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  • Jennifer M Mueller-Phillips
    Investor Reaction to the Prospect of Mandatory Audit Firm...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 01.06 Impact of PCAOB, 04.07 Audit Firm Rotation 
    Title:
    Investor Reaction to the Prospect of Mandatory Audit Firm Rotation
    Practical Implications:

    The implementation of a mandatory audit firm rotation in the United States would have large implications within the accounting industry. This study provides the PCAOB and other regulators with relevant information regarding the potential policy. The evidence indicates that the majority of investors would have a negative reaction to a mandatory audit firm rotation. It is possible the investors believe the potential benefits of rotation are outweighed by the costs, direct and indirect.

    Citation:

    Reid, Lauren C., and J. V. Carcello. 2017. “Investor Reaction to the Prospect of Mandatory Audit Firm Rotation”. The Accounting Review. 92.1 (2017): 183.

    Keywords:
    mandatory audit firm rotation; event study; PCAOB; investor perception
    Purpose of the Study:

    In recent years the PCAOB has considered implementing a mandatory audit firm rotation in order to better align auditors’ interests with investors’ interests. This study examines investor reactions to a mandatory audit firm rotation in the United States. It is important to understand investor reactions because the implementation of such a policy would be enacted for their benefit. Due to the fact that it is still a potential policy, it is difficult to determine how investors will react if the PCAOB moves forward. Broadly, the authors test the overall stock market reaction. However, the primary focus is on whether certain markets react differently based on a company’s auditor characteristics. The characteristics considered were industry specialization, audit firm tenure, Big 4/non-Big 4, and audit quality.

    Design/Method/ Approach:

    The sample contains 3,688 companies and represents over 75% of the entire market capitalization of U.S. companies. The authors obtained U.S. company returns through CRSP and the prices for the MSCI World Index excluding the U.S. through DataStream. The auditor tenure and fee data were collected through Compustat and Audit Analytics. The authors determined 10 main dates to observe investors’ reactions and how that affected the markets for the following 3 days. 

    Findings:

    Overall, the authors find a significant negative market reaction to events that increased the likelihood of rotation.

    Specifically, the authors find the following:

    • Companies that were audited by Big 4 firms were significantly more likely to have a negative reaction on dates that increased the likelihood of rotation.
    • Similarly, companies that were audited by an industry-expert were significantly more likely to have a negative reaction on dates that increased the likelihood of rotation.
    • Companies with a lower-audit quality experienced a negative market reaction on dates that decreased the likelihood of rotation.
    Category:
    Independence & Ethics, Standard Setting
    Sub-category:
    Audit Firm Rotation, Impact of PCAOB
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Spatial Competition in Local Audit Markets and the Fallout...
    research summary posted May 30, 2017 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 03.0 Auditor Selection and Auditor Changes, 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Spatial Competition in Local Audit Markets and the Fallout on Deloitte from the 2007 PCAOB Censure
    Practical Implications:

    The results from this study demonstrate that product differentiation in the form of market leadership and industry specialization may not provide a firm the power to mitigate the adverse consequences of a PCAOB censure.

    Citation:

    Boone, J. P., I. K. Khurana, and K. K. Raman. 2017. Spatial Competition in Local Audit Markets and the Fallout on Deloitte from the 2007 PCAOB Censure. Auditing, A Journal of Practice and Theory 36 (21): 1-19.

    Keywords:
    PCAOB; Big 4 auditors; local audit markets; spatial competition
    Purpose of the Study:

    The 2007 PCAOB censure on Deloitte regarding a pharmaceutical client in California caused the firm to suffer both audit fee and client losses. The objective of the paper is to determine whether auditor market power in a local area overrides the audit quality issues resulting from a censure. Specifically, authors investigate the effects of the censure on Deloitte’s ability to retain existing clients (or, switching risk) and potential loss of audit fees. The initial assumption is that auditor-client alignment and auditor-closest-competitor distance can help create differentiation among the Big 4 and this would lead to lower audit fee and client losses for a particular metropolitan area. Researchers looked at specific market specialization and geographic areas to analyze the effects on Deloitte. 

