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  • 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
    Can Auditors Mitigate Information Asymmetry in M&As? An...
    research summary posted February 24, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality 
    Title:
    Can Auditors Mitigate Information Asymmetry in M&As? An Empirical Analysis of the Method of Payment in Belgian Transactions
    Practical Implications:

    Our findings provide support for the notion that a BigN quality effect reduces information asymmetry in the Belgian context. In addition, we illustrate that audit quality significantly affects a firm’s financial choices related to strategically important projects such as M&As. Finally, we also show that high-quality audits mitigate the market timing behavior of managers.

    For more information on this study, please contact Mathieu Luypaert.

    Citation:

    Luypaert, M. and T. Van Caneghem. 2014. Can Auditors Mitigate Information Asymmetry in M&As? An Empirical Analysis of the Method of Payment in Belgian Transactions. Auditing: A Journal of Practice and Theory 33 (1): 57-91.

    Keywords:
    mergers and acquisitions, audit quality, Big N auditor, method of payment
    Purpose of the Study:

    The need for external auditing stems from information asymmetry between the insiders and outsiders of the firm. The main purpose of an external financial statement audit is to enhance the credibility of the disclosed financial figures vis-à-vis potential investors by providing an independent certification of the information presented in the financial statements. In this study, we investigate the effectiveness of the external financial statement audit in reducing information asymmetry in the context of mergers and acquisitions (M&As) by analyzing the method of payment.

    We focus on two areas of information asymmetry:

    • First, bidders make an offer to target shareholders based upon their estimate of the target value but the target firm is better informed about its own value than the bidder. The bidder may solve this problem by making the payment to the target shareholders contingent upon future performance. This can be achieved through stock offers because the value of such offers depend upon how the market assesses the M&A, resulting in risk-sharing between the target and the acquirer. We argue that a high-quality external financial statement audit reduces the need for risk-sharing behavior.
    • A second information asymmetry relates to the value of the bidder. Because bidders have private information about their own value, they may try to exploit this information advantage by offering stock when they are overvalued. This might explain why stock offers are typically found to result in inferior returns for bidding firm shareholders. We contend that the certification of the bidder’s financial statements by a high-quality auditor limits the bidder’s incentives to use stock as a method of payment.
    Design/Method/ Approach:

    We use ordered probit analysis and binary regression analysis to investigate the impact of the external financial statement audit on the method of payment across a sample of 125 M&As between Belgian firms using data from the period 1997-2009. We believe Belgium to be an interesting setting in which to investigate auditor impact because an external financial statement audit is mandatory for large Belgian firms regardless of whether they are listed.  In addition, small firms can opt for a voluntary financial statement audit. 

    Findings:
    • We show that contingent payments are significantly less likely if the target firm is audited by a BigN auditor. This conclusion is valid under different specifications.
    • In addition, a BigN audit of the acquiring firm is found to reduce market timing behavior by acquirers.
    • Also, target shareholders are more likely to accept contingent offers when the acquirer’s financial statements are certified by a BigN auditor. 
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Attempts to Measure Audit Quality
  • Jennifer M Mueller-Phillips
    Do Big 4 Auditors Provide Higher Audit Quality after...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality, 11.08 Proxies for Audit Quality, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Do Big 4 Auditors Provide Higher Audit Quality after Controlling for the Endogenous Choice of Auditor?
    Practical Implications:

    The evidence presented in this paper is of interest to managers, audit committees, investors, creditors, and regulators. Managers and audit committees would like to know whether the Big 4 actually do provide higher quality audits. This information will help them choose an auditor. Given that Big 4 auditors earn a fee premium, managers and audit committees must decide whether the services they receive from the auditor are worth the premium. Investors and creditors will also be interested in the results, as this will help them assess the credibility of firms’ financial reports. Regulators are also interested in whether the Big 4 accounting firms actually provide higher quality audits.

    Citation:

    Eshleman, J. D., and G. Peng. 2014. Do Big 4 Auditors Provide Higher Audit Quality after Controlling for the Endogenous Choice of Auditor? Auditing: A Journal of Practice & Theory 33 (4): 197-219.

