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  • Jennifer M Mueller-Phillips
    A Perspective on the PCAOB - Past and Future.
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 01.06 Impact of PCAOB 
    Title:
    A Perspective on the PCAOB - Past and Future.
    Practical Implications:

    The quality of the firm performing the audit is important but must be viewed through the perspective of a specific engagement team and a specific set of circumstances. Information supplied by the PCAOB is one component of the evaluation of the likelihood that an engagement team will perform a quality audit and of specific areas of audit practice where deficiencies have been identified. In the end, however, issues of independence, auditor rotation, industry competence, attention to the work, and all the other important aspects of audit quality must be monitored by the audit committee at the engagement level in the context of the specific engagement.

    Citation:

    Wedemeyer, P. D. 2014. A Perspective on the PCAOBPast and Future. Accounting Horizons 28 (4): 937-947.

    Keywords:
    internal auditing, auditing standards, PCAOB, Sarbanes-Oxley
    Purpose of the Study:

    The passage of Sarbanes-Oxley (SOX), the creation of the Public Company Accounting Oversight (PCAOB), and subsequent developments have substantially increased the political visibility of auditors and audits of financial statements. These same events have substantially decreased the role of the auditing profession in establishing audit standards and standards of audit performance; auditing is now an industry regulated primarily by persons who are not professional auditors. The perceived interest of each of the parties involved in the political process is often in conflict with those of any, or all, of the other parties.

    The author’s primary concern is the quality of the audit performed on a specific engagement.

    Design/Method/ Approach:

    This paper summarizes and synthesizes information on the PCAOB and its effect on the business model of an audit firm.

    Findings:

    SOX requirements for PCAOB inspections of audit firms substantially increased the possibility that an audit will be subsequently evaluated despite the absence of identified errors in audited financial statements. The SOX requirement for an auditor's opinion on internal controls over financial reporting (ICFR) immediately increased audit costs. The net effect of these changes has been to increase the cost of audits, particularly as a result of increased review, other quality control activities, and the performance of audits of ICFR, where required. In return, the quality of audits in terms of compliance with audit standards has improved significantly. However, the business models of audit firms and the processes for education and certification of accountants have remained substantially unchanged and are major influences on the quality of audits.

    Category:
    Standard Setting
    Sub-category:
    Impact of PCAOB, Impact of SOX
  • Jennifer M Mueller-Phillips
    A Post-SOX Examination of Factors Associated with the Size...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 05.0 Audit Team Composition, 05.04 Staff Hiring, Turnover and Morale, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    A Post-SOX Examination of Factors Associated with the Size of Internal Audit Functions
    Practical Implications:

    This study provides insights that should be useful for CAEs and boards of directors (or audit committees) in discussions related to (1) internal audit philosophy regarding its potential contributions to an organization, (2) alternative staffing models, (3) resource allocation, and (4) embracement of audit technology. The study could also help guide external auditors’ evaluation of client internal audit functions. The authors find that the mission of internal audit functions differs from organization to organization. Additionally, the results suggest that internal audit functions used for leadership development purposes (i.e., a rotational staffing strategy) are larger, presumably because the staff have less experience and staff are rotating in and out of the department more frequently. Finally, these findings help illustrate the importance of internal audit proving that it is ‘‘value added’’ to the organization. Management and audit committees are often looking for more than financial statement compliance, and those internal audit functions that have responded to these greater needs are rewarded with more resources, likely because they are perceived to deliver more value.

    For more information on this study, please contact Karla Johnstone.
     

    Citation:

    Anderson, U. L., M. H. Christ, K. M. Johnstone, and L. E. Rittenberg. 2012. A Post-SOX Examination of Factors Associated with the Size of Internal Audit Functions. Accounting Horizons 26(2): 167-191

    Keywords:
    Internal Audit; resource allocation; budgeting; staffing.
    Purpose of the Study:

    Internal auditing is a key element of an organization’s governance, risk management, and internal control structure. However, many organizations struggle to know if the investments they make in the internal audit function are appropriate and use size benchmarking data (e.g., firm assets, revenues, number of employees) to determine if internal audit is appropriately sized. However, benchmark data fails to incorporate other factors that influence internal audit size such as the effectiveness and efficiency of an internal audit function, the scope of the internal audit mission, or internal audit objectives and staffing strategies. Therefore, the objectives of the study include the following:

