EFFECT OF EXTERNAL AUDITING EXPENDITURE ON THE PROFITABILITY OF NIGERIAN BANKS: A STUDY OF FIRST BANK (2002-2016)

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Auditing plays an important role in ensuring accountability, transparency, and reliability of financial information in business organizations. In modern corporate environments, organizations rely on auditing to examine financial records and provide assurance regarding the accuracy and fairness of financial statements. External auditing in particular has become an essential aspect of corporate governance and financial management within banking institutions. According to Arens, Elder, and Beasley (2017), external auditing refers to an independent examination of financial statements conducted by qualified auditors for the purpose of expressing an opinion on the truth and fairness of such statements.

The banking industry occupies a central position in the economic development of every nation because banks facilitate financial intermediation, mobilization of savings, granting of loans, and implementation of monetary policies. Due to the sensitive nature of banking operations, stakeholders such as investors, depositors, regulators, and shareholders require reliable financial information regarding the performance and financial position of banks. External auditing therefore helps enhance public confidence in financial statements prepared by banks (Adeniji, 2019).

In Nigeria, the banking sector has undergone several reforms aimed at strengthening financial stability and improving corporate governance. These reforms became necessary following cases of bank distress, financial scandals, and weak internal control systems experienced within the banking industry. External auditors play a crucial role in evaluating financial records, identifying irregularities, and ensuring compliance with accounting standards and banking regulations (Okaro and Okafor, 2017).

External auditing involves the independent examination of accounting records, financial statements, and operational activities of organizations. External auditors provide assurance that financial reports are prepared in accordance with generally accepted accounting principles and applicable regulatory requirements. According to the International Federation of Accountants, external auditing enhances credibility and reliability of financial information provided to stakeholders (IFAC, 2020).

The importance of external auditing increased significantly following major corporate scandals involving organizations such as Enron and WorldCom. These scandals exposed weaknesses in financial reporting systems and raised concerns regarding auditor independence and professional ethics. Consequently, governments and regulatory authorities introduced stricter auditing standards and corporate governance requirements aimed at improving accountability within organizations (Messier, Glover, and Prawitt, 2017).

External auditing expenditure refers to the amount paid by organizations to external auditors for audit services rendered. Audit expenditure includes audit fees, consultancy charges, compliance costs, and other professional expenses associated with external auditing activities. Banks spend significant amounts on external auditing due to the complexity of banking operations and the need to comply with regulatory requirements established by the Central Bank of Nigeria and other financial authorities (CBN, 2021).

The relationship between external auditing expenditure and profitability has attracted considerable attention among researchers and financial analysts. Profitability refers to the ability of an organization to generate income and maximize returns on investment. While external auditing expenditure represents an additional cost to organizations, effective auditing may contribute positively to profitability by improving financial accountability, reducing fraud, and enhancing investor confidence (Adeniji, 2019).

Banks incur audit expenditure in order to obtain independent assurance regarding the accuracy of financial statements and effectiveness of internal control systems. External auditors evaluate accounting procedures, verify financial transactions, and assess compliance with accounting standards. These activities help organizations identify weaknesses in financial management and implement corrective measures that may improve operational efficiency and profitability (Arens et al., 2017).

First Bank of Nigeria Limited is one of the oldest and largest commercial banks in Nigeria. Established in 1894, the bank has played a significant role in the development of the Nigerian banking industry. Due to the size and complexity of its operations, the bank relies heavily on external auditing to ensure transparency, accountability, and compliance with financial regulations.

Between 2002 and 2016, the Nigerian banking sector experienced major reforms, consolidation exercises, and technological advancement. During this period, banks faced increasing pressure to improve financial reporting standards and strengthen corporate governance mechanisms. External auditing became more important as regulatory authorities emphasized accountability and transparency within the banking industry (CBN, 2021).

