0.002 0.001 0.000 0.000 0.001 0.001 0.002 0.001
AbnLLP- -0.002 -0.002 -0.002 -0.001 -0.002 -0.002 -0.002 -0.001 0.000 -0.001 0.000 0.000 0.000 -0.001
PT 5.034 4.000 3.239 3.000 4.429 4.000 4.432 3.000 0.602 1.000 -1.193 0.000 -0.003 1.000
FT 15.000 15.000 12.609 14.000 11.214 11.500 8.989 6.500 6.011*** 8.500*** 3.620*** 7.500*** 2.225 5.000*
Listed 0.483 0.000 0.500 0.500 0.286 0.000 0.386 0.000 0.097 0.000 0.114 0.500 -0.100 0.000
Big 4 1.000 1.000 1.000 1.000 1.000 1.000 0.909 1.000 0.091** 0.000** 0.091** 0.000** 0.091** 0.000**
Size 20.311 20.528 20.023 19.683 20.523 20.775 19.804 19.483 0.507** 1.045** 0.219 0.200 0.719** 1.292**
Growth 0.039 0.037 -0.020 0.009 0.015 0.017 0.015 0.004 0.024 0.033 -0.035 0.005 0.000 0.013
Loss 0.241 0.000 0.370 0.000 0.357 0.000 0.352 0.000 -0.111 0.000 0.018 0.000 0.005 0.000
EBEL 0.011 0.008 0.008 0.008 0.003 0.004 0.006 0.006 0.005** 0.002 0.002 0.002 -0.003 -0.002*
LagLLP 0.006 0.005 0.012 0.007 0.008 0.006 0.008 0.005 -0.002 0.000 0.004** 0.002* 0.000 0.001
CADQR 12.913 11.030 11.454 10.355 10.626 10.440 10.602 10.805 2.311** 0.225* 0.852 -0.450 0.024 -0.365
Notes. ***, **, and * denote the 1%, 5%, and 10% significance levels in a test of difference in means (medians) between two
sub-samples using a two-tailed t-test (Wilcoxon rank sum z-test). See Appendix for variable definitions and Panel D in Tables 2
and 3 for classification of Both, Firm-Only, Partner-Only, and None.
Panel B in Table 4 presents descriptive statistics for the sample in the mandatory audit partner rotation
regime. Among nine differences in mean and median AbnLLP (|AbnLLP|, AbnLLP+, or AbnLLP−) between Both
and None, between Firm-Only and None, and between Partner-Only and None columns, respectively, none is
significant. This suggests that there is no association between audit quality (proxied by |AbnLLP|, AbnLLP+, or
AbnLLP−) and auditor industry expertise (proxied by ExpertBoth, ExpertFirm-Only, and ExpertPartner-Only) in the
mandatory audit partner rotation regime, consistent with our argument that mandatory partner rotation makes
an auditor’s within-industry market share (i.e., ExpertBoth, ExpertFirm-Only, and ExpertPartner-Only) a unreliable
proxy for industry expertise.
Regression Results
Table 5 shows the regression results from estimating Equation (2) using the sample in the voluntary audit
partner rotation regime. As shown, the coefficient on ExpertBoth is significantly negative (-0.0026, p < 0.05)
when the dependent variable is |AbnLLP|. In addition, the coefficient on ExpertBoth is also significantly negative
(-0.0028, p < 0.01) when the dependent variable is AbnLLP+. On the other hand, the coefficient on ExpertBoth is
significantly positive (0.0037, p < 0.10) when the dependent variable is AbnLLP−. These results suggest that
auditors who are industry experts at both the firm and partner levels constrain managers’ extremely positive and
extremely negative AbnLLP and thus provide high-quality audits. However, none of the coefficients on
ExpertFirm-Only and on ExpertAuditor-Only is significant. Therefore, in the voluntary partner rotation regime, only
auditors who are industry experts at both the firm and partner levels enhance audit quality. This is consistent
with the univariate evidence in Table 4.
Table 5
Regression Results in the Voluntary Audit Partner Rotation Regime
|AbnLLP| AbnLLP+ AbnLLP−
Variable
Coeff. p-value Coeff. p-value Coeff. p-value
Intercept 0.0062 0.364 0.0153 0.193 0.0054 0.813
ExpertBoth -0.0026** 0.016 -0.0028*** 0.000 0.0037* 0.087
Firm-Only
Expert -0.0024 0.142 -0.0015 0.235 0.0049 0.115
ExpertAuditor-Only 0.0010 0.541 -0.0011 0.539 -0.0003 0.910
***
PT -0.0001 0.308 -0.0001 0.781 0.0002 0.006
FT 0.0002 0.164 0.0001 0.516 -0.0004* 0.075
Listed 0.0000 0.973 0.0004 0.889 0.0003 0.840
Big 4 -0.0023 0.173 -0.0024 0.137 0.0010 0.572
Size 0.0001 0.820 -0.0003 0.683 -0.0006 0.537
Growth 0.0174** 0.028 0.0154** 0.033 -0.0192** 0.025
Loss 0.0008 0.294 0.0036 0.240 0.0011 0.342
EBEL -0.2067** 0.014 -0.1798*** 0.002 0.2495 0.265
LagLLP 0.0651 0.209 0.0643 0.495 -0.0843 0.516
CADQR 0.0001*** 0.001 0.0001 0.705 -0.0003 0.228
2
Adj. R 0.3438 0.4328 0.1924
F-statistics 3.1194*** 0.001 4.2143*** 0.001 1.3228 0.258
No. of observations 83 41 42
Notes. ***, **, and * denote the 1%, 5%, and 10% significance levels for regression coefficients based on two-tailed t-statistics
calculated using the two-way clustered standard errors (Gow et al., 2010). See Appendix for variable definitions.
We now discuss the coefficients on the remaining variables in Table 5. First, the coefficient on PT is
significantly positive when the dependent variable is AbnLLP−, suggesting that audit partners with longer
tenure constrain extremely negative AbnLLP− (or extremely positive reported earnings). This is consistent with
the finding of Chen et al. (2008) that audit partners with longer tenure provide higher-quality audits. However,
the coefficients on PT are both insignificant when the dependent variable is |AbnLLP| or AbnLLP+. Thus, our
evidence that partners with longer tenure provide higher-quality audits is very weak. Second, among three
coefficients on FT, the only significant one is -0.0004 (p = 0.075) when the dependent variable is AbnLLP−, but
the sign of the coefficient is in the wrong direction. That is, this significantly negative coefficient suggests that
audit firms with longer tenure allow, instead of constraining, managers’ extremely negative AbnLLP− (or
extremely positive reported earnings). Thus, unlike Chen et al. (2008), we do not find that audit firms with
longer tenure provide higher-quality audits in the banking industry. Third, while Beatty, Ke, and Petroni (2002)
found that private banks have better earnings quality, we find no difference in earnings quality between public
(or listed) banks and private (or non-listed) banks. We do not find a Big 4 effect or a size effect. Fourth, we find
that the coefficients on Growth are significantly positive when the dependent variable is |AbnLLP| (0.0174,
p < 0.05) or when the dependent variable is AbnLLP+ (0.0154, p < 0.05). In contrast, the coefficient on Growth
is significantly negative when the dependent variable is AbnLLP− (-0.0192, p < 0.05). These results suggest that
banks with higher growth tend to have more extremely positive or more extremely negatively AbnLLP (or more
extreme reported earnings), consistent with Chen et al. (2008). Finally, the coefficients on EBEL are
significantly negative when the dependent variable is |AbnLLP| (-0.2067, p < 0.05) or when the dependent
variable is AbnLLP+ (-0.1798, p < 0.01), suggesting that banks with better operating performance tend to have
less extremely positive AbnLLP. However, banks with higher CADQR tend to have more extreme |AbnLLP|
(0.0001, p < 0.01).
Taken together, the above results suggest a significantly positive association between audit quality and
auditor industry expertise (as measured by ExpertBoth) in the voluntary audit partner rotation regime.
Table 6
Regression Results in the Mandatory Audit Partner Rotation Regime
|AbnLLP| AbnLLP+ AbnLLP−
Variable
Coeff. p-value Coeff. p-value Coeff. p-value
Intercept -0.0014 0.471 0.0060 0.197 0.0020 0.631
ExpertBoth 0.0001 0.910 0.0015 0.162 -0.0001 0.869
ExpertFirm-Only 0.0007 0.368 0.0018 0.105 -0.0004 0.423
ExpertAuditor-Only 0.0012 0.318 0.0034 0.377 -0.0004 0.367
PT 0.0000*** 0.002 -0.0001** 0.021 -0.0001*** 0.000
FT 0.0000 0.526 -0.0001** 0.039 0.0000 0.598
Listed 0.0002 0.780 -0.0012 0.334 -0.0012*** 0.001
Big 4 -0.0001 0.959 0.0001 0.935 -0.0001 0.872
Size 0.0001 0.374 -0.0003 0.385 -0.0001 0.690
**
Growth 0.0002 0.815 -0.0011 0.018 -0.0006 0.742
Loss 0.0023* 0.049 0.0043*** 0.003 -0.0008 0.371
EBEL 0.0653** 0.014 0.0973*** 0.008 -0.0366** 0.016
LagLLP 0.0025 0.930 -0.0769 0.264 -0.0468 0.136
CADQR 0.0000 0.347 0.0001 0.529 0.0000 0.854
Adj. R2 0.1482 0.2488 0.1312
F-statistics 1.7076** 0.043 2.5456*** 0.004 3.0751*** 0.000
No. of observations 177 78 99
Notes. ***, **, and * denote the 1%, 5%, and 10% significance levels for regression coefficients based on two-tailed t-statistics
calculated using the two-way clustered standard errors (Gow et al., 2010). See Appendix for variable definitions.
Table 6 reports the regression results from estimating Equation (2) using the sample in the mandatory
audit partner rotation regime. As shown, none of the coefficient on ExpertBoth, ExpertFirm-Only, or ExpertPartner-Only
is significant. These results are in contrast to their counterparts in Table 5 under the voluntary audit partner
rotation regime. A positive relation between audit quality and auditor industry expertise (ExpertBoth) that exists
in the voluntary rotation regime is lost in the mandatory rotation regime. We interpret this finding as supporting
our argument that mandatory audit partner rotation decouples the link between an auditor’s within-industry
market share and auditor industry expertise. That is, mandatory audit partner rotation artificially increases or
decreases an auditor’s within-industry market share and makes it a noisy proxy for auditor industry expertise.
We caution researchers against using an auditor’s within-industry market share as a proxy for auditor industry
expertise in the mandatory audit partner rotation regime.
Additional Analysis
The macro-economic environments in the voluntary audit partner rotation regime (2001-2003) and the
mandatory rotation regime (2004-2009) are different. In particular, the mandatory rotation period includes the
years 2008 and 2009 when the financial crisis hurts the performance of banks. To test whether our finding of no
relation between audit quality and an auditor’s within-industry market share in the mandatory audit partner
rotation is due to the financial crisis, we delete the years 2008 and 2009 and re-run Table 6. Our untabulated
results show that the findings in Table 6 are qualitatively unchanged.
Conclusions
Using data in the banking industry in Taiwan, we find that audit quality is positively related to auditor
industry expertise proxied by the auditor’s within-industry market share in the voluntary audit partner rotation
regime. Such a positive relation, however, disappears in the mandatory partner rotation regime. Our findings
suggest that mandatory audit partner rotation decouples the link between an auditor’s within-industry market
share and auditor industry expertise. This is due to the fact that, in the voluntary audit partner rotation regime,
an audit partner’s market share in an industry is determined by the free choice of the market—expert partners
are more likely to attract clients than non-expert partners. Consequently, an audit partner’s market share
naturally reflects his industry expertise. Mandatory audit partner rotation, however, disrupts the free choice of
the market and thus makes an auditor’s within-industry market share a noisy proxy for auditor industry
expertise. We thus caution researchers against using the auditor’s within-industry market share as a proxy for
auditor industry expertise.
We mention two caveats in interpreting our findings. First, we obtain our results using the banking
industry data in Taiwan. The litigation risk that auditors face in Taiwan is relatively low. Whether our findings
generalize to other countries and regions is uncertain. Second, we deem extremely negative earnings
(“big bath”) as low earnings quality and low audit quality following Myers et al. (2003). In contrast,
Kanagaretnam, Krishnan, and Lobo (2010) deemed extremely negative earnings as high-quality earnings. We
encourage future studies to use different data and alternative proxies for audit quality to examine whether
mandatory audit partner rotation makes an auditor’s within-industry market share a noisy proxy for auditor
industry expertise.
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research. The Accounting Review, 85(2), 483-512.
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auditor reputation? Journal of Banking and Finance, 33(6), 1039-1047.
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The Accounting Review, 85(6), 2011-2046.
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banking industry. Journal of Banking and Finance, 34(10), 2318-2327.
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auditor switches. Auditing: A Journal of Practice and Theory, 26(1), 19-45.
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Appendix: Variable Definition
Variable Definition
LLPt Loan loss provisions.
LLAt-1 Beginning-of-the-year loan loss allowance.
NPLt-1 Beginning-of-the-year non-performing loans.
ΔNPLt Change in non-performing loans.
LCOt Net loan charge-offs.
ΔLoant Change in total loans.
Loant Total loans outstanding.
LLPt = α 0 + α1 LLAt −1 + α 2 NPLt −1 + α 3 ΔNPLt + α 4 LCOt + α 5 ΔLoant + α 6 Loant + ε t

