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  • Jennifer M Mueller-Phillips
    Auditor Changes and the Cost of Bank Debt
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes 
    Title:
    Auditor Changes and the Cost of Bank Debt
    Practical Implications:

    Currently, bank loans account for more than half of the total debt financing in the United States. The results from this study indicate that there is an increase in loan costs for companies within the following year of an auditor change. This is a factor companies should consider when applying for loans after a switch. 

    Citation:

    Francis, Bill B., D. M. Hunter, D. M. Robinson, Michael N. Robinson, and X. Yuan. 2017. “Auditor Changes and the Cost of Bank Debt”. The Accounting Review. 92.3 (2017): 155.

    Keywords:
    auditor change; information risk; financial reporting quality; information signaling; loan contracting; cost of bank debt; loan spreads; private credit market
    Purpose of the Study:

    Companies change auditors for various reasons, however due to the costs associated with switching, it is often an indication of potential problems between the auditor and company. This study examines the effects that an auditor change has on bank loan contracting. Specifically, whether companies that switch auditors incur increased costs and more stringent nonprice terms on loans. The authors address two potential reasons of why an auditor change would lead to information risk, and subsequently higher costs on loans. The first is if creditors perceive that the auditor change is opportunistic, such as management trying to find a more compliant auditor. The second information risk is related to the new auditor’s lack of client-specific knowledge. Both of these risks would cause for audit quality to decrease and, therefore loan costs would increase. The authors also consider the type of switch and its effect on loan costs. The three types examined are from (Non)Big 4 to (Non)Big 4, Big 4 to Non-Big 4, and Non-Big 4 to Big 4.

    Design/Method/ Approach:

    The sample includes 312 pairs of auditor change companies and non-audit change companies from 1998-2014. The audit change information was gathered using Audit Analytics and the bank loan data was from DealScan. Additionally, the authors excluded all audit switches due to the collapse of Arthur Andersen in 2002. The authors utilize a difference-in-differences (DID) research design comparing loan spreads between auditor change companies (before and after switch) and non-audit change companies.

    Findings:

    Overall, the authors find that when companies initiate a loan within a year of changing auditors there is a 22% increase in loan costs.           

    Specifically, the authors find the following:

    • There is no significant difference in the incremental loan spread between the three types of auditor switches. This evidence suggests creditors place a stronger emphasis on the two information risks instead of the potential differences between Big 4 and Non-Big 4 audit quality.
    • There is still a substantial increase in information risk following the change regardless of whether the company initiates the auditor switch (dismissal) or the auditor resigns
    • There is a 13.65% increase in the probability that banks add collateral requirements following an auditor change. The upfront and annual fees also increase by an average of about 53% and 25% respectively.
    Category:
    Auditor Selection and Auditor Changes
    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
    Shareholder Votes on Auditor Ratification and Subsequent...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers 
    Title:
    Shareholder Votes on Auditor Ratification and Subsequent Auditor Dismissals
    Practical Implications:

    The results of this study are important for audit firms to consider given interest from regulators on the role of shareholder ratification on auditor selection.  The evidence indicates that while shareholders, through auditor ratification voting, are not responsible for the acceptance or dismissal of a firm’s auditor, subsequent auditor dismissals do appear to be influenced by increased shareholder resistance.  A one percent increase in shareholder votes against auditor ratification is associated with a four percent increase in the likelihood of auditor dismissal within the following year.

    Citation:

    Abhijit Barua, K. Raghunandan, and Dasaratha V. Rama (2017) Shareholder Votes on Auditor Ratification and Subsequent Auditor Dismissals. Accounting Horizons: March 2017, Vol. 31, No. 1, pp. 129-139.

    Keywords:
    shareholder voting; auditor ratification; auditor dismissal
    Purpose of the Study:

    The role of shareholders in the process of auditor selection is of great interest to regulators, investors, activists, and audit firms.  Corporate governance activists as well as the U.S Treasury’s Advisory Committee on the Auditing Profession have recommended the adoption of an annual ratification of a firm’s independent auditors, since the primary responsibility of auditors is to the shareholders of their clients.  This study looks at whether shareholder voting on auditor ratification is associated with the likelihood of subsequent auditor dismissal.  As many of these votes are non-binding and on average an auditor ratification vote receives over 98% approval, the role of shareholder ratification in the auditor selection process remains an empirical question.

