The findings of this study shed light on the perceived benefits and detriments of the five versus seven year partner rotation requirements. The results highlight the potential unintended consequences of implementing the accelerated rotation including a reduction in partner quality of life and auditor independence and audit quality.
For more information on this study, please contact Brian Daugherty.
Daugherty, B., D. Dickins, R. Hatfield, and J. Higgs. 2012. An Examination of Partner Perceptions of Partner Rotation: Direct and Indirect Consequences to Audit Quality. Auditing: A Journal of Practice & Theory 31 (1): 97-114.
This study examines practicing audit partner perceptions regarding the mandatory partner rotation and cooling off periods. Specifically, the authors investigate how recently enacted and stringent rules might negatively impact auditor quality of life leading to deterioration in audit quality. As a result of the Sarbanes-Oxley Act of 2002 (SOX), the US moved from a seven-year rotation with a two-year cooling-off period to a five-year rotation and five-year cooling-off period. This change in standard provides the authors the opportunity to investigate the perceptions of partner that have worked under both standards.
The authors conducted in-depth semi-structured interviews with seven practicing audit partners. Most of these partners were managing partners from various geographic locations. Based on those interviews, the authors developed a model of the effects of mandatory rotation and created a field survey that was completed by 370 audit partners. Collection of survey results occurred prior to May 2011.
The audit partners in the study believed that rotation generally improved independence which has a positive impact on audit quality. However, partners also expressed that accelerated rotation reduced client-specific knowledge and had a negative impact on audit quality. Partners suggested that the accelerated rotation and extended cooling-off period imposed by SOX has increased the need to relocate if the partner wishes to remain in the same industry. As a result partners often choose to gain new industry experience and stay in the same location, rather than to relocate. This decision maintains the partner quality of life, but possibly at the expense of industry depth and to the detriment of overall audit quality. Partners also discussed a two to three-year new-client familiarization process, resulting in an increase in the amount of time that engagements suffer from “start-up efficacy”. In sum, although the partners view rotation in general as a means to improve independence, they believe the accelerated rotation imposed by SOX may actually result in a reduction in independence and possibly audit quality.
This paper contains important applications for borrowing firms wanting to have more favorable loan contract terms. By hiring a high-quality auditor this decreases risks for the creditors and therefore oftentimes reduces the stringency of debt covenants. Subsequently, the borrowing firm will violate the debt covenants less.
Robin, Ashok, Q. Wu, and H. Zhang. 2017. “Auditor Quality and Debt Covenants”. Contemporary Accounting Research 34.1 (2017): 154.
Debt covenants are in place to help mitigate information asymmetry and agency problems between lender and borrower. This study examines whether high-quality auditors decrease the lenders’ demand for strict covenants (contracting effect), therefore reducing the likelihood of covenant violations (violation reduction effect). The assumption is that the information provided by a high-quality auditor would lower information asymmetry and agency problems, and consequently there would be no reason for strict debt covenants.
There was a sample of 35,181 observations from 1996-2007. Compustat was used to gather annual covenant-violation data and Deal Scan was used to gather U.S. loan facility information. The authors used an ordinary least squared (OLS) regression model in the analysis.
Overall, the authors find high-quality audits are in fact related with fewer and looser covenants in debt contracts.
Specifically, the authors find the following:
http://commons.aaahq.org/groups/e5075f0eec/summary
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.
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.
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.
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.
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:
This paper complements and extends the limited extant research on inspection risk by clearly defining the construct and providing empirical evidence consistent with its existence and impact on auditors’ planning decisions. The authors contend that while auditors may perceive that PARs do not influence effort or fees, both PARs likely cause auditors, perhaps unconsciously, to increase effort and fees.
C. M. Stefaniak, R. W. Houston, and D. B. Brandon. 2017. Investigating Inspection Risk: An Analysis of PCAOB Inspections and Internal Quality Reviews. Auditing: A Journal of Practice and Theory 36 (1): 151 – 168.
The authors report the results of an experiment that examines how auditor anticipation of the two primary external and internal post-audit reviews (PAR), specifically, U.S. Public Company Accounting Oversight Board (PCAOB) inspections or public accounting firms’ internal quality reviews (IQRs), affects auditors’ perceptions of overall engagement risk, as well as effort and pricing decisions. The authors define inspection risk as “the risk that an auditor or audit firm will suffer harm as a result of a PAR.” Although the current PAR regime has been in place for over ten years, there is little empirical evidence concerning whether, and to what extent, anticipating a PAR impacts auditor behavior, and whether the effects of anticipating a PCAOB inspection or IQR differ. IQRs also remain largely uninvestigated, despite researchers beginning to investigate external PCAOB reviews.