    Design/Method/ Approach:

    The research evidence was collected from 2008-2010, the period after the censure. There were 65 local audit markets used within the sample. Each of these markets had a minimum of 6 to a maximum of 1,662 clients observed. Deloitte-client alignment for the individual local audit markets was based on Deloitte’s expertise in the client’s industry, measured according to whether Deloitte is the national leader in the industry (top fee earner), an industry specialist (significant fee earner), or a local audit market leader (top fee earner locally). Deloitte-closest-competitor distance measures Deloitte’s implied differentiation and reputation. It was calculated by comparing the distance between the firm’s fee market share and its closest competitor both at the national level and in the local market.

    Findings:

    The overall finding is that audit quality issues override auditor market power and that differentiation does not provide Big 4 firms market power against adverse regulatory action.

    The authors specifically find that:

    • Deloitte’s audit fee losses were concentrated in the pharmaceutical industry. However, the majority of client losses were not limited to one geographical area or industry.
    • In all cases observed, the results indicate that Deloitte’s leadership or specialty engagements suffered client loss risk odds that were not different from that of its non-leader or non-specialty engagements.
    • Evidence with respect to Deloitte-closest-competitor distance suggests that there was no difference in client loss risk across the local audit market areas.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes, Standard Setting
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of PCAOB
  • Jennifer M Mueller-Phillips
    The Effects of Critical Audit Matter Paragraphs and...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats 
    Title:
    The Effects of Critical Audit Matter Paragraphs and Accounting Standard Precision on Auditor Liability
    Practical Implications:

    These results provide new insight into conflicting results in contemporaneous studies that investigate the relationship between CAMS and auditor liability. The results will also be informative to the PCAOB and SEC because they highlight a potential unintended consequence of the proposed audit reporting model and reinforce the importance of the two oversight bodies considering the relationship between their regulatory actions. 

    Citation:

    Gimbar, C., B. Hansen and M. E. Ozlanski. 2016. The Effects of Critical Audit Matter Paragraphs and Accounting Standard Precision on Auditor Liability. The Accounting Review 91 (6): 1629 – 1646.

    Keywords:
    PCAOB, audit reporting, auditor litigation, critical audit matter (CAMs), and accounting standard precision
    Purpose of the Study:

    The PCAOB is currently considering substantial changes to the audit reporting model that would require auditors to disclose critical audit matters (CAMs) in the audit report. CAMs discuss areas of the audit that required a significant amount of professional judgment to evaluate appropriately or that posed the most difficulty in obtaining and evaluating evidence. Although this additional disclosure is expected to increase the information content of the audit report for investors, several interest groups have expressed concerns that CAMs will also increase the audit profession’s liability risks. In addition, the SEC, FASB and IASB have the potential to make sweeping changes to accounting standards in the coming years. These changes have the potential to significantly impact assessments of auditor liability. The purpose of this study is to investigate how jurors’ perceptions of auditor liability are affected by CAMs, accounting standard precision, and the interaction between CAMs and accounting standard precision. 

    Design/Method/ Approach:

    The authors use an experiment in which participants, acting the role of jurors, evaluate auditor liability for an alleged misstatement of financial statements due to inaccurate lease reporting and the subsequent bankruptcy of an audit client.  Following the experiment, the authors use mediation analysis to provide additional evidence regarding participants’ decision making underlying the hypothesized and observed significant association between auditor liability under precise accounting standards and both related and unrelated CAMs. 

    Findings:
    • The authors find that when no CAM is present, the participants have a lower propensity to issue verdicts against the auditor when the client’s accounting conforms to a precise standard than under an imprecise standard with the same accounting treatment.
    • The authors find that under precise standards and an accounting treatment that meets the letter of the law, both related and unrelated CAMs increase auditor liability.
    • The authors observe an interaction between standard precision and CAMs such that CAMs increase auditor liability by a lesser amount under imprecise standards than precise standards.
    • The authors find that, under precise accounting standards, related CAMs increase jurors’ assessments of the auditor’s control over financial reporting, and this increased level of perceived control mediates the relationship between related CAMs and jurors’ assessments of the auditor’s liability.
    • The authors find that unrelated CAMs are significantly associated with a decrease in participants’ evaluation of the audit performed, and this result mediates the relationship between unrelated CAMs and auditor liability under precise standards. 
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Changes in Reporting Formats, Impact of PCAOB
  • Jennifer M Mueller-Phillips
    Do Income Tax-Related Deficiencies in Publicly Disclosed...
    research summary posted September 13, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 09.0 Auditor Judgment, 09.12 Impact of potential post-audit review - e.g., PCAOB, internal firm inspections 
    Title:
    Do Income Tax-Related Deficiencies in Publicly Disclosed PCAOB Part II Reports Influence Audit Client Financial Reporting of Income Tax Accounts?
    Practical Implications:

