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

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

    Citation:

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

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

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

    Design/Method/ Approach:

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

    Findings:

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

    Specifically, the authors find the following:

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

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

  • Jennifer M Mueller-Phillips
    The Effect of Lame Duck Auditors on Management Discretion:...
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    The Effect of Lame Duck Auditors on Management Discretion: An Empirical Analysis
    Practical Implications:

    These results should be of specific interest to regulators who have proposed rules to increase the accountability of auditors by more clearly aligning their reputations with assurance quality, as well as to regulators who have expressed concerns that pressures associated with future audit fee dependence could influence the extent to which auditors behave independently. This study is not meant to be used to influence discussion surrounding mandatory audit firm rotation, as the study focused on voluntary, not mandatory, terminations of the audit-client relationship.

    Citation:

    Cassell, C., L. Myers, T. Seidel, and J. Zhou. 2016. The Effect of Lame Duck Auditors on Management Discretion: An Empirical Analysis. Auditing: A Journal of Practice and Theory 35 (3): 51-73.

    Keywords:
    auditor independence, earnings management, discretionary accruals, management discretion, and mandatory audit rotation
    Purpose of the Study:

    This study focuses on the unique situation in which the auditor-client bond is severed for future reporting periods but continues for the current reporting period. The authors label the auditors in this situation “lame duck auditors,” borrowing the expression from the political realm. In the context of politics, lame duck politicians frequently act with greater freedom because they are not concerned about how their actions will affect their chances of re-election. This could mean a politician would vote for measures that are better for his constituents no matter the consequences, or he could more easily succumb to pressures from outside influences like lobbyists. Just like in the political setting, the term “lame duck”” should not necessarily convey a negative connotation; the term simply refers to a situation that could alter an auditor’s responsibilities and incentive structures, which could lead to a change in behavior. The authors believe that financial reporting quality is higher in lame duck situations and completed this study to test that hypothesis. 

    Design/Method/ Approach:

    The authors use data from 2000-2010 and focus their investigation on the effect of lame duck auditors on the quality of the quarterly financial statements. Interim quarterly reporting is the primary focus because it allows the authors to focus on the effect of reputation concerns rather than litigation risk.

    Findings:
    • The authors find that auditor independence and/or reputation concerns are strengthened in lame duck situations because financial reporting quality is higher when a lame duck auditor performs the quality review.
    • The authors find that lame duck auditors are more likely among older companies, accelerated filers, companies with a material weakness in internal control, and companies announcing a restatement during the current or prior year.
    • The authors find that lame duck auditors are less likely among larger companies, companies audited by a Big N auditor, and companies with higher leverage and higher revenue volatility.
    • The authors’ findings verify that the main results of the study are not attributable to systematic differences between lame duck and non-lame duck auditor observations. 
    • The authors’ findings suggest that creating more uncertainty regarding the present value of expected future cash flows or increasing potential reputational concerns has the potential to improve assurance quality.
    Category:
    Corporate Matters, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Earnings Management
  • Jennifer M Mueller-Phillips
    Evidence of Organizational Learning and Organizational...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 11.0 Audit Quality and Quality Control 
    Title:
    Evidence of Organizational Learning and Organizational Forgetting from Financial Statement Audits
    Practical Implications:

     Organizational learning and knowledge depreciation play a significant role in a firm’s audit strategy, pricing strategy, budgeting and forecasting. Failing to account for knowledge dissipation and differences in learning across personnel may lead to costly errors in the budgeting process. Furthermore, finding that there is little or no learning among lower-level staff provides empirical support for the concern of the effects of high turnover rates among lower-level staff in public accounting. This suggests that targeting retention at this level might reduce costs, including the costs of continuously having to train new personnel.

    Citation:

     Causholli, M. 2016. Evidence of Organizational Learning and Organizational Forgetting from Financial Statement Audits. Auditing: A Journal of Practice and Theory 35 (2): 53-72.

