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  • Jennifer M Mueller-Phillips
    Industry- versus Task-Based Experience and Auditor...
    research summary posted September 26, 2013 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience 
    Title:
    Industry- versus Task-Based Experience and Auditor Performance
    Practical Implications:

    The results of this study are important for audit firms to consider when staffing their engagements, particularly for mid-tier accounting firms.  The authors note that firms may want to consider allocating non-specialist staff among a few different industries. According to their research, there appears to be benefits due to the industry experience regardless of whether they have task-related experience.  This allows for non-specialist auditors to continue gaining task-based experiences while expanding their industry-based experiences. 

    For more information on this study, please contact Robyn Moroney.
     

    Citation:

    Moroney, R., and P. Carey. 2011. Industry- versus Task-Based Experience and Auditor Performance. Auditing: A Journal of Practice & Theory 30 (2):1-18.

    Keywords:
    Audit quality; industry-based experience; task-based experience
    Purpose of the Study:

    Prior research has shown that both industry-related experience and task-related experience improve auditor performance.  This is important because, other than training, experience is the main opportunity for an auditor to gain knowledge and improve their audit performance.  In these earlier studies, researchers focused on either task-based experience or industry-based experience.  This allows researchers to find that task-based experiences improve performance or industry-based experience improves performance but not which one is more important.  Since auditors gain industry experience by working on audit tasks for clients within an industry and vice versa, the relative importance of each has not been evaluated.  The purpose of this study is to make comparisons about whether industry-based or task-based experience is more important in the performance of non-specialist auditors.  It also seeks to determine whether continued experiences within one industry continues to increase auditor performance or if it levels out.

    Design/Method/ Approach:

    The authors collected evidence from their experiment prior to January 2009.  The authors use a sample of non-specialist auditors (including senior associates, managers, and partners) from 8 non-Big 4 accounting firms.  Participants completed two cases, one with a research and development expenditure in the manufacturing industry and another case involving investments in the superannuation (pension fund) industry.  Answers from 5 questions about each case resulted in a performance rating based on comparison of the participant’s answers to the “correct” answer as provided by an expert panel.

    Findings:
    • The authors find that industry-based experience is relatively more important than task-based experience in non-specialist auditors.
    • The authors find performance due to industry-based experience increases quickly.  As auditors spend higher percentages of their annual time in a particular industry their performance scores increase noticeably between the 0% category and the 1-10% category and again between the 1-10% category and 11-20% category. 
    • The authors also find that the impact of industry-based experience levels out once auditors spend approximately 20% of their annual time in that industry. 
       
    Category:
    Audit Quality & Quality Control, Audit Team Composition
    Sub-category:
    Industry Expertise – Firm and Individual, Industry Experience
  • Jennifer M Mueller-Phillips
    Market Reaction to Auditor Switching from Big 4 to...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 11.08 Proxies for Audit Quality 
    Title:
    Market Reaction to Auditor Switching from Big 4 to Third-Tier Small Accounting Firms
    Practical Implications:
    • Our results suggest that the market has confidence in companies choosing third-tier audit firms to enhance the economic benefit in terms of better audit services.
    • The results confirm the regulator’s encouragement of selecting smaller audit firms to improve competition, and the results will ease the reluctance that companies have in choosing a smaller audit firm.
    • The results confirm that the market viewed the regulatory changes in 2004 as an improvement to audit quality of the small audit firms, which included SOX 404 audits of internal controls over financial reporting, PCAOB inspections of audit firms, and a shorter filing deadline for Form 8-K.

    For more information on this study, please contact Kenneth J. Reichelt.

    Citation:

    Chang, H, C. S. A. Cheng, and K. J. Reichelt. 2010. Market reaction to auditor switching from big 4 to third-tier small accounting firms. Auditing: A Journal of Practice and Theory 29 (2): 83-114.

    Keywords:
    market reaction; auditor switching; Big 4; small accounting firms; audit quality.
    Purpose of the Study:

    After the demise of Arthur Andersen, the public accounting industry had witnessed a significant migration of public clients to second-tier (Grant Thornton and BDO Seidman) and smaller third-tier accounting firms. While prior literature documents that smaller auditors are perceived by the stock market as an inferior substitute for a Big 4 auditor, this perception appears to have changed in recent years. For instance, a 2006 Wall Street Journal article (Reilly 2006) reported that more IPOs are relying on smaller accounting firms. In this paper, we analyze stock market responses to auditor switching from Big 4 to smaller accounting firms from 2002 to 2006.