    Design/Method/ Approach:

    The authors use company-year observations from public U.S. companies with shareholder voting on auditor ratification from 2011 to 2014.  Auditor dismissal within one year of a shareholder ratification vote occurred in 3.3% of the sample.

    Findings:

    The authors find that:

    • Shareholder votes against auditor ratification are significantly associated with the likelihood of subsequent auditor dismissal (within a year as well as within 3-months and 6-months from the time of shareholder voting).
    • The successor auditor is significantly more likely to be a non-Big 4 firm, indicating that Big 4 auditors may view shareholder ratification votes as a client-related risk factor and may be reluctant to accept a new client with higher resistance from shareholders.
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc
  • Jennifer M Mueller-Phillips
    Auditor Ratification: Can’t Get No &...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications 
    Title:
    Auditor Ratification: Can’t Get No (Dis)Satisfaction
    Practical Implications:

    The results of this study are important for audit firms to consider given interest from regulators on the role of shareholder ratification on auditor selection.  The evidence indicates that proxy advisor recommendations significantly influence the number of dissenting auditor ratification votes.  Unfavorable recommendations are more likely when there are concerns regarding auditor independence rather than audit quality.

    Citation:

    Lauren M. Cunningham (2017) Auditor Ratification: Can't Get No (Dis)Satisfaction. Accounting Horizons: March 2017, Vol. 31, No. 1, pp. 159-175.

    Keywords:
    auditor ratification; corporate governance; proxy advisor; proxy disclosure; shareholder voting.
    Purpose of the Study:

    This study looks at the role of proxy advisor recommendations in shareholder voting on auditor ratification.  Given the importance of shareholder involvement and the influence of proxy advisors to influence other voting outcomes, the author investigates the characteristics of the company and audit firm that lead to an unfavorable recommendation on auditor ratification.

    Design/Method/ Approach:

    The author uses company-year observations for the Russell 3000 firms with shareholder voting on auditor ratification occurring during shareholder meetings from January 1, 2009 to June 30, 2012.  More than ninety percent of firms in their sample voluntarily include auditor ratification on the ballot.

    Findings:

    The author finds that:

    • On average, the percentage of dissenting votes on an Auditor ratification is 8.6 percent when proxy advisors issue an Against recommendation.
    • The dissenting votes are higher when there are concerns over auditor independence (non-audit service fees are higher, auditor tenure is longer) or when the proxy advisor’s recommendation is more influential (percentage of blockholders is lower and institutional ownership is higher).
    • Proxy advisors are less likely to issue an unfavorable recommendation when firms have stronger performance or a willingness to disclose internal control issues and are more likely to issue an unfavorable recommendation when the auditor tenure is longer or when the audit firm is a Big 4 Audit firm.
    • Proxy advisors issue more unfavorable recommendations when there are suspected concerns about auditor independence (69 to 85 percent) then when there are concerns regarding audit quality (4 to 12 percent).
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise)
  • Jennifer M Mueller-Phillips
    Audit Report Restrictions in Debt Covenants
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Audit Report Restrictions in Debt Covenants
    Practical Implications:

     Private debt lenders are more likely to include a covenant that prohibits the borrower from receiving an audit report with going-concern modifications (GCAR) when the borrower has poor creditworthiness and the loan term is long. The auditor choice is more likely to be specified in the loan agreement when a GCAR covenant is included. The borrower with a GCAR covenant experiences both increased audit fees and higher probability of getting a GCAR when financial distress occurs. The results imply the GCAR covenant may complement traditional financial covenants in protecting the lenders but comes with a cost borne by the borrowers. It also shows the lenders’ use of audit reports can influence the auditors’ behavior.

    Citation:

     Menon, K., and D. D. Williams. 2016. Audit Report Restrictions in Debt Covenants. Contemporary Accounting Research 33 (2): 682–717.

    Keywords:
    going concern, auditor choice, debt covenants, audit fees, audit reports
    Purpose of the Study:

    Prior studies on debt contracting mainly focus on financial covenants. This paper extends prior research by investigating why lenders put an audit-related covenant – GCAR covenant – into the loan agreement and the effect of this covenant on auditors. The authors argue a GCAR serves as an effective warning for potential defaults even if common financial covenants are not violated. They expect borrowing firms with low credit quality to have a GCAR covenant. They also expect long-term loans to have a GCAR covenant because the lenders face higher probability that the firm’s financial condition deteriorates before the loan matures. To prevent opinion shopping and for insurance purpose, lenders who impose a GCAR covenant are expected to restrict the borrower’s freedom on auditor selection. From the auditor’s stand point, the authors believe the GCAR covenant increases litigation risk to the auditor and/or require additional audit effort. As a result, audit fees are expected to increase and the borrowers are more likely to receive a GCAR.  