     While many studies examine how the Part I inspection report or the PCAOB inspection process as a whole impact the auditor and audit committee decision making, the research on the impact of Part II reports is limited. Furthermore, the PCAOB is publicly issuing Part II inspection reports with greater frequency; thus, an understanding of how the failed remediation of Part II reports influences the audit firm and its clients is of importance to a number of parties.

    Citation:

     Drake, K. D., N. C. Goldman, and S. J. Lusch. 2016. Do Income Tax-Related Deficiencies in Publicly Disclosed PCAOB Part II Reports Influence Audit Client Financial Reporting of Income Tax Accounts? The Accounting Review 91 (5): 1411-1439.

    Keywords:
    PCAOB inspections, auditor scrutiny, valuation allowances, and uncertain tax benefits
    Purpose of the Study:

    The Public Company Accounting Oversight Board (PCAOB) is responsible for overseeing the quality of external audits through a rigorous inspection process that examines both audit engagements and audit firm quality control processes. At the completion of their review, the PCAOB issues their findings to the inspected audit firm via inspection reports. This led the authors to investigate whether a change in auditor scrutiny over income tax accounts, prompted by the failed remediation of a PCAOB Part II inspection report, results in changes in client financial reporting of income taxes. Utilizing the unique situation of Deloitte & Touche LLP’s 2007 Part II inspection report, which identifies concerns about the firm’s quality controls with respect to the audit procedures performed on income tax accounts, the authors delve into whether the failed remediation and subsequent public disclosure of the report led to observable changes in financial reporting for income tax accounts among Deloitte’s client.  

    Design/Method/ Approach:

    The authors focus on the time period beginning with Deloitte’s 2007 Part II report, which was issued privately to Deloitte on May 19, 2008 and ending with the remediation period on May 18, 2009. The sample chosen was annually inspected audit firms between 2006 and 2012. The authors also investigate which components of the annual UTB reconciliation drive the changes in the total UTB balance.

    Findings:
    • The authors find that an increase in auditor scrutiny over income tax accounts in response to PCAOB Part II findings is associated with changes in financial reporting of income tax accounts.
    • The authors find that the changes implemented by Deloitte result in an increase in reported valuation allowances and an increase in the reserve for uncertain tax positions among its clients.
    • The authors find that the UTB result is not driven by changes in tax avoidance but is driven but increases in the reserve related to current-year and prior-year positions.
    • The authors do not find that additional auditor scrutiny influences the income tax accounts when examining non-tax related Part II reports. This suggests that the effect the authors identify is in response to the specific deficiencies identified in the Part II report rather than a general reaction to failing the remediation of a Part II report. 
    Category:
    Auditor Judgment, Standard Setting
    Sub-category:
    Impact of PCAOB, Impact of potential post-audit review (e.g. PCAOB - internal firm inspections)
  • Jennifer M Mueller-Phillips
    Did the PCAOB’s Restrictions on Auditors’ Tax Services Imp...
    research summary posted September 13, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 04.0 Independence and Ethics, 04.03 Non-Audit Services 
    Title:
    Did the PCAOB’s Restrictions on Auditors’ Tax Services Improve Audit Quality?
    Practical Implications:

     This study serves the purpose of examining the PCAOB’s role as overseer of public company auditing, while separating from previous studies by targeting the PCAOB’s restrictions on auditors’ tax services, which have not been examined in the past. This study also examines whether APTS pose a threat to audit quality but again differentiates itself from previous literature by focusing on only the tax services that the PCAOB chose to ban and by utilizing the difference-in-differences design to address the limitation of the cross-sectional approach utilized by other studies in the past. After reviewing these findings, it is possible that the PCAOB restrictions did not fully accomplish their objective.