    We predict that three major regulatory changes likely improved investor perceptions of smaller third-tier auditors: 1) audits of internal controls over financial reporting under Section 404 of the Sarbanes Oxley Act of 2002 (SOX), 2) Public Company Accounting Oversight Board (PCAOB) inspections of audit firms, and 3) a tighter Form 8-K filing deadline. These regulatory changes were intended to improve audit quality for all firms, but the smaller audit firms had the most room to improve. Consequently, after these regulatory changes, switches to smaller audit firms were perceived more favorably by investors.

    Design/Method/ Approach:
    • We compare market adjusted returns of Big 4 to third-tier auditor switches between two periods: 1) February 1, 2002 to August 23, 2004 - when SOX was proposed and passed but when investor perceptions of smaller third-tier auditors were unlikely to have changed, and 2) August 24, 2004 to December 31, 2006 - when major regulatory changes occurred that likely improved investor’s perceived quality of third-tier auditors. 
    • We also perform multivariate analysis that compares the market reaction to switches from Big 4 to Third-tier auditors where audit quality changes are more noticeable by the market. For instance, 1) switches from Big 4 non-specialists to third-tier auditors when accruals quality of the Big 4 auditor was lower than normal, 2) switches from a Big 4 non-specialist auditor to a third-tier industry specialist auditor when accruals quality of the Big 4 auditor was lower than normal, and 3) switches from a Big 4 non-specialist auditor to a third tier auditor when audit fees decreased and when accrual quality of the Big 4 auditor was lower than normal.
    Findings:
    • We find that in the second period (after August 23, 2004), that the market responded more positively to auditor switches from Big 4 to third-tier auditors (BtS), as well as to switches form Big 4 to second-tier auditors and to Big 4 auditors, when compared to the first period (February 1, 2002 to August 23, 2004).
    • We find that the more positive stock market reaction to BtS switches occurred when the Big 4 predecessor did not warrant high audit quality (a non-specialist auditor and lower accruals quality), thus implying a low likelihood of an audit quality decrease.
    • We find that the more positive stock market reaction to BtS switches is not due to an audit fee decrease, but rather to engaging a third-tier industry specialist auditor that can provide better services.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Industry Expertise – Firm and Individual, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    National Level, City Level Auditor Industry Specialization...
    research summary posted February 24, 2015 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience 
    Title:
    National Level, City Level Auditor Industry Specialization and Cost of Debt
    Practical Implications:

    The results of this study are important for public companies to consider when choosing auditors.  The results clearly show that city-level industry specialist auditors are associated with lower cost of debt. Public companies which are thinking about engaging debt financing should seriously consider hiring city-level industry specialist auditors. The results of this study are also important for auditors. City-level industry specialist auditors can use this finding to promote themselves to existing and potential clients. Non city-level industry specialist auditors can consider the benefit of becoming city-level industry specialist auditors.

    For more information on this study, please contact Xie.

    Citation:

    Li, C., Y. Xie and J. Zhou. 2010. National level, city level auditor industry specialization and cost of debt. Accounting Horizons 24 (3): 395-417.

    Keywords:
    auditor industry specialization; national level industry specialist; city level industry specialist; credit rating; bond spread
    Purpose of the Study:

    Prior studies using industry specialist as a proxy for audit quality usually focus on two areas: (1) the relationship between auditor industry specialization and audit fees; and (2) the relationship between auditor industry specialization and client earnings quality. The findings from these two strands of literature generally indicate that clients of industry specialist auditors pay higher audit fees, and, in turn, are associated with higher earnings quality as measured by discretionary accruals. In sum, these studies show that auditor industry specialization matters in addition to the Big N versus non-Big N differentiation.

    Recent research has begun to explore differences in industry leadership at the national and city levels. Examining audit fees and earnings quality, recent research finds that audit quality is a city level phenomenon with joint city and national industry leaders having the highest quality, followed by city-only leaders. National-only leaders do not distinguish themselves from non-leaders. The city-only industry specialization is important because individual auditors’ deep industry knowledge at the office level is an important determinant of audit quality. However, the empirical evidence that links national-city level industry specialists to investors, especially debt holders, is limited. Therefore, we investigate whether higher audit quality associated with industry specialist auditors at the city level benefits clients in their debt financing.

    Design/Method/ Approach:

    The research sample is from 2001 to 2006 focusing on US public companies. The authors use regression methods to identify the relationship between national level, city level auditor industry specialization and cost of debt. The authors use two alternative methods to measure cost of debt: credit ratings and bond spreads. 