    Keywords:
    audit efficiency, organizational learning, and audit production
    Purpose of the Study:

    Organizational learning occurs when an organization gains knowledge from the repetition of producing a product or providing a service and uses this knowledge to operate more efficiently and at a lower cost. Organizational forgetting is when this knowledge is lost over time and results in losses in productivity and increases in the cost of production. A good amount of research exists on these topics as they relate to production, but the research on the correlation between these topics and professional services is underserved. Causholli investigates the nature of learning in the production of financial statement audits in this paper. This investigation comes at a good time due to the increasing debate surrounding whether mandatory audit firm rotation should be enforced. In 2013, the U.S. House of Representatives prohibited the PCAOB from mandating audit firm rotation, but in 2014 the European Parliament passed new regulation that requires audit firm rotation after a maximum of ten years. Because of these differing viewpoints, Causholli hopes to shed light on the discussion by showing how audit production costs vary with audit firm tenure.

    Design/Method/ Approach:

    Two equations were used to provide empirical specifications and test the hypotheses. Engagements were divided into three groups based on the number of years with a client, the short-tenure group, the medium-tenure group, and the long-tenure group. The audit production data are provided by a large international accounting firm and were collected as part of the annual internal quality reviews performed in late spring through early fall 2003.

    Findings:
    • The author’s findings show that an increase in audit experience leads to an initial reduction in total labor hours.
    • The author finds that when labor hours are disaggregated, learning effects are not homogenous across different ranks of labor; specifically, learning is significant among higher labor ranks (partners, managers, and in-charge) and is not significant for the lower ranks (staff).
    • The author finds some evidence of knowledge depreciation; specifically, an increase in experience beyond the learning period negatively affects productivity. This leads to an increase in production costs for partners and in-charge, but not for managers.
    • Overall, the author’s findings suggest that learning by doing as well as knowledge depreciation occur in a professional service industry.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Audit Firm Rotation
  • Jennifer M Mueller-Phillips
    Benefits and Costs of Appointing Joint Audit Engagement...
    research summary posted May 31, 2016 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 05.0 Audit Team Composition, 05.03 Partner Rotation, 15.0 International Matters, 15.03 Audit Partner Rotation 
    Title:
    Benefits and Costs of Appointing Joint Audit Engagement Partners
    Practical Implications:

     The results of this study are important to understanding the potential benefits of joint engagement partner audits compared to single-partner audits. The results of this study identify an association between the type of partner audit (joint vs. single) and audit quality and audit fees. As regulators consider the association between joint audits and audit quality, the results of this study suggest there are benefits to joint-partner audits, particularly when the partners are located in the same office. Compared to single-partner audits, joint-partner audits are associated with higher audit quality. Compared to joint audit firms, joint-partner audits appear to provide the same benefits without the increased cost.

    Citation:

    Ittonen, K., and P. C. Trønnes. 2015. Benefits and costs of appointing joint audit engagement partners. Auditing: A Journal of Practice & Theory 34 (3): 23-46.

    Keywords:
    Joint auditing; engagement partners; audit quality; audit fees
    Purpose of the Study:

    Audits using joint engagement partners versus audits using a single engagement partner may produce significant benefits. The purpose of this study is to examine the relationship between joint engagement partners and audit quality and audit fees. The authors of the study predict that joint audit partners improves audit quality via benefits in knowledge and experience, consultation availability with a joint partner, and reducing client-specific knowledge lost due to partner rotation.

    Design/Method/ Approach:

    The authors use 1,345 firm-year observations from the NASDAQ OMX Exchanges in Finland and Sweden for the period 2005 to 2009.