External auditors contribute significantly to fraud prevention and detection within banks. Fraud remains one of the major challenges confronting financial institutions in Nigeria. Cases of financial manipulation, insider abuse, unauthorized transactions, and misappropriation of funds have negatively affected public confidence in the banking sector. External auditors help identify suspicious activities and evaluate the effectiveness of internal control systems designed to prevent fraud (Okafor and Ibadin, 2019).

The profitability of banks depends largely on effective management of resources, customer confidence, operational efficiency, and compliance with regulatory requirements. Effective external auditing contributes indirectly to profitability by enhancing the credibility of financial statements and attracting investors and depositors. Reliable financial reporting also improves decision-making and reduces the likelihood of financial mismanagement (Messier et al., 2017).

Corporate governance is another important aspect of banking operations closely associated with external auditing. Corporate governance refers to the system through which organizations are directed and controlled. External auditors support corporate governance by providing independent evaluations of financial statements and ensuring accountability among management and directors (Solomon, 2018).

Despite the importance of external auditing, banks often incur substantial audit expenditure due to increasing regulatory requirements and complexity of financial operations. Some organizations view audit expenditure as a financial burden capable of reducing profitability. However, others argue that effective external auditing contributes positively to organizational performance by reducing risks and improving financial credibility (Okaro and Okafor, 2017).

The Nigerian banking industry continues to face challenges such as financial fraud, cybercrime, weak corporate governance, and operational inefficiencies. These challenges increase the need for effective external auditing capable of ensuring financial accountability and regulatory compliance. External auditors are therefore expected to maintain independence, professional competence, and ethical standards in performing their duties (Adeniji, 2019).

The period between 2002 and 2016 witnessed increased investment in auditing and compliance activities among Nigerian banks. Regulatory reforms introduced by the Central Bank of Nigeria required banks to strengthen internal controls, improve financial reporting, and comply with international accounting standards. Consequently, audit expenditure increased significantly within the banking industry (CBN, 2021).

1.2 Statement of the Problem

The banking sector in Nigeria has continued to experience challenges relating to financial fraud, weak corporate governance, and poor financial accountability. These problems have raised concerns regarding the effectiveness of external auditing in ensuring transparency and reliability of financial statements.

Banks spend substantial amounts on external auditing in order to comply with regulatory requirements and improve financial accountability. However, there are concerns that increasing audit expenditure may negatively affect profitability due to the high cost associated with audit services.

Despite the importance of external auditing, some banks still experience cases of financial irregularities, poor disclosure practices, and operational inefficiencies. Questions therefore arise regarding whether external auditing expenditure contributes positively to profitability or merely increases operational costs without significant financial benefits.

It is against this background that this study seeks to examine the effect of external auditing expenditure on the profitability of Nigerian banks using First Bank of Nigeria Limited as a case study.

1.3 Aim of the Study

The aim of this study is to examine the effect of external auditing expenditure on the profitability of Nigerian banks using First Bank of Nigeria Limited as a case study.

1.4 Objectives of the Study

The objectives are to:

1. Examine the relationship between audit expenditure and bank profitability.
2. Determine the effect of audit fees on financial performance.
3. Assess the contribution of external auditing to financial accountability.
4. Examine the role of external auditing in corporate governance.
5. Identify challenges associated with external auditing in Nigerian banks.

1.5 Research Questions

1. What relationship exists between audit expenditure and bank profitability?
2. How do audit fees affect financial performance?
3. What contribution does external auditing make to financial accountability?
4. How does external auditing promote corporate governance?
5. What challenges affect external auditing in Nigerian banks?

1.5 Research Hypotheses

Hypothesis One

H0₁ (Null Hypothesis): External auditing expenditure has no significant effect on the profitability of Nigerian banks.

H1₁ (Alternative Hypothesis): External auditing expenditure has a significant effect on the profitability of Nigerian banks.

Hypothesis Two

H0₂ (Null Hypothesis): Audit fees do not significantly influence the financial performance of First Bank of Nigeria Limited.

H1₂ (Alternative Hypothesis): Audit fees significantly influence the financial performance of First Bank of Nigeria Limited.