    Design/Method/ Approach:

    The initial sample comes from new private debt placement made by public companies between 2003 and 2009. The final sample consists of 7,749 loan contracts (firm-years) from 3,304 unique companies. The authors obtain debt information from DealScan, financial information from COMPUSTAT and audit-related data from Audit Analytics. The authors first test what factors determine the inclusion of a GCAR covenant and then examine the effect of this covenant on audit-related issues.  

    Findings:
    • Private debt lenders are more likely to impose a GCAR covenant in the loan contract when the credit quality of the borrower is poor and/or the debt’s maturity is long. Additional analyses show the GCAR covenant can capture events or situations lead to potential defaults even if traditional covenants are not violated.

     

    • If the loan contract contains a GCAR covenant, it is more likely that the lenders will require the borrower to engage a specific auditor. The auditors accepted by the lenders are usually the Big 4 auditors or at least national auditors. The auditor choice reflects the view that reputable auditors are stricter in going-concern assessment and have deep pockets to settle litigations.

     

    • Auditors charge higher audit fees on and are more likely to issue a GCAR to clients who have loan contracts contain a GCAR covenant, holding the degree of financial distress constant. The results are consistent with the argument that the GCAR covenant increases auditors’ perception on litigation risk and the demand on audit effort. 
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Investor Heterogeneity, Auditor Choice, and Information...
    research summary posted May 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 11.0 Audit Quality and Quality Control 
    Title:
    Investor Heterogeneity, Auditor Choice, and Information Signaling
    Practical Implications:

      This study is directly related to research on institutional factors that affect firms’ auditor choice and the overall audit quality in the market. It also stresses how investors’ knowledge in auditor quality could potentially affect firms’ auditor choice when investors are not allowed to choose auditors directly, which is currently an under-researched area. The paper also suggests that it is necessary to control for investor heterogeneity in archival studies on the market reactions to auditor choice and auditor switch; furthermore, this paper adds to the discussion on limitations of regulations.

    Citation:

    Wei, X., X. Xiao, and Y. Zhou. 2015. Investor Heterogeneity, Auditor Choice, and Information Signaling. Auditing: A Journal of Practice and Theory 34 (3): 113-138 

    Keywords:
    Investor heterogeneity, auditor choice, auditor quality, and information signaling
    Purpose of the Study:

    It is a long established fact that the audit market is differentiated.  This differentiation leads to two distinct effects on firms’ auditor choices.  For one, firms can hire high-quality auditors and use them to signal the credibility of their prospects to investors and distinguish themselves from low-value firms. On the other hand, firms can hire low-quality auditors if the firm engages in earnings management or adopts an aggressive accounting practice to reduce the risk of being detected or forced to switch to conservative accounting practices.  The decision on which type of auditor to hire is not taken lightly, and it is the belief of the authors that firms are considering both how investors will perceive their auditor choices and how investor perception will likely affect their share prices during the hiring process.  As a result, this paper provides a theoretical investigation of the consequences of investor heterogeneity on both firms’ auditor choices and the overall audit quality in the market. 

    Design/Method/ Approach:

    The authors developed a model of firms’ auditor choices based on the assumption that there are only two types of firms, high-value and low-value, and two types of auditors, high quality and low quality.  The Perfect Bayesian Equilibrium (PBE) was applied as the equilibrium concept to the model. 

    Findings:
    • The authors find that in any PBE a high-value firm is more likely to choose a high-quality auditor than a low-value firm.
    • The authors find that the market share of high-quality auditors increases with the proportion on sophisticated investors.
    • The authors find that as the penalty for firms that receive qualified audit opinions increases, the overall audit quality decreases.
    • The authors find that when there are sufficient investors who appreciate high-quality audits, managers who care about investor reactions will benefit from choosing high-quality auditors and the overall audit quality in the market will increase.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
  • Jennifer M Mueller-Phillips
    Small Audit Firm Membership in Associations, Networks, and...
    research summary posted May 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 05.0 Audit Team Composition, 05.08 Impact of Office Size 
    Title:
    Small Audit Firm Membership in Associations, Networks, and Alliances: Implications for Audit Quality and Audit Fees
    Practical Implications:

    The results of this study are important for regulators concerned about the lack of competition in the audit market for large publicly-traded companies.  These data indicate that audit firm associations can increase competition in this sector of the market by providing small firms with the necessary resources to adequately audit large, global, and complex audit clients.  These findings should also be of interest to small audit firms interested in better serving larger audit clients.  Lastly, these results should be of interest to corporate governance bodies and investors interested in the relationship between audit firm type and audit quality.