    Findings:
    • The authors find a stronger association between joint engagement partners and higher audit quality when the partners are from the same, rather than a different, office.
    • The authors find that joint engagement partners, compared to single partners, are associated with less accruals (two proxies for audit quality).
    • The authors find a small decrease in audit fees for joint engagement partners from different offices compared to single-partner audits. The authors find no difference in audit quality. 
    Category:
    Audit Team Composition, Independence & Ethics, International Matters
    Sub-category:
    Audit Firm Rotation, Audit Partner Rotation, Partner Rotation
  • Jennifer M Mueller-Phillips
    Audit Firm Tenure, Non-Audit Services, and Internal...
    research summary posted September 15, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 04.07 Audit Firm Rotation, 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Title:
    Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality.
    Practical Implications:

    In first-year audits, lower audit process quality and higher total audit hours are possible additional costs that should be considered in the ongoing debate on mandatory audit firm rotation. Moreover, study results are consistent with the notion thateven prior to the effective date of the Sarbanes-Oxley Act (SOX)market and related regulatory forces disciplined auditors of public entities to achieve a high level of audit quality when tenure was long or fees from auditor-provided non-audit services were large. In order to serve the public interest, these considerations should be included in assessments of the economic costs and benefits of restrictions on audit firm tenure and non-audit services.

    Furthermore, the results suggest that, in the private-client market, audit process quality declines in the long tenure range and when non-audit fees become large, which may be of interest to standard setters in the private sector (e.g., the Auditing Standards Board and US State Boards of Accountancy).

    Citation:

    Bell, T.B., M. Causholli, and W.R. Knechel. 2015. Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality. Journal of Accounting Research 53(3):461-509.

    Keywords:
    audit quality, audit firm tenure, non-audit services
    Purpose of the Study:

    This study asks whether audit quality declines when audit firm tenure becomes long or when fees from auditor-provided non-audit services become large. The financial crisis of 2008 reignited a long standing debate on the impact of audit firm tenure and auditor-provided non-audit services on audit quality. Prior literature examining effects of audit firm tenure and non-audit services on audit quality have had to use externally observable proxies for audit quality which are, therefore, indirect measures of audit-related outcomes that may not fully reflect the quality of auditors’ execution of the audit process. However, regulators focus on process-related characteristics of audit quality including (1) the extent and appropriateness of evidence supporting the auditor’s opinion and (2) the degree of correspondence between the auditor’s procedures and auditing standards. Therefore there may be a difference between indirect external proxies for audit quality and audit quality proxies actually used by regulators. This study assesses audit quality using direct assessments of attributes of the audit process made by internal reviewers at a large international audit firm in 265 US audits of publicly and privately held clients. Primary analyses are based on two quality measures developed from the review data: 1) the total number of assessed audit deficiencies across 55 separate audit process activities; and 2) a composite assessment of the overall quality of the audit.

    Design/Method/ Approach:

    The data set used in this research was obtained from a large international accounting firm by one of the authors who was employed by the firm at the time the data were collected. The author developed a questionnaire to gather information during the reviews on various audit fee, production, and other engagement characteristics. The data were gathered in October 2003.

    Findings:
    • Audit quality is lowest in first-year audits, improves shortly thereafter, and then declines somewhat as audit firm tenure becomes long. The decline in quality in the long-tenure range is attributable to audits of private clients.
    • In public-client audits, quality increases slowly over the entire tenure range and is not significantly higher than in a first-year audit until the longest period where tenure exceeds 13 years.
    • In contrast, quality in private-client audits improves quickly after the first year but declines with very long tenure to the point where it is indistinguishable from audit quality in the first year.
    • Audit quality is not associated with non-audit fees in the full sample but, as above, the public- and private-client subsamples exhibit different patterns of association. The association of audit quality with non-audit fees is positive in audits of public clients and negative in the audits of private clients.
    • For public clients, the probability of a high-quality audit is 7 percentage points higher for clients purchasing non-audit services than for clients not purchasing these services.
    • For private clients, the probability of a high-quality audit of a private client purchasing non-audit services is 18 percentage points lower than for those not purchasing non-audit services.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Audit Firm Rotation, Non-audit Services, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    The Effects of Auditor Rotation, Professional Skepticism,...
    research summary posted September 15, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind 
    Title:
    The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality.
    Practical Implications:

    The results of this study are important for both audit firms and regulators when considering the potential impact of mandatory audit firm rotation. Standard setters appear to increasingly advocate for auditors to utilize a mental frame in which they evaluate management assertions in terms of their level of dishonesty relative to verification their honesty. If this preference is ultimately paired with mandatory audit firm rotation, it could actually have a deleterious effect on audit quality. Conversely, this study finds that audit firm rotation can increase audit quality when auditors frame their mental representations of management’s assertions in terms of verification of their honest representations.

    Citation:

    Bowlin, K. O., J. L. Hobson, and M. D. Piercey. 2015. The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality. The Accounting Review 90 (4): 1363-1393.

    Keywords:
    auditor rotation, professional skepticism, audit quality, game theory
    Purpose of the Study:

    Regulators argue that audit firm rotation can improve audit quality by reducing the potential for longstanding auditor-client relationships to impair auditor independence. Standard setters have also recently noted that auditors often focus on verifying the honesty of management representations, and have encouraged auditors instead to evaluate them in terms of their potential dishonesty. This study examines whether the effects of auditor rotation on audit quality is dependent upon the mental frame used to evaluate either the honesty or dishonesty of management representations about the financial statements.

    Mental frame refers to whether an auditor frames their assessments of management representations in terms of either their potential honesty or their potential dishonesty. Psychology research finds that individuals do not make subjective probability assessments, like the probably that management’s assertions are honest (dishonest), based on normative laws of probability, but rather on the amount of subjective psychological support that comes to mind. When decision makers feel relatively unfamiliar with, and therefore, less competent to evaluate, subjective probabilities these individuals often find it difficult to produce psychological support for the probably of their current assessment frame, making them less likely to choose the action associated with that mental frame.  

    Design/Method/ Approach:

    The authors’ model the auditor-client relationship as a strategic game in which the auditor chooses a level of effort based on their perceived level of honesty within management’s financial statements whereas managers choose a level of honesty in reporting based on their perceived level of effort outlayed by the auditor. The researchers utilized an experimental economics experiment. The participants were undergraduate students who were tasked to repeatedly play a game for money designed to model this strategic interaction between auditors and clients. In the audit firm rotation condition the auditor was paired with a different manager each round. The evidence was gathered prior to October 2012.

    Findings:
    • When auditors assess the honesty of management representations, auditor rotation increases audit effort and decreases the frequency of low-effort audits paired with aggressive financial reporting, decreasing the likelihood of audit failure.
    • When auditors assess the dishonesty of management representations, auditor rotation decreases audit effort and increases low-effort audits paired with aggressive reporting.
    • Increasing the level of interpersonal interaction between auditors and managers via informal communication decreases audit effort, but does not interact with the auditor’s mental frame (honest versus dishonest).
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Prior Dispositions/Biases/Auditor state of mind
  • Jennifer M Mueller-Phillips
    How Do Regulatory Reforms to Enhance Auditor Independence...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.07 Audit Firm Rotation, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness 
    Title:
    How Do Regulatory Reforms to Enhance Auditor Independence Work in Practice?
    Practical Implications:

    This study sheds light on what underlies decision making in the imperative audit committee responsibility of auditor appointment: nuanced interactions and power asymmetry among management, the audit committee, and auditors. The auditors viewed the CFO as the client and tailored the proposal accordingly. The audit committee will not be effective unless both auditors and audit committee members fundamentally change their mindsets about their respective roles in relation to client management. As large public companies employ multiple Big 4 firm, the viability of severing existing relationships to bring in a truly independent auditor mindset through audit firm rotation is questionable.

    Citation:

    Fiolleau, K., Hoang, K., Jamal, K., & Sunder, S. 2013. How Do Regulatory Reforms to Enhance Auditor Independence Work in Practice? Contemporary Accounting Research 30 (3): 864-890.

