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  • Jennifer M Mueller-Phillips
    Audit Partner Perceptions of Post-Audit Review Mechanisms:...
    research summary posted April 28, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.12 Impact of potential post-audit review - e.g., PCAOB, internal firm inspections, 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Audit Partner Perceptions of Post-Audit Review Mechanisms: An Examination of Internal Quality Reviews and PCAOB Inspections
    Practical Implications:

    The results of this study make several contributions. It is beneficial to researchers interested in furthering our understanding of the effects and effectiveness of IQRs and PCAOB inspections, as well as to practitioners and regulators. While many opportunities for further research exist, results indicating a large portion of partners try to predict the engagements that will be selected for either PAR can serve as a foundation to investigate further the effects of PAR salience on audit planning and reporting decisions.

    For more information on this study, please contact Richard W. Houston
     

    Citation:

    Houston, R. W., and C. M. Stefaniak. 2013. Audit Partner Perceptions of Post-Audit Review Mechanisms: An Examination of Internal Quality Reviews and PCAOB Inspections. Accounting Horizons 27 (1).

    Keywords:
    audit quality; internal quality reviews; PCAOB inspections
    Purpose of the Study:

    Tis study attempts to examine audit partner perceptions of the two primary post-audit review (PAR) mechanisms intended to help maintain and improve the quality of public company audits (PCAOB inspections and firms’ internal quality reviews [IQRs]). Using a survey of audit partners, the authors investigate and compare partners’ perceptions of each review’s predictability, conduct, inspector qualifications and behavior, and effects. This study extends upon prior research by reporting perceptions of experienced partners from large firms, providing detailed evidence concerning IQRs, and examining partners’ perceptions of both PCAOB inspections and IQRs. Finally, the authors are also the first to study PAR perceptions to consider the effects of partner experience, complementing research suggesting that partner experience affects audit performance. 
     
     

    Design/Method/ Approach:

    To learn more about PCAOB inspections and IQRs, the authors investigate and compare partners’ perceptions of each PAR. The research questions concern perceptions of each PAR’s (1) predictability, (2) conduct, (3) inspector qualifications and behavior, and (4) effects, as well as whether results differ based on partner experience. To examine the research questions, the authors distributed a survey to large-firm audit partners. Survey participants were obtained via a mailing list obtained through the AICPA. The list included U.S. professionals who were (1) partners, shareholders, or owners; (2) audit focused; (3) employed by U.S. public accounting firms with over 100 employees. The packets were mailed to 1,400 auditors who met the above criteria. 125 partners responded resulting in approximately a 9 percent response rate.

    Findings:
    • Partners can or try to predict the engagements that will be selected for either an IQR or PCAOB inspections.
    • While partner believe they can more easily predict the specific year of an IQR, no difference was found in their abilities to select which specific engagements will be selected for IQRs or PCAOB inspections.
    • Partners perceive both PARs to be very detailed.
    • Partners believe that IQRs are more likely to cover all audit areas and that IQR reviewers have a better understanding of their firms’ audit methodologies than do PCAOB inspectors.
    • Partners believe that both IQRs and PCAOB inspections affect their professional reputation.
    • IQRs provide more timely feedback than do PCAOB inspections, and partners perceive IQR feedback to be more beneficial.
       
    Category:
    Audit Quality & Quality Control, Auditor Judgment
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of potential post-audit review (e.g. PCAOB - internal firm inspections)
  • 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
    Investigating Inspection Risk: An Analysis of PCAOB...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.12 Impact of potential post-audit review - e.g., PCAOB, internal firm inspections, 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Investigating Inspection Risk: An Analysis of PCAOB Inspections and Internal Quality Reviews
    Practical Implications:

    This paper complements and extends the limited extant research on inspection risk by clearly defining the construct and providing empirical evidence consistent with its existence and impact on auditors’ planning decisions. The authors contend that while auditors may perceive that PARs do not influence effort or fees, both PARs likely cause auditors, perhaps unconsciously, to increase effort and fees. 

    Citation:

    C. M. Stefaniak, R. W. Houston, and D. B. Brandon. 2017. Investigating Inspection Risk: An Analysis of PCAOB Inspections and Internal Quality Reviews. Auditing: A Journal of Practice and Theory 36 (1): 151 – 168.

    Keywords:
    inspection risk, audit quality, PCAOB inspections, and internal quality reviews
    Purpose of the Study:

    The authors report the results of an experiment that examines how auditor anticipation of the two primary external and internal post-audit reviews (PAR), specifically, U.S. Public Company Accounting Oversight Board (PCAOB) inspections or public accounting firms’ internal quality reviews (IQRs), affects auditors’ perceptions of overall engagement risk, as well as effort and pricing decisions. The authors define inspection risk as “the risk that an auditor or audit firm will suffer harm as a result of a PAR.” Although the current PAR regime has been in place for over ten years, there is little empirical evidence concerning whether, and to what extent, anticipating a PAR impacts auditor behavior, and whether the effects of anticipating a PCAOB inspection or IQR differ. IQRs also remain largely uninvestigated, despite researchers beginning to investigate external PCAOB reviews. 

    Design/Method/ Approach:

    To investigate how PAR salience affects auditors’ judgments and decisions, the authors conduct a 1 x 3 between-subjects experiment using a number of high-level auditors as participants. They manipulate PAR salience as PCAOB inspection salient, IQR salient, or no explicit expectation of a PAR. 