    Citation:

    Bills, K. L., L. M. Cunningham, and L. A. Byers. 2016. Small Audit Firm Membership in Associations, Networks, and Alliances: Implications for Audit Quality and Audit Fees. The Accounting Review 91 (3): 767-792.

    Keywords:
    associations; networks; small audit firms; audit fees
    Purpose of the Study:

    Small audit firms are often restricted in their ability to audit large public companies because these companies often have global operations and complex business and financial reporting environments which demand a level of resources difficult for smaller firms to provide.  Many of these small firms seek membership in accounting firm associations in an effort to overcome these barriers.  Accounting firm associations are autonomous organizations in which all firm members are independent in legal name and structure, but membership affords participating firms access to resources provided by the association itself as well as fellow association members.

    Because accounting firm associations can pre-screen affiliate members and provide access to resources that would otherwise be more difficult or costly for small audit firms to obtain, audit quality for the clients of these affiliate members is likely to be higher than the clients of unaffiliated small audit firms.  Addressing this issue is important because over half of all publicly traded companies are audited by small audit firms and little accounting research to date examines differences in audit quality across the clients of small audit firms.  Below are three objectives the authors address in their study:

    • Examine whether audit quality is higher for clients of affiliated audit firms relative to the level of quality provided by nonmember firms.  The pre-screening process and access to additional resources is expected to result in higher quality for affiliated small audit firms relative to unaffiliated small audit firms.
    • Examine whether clients who choose to engage an affiliated small audit firm pay a fee premium.  If membership in an accounting firm association is associated with a perceived reputation for higher audit quality, then audit fees for affiliated small audit firms should be higher relative to unaffiliated small firms.
    • Examine whether the potential increase in audit quality associated with membership in an accounting firm association affects the extent to which audit quality differs between Big 4 firms and small, but affiliated audit firms. While prior research indicates audit quality is lower for small audit firms relative to Big 4 firms, affiliation in an accounting firm association may provide small firms with the additional resources necessary to close this gap.
    Design/Method/ Approach:

    The authors use hand-collected audit firm association membership data from 2010-2013, along with financial statement data for publicly traded firms, to examine whether audit quality and audit fees for publicly traded clients differs between small audit firms affiliated with an audit firm association and small firms with no such affiliation.  Audit quality was measured using PCAOB inspection findings, financial statement misstatement rates, and differences in levels of client discretionary accruals.

    Findings:
    • Affiliated small audit firms provide on average higher quality audits to their publicly traded clients relative to small, un-affiliated audit firms.  In particular affiliated small audit firms are less likely to receive accounting related deficiencies, or audit related deficiencies in their PCAOB inspection reports.  In addition, the clients of affiliated members report fewer annual financial statement misstatements, and less extreme discretionary accruals.  In addition, the findings indicate that when a small audit firm joins an accounting firm association, audit quality increases in subsequent years.  Lastly audit quality is increasing in the size of the audit firm association.  This indicates that the increase in audit quality is driven by an increased access to valuable resources provided by the affiliation.
    • Affiliated small audit firms receive an audit fee premium from their clients relative to unaffiliated small audit firms and this premium is increasing in the size of the audit firm association. 
    • The researchers observe no significant differences in audit quality between affiliated small audit firms and Big 4 firms.  This indicates that affiliated small audit firms provide high-quality audits to large publicly-traded companies.  In addition, while affiliated small audit firms experience a fee premium relative to unaffiliated firms, these fee premiums remain lower than those experienced by Big 4 firms.
    Category:
    Audit Team Composition, Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Impact of Office Size
  • Jennifer M Mueller-Phillips
    Non-Big 4 Local Market Leadership and its Effect on...
    research summary posted May 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications 
    Title:
    Non-Big 4 Local Market Leadership and its Effect on Competition
    Practical Implications:

    The results of this study are important to audit policymakers, academics, and practitioners. Though Non-Big 4 firms audit fewer publicly traded companies, the results indicate that they are still able to develop a reputation on their full book of business that enables them to become market leaders. In addition, policymakers’ efforts to increase Non-Big 4 market share may not work nationwide. The authors show that certain local characteristics impact the likelihood of Non-Big 4 local leadership, which suggests that targeted efforts may be more beneficial than nationwide efforts. Finally, the results imply that though the presence of a Non-Big 4 local market leader creates downward fee pressure on audit firms, Big 4 and Non-Big 4 firms are not substitutes as Big 4 firms still earn a fee premium in these markets. 