    Keywords:
    audit committees, reforms, auditor independence, audit firm rotation, independence
    Purpose of the Study:

    This article presents a study on regulatory reforms that aim to enhance auditor independence work. In order to achieve the right balance between the auditors serving commercial versus professional interests, regulators implemented a set of alternative remedies that include mandatory audit partner rotation and enhanced audit committee responsibilities, expertise and independence. As of September 2013, regulators based in Europe and the U.S. are considering to extend rotation requirement to encompass audit firm rotation rather than partner rotation. In this paper, the authors conduct a field study to investigate how regulatory reforms designed to promote auditor independence (specifically audit committee reforms and proposed audit firm rotation requirements) may actually work in the context of auditor change. This study of auditor change also yields insights into the potential consequences of increasing the frequency of auditorclient courtships through mandatory audit firm rotation, which has recently been proposed by regulators as a way of reinforcing auditor independence. The underlying premise is that audit quality would be enhanced by weakening the economic and relationship bonds between auditors and their clients. The authors investigate how the audit committee interprets and executes its legislative mandate in appointing an independent external auditor.

    Design/Method/ Approach:

    The authors collected data six months after the company’s RFP process and new auditor appointment. The authors obtained a copy of the company’s RFP document from the CFO, and copies of the bid documents directly from all Big 4 audit firms who bid for this audit. They interviewed the company’s CFO and the chair of the audit committee. The authors interviewed each of the four proposed engagement audit partners for 60-90 minutes.

    Findings:
    • Management controlled access to documents and people, and played a powerful role in making the auditor appointment decision.
    • Management engaged the audit firm that offered the least senior level expertise and the lowest fee.
    • The audit committee adopted management’s priorities in encouraging prospective auditors to demonstrate responsiveness to management.
    • Prospective auditors were reticent to probe the client for information that would have helped them identify risks before accepting the engagement.
    • The auditors were focused on winning the client and were willing to cut fees, move partners to the client’s head office city, and curtail quality control.
    • If management, with private information and interests, continues to have substantial influence over hiring the auditor, then regulatory reforms for audit firm rotation and/or audit committee empowerment are likely to be ineffective.
    • Auditor change puts pressure on audit fees, and requires auditors to demonstrate commitment and responsiveness to the management of both prospective clients and current ones used as referees.
    • Instead of strengthening independence and providing a fresh auditor perspective, the authors find that the auditor change process is dominated by management and is characterized by gestures from prospective auditors to win client favor during the courtship, potentially rendering proposed audit firm rotation ineffective.
    Category:
    Corporate Matters, Independence & Ethics
    Sub-category:
    Audit Committee Effectiveness, Audit Firm Rotation, Audit Firm Rotation, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Audit Firm Tenure, Non-Audit Services, and Internal...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 04.07 Audit Firm Rotation, 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality 
    Title:
    Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality.
    Practical Implications:

    The lower quality and higher effort associated with first-year audits represent additional costs that should be considered in the ongoing debate on mandatory audit firm rotation. The differential findings for private and public clients suggest that market and related regulatory forces discipline auditors of SEC clients to maintain a high level of audit quality even when tenure is long or NAS fees are high. The findings are important for regulatory policies related to audit firm tenure and auditor-provided NAS. The finding that quality declines in private-client audits as NAS fees increase or tenure becomes long should be of interest to standard setters in the private sector.

    Citation:

    Bell, T. B., Causholli, M., & Knechel, W. R. 2015. Audit Firm Tenure, Non-Audit Services, and Internal Assessments of Audit Quality. Journal Of Accounting Research 53 (3): 461-509.

