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  • Jennifer M Mueller-Phillips
    The Effect of National Culture on Auditor-in-Charge...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Title:
    The Effect of National Culture on Auditor-in-Charge Involvement
    Practical Implications:

    The results of this study may help researchers, practitioners, and others to develop a more nuanced approach toward the information value of auditor-in-charge involvement as potentially indicating audit quality. This would be a very timely contribution for audit firms given their desire to globalize their approach to and procedures followed during audits. Specifically, the results indicate that, while the extent of auditor-in-charge involvement may serve as a relevant audit quality indicator, culture needs to be taken into account; consequently, different thresholds may need to be considered for different regions in the world, as opposed to one global standardization.

    Citation:

    Bik, O. and R. Hooghiemstra. 2017. The Effect of National Culture on Auditor-in-Charge Involvement. Auditing: A Journal of Practice and Theory 36 (1): 1 – 19. 

    Keywords:
    auditor behavior, auditor-in-charge involvement, cross-national cultural differences, international auditing, and national culture
    Purpose of the Study:

    Although audits are conducted in teams, the auditor-in-charge performs a pivotal role in the audit process. In fact, in an attempt to strengthen audit quality, global audit firms have contemplated setting some standardized thresholds for the number of hours an auditor-in-charge should spend on an audit. However, auditor-in-charge involvement is affected by numerous contextual factors at both the engagement level and the country level. In this study, the authors aim to advance the understanding of what affects differences in auditor-in-charge involvement by focusing on the effects of national culture. 

    Design/Method/ Approach:

     The analyses are based on unique, archival data from a Big 4 audit firm comprising time-record data regarding individual audit engagements reflecting audit practices in 50 countries across the globe. 

    Findings:
    • The authors find that differences in the extent of auditor-in-charge involvement was associated with power distance, individualism versus collectivism and uncertainty avoidance. 
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Understanding Audit Quality: Insights from Audit...
    research summary posted February 16, 2017 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 
    Title:
    Understanding Audit Quality: Insights from Audit Professionals and Investors
    Practical Implications:

    This study provides evidence that should help inform the public discussion of audit quality in the post-Sarbanes-Oxley era and adds empirical substance to theoretical frameworks of audit quality.  

    Citation:

    Christensen, B. E., S. M. Glover, T. C. Omer, and M. K. Shelley. 2016. Understanding Audit Quality: Insights from Audit Professionals and Investors. Contemporary Accounting Research 33 (4): 1648 – 1684. 

    Purpose of the Study:

    Much debate exists surrounding the definition, composition, and measurement of audit quality. This debate continues despite the importance of audit quality and the large body of research investigating the topic. This paper contributes to this debate by obtaining perceptions and measures of audit quality from audit professionals and investors, two groups heavily interested in the audit and financial reporting process.  Furthermore, this study provides evidence that contributes to understanding and defining audit quality, providing empirical evidence regarding many of the audit quality indicators proposed by the PCAOB, adding empirical substance to existing theoretical frameworks of audit quality and highlighting differences and consistencies between auditor and investor expectations about the audit process. 

    Design/Method/ Approach:

    The authors conducted a survey of audit professionals and investors to obtain their insights on audit quality.

    Findings:
    • The authors find that audit professionals define audit quality primarily in terms of compliance with professional auditing standards, while investors rely more on the individual characteristics of the engagement team performing the audit.
    • The authors find almost unanimous agreement that individual auditor characteristics influence audit quality.
    • The authors find evidence that input from parties outside the core engagement team such as the national office and engagement review partners is an important attribute of audit quality.
    • The authors find evidence that client-specific factors such as restatements, SEC enforcement actions, and the frequency of audit committee meetings are significant indicators of audit quality; however, they also find that investors’ perceptions of audit quality do not fully incorporate the importance of the audit committee in the audit process to the same extent as auditors. 
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Attempts to Measure Audit Quality, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Understanding the Relation between Financial Reporting...
    research summary posted January 17, 2017 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 
    Title:
    Understanding the Relation between Financial Reporting Quality and Audit Quality
    Practical Implications:

    These findings imply that recognizing the relation between financial reporting quality and audit quality and the observability of differing outcomes can provide greater insight into the interpretation of research findings. They also suggest that greater consideration of how changing and differing economic situations affect financial reporting and audit outcomes will provide deeper insight into the determinants and consequences of both audit quality and financial reporting quality. Finally, recognizing and controlling for the potential endogeneity can lead to greater insights into both financial reporting quality and audit quality. The authors also provide a framework for identifying potential areas for future research. 