    Keywords:
    audit quality, audit quality proxies, Big 4 auditor, propensity-score matching
    Purpose of the Study:

    The purpose of this paper is to re-examine whether Big 4 auditors deliver higher audit quality after controlling for the endogenous choice of auditor.

    One of the earliest theories in the audit literature is that Big 4 auditors, due to their larger size and better training programs, provide higher audit quality than other auditors. The argument is that larger audit firms have more reputation to lose by sacrificing their independence on any given audit engagement. In addition, larger audit firms have more resources to invest in training programs, resulting in better trained auditors. To the extent that discretionary accruals capture opportunistic earnings management, this implies that Big 4 auditors tolerate less earnings management than other auditors. However, firms select their auditors and auditors decide if they will accept the firm as their client. Audit firms will tend to prefer less risky clients with higher earnings quality. In this study, the authors choose an audit quality proxy, which they believe better captures whether the client engaged in non-GAAP reporting. The proxy is the likelihood of a firm issuing an accounting restatement.

    Design/Method/ Approach:

    The authors use a regression model to test their hypotheses. The authors obtain financial statement data from the Compustat Fundamentals Annual file, and auditor and restatement data from Audit Analytics for the period 20002009. The first hypothesis is tested with a sample of 5,950 observations. The second hypothesis is tested with a sample of 3,248 observations.

    Findings:
    • Clients of non-Big 4 auditors are significantly more likely to subsequently issue an accounting restatement than are clients of the Big 4. This result holds after controlling for a set of innate firm characteristics known to affect the likelihood of issuing a restatement. This is consistent with non-Big 4 auditors allowing a higher frequency of material misstatements than Big 4 auditors.
    • In additional analyses, results show that clients of Big 4 auditors are significantly less likely to be sanctioned by the SEC for an Accounting and Auditing Enforcement Release (AAER) than are clients of other auditors.
    • The authors construct a matched sample of Mid-tier and small auditors. They find no evidence that Mid-tier auditors provide higher audit quality than the small audit firms.
    • The authors also construct a matched sample of Big 4 and small auditors. Clients of small auditors are significantly more likely to subsequently issue an accounting restatement than are clients of the Big 4.
    • Taken together, the evidence suggests a hierarchy of audit firms, with Big 4 auditors providing the highest audit quality, small auditors providing the lowest level of audit quality, and Mid-tier auditors providing audit quality in between the Big 4 and the small auditors.
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Attempts to Measure Audit Quality, Impact of Firm & External Inspection Programs, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Do Industry-Specialist Auditors Influence Stock Price Crash...
    research summary posted May 31, 2016 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.05 Training and General Experience, 11.07 Attempts to Measure Audit Quality 
    Title:
    Do Industry-Specialist Auditors Influence Stock Price Crash Risk?
    Practical Implications:

    This study shows that industry specialists reduce a specific type of risk, stock price crash risk, which has become increasingly important following the Enron scandal and the recent financial market crisis. It also shows that the effects of opacity and conservatism on crash risk are moderated by auditor quality, furthering the emerging literature on the determinants of crash risk. 

    Citation:

    Robin, J. Ashok and Hao Zhang. 2015. Do industry-specialist auditors influence stock price crash risk? Auditing: A Journal of Practice and Theory 34 (3): 47-79.

    Keywords:
    Auditor quality, industry specialization, crash risk
    Purpose of the Study:

    In the past, a great deal of research has been done examining the idea that high-quality auditors benefit reporting quality in a variety of ways.  Other research has been done to focus on direct economic consequences for investors.  Some of this research has found that high-quality auditors can reduce the cost of debt, lower equity costs, diminish IPO underpricing, and even influence loan syndicate structure.  One issue that has not been examined, however, is whether high-quality auditors can reduce the crash risk for equity investors.  This paper focuses on this question.  Because crash risk is primarily caused by bad news hoarding, the authors believe that high-quality auditors can function as information mediators and reduce the crash risk in the following ways:

     

    • High-quality auditors are more likely to uncover bad news and suppress the mangers’ bad-news hoarding activities due to their greater capability
    • High-quality auditors have stronger incentives to disclose bad news in a timely manner and suppress managers’ bad-news hoarding activities

     

    In addition to mediating some of the bad news, the authors also believe that high-quality auditors also reduce crash risk by decreasing agency costs, decreasing malfeasance by managers, improving operating decisions, and decreasing expropriation.  This study could prove very valuable to investors, as crash risk is an important consideration in portfolio management. 