    Keywords:
    audit firm tenure, audit quality, non-audit services, independence
    Purpose of the Study:

    After decades of debate and research, the auditing profession, regulators, and researchers continue to wrestle with two longstanding concerns about perceived threats to auditor independence and audit quality: (1) Social bondingbecoming personally friendly with, or increasingly trusting of, client management, and (2) Economic bondingbecoming financially dependent on multiperiod fees from audits and non-audit services (NAS) provided to the client. Regulators have argued that social bonding from long tenure erodes professional skepticism and induces auditor complacency, while economic bonding from non-audit fees prompts auditor concessions or shirking in response to management’s financial reporting demands. On the other hand, the auditing profession has argued that there is no systemic decline in audit quality as audit firm tenure or fees from NAS increase, and that restrictions on tenure or NAS disrupt auditor learning, constrain the financial and human resources available for audit production, and impede knowledge spillovers.

    The authors use data from internal assessments of audit quality in a Big 4 firm to investigate the impact of audit firm tenure and auditor-provided non-audit services (NAS) on audit quality.

    Design/Method/ Approach:

    The data used in this study consists of audit quality assessments, audit firm tenure, audit and NAS fees, total and staff-level audit labor hours, and other key client and engagement characteristics for 265 U.S. audits conducted by a Big 4 firm for both publicly listed (57%) and privately held (43%) clients. Audit firm personnel collected the data during the annual internal quality reviews performed during late spring through early fall of 2003.

    Findings:
    • Audit quality is lowest in first-year audits, improves shortly thereafter, and declines somewhat as tenure becomes very long.
    • The probability that a second-, third-, or fourth-year audit receives a high quality rating is, on average, 21 percentage points higher than the probability for a first-year audit, while audit quality for audits where tenure is greater than 13 years is not significantly different from that of a first-year audit.
    • Audit effort is significantly higher in first-year audits in spite of discounted fees.
    • In audits of SEC registrants, quality increases slowly over the entire tenure range, while audits of private clients exhibit a rapid increase in quality in early years and an equally steep decline in later years.
    • Audit partner specialization in the client’s industry is associated with higher audit quality in both the full sample and in first-year audits. For SEC clients, the authors also find that audit quality and audit effort each are positively associated with discretionary accruals (DAs), suggesting that auditors recognize the risks associated with unusual accruals and respond by conducting more effective procedures.
    • When ex-Andersen clients are removed from the sample, the authors no longer observe lower audit quality in first year audits.
    Category:
    Audit Quality & Quality Control, Independence & Ethics
    Sub-category:
    Attempts to Measure Audit Quality, Audit Firm Rotation, Audit Firm Rotation, Non-audit Services
  • Jennifer M Mueller-Phillips
    The Effects of Client Identity Strength and Professional...
    research summary posted February 17, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind 
    Title:
    The Effects of Client Identity Strength and Professional Identity Salience on Auditor Judgments
    Practical Implications:

    The results of this study provide an improved understanding of the joint effects of identity strength and salience on auditor judgments. Even in a setting with no prior auditor-client history, auditors who more strongly identify with the clients (i.e., share common values) agree more with the client. This is informative to debates about auditor rotation and independence, as it highlights short-tenure independence threats that rotation is unlikely to mitigate. Fortunately, the results also suggest heightening professional identity salience is a cost-effective alternative to auditor rotation to maintain auditor independence, even when auditor tenure is short.

    For more information on this study, please contact Tim Bauer.

    Citation:

    Bauer, T. D. 2015. The effects of client identity strength and professional identity salience on auditor judgments. The Accounting Review 90 (1): 95-114.

    Keywords:
    auditor independence; professional skepticism; professional identity; client identity; identity salience; identity strength.
    Purpose of the Study:

    Considerable accounting research, as well as recent proposed and mandated audit regulation has focused on auditor independence threats arising over long auditor tenure. Psychology research, however, suggests independence threats also likely arise when auditor tenure is short because auditors can quickly develop a strong client identity (i.e., overlap of norms and values), due to extensive auditor-client interaction. Rotation can even accelerate strong identity formation because it can increase bidding for clients and research has shown auditors try to strengthen social bonds with clients during the client acquisition process. This raises questions about the effectiveness of mandatory audit partner or firm rotation to address independence concerns.