    Citation:

    Gaynor, L. M., A. S. Keaton, M. Mercer and T. L. Yohn. 2016. Understanding the Relation between Financial Reporting Quality and Audit Quality. Auditing: A Journal of Practice and Theory 35 (4): 1 – 22. 

    Keywords:
    financial reporting quality, audit quality, quality proxies, and quality determinants.
    Purpose of the Study:

    Understanding the determinants of high quality reporting is an important goal of both auditing and financial accounting research. These two areas share many related issues; however, the research within each area tends to draw on prior research within that area. This exclusion has created a pressing need for a review of each stream of literature, with a special focus on how the areas of research intersect and relate to each other. This paper attempts to bridge the gap between the financial reporting quality and audit quality literatures.

    Design/Method/ Approach:

    The authors begin by developing definitions of financial reporting quality and audit quality that are grounded the authoritative literature. Next, they link the new definitions to the operational measures of these constructs used in financial reporting and audit quality research. With this understanding, the authors create a person/task/environment framework for conceptualizing the determinants of financial reporting and audit quality. 

    Findings:
    • The authors find that both audit quality and financial reporting quality literatures often underplay the distinction between pre-audit financial reporting quality and audit quality and use the same metric as a proxy for either financial reporting or audit.
    • The authors find that financial reporting quality and audit quality are often inseparable in terms of observable financial reporting outcomes in archival research.
    • The authors find that both financial reporting quality and audit quality are heavily influenced by the underlying economics of the business.
    • The authors find that financial reporting quality and audit quality are often endogenously determined. 
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Attempts to Measure Audit Quality, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Investors' Perceptions of Audit Quality: Effects of...
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Title:
    Investors' Perceptions of Audit Quality: Effects of Regulatory Change.
    Practical Implications:

    The results from this study should also be of interest to regulators and legislators around the world who continue to debate the potential costs and benefits of auditor liability reform. Implications of these findings are threefold. First, contrary to regulators’ intent that AS5 would improve efficiency without sacrificing effectiveness of the audit of internal controls, investors appear to believe the new standard will achieve the improved efficiency by sacrificing audit quality. Second, investors appear to believe that economic incentives to reduce audit quality outweigh auditors’ reputation concerns following auditor liability reform. Third, individuals are likely to reduce their equity investments if shareholder recourse is further limited by additional liability reform.

    Citation:

    Smith, J. L. 2012. Investors' Perceptions of Audit Quality: Effects of Regulatory Change. Auditing: A Journal of Practice & Theory 31 (1): 17-38.

    Keywords:
    auditor quality, audit liability, internal control, investor perceptions
    Purpose of the Study:

    Auditors provide a critical service to the world’s capital markets. Without high-quality audits, managers would face a higher agency cost, and investors would be less confident in corporate disclosures. Because actual audit quality is an unobservable state, investors’ perceptions of audit quality become their view of reality and likely affect their judgments and decisions.

    The author examines the effects of two heavily debated regulatory changes on individual investors' perceptions of audit quality. The first change he examines is from a bottom-up coverage-based standard (i.e., Auditing Standard No. 2) to a top-down risk-based standard (i.e., Auditing Standard No. 5) for conducting the audit of internal control pursuant to Section 404 of the Sarbanes-Oxley Act. The second change examined is the proposed passage of legal reform that reduces auditors’ liability exposure following an alleged audit failure. The author examines individual investors because they represent an important set of financial reporting users whose protection and advocacy is charged to oversight bodies like the Securities and Exchange Commission (SEC) and because international regulators have recently called for research to enhance the understanding of various stakeholders’—including investors’—perceptions of audit quality. He studies the effects of the two aforementioned regulatory issues because they both represent significant changes in the auditing environment that affect auditors’ incentives and loss function for an integrated audit engagement.

    Design/Method/ Approach:

    The author implements a 232 between-subjects repeated measures design. The participants in this study are 101 Executive and evening M.B.A. students from a large, public university. Participants have an average of 11.57 years of full-time work experience. Most of them have previously invested in mutual funds (85 percent), have purchased individual stocks within the past three years (57.4 percent), and plan to invest in individual stocks within the next two years (71.3 percent).The evidence was gathered prior to November 2010.