Hypothesis Three

H0₃ (Null Hypothesis): External auditing does not significantly contribute to financial accountability in Nigerian banks.

H1₃ (Alternative Hypothesis): External auditing significantly contributes to financial accountability in Nigerian banks.

Hypothesis Four

H0₄ (Null Hypothesis): There is no significant relationship between external auditing and corporate governance in Nigerian banks.

H1₄ (Alternative Hypothesis): There is a significant relationship between external auditing and corporate governance in Nigerian banks.

Hypothesis Five

H0₅ (Null Hypothesis): External auditing does not significantly reduce fraud and financial irregularities in Nigerian banks.

H1₅ (Alternative Hypothesis): External auditing significantly reduces fraud and financial irregularities in Nigerian banks.

1.6 Significance of the Study

This study will be beneficial to bank management by providing information regarding the importance of external auditing in improving accountability and profitability.

The study will also assist regulatory authorities such as the Central Bank of Nigeria in strengthening auditing policies and corporate governance practices within the banking industry.

External auditors and accounting professionals will benefit from the study through improved understanding of the relationship between audit expenditure and organizational performance. Academically, the study will contribute to existing literature on auditing and banking performance and serve as a reference material for students and researchers.

1.7 Scope of the Study

The study focuses on the effect of external auditing expenditure on the profitability of Nigerian banks using First Bank of Nigeria Limited as a case study. The study covers the period from 2002 to 2016 and examines audit expenditure, profitability, corporate governance, and financial accountability.

1.8 Limitation of the Study

The study may encounter limitations such as inadequate access to confidential financial records, reluctance of respondents to provide information, financial constraints, and limited time available for conducting the research.

1.9 Definition of Terms

External Auditing: Independent examination of financial statements conducted by qualified auditors.

Audit Expenditure: Cost incurred by organizations for external auditing services.

Profitability: Ability of an organization to generate income and maximize returns.

Audit Fees: Payments made to auditors for audit services rendered.

Corporate Governance: System through which organizations are directed and controlled.

CHAPTER TWO

REVIEW OF RELATED LITERATURE

2.1 Conceptual Framework

The conceptual framework of this study focuses on the major concepts relating to external auditing expenditure and bank profitability in the Nigerian banking sector. External auditing has become an important mechanism for ensuring accountability, transparency, credibility of financial reports, and effective corporate governance in financial institutions. Banks operate in highly regulated environments characterized by complex financial transactions, technological innovations, and increasing exposure to financial risks. Consequently, external auditing serves as a critical tool for evaluating financial statements, monitoring compliance with regulations, and promoting investor confidence.

This chapter examines the concepts of external auditing, audit expenditure, profitability, financial accountability, and corporate governance. It also discusses the relationship between external auditing expenditure and profitability of Nigerian banks.

2.1.1 Meaning of External Auditing

External auditing refers to the independent examination and evaluation of financial statements prepared by an organization by professionally qualified auditors who are not employees of the organization being audited. The purpose of external auditing is to determine whether financial statements are prepared in accordance with generally accepted accounting principles and whether they present a true and fair view of the organization’s financial position. According to Arens, Elder, and Beasley (2017), external auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events in order to ascertain the degree of correspondence between those assertions and established criteria.

External auditing is an important aspect of corporate governance because it provides independent assurance to shareholders, investors, creditors, regulators, and other stakeholders concerning the reliability and credibility of financial reports. External auditors are expected to maintain professional independence and objectivity while conducting audit assignments. Their opinions enhance public confidence in financial statements and improve transparency within organizations (Adeniji, 2019).

The banking sector requires effective external auditing because banks manage large volumes of public funds and engage in highly sensitive financial transactions. Weak financial reporting and poor accountability in banks may result in loss of investor confidence, financial distress, and economic instability. External auditors therefore evaluate accounting systems, internal controls, and financial records to ensure compliance with banking regulations and accounting standards (Okaro and Okafor, 2017).