    Citation:

    Keune, M.B., B.W. Mayhew, and J.J. Schmidt. 2016. Non-Big 4 local market leadership and its effect on competition. The Accounting Review. 91(3): 907-931.

    Keywords:
    local audit market; Big 4 market competition; audit fee premium
    Purpose of the Study:

    Non-Big 4 public accounting firms in many major metropolitan areas are as large as or larger than the Big 4 firms present in the market. However, prior academic research has assumed that little competition exists between Big 4 and Non-Big 4 public accounting firms. As a result of this supposed lack of competition, policymakers in the U.S. and Europe have suggested that they step in to grow Non-Big 4 firms. Regulatory intervention may be unwarranted though given a Government Accountability Office study from 2008 that shows that though large publicly traded companies are limited in their choice of auditor, they still obtain competitive fees. This paper investigates whether and how these seemingly contradictory findings can be accurate. Specifically, the authors:

     

    • Examine the local factors associated with Non-Big 4 local market leadership from both the demand and supply sides.

     

    • Examine the relationship between Non-Big 4 local market leadership and competition.

     

    The authors also introduce a new measure of market leadership based on overall office size. 

    Design/Method/ Approach:

    The authors collected the accounting firm rankings from local business publications for the top 50 largest U.S. Metropolitan Statistical Areas. The accounting firm rankings are based on the number of employees, professional staff, or CPAs in the local office. Audit fees, local market characteristics, and other variables were obtained from the Audit Analytics database and Compustat. The information collected on these firms was for years 2005-2010. 

    Findings:
    • The authors find that Non-Big 4 market leadership is less likely in markets that have more Fortune 1000 clients and more initial public offerings.

     

    • The authors find that Non-Big 4 market leadership is more likely in markets without a large airport hub, with lower litigation costs, and with lower average educational attainment of the labor pool.

     

    • The authors find that, on average, audit fees are 18% lower in markets with Non-Big 4 firm leadership. Fees are lower the closer the Non-Big 4 leaders are in size to the Big 4 firms in the market.

     

    • The authors find that the Non-Big 4 leader firms are able to earn a fee premium, but that the Big 4 firms in those markets still earn a fee premium above and beyond the Non-Big 4 leader’s fee premium. 
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise)
  • Jennifer M Mueller-Phillips
    Internal Control Opinion Shopping and Audit Market...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions 
    Title:
    Internal Control Opinion Shopping and Audit Market Competition.
    Practical Implications:

    The study results are important to regulators, practitioners, and academics. The findings show that internal controls opinion shopping appears to occur among firms that have clean internal control opinions prior to a restatement. In addition, clients have the incentive to manipulate the audit process, via internal control opinion shopping, due to the increased focus and oversight on internal controls reporting. Finally, auditor dismissals that occur late in the fiscal period are more likely to be associated with internal control opinion shopping.   

    Citation:

    Newton, N. J., J. S. Persellin, D. Wang, and M. S. Wilkins. 2016. Internal Control Opinion Shopping and Audit Market Competition. The Accounting Review 91 (2): 603623.

    Keywords:
    opinion shopping, internal control weaknesses, audit opinion, audit quality, audit market competition
    Purpose of the Study:

    This study evaluates three research questions related to opinion shopping using the internal controls environment. There have been historical concerns with the presence of audit opinion shopping. However, most studies use going concern opinions in assessing audit clients retention and dismissal behavior. This study expands the opinion shopping environment to internal control reporting. Going concern opinions typically have a low base rate of occurrence and have leading indicators (poor growth, bankruptcy indicators, etc.). Internal control opinions do not have similar indicators that give rise to a warning of an adverse internal control opinion. From this background, the authors investigate: 1) whether internal control opinion shopping exist; 2) how audit market competition influences internal control opinion shopping; and 3) does the timing of an auditor dismissal indicate opinion shopping motivations.  