    Findings:

    The author finds that both regulatory changes cause significant reductions in investors’ perceptions of audit quality. In the case of the change in auditing standards, he finds evidence suggesting that the perceived reduction in audit quality is driven by a perceived focus on efficiency in the new standard. The results also suggest the perceived reduction in audit quality following the auditor liability reform is driven by a perceived reduction in the auditor’s cost of an audit failure. Interestingly, he finds that the perceived reduction in audit quality following both regulatory changes leads investors to expect a reduction in management’s investment in internal control. Finally, the author finds that investors significantly reduce their equity investments following the liability reform, but the effect of a change in auditing standards appears to be conditional on investors’ experience. Specifically, investors who purchased individual stocks within the past three years appeared more likely to increase their investment allocation following the change from AS2 to AS5 while individuals who had not purchased individual stocks were more likely to reduce their equity investment allocation.

    Category:
    Audit Quality & Quality Control
    Sub-category:
    Proxies for 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
    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
    Audit quality: Insights from the academic literature
    research summary posted March 11, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Title:
    Audit quality: Insights from the academic literature
    Practical Implications:

    This study provides a framework for synthesizing and understanding research related to audit quality by adopting a much broader perspective by including archival, behavioral, experimental, and survey method research, as well as including international research. This study should be useful to academic researchers, practitioners, regulators, investors, and others who are interested in understanding audit quality.

    For more information on this study, please contact Robert Knechel.

    Citation:

    Knechel, W. R., G. V. Krishnan, M. Pevzner, L. B. Shefchik, and U. K. Velury. 2013. Audit quality: Insights from the academic literature. Auditing: A Journal of Practice & Theory 32(sp1): 385-421.

    Keywords:
    audit quality; audit quality indicators; auditor judgment; PCAOB synthesis
    Purpose of the Study:

    Despite more than two decades of research, audit quality is much debated but little understood. Different views suggest different metrics.  For example, audit quality can be absence of material misstatements from a user of financial report perspective, satisfactorily completing all tasks required by the firm’s audit methodology from an auditor’s perspective, one for which the work can be defended against challenge in an inspection or court of law from the audit firm perspective, in compliance with professional standards from a regulator perspective, or the avoidance of economic problems for a company or the market, from a society perspective.

    Therefore, this study intends to

    • Provide a review of existing definitions of audit quality and describe general frameworks for establishing audit quality.
    • Summarize research on indicators of audit quality such as inputs, process, and outcomes.
    • Discuss opportunities for future research
    Design/Method/ Approach:

    The authors use a ‘‘balanced scorecard’’ approach to understanding audit quality. They develop a framework for synthesizing and understanding research related to audit quality. The framework includes linkages across the primary attributes of the audit (incentives, uniqueness, process, uncertainty, and judgment) and among the different aspects of the audit—inputs, process, outcomes, and context.

    Findings:

    The synthesis study documents the following:

    • To consider what matters the most for improving audit quality, it is important to keep in mind all five attributes of the audit itself: incentives, uncertainty, uniqueness, process, and judgment.
    • It is important to bear in mind that audit quality is a perceived, rather than directly observed, and a ‘‘balanced scorecard’’ that captures the key attributes of auditing is a useful strategy to facilitate stakeholder perceptions about audit quality

    In summary, one might conclude that a ‘‘good’’ audit is one where there is execution of a well-designed audit process by properly motivated and trained auditors who understand the inherent uncertainty of the audit and appropriately adjust to the unique conditions of the client

    Category:
    Audit Quality & Quality Control
    Sub-category:
    Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Auditor-provided nonaudit services and audit effectiveness...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Title:
    Auditor-provided nonaudit services and audit effectiveness and efficiency: Evidence from pre-and post-SOX audit report lags
    Practical Implications:

    The results of this study have important implications for regulators, the accounting profession, and clients concerned with the escalating costs of the audit:

    • This study extends prior empirical evidence by showing that the joint provision of audit and nonaudit services does not reduce audit quality even when audit lags are shorter due to potential knowledge spillover
    • It also suggests that audit efficiencies may flow from the joint provision of audit and nonaudit services. The loss of potential synergies between audit and nonaudit services following the SOX ban on most auditor-provided nonaudit services will impose a greater cost burden on firms and may lead to lower audit quality.
    • The significance of audit lag as a determinant of reporting timelines is even more important in an era of accelerated SEC filing.