External auditing differs significantly from internal auditing. While internal auditors are employees of the organization responsible for evaluating internal controls and operational efficiency, external auditors are independent professionals appointed to examine financial statements and express opinions regarding their reliability. Internal auditing is continuous in nature, whereas external auditing is usually conducted periodically, often annually (Messier, Glover, and Prawitt, 2017).

The importance of external auditing increased globally following major corporate scandals involving organizations such as Enron and WorldCom. These scandals exposed weaknesses in auditing practices and corporate governance systems, leading to increased emphasis on auditor independence, professional ethics, and regulatory compliance (Solomon, 2018).

In Nigeria, external auditing is regulated by several institutions including the Financial Reporting Council of Nigeria and the Central Bank of Nigeria. These institutions establish standards and guidelines aimed at improving financial reporting quality and accountability within organizations.

2.1.2 Objectives of External Auditing

The primary objective of external auditing is to determine whether financial statements are prepared in accordance with established accounting standards and whether they present a true and fair view of the financial position of an organization. External auditors provide independent opinions regarding the reliability of financial reports prepared by management (Arens et al., 2017).

Another important objective of external auditing is fraud prevention and detection. Fraud has become one of the major challenges confronting financial institutions globally. External auditors evaluate transactions, accounting systems, and internal controls in order to identify irregularities and suspicious activities capable of affecting organizational performance. Effective external auditing helps reduce financial misconduct and enhances accountability within organizations (Okafor and Ibadin, 2019).

External auditing also promotes compliance with laws, regulations, and accounting standards. Banks are required to comply with guidelines established by the Central Bank of Nigeria and other regulatory authorities. External auditors examine organizational activities to ensure adherence to these requirements and report cases of non-compliance where necessary (CBN, 2021).

Another objective of external auditing is to improve investor confidence. Investors and shareholders rely heavily on audited financial statements when making investment decisions. External auditing therefore enhances the credibility of financial reports and encourages investment in organizations. According to Adeniji (2019), reliable financial reporting contributes significantly to economic growth and development because it promotes investor trust and market stability.

External auditing further contributes to effective corporate governance by ensuring transparency and accountability in organizational management. Corporate governance refers to the system through which organizations are directed and controlled. External auditors support corporate governance by independently evaluating financial statements and monitoring management activities (Solomon, 2018).

2.1.3 External Audit Process

The external audit process involves several stages aimed at obtaining sufficient and appropriate evidence regarding financial statements. One of the first stages is audit planning. During this stage, auditors obtain an understanding of the organization, evaluate business risks, and determine the scope of audit activities. Audit planning helps auditors allocate resources effectively and identify areas requiring special attention (Messier et al., 2017).

Risk assessment is another important stage in the audit process. Auditors identify and evaluate risks that may result in material misstatements within financial statements. These risks may arise from fraud, weak internal controls, operational inefficiencies, or accounting errors. Risk assessment enables auditors to design appropriate audit procedures for addressing identified risks (Arens et al., 2017).

The evaluation of internal control systems is also a critical component of external auditing. Internal controls refer to policies and procedures established by management to safeguard assets, ensure reliability of financial information, and promote operational efficiency. Auditors examine these controls to determine their effectiveness and reliability (Adeniji, 2019).

External auditors also collect audit evidence through various methods such as inspection of documents, observation of activities, confirmation of balances, analytical procedures, and inquiry from management. Sufficient audit evidence is necessary for auditors to express reliable opinions on financial statements (IFAC, 2020).

After completing audit procedures, auditors prepare audit reports containing their opinions regarding the fairness and reliability of financial statements. Audit opinions may be unqualified, qualified, adverse, or disclaimer opinions depending on the nature of findings obtained during the audit process (Messier et al., 2017).