AbnLLP = residuals from the yearly estimation of Equation (1) below:
AbnLLP
Audit quality based on AbnLLP = |AbnLLP| (absolute value of AbnLLP), AbnLLP+ (positive value of
AbnLLP), and AbnLLP− (negative value of AbnLLP), respectively.
Audit Quality
One if both the audit firm and at least one audit partner are leaders in the banking industry in terms of
ExpertBoth market share (the first and the second largest market share in terms of number of clients), and zero if
otherwise.
One if only the audit firm is a leader in the banking industry in terms of market share while neither of the
ExpertFirm-Only
audit partners is a leader, and zero if otherwise.
One if at least one audit partner is a leader in the banking industry in terms of market share while the audit
ExpertPartner-Only
firm is not a leader, and zero if otherwise.
Audit partner tenure for the partner with longer tenure, where each partner’s tenure is the number of
PT
consecutive years the client has retained the audit partner.
Audit firm tenure, which is equal to the number of consecutive years that the client has retained the audit
FT
firm.
Listed One if the client company is a listed bank, and zero if otherwise.
One if the audit firm is a Big 4 auditor after 2001 (Deloite & Touche, Ernst & Young, KPMG, and PwC)
Big 4 or a Big 5 auditor before 2002 (Arthur Andersen, Deloite & Touche, Ernst & Young, KPMG, and PwC),
and zero if otherwise.
Size Natural log of total assets.
Growth Percentage of net interest revenue growth.
Loss One if the client company reports a loss, and zero if otherwise.
LagLLP Prior period’s LLP.
EBEL Earnings before extraordinary items and LLP.
CADQR Capital adequacy ratio reported in TEJ database.
January 2014, Vol. 10, No. 1, 97-103
D DAVID PUBLISHING
Monetary Model of Exchange Rate Determination: Evidence

From the Czech Republic, Hungary, and Poland∗
Victor Shevchuk
Cracow University of Technology, Cracow, Poland
Using a monetary model of exchange rate determination that suggests a strong link between the nominal exchange
rate and a set of monetary fundamentals, exchange rate dynamics for the Czech Republic, Hungary, and Poland is
studied. As the cointegration relationship among exchange rate, output, and the monetary fundamentals (money
supply and interest rate) is found, vector autoregressions (VAR)/vector error-correction (VEC) and two-stage least
squares (2SLS) error-correction models are used in this context, since both approaches allow estimating short-run
correlations between exchange rates and fundamentals while taking into account the existent long-run exchange
rate constraints. Based on the quarterly data for the period of 1998-2012, it is found that for all countries, an
increase in the money supply, domestic output slowdown, or stronger growth abroad are factors behind a nominal
exchange rate depreciation, just as predicted by the monetary model of exchange rate. However, the effects of
domestic-foreign interest rate differential are quite heterogeneous, being in line with theoretical predictions of a
standard monetary model for Poland only. According to the decomposition of variance, money supply and interest
rates account for 30%-46% of the exchange rate variation in the Czech Republic, from 10% to 14% in Hungary,
and from 23% to 42% in Poland.
Keywords: monetary model of exchange rate, the Czech Republic, Hungary, Poland, error-correction models
Introduction
Main implication of the monetary model of exchange rate determination is that the nominal exchange rate is
determined by relative levels of money supply, output, and interest rate (Bilson, 1978; Frankel, 1983; Frenkel,
1976). Despite strength of its theoretical foundations, empirical evidence in favour of the monetary model had
not been overwhelming, especially in the 1980s and 1990s (Baillie & Peccenino, 1991; Rapach & Wohar, 2002).
Based on the study of fiscal and monetary models of exchange rates over the period of 1974-1993 for main
industrial countries, Chinn (1997) concluded that no model consistently and significantly outperforms a random
walk, with the fiscal models outperforming monetary models in out-of-sample forecasting exercises. However,
recently, there are numerous studies in favour of the monetary model, including the assumption of cointegration
between nominal exchange rates and monetary fundamentals (Basher & Westerlund, 2009; Cerra & Saxena,
2010; Civcir, 2003). Arguments in favour of the monetary model are found for the Central and East European
(CEE) countries as well (Crespo-Cuaresma, Fidrmuc, & MacDonald, 2003).
∗
Acknowledgements: This paper is part of the research project F-4/DS/143/12, and the financial support provided by the Cracow
University of Technology is gratefully acknowledged. JEL classification: E41; F31; F37. AMS classification: 62P20.
Victor Shevchuk, professor of Economics, Institute of Economy, Sociology, and Philosophy, Cracow University of Technology.
Email: [email protected].
98 MONETARY MODEL OF EXCHANGE RATE DETERMINATION
A main contribution of this paper is reconsideration of a standard monetary model of exchange rate
determination for the Czech Republic, Hungary, and Poland. In Section 2, theoretical arguments and empirical
evidence for the monetary model are discussed. Section 3 contains a description of data and statistical
methodology. Estimation results are presented in Section 4. Main findings are summarized in Section 5.
Theoretical Framework and Empirical Evidence for the Monetary Model to Exchange Rate
Determination
Regardless of the price specification1, the monetary model assumes a stable real money-demand function
in domestic and foreign countries (in logs):
mt − pt = α1 yt − β1it (1)
mt* − pt* = α1 yt* − β1it* (2)

* * * *
where mt and mt , pt and pt , yt and yt , and it and it are the domestic and foreign money supply,
price level, output, and nominal interest rate, respectively.
Assuming that the purchasing power parity (PPP) does hold:
et = pt − pt* (3)
rearrangement of Equations (1) and (2) for domestic and foreign price levels brings about a flexible-price
monetary model:
et = mt − mt* − α1 ( yt − yt* ) + β1 (it − it* ) + ε t (4)
where et is the nominal exchange rate (units of domestic currency per foreign currency).
Following Frenkel (1976), the nominal exchange rate is defined as:
et = mt − mt* − α1 ( yt − yt* ) + γ 1 (π te − π te* ) + ε t (5)
where π te and π te* are the expected domestic and foreign inflation rates, respectively.
As noticed by Hsing (2008), several well-known monetary models share the assumption of Equations (4)
and (5) for the money supply and relative output effects, but differ in respect to the effects of interest rate
differential. According to the Frankel model, an inverse relationship between the interest rate differential and a
nominal exchange rate is explained by the capital flows effects. Recent empirical studies are predominantly in
support of the monetary model. While Basher and Westerlund (2009) established that the monetary model
emerges for industrial countries only when the presence of structural breaks and cross-country dependence have
been taken into account, strong evidence for cointegration between nominal exchange rates and monetary
fundamentals is found by Cerra and Saxena (2010). With the use of the vector autoregression (VAR)/vector
error-correction model (VEC), empirical support for the monetary model is found for Mexico (Lorıa, Sanchez, &
Salgado, 2010) and Turkey (Civcir, 2003). Crespo-Cuaresma et al. (2003) showed that the monetary model,
augmented for the Balassa-Samuelson effect, provides a good description of nominal exchange rate trends in
1
Regarding different assumptions of the price setting, there are several versions of the monetary approach to exchange rate
determination: (1) the flexible-price monetary model; (2) the sticky-price monetary model; and (3) the sticky-price monetary
model augmented with relative price differential (Civcir, 2003).
MONETARY MODEL OF EXCHANGE RATE DETERMINATION 99
several CEE countries. For Poland, Hsing (2008) established that the monetary model can explain the behaviour
of the zloty/USD exchange rate reasonably well, with all the components of Model (4) having expected signs.
Data and Statistical Methodology

We used quarterly time series data for the Czech Republic, Hungary, and Poland for the period of
1998-2012, as provided by the online International Monetary Fund (IMF) International Financial Statistics.
The data consist of a nominal exchange rate vis-à-vis United States (US) dollar (Et), the money supply (Mt), the
real growth domestic product (GDP) (Yt), domestic interest rate on government bonds (It), and the 6-month
London Interbank Offered Rate (LIBOR) ( I t* ), as a proxy for foreign interest rate. As all the variables are I(1)
processes, it is possible to make use of the Johansen cointegration test to take into account short-run dynamics
of the exchange rate. As reported in Table 1, the Likelihood ratio (LR) statistic test on the nested hypotheses
H0(r): r = r0 vs. H1(r0): r > r0 implies the existence from r = 3 (Hungary, Poland) to r = 5 (the Czech Republic)
cointegrating vectors at 5% of confidence among Et, Mt, Yt, and It for all the three countries.
Table 1
Cointegration Tests for the Nominal Exchange Rate and Its Determinants
Lags LR(0) LR(1) LR(2) LR(3) LR(4) LR(5)
* * * * *
The Czech Republic 2 243.1 163.8 107.5 70.2 34.3 12.6**
* * * **
Hungary 2 138.3 91.4 51.9 26.1 5.9 0.4
Poland 2 150.8* 97.5* 49.6* 23.6*** 8.3 2.4
Notes. LR(r) denotes the likelihood ratio statistic for H0: r cointegrating vectors against H1: stationary VAR; * denotes rejection of
the hypothesis of H0 at the level of 1%, ** at the level of 5%, and *** at the level of 10%. Source: the author’s calculations.
Following the Engle-Granger two-step methodology (Engle & Granger, 1987), cointegration of the data
containing unit roots allows estimating the long-run relationship (in levels):
Et = α + β X t + ε t (6)
and then using the lagged residuals to estimate a short-run dynamics (in first differences):
ΔEt = δ 0 + δΔX t − γε t −1 + ξt (7)
where Xt is a vector of independent variables, and ε t and ξ t are stochastic factors.