    For more information on this study, please contact Robert Knechel.

    Citation:

    Knechel, W. R., and D. S. Sharma. 2012. Auditor-provided nonaudit services and audit effectiveness and efficiency: Evidence from pre-and post-SOX audit report lags. Auditing: A Journal of Practice & Theory 31(4): 85-114.

    Keywords:
    audit quality; fee; lag; nonaudit; knowledge spillover; Sarbanes-Oxley
    Purpose of the Study:

    The debate about auditor-provided nonaudit services and whether they adversely affect audit quality or auditor independence has been a controversial topic in the profession for many years. The accounting profession generally disagreed with the prohibition against nonaudit services and argued that the joint provision of audit and nonaudit services improves the performance of the audit, claiming that knowledge spillover between the audit and nonaudit functions improves the quality of both. In academic area, empirical research has concentrated on the stream of the literature that focuses exclusively on audit effectiveness, because regulatory allegations pointed to auditors compromising their independence. Another stream of the literature that focuses on the association between nonaudit services and audit efficiency has received limited academic attention.  This study examines the relationship between nonaudit services and both audit effectiveness and efficiency using evidence from fees paid for nonaudit services and lags in audit reports.

    Design/Method/ Approach:

    The authors’ final sample consists of 5,004 firm-year observations of Big 5/Big 4 audit firms over the period 2000 to 2003 inclusive (data available in Compustat). The study used nonaudit service fees as a proxy for the extent of nonaudit services provided by the audit firm. 

    Findings:
    • Higher nonaudit service fees are associated with shorter audit report lags—a potential indicator of audit efficiency— prior to the passage of SOX, but such effects dissipate after SOX.
    • Audit quality, as measured by discretionary accruals and financial restatements, does not deteriorate when audit report lags are shorter for clients purchasing high levels of nonaudit services.
    • Discretionary accruals and financial restatements—potential indicators of audit effectiveness—do not increase when shorter audit lags occur in conjunction with high nonaudit service fees. This study also find that the firms with the highest levels of nonaudit service fees prior to SOX have the largest increase in audit lags after SOX.

    The authors claimed that taken together, the results are consistent with the concept of the auditor accumulating client-specific knowledge and expertise (i.e., knowledge spillovers) through the joint provision of audit and nonaudit services that can benefit both the audit and nonaudit services provided to clients. Additionally, the authors state the results imply that joint provision of audit and nonaudit services does not undermine the effectiveness of the audit but yields audit efficiency, and any gains in audit efficiency do not come at the loss of audit effectiveness.

    Category:
    Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of SOX, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Market Reaction to Auditor Switching from Big 4 to...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 11.08 Proxies for Audit Quality 
    Title:
    Market Reaction to Auditor Switching from Big 4 to Third-Tier Small Accounting Firms
    Practical Implications:
    • Our results suggest that the market has confidence in companies choosing third-tier audit firms to enhance the economic benefit in terms of better audit services.
    • The results confirm the regulator’s encouragement of selecting smaller audit firms to improve competition, and the results will ease the reluctance that companies have in choosing a smaller audit firm.
    • The results confirm that the market viewed the regulatory changes in 2004 as an improvement to audit quality of the small audit firms, which included SOX 404 audits of internal controls over financial reporting, PCAOB inspections of audit firms, and a shorter filing deadline for Form 8-K.

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

    Citation:

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

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

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

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

    Design/Method/ Approach:
    • We compare market adjusted returns of Big 4 to third-tier auditor switches between two periods: 1) February 1, 2002 to August 23, 2004 - when SOX was proposed and passed but when investor perceptions of smaller third-tier auditors were unlikely to have changed, and 2) August 24, 2004 to December 31, 2006 - when major regulatory changes occurred that likely improved investor’s perceived quality of third-tier auditors. 
    • We also perform multivariate analysis that compares the market reaction to switches from Big 4 to Third-tier auditors where audit quality changes are more noticeable by the market. For instance, 1) switches from Big 4 non-specialists to third-tier auditors when accruals quality of the Big 4 auditor was lower than normal, 2) switches from a Big 4 non-specialist auditor to a third-tier industry specialist auditor when accruals quality of the Big 4 auditor was lower than normal, and 3) switches from a Big 4 non-specialist auditor to a third tier auditor when audit fees decreased and when accrual quality of the Big 4 auditor was lower than normal.
    Findings:
    • We find that in the second period (after August 23, 2004), that the market responded more positively to auditor switches from Big 4 to third-tier auditors (BtS), as well as to switches form Big 4 to second-tier auditors and to Big 4 auditors, when compared to the first period (February 1, 2002 to August 23, 2004).
    • We find that the more positive stock market reaction to BtS switches occurred when the Big 4 predecessor did not warrant high audit quality (a non-specialist auditor and lower accruals quality), thus implying a low likelihood of an audit quality decrease.
    • We find that the more positive stock market reaction to BtS switches is not due to an audit fee decrease, but rather to engaging a third-tier industry specialist auditor that can provide better services.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Industry Expertise – Firm and Individual, Proxies for Audit Quality
  • Jennifer M Mueller-Phillips
    Fee Pressure and Audit Quality
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Title:
    Fee Pressure and Audit Quality
    Practical Implications:

    The results of this study are important evidence that a large proportion of audit engagements during the Recession were characterized by positive fee pressure, and that fee pressure was associated with lower audit quality during the Recession. The results suggest that auditors who experienced fee pressure from clients during the Recession were not able to maintain or increase audit effort in line with client risks due to pressure on fees. These results should be of interest to the PCAOB who expressed concern that audit fee pressure may have had negative effects on audit quality during the Recession.

     

    For more information on this study, please contact Mike Ettredge.  

    Citation:

    Ettredge, M., E. E. Fuerherm, and C. Li. 2014. Fee pressure and audit quality. Accounting, Organizations and Society 39 (4):247-263

    Keywords:
    Audit fee, audit quality, fee pressure, recession, misstatements, PCAOB
    Purpose of the Study:

    The purpose of this study is to investigate the association of audit fee pressure with audit quality during the recent recession. The Recession started in December 2007 and officially ended in June 2009. Regulators expressed concerns that clients may expect their auditors to share in the economic pain of the Recession by agreeing to fee reductions and that fee pressure might cause auditors to ease up on the rigor of audits or to curtail necessary audit work to cope with falling revenue. However, it is not clear that auditors would respond to fee pressure by reducing audit quality given the litigious climate in which they operate. Prior research suggests that auditors have incentives to maintain or increase audit effort when faced with greater engagement risk. This paper addresses this question empirically by:

    • Developing a model to proxy for fee pressure
    • Comparing the existence of fee pressure in pre-recession years (2006-2007), during the Recession (2008), and the year the Recession ended (2009)
    • Studying the association of fee pressure with misstatements of the financial statements, an inverse proxy for audit quality, during the Recession. 
    Design/Method/ Approach:

    The data for the main analysis are collected for public companies in 2008, the main year of the Recession. The authors compare each client’s actual fee in the test year (2008) with a benchmark audit fee to identify fee pressure. The benchmark audit fee is calculated using actual audit fee data from previous year (2007) to predict audit fees for the test year (2008). The authors use misstatements of financials as an inverse measure of audit quality. All else equal, a higher quality audit should lead to fewer misstatements of the audited financials. 

    Findings:
    • The authors find that fee pressure is significantly greater in 2008 than in both 2006 and 2007 suggesting that auditors faced increased fee pressure from clients during the Recession.
    • The authors find that fee pressure is positively associated with financial misstatements during the Recession (2008), but is not associated with misstatements in 2007 and 2009 and is only weakly associated in 2006. This suggests that the decrease in audit quality during the Recession year is related to fee pressure from audit clients.
    • In sensitivity analyses, the authors find that the impact of fee pressure does not differ for Big 4 vs. non-Big4 auditors or larger vs. smaller audit offices.
    • In sensitivity analyses, the authors find that fee pressure in 2008 is positively associated with the occurrence with severe misstatements, but not less severe misstatements. This result suggests that fee pressure during the Recession was associated with serious decreases in audit quality, not just with small errors in the financial statements. 
    Category:
    Audit Quality & Quality Control, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Proxies for Audit Quality

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