To investigate how PAR salience affects auditors’ judgments and decisions, the authors conduct a 1 x 3 between-subjects experiment using a number of high-level auditors as participants. They manipulate PAR salience as PCAOB inspection salient, IQR salient, or no explicit expectation of a PAR.
Most importantly, the findings of this study educate on the audit quality implications of a subordinate making judgments with knowledge of their superior’s preference. While knowledge of a superior’s preference may negatively affect the objectivity of audit judgments, the findings suggest that is also has the potential to improve audit judgment quality. Second, possible cross-nation variation in audit judgment has important implications for the audit of multinational organizations and offshoring of audit work, among others.
Kim, S. and N. Harding. 2017. The Effect of a Superior’s Perceived Expertise on the Predecisional Distortion of Evidence by Auditors. Auditing: A Journal of Practice and Theory 36 (1): 109 – 127.
Auditors are influenced by the known preferences of their superiors such that they are motivated to make judgments that favor those preferences. In this study, the authors examine the potential for the influence of a superior’s known preferences to positively affect audit quality, and whether that influence varies across nations that differ in their hierarchical culture. There is a potential for a superior’s preference to have information value such that a judgment favoring the superior’s preference may not be entirely non-normative; however, there is an implicit assumption that this is a threat to the objectivity of auditor judgments and detracts from audit quality. With this study, the authors hope to address a gap in the existing literature and, in doing so, to contribute to an understanding of what superiors should communicate to their subordinates in order to enhance audit quality.
The authors conduct an experiment in which auditors from Australia and South Korea evaluate a number of going concern evidence items and then make a judgment as to whether the firm for which the evidence items relate would continue as a going concern.
Requiring engagement partners to sign their names to audit reports appears to result in increased audit quality, earnings informativeness, and audit fees, suggesting that the signature requirement emphasizes personal accountability for engagement partners. Requiring the identification of engagement partners in audit reports would likely have similar effects. Thus, there are both costs and benefits that the PCAOB should consider in making its decision regarding partner identification.
For more information on this study, please contact Chan Li: chanli@katz.pitt.edu.
Carcello, J. V. and C. Li. 2013. Costs and benefits of requiring an engagement partner signature: Recent experience in the United Kingdom. The Accounting Review 88 (5): 1511-1546.
The Public Company Accounting Oversight Board (PCAOB) is considering requiring the identification of the engagement partner in audit reports. Proponents of the proposal argue that it will increase accountability and transparency, which will result in improved audit quality. Opponents argue that engagement partner identification is unnecessary, as audit firms’ quality control systems and the threats of sanctions by regulators and private litigation are sufficient to hold partners accountable. Identifying engagement partners is similar to them signing audit reports in their own name, which the U.K. began requiring in 2009. Because of the similarities between the U.K. and the U.S., it is likely that the effects of requiring engagement partner identification in the U.S. will be similar to the effects of requiring the engagement partner to sign the audit report in the U.K. Therefore, the authors investigate the benefits and costs of requiring partner signatures in the U.K. in the form of changes in audit quality and audit fees. The results are likely informative of the benefits and costs of requiring partner identification in the U.S.
Using publicly-disclosed data on companies listed on the London Stock Exchange (LSE) between 2008 and 2010 (the years surrounding the implementation of the signature requirement), the authors examine audit quality changes using the following measures:
The authors also examine the change in audit fees following the implementation of the signature requirement.
The authors find that following the implementation of the signature requirement, abnormal accruals and the likelihood of meeting earnings thresholds decrease in the U.K. These results suggest that audit clients’ earnings management declines due to the signature requirement. Further, the association between return on assets and stock market returns increases following the signature requirement, implying that reported earnings becomes more informative of firm value to investors following the implementation of the signature requirement. The likelihood of audit clients receiving a qualified audit opinion following the signature requirement also increases, suggesting that audit reporting becomes more conservative with the signature requirement. Finally, audit fees increase with signature requirement. Thus, signature requirement appears to result in higher fees for audit clients. These changes do not occur for U.S. firms or other European firms during the same period and do not occur for the U.K. in the period prior to the introduction of the signature requirement, providing evidence that the changes in the U.K. are the result of the signature requirement.
The results of this study may help researchers, practitioners, and others to develop a more nuanced approach toward the information value of auditor-in-charge involvement as potentially indicating audit quality. This would be a very timely contribution for audit firms given their desire to globalize their approach to and procedures followed during audits. Specifically, the results indicate that, while the extent of auditor-in-charge involvement may serve as a relevant audit quality indicator, culture needs to be taken into account; consequently, different thresholds may need to be considered for different regions in the world, as opposed to one global standardization.
Bik, O. and R. Hooghiemstra. 2017. The Effect of National Culture on Auditor-in-Charge Involvement. Auditing: A Journal of Practice and Theory 36 (1): 1 – 19.