As the Engle-Granger procedure cannot deal with cases of more than one cointegrating vector (see Table 1),
ΔX t = ∑ δ i ΔX t −i − γε t −1 + ξt
an alternative procedure of VAR/VEC can be used (Alogoskoufis & Smith, 1991):
(8)
where γ measures feedback coefficients, which allows estimating the instantaneous correlations (very short-run)
between exchange rates and fundamentals while taking into account the existent long-run exchange rate
equation in the estimation procedure.
Estimation Results
As implied by the Engle-Granger two-step methodology, the long- and short-run two-stage least squares
(2SLS) estimates of the exchange rate vis-à-vis US dollar are as follows (uppercase letters are for the levels,
and lowercase ones are for the first differences):
Et = 1.259 Et −1 − 0.667 Et − 2 − 0.355M t − 0.106Yt + 0.842Yt*

(1) The Czech Republic:
(8.35* ) (-3.87* ) (-1.78*** ) (-0.17) (1.73*** )

+ 0.305I t − 0.015 I t* ;
(9a)
(1.77*** ) (-0.88) R 2 = 0.94 ADF = -2.98**

et = 0.622mt − 3.219 yt + 1.099 yt*
(1.75*** ) (-4.72* ) (1.22)
− 0.597it + 0.097it* + 0.141ε t −1 ;
(9b)
(-1.62) (3.20* ) (0.831) R 2 = 0.35 ADF = -3.02*
Et = 1.174 Et −1 − 0.288 Et − 2 − 0.053M t − 0.249Yt + 0.525Yt *

(2) Hungary:
(9.70* ) (-2.58** ) (-0.97) (-1.17) (2.66** )

− 0.064 I t + 0.004 I t* ;
(10a)
(-1.68*** ) (0.76) R 2 = 0.92 ADF = -3.52**

et = -0.182et − 2 + 0.629mt − 2.502 yt + 1.463 yt*−1
(-1.72*** ) (2.37** ) (-2.73* ) (1.47)
− 0.104it + 0.057i + 0.251ε t −1 ;
(10b)
*
R 2 = 0.20 ADF = -3.84*

t
(-1.73*** ) (1.81*** ) (1.83*** )
Et = 0.669 Et −1 + 0.548M t − 1.768Yt + 0.306Yt *

(3) Poland:
(7.60* ) (3.02* ) (-3.56* ) (1.83** )

+ 0.033I t − 0.038 I t* + 0.077crisis;
(11a)
(1.43) (-3.01* ) (2.51** ) R 2 = 0.90 ADF = -3.08**

et = 0.931et −1 + 0.786mt − 2.233 yt + 1.494 yt*−1
(5.64* ) (2.90* ) (-3.47* ) (1.95*** )
+ 0.094it − 0.021it* − 1.061ε t −1 ,
(11b)
(1.34) (-0.74) (-2.87*** ) R 2 = 0.43 ADF = -3.64*

where the dummy crisis is included to capture the effects of the 2008-2009 financial crisis2.
For all countries, the positive short-run coefficient of the domestic money supply and the asymmetric
coefficients of the domestic and foreign output are as expected. However, the long-run coefficients on Mt and Yt
are consistent with the monetary model only for Poland. The coefficients on Mt have perverse negative values
2
The coefficient of determination R2 ranges from 0.90 to 0.94 for the estimates of long-run coefficients, and from 0.20 to 0.43 for
the estimates of short-run coefficients. The ADF test suggests stationarity of residuals at 5% statistical significance for all
regression equations. Domestic and foreign output, as well as interest rates, are separately included, assuming different income
and interest rate elasticities for industrial and CEE economies.
for the Czech Republic and Hungary, while the negative coefficients on Yt lack statistical significance. The
long-run coefficients on It are in accordance with the Frankel model for the Czech Republic and Hungary, while
the estimates for Poland support the Bilson model (see Equation (4)). The long-run effects of LIBOR are
consistent with the Bilson model for Poland, being neutral in respect to the nominal exchange rate for the
Czech Republic and Hungary. However, in the latter case, the short-run coefficients on rt* are in favour of the
Frankel model. The error-correction negative coefficient on εt-1 is statistically significant for Poland, but in two
other countries, it is small and positive. A dummy for the 2008-2009 financial crisis suggests the long-run
depreciation of the nominal exchange rate only in Poland.
To check out the robustness of our results, the VAR/VEC methodology is implemented. The VAR/VEC
system consists of six variables at a quarterly frequency, has two lags (a lag-length is chosen according to the
Akaike Information Criterion (AIC)), no constant or a time trend, dummy for control of the 2008-2009
financial crisis, and uses the logarithm for all variables (in levels). The impulse responses of the exchange rate
to the shocks and the estimated variance decompositions are presented in Figure 1 (the responses of other
variables are not reported). In response to the money supply shock, the exchange rate depreciates in all
countries (see Part (3) of Figure 1). Innovations to the money supply have a positive impact on the exchange
rate, and the responses start to increase over the 2-year horizon for the Czech Republic and Hungary. The
proportion of variance explained by the money supply shock ranges from 10% (Hungary) to 15% (Poland) and
20% (the Czech Republic).
(1) Foreign output:
0.018 100 Czech Republic
0.016 90
Hungary
0.014 80
Poland
0.012 70
0.01 60
0.008 50
0.006 40
0.004 30
0.002 20
0 10
-0.002 1 2 3 4 5 6 7 8 9 10 11 12 0
-0.004 1 2 3 4 5 6 7 8 9 10 11 12
(2) Domestic output:
0 100
1 2 3 4 5 6 7 8 9 10 11 12 90
-0.005
80
-0.01
70
-0.015 60
-0.02 50
40
-0.025
30
-0.03
20
-0.035 10
-0.04 0
-0.045 1 2 3 4 5 6 7 8 9 10 11 12
(3) Money supply:

0.035 100
90
0.03
80
0.025 70
0.02 60
50
0.015
40
0.01 30
20
0.005
10
0 0
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
(4) Foreign interest rate:

0.03 100 Czech Republic
0.025
90 Hungary
0.02
80 Poland
70
0.015
60
0.01
50
0.005 40
0 30
-0.005 1 2 3 4 5 6 7 8 9 10 11 12 20
-0.01 10
-0.015 0
-0.02 1 2 3 4 5 6 7 8 9 10 11 12
(5) Domestic interest rate:

0.02 100
90
0.015 80
70
0.01 60
50
0.005 40
30
0
20
1 2 3 4 5 6 7 8 9 10 11 12 10
-0.005
0
1 2 3 4 5 6 7 8 9 10 11 12
-0.01
Figure 1. Effects of VAR shocks on the exchange rate. Note: Impulse responses and variance decomposition are on the
left and right graphs, respectively. Source: the author’s calculations.
As predicted by the monetary model, the domestic output is the factor behind an exchange rate
appreciation (see Part (2) of Figure 1), while the opposite relationship does hold for the foreign output (see
Part (1) of Figure 1). Domestic output contributes as much as 40% to the variation in the exchange rate at
horizons longer than five quarters in the Czech Republic, while accounting for less than 6% of the variation in
the exchange rate in Hungary and Poland. Gradually, foreign output accounts for 15% of the exchange rate
variation in Poland, while its impact fades away from 11% in the first period to less than 3% at the 12-quarter
horizon in the Czech Republic. The proportion of foreign output in the variation of exchange rate is marginal in
Hungary.
Except Poland, the nominal exchange rate depreciates in response to a positive LIBOR shock (see Part (4)
of Figure 1). The same outcome does hold for a domestic interest rate shock, though with an inverse
relationship between It and Et on impact for Poland (see Part (5) of Figure 1). The LIBOR explains up to 18%
and 20% of the variation of exchange rate in the Czech Republic and Poland, respectively, but it is of much less
importance in Hungary. The combined effect of money supply and interest rates ranges at different time
horizons from 30% to 46% in the Czech Republic, from 10% to 14% in Hungary, and from 23% to 42% in
Poland. Domestic and foreign output account for 36%-47% of the variance of the exchange rate in the Czech
Republic, from 1% to 4% in Hungary, and from 1% to 20% in Poland.
Conclusions
In general, our empirical results of this study are in favour of the long- and short-run relationships among
the nominal exchange rate, money supply, and macro-economy, which are consistent with the monetary model
of exchange rate determination, as the increase in the money supply and negative growth differential are factors
behind the nominal exchange rate depreciation (combined evidence squares best with the monetary model
implications for Poland). A quite heterogeneous impact of the domestic and foreign interest rates could be
explained by country-specific effects of capital flows.
References
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506-513.
Bilson, J. (1978). Rational expectations and the exchange rate. In J. Frenkel, & H. Johnson (Eds.), The economics of exchange
rates (pp. 75-96). Cambridge: Addison-Wesley Press.
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81(2), 184-196.
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determination. Journal of Policy Modeling, 19(1), 51-78.
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Journal of Economics and Finance, 53(3-4), 113-129.
Crespo-Cuaresma, J., Fidrmuc, J., & MacDonald, R. (2003). The monetary approach to exchange rates: Panel data evidence for
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Engle, R., & Granger, C. (1987). Cointegration and error correction: Representation estimation and testing. Econometrica, 55(2),
251-276.
Frankel, J. (1983). Monetary and portfolio-balance models of exchange rate determination. In J. Bhandari, & B. Putnampp (Eds.),
Economic interdependence and flexible exchange rates (pp. 84-115). Cambridge: MIT Press.
Frenkel, J. A. (1976). A monetary approach to the exchange rate: Doctrinal aspects and empirical evidence. Scandinavian Journal
of Economics, 78(2), 200-224.
Hsing, Y. (2008). Application of monetary models of exchange rate determination for Poland. South East European Journal of
Economics and Business, 3(2), 19-24.
Lorıa, E., Sanchez, A., & Salgado, U. (2010). New evidence on the monetary approach of exchange rate determination in Mexico
1994-2007: A cointegrated SVAR model. Journal of International Money and Finance, 29(3), 540-554.
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January 2014, Vol. 10, No. 1, 104-115
D DAVID PUBLISHING
An Evaluation of the Effect of Credit Risk Management (CRM)

on the Profitability of Nigerian Banks
Junaidu Muhammad Kurawa

Bayero University, Kano, Nigeria
Sunusi Garba
Federal University Dutse, Jigawa, Nigeria
This paper assesses the effect of credit risk management (CRM) on the profitability of Nigerian banks with a view
to discovering the extent to which default rate (DR), cost per loan asset (CLA), and capital adequacy ratio (CAR)
influence return on asset (ROA) as a measure of banks’ profitability. Data were generated from secondary sources,
specifically, the annual reports and accounts of quoted banks from 2002 to 2011. Descriptive statistics, correlation,
as well as random-effect generalized least square (GLS) regression techniques were utilized as tools of analysis in
the study. The findings establish that CRM as measured by three independent variables has a significant positive
effect on the profitability of Nigerian banks as indicated by the coefficient of determinations “R2 value” which
shows the within and between values of 40.89% and 58.35% (which are impressive) while the overall R2 is 43.91%,
indicating that the variables considered in the model account for about 44% change in the dependent variable, that
is, profitability. The study recommends that banks’ management should be more scientific (application of risk
evaluation techniques) in their credit risk assessment and management of loan portfolios in order to minimize the
high incidence of non-performing loans and their negative effect on profitability.
Keywords: credit risk, default rate (DR), cost per asset, capital adequacy, return on asset (ROA)
Introduction
In the aftermaths of the global economic crisis, banks are under serious pressure to develop better credit risk
management (CRM) strategies, especially as the lack of powerful CRM is one of the factors that helped trigger
the recent financial crisis in Nigeria. And, with supervisory bodies looking for higher capital requirements and
liquidity protections, the cost of banking business is increasing globally. As stated by Njanike (2009), the major
reason of the banking crisis is a bad CRM system characterized by sophisticated insider loans, speculative loans,
and high concentration of credit in certain sectors among others. Thus, in the recent past, the inability of the
financial system to efficiently handle CRM in banking business triggered similar problems in countries such as
Mexico, Venezuela, and Zimbabwe.
Credit risk has remained one of the topical issues of current financial studies that had enjoyed special
attention from both scholars and professionals. In fact, this debate was more pronounced immediately after the
recent global economic crisis. A number of scholars concede that one of the key causes of severe banking
Junaidu Muhammad Kurawa, Ph.D., Department of Accounting, Bayero University. Email: [email protected].
Sunusi Garba, accountant, Bursary Department, Federal University Dutse.
THE EFFECT OF CRM ON THE PROFITABILITY OF NIGERIAN BANKS 105
trouble is motionless credit risk control, and since supply of credit is still the primary business of every bank,
credit quality is regarded as a major sign of financial dependability and healthiness of banks. The interests that
are charged on loans and advances form substantial component of banks’ assets, as such, non-repayment of
loans and advances, created serious hindrance not only for borrowers and lenders but also for the whole
financial system of a country. Studies of banking tragedies all over the world have exposed that poor loans
(asset quality) is the key cause of bank distresses (Boahene, Dasah, & Agyei, 2012).
Risk management is the individual effort which incorporates acknowledgment of risk, risk evaluation,
developing policies to control it, and lessening of risk by means of managerial resources (Appa, 1996),
whereas credit risk is the possibility of loss caused by debtor’s default of a loan or other earnings that relate to
credit (principal and/or interest). Default rate (DR) is the possibility that a borrower will fail to pay back
principal and interest in suitable and agreed terms and conditions. CRM is extremely essential to banks, as it is
an integral part of the loan process. It capitalizes on bank risk, adjusted risk rate of return
through safeguarding credit risk exposure with a view to defending the bank from the adverse effects of credit
defaults.
The Nigerian banking sector has been stressed with the dwindling value of its credit assets as a result of
the large plunge in stock market indicators, worldwide oil prices, and rapid drop of the value of Naira compared
with international currencies (Banc Garanti Limited (BGL) Research, 2010). The weak aspect of the banks’
loan assets held up banks to expand other credits to the local economy, in consequence, unfavorably distressing
financial performances were recorded in a number of instances. This pressed the Nigerian government to
establish the Asset Management Corporation of Nigeria (AMCON) in July 2010 to grant a durable resolution to
the persistent dilemma of non-performing loans bedeviling Nigerian banks.
In line with the position above, the debate on the relationship between CRM and profitability in finance
literature represents a topic of great importance to finance scholars and professionals, since the core activity of
every bank (key players in the money market) is credit financing. Again, to lend additional support to the
argument, the bank theory identifies six main types of risk which are linked with credit policies of banks and
these are: credit risk (risk of repayment), interest risk, portfolio risk, operating risk, credit deficiency risk, and
trade union risk. However, the most fundamental of these risks is the credit risk and for that reason, it is worthy
of special attention in financial management research.
This paper evaluates the effect of CRM on the profitability of Nigerian banks for a period of 10 years
(2002-2011). The study is encouraged by the current government policy of establishing AMCON as an
important element of distress resolution in Nigerian banks. The policy was expected to help existing banks to
turn around non-performing loans or classified assets on their balance sheets into viable or at least
recoverable investments. The study would be particularly relevant in the context of the ongoing debate
on how banks should minimize the incidence of increasing non-performing loans on their balance
sheets.
On the basis of the background, the study formulates the following hypothesis for testing:
Ho: CRM does not have any effect on the profitability of Nigerian banks.
The rest of this paper is outlined as follows: Section two reviews related literature on issues related to the
subject matter; section three talks about the methodology; section four centered on data analysis and
interpretation of findings; and section five concludes the paper and suggests recommendations.
106 THE EFFECT OF CRM ON THE PROFITABILITY OF NIGERIAN BANKS
Literature Review on CRM and Profitability