    Citation:

     Lennox, C. S. 2016. Did the PCAOB’s Restrictions on Auditors’ Tax Services Improve Audit Quality? The Accounting Review 91 (5): 1493-1512.

    Keywords:
    PCAOB, audit quality, and auditors’ tax services.
    Purpose of the Study:

    In 2005, the Permanent Subcommittee on Investigations of the U.S. Senate reported that audit firms were selling potentially abusive or illegal tax-planning strategies to audit clients and their top executives on a contingent fee basis. This concerned regulators for many reasons; consequently, the PCAOB adopted three new rules to address these potential threats to audit quality. First, Rule 3521 reaffirms the ban on contingent fees that existed under Rule 302 of the American Institute of Certified Public Accountants’ Code of Professional Conduct. Second, Rule 3522 bars audit firms from selling aggressive tax services to audit clients. Finally, Rule 3523 forbids audit firms from selling tax services to executives in a financial reporting role. These three rules became effective from October 31, 2006 onward. The PCAOB stated that the rules were intended to improve audit quality, and, by extension, the quality of financial reporting. The purpose of this study is to test whether the restrictions met this objective.

    Design/Method/ Approach:

    Because audit quality is not directly observable the author focuses on accounting misstatements, both misstatements that are tax-related and other types, and the issuance of going-concern opinions. The author separates companies into groups based upon the reduction of APTS purchases between July 26, 2005 and October 31, 2006. He then compares the differences in misstatements and going-concern opinions between the treatment and control groups and tests whether these differences change after the PCAOB imposed the restrictions on auditors’ tax services. 

    Findings:
    • The author finds that in the period before the restrictions, there is no difference in the incidence of going-concern opinions between the treatment and control companies; however, the treatment companies are more likely than the control companies to have accounting misstatements and tax-related misstatements. This supports the premise of regulators that the treatment companies had lower-quality auditing before the restrictions were introduced. 
    • The author finds no significant changes in misstatements, tax-related misstatements, or going-concern opinions subsequent to the APTS restrictions after using a difference-in-differences research design. In fact, the treatment companies continue to have significantly more accounting misstatements and more tax-related misstatements in the period subsequent to the APTS restrictions.
    • The author finds large and highly significant reductions in APTS fees when the restrictions were introduced. 
    Category:
    Independence & Ethics, Standard Setting
    Sub-category:
    Impact of PCAOB, Non-audit Services
  • Jennifer M Mueller-Phillips
    The Impact of Audit Completeness and Quality on Earnings...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 14.0 Corporate Matters, 14.08 Press Release Language and Signaling 
    Title:
    The Impact of Audit Completeness and Quality on Earnings Announcement GAAP Disclosures.
    Practical Implications:

    The results of this study are important for regulators when considering the potential impact of the timeliness of audits and the subsequent impact on capital markets. The focus of the PCAOB is to improve the quality of public company audits and to ensure higher quality financial reporting for all stakeholders. However, higher quality audits may come at the cost of less timely financial information. This study indicates that this in turn can influence firm voluntary disclosure behavior. Consequently, this result could have potentially negative consequences for investors seeking the timeliest information possible.

    Citation:

    Schroeder, J. H. 2016. The Impact of Audit Completeness and Quality on Earnings Announcement GAAP Disclosures. The Accounting Review 91 (2): 677-705.

    Keywords:
    audit completeness, audit quality, earnings announcement, PCAOB standards, GAAP disclosures
    Purpose of the Study:

    Annual earnings announcements are important disclosures that public companies provide investors. Prior research indicates that earnings announcements are more informative to investors when the disclosures contain more detailed GAAP disclosure information. This is consistent with best practices supplied by regulators and practitioners which strongly encourage companies to include in their annual earnings announcements more detailed GAAP financial statement information.