    This study also provides an avenue to evaluate opinion shopping in the period after the passage of the Sarbanes-Oxley Act. In addition, it highlights the unintended consequences of increased audit market competition. Finally, it lends support to recent regulatory concern over the decrease in material weakness assessments that may not be the caused by improved internal control environments.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. Audit opinion and audit client data is from Compustat, Audit Analytics, and the Center for Research in Security Prices (CRSP). The sample period starts in 2005, the year after the implementation of SOX Section 404, and ends in 2011.

    Findings:
    • The authors find that audit clients are successful at internal control opinion shopping. The results show that clients would have received adverse internal control opinions at a higher rate if they made different auditor retention or dismissal choices.
    • When assessing the type of audit firm changes, the results suggest that opinion shopping may be more prevalent for audit clients that do not need the services of a Big 4 auditor.
    • Using three proxies for audit market concentration, the authors find a higher likelihood of opinion shopping in markets with high concentration.
    • The authors also find that auditor dismissals that occur in the third fiscal quarter are more likely to be associated with opinion shopping compared to auditor dismissals occurring prior to the end of the second quarter, especially in competitive markets.
    • The authors performed supplemental analyses to determine the association between internal control opinion shopping and going concern opinion shopping. They find that internal control opinions are less predictable and therefore more valuable than going concern opinions. They did find evidence of going concern opinion shopping in the pre-SOX period but not in the post-SOX period. This gives rise to the possibility that going concern reporting has a reduced role in auditor retention decisions after the introduction of SOX.
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes, Internal Control
    Sub-category:
    Consequences of Adverse 404 Opinions, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Restatements: Do They Affect Auditor Reputation for Quality.
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 11.0 Audit Quality and Quality Control, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Restatements: Do They Affect Auditor Reputation for Quality.
    Practical Implications:

    This study offers insights into how restatements by one client may impact an auditor’s other clients. The authors find evidence suggesting that when an auditor’s clients restate their financial statements, the auditor’s reputation for audit quality suffers. Non-restating clients experience a small negative market reaction around the restatement date and a higher likelihood of dismissing that auditor. These findings may inform audit firms and their clients about the potential negative consequences of restatements by other clients.

    Citation:

    Irani, A.J., S.L. Tate, and L. Xu. 2015. Restatements: Do They Affect Auditor Reputation for Quality. Accounting Horizons 29 (4): 829-851.

    Keywords:
    financial restatements, audit quality, auditor reputation, auditor dismissal
    Purpose of the Study:

    Signals of low audit quality should harm an audit firm’s reputation for quality in order to make the reputation more accurately reflect the firm’s true audit quality. While prior research has found negative responses from clients and the stock market following strong signals of low audit quality (e.g., SEC disciplinary actions), it is unknown how these stakeholders will react to weaker signals of low audit quality (e.g., restatements). However, the research on industry contagion effects suggests that restatements by one firm in an industry lead to decreased expectations for other firms in the industry, so it would not be surprising if restatements by one firm lead to decreased expectations for other firms that share its auditor. The authors attempt to tie up these loose ends by investigating whether restatements by one firm lead to (1) auditor dismissals by and (2) negative market adjusted returns for other firms that share its auditor(s), especially when restatements are more severe.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies during the 2004-2012 time period. First, they test whether non-restating companies are more likely to dismiss auditors whose other clients filed restatements in the prior year. Second, they test whether non-restating companies experience negative market adjusted returns after one of their auditor’s other clients files a restatement. For both tests, they investigate whether the predicted reputation effect is stronger for more severe restatements.

    Findings:
    • About 4.5% of non-restating companies dismissed their auditor.
    • Non-restating companies more likely to dismiss their auditor had auditors with a higher percent of clients filing restatements and more misstated items in the restatements. The non-restating companies more likely to dismiss their auditor had weaker internal controls, a net loss, higher leverage, and a smaller size.
    • Auditor resignations are not related to the number of clients filing restatements.
    • On average, restating companies (non-restating companies sharing a restating company’s auditor) had a -1.78% (-0.04%) market adjusted return over the 2 day restatement window.
    • Over the 2 day restatement window, the decrease in market value of a non-restating company was higher when there was a stronger decrease in market value for the shared auditor’s restating client, the restatement adversely affected the restating client’s net income, the restatement had more restated items, a larger window existed between the misstatement period and the restatement announcement, the auditor was an industry expert, the auditor was one of the Big 4, the non-restating company had higher cash flow from operations, the non-restating company had lower total accruals, and the non-restating company was bigger.
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements

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