    • Develop and test a conceptual model that articulates the factors associated with internal audit size in the contemporary post-SOX era. The model includes four determinants of internal audit size: (1) audit committee characteristics, (2) internal audit characteristics and mission, (3) assurance activities performed by others (including internal audit outsourcing providers and assurance provided by other functions within the organization), and (4) organization characteristics.
    • Conduct an examination using contemporary post-SOX data in order to extend earlier related research on internal audit sizing by considering a variety of previously unexamined characteristics that differentiate internal audit functions from one another.
    • Examine the state of internal audit staffing in the post-SOX environment.
       
    Design/Method/ Approach:

    The authors collected data with which to test their model by first conducting field interviews with a variety of chief audit executives across a broad range of industries. The authors then distributed a survey to chief audit executives that are members of the Institute of Internal Auditors. The survey includes questions related to each of the four determinants of internal audit size (as mentioned above), as well as internal audit size based on number of internal audit personnel. The field interviews were conducted between August 2006 to November 2006 and the survey was conducted from August 2007 and October 2008.

    Findings:

    The authors find that internal audit size is positively associated with:

    Audit Committee Characteristics:

    • the size of the audit committee;
    • the frequency of audit committee meetings with the CAE
    • audit committee review and approval of the internal audit budget.

    Internal Audit Characteristics and Mission:

    • CAE tenure in the organization;
    • performance of IT auditing;
    • the use of a staffing model in which internal audit is used for rotational leadership development
    • the use of sophisticated audit technology.

    Organization Characteristics:

    • the total assets of the organization
    • the number of foreign subsidiaries that the organization possesses.


    Further, the authors find that internal audit size is inversely associated with:

    Internal Audit Characteristics and Mission:

    • the percent of audit staff designated as Certified Internal Auditors.

    Internal Audit Activities Performed by Others:

    • the extent of internal audit activities outsourced to a third party.
    Category:
    Audit Team Composition, Governance, Standard Setting
    Sub-category:
    Board/Audit Committee Composition, Impact of SOX, Staff Hiring - Turnover & Morale
  • Jennifer M Mueller-Phillips
    A Summary of Research on External Auditor Reliance on the...
    research summary posted February 16, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control 
    Title:
    A Summary of Research on External Auditor Reliance on the Internal Audit Function
    Practical Implications:

    Regulators should draft regulations and oversee the profession in such a way that reflects an understanding of the complex environment in which practitioners are making reliance decisions. Standard setters, both domestic and international can learn from the cultural and jurisdictional nuances of different countries, which will facilitate appropriate internal audit reliance as corporations continue to have multi-national presences. Practitioners can benefit from the study by utilizing the review to improve upon their reliance decision frameworks.

    For more information on this study, please contact Chad Stefaniak.

    Citation:

    Bame-Aldred, C. W., D. M. Brandon, W. F. Messier, Jr., L. E. Rittenberg, and C. M. Stefaniak. 2013. A Summary of Research on External Auditor Reliance on the Internal Audit Function. Auditing: A Journal of Practice and Theory 32 (Supplement 1): 251-286

    Keywords:
    external audit; internal audit; reliance on the internal audit function; audit judgments.
    Purpose of the Study:

    The Public Company Accounting Oversight Board (PCAOB) requested a synthesis of existing research on the external auditor’s reliance of the internal audit function. Auditing Standard No. 5 (AS5) allows external auditors to rely on the internal audit function under certain criteria. This paper synthesizes post Sarbanes-Oxley research (2004 – 2012) that examines external auditor reliance of the internal audit function. The research reviewed pertains to:

    1. The influence of environmental factors on internal auditor reliance (i.e., Regulatory Environment and Governance and Client Management Characteristics),
    2. The impact of internal audit specific factors on reliance (i.e., Competence, Objectivity, and Work Quality),
    3. The nature and extent of the external auditor’s reliance, and
    4. The outcome effects of external auditor reliance on the internal auditor (i.e., Audit Efficiency, Fees, Financial Statement Quality, and Litigation).