    Due to its informativeness, most companies release their annual earnings announcement in advance of the completed year-end audit. However, regulators and practitioners recommend that companies not only include the external auditor in the earnings announcement disclosure review process, but also wait until the audit is complete or substantially complete prior to releasing the earnings announcement. This situation creates the possibility that audit completeness and auditor quality influence the firms disclosure behavior related to the annual earnings announcement. In spite of stated best practices, companies face strong market demand pressures to release more timely information, and existing regulatory requirements do not require auditor oversight before releasing this information. Thus, the extent to which audit completeness and audit quality influence the level of GAAP information included in annual earnings announcement disclosures remains unclear. Below are two primary objectives addressed by the author:

    • Examines whether the level of completeness of the audit on the date of the annual earnings announcement influences the level of GAAP information provided in the disclosure. Management may be more willing to disclose additional GAAP information when there is a more complete audit as of the earnings announcement date because management may have greater confidence in the underlying financial statement balances.
    • Examines whether the quality of the audit influences the level of GAAP information provide in the disclosure. Management may be more willing to disclose additional GAAP information when a higher quality audit is performed because management may have a higher level of confidence in the accuracy of the financial reporting system.
    Design/Method/ Approach:

    The author uses data on publicly traded U.S. firms from the years 2001-2011 to examine how the level of completeness of the audit, as well as audit quality influences the amount of GAAP financial information included in annual earnings announcements which occur in advance of the audit completion date. The level of audit completeness was calculated as the difference between the annual earnings announcement date and the audit report date. Audit quality was measured as either the level of audit fees paid by the company, or whether the firm engaged a Big 4 auditor.

    Findings:
    • Annual earnings announcements for firms in which the audit is closer to completion include higher levels of GAAP financial information as part of the disclosure.
    • Annual earnings announcements for firms in which the audit is of a higher quality include higher levels of GAAP financial information as part of the disclosure. These results indicate that management is more likely to provide more detailed earnings announcement GAAP disclosures when the annual audit is more complete or when the external auditor is higher quality.
    • The increase in disclosed GAAP information for firms with more complete audits or audits from higher quality auditors is driven primarily by an increase in disclosure related to balance sheet and cash flow statement information
    Category:
    Corporate Matters, Standard Setting
    Sub-category:
    Impact of PCAOB, Press Release Language & Signaling
  • Jennifer M Mueller-Phillips
    The Effect of Auditing Standard No. 5 on Audit Report Lags.
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 01.04 Impact of 404, 01.05 Impact of SOX, 01.06 Impact of PCAOB, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
    Title:
    The Effect of Auditing Standard No. 5 on Audit Report Lags.
    Practical Implications:

    The findings support the regulators’ contention that the new top-down, risk-based approach under AS5 makes the audit process timelier and efficient by decreasing audit report lags and facilitating firms’ efforts to meet the reporting deadline set by the SEC, especially when the firms have an effective internal control system. However, the firms with material internal control problems that persist either at the company level or at the accounts/transaction level continue to experience larger reporting lags in the post-AS5 years compared with the clean SOX 404 firms. The results are generally consistent with auditors focusing more on critical risk areas associated with ineffective internal controls and applying principle-oriented top-down, risk-based audit procedures to minimize risk, which requires increased audit efforts and longer audit time to accomplish their work properly.

    Citation:

    Mitra, S., H. Song, and J. S. Yang. 2015. The Effect of Auditing Standard No. 5 on Audit Report Lags. Accounting Horizons 29 (3): 507-527.

    Keywords:
    AS5, audit report lags, PCAOB, SOX 404
    Purpose of the Study:

    This study investigates whether the Public Company Accounting Oversight Board’s (PCAOB) Auditing Standard No. 5 (AS5), which was introduced in June 2007, makes the audit process timelier in an extended post-AS5 period from 2007 to 2011 relative to a pre-AS5 period of 20062007. For this, the authors focus on evaluating the AS5 effect on audit report lags (ARL) both for the firms with material internal control weaknesses (ICW) and the firms with a clean SOX 404 opinion (non-ICW). ARL, a proxy for audit effort, has long been an important topic of academic research because ARL is considered critical in influencing timely judgment and decision making by financial statement users.

    First, the authors investigate the impact of the change from AS2 to AS5 on audit report lags over an extended period from 2006 to 2011. Second, they compare the effect of AS5 on report lags separately for the large accelerated filers and accelerated filers given significant differences in the 10-K filing deadlines for these two types of filers. Third, they examine the impact of AS5 on audit report lags for firms with internal control weaknesses (ICW) with separate analyses for firms with company-level control weaknesses and for firms with account-specific control weaknesses.