    Design/Method/ Approach:

    The research evidence is collected from a twenty-year sample period ranging from 1990-2009.  The authors obtained stock return data from the Center for Research in Security Prices (CRSP) database.  Accounting data and auditor characteristics were obtained from the Standard and Poor’s Compustat database. After making exclusions based on a number of criteria, the final sample amounted to 58,365 firm-year observations. Regression models were run on these observations to arrive at the author’s findings. 

    Findings:
    • The authors find that across all six models tested, to a statistically significant degree, stock price crash risk is lower for firms audited by industry-specialist auditors.
    • Results also indicated that crash risk is higher in firms with higher standard deviation and mean of stock returns, younger age, higher ROA, greater intangible assets, greater share turnover, and lagged negative skewness.
    • Concentrated institutional ownership can induce effective monitoring and lead to lower further crash risk.
    • Conservatism is negatively and significantly related to crash risk.
    • Auditor specialization provides benefits beyond reporting benefits.
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Attempts to Measure Audit Quality
  • Jennifer M Mueller-Phillips
    Female Auditors and Accruals Quality
    research summary posted February 24, 2015 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 05.10 Impact of Diversity - e.g., gender - on Group Decision Making, 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality 
    Title:
    Female Auditors and Accruals Quality
    Practical Implications:

    The findings imply that female auditors may have a constraining effect on earnings management and thus provide higher audit quality. In general, our findings indicate that the behavioral differences between women and men may have important implications for the quality of auditing and financial reporting.

    For more information on this study, please contact Kim Ittonen.

    Citation:

    Ittonen, K., E. Vähämaa, and S. Vähämaa. 2013. Female Auditors and Accruals Quality. Accounting Horizons 27 (2): 205–228.

    Keywords:
    Auditor gender, female auditors, gender differences, discretionary accruals, abnormal accruals, accruals quality, earnings management.
    Purpose of the Study:

    This paper examines the association between accruals quality and the gender of the firm’s audit engagement partner. Specifically, we aim to assess whether and how female auditors affect the quality of financial reporting. The motivation for this analysis is based upon the behavioral differences between women and men that have been extensively documented in the psychology and behavioral economics literature. In particular, we presume that gender-based differences in cognitive information processing, diligence, conservatism, overconfidence, and risk tolerance may have important implications for the audit process and auditor judgments and, thus, ultimately, for the quality of audited financial information.

    Design/Method/ Approach:

    Data and method used in the analysis:

    • Finnish and Swedish NASDAQ OMX-listed non-financial firms, covering the years 2005-2007.
    • We identify the gender of the engagement partner from the signature on the audit report, and  use abnormal accruals as a measure of the earnings quality and audit quality
    Findings:

    The results suggest that

    • firms with female audit engagement partners are associated with higher earnings quality
    • firms that change the engagement partner from male to female have significantly higher earnings quality in the subsequent year.
    Category:
    Audit Quality & Quality Control, Audit Team Composition
    Sub-category:
    Attempts to Measure Audit Quality, Impact of Diversity (e.g. gender) on Group Decision Making
  • Jennifer M Mueller-Phillips
    Firm versus Partner Measure of Auditor Industry Expertise...
    research summary posted October 10, 2013 by Jennifer M Mueller-Phillips, tagged 11.01 Supervision and Review – Effectiveness, 11.02 Engagement Quality Review – Processes and Effectiveness, 11.04 Industry Experience, 11.07 Attempts to Measure Audit Quality, 11.08 Proxies for Audit Quality 
    Title:
    Firm versus Partner Measure of Auditor Industry Expertise and Effects on Auditor Quality
    Practical Implications:

    The findings of this study imply that firm level expertise impacts audit quality but has a greater impact in conjunction with office level or partner level expertise. Similarly, concurring auditors have a greater impact on audit quality when their abilities are paired with those of a lead or signing partner. This study implicitly emphasizes the importance in cooperation and the sharing of intellectual resources among partners in Big 4 firms considering that expertise is not homogeneous across a firm. Additionally, this study has implications on what could result if the Public Company Accounting Oversight Board in the United States decided to require an engagement partner’s signature on the audit report.

    For more information on this study, please contact Hsin-Yi Chi.
     

    Citation:

    Chi, H., and C. Chin. Firm versus partner measures of auditor industry expertise and effects on auditor quality.  Accounting: A Journal of Practice and Theory 30 (2): 201-229.

    Keywords:
    individual partner industry expertise; discretionary accruals; modified audit opinion; audit quality.
    Purpose of the Study:

    This study explores the relationship between Big 4 audit quality and auditor expertise with respect to both the individual partners and the audit firm. The authors used accruals analysis as well as analysis of audit opinions to assess audit quality. To take the study a step further, an examination of the possible existence of differential audit quality between signing auditors whether lead or concurring partners was also performed. An office level perspective was used and deemed appropriate under the assumption that auditor expertise is permanently tied to individual professionals and their client knowledge which cannot be readily captured and distributed across the firm offices; additionally, the individual practice office is the decision-making unit of the firm when it comes to specific clients.

    To accomplish their purpose, first the authors studied whether audit industry expertise is driven by firm expertise, individual partner expertise, or a combination of both. They also studied whether the association between audit quality and industry expertise of the signing auditor specialist was more or less prominent for the lead auditor or the concurring auditor. One would expect that the lead partner generally would exhibit a more prominent association with audit quality than concurring audit specialists because it is the lead partner who is actively engaged with daily audit proceedings; this study aims to discover if that is truly the case. The study assesses the effectiveness of an individual partner-level and firm-level auditor specialists in enhancing audit quality as well as provides evidence regarding industry expertise homogeneity between individual partners within the same firm.  
     

    Design/Method/ Approach:

    The evidence for this study was collected from Taiwanese publicly listed companies audited by the Big 4 firms from 1983 to 2004. Financial data, audit opinions data, and auditor names were obtained from the Taiwan Economic Journal. Taiwan was the chosen location for this evidence because the audit report in Taiwan contains two signing auditor names as well as the firm name. 

    Findings:
    • Both firm-level industry expertise alone and partner- level industry expertise alone are associated with lower accruals. However, a combination of the two creates an effect above and beyond either level of expertise in isolation; therefore, differential discretionary accruals due to industry expertise are driven by a combination of firm and partner expertise.
    • Differential accruals due to industry expertise of signing are primarily driven by the lead auditor rather than the concurring auditor.
    • The differential likelihood of the issuance of a modified audit opinion is primarily attributable to signing auditor specialists and partner-level expertise.
    • Firm level specialists alone are not associated with a higher likelihood of issuing a modified audit opinion. Instead, firm level specialists along with signing auditor specialists create effects above and beyond those observed with auditor specialists alone.
    • Clients of lead signing auditor specialists have smaller accruals and are more likely to receive a modified audit opinion relative to those of non-specialists  whether the auditor specialists works alone or with a concurring auditor specialist.
    • Concurring auditor specialists alone are not associated with higher audit quality.
    • Industry expertise is not homogeneous across individual auditors within the same audit firm in Taiwan.
       