2.1.4 Audit Fees and Audit Expenditure

Audit fees refer to payments made by organizations to external auditors for professional audit services rendered. Audit expenditure, however, is broader and includes all costs associated with external auditing activities such as consultancy charges, compliance expenses, and professional service fees. Audit expenditure represents a significant operational cost for many organizations, especially banks operating in highly regulated environments (Adeniji, 2019).

The level of audit expenditure incurred by banks depends on several factors including organizational size, complexity of operations, regulatory requirements, and risk exposure. Large banks with extensive branch networks and sophisticated financial transactions usually incur higher audit fees due to the volume and complexity of audit work required (Okaro and Okafor, 2017).

Audit expenditure has generated considerable debate among researchers and financial analysts. Some scholars argue that high audit expenditure may negatively affect profitability because it increases operational costs. Others maintain that effective auditing contributes positively to organizational performance by improving financial accountability, reducing fraud, and enhancing investor confidence (Pandey, 2015).

In the Nigerian banking sector, audit expenditure increased significantly following banking reforms introduced by the Central Bank of Nigeria. These reforms emphasized stronger corporate governance, improved financial reporting, and compliance with international accounting standards. Consequently, banks were required to invest more resources in auditing and compliance activities (CBN, 2021).

External auditing expenditure also reflects the growing complexity of modern banking operations. Technological advancement, electronic banking systems, and globalization have increased financial risks and regulatory requirements within the banking sector. Banks therefore engage highly skilled audit firms capable of evaluating sophisticated financial systems and ensuring compliance with international standards (Solomon, 2018).

2.1.5 Bank Profitability

Profitability refers to the ability of an organization to generate income and maximize returns on investment. In the banking sector, profitability is essential for sustainability, growth, shareholder wealth maximization, and financial stability. According to Pandey (2015), profitability measures the efficiency with which organizations utilize available resources to generate earnings.

Bank profitability is commonly measured using financial indicators such as return on assets (ROA), return on equity (ROE), net profit margin, and earnings per share. Return on assets measures the efficiency with which banks utilize total assets to generate profits, while return on equity evaluates returns generated from shareholders’ investments (Pandey, 2015).

Several factors influence bank profitability including management efficiency, customer confidence, operational costs, economic conditions, regulatory policies, and quality of internal controls. Effective risk management and financial accountability also contribute significantly to profitability within banks (Okafor and Ibadin, 2019).

The profitability of banks is important because it determines their ability to expand operations, meet financial obligations, attract investors, and contribute to economic development. Profitable banks are more likely to maintain public confidence and survive competitive pressures within the financial industry (Adeniji, 2019).

2.1.6 Relationship Between External Auditing and Profitability

The relationship between external auditing and profitability has attracted significant attention among researchers and financial analysts. External auditing contributes indirectly to profitability by improving financial accountability, reducing fraud, enhancing investor confidence, and promoting operational efficiency. Reliable financial statements encourage investment and improve organizational reputation within the financial market (Okaro and Okafor, 2017).

External auditing also helps management identify weaknesses in accounting systems and internal controls. Through audit recommendations, organizations can improve operational procedures, reduce wastage, and strengthen financial management practices. These improvements may contribute positively to profitability over time (Messier et al., 2017).

However, external auditing involves substantial expenditure which may reduce short-term profitability. Audit fees, consultancy charges, and compliance costs represent additional operational expenses for organizations. Excessive audit expenditure may therefore reduce net earnings, especially where organizations fail to derive adequate benefits from audit activities (Pandey, 2015).

Despite these costs, many scholars argue that effective external auditing contributes positively to long-term profitability because it strengthens corporate governance, improves transparency, and reduces risks associated with financial mismanagement. Banks with strong auditing systems are more likely to attract investors and maintain public confidence (Solomon, 2018).

2.1.7 Benefits of External Auditing in Banks

External auditing provides numerous benefits to banks and other financial institutions. One major benefit is improved financial accountability. External auditors independently examine financial statements and ensure that management provides accurate and reliable financial information to stakeholders (Adeniji, 2019).