    Design/Method/ Approach:

    The analyses are conducted for the period from 2006 to 2011, which covers the AS2 period of 20062007 and the AS5 period of 20072011. The sample comprises 2,062 AS2 observations (divided between 1,877 non-ICW and 185 ICW observations) and 9,200 AS5 observations (divided between 8,870 non-ICW and 330 ICW observations). The authors use Compustat Annual and Business Segment files to gather information.

    Findings:
    • Audit report lags in the AS5 years were significantly lower than those in the AS2 years; the report lags decline, on an average, by 1.85 days.
    • ICW firms, in general, have larger report lags than the clean SOX 404 firms, but AS5 does not have an incremental effect on the report lags for the ICW firms, indicating the report lags decline only for the firms with a clean SOX 404 opinion.
    • Separate analyses for the ICW firms with company-level and account-specific material weaknesses show that audit report lags for those firms do not significantly change between the AS2 and AS5 periods and continue to be higher compared with those for the clean SOX 404 firms.
    • Additional tests using a constant sample of firms demonstrate a learning curve effect of AS5 in reducing report lags in the post-AS5 period both for the full sample and for the firms with a clean SOX 404 opinion.
    • The report lags significantly decline in both the early and late AS5 periods for both the large accelerated filers and accelerated filers and for the full constant sample.
    • Overall, the results show that the new top-down, risk-based approach under AS5 makes the audit process more efficient and timelier by decreasing audit report lags.
    Category:
    Accountants' Reporting, Standard Setting
    Sub-category:
    Changes in Audit Standards, Consequences of Adverse 404 Opinions, Impact of 404, Impact of PCAOB, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Impact of PCAOB AS5 and the Economic Recession on Client...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 01.06 Impact of PCAOB, 06.0 Risk and Risk Management, Including Fraud Risk 
    Title:
    The Impact of PCAOB AS5 and the Economic Recession on Client Portfolio Characteristics of the Big 4 Audit Firms.
    Practical Implications:

    These findings should be of interest to regulators (e.g., ACAP and Department of Treasury) that have focused efforts on assessing the sustainability of the audit profession. However, the results can be viewed as good news in terms of the overall risk level of the Big 4 client portfolio, but possibly as bad news if regulators believe the Big 4 firms are the most qualified to provide audit services to riskier clients and should not use market forces as an excuse to shed or avoid these riskiest clients.

    Citation:

    Schroeder, J. H., and C. E. Hogan. 2013. The Impact of PCAOB AS5 and the Economic Recession on Client Portfolio Characteristics of the Big 4 Audit Firms. Auditing: A Journal of Practice & Theory 32 (4): 95-127.

    Keywords:
    audit risk, auditor portfolio, economic recession, PCAOB Auditing Standard No. 5 (AS5), Sarbanes-Oxley Act
    Purpose of the Study:

    The accounting scandals of the early 2000s, and the resulting loss of investor confidence in the U.S. capital markets, led to significant changes in the U.S. audit market. These changes include a decrease in the number of large international audit firms from five to four with the demise of Andersen, an increase in regulatory scrutiny with the passage of the Sarbanes-Oxley Act of 2002 (SOX) and the establishment of the Public Company Accounting Oversight Board (PCAOB), as well as an increase in the demand for assurance services associated with SOX Section 404.

    The authors examine the impact of PCAOB Auditing Standard No. 5 (AS5) and the economic recession on risk characteristics and degree of auditor/client misalignment in the publicly traded client portfolios of Big 4 firms. AS5 and the economic recession both likely resulted in an increase in audit firm personnel capacity as well as a decline in current and future revenue prospects, leading to concerns that the Big 4 firms may pursue clients that present greater risk to the portfolio.

    Design/Method/ Approach:

    Using Audit Analytics and Compustat the authors compile a sample for 20,736 firm-year observations. The pre-AS5/recession period is from 2002 through November 14, 2007 and the post-AS5/recession period is from November 15, 2007 through 2009. 