The Concept of CRM and Profitability
Banks raise finances through collecting deposits from businesses and other institutions, households, and
the government on the one hand and provide loans to households, businesses and other institutions, and the
government through several different types of arrangements. Therefore, the crucial assets of banks are loans
and bonds whilst major liabilities are customer deposits. In accordance with Cornett and Saunders (2005),
balance sheet of a bank has loans representing the bulk amount of a bank’s assets; nevertheless, these loans
come with risk. Where the bank makes bad loans to customers, the bank will be in serious problems if those
loans are not repaid. Credit management is therefore concerned with rewards and risks that have to be objective
through cautious and careful risk management, failure of which may possibly bring about legal action,
economic loss or harm the banks’ name (Reserve Bank of Zimbabwe (RBZ) Guideline No. 1, 2006; as citied in
Mavhiki, Mapetere, & Mhonde, 2012).
Bank credit is the borrowing facility made available to an individual by the bank in the form of a credit or
a loan. The fundamental expectation of the financial system is that when funds are loaned out, there should be
reasonable anticipation of refund of the loans, plus interest. Credit risk comes up from uncertainty in a given
counterparty to meet up with the obligation of honoring the terms and conditions of the credit arrangement
(Fatemi & Foolad, 2006). It is the risk of loss originated by a debtor’s failure to pay a loan or line of credit. In
essence, credit risk arises from uncertainty in counterparty’s ability or willingness to meet its contractual
obligations. Another scholar, Rene (2000) also included a decline in the credit standing of counterparty as part
of credit risk.
In the same vein, Naomi (2011) argued that credit risk represents the potential variation in the net income
from non-payment or delayed payment of credit facility granted to customers. The Global Risk Management
Group 1999 in its report conceded that credit risk is the possibility that bank borrower will fail to meet
obligation in accordance with the agreed terms. It added that, the effective management of credit risk is a
critical component of a comprehensive approach to risk management and essential to the long-term success of
any banking organization. Lending involves the creation and management of risk assets, and it is an important
task of bank management.
CRM covers both the decision-making process, before the credit decision is made, and the follow-up of
credit commitments, plus all monitoring and reporting processes (Miller, 1996). Risk is a condition in which
there exists a quantifiable dispersion in the possible outcomes from any activity (The Chartered Institute of
Management Accountants, 2005). In other words, it refers to the process by which all loans, advances, credit
facilities, or accommodation granted by a bank to a customer are administered to ensure that the facilities run
satisfactorily according to the terms governing them and are ultimately repaid on due date.
Modern risk management is the management procedure devised to eliminate or minimize the adverse
effects of possible financial loss by identifying all the potential sources of loss, measuring the financial
consequences of a loss occurring, and using controls to minimize actual losses or their financial consequences
(Irukwu, 1998). Accordingly, the most important topic in the business world today is the management and
control of risk. Every day, we learn about big-, small-, and medium-sized companies that have collapsed or
gone into liquidation, because their management ignored the risks to which the organization was exposed due
to the absence of an efficient risk management system.
The effective management of credit risk is a critical component of a comprehensive approach to risk
management and essential to the long-term success of any banking organization. A major function of
commercial banks is to deal in the credit market; they perform this function by mobilizing funds from surplus
economic units and channeling the same to deficit units for productive activities. This implies that, commercial
banks grant loans to customers from the public’s funds with the overall object of increasing profitability
resulting from earnings. Now, because profitability is a function of earnings resulting from viable loans and
advances, it follows that banks ought to effectively manage its credit risks in order to protect and enhance
profitability.
Review of Related Empirical Literature
Credit risk represents a measureable threat to the banks’ profitability; as a result, several researchers have
examined the impact of CRM on bank performance in different scopes. Ahmed, Takeda, and Shawn (1998)
employed multi-variant regression and found that loan loss provision has an important positive impact on
non-performing loans. So, a raise in loan loss provision implies an elevation in credit risk and decomposition in
the value of loans subsequently distressing bank performance negatively.
In another study, Ahmad and Ariff (2007) used regression analysis in their study to establish the most
important determinant of credit risk of commercial banks in emerging economies’ banking systems weighted
against the developed economies’ banking systems. It establishes that a rise in loan loss provision is as well
regarded as a major determinant of potential credit risk. They added that credit risk in emerging economies’
banks is greater than that in developed economies.
In an effort to study the impact of bank regulations, concentration, financial and institutional development
on commercial banks’ margin, and profitability in the Middle East and North Africa (MENA) nations from
1989 to 2005, using the unbalanced panel data regression, Ben-Naceur and Omran (2008) found that bank
capitalization and credit risk have considerable and positive influence on net interest margin, cost efficiency,
and profitability of banks.
Similarly, in an attempt to find the impact of effective CRM on bank survival, Njanike (2009) appraised
the degree to which failure to efficiently deal with credit risk leads to banks’ failure in Zimbabwe between 2003
and 2004. The study established that the failure to efficiently handle credit risk led to a higher-level
banking crisis. It recommended that banks should establish and implement credit scoring and evaluation
methodologies, review and revise the insider loans policies, and implement prudential corporate governance
practices.
In another study conducted in Kenya, Kithinji (2010) measured the effect of CRM on banks’ profitability
through the use of regression model. The study uses records on the total credit, level of non-performing loans,
and profits for the period of five years. It reveals that the accumulated profits of banks are not influenced by the
quantity of credit and non-performing loans. Hence, Kithinji (2010) proposed that other variables other than
credit and non-performing loans have greater effects on the profitability of banks.
Al-Khouri (2011) further evaluated the effect of bank’s specific risk characteristics and the overall banking
environment on the performance of 43 commercial banks operating in six of the Gulf Cooperation Council
(GCC) countries over the period of 10 years. The study adopt regression as an analysis tool, and its findings
prove that credit risk, liquidity risk, and capital risk are the key aspects that influence bank profitability in the
GCC countries.
In Nigeria, Kargi (2011) reviewed the impact of credit risk on the profitability of Nigerian banks, using
five years’ data for the period of 2004-2008. The study examines the relationship through the use of descriptive,
correlation, as well as regression model. He established that CRM has an important role in the profitability of
Nigerian banking sector. The study supports the claim that profitability of bank is negatively controlled by
loans and advances, non-performing loans, and deposits levels, thus exposing banks to huge risk of illiquidity
and distress.
In Costa-Rica, Epure and Lafuente (2012) applied regression analysis to study the presence of credit risk
on bank performance. They discovered that performance improvements led to regulatory changes and that
credit risk accounts for differences in bank performance, while non-performing loans inversely affect efficiency
and return on assets (ROA) and the capital adequacy ratio (CAR) has a positive influence on the net interest
margin.
In another recent study conducted in Nepal, Poudel (2012) assessed the effect of CRM on the financial
performance of Nepalese banks using regression analysis. The study establishes that all credit risk factors have
an inverse influence on the financial performance of banks; conversely, the DR exerts a major impact on bank
performance. The study proposes banks to create and develop policies with the aim of not only reducing the
exposure of the banks to credit risk but also improving profitability.
In another study conducted in Taiwan, Chen and Pan (2012) assessed the credit risk efficiency of banks for
the period of four years (2005-2008). The study employs financial ratio to measure the credit risk and evaluate
using Data Envelopment Analysis (DEA). The credit risk measures were credit risk technical efficiency, credit
risk allocation efficiency, and credit risk cost efficiency. The findings suggest that only one bank is competent
in all forms of efficiencies over the assessment periods.
The Ghanaian study of Boahene et al. (2012) utilized regression analysis in an attempt to reveal the
connection between credit risk and profitability of selected banks and established that credit risk components
(non-performing loan rate, net charge-off rate, and the pre-provision profit as a percentage of net total loans and
advances) have a positive and significant relationship with bank profitability. This shows that banks in Ghana
enjoy high profitability regardless of high credit risk, an opposing view to other views expressed in many
studies that credit risk indicators are negatively related to profitability.
In contrast to the position of the Ghanaian study, scholars like Kolapo, Ayeni, and Oke (2012) studied
CRM and performance of Nigerian banks using panel model regression analysis. They argued that the impact
of credit risk on bank performance considered using the ROA of banks as a measure of performance in Nigeria
is cross-sectional invariant. A rise in non-performing loans or loan losses provision reduces profitability (ROA),
whereas a rise in total loan and advances improves profitability. The study suggests that Nigeria banks have to
improve their ability in credit analysis and loan management, whereas the regulatory authorities ought to give
extra concentration to banks’ conformity to applicable requirements of the Bank and Other Financial
Institutions Act (BOFIA)1 and prudential guidelines governing banking practices in Nigeria.
The findings of these studies reviewed reveal diverse outcomes. Based on the above studies, the common
determinants for CRM are the level of bad loans (non-performing loans), problem loans, or provision for loan
losses on the one hand, and on the other hand, the frequently used proxy for profitability is ROA. The regular
approach used by the largest part of these studies was to analyze the effect of CRM on any other variable
1
BOFIA No. 25. Retrieved from http://www.ndic.org.ng/files/bofia.pdf.
suitable to the debate using regression analysis; the regression analysis measures the actual impact of CRM on
profitability of firms.
The literature is further evaluated in terms of the number of recent studies, extent of the relationship
discovered by scholars, and the methods of analysis employed by the studies reviewed. Figure 1 illustrates that
50% of the reviewed studies are African studies and 50% are non-African studies. This indicates a balanced
consideration by this study in the review of related literature and the extent of the importance of the subject
matter within the current finance literature. Figure 2 illustrates the position of several scholars on the relationship
between CRM variables and firm performance (profitability). About 50% of the studies reviewed indicate a
negative relationship, 17% indicate a positive relationship, 17% indicate a mixed relationship, and 16% show no
relationship at all between the dependent and independent variables. And finally, Figure 3 illustrates the methods
used in the evaluation among the variables of study. It can be seen that 92% of the studies used regression
analysis, while 8% of the studies used other methods to evaluate the relationships.
Empirical Studies Between African Countries and

Other Countries
Africa Others
50% 50%
Figure 1. Evaluation of recent studies in the literature.
CRM and Profitability
Positive
None Relationship
17% 16%
Mixed
Rrelationship
17%
Negative
Rrelationship
50%
Figure 2. Evaluation of results of the studies in the literature.