    Findings:

    Consistent with the assumption that higher audit quality is associated with lower information risk, which benefits clients in raising debt capital, we find that firms audited by city level industry specialist auditors, either alone or jointly with national level industry specialist auditors, enjoy significantly lower cost-of-debt financing measured by both credit rating and bond spread. Our results suggest that, compared to clients of non-industry specialists, firms’ odds of worse credit ratings are 0.859 (0.664) times lower, and their bond spreads are 17 (16) basis points lower if they are clients of city-level-only (joint national and city level) industry specialists. In addition, our evidence shows that, for joint national and city level industry specialists, both information and insurance roles are significant to reduce cost-of-debt financing.

    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Industry Expertise – Firm and Individual
  • Jennifer M Mueller-Phillips
    The Effect of a Superior’s Perceived Expertise on the P...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.03 Management/Staff Interaction, 11.04 Industry Experience 
    Title:
    The Effect of a Superior’s Perceived Expertise on the Predecisional Distortion of Evidence by Auditors
    Practical Implications:

    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. 

    Citation:

    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.

    Keywords:
    audit quality, culture, predecisional distortion, superior’s expertise, Australia, and South Korea
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    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. 

    Findings:
    • The authors find that auditors exhibit greater levels of predecisional distortion toward the known preference of a superior perceived to possess higher levels of expertise as opposed to those perceived to have lower levels of expertise, and this is the case for auditors in both Australia and South Korea.
    • The authors find no evidence of differences in the level of predecisional distortion exhibited by auditors from Australia and South Korea. 
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Industry Expertise – Firm and Individual, Management/Staff Interaction
  • The Auditing Section
    The Influence of Audit Firm Specialization on Analysts’ F...
    research summary posted April 16, 2012 by The Auditing Section, tagged 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior 
    Title:
    The Influence of Audit Firm Specialization on Analysts’ Forecast Errors
    Practical Implications:

    The results of this study suggest that industry specialist auditors help constrain management’s tendency to manipulate earnings to achieve certain earnings thresholds.  These results do appear weaker when limiting the analysis to the post-SOX period, which could reflect the significant changes to the auditing market that occurred during and after 2002, but the post-SOX analysis is subject to limited data availability.

    Citation:

    Payne, J. 2008. The Influence of Audit Firm Specialization on Analysts’ Forecast Errors. Auditing: A Journal of Practice & Theory 27 (2): 109-136.

    Keywords:
    auditor specialization; analysts’ forecast error; audit quality
    Purpose of the Study:

    The prior literature shows that analysts’ forecasts provide information to financial market participants.  Also, it shows that managers have incentives to meet or beat analysts’ forecasts because failure to do so could result in negative stock price reactions, reduced compensation, costly legal actions, or all of the above.  However, managers also have incentives to reduce reported earnings down to analysts’ forecasted amount if earnings were to exceed the forecasted amount and establishing accrual reserves would allow  management to more easily meet future earnings expectations.  Therefore, the amount of analyst forecast error (i.e., the difference between the consensus analyst forecast and actual earnings) provides a proxy for management’s use of earnings manipulation activities.

    Prior literature also shows that higher quality auditors constrain management’s earnings manipulation activities, including their use of total and discretionary accruals.  Additionally, prior literature examines and shows a decreased level of reported earnings that just meet or beat analysts’ forecasts when the companies are audited by city-specific auditor specialists, as well as reduced analyst forecast errors for quarterly periods that are subject to financial statement audit requirements versus review requirements (i.e., the 4th quarter versus quarters 1 through 3).  However, the purpose of this paper is to fill a void in the literature and examine the impact of higher audit quality, as proxied by industry specialist auditors, on managements’ use of accruals when management has specific incentives to manipulate earnings (up or down) towards a predetermined target level.

    Design/Method/ Approach:

    To isolate industry specialization, the author examines U.S. publicly traded companies who are audited by Big N firms during the period of 1989-2005.  The author measures managements earnings manipulation by modeling  the absolute value of analyst forecast error and reported earnings exceeding analysts’ forecasts by exactly 1 cent.  Differential audit quality is based on measures for auditor specialization as proxied by the auditor’s industry market share, audit firm portfolio market share, and a combined indicator of those two measures.  The author examines both measures in the pre- and post- SOX period.

    Findings:
    • The results indicate that absolute analyst forecast errors are greater for companies audited by industry specialist auditors. 
    • Companies audited by industry specialist auditors are less likely to just meet or beat analysts’ earnings forecasts.
    • There is no difference with respect to the period absolute analyst forecast errors analysis in the pre- or post-SOX period.
    • The negative association between auditor specialists and companies that just meet or beat analysts’ earnings forecasts is weaker during the post-SOX period.
    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Industry Experience, Earnings Targets & Management Behavior
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