    The research examined is limited and does not fully address the PCAOB’s inquiries, specifically jurisdictional limitations on internal audit reliance and overall threshold limitations on internal audit reliance. This paper identifies gaps in the research and proposes a series of research questions aimed at closing these gaps.

    Design/Method/ Approach:

    The review included current and proposed U.S. and international auditing standards, academic literature and selected practitioner research related to the nature of internal audit work, and the external auditor’s reliance on this work. Based on this review, the paper includes a proposed summation model and organizing framework to help capture the various factors in the reliance decision. This organizing framework is used to present the synthesis of the relevant research, identify gaps in the research and propose research questions aimed at closing these gaps. In addition, the relevant papers are summarized for ease of understanding. This summary includes the methodology, the objective of the research project, the sample (if applicable), the results of each study, and a cross-reference to the proposed research questions. 

    Findings:
    • The environment (i.e., the regulatory environment and governance and client characteristics) in which external auditors must make a reliance decision is complex – involving several factors that must be considered simultaneously. The evolving set of global auditing standards further complicates the reliance decision process.
    • Researchers have made some progress in understanding the influence of external auditors’ evaluations of internal auditor quality factors (i.e., competence, objectivity, and work performance); however, very little is known about how, and to what extent, external auditors are evaluating internal audit quality factors.
    • Research notes that the nature and extent of external auditors’ reliance on internal auditors is influenced by account risk, inherent risk, and internal audit sourcing (e.g., outsourced, co-sourced, or in-house). How the external auditors choose task environments (e.g., revenue recognition versus payroll) and the types of tests to rely upon within these task environments is not completely understood.
    • There are several unaddressed issues in the current research. These include:
      • Research examining the influence of continuous monitoring on the reliance decision
      • Research examining the reliance decision for integrated audits of public companies, specifically the audit of internal control over financial reporting.
      • Research examining the evolving nature of the internal audit function.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of SOX
  • Jennifer M Mueller-Phillips
    An Examination of Partner Perceptions of Partner Rotation:...1
    research summary posted October 10, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience 
    Title:
    An Examination of Partner Perceptions of Partner Rotation: Direct and Indirect Consequences to Audit Quality
    Practical Implications:

    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. 
     

    Citation:

    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. 

    Keywords:
    Sarbanes-Oxley; audit partner rotation; auditor independence; audit quality; quality of life.
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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. 

    Findings:

    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.

    Category:
    Audit Quality & Quality Control, Independence & Ethics, Standard Setting
    Sub-category:
    Impact of SEC Rules Changes/SarBox, Impact of SOX, Industry Experience
  • Jennifer M Mueller-Phillips
    Associations between Internal and External Corporate...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements, 13.0 Governance 
    Title:
    Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements
    Practical Implications:

    Prior studies’ conflicting results regarding the association between corporate governance measures and restatements are explained (at least partially) by the time period in which the relationship is examined. The relationship is different before and after Sarbanes Oxley (2002). However, this paper cannot determine whether the change in relationship was caused by Sarbanes Oxley or whether it happened for another reason.

    For more information on this study, please contact William R. Baber.
     

    Citation:

    Baber, W. R., L. Liang, and Z. Zhu. 2012. Associations between Internal and External Corporate Governance Characteristics: Implications for Investigating Financial Accounting Restatements. Accounting Horizons 26 (2): 219-237.

    Keywords:
    corporate governance; governance regulation; accounting restatements
    Purpose of the Study:

    Prior studies have found conflicting results as to whether corporate governance characteristics are related to accounting restatements. Some of these prior students examine restatements prior to Sarbanes Oxley (2002), and some examine restatements afterwards. This study seeks to reconcile the findings of previous research and determine whether the relationship between corporate governance and accounting restatements has changed over time.

    Design/Method/ Approach:
    • Authors examine corporate governance data from 1997 and 2005 to compare differences in governance over time.
    • Corporate governance characteristics are divided between factors that affect internal governance (defined as characteristics that presumably govern the efficacy of board of director oversight of management) and factors that affect external governance (defined in terms of the ability of shareholders to intervene in decisions by both management and the board of directors)
    • Investigate the association between 1997 corporate governance and the probability that financial statements from 1995-1999 are restated; also investigate the association between 2005 corporate governance and the probability that financial statements from 2003-2007 are restated.
       