Analytical Tools
Regression Other
8%
92%
Figure 3. Evaluation of the methods used by scholars.
Methodology
The research design used for the study is ex-post facto research design. The population of interest
comprised all quoted banks that operate in Nigeria. The study covered the period from 2002 to 2011, because
this was the period when the banking industry has undergone various changes, and some of the anticipated
effects are quite visible.
Table 1
Study Population
S/N Bank Year of incorporation Year of listing
1 Access Bank Plc. 1989 1998
2 Diamond Bank Plc. 1990 2005
3 Eco Bank Plc. 1985 2003
4 Fidelity Bank Plc. 1988 2005
5 First Bank of Nigeria Plc. 1894 1971
6 First City Monument Bank Plc. 1982 2004
7 Guaranty Trust Bank (GT Bank) Plc. 1990 1996
8 Nigeria Police Force (NPF) Micro Finance Bank Plc. 1993 2010
9 Skye Bank Plc. 1989 2006
10 Stanbic IBTC Plc. 2005 2007
11 Sterling Bank Plc. 1960 2006
12 Union Bank Plc. 1917 1971
13 United Bank of Africa Plc. 1948 1971
14 Unity Bank Plc. 2006 2006
15 Wema Bank Plc. 1945 1990
16 Zenith Bank 1990 2004
Note. Source: Developed by the researcher using Nigerian Stock Exchange (NSE) Fact Book 2011/2012 (NSE, 2012).
The study covered the quoted banks operating in the NSE as at 2011/2012 as presented in Table 1. In order
to be critical, the working population has been derived from the study population in which companies that had
been quoted on or before the study period will be considered, since their annual reports and accounts are
available for the study period (2002-2011). The working population of banks is listed in Table 2 along with
their quotation dates in the NSE.
Table 2
Working Population
S/N Bank Founded Quotation date
1 Access Bank Plc. 1989 1998
2 First Bank of Nigeria Plc. 1894 1971
3 GT Bank Plc. 1990 1996
4 Union Bank Plc. 1917 1971
5 United Bank of Africa Plc. 1945 1971
6 Wema Bank Plc. 1945 1990
Note. Source: Developed by the researcher.
Secondary data were used for the study. The data were analyzed by calculating the profitability for each
year for the period of study. Random-effect generalized least squares (GLS) regression was done by comparing
the profitability ratio (proxy by ROA) to DR, cost per loan assets (CLA) and CAR, as well as loan and age as
control variables. Further, the ratio was analyzed using regression statistical tool run using Stata program
Version 12.
Variables and Their Measurements
The ROA is a ratio that measures a company’s profit after tax (PAT) against its total assets. The ratio is
considered as an indicator of how efficient a company is using its assets to generate earnings before contractual
ROA = PAT / Total Assets

obligation must be paid. It is calculated as:
ROA gives a sign of the capital strength of the banking industry, which will depend on the industry; banks
that require large initial investment will generally have lower ROA (Appa, 1996; Ahmed et al., 1998; Kolapo
et al., 2012).
DR is a ratio that measures the proportion of non-performing loans as against the total loans for a period. It
gives an assessment of the total borrowers default on the conditions of loans and advances for a given period. It
simply measures the efficiency of the loan portfolio management for a given bank within a given period (Appa,
1996; Ahmed et al., 1998; Kolapo et al., 2012). DR ratio can be calculated as:
DR Ratio = Non- performing Loans / Total Loan
CLA is the average cost per loan advanced to customer in monetary terms. The function of this is to point
out efficiency in distributing loans to customers (Appa, 1996; Ahmed et al., 1998; Kolapo et al., 2012). CLA
ratio can be calculated as:
CLA Ratio = Total Operating Cost / Total Amount of Loans
CAR is a ratio that measures the total capital of bank articulated as a percentage of its risk weighted credit
coverage (Appa, 1996; Ahmed et al., 1998; Kolapo et al., 2012). CAR can be calculated as:
CAR = Capital Fund / Risk Weighted Assets

Age is the amount of years spent in the NSE listing by the bank. It is also used as a control variable. It is
assumed that the longer the time spent in business by the firm, the higher the expected customers and returns,
consequently the higher profit (Appa, 1996).
Loan is a measure of the total facilities given out by the bank to its customers and staff in form of credit or
advance. It is used as a control variable. It is assumed that the higher the amount of loan given out to customers,
the higher the expected returns, hence the higher profit (Ahmed et al., 1998).
Model Specification
The econometric model employed in the study (which is corresponding to what is predominantly found in
the literature, such as the works of Ahmed et al. (1998) and Kolapo et al. (2012)) is given as:
Y = β 0 + β Fit + ε it
where Y is the dependent variable; β0 is constant; β is the coefficient of explanatory variable; Fit is the
explanatory variable; and εit is the error term (assumed to have zero mean and independent across the time
period).
By adopting the econometric model as in equation above particularly to this study, the equation below
develops:
Profitability ( ROA) = β 0 + β1 DR + β 2CLA + β3CAR + β 4 LOAN + β5 AGE + ε it
Data Analysis and Discussion of Results

As previously stated, the study employs regression models with the purpose of testing the formulated
hypothesis. Table 3 provides the summary of the descriptive statistics of the variables in the study.
Table 3
Descriptive Statistics of Variables
Min. Max. Mean Std. deviation No.
ROA 0.41 29.32 2.98 4.03 60
DR 0.90 74.12 17.35 16.48 60
CLA 7.28 46.89 20.38 9.07 60
CAR -9.47 197.44 12.06 27.32 60
AGE 4.00 40.00 23.67 12.52 60
LOAN 6.63 9.09 8.09 0.56 60
Note. Source: Generated by the researcher from the annual reports and accounts of the sampled companies using Stata (Version 12).
It can be seen from Table 3 that the average value of the dependent variable ROA is 2.98 and the standard
deviation is 4.03, indicating lack of substantial variation. The other variables which are all independent in
Table 3 also show evidence of some level of variability. Overall, the CRA has the highest standard deviation
with about 27.32 and ROA has the lowest standard deviation, accounting for only 4.03. The higher the standard
deviation of the independent variables (DR, CLA, and CAR) in relation to the standard deviation of the
dependent variable (ROA), the higher the risk exposure of the profitability of the banks.
In an effort to establish the nature of the correlation between the dependent and the independent variables
and also to ascertain whether or not multi-collinearity exists as a result of the correlation among variables,
Table 4 is computed for this purpose. The correlation matrix in Table 4 provides some insights into which of the
independent variables are related to the dependent variable ROA.
Table 4
Correlation Matrix of Variables
ROA DR CLA CRA
ROA 1.000
DR -0.5163 1.000
CLA -0.3622 0.2847 1.000
CAR 0.1004 -0.3133 -0.1886 1.000
As seen from Table 4, the values on the diagonal are all 1.000, indicating that each variable is perfectly
correlated with itself. The highest correlations with ROA are for DR (-0.5163) and CLA (-0.3622). Both
correlations are negative, which implies that as the value of DR and CLA increases, the profitability of banks
decreases. On the other hand, CAR and ROA show a positive correlation of 0.1004, which implies that as the
value of CAR increases, the profitability of banks also increases. Though, correlation is positive, the
relationship is not strong (barely 10%).
The correlations among independent variables are positive with the exception of correlations that exist
between CAR and other independent variables. To further assess the validity of non-multi-collinearity in the
model, Table 5 reveals the correlation matrix of the variables in the study. We use the tolerance value (TV) and
variance inflation factor (VIF) as a test to check for the presence of multi-collinearity. Table 5 represents the
results of TV and VIF for the CRM components.
Table 5
Correlation Matrix of Variables
VIF 1/VIF (TV)
DR 1.18 0.84601
CLA 1.99 0.502869
CRA 1.16 0.859656
AGE 2.15 0.464167
LOAN 2.41 0.415441
Note. Source: Generated by the researcher from the annual reports and accounts of the sampled banks using Stata (Version 12).
From Table 5, TV ranges from 0.415441 to 0.859656, which suggests non-multi-collinearity feature.
Multi-collinearity feature exists when the value of TV is less than 0.2. The VIF which is simply the reciprocal
of TV ranges from 1.16 to 2.41, and this indicates the absence of Multi-collinearity. VIF shows
multi-collinearity when its value exceeds 10 (Tobachnick & Fidell, 1996; as cited in Sabari, 2012).
Table 6 provides the summary of the regression results of the model.
In appraising the model, based on the regression result in Table 6, the result shows that as the ROA
increases, all the independent variables (DR, CLA, and CAR) and the control variable (LOAN) increase, which
can be justified with their positive “z” values. This is consistent with the findings of Ahmed et al. (1998),
Ben-Naceur and Omran (2008), and Boahene et al. (2012) which found a positive relationship between credit
risk indicators and profitability. However, this contradicts the studies of Epure and Lafuente (2012), Kargi
(2011), Kolapo et al. (2012), and Poudel (2012) which found a negative relationship between credit risk
indicators and profitability. On the other hand, the AGE decreases as the ROA increases, this is because as the
bank is becoming older, it is more likely to build up more assets.
Table 6
Random-Effect GLS Regression
ROA Coefficient Std. error z P > |z|
DR 0.1110279 0.0270698 4.10 0.000
CLA 0.2497349 0.0637928 3.91 0.000
CAR 0.003934 0.0161927 0.24 0.808
AGE -0.1414831 0.0481023 -2.94 0.003
LOAN 3.610106 1.143497 3.16 0.002
Constant -29.92251 9.298401 -3.22 0.001
R-square
Within 0.4089
Between 0.5835
Overall 0.4391
Probability 0.0000
The coefficient of determinations “R-square” shows the within and between values of 40.89% and 58.35%
which are highly impressive, while the overall R2 is 43.91%, indicating that the variables considered in the
model account for about 44% change in the dependent variables, that is profitability, while about 56% change
may be as a result of other variables not addressed by this model. In general, the overall probability is positively
significant at 1%, and of all the independent variables in this study, CAR is the only independent variable which
indicates a positively weak relationship (0.24) to profitability. Thus, the model equation can be written as:
Profitability ( ROA) = -29.92 + 0.1110279 β1 + 0.2497349 β 2 + 0.003934β3 + 3.610106 β 4 − 0.1414831β 5 + ε
Conclusions and Recommendations

From our discussions of the results above, the assumption which states that the CRM does not have any
effect on the profitability of Nigerian banks is discarded. The result confirms that the independent variables
(CRM indicators) have individual and uniting effect on the profitability (ROA) of Nigerian banks.
Consequently, this study provides additional evidence that there is a significant positive relationship between
CRM and profitability of Nigerian banks. Two independent variables, DR ratio and CLA ratio, have indicated a
clear and strong positive relationship with the independent variable ROA. These two independent variables are
influenced by loan losses, operating expenses, and the proportion of non-performing loans which are the key
determinants of asset quality of a bank. In line with this position, therefore, our study has established evidence
that is consistent with that of the group of scholars who established that a positive relationship exists between
CRM components and profitability of firms. This is also in line with the work of Al-Khouri (2011) who
affirmed that CRM indicators affect profitability of bank and contradicted the findings of Kithinji (2010) who
revealed that the banks’ profitability is not influenced by CRM components. The study recommends that it is
fundamental for Nigerian banks to practice scientific credit risk control (application of risk evaluation
techniques), improve their efficacy in credit analysis and loan management to secure as much as possible their
assets, and minimize the high incidence of non-performing loans and their negative effects on profitability.
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January 2014, Vol. 10, No. 1, 116-124
D DAVID PUBLISHING
International Supply Chain Management (ISCM): An Emergent