    Findings:
    • During the post-AS5/economic recession period the authors continue to see a net loss of clients to the non-Big 4 level; however, at a lower rate than documented during the pre-AS5/recession period.
    • When comparing the overall Big 4 portfolio characteristics, the authors find that the public client portfolio in 2009 presents greater financial risk, but lower audit risk and auditor business risk relative to 2006 (last year of the pre-AS5 period).
    • The net increase in financial risk is attributable to the impact of the economic recession on continuing clients.
    • The net decrease in audit and auditor business risks is also attributable to clients that remain in the portfolio over this period, as post-AS5/recession increases in audit risk and auditor business risk for new clients is offset by reductions due to departing clients.
    • The overall portfolio has a lower percentage of misaligned” clients in 2009 relative to 2006.
    • The findings suggest the Big 4 firms have continued to balance their portfolios with risk in mind, and continue to reduce the percentage of misaligned clients, consistent with portfolio trends of Big 4 firms documented in earlier post-Enron/SOX studies.
    Category:
    Risk & Risk Management - Including Fraud Risk, Standard Setting
    Sub-category:
    Impact of PCAOB, Impact of SOX
  • Jennifer M Mueller-Phillips
    When the PCAOB Talks, Who Listens? Evidence from Stakeholder...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 11.0 Audit Quality and Quality Control, 11.10 Impact of Quality Reviewers, 11.11 Impact of Firm and External Inspection Programs, 12.0 Accountants’ Reports and Reporting, 12.04 Investigations 
    Title:
    When the PCAOB Talks, Who Listens? Evidence from Stakeholder Reaction to GAAP-Deficient PCAOB Inspection Reports of Small Auditors.
    Practical Implications:

    The authors provide initial empirical evidence that Securities and Exchange Commission (SEC) registrants found GAAP-deficient PCAOB inspection reports to be a useful signal of audit quality for triennially inspected auditors. This evidence indicates that PCAOB inspection reports created heterogeneity in auditor brand name that did not previously exist. Also, this paper is the first to empirically link audit committee characteristics to PCAOB inspection report severity and auditor choice. The authors believe this is an increasingly relevant finding as audit committees have been granted much greater auditor dismissal and hiring authority due to SOX. This study indicates that a PCAOB inspection report may serve as an audit quality signal for auditors of broker-dealers, who were previously exempt from the inspection process. Such a finding has current relevance given the PCAOB has recently sought to expand the inspection program to foreign auditors, such as those based in China whose clients are cross-listed on U.S. security exchanges or are listed due to a reverse merger.

    Citation:

    Abbott, L. J., K. A. Gunny, and T. C. Zhang. 2013. When the PCAOB Talks, Who Listens? Evidence from Stakeholder Reaction to GAAP-Deficient PCAOB Inspection Reports of Small Auditors. Auditing: A Journal of Practice & Theory 32 (2): 1-31.

    Keywords:
    audit quality signals, PCAOB inspection process
    Purpose of the Study:

    The PCAOB is a private regulatory agency, independent of the accounting industry. Congress bestowed upon the PCAOB the ability to inspect the work of all accounting firms that audit publicly traded companies. Inspections are conducted annually for Big 4 and national auditors with greater than 100 publicly held registrants (annually inspected auditors). The inspection process is conducted every three years for auditors with fewer than 100 publicly held clients (triennially inspected auditors). The authors classify inspection reports into three categories according to severity. In a clean report, the PCAOB finds no audit deficiencies. In a GAAS-deficient report, the PCAOB notes that the financial statements audited by the auditor are free of material error, but that the audit process did not fully follow GAAS-recommended audit procedures. In a GAAP-deficient report, the PCAOB states that the auditor “failed to identify a material departure from GAAP” or that the audited company “restated certain of its financial statements to make changes relating to” matters/audit deficiencies uncovered by the PCAOB inspection.

    The current study examines the PCAOB in the context of whether GAAP-deficient PCAOB inspection reports of triennially inspected auditors are enough of a deleterious audit-quality signal to prompt dismissals of these auditors. This study then identifies the successor triennially inspected auditor and uses the three-tiered categorization scheme to denote an increase in auditor quality. Specifically, the authors create a dichotomous dismissal-based dependent variable coded “1” in cases where the dismissal results in a higher-quality triennially inspected successor auditor, and “0” otherwise.