    Findings:
    • There is a substantial increase in internal governance during the period when changes were imposed by stock exchanges and by the U.S. Congress in the Sarbanes-Oxley Act (2002). The change in internal governance is offset by a less substantial, yet statistically significant, decrease in external governance which is consistent with the observation that shareholder oversight is recently declining.
    • In 1997, internal and external governance characteristics are substitutes for each other (firms tend to do one or the other); in 2005, however, internal and external governance is not related.
    • Corporate governance characteristics in 1997 (prior to Sarbanes Oxley) are unrelated to the probability of financial statement restatements, whereas the correlation between corporate governance characteristics and restatements is statistically significant in 2005 (after Sarbanes Oxley).
      • Thus, the cross-sectional relationship between governance characteristics and restatement changed between 1997 and 2005.
    • The relationship between corporate governance measures in 2005 and restatements in 2003-2007 is not significant if interactions between internal and external governance measures are omitted from the model.
       
  • Jennifer M Mueller-Phillips
    Audit Committee Director-Auditor Interlocking and...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.02 Board/Financial Experts, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    Audit Committee Director-Auditor Interlocking and Perceptions of Earnings Quality
    Practical Implications:

    This study is important to provide an insight into the personal relationships and familiarity between audit committee directors and external auditors in terms of auditor independence. Furthermore, our examination of AC director-auditor interlocking provides a more complete basis for understanding the effectiveness of corporate governance in guarding earnings quality. The results not only support the view that AC director-auditor interlocking positively affects investors’ perception of earnings quality, but also support the regulatory requirement that audit committees include at least one financial expert.

    For more information on this study, please contact Jeng-Fang Chen.

    Citation:

    Chen, J.-F., Y.-Y. Chou, R.-R. Duh, and Y.-C. Lin. 2014. Audit committee director-auditor interlocking and perceptions of earnings quality. Auditing: A Journal of Practice and Theory 33 (4): 41-70

    Keywords:
    Audit committee director-auditor interlocking, investor perceptions, earnings response coefficients, financial expert
    Purpose of the Study:

    In response to Enron and subsequent financial reporting scandals, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (SOX, hereafter), which put particular emphasis on the role of audit committees in ensuring financial reporting quality. Although existing regulations stipulate the composition and qualifications of audit committee directors, audit committee director interlocking that arises when an audit committee director serves on more than one audit committee is allowed. Therefore, we analyze how investors perceive reported earnings when companies with interlocking audit committee directors are audited by the same audit firm (hereafter, AC director-auditor interlocking), using earnings response coefficients (ERCs) as a proxy for investor perceptions of earnings quality. The tendency of AC director-auditor interlocking could have positive or negative implications for the audit committee’s effectiveness in guarding earnings quality.

    • A positive influence may result insofar as closer personal relationships enhance the audit committee’s understanding and trust of auditors, thereby making interlocking audit committee directors more likely to support the auditor in accounting and auditing disputes.
    • An opposing argument is that economic incentives may compromise auditor independence. Also, interlocking audit committee directors may be less critical of auditor performance due to personal relationships with the interlocking auditor.

    Besides the relationship between AC director-auditor interlocking and ERCs, this study investigates whether the potential positive impact of AC director-auditor interlocking in improving earnings quality would be outweigh the potential negative influence in the post-SOX period, when shareholders and regulators have higher expectations and heighten liability concerns for both interlocking audit committee directors and auditors. In particular, this study examines if earnings quality is higher when interlocking audit committee directors are financial experts who are better placed to recommend streamlining of audit committee procedures on the financial reporting process.

    Design/Method/ Approach:

    We collect director information through the RiskMetrics database, which covers S&P 1500 companies, from fiscal years 1998 to 2010, while the impact of financial experts is examined by a sample from fiscal years 2003 to 2010. This study uses ERCs from returns-earnings regressions and designs three measures for the degree of a firm’s AC director-auditor interlocking to examine its impact on earnings quality. 