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Attempts to Measure Audit Quality, Engagement Quality Review – Processes & Effectiveness, Industry Experience, Proxies for Audit Quality, Supervision & Review – Effectiveness
  • Jennifer M Mueller-Phillips
    Malleable Standards of Care Required by Jurors When...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 06.09 Litigation Risk, 11.07 Attempts to Measure Audit Quality 
    Title:
    Malleable Standards of Care Required by Jurors When Assessing Auditor Negligence
    Practical Implications:

    This study is relevant for practitioners, investors, and regulators. It demonstrates to firms that the effectiveness of high audit quality as a defense in litigation may be decreased depending on the timing of jurors’ assessment of SOC. One way to try and lower the probability of jurors’ assessing SOC after receiving audit knowledge is to warn the jury about the potential affects. Simply changing the jurors’ instructions has been found to mitigate the outcome effects.

    Citation:

    Maksymove, Eldar M., and M. W. Nelson. 2017. “Malleable Standards of Care Required by Jurors When Assessing Auditor Negligence”. The Accounting Review. 92.1 (2017): 165.

    Keywords:
    auditor liability; jury; audit quality; mediation; anchoring; sample size; audit adjustment
    Purpose of the Study:

    In court cases against auditors due to audit failure, often times the main defense used is that there was a high audit quality. This is true if the audit was performed at a level similar to what prudent auditors would have done in the same circumstances, also known as standard of prudent care (SOC). This study examines whether jurors’ definition of SOC is malleable based on the timing of the SOC assessment in accordance with the jurors’ exposure to the audit quality of the case. Specifically, whether or not the juror learns of audit quality first and then assesses SOC, or vice versa. 

    Design/Method/ Approach:

    The research project contains four experiments. The first experiment is a simulation where 125 participants, found using Amazon’s Mechanical Turk (AMT), are asked to assume the role of jurors who are considering a case of alleged auditor negligence. The level of audit quality and the timing of jurors’ SOC assessments are manipulated. In the subsequent three experiments 60-63 of the previous participants were asked to determine SOC based on the level of audit quality being manipulated and a change in some of the background information.

    Findings:

    Overall, the authors find that the timing of the SOC assessment in accordance with the jurors’ exposure to the audit quality of the case does in fact change the outcome of the SOC assessment. Therefore, the results indicate the jurors SOC assessments are malleable.

    The authors find the following:

    • In situations where SOC is determined prior to jurors learning about the audit quality of the case, the verdict better discriminates between high and low-quality auditors. This is due to the fact that the audit quality of the case cannot affect the jurors’ decision of what SOC should be.
    • On the other hand, when SOC is assessed after jurors learn about the audit quality of the case, it can cause SOC assessments to vary. This leads to inconsistent rulings of whether or not the auditor was negligent.
    • The reasoning behind the second situation is as follows. The jurors’ knowledge of higher audit quality in the case directly lowers the negligence judgment. However, when doing the SOC assessment after learning about the higher audit quality, the jurors raise SOC. This then increases the negligence judgment. The authors refer to this effect as competitive mediation. 
    Category:
    Audit Quality & Quality Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Attempts to Measure Audit Quality, Litigation Risk
    Home:

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

  • Jennifer M Mueller-Phillips
    On the Benefits of Audit Market Consolidation: Evidence from...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality 
    Title:
    On the Benefits of Audit Market Consolidation: Evidence from Merged Firms.
    Practical Implications:

    The study results are important to audit firms and audit clients as they show audit efficiency benefits (lower audit hours and improved audit quality) post-merger. Although a merger with an international Big 4 firm may bring some reputational improvements, mergers with domestic Big 10 firms create improvements in audit efficiency. Audit firms interested in merging in the Chinese market should consider the benefits of local expertise and higher fees in a merger transaction. These results provide further insights into mergers and acquisitions and the benefits of economies of scale when performing audits.   

    Citation:

    Gong, Q., O. Z. Li, Y. Lin, and L. Wu. 2016. On the Benefits of Audit Market Consolidation: Evidence from Merged Audit Firms. The Accounting Review 91 (2): 463488.