Perspective on Internationalization Driven by Information
and Communications Technology (ICT)
Thomas Borghoff
Alanus University of Arts and Social Sciences, Alfter, Germany
The focus of the article is on the contribution of the perspective of supply chain management (SCM) to the
explanation of internationalization processes. The empirical study is based on case studies of 20 small- and
medium-sized enterprises (SMEs) with international activities from China, India, New Zealand, and Singapore. All
chosen firms were founded after 1980 in order to capture retrospectively the whole globalization process of each
firm. All sample firms operate their supply chains (SCs) on the basis of information and communications
technology (ICT). Depending on size, strategy, business model, industry, and mindset of the managers, firms use
ICT on a range from integrating individual functional areas to integrating the whole SC through enterprise resource
planning (ERP) and customer relationship management (CRM) systems.
Keywords: international supply chain management (ISCM), globalization, Asia/Pacific, information and
communications technology (ICT)
Introduction
Since the late 1990s, the Internet and the Web are having a profound effect on how business is conducted
from local to global scale. Available e-business technologies comprise technologies such as websites, browsers,
electronic procurement software, desk-top video-conferencing tools, intelligent database search engines,
computer-supported cooperative working packages, and many other technologies, as well as the Web-enabling
of more established software, such as enterprise resource planning (ERP), supply chain management (SCM),
and customer relationship management (CRM) systems (Chang & Wang, 2008). This case-based study has the
objective to study the role of information and communications technology (ICT) in the globalization process of
small- and medium-sized enterprises (SMEs) and their supply chains (SCs) in four countries from Asia/Pacific.
Literature Review
Information systems increasingly span inter- and inter-organizational boundaries (Timmers & van der Veer,
1999). Evidence exists that inter-organizational relationships influence adoption and implementation of ICT
depending on size and power position (Benbasat, Goldstein, & Mead, 1987; Dos Santos & Peffers, 1998).
Immediate external pressure on firms is exerted by customers requiring conformance to their supply
Thomas Borghoff, senior lecturer, School of Business Administration, Alanus University of Arts and Social Sciences. Email:
[email protected].
INTERNATIONAL SUPPLY CHAIN MANAGEMENT 117
management practices (Johnston & Wright, 2004). In inter-organizational networks, good relationships and trust
between firms are important to successful implementation (Chan & Swatman, 2000), and organizational culture
plays an important role in the integration of external boundary-spanning information systems (Weber & Pliskin,
1996).
Doing e-business puts new strains on the whole organization, which can have both internal and external
effects. In case of a failure, orders or goodwill may be lost and back office services or internal communication
may break down. In fact, the whole SC may break down. Further risks specifically attached to e-commerce are
client/server, data transfer, transaction, and virus risks (Kaynak, Tatoglu, & Kula, 2005). Because meaning is
context sensitive, and institutions can vary dramatically from one environment to another, differences between
source and receiver institutions can lead to the source not understanding key factors of the receiver’s
environment due to missing contextual information. Effective use of ICT to communicate knowledge requires
an organization to share an interpretive context. When communicators share similar knowledge and experience,
they can more effectively communicate knowledge via electronically mediated channels (Zack, 1999).
Effective capture and re-use of tacit, contextual knowledge may be achieved by utilizing a well-structured
“common and shared vocabulary” (Dzbor, Motta, & Domingues, 2004).
The Internet allows for instant global dissemination of information. The downside is that this also means
an instant global exposure of firms in the case of bad news. For example, Prahalad (2008, p. 225) stated that
“any blogger can start a global crisis for a large company”. A major downside in the use of Internet resources
may be that there is no way of assessing the information provider’s expertise and intentions as well as the
reliability of information.
Literature on the influence of ICT on the management of firms first focused on the creation to generate
competitive advantages, and some authors even promoted the “magic bullet” theory that ICT even fires itself as
a strategic weapon. Later empirical studies proved that this assumption is too simplistic and provided evidence
that ICT can contribute to the generation of competitive advantage, but only in the context of other
organizational resources. ICT provides a huge potential to contribute to a firm’s success, and this has to be seen
in a wider context of other organizational resources and contextual attributes.
Internationalization Process
Internationalization theories increasingly focus on the influence of ICT. On the other hand, the
resource-based view (RBV), which is also providing one perspective on internationalization, is increasingly
being used by ICT researchers, although it is not ideally suited to studying ICT (Wade & Hulland, 2004),
because ICT does not constitute a strategic resource itself. Rather, institutional environment, technological
complexity, and dynamic capabilities interact synergistically to impact the growth and performance of
ICT-enabled firms (Singh & Kundu, 2002). ICT thus has to be seen in its context.
More closely linked to ICT than explicit internationalization theories is the emerging perspective focusing
on the internationalization of the SC, linking research in the field of internationalization to influences of ICT on
these processes. The perspective of international supply chain management (ISCM) has emerged from different
perspectives on operations management. Studies on international marketing, production, outsourcing, logistics,
and other operations span the whole value chain and cumulated in the strategic perspective on the whole
international supply chain (ISC). Overby and Min (2001) hence claimed that a more pragmatic theoretical
explanation of internationalization of post-Internet stems from SCM.
118 INTERNATIONAL SUPPLY CHAIN MANAGEMENT
Even industry dynamics are changing as the structures of SCs are influenced by ICT and even boundaries
between industries are blurring (Ernst & Kim, 2002). The Internet is enabling greater integration of businesses
and a blurring of traditional organizational boundaries (Overby & Min, 2001). Different types of industrial
structure emerge with mutually beneficial cooperation and networking (Roche, 2000). SCs become more elastic
and flexible. By far, the greatest contribution ICT can make to an international business is to support a global
view of business processes. However, processes may be dependent on local culture or legislation, and growth
through acquisition can also make it hard to integrate ICT systems. Upstream activities are more global in
nature. Business to business (B2B) e-commerce can be applied in a standardised way on a global basis and thus
benefits from economies of scale, while business to customer (B2C) requires significant local adaptation.
Instead, local firms may have inherent advantages over global firms in doing business online with costumers
(Kraemer, Gibbs, & Dedrick, 2005).
ICT facilitates product standardization, internationally integrated production planning systems, integrated
warehouse systems, and the coordination of geographically remote work processes (Schober, 1993). ICT allows
for the coordination of research and development (R&D) labs dispersed across regions and time zones and thus
innovation processes around the clock based on knowledge from all locations. Externally, by linking intranets to
the Internet, organizations are beginning to integrate their internal operations more closely with their vendors,
partners, and customers (Bollier, 1998). ICT can support vertical quasi-integration, outsourcing, and
quasi-diversification (all cooperative modes. The value of the network even increases with network size due to
increasing economies (Clemons & Row, 1991)). Due to the globalization of local markets and the emergence of
the global electronic markets, worldwide acquisitions and cooperation strategies also gain importance (Bicak,
2005).
Fully integrated SCs would drastically reduce the time it would take to place orders (Apigian,
B. S. R. Nathan, T. S. R. Nathan, & Kunnathur, 2005). ICT is permeating the SC, transforming the way value
activities are performed and the nature of the linkages among them. A main focus in literature is on influences
of ICT on global value chains on outsourcing. This applies both to the perspective of ICT as a driver of
outsourcing and to the outsourcing of ICT activities themselves. Regarding the role of ICT as a driver of
outsourcing, Hall (2000, p. 56) even stated that, “The outsourcing trend is happening due to advances in ICT”.
Overby and Min (2001) and Mathews and Healy (2008) suggested that ISCM may even be viewed as an
“emergent” theory of internationalization, having roots in different functional perspectives and extending the
network theory of internationalization. They proposed that ISCM as the implementation of international
networks provides a better explanation of internationalization in an Internet commerce environment. They also
suggested that the ISC is an alternative mode of global distribution structure that does not correspond with
traditional internationalization. In this context, e-commerce may induce more tight integration with customers
and suppliers, up and down the SC, spanning organisational boundaries (Zhu & Kraemer, 2002).
More transparency in the SC (“SC visibility”) allows for real-time communication, making it possible for
SC partners to simulate operations and design new responsive collaborative processes (Salcedo & Grackin,
2000). Visibility across the ISC through information-sharing helps reduce uncertainty. SME internationalization
is facilitated by ICT due to better opportunity identification execution of international activities. The Internet
allows for instantaneously positioning of a business on different foreign markets and increases the temporal
density of expansion as firms can enter new markets rapidly.
Global Network Development

Processes of global network development create growing interdependencies on a global scale and a
growing integration of communication, activities, and structures. There are several levels on which network
formation can be observed. Inter-organizational networks from local to global level dominate the external
network context of a firm. A cornerstone in the management of a geographically complex international network
lies in a firm’s specialization in ICT. The enhanced expertise in ICT seems to provide a company with greater
flexibility in the management of its geographically dispersed network, and an enhanced ability to combine
distant learning processes in formerly separate activities. Affiliate networks are increasingly used to source new
technology. Global learning has become an important mechanism for corporate technological renewal within
multinational enterprises (MNEs) (Cantwell, 2002). Common to all inter-organizational network approaches is
the central concepts of positioning and strategic role in a network. ICT offers the possibility to coordinate value
chains and inter-organizational networks on a global basis. MNEs such as Nike or Dell organize their value
chains on the basis of ICT and succeed in outsourcing most parts of their ISC, with a focus on product
development and brand management. The empirical study will provide evidence that SMEs coordinate their
external networks and their whole ISC by using ICT.
The globally differentiated pursuit of competitive advantages may also be facilitated by the formation of
global intra-organizational networks. Global network formation emerges in the course of initial
internationalization but is traditionally the subject of MNE research (Bartlett & Ghoshal, 1987). From this
perspective, MNEs are conceptualized as global networks due to their internal differentiation and the global
dispersion of organizational units and cooperation. Along with the dispersion emerge interdependencies among
the MNE units. In this context, cross-unit learning and structural flexibility are crucial in the evolutionary
interplay of strategy and structure. In the coordination of intra-organizational networks, ICT provides a very
powerful basis in order to harmonize and sustain relations between organizational units that may be dispersed
on a global scale. ICTs allow for the exchange of information, communication, and interactive decision-making
across borders. ICT brings extended connectivity with speed and expands boundaries of firms and networks
(Samii, 2004). Emphasis on connectivity is nowhere as evident as in globally operating firms (King & Sethi,
1992). There is a progressive transformation of business into relations of information exchange, leading to
globalization and network building (McMahon, 2002). Thus, a cornerstone in the management of a
geographically complex international network lies in a firm’s specialization in ICT.
Evolutionary Dynamics: Speed of Internationalization

The Internet is an important tool that contributes to a more rapid internationalization of SMEs (Moen,
Endresen, & Gavlen, 2003). Jaw and Chen (2006) even suggested that the Internet will revolutionize the
dynamics of international commerce and lead to a more rapid internationalization of SMEs. The Internet reduces
the costs incurred by SMEs and provides them with considerable information that helps to significantly reduce
the uncertainties of foreign markets, even though it does not eliminate risk. Karavdic and Gregory (2005)
nonetheless identified two conflicting schools of thought concerning the impact of e-commerce on the exporting
process: one is predicting little or no impact, based on the persistent key role of experience and commitment in
internationalization efforts, while the other is predicting a speeding up of export processes through an expansion
of communication and distribution channels. The limited empirical evidence about the link between e-commerce
adoption and internationalization also shows mixed results. Some authors find a positive link (Rask, 2002; Lal,
2004), while other studies do not provide a clear answer (Raymond, Bergeron, & Blili, 2005; Morgan-Thomas &
Paton, 2007). Research suggests that the internationalization process is accelerated by ICT (Mathews & Healy,
2008). The Internet facilitates knowledge accumulation, which in turn can alter the firm’s progression through
the internationalization stages. According to Danford (2008, p. 390), “the ultimate impact is accelerated
internationalization”.
SMEs have limited resources so that a major aspect in the study of ICT in SMEs is the degree of adoption
despite these constraints. Most studies suggest that SMEs are followers in the adoption of ICT due to these
constraints but on the other hand, studies also suggest a “leveling of the playing field” in international business
(Shneor, 2009). The extended connectivity of SMEs allows expanding boundaries of both activities and
networks. As suggested by the born global or international entrepreneurship literature, founders and managers
of SMEs have a strong impact on the adoption and use of ICT.
Methodology
The empirical study is based on case studies of 20 SMEs with international activities from China, India,
New Zealand, and Singapore. The choice of at least four firms from each country allows for both a within-country
and an across-country comparison, providing a robust basis for cross-case analysis (Eisenhardt, 1989). All chosen
firms were founded after 1980 in order to capture retrospectively the whole globalization process of each firm, as
either the founder or a senior manager who joined the firm at foundation was interviewed. The interviews were
taped, transcribed, and analyzed with NVivo 8, providing the basis for histographic case studies, triangulated by
the use of different sources of data (e.g., publications, reports) and the use of different theoretical lenses. Multiple
histographic case studies serve to explore characteristics of the four sub-processes of globalization and the impact
of ICT on them. The interviews were taped, transcribed, and analyzed on the basis of open, axial, and selective
coding.
Empirical Results
All sample firms operate their SCs on the basis of ICT. Depending on size, strategy, business model,
industry, and mindset of the managers, firms use ICT either rather isolated in individual functional areas,
integrating those units through email-based or personal communication or integrating the whole SC through
ERP and CRM.
Best Practices in ICT Management