    Findings:
    • This study finds that a greater extent of AC director-auditor interlocking is perceived as associated with higher earnings quality.
    • This study finds that investors’ perceptions of earnings quality are more affected by the extent of AC director-auditor interlocking in the post-SOX era than before it, whatever we use the pre- and post-SOX subsamples or the interaction item of SOX for the test.
    • This study finds that investors perceive AC director-auditor interlocking especially positively when interlocked audit committee directors are financial experts. That is, the results document that the positive impact of AC director-auditor interlocking on the ERCs is more pronounced when interlocking audit committee directors are financial experts.
    Category:
    Corporate Matters, Governance, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Board/Financial Experts, Impact of SOX
  • Jennifer M Mueller-Phillips
    Audit committee stock options and financial reporting...
    research summary posted July 30, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 13.0 Governance, 13.04 Board/Audit Committee Compensation 
    Title:
    Audit committee stock options and financial reporting quality after the Sarbanes-Oxley Act of 2002.
    Practical Implications:

    This study contributes to existing literature by re-examining the relationship between audit committee compensation and financial reporting quality. The findings indicate the continuance of a negative relationship between audit committee members’ stock-option compensation and financial reporting quality in the post-SOX era. These results are relevant to regulators, compensation committees, and auditors because they imply that shifting audit committee director compensation away from stock options has the potential to improve financial reporting quality.

    Citation:

    Campbell, J. L., J. Hansen, C. A. Simon, and J. L. Smith. 2015. Audit Committee Stock Options and Financial Reporting Quality after the Sarbanes-Oxley Act of 2002. AUDITING: A Journal of Practice & Theory 34 (2):91-120.

    Keywords:
    audit committee quality, financial reporting oversight, financial reporting quality, independence
    Purpose of the Study:

    The Sarbanes-Oxley Act (SOX) was passed by Congress in 2002 in order to improve the accuracy and reliability of corporate disclosures. The introduction of SOX resulted in a substantial increase in audit committee members’ required level of independence and responsibility. In defining independence, however, regulators did not restrict companies from providing equity incentives for audit committee members. Pre-SOX research has shown stock option incentives to be associated with lower financial reporting quality. This study aims to re-examine the association between audit committee equity-based incentives and financial reporting quality (as proxied by a company’s propensity to meet or beat its consensus analyst forecast) in the post-SOX environment.

    Design/Method/ Approach:

    After removing problematic data, the sample collected for the study consisted of audit committee members’ equity holdings and compensation data for a sample of 2,172 company-year observations from 2006 to 2008. This information was then used in conjunction with a series of probit models in order to examine whether audit committee member’ equity incentives are associated with the likelihood of meeting or beating the analyst forecast. In order to mitigate the effect of outliers, the top and bottom 1% of the selection was winsorized.

    Findings:

    Findings were consistent with stock-option incentives being associated with lower financial reporting quality. Specifically, it was found that:

    • 58.8 percent of the average audit committee members’ pay is in the form of stock options and grants.
    • The likelihood of meeting or beating analyst expectations is positively associated with audit committee members’ stock-option compensation and holdings.
    • There is no association for non-equity compensation and holdings, and meeting or beating analyst expectations.
    • A company whose audit committee holds the mean value of exercisable options (i.e., about $200,000 in exercisable options) is associated with a 10.0 percent increase in the likelihood of meeting or beating its consensus analyst forecast.
    • A high-growth opportunity company whose audit committee holds the mean value of exercisable options is associated with a 17.8 percent increase in the likelihood of meeting or beating its consensus analyst forecast.
    Category:
    Governance, Independence & Ethics
    Sub-category:
    Board/Audit Committee Compensation, Impact of SEC Rules Changes/SarBox
  • Jennifer M Mueller-Phillips
    Audit Partner Rotation and Financial Reporting Quality
    research summary posted February 15, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 11.0 Audit Quality and Quality Control, 11.01 Supervision and Review – Effectiveness 
    Title:
    Audit Partner Rotation and Financial Reporting Quality
    Practical Implications:

    This study informs the debates on costs and benefits of audit partner rotation. The results support concerns of the audit profession that audit partner rotation may impair the quality of audited financial information in the initial years of a new partner’s engagement with a client. This impairment appears to be more pronounced for larger clients and clients of non-Big 4 audit firms. Furthermore, the persistence of these quality consequences for non-Big 4 audit firms raises questions about the resource capacity of such firms to cope with imposing regulations. Given that partner rotation has both monetary and social costs, perhaps the decision to shorten partner engagement with a client from seven to five years is not in the best interests of auditors and investors. Ultimately, the costs of an audit will be passed onto investors, and as the study suggests, more frequent rotation may mean more periods of lower financial statement quality in the initial years of a partner’s engagement with a client. Additionally, the study’s city-level industry specialist and office size results suggest industry specialists and larger audit firm offices may have more capacity to absorb and manage partner rotation effects than non-specialists and smaller offices. Such findings support the audit profession’s concern over resource challenges brought on by more stringent partner rotation requirements. 