    Keywords:
    audit mergers, efficiency gains, audit fees, audit hours
    Purpose of the Study:

    This study assesses whether there is an improvement in audit efficiency associated with audit firm mergers. The authors specifically investigate if there is a change in audit hours, quality, and fees in the period after the audit firm merger. With the public disclosure of Chinese audit firm hours, the authors can empirically assess changes in audit operations subsequent to an audit firm merger.

    The Chinese audit market has undergone rapid transformation due to the increase in stock offerings and publicly traded firms. International Big 4 firms have increased financial and human resource investments in the Chinese audit firm market. In response to this changing environment, domestic Chinese firms have entered into merger transactions to bolster their market share to achieve economies of scale to compete with the Big 4 firms. The Chinese government and the China Institute of Certified Public Accountants (CICPA) have supported increasing the size for domestic firms. This rapid market consolidation provides a unique context to evaluate the effects on audit firm mergers on audit efficiency and quality. Due to limited empirical studies on audit firm mergers, the authors embark on this study to understand the impact of audit firm mergers on auditor effort and audit quality.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. Audit firm merger information is from the CICPA database, financial newspapers, and audit firm websites. Audit firm client financial information is from the China Stock Market and Accounting Research Database (CSMAR). The sample period is from 2005-2009. Eighteen mergers are included in the sample population.

    Findings:
    • The authors find that audit firm mergers reduce audit effort represented by a 15.38 percent decrease in audit hours after an audit firm merger.
    • When assessing audit quality, the authors find that the probability of a financial statement decreases after an audit firm merger and that the probability of a modified audit opinion increases. These both support that audit quality improves after a merger. In addition, the probability of earning manipulation decreases with accounting conservatism increasing. The audit firm client’s accrual quality is not associated with audit firm mergers.
    • Combining the reduction in audit effort with the improvement in audit quality, these results show an improvement to audit efficiency after an audit firm merger. 
    • In supplemental analyses, the authors evaluate the effect of audit efficiency over time and note that the improvements occur over a three-year period with the highest reduction in audit effort (hours) occurring in the third year.
    • The authors also find that audit efficiencies are greater when the audit firm merges with a domestic Big 10 audit firm rather than with international Big 4 firm. The authors note that this difference could result from differences in the types of firms that the acquirers target.
    • In evaluating audit fees, the authors find that audit fees increase after an audit firm merger and the increase is not a result of market conditions.  
    Category:
    Audit Quality & Quality Control, Engagement Management
    Sub-category:
    Attempts to Measure Audit Quality, Audit Fees & Fee Negotiations
  • Jennifer M Mueller-Phillips
    The Contagion Effect of Low-Quality Audits at the Level of...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 03.01 Auditor Qualifications, 11.07 Attempts to Measure Audit Quality 
    Title:
    The Contagion Effect of Low-Quality Audits at the Level of Individual Auditors
    Practical Implications:

    This study highlights the importance of individual auditor identification in audit reports. The results are also useful for financial information users, regulators, and policymakers to help them understand the impact of an auditor’s characteristics on an audit. The results are especially helpful for firms trying to understand the reasons behind audit failures and subsequently, to mitigate audit failures in the future.

    Citation:

    Li Baolei Qi Gaoliang Tian, Liuchuang, and G. Zhang. 2017. “The Contagion Effect of Low-Quality Audits at the Level of Individual Auditors”. The Accounting Review 92.1 (2017): 137.

    Keywords:
    contagion effect; individual auditors; audit failures; audit quality; auditors’ personal characteristics
    Purpose of the Study:

    This study examines whether there is a relation between audit failure by an individual auditor and the quality of other audits performed by this individual, and if the audit failure creates a rippling effect onto the rest of the office’s audit quality. In China, unlike most other countries, the identity and personal profile of signing auditors are disclosed in the public domain. This allows for the authors to determine the role of an individual auditor in an audit failure. The authors also consider whether or not qualitative characteristics (experience, gender, education) of an auditor can decrease the contagion effect of audit failure within an office location.