The intensity of ICT usage among the sample firms is very different and ranges from assessing a website
as being very important to find customers and suppliers to the complete integration of the value chain through
ERP. Many firms are, to a large extent, dependent on ICT, and thus, the failure of ICT is seen as a major risk.
Reliability and trustfulness of information and actors in the Internet are seen as further obstacles. The problem
of sending rich and contextual information is a source of limited exchange of such information. Due to these
potential risks, the selection of reliable and substantive information is a key practice at the sample firms. All
sample firms choose an active but cautious approach to the use of ICT rather than “following every new trend”.
As reasons, the sample firms often mentioned not only their limited resource bases but also a learning process
that resulted in the preference for reliable and sustainable solutions.
Internationalization
The interviews suggest that in addition to the contribution to a large ratio of global foundations in the
sample, ICT also increases the potential for internationalization of the sample firms also at later stages. Even
passive globalizers (defined as firms with less than 50% of sales abroad) get increasingly unsolicited orders and
requests from interested sales agents or distributors due to the global visibility through the Internet. The options
for firms that pursue an active strategy of internationalization are even better. ICT allows firms entry into
foreign markets through exports. This would be impossible for some firms without ICT. On the other hand, ICT
reduces the necessity to choose more intensive forms of market entry such as setting up affiliates. Depending
on the industry, market entry may also be influenced by the ICT infrastructure of a country. For example, one of
the biggest challenges that India B faced in the Middle East was Internet connectivity in banking systems—an
obstacle for all firms using e-commerce. The most dominant entry mode among the sample firms is exporting.
Particularly, none of the firms from the emergent markets China and India has more intensive forms of serving
other markets, though some intend to do so in the future. Hence, the influence of ICT on the choice of entry
modes is not particularly high, as this choice has not occurred to most firms, yet. On the other hand, some firms
generate all revenues abroad, and this would be almost impossible without ICT. ICT seems to “virtually”
exempt most sample firms from the necessity to choose more intensive forms of market entry, as the global
market is accessible through ICT and exporting. For example, India B realizes that it would either have to set
up an affiliate in the Middle East or other markets if there was no Internet. On balance, ICT seems to relieve the
sample firms from the necessity to enter foreign markets with more intensive entry modes in downstream
activities. Firms with resource-seeking motives or efficiency-seeking motives build up subsidiaries at least for
upstream activities.
On balance, ICT facilitates individual and organizational learning significantly. The extent to which these
instruments are used depends not only very much on the mindset and knowledge of key decision makers but
also particularly on the kind of business and the size of the firm. ICT has a strong impact on the
internationalization of most sample firms, facilitating international activities very early and allowing for
business with foreign markets without the need to set up affiliates abroad to serve these markets. The Internet
allows for an earlier build-up of international activities and for a prolongation of the export phase for most
sample firms with foreign markets. The sample firms have a clear view of best practices in the
internationalization process. Particularly, international experiences as well as understanding foreign customers
and markets are seen as the most important contributors to international success. All actively globalizing firms
in the sample have the same view in this regard. ICT is seen as an important facilitator in building up
international knowledge and experience.
Global Evolutionary Dynamics

The rate of change itself is the most important factor for most of the firms. Depending on variables such as
the mindset and experiences of the founder and key decision makers or the context of the home country, there
are markedly different trajectories in globalization. ICT helps to reduce complexity in decision-making not only
through efficient information-gathering and processing but also by facilitating empowerment in flatter
hierarchies. Life cycles are generally shortened—surprisingly less of products but particularly the life cycles of
practices and in more complex firms also of organizational units. Darwinian (incremental) processes of
variation and selective retention (VSR) are accelerated as the Internet, and other global media increase the
availability and diffusion of more variations (e.g., information, ideas). Dialectical processes among social
actors are changing to different degrees. Depending on the industry, such changes do not apply to structural
balances in some industries, while in others, there might be a complete change in the industry structure.
Changes in perceptions and priorities in decision-making also lead to changes in the cognitive structure.
ICT in the Management of Global Evolutionary Process

A main indicator for the adaptability is the speed with which the firm reacts to changes. ICT provides the
potential to better cope with complexity and dynamics, but most sample firms also actively look for ways to
increase their adaptability. ISC coordination depends heavily on ICT. Dominant players in ISCs often prescribe
ICT for inter-organizational links. ISCs are increasingly designed globally either internally or externally, and
ICT provides the informational backbone.
Discussion
All sample firms operate their SCs both internally and externally on the basis of ICT, supporting not only
the ISC but also the resource and network perspective of internationalization in studying the link between ICT
and the globalization of firms. Despite a missing direct link, incremental and born global or international
entrepreneurship models complement these perspectives in sketching the internationalization process of firms.
The ISC perspective provides a valuable view at a more operational level. Global sourcing, foreign market
entries, and offshoring directly affect the global profile and the globalization process of firms and their SCs.
Conclusions
The study provided evidence on different levels. In general, the results indicate that the dynamics of the
globalization processes are increasing and in the view of most sample firms are even accelerating, putting high
demands on the adaptability of firms. The results also show that ICT can not only provide valuable means to
cope with increasing complexity and dynamics at the firm level but also contribute to increasing dynamics
themselves. The third conclusion is that the emerging ISCM perspective might be very valuable in the
description and explanation of globalization processes. Due to the link to the level of business operations, it is
complementary to the established internationalization theories which have a more strategic and evolutionary
perspective.
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January 2014, Vol. 10, No. 1, 125-132
D DAVID PUBLISHING
Analysis of Leader Intelligence in Telecommunication

Industry in Indonesia
Ratri Wahyuningtyas
Telkom University, Bandung, Indonesia
Intelligence is individual capacity to act appropriate with purpose, think rationally, and adjust with environmental
conditions. A successful company is related with the intelligence and ability of its leader to create excellent
strategies to be a winner in a competition. High competition occurs among cellular operators in Indonesia. The
big-five companies in telecommunication industry are PT. Telkomsel Tbk., PT. XL Axiata Tbk., PT. Indosat Tbk.,
PT. Telkom Tbk., and PT. Bakrie Telecom Tbk.. Intelligence development is a main focus for an individual to be
an effective leader in every situation. The purpose of this research is to find out more about leader intelligence in
telecommunication industry. This research uses survey and descriptive method. Operational variables consist of
intellectual intelligence (X1), emotional intelligence (X2), spiritual intelligence (X3), and adversity intelligence (X4).
We use the Likert type as a scale of quetionaire. We use convenience sampling as a sampling technique. Results
from data processing show that intellectual intelligence, emotional intelligence, spiritual intelligence, and adversity
intelligence of leader in telecommunication industry are included in high category with an average percentage of
77.95%. There is no dominant intelligence that is needed to be a successful leader. The main focus is how leaders
can synergize all the intelligence that they have to solve a problem, and they must also realize that changes in the
telecommunication industry are very fast, so they must familiarize themselves to uncertain situations.
Keywords: intellectual intelligence, emotional intelligence, spiritual intelligence, adversity intelligence
Introduction
Research Background
There are 13 competitive cellular operators in Indonesia to reach their customers. The number is the
largest compared with other countries. It is considered that the fierce competition only occurs in Indonesia. The
big-five telecommunication companies with larger customers are PT. Telkomsel Tbk., PT. XL Axiata Tbk.,
PT. Indosat Tbk., PT. Telkom Tbk., and PT. Bakrie Telecom Tbk.. However, from the big-five companies, the
company with the largest number of customers is Telkomsel, reaching 100 million clients. It means that
Telkomsel has 40% of the whole cellular telephone users around the country (Merdeka, 2011). The success of a
business relates to the leader’s leadership capability of creating superior strategies in order to survive the
competition. Yukl (2009) said that leadership is a process to influence other people to understand and agree on
how and what kind of job must be done effectively and also a process to facilitate individual and collective
effort to achieve organizational goals. Therefore, an intelligent leader is required to promote the development of
Ratri Wahyuningtyas, lecturer, Business Management of Telecommunication and Informatics, Telkom University. Email:
[email protected].
126 LEADER INTELLIGENCE IN TELECOMMUNICATION INDUSTRY
the business in the dynamic setting.

Intelligence associated with leadership is how to develop self-intelligence to make someone to be an
effective leader. To be a leader is not a simple matter, as he/she should meet a large number of people including
the subordinates, respond to any problems in duty whether internal or external, and accomplish the demand for
a successful business.
Research Question
The research question of this paper is: How is leader intelligence in telecommunication industry in
Indonesia?
Purpose and Objective of the Research
Based on the background and research question mentioned above, the objective of this research is to
identify the intelligence of a leader in telecommunication industry in Indonesia.
Intellectual Intelligence
Intellectual intelligence refers to an individual’s ability to act mentally, such as thinking and pondering.
Analysis of personal intelligence quotient (IQ) is obtained by comparing mental age to the chronological
one (Goleman, 1995). While mental age talks about an individual’s ability to solve problems, chronological
age is the ability which an individual should have in accordance with the age. For example, if a
10-year-old child has the same ability with a 12-year-old child, the IQ for this child is 120 (after multiplying
with 100).
Intellectual intelligence is classified into two categories: general cognitive ability and specific ability.
Generally, the G-factor known as cognitive capability means, for example, an individual’s ability to think and
remember, while S-factor is the special ability of an individual. People with general cognitive ability will make
better performance, but we must realize that specific ability also plays an important role in how individuals
perform (Ree, Earles, & Teachout, 1994; as cited in Trihandini, 2005).
Emotional Intelligence
Goleman (1995) defined emotion as an encouragement of act, an immediate planning to solve the problem
which has been implanted gradually. Robbins (2005) described that a great leader shows his/her emotional
intelligence through the following five key components:
(1) Self-awareness. A leader has high confidence, realistic self-assessment, and self-depreciating sense of
humor;
(2) Self-management. A leader is able to manage the disruptive emotions and stimuli of others when they
encounter difficulties, comforts them with ambiguity and change, and helps them to find possible solutions to
solve those difficulties;
(3) Self-motivation. A leader must be optimistic in the face of failure and able to get over the setback or
breakdown by showing a high commitment to others, in addition, he/she must also learn from experiences and
provide powerful support to achieve the business success;
(4) Empathy. A leader must consider and learn to understand others’ feelings or thoughts, which will bring
a win-win situation for both parties;
LEADER INTELLIGENCE IN TELECOMMUNICATION INDUSTRY 127
(5) Social ability. A leader must be able to manage his/her relationships with others and move people in
desired directions, he/she must also be effective in leading change, inspiring others, and making others feel
comfortable; apart from that, he/she must also have expertise in building and leading teams.
Spiritual Intelligence
Spiritual intelligence (often abbreviated as spiritual quotient (SQ)), according to Masaong and Tilomi
(2011), is a new level of awareness correlated with conscious soul, which heals and builds human beings as a
whole so as to balance the meaning and value of life and put in a broader context. Values of spiritual
intelligence based on SQ components in which many of them are needed in the business world are absolute
honesty, openness, self-knowledge, focusing on the contribution, non-dogmatic spiritual (Setyawan, 2004; as
cited in Trihandini, 2005).
Adversity Intelligence
It is a determinant variable to find out how individuals put an expectation and behave in the face of
adversity continuously. According to Stoltz (2005), there are three kinds of people according to their responses
to adverse situations:
(1) Quitters. Quitters typically have lower adversity quotient (AQ) scores and tend to be overwhelmed by
difficulties and setbacks;
(2) Campers. Campers generally have moderate AQ scores and some capacity for challenge and change.
They tend to face and overcome the adversity, but will lose faith when the adversity is high;
(3) Climbers. Climbers generally have high AQ scores and determined to reach their targets regardless of
the advantages or disadvantages, fortune or bad luck.
Adversity intelligence measurement consists of the following four dimensions: control, ownership, reach,
and durability.
Methodology
Research Method
The research method used is descriptive one conducted through a survey. Sugiyono (2006) said that
descriptive research is a research to find out the value of independence variable without making a comparison
or correlation among variables. This research tries to gather facts, describe, analyze, and interpret the data to
present some clear and appropriate information. The information obtained is concerned with leader intelligence
in telecommunication industry in Indonesia.
Operating of Research Variables
The variables used are shown in Table 1.
Table 1
Operating of Research Variables
Variable Sub-variable Indicator
Ability to remember
Cognitive ability
Ability to think
Intellectual intelligence
Ability to learn
Specific ability
Adaptability
(Table 1 continued)
Variable Sub-variable Indicator
Self-confidence
Self-awareness
Realistic self-assessment
Pleased to ambiguity
Self-management Open to change
Able to control emotions
Organizational commitment
Emotional intelligence Self-motivation Strong drive for success
Positive thinking
Consider and understand others’ feelings
Empathy
Excellent services to customers
Able to handle the emotions of others
Social skill Create harmonious relationships
Make others comfortable
Tell the truth
Honesty
Consistency
Be open
Openness
Be fair
High motivation to add the knowledge
Self-knowledge
Spiritual intelligence Create a learning environment
Fulfill the right of others
Contribution
Not demanding personal rights
Flexibility
Non-dogmatic spiritual High awareness
Exploit the suffering
The belief that everything can be achieved
Control
Ability to deal with difficulties
Learn from mistakes
History and ownership Feeling guilty about the trouble
Adversity intelligence Responsibility
Assumption about the difficulties that arise
Reach
Ability to make the problem not to extend
Assumption of the difficulties that arise
Durability
Act against difficulties
Sampling Technique
The populations of research are all employees working on the big-five telecommunication companies,
such as PT. Telkomsel Tbk., PT. XL Axiata Tbk., PT. Indosat Tbk., PT. Telkom Tbk., and PT. Bakrie Telecom
[Z ] × p×q
Tbk.. The number of samples for each company is determined by the Bernoulli formula:
N ≥ a/2
2
E2
where:
N = Total minimum sample;
Z = Standard coefficient value of a/2 that can be seen by normal distribution table;
p = Denied probability;
q = Accepted probability (1 − p);