    For more information on this study, please contact Paul Tanyi.

    Citation:

    Litt, B., D. S. Sharma, T. Simpson and P. N. Tanyi. 2014. Audit Partner Rotation and Financial Reporting Quality. Auditing: A Journal of Practice and Theory 33 (3): 59-86

    Keywords:
    Audit quality, earnings management, financial reporting quality, discretionary accruals, meet or beat, partner rotation, partner change
    Purpose of the Study:

    Audit partner rotation has received considerable attention globally and in the U.S. since Section 203 of the Sarbanes-Oxley Act of 2002 accelerated the rotation period for lead and concurring engagement partners from seven to five years and expanded their cooling-off period from two to five years. Policymakers have rationalized these regulations based on enhanced partner independence and a fresh set of eyes examining the financial statements, thus increasing overall audit quality. However, the audit profession has argued that the loss of engagement partner continuity and client-specific knowledge brought on by increased rotation may actually hinder the quality of the audit. Despite such debate, there is a paucity of research on the effects of audit partner rotation in the U.S., largely due to the absence of publicly available information on audit partners. Using a novel approach to determine audit partner rotation, the authors are able to investigate the effect of rotation on financial reporting quality in the U.S. 

    Design/Method/ Approach:

    After performing procedures to obtain assurance on audit firm compliance with rotation regulations, the authors collect data from 2000 to 2010 for a sample of U.S. public clients that have changed audit firms. From this data, they are able to determine: (1) the first year of a partner’s engagement with a client (the year of audit firm change), (2) the year of audit partner rotation (five years later), and (3) the post-rotation year that a new audit partner leads the audit engagement (the sixth year post-audit firm change). The authors then examine whether financial reporting quality differs between the final two years with an outgoing partner and the first two years with a new partner post-rotation by evaluating discretionary accruals and going-concern reporting for these periods.

    Findings:
    • The authors find that financial reporting quality is lower during the first two years with a new audit partner as compared to the last two years with an outgoing partner. 
    • The authors find that partner rotation has a more adverse effect on financial reporting quality for larger clients of Big 4 auditors and across all clients of non-Big 4 auditors. 
    • The authors find the decline in financial reporting quality to be limited to the first year post-rotation for larger Big 4 clients, but persistent for up to three years post-rotation for non-Big 4 clients.
    • The authors find that non-specialist audit firms and audit firms with smaller offices at the city-level exhibit lower financial reporting quality as a result of rotation.
    • The authors find that financial reporting quality is less negatively affected during the first two years of an audit partner’s engagement with a client relative to the first two years of an audit firm’s engagement with a client.
    Category:
    Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of SOX, Supervision & Review – Effectiveness
  • Jennifer M Mueller-Phillips
    Auditor Attestation under SOX Section 404 and Earnings...
    research summary posted June 2, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Auditor Attestation under SOX Section 404 and Earnings Informativeness
    Practical Implications:

    Section 404 is one of the most controversial provisions of the Sarbanes-Oxley Act. Many studies have examined the negative consequences of adverse reports on internal control issued by the auditor. Other studies have looked at the cost of compliance of Section 404 and find that it is burdensome, disproportionately so for small companies. This study focuses on the benefits of internal control audits. Regulators have argued that the benefits of Section 404 are hard to measure because of the difficulty in quantifying the benefits. This study contributes to the debate on the benefits of Section 404 by documenting evidence that although compliance with Section 404’s requirements has been reported to be associated with high costs, the first-time internal control reports seem to have increased earnings informativeness. 

    Citation:

    Chen, L. H., J. Krishnan, H. Sami, and H. Zhou. 2013. Auditor Attestation under SOX Section 404 and Earnings Informativeness. Auditing 32 (1).