    Design/Method/ Approach:

    The sample consists of 11,706 audit decisions and 3,357 of which were audited by failed auditors from 1999-2011. The China Securities Markets and Accounting Research (CSMAR) database was used to find financial information and information about the financial restatement reports were found on the China Information website. The qualitative characteristics of auditors used were age, gender, education level, major, CCP membership, and experience. This data was gathered from the CICPA website.

    Findings:

    The authors find the following:

    • Auditors who experience audit failure are more likely to have further failures in the subsequent four years. Additionally these auditors are more likely to have higher levels of abnormal accruals in other audits as well, indicating an overall lower audit quality. This combination suggests that there is a contagion effect between individual audit failure and future audit quality.
    • Offices that experience audit failures and offices that do not have no significant differences in failed audits in subsequent years or audit quality. This suggests that contagion does not seem to occur across different auditors in the same office.
    • The contagion effect can be decreased based on certain qualitative characteristics of the auditor. Specifically, it is decreased for female auditors, auditors holding a master’s degree, and auditors with more auditing experience.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Attempts to Measure Audit Quality, Auditor Qualifications (e.g. size - industry expertise)
    Home:

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

  • The Auditing Section
    The Effect of Auditor Quality on Financing Decisions
    research summary posted May 7, 2012 by The Auditing Section, tagged 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality 
    Title:
    The Effect of Auditor Quality on Financing Decisions
    Practical Implications:

    This study provides a theoretical model and empirical analysis on the relationship between quality-differentiated audits and companies’ financing decisions.  The study extends prior results from the IPO setting, suggesting that audit quality has a first-order effect on debt-equity choices.

    Citation:

    Chang, X., S. Dasgupta, and G. Hilary. 2009. The Effect of Auditor Quality on Financing Decisions.  The Accounting Review 84 (4): 
    1085-1117. 

    Keywords:
    Auditor quality, financial decisions, adverse selection, capital structure
    Purpose of the Study:

    Theoretical models suggest that companies’ financing decisions are affected by the information asymmetry that exists between well-informed companies and relatively less-informed investors. The integrity of companies’ financial statements plays an important role in reducing this asymmetry.  Similarly, because financial statements are jointly produced by the companies and their external auditor, the auditor plays a critical role in assuring the integrity of the financial information.  Big N auditors are widely perceived to provide higher-quality audits than non-Big N auditors. Thus, the higher-quality audits provided by Big N auditors should better reduce the information asymmetry between informed managers and uninformed investors and thus affect companies’ financing decisions. This study investigates companies’ timing and choice of securities issuances to determine whether:

    • Companies with a Big N auditor are more likely to issue equity as opposed to debt than are companies with non-Big N auditors;
    • The size of equity issues will be larger for companies with Big N auditors;
    • The size of equity issues will be larger following good recent stock performance; and
    • The gap in the average equity issue size between companies with and those without Big N auditors will be smaller subsequent to good recent stock price performance. 
    Design/Method/ Approach:

    The authors develop a theoretical model based on the idea that the quality of the auditor can reduce information asymmetry, which subsequently affects debt versus equity decisions. They then test the model using data on publicly-traded companies for the years 1985 to 2005. Identifying equity and debt issues using cash flow statement data, they examine whether auditor quality affects the probability of debt-equity choices of companies in a given year. The size, timing, and market conditions of the debt-equity issues are also analyzed.

    Findings:

    The authors suggest that differences in information asymmetry associated with high quality auditors affect the financing choices of companies in the following ways: 

    • Companies audited by Big N auditors are more likely to issue equity as opposed to debt and to have more equity in their capital structures. 
    • Companies audited by Big N auditors tend to issue larger amounts of equity when they do issue.
    • Companies tend to issue larger amounts of equity when market conditions are favorable; however this association is significantly weaker for companies audited by Big N auditors.
    • Debt ratios of companies audited by Big N firms are less affected by market conditions.           

    The authors suggest that their findings provide evidence that high-quality Big N auditors reduce information asymmetry, and conclude that audit quality is relevant for companies’ financing decisions.  

    Category:
    Audit Quality & Quality Control
    Sub-category:
    Attempts to Measure Audit Quality
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