E = Fault level of 10%.
(1.96)2 × 0.5 × 0.5

Therefore:
N≥
N ≥ 96.04
(0.1)2
Thus, 100 respondents will be taken from each business, meaning 500 respondents from all business. The
study uses convenience sampling. Convenience samples are non-probability samples that are unrestricted
(Cooper & Schindler, 2006). In this case, researchers have the freedom to choose whomever they find.
Data-Processing Technique
To find out respondents’ responses to leader intelligence, the author uses data analysis of ranking order as
follows (see Table 2).
Table 2
Categories of Percentage
Number Percentage (%) Category
1 25.00-43.75 Very low
2 > 43.75-62.50 Low
3 > 62.50-81.25 High
4 > 81.25-100 Very high
Findings
Respondent Characteristic
Based on gender. According to Table 3, it is shown that most respondents are male employees.
Table 3
Characteristics of Respondents Based on Gender
Composition
Number Company
Male (%) Female (%)
1 PT. Telkomsel Tbk. 52 48
2 PT. XL Axiata Tbk. 53 47
3 PT. Indosat Tbk. 54 46
4 PT. Telkom Tbk. 52 48
5 PT. Bakrie Telecom Tbk. 52 48
Based on age. Table 4 shows that most respondents aged from 20 to 30 years old.
Table 4
Characteristics of Respondents Based on Age
Composition
Number Company
< 20 years old (%) 20-30 years old (%) 31-40 years old (%) > 40 years old (%)
1 PT. Telkomsel, Tbk. 0 37 37 26
2 PT. XL Axiata, Tbk. 0 54 41 5
3 PT. Indosat, Tbk. 0 51 38 11
4 PT. Telkom, Tbk. 0 39 38 23
5 PT. Bakrie Telecom, Tbk. 0 54 41 5
Based on tenure. In Table 5, it is shown that respondents in every business are dominated by different
working periods. Respondents from PT. Telkomsel Tbk., PT. XL Axiata Tbk., and PT. Bakrie Telecom Tbk. have
worked for 1-5 years, while respondents from PT. Indosat Tbk. and PT. Telkom Tbk. have worked for 6-10 years.
Table 5
Characteristics of Respondents Based on Tenure
Composition
Number Company
< 1 year (%) 1-5 years (%) 6-10 years (%) > 10 years (%)
1 PT. Telkomsel, Tbk. 10 45 36 9
2 PT. XL Axiata, Tbk. 14 61 23 2
3 PT. Indosat, Tbk. 2 29 53 6
4 PT. Telkom, Tbk. 9 32 51 8
5 PT. Bakrie Telecom, Tbk. 9 65 26 0
Average in Telecommunication Industry

Intellectual intelligence. On average, leaders in telecommunication industry in Indonesia generally have a
high level of intellectual intelligence of 80.43% (see Table 6). The highest level of intellectual intelligence is
shown by leader of PT. Bakrie Telecom Tbk. through the capability to consider, think, and behave appropriately
in adverse situations.
Table 6
Intellectual Intelligence of Leader in Telecommunication Industry
Number Company Percentage (%) Average (%) Category
1 PT. Telkomsel, Tbk. 79.25
2 PT. XL Axiata, Tbk. 80.50
3 PT. Indosat, Tbk. 80.50 80.43 High
4 PT. Telkom, Tbk. 80.50
5 PT. Bakrie Telecom, Tbk. 81.38
Emotional intelligence. On average, leaders in telecommunication industry in Indonesia generally have a

high level of emotional intelligence of 75.21% (see Table 7). Similar results of the assessment of the leader’s
emotional intelligence are obtained. Emotional intelligence of the leader is shown through his/her emotion
control capability, empathy, commitment to the management, self-confidence, realistic self-assessment,
positive viewing, and openness to change. Statement which has the lowest ratings in all of the companies is the
leader in the face of uncertain situations. However, even though a leader is very open to change, he/she does
not attempt to go through with it.
Table 7
Emotional Intelligence of Leader in Telecommunication Industry
Spiritual intelligence. Spiritual intelligence of the leaders in telecommunication industry is categorized

into the high level of 77.91% (see Table 8). They were in the high level on each business. Spiritual intelligence
is measured by leader’s honesty, consistency in greeting behaviors, openness, fairness in making decisions,
flexibility, and high responsibility.
Table 8
Spiritual Intelligence of Leader in Telecommunication Industry
Adversity intelligence. Adversity intelligence of the leader in telecommunication industry, according to

Table 9, was in high category with the score of 78.23% (see Table 9). This figure shows that leaders in
telecommunication industry in Indonesia typically have high confidence that any problem or difficulty can be
settled, they always learn from mistakes and experiences, act appropriately to solve problems, and consider that
problems are usual and temporary.
Table 9
Adversity Intelligence of Leader in Telecommunication Industry
Conclusion
According to the result of data-processing, it is concluded that intellectual intelligence, emotional
intelligence, spiritual intelligence, and adversity intelligence of leaders in telecommunication industry were in
the high-level category. It means that in telecommunication industry, especially in Indonesia, there is no
superior intelligence that is required to be a successful leader. Each leader should have all intelligence types
because the problems faced by them also varied with regard to the management, strategy formulation, as well
as in managing the changes. The telecommunication industry is a business with rapid transformation,
especially the technology that will finally influence the change such as infrastructure, method, expertise,
strategy, and mindset of employees. Leaders must realize that the change almost appears in an unpredictable
situation, thus leading to the fact that leaders should familiarize themselves in a situation that is fraught with
uncertainties.
Managerial Implication
The author’s suggestions for leaders in telecommunication industry are as follows:
(1) Leaders must be able to preserve the stability between their own intellectual intelligence, emotional
intelligence, spiritual intelligence, and adversity intelligence. It means that all of them are important and
necessary to be a successful leader especially in the business;
(2) Leaders must be able to synergize their own intelligence to meet any experienced problem.
References
Cooper, D. R., & Schindler, P. S. (2006). Business research methods (9th ed.). New York, NY: McGraw-Hill Companies, Inc..
Goleman, D. (1995). Emotional intelligence (T. Hermaya Trans.). Jakarta: PT. Gramedia Pustaka Utama.
Masaong, A. K., & Tilomi, A. A. (2011). Kepemimpinan Berbasis Multiple Intelligence: Sinergi Kecerdasan Intelektual,
Emosional dan Spiritual Untuk Meraih Kesuksesan yang Gemilang (Multiple intelligence-based leadership: Synergy of
intellectual, emotional, and spiritual intelligence to reach bright success). Alfabeta, Bandung.
Merdeka, S. (2011). Inilah Lima Perusahaan Pemilik Pasar Telekomunikasi di Indonesia (This is five company owner
telecommunications market in Indonesia). Semarang.
Robbins, S. (2005). Organizational behavior. New Jersey, NJ: Pearson Education, Inc..
Stoltz, P. G. (1997). Adversity quotient: Turning obstacles into opportunities. New York, NY: John Wiley & Sons, Inc..
Sugiyono. (2006). Statistika Untuk Penelitian (Statistics for research). Alfabeta, Bandung.
Trihandini, R. A. F. M. (2005). Analisis Pengaruh Kecerdasan Intelektual, Kecerdasan Emosi dan Kecerdasan Spiritual terhadap
Kinerja Karyawan (Tesis Program Studi Magister Manajemen. Universitas Diponegoro) (Influence analysis of intellectual
intelligence, emotional intelligence, and spiritual intelligence on employee performance (Master of management thesis,
Diponegoro University)).
Yukl, G. A. (2009). Leadership in organization. New Jersey, NJ: Prentice Hall.

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Journal of

Modern Accounting and Auditing

Volume 10, Number 1, January 2014 (Serial Number 104)

David Publishing Company

Aims and Scope:

Editorial Board Members:

David Publishing Company

David Publishing Company

A Possible Narrative Section Harmonisation? The Role of the Practice Statement

Cost Accounting, Ethical Accountability, and Accounting Principles 20

From Consolidation to Segment Reporting in Local Government: Accountability Needs,

A Study of the Factors Affecting Choice of the Accounting Profession 47

Linear Programs in Cost Accounting: A Linear Cost Model 55

Measuring Audit Firms’ Intellectual Capital as a Determinant of Audit Quality:

Does an Auditor’s Within-Industry Market Share Still Capture Auditor Industry

An Evaluation of the Effect of Credit Risk Management (CRM) on the Profitability of

International Supply Chain Management (ISCM): An Emergent Perspective on

Analysis of Leader Intelligence in Telecommunication Industry in Indonesia 125

A Possible Narrative Section Harmonisation? The Role of the

C. Carini, M. Veneziani, G. Bendotti, C. Teodori

Keywords: management commentary, content analysis, disclosure

The Aim and the Research Questions

More specifically, the following research questions will be addressed:

The Practice Statement, Objective, and Structure

(4) The results and prospects;

The Evolution of the Management Discussion Regulation in the EU Directives

sources or alternative methodology to conventional accounting (i.e., performance indicators reflecting

The Methodology Applied

Research Sample and Documents Analysed

Empirical Evidence and Discussion

variability is limited (0.73 for Italy; 0.79 for UK).

Limitations and Future Research

Cost Accounting, Ethical Accountability, and Accounting

Hossein Pashang, Urban Österlund, Kjell Johansson

Keywords: accountability deficit, principle of invested cost, ethical accountability

Perspectives and Problems of the Essay

Defining and Distinguishing the Paradigm of Cost Accounting

The Legal Connotation of Cost Accounting

History of Cost Accounting

Accounting Principles and Cost Accounting

Conclusion and Implications

From Consolidation to Segment Reporting in Local Government:

This has also permitted the municipality to compile its CFS.

The CF added that:

The HWO argued that:

Home services for

Daily care centers

Action n. 1.1.5 Segment 1

Figure 1. Example of attribution of programs, strategic objectives, and actions to segments.

Segment: Welfare Municipality of Reggio Emilia

Sub-segments Cost centers

Cost center n. 128

Cost center n. 131

Cost center n. 139

Cost center n. 144

Discussion and Conclusions

A Study of the Factors Affecting Choice of the Accounting

Linear Programs in Cost Accounting: A Linear Cost Model∗

Theoretical: Cost Accounting

Labor cost bX2 Unit cost

(8.35* ) (-3.87* ) (-1.78* ) (-0.17) (1.73* )

(1.77* ) (-0.88) R 2 = 0.94 ADF = -2.98

(9.70* ) (-2.58 ) (-0.97) (-1.17) (2.66 )

(-1.68* ) (0.76) R 2 = 0.92 ADF = -3.52

(-1.73* ) (1.81* ) (1.83*** )

(1.43) (-3.01* ) (2.51 ) R 2 = 0.90 ADF = -3.08