    Relying on Social Identity Theory (SIT), this paper examines mechanisms for promoting auditor independence that can be implemented regardless of auditor tenure or rotation. Specifically, SIT suggests arousing an auditor’s identity as a professional (i.e., by increasing its salience) can promote auditor independence in mind, and mitigate threats to auditor judgment quality that stem from a stronger client identity. 

    Design/Method/ Approach:

    Two experiments are used to test hypotheses, in a setting with no prior auditor-client history.

    • Experiment One: going concern setting; conducted in 2010; participants are seniors, managers, and senior managers from several Big 4 accounting firms in Canada.
    • Experiment Two: inventory writedown setting; conducted in 2013; participants are seniors from a Big 4 firm in the U.S.
    Findings:
    • As predicted, auditors who identify more strongly with their clients, by sharing their values, agree more with the client’s preferred accounting treatment, unless the salience or arousal of their professional identity is heightened.
    • Further, as predicted, heightening professional identity salience increases professional skepticism. 
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Audit Firm Rotation, Prior Dispositions/Biases/Auditor state of mind
  • Jennifer M Mueller-Phillips
    Audit Report Lags after Voluntary and Involuntary Auditor...
    research summary posted June 22, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.07 Audit Firm Rotation, 05.0 Audit Team Composition, 05.03 Partner Rotation 
    Title:
    Audit Report Lags after Voluntary and Involuntary Auditor Changes
    Practical Implications:

    Regulators have long debated mandating auditor rotation. This study quantifies some of the costs of auditor rotation, specifically its impact on audit report lag. The findings lend support to opponents of mandatory rotation, since the first year after rotation requires more audit effort. The study also highlights one benefit that partner-firm familiarity can have (in decreasing audit report lag).

    Citation:

    Tanyi P., K. Raghunandan, and A. Barua. 2010. Audit Report Lags after Voluntary and Involuntary Auditor Changes. Accounting Horizons 24 (4): 671-688.

    Keywords:
    Auditor tenure; auditor rotation; audit partner rotation
    Purpose of the Study:

    Because of recent debate about the costs of auditor rotation, the authors examine how mandatory and voluntary auditor rotation affects audit report lag, or the number of days between the fiscal year end and the audit report date.Prior research examines only voluntary auditor rotation, which might have different effects than the mandatory rotation advocated by regulators.

    Design/Method/ Approach:

    Authors use the demise of Arthur Andersen and firms’ subsequent auditor changes as a setting in which to learn about mandatory auditor rotation.

    Authors compare audit report lags for firms with fiscal yearend of December 31, 2002. Audit report lag is the only publicly observable, quantifiable measure of auditor effort.

    Andersen firms switch from Andersen to another audit firm in fiscal 2002, and control firms (voluntary rotation) switch from a Big5 audit firm in fiscal 2002.

    Authors also examine audit report lags in fiscal 2000.

    Authors also partition Andersen firms into firms that follow their Andersen partner into a new audit firm and those that do not.

    Findings:

    Andersen firms that do not follow their partners into a new audit firm have longer audit report lags than clients of other Big 5 auditors who switched to a new auditor in 2002. The audit report lag increases by 6.5 days (from 58.02 days to 62.57 days).

    Andersen firms that follow their audit partners into a new audit firm have shorter audit report lags (by 4.56 days or 7.8 percent) than Andersen firms that did not follow their audit partners.

    Compared with firms that do not change audit clients, firms with voluntary auditor changes experience only marginally longer audit report lags. Firms with mandatory auditor changes have significantly longer audit report lags.

     

    For more information on this study, please contact K. Raghunandan.

    Category:
    Independence & Ethics, Audit Team Composition
    Sub-category:
    Audit Partner Rotation, Audit Firm Rotation
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