    Design/Method/ Approach:

    The authors obtain all inspection reports from the PCAOB website from January 21, 2005 to December 31, 2007. A total of 521 triennially inspected nonforeign accounting firm PCAOB inspection reports were filed, of which 256 (49.1 percent) were clean, and 61 (11.7 percent) were GAAP-deficient. The 54 GAAP-deficient, triennially inspected auditors are included in the sample. The 54 GAAP-deficient auditors report 525 publicly held clients per their PCAOB inspection reports.

    Findings:
    • The authors find that GAAP-deficient, triennially inspected auditors are more likely to be dismissed by their clients and are overwhelmingly replaced by a triennially inspected successor that has not received a GAAP-deficient inspection report.
    • They also document that the dismissal rate for the clean PCAOB inspection report sample is 17.9 percent, while the dismissal rate for the GAAP-deficient sample is a significantly higher 44.3 percent.
    • The authors find that greater agency conflicts, the presence of an independent and expert audit committee, and blockholdings magnify the likelihood of dismissing a GAAP-deficient, triennially inspected auditor in favor of a triennially inspected auditor that is not GAAP-deficient.
    • Interestingly, the authors find that opinion shopping or fee shopping does not differentially impact the likelihood of dismissing a GAAP-deficient, triennially inspected auditor in favor of a triennially inspected auditor that is not GAAP-deficient.
    • The authors link the use of PCAOB inspection reports to an agency-based demand for audit quality signals.
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of PCAOB, Impact of Quality Reviewers, Investigations
  • Jennifer M Mueller-Phillips
    Engagement partner identification: A theoretical analysis.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 15.0 International Matters, 15.01 Audit Partner Identification by Name 
    Title:
    Engagement partner identification: A theoretical analysis.
    Practical Implications:

    The conclusions in this paper are relevant to audit firms and audit partners, as both are directly affected by the PCAOB’s proposal to identify partners on the audit report. The paper models the impact of partner identification on the choices of partners on engagements with inconclusive audit evidence, showing that partners are more likely to make decisions that decrease firm profitability in order to reduce the risk of reputational damage. They suggest that this will be more detrimental to large audit firms since the difference between the partner’s share of firm risk and overall firm risk is greater relative to small firms.

    Citation:

    Carcello, J., and R. Santore. 2015. Engagement partner identification: A theoretical analysis. Accounting Horizons 29 (2): 297-311.

    Keywords:
    PCAOB, audit partner identification
    Purpose of the Study:

    The PCAOB has proposed regulation requiring disclosure of the audit engagement partner’s name within the audit report. This proposal has been met with much resistance from the audit community. The authors establish a model to determine the audit partner reaction to inconclusive evidence under each regime: no partner identification and partner identification. The authors aim to determine which partythe firm or the partnerbears the risk associated with the audit report for an inconclusive set of audit evidence and, in doing so, identify if requiring the partner signature incentivizes the partner to act in a manner inconsistent with the firm’s incentives. The authors also address how this misalignment of incentives differs for small and large audit firms.

    Design/Method/ Approach:

    The authors develop an analytical model, which abstracts away from actual data. The model predicts aggressive/conservative reporting decisions of the partner when audit evidence is inconclusive and accounts for the influence of:

    • Number of partners
    • Partner’s share of the firm and salary
    • Partner’s portfolio revenue
    • Quality of the financial statements
    • Cost of conducting additional audit work
    • Non-audit fees
    • Firm and Partner reputation damages, including litigation risk
    Findings:

    The reporting decision for an audit partner on an audit with inconclusive audit evidence is shown to be influenced by requiring partner identification. This occurs as identification creates a risk of reputational damage to the partner, adding to the partner’s consequences of lost future fees and share of litigation risk which exist absent partner identification. The authors show that audit firm profitability is decreased as partners make decisions to reduce their own reputational damage at the cost of increased costs to the firm, even when extra audit effort may not be merited. They also show that larger firms are more likely to be affected by partner identification since partners have a smaller relative ownership stake in large firms and therefore more readily act against the best interest of the firm (on the other extreme, a sole practitioner will always act in the best interest of the firm since there is no difference between her incentives and the firm’s incentives).

    Category:
    International Matters, Standard Setting
    Sub-category:
    Audit Partner Identification by Name, Impact of PCAOB

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