External auditing also enhances investor confidence in financial reports. Investors and creditors are more willing to invest in organizations with credible and transparent financial statements. Audited reports therefore facilitate access to capital and improve organizational reputation (Arens et al., 2017).

Fraud prevention and detection constitute another important benefit of external auditing. External auditors examine transactions and internal controls in order to identify irregularities and suspicious activities. Effective auditing reduces opportunities for fraud and financial misconduct within organizations (Okafor and Ibadin, 2019).

External auditing further contributes to compliance with regulations and accounting standards. Banks are expected to comply with guidelines established by regulatory authorities. External auditors evaluate organizational activities and report cases of non-compliance where necessary (CBN, 2021).

Another benefit of external auditing is improvement in corporate governance. External auditors provide independent evaluations of financial reports and management activities, thereby strengthening accountability and transparency within organizations (Solomon, 2018).

2.1.8 Challenges of External Auditing in Nigerian Banks

Despite its importance, external auditing in Nigerian banks faces several challenges affecting its effectiveness. One major challenge is management interference in audit activities. In some organizations, management may attempt to influence audit findings or restrict auditors from accessing necessary information. Such interference undermines auditor independence and objectivity (Okaro and Okafor, 2017).

Another challenge is inadequate regulatory enforcement. Weak enforcement of auditing standards and professional ethics may encourage poor auditing practices and reduce audit quality. Regulatory authorities therefore need to strengthen monitoring and compliance mechanisms within the banking sector (CBN, 2021).

Technological complexity also presents significant challenges to external auditors. Modern banking operations involve sophisticated information systems, electronic transactions, and digital financial services. Auditors lacking adequate technological skills may find it difficult to evaluate computerized systems effectively (Okafor and Ibadin, 2019).

Cybercrime and financial fraud have become increasing threats within the banking industry. Fraudsters employ advanced technological methods to manipulate financial systems and conceal illegal transactions. External auditors must therefore continuously update their knowledge and adopt modern auditing techniques to address emerging risks (Adeniji, 2019).

High audit expectations from stakeholders also create pressure on auditors. Stakeholders often expect auditors to detect all forms of fraud and financial irregularities, even though auditing standards recognize inherent limitations in audit procedures. Failure to meet these expectations may result in criticism and legal liabilities against auditors (Messier et al., 2017).

2.1.9 External Auditing and Financial Accountability

Financial accountability refers to the obligation of organizations and management to provide accurate information regarding the utilization of financial resources. Accountability is essential for promoting transparency, trust, and efficient management of organizational resources. External auditing contributes significantly to financial accountability by independently examining financial statements and ensuring compliance with accounting standards (Solomon, 2018).

External auditors evaluate accounting records, verify transactions, and assess the effectiveness of internal control systems. Through these activities, auditors help ensure that organizational resources are properly utilized and that financial statements accurately reflect organizational performance (Adeniji, 2019).

In the banking sector, financial accountability is particularly important because banks manage public funds and play critical roles in economic development. Weak accountability may lead to financial scandals, bank distress, and loss of public confidence. External auditing therefore strengthens accountability by ensuring transparency and credibility in financial reporting (CBN, 2021).

2.1.10 External Auditing and Corporate Governance

Corporate governance refers to the system through which organizations are directed, controlled, and monitored. Good corporate governance promotes accountability, transparency, fairness, and ethical behavior within organizations. External auditing is an important component of corporate governance because it provides independent assurance regarding the credibility of financial statements (Solomon, 2018).

External auditors support corporate governance by monitoring financial reporting processes and evaluating management activities. Through independent examination of financial records, auditors help shareholders and stakeholders assess whether management acts in the best interest of the organization (Arens et al., 2017).

Effective corporate governance enhances investor confidence and contributes to organizational sustainability. Banks with strong governance systems are more likely to maintain public trust and achieve long-term profitability. External auditing therefore plays a significant role in strengthening governance practices and promoting accountability within the banking industry (Okaro and Okafor, 2017).