Although audits are conducted in teams, the auditor-in-charge performs a pivotal role in the audit process. In fact, in an attempt to strengthen audit quality, global audit firms have contemplated setting some standardized thresholds for the number of hours an auditor-in-charge should spend on an audit. However, auditor-in-charge involvement is affected by numerous contextual factors at both the engagement level and the country level. In this study, the authors aim to advance the understanding of what affects differences in auditor-in-charge involvement by focusing on the effects of national culture.
The analyses are based on unique, archival data from a Big 4 audit firm comprising time-record data regarding individual audit engagements reflecting audit practices in 50 countries across the globe.
The findings show that managers implicitly encourage auditors to underreport time when dealing with a favorable client. While CPA firms have decreased explicit incentives to underreport, these implicit incentives makes it likely that seniors are underreporting their time. This can lead to unrealistic budgets and possible costing issues for firms. Also, if a senior does not underreport they could risk getting a bad evaluation or not be assigned to desirable future engagements. These situations could lead to a reduction in raises, promotions, and continued employment.
Agoglia, C. P., R. C. Hatfield, and T. A. Lambert. 2015. Audit team time reporting: An agency theory perspective. Accounting, Organizations and Society 44: 1-14.
There is a substantial concern that audit teams underreport time for audit engagements. While some recent research suggests that explicit incentives to underreport have been reduced, other research suggests that there still may be implicit incentives to underreport. Based on agency theory, it is likely that reviewers rate the preparer more favorably when the client is desirable and the preparer underreported their time. The purpose of this study is to investigate this concern by evaluating how reviewer’s performance evaluations of the preparer and future staffing decisions are influenced by the following factors:
Data for this paper was collected prior to May 2015 by mailing experimental instruments to both managers and partners of CPA firms.
Managers rated the performance of a senior higher when they underreported time and were working on a desirable client. The findings also show that managers are more likely to request an underreporting senior on a future audit engagement. However, partners did not show any preference to seniors who underreported time.
The authors’ results may be of interest to policy makers for two important reasons. First, regulatory discussions on mandatory audit firm rotation could have implications for the cost and quality of auditing if a client is forced to switch from a compatible auditor to one that is less compatible. Second, proposals to expand the auditor’s reporting responsibilities might mitigate the loss of audit quality when similarity arises in unaudited disclosures.
Brown, S. V. and W. R. Knechel. 2016. Auditor-Client Compatibility and Audit Firm Selection. Journal of Accounting Research 54 (3): 725-775.
A great number of factors affect the complicated process of a client selecting an auditor. The factors that might affect the degree of compatibility between an auditor and a client include pricing, expertise, location, interpersonal associations and the extent of agency problems in the client. Research in the past has looked into some of these attributes and how they are relevant in determining the overall quality of the resulting audit. A limited amount of research has examined alignment between clients and certain types of auditors based on factors such as the size of the audit firm or degree of industry specialization. However, there is less research on the compatibility of specific auditors and specific clients. The authors define auditor-client compatibility as the ability of the auditor to satisfy a client’s preferences, given the auditor’s own preferences, abilities and constraints. With this in mind, the authors examine the narrative disclosures included in the text-based parts of the financial statements that provide information about a company, its operations and its accounting choices. Next, they develop a unique measure of auditor-client compatibility for Big 4 firms based on the similarity of their financial disclosures rather than their financial results.
The authors focus on three narrative disclosures separately and together: the company’s business description, the accounting footnotes, and management discussion and analysis. They also compare the similarity of an individual client to all of the current clients within an industry of a specific auditor to generate a proxy for how well that company fits into each auditor’s client base.
This study provides evidence that should help inform the public discussion of audit quality in the post-Sarbanes-Oxley era and adds empirical substance to theoretical frameworks of audit quality.
Christensen, B. E., S. M. Glover, T. C. Omer, and M. K. Shelley. 2016. Understanding Audit Quality: Insights from Audit Professionals and Investors. Contemporary Accounting Research 33 (4): 1648 – 1684.
Much debate exists surrounding the definition, composition, and measurement of audit quality. This debate continues despite the importance of audit quality and the large body of research investigating the topic. This paper contributes to this debate by obtaining perceptions and measures of audit quality from audit professionals and investors, two groups heavily interested in the audit and financial reporting process. Furthermore, this study provides evidence that contributes to understanding and defining audit quality, providing empirical evidence regarding many of the audit quality indicators proposed by the PCAOB, adding empirical substance to existing theoretical frameworks of audit quality and highlighting differences and consistencies between auditor and investor expectations about the audit process.
The authors conducted a survey of audit professionals and investors to obtain their insights on audit quality.