    Keywords:
    earnings informativeness; internal control; Sarbanes-Oxley; Section 302; Section 404
    Purpose of the Study:

    Section 404 of the Sarbanes-Oxley Act (SOX) requires managers to assess, and their auditors to express an opinion on, the effectiveness of internal controls over financial reporting (ICFR). This policy is intended to enhance the credibility of firms’ financial statements. Prior research suggests that audit characteristics that enhance the credibility of financial reporting are associated with higher informativeness compared with earnings in the prior year when only financial statement audit reports were available. This study examines the SEC’s and PCAOB’s expectation about the increased quality and reliability of financial reporting resulting from Section 404. By using a difference-in-differences approach, the authors compare the change in earnings informativeness for the test sample used with that for a control sample of non-accelerated filers. 

    Design/Method/ Approach:

    The authors used previous research and policy makers’ expectations to develop the following hypothesis for testing:

     

    H1: Earnings accompanied by the first-time clean SOX404 ICFR reports are more informative that the previous annual earnings that were not accompanied by ICFR.

     

    This hypothesis was tested by comparing earnings informativeness for the annual filings containing the first-time ICFR reports and the annual filings of the previous year. The sample consisted of two types of firms (1) accelerated filers with clean Section 404 reports for the current year and clean Section 302 management reports for the seven preceding quarters, and (2) non-accelerated filers with clean Section 302 management reports throughout the sample period. The sample period included firm year-ends between November 15, 2003 and November 15, 2005. The final sample consisted of 381 firms. 

    Findings:
    • Firms with first-time clean ICFR reports have higher earnings informativeness in SOX years than in the pre-SOX years when they received only financial statement audit reports.
    • The firms that benefited the most are those with higher likelihood of material weaknesses.
    • Firms with both low and high costs of compliance experience an increase in earnings informativeness. 
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
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  • Jennifer M Mueller-Phillips
    Auditor Realignments Accompanying Implementation of SOX 404...
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality 
    Title:
    Auditor Realignments Accompanying Implementation of SOX 404 ICFR Reporting Requirements
    Practical Implications:

    The results of this study are important for showing the impact of SOX requirements on the audit environment.  The evidence suggests that ICFR opinions provide clients with information to assess the effectiveness of auditors.  After adverse internal control opinions, clients dismiss auditors in order to obtain higher quality audits, measured by switches to Big 4 and industry specialist auditors.  However, only industry specialist auditors are associated with remediation of adverse reports. 

    Citation:

    Ettredge, M., J. Heintz, C. Li, and S. Scholz. 2011. Auditor realignments accompanying implementation of SOX 404 ICFR reporting requirements. Accounting Horizons 25 (1): 17-39.

    Keywords:
    auditor realignments; dismissals; internal control; SOX Section 404; remediation
    Purpose of the Study:

    This study was motivated by the increased frequency of client dismissals of auditors since the implementation of SOX in 2002.  The added requirement that auditors opine on the client’s internal control over financial reporting (ICFR) brought concern among financial statement users that clients would seek more compliant auditors decreasing the quality of the audit.  This paper studies the impact of adverse auditors’ opinions on clients’ internal controls to determine whether:

    • Clients dismiss auditors after receiving an adverse SOX 404 ICFR opinion.
    • Clients dismiss auditors to improve financial reporting by obtaining a higher-quality auditor.
    • Dismissals and hiring a new auditor are associated with subsequent improved ICFR opinions.
    Design/Method/ Approach:

    The authors study accelerated filers from November 2004 through December 2007 and obtain data on ICFR opinions, auditor dismissals, and auditor switches.  Higher audit quality is measured as changes to Big 4 and industry specialist auditors. 

    Findings:
    • Companies receiving adverse ICFR opinions are more likely to dismiss their auditor in the subsequent year.
    • Companies that dismiss their auditor after an adverse ICFR opinion are more likely to hire Big 4 and industry specialist auditors.
    • Remediation of adverse reports is only associated with clients that switch to an industry specialist auditor.
    Category:
    Standard Setting, Internal Control
    Sub-category:
    Impact of 404, Impact of SOX, Impact of 404 on Fees and Financial Reporting Quality
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