    Findings:
    • The authors find that PAR salience yields greater perceived overall engagement risk, even after controlling for traditional engagement risk-related factors, implying that auditors perceive inspection risk as incremental to these factors.
      • In addition, increased PAR salience results in greater audit effort and fees, consistent with an inspection risk component.
    • The authors find that both PARS yield higher fees, with the higher fees attributable only to greater effort, rather than an “inspection risk premium.”
    • PCAOB inspection results are more visible than IQRs, and partners perceive that PCAOB inspections can yield greater negative consequences for themselves and their firms; therefore, the authors find that PCAOB inspection salience involves larger increases in perceived overall engagement risk and audit effort than does IQR salience.
      • However, the authors do not find differences in audit fees between PCAOB and IQR salience. 
    Category:
    Audit Quality & Quality Control, Auditor Judgment
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of potential post-audit review (e.g. PCAOB - internal firm inspections)
  • Jennifer M Mueller-Phillips
    Investor Protection, Firm Informational Problems, Big N...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs, 15.0 International Matters 
    Title:
    Investor Protection, Firm Informational Problems, Big N Auditors, and Cost of Debt around the World.
    Practical Implications:

    This study shows that Big N auditors are more effective in reducing the cost of debt in countries with strong investor protection. In particular, the authors find that high-quality auditors are perceived by creditors as providing higher-quality audits in strong investor protection countries other than the U.S., including the U.K. and Canada. The study has implications for policy makers because it suggests that auditors (and, perhaps, auditing standards) may not be effective in weak investor regimes. High-quality auditors may be less effective in performing a governance role without the support of a strong investor protection regime. 

    Citation:

    Gul, F. A., G. S. Zhou, and X. K. Zhu. 2013. Investor Protection, Firm Informational Problems, Big N Auditors, and Cost of Debt around the World. Auditing: A Journal of Practice & Theory 32 (3): 1-30.

    Keywords:
    audit quality, cost of debt, information asymmetry, informational problems, investor problems
    Purpose of the Study:

    In this paper, the authors first confirm that auditor quality reduces the cost of debt across countries. Next, they examine (1) the joint effect of investor protection and auditor quality on the cost of debt across countries, and (2) whether informational quality affects this relationship. The authors investigate the question of whether, in an international setting, firms with more informational problems are more likely to benefit from high-quality auditors and/or strong investor protection than firms with fewer informational problems.

    The authors are motivated to examine these issues because of four factors.

    • First, although prior studies using U.S. data have documented a link between the choice of Big N auditors and lower cost of debt, these findings have focused on the U.S., where auditors are exposed to high levels of litigation risks. It is unclear whether the relationship holds in jurisdictions with low litigation risks.
    • Second, there are competing views of the relationship between the effectiveness of Big N auditors and countrywide governance regimes in international settings.
    • Third, prior international studies on the role of auditor quality have not recognized that firms with higher levels of informational problems may benefit more from auditor quality and/or stronger investor protection than do firms with lower levels of informational problems.
    • The final motivation for the study lies in the importance of debt in corporate financing for firms across countries.
    Design/Method/ Approach:

    The auditor and financial data are obtained from the Compustat Global Industrial and Commercial file. The data on analysts are obtained from the Institutional Brokers’ Estimate System (I/B/E/S). The investor protection data are extracted from LLSV and LLS. The other macroeconomic data are collected from the World Bank. There are 96,396 observations from 30 countries for the period from 1994 to 2006.

    Findings:
    • The results show that firms with Big N auditors are significantly and negatively associated with the cost of debt. 
    • Big N auditors play a role in reducing a firm’s cost of debt across all countries.
    • The results show that the relationship between Big N auditors and the cost of debt is stronger in stricter investor protection regimes.
    • The authors find that firms with higher informational problems benefit more from high-quality auditors in terms of lower cost of debt in stronger investor protection countries.
    • The results suggest that in weaker investor protection countries, creditors seem to price firms’ information asymmetry problems in the cost of debt, and Big N auditors do not seem to play an effective role in reducing debt-monitoring costs.
    Category:
    Audit Quality & Quality Control, International Matters
    Sub-category:
    Impact of Firm & External Inspection Programs
  • The Auditing Section
    Is Self-Regulated Peer Review Effective at Signaling Audit...
    research summary posted May 7, 2012 by The Auditing Section, tagged 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Is Self-Regulated Peer Review Effective at Signaling Audit Quality?
    Practical Implications:

    The results of this study are important for regulators and audit firms to consider as they indicate that peer-review reports credibly capture the actual audit quality of an audit firm and support the effectiveness of a self-regulated peer-review system. Regulators may find these results useful as part of their continuing oversight of the peer-review process since most firms continue to rely on self- regulated peer reviews to guide their quality-control efforts.

    Citation:

    Casterella, J. R., K. L. Jensen, and W. R. Knechel. 2009. Is Self-Regulated Peer Review Effective at Signaling Audit Quality?  The Accounting Review 84 (3) 713-735.

    Keywords:
    Peer review; audit quality; litigation risk
    Purpose of the Study:

    For over 30 years the AICPA has used a system of self-regulated peer reviews as one of its primary methods of controlling audit quality. The underlying concern is that the general lack of independence among reviewers and reviewees reduces the peer-review process to an ineffective, ceremonial checklist. However, the key to determining whether peer review is effective is to examine whether it successfully identifies quality differences among audit firms. This paper addresses this point by investigating whether peer reviews conducted under the AICPA’s self-regulatory model have been effective at signaling actual audit quality. Below are two objectives that the authors address in their study: 

    • Examine the likelihood that audit failure (i.e. poor audit quality) is associated with peer review findings.
    • Examine the relationship between peer-review findings and the presence of audit-firm attributes indicative of audit-firm risk and/or lower audit quality.
    Design/Method/ Approach:

    Data is collected from the proprietary files of an insurance company specializing in professional liability coverage for local and regional accounting firms. The authors identify 79 malpractice claims (low audit quality) and 79 non-claim observations (high audit quality) from 1987-2000 and associate peer-review variables and audit-firm characteristics to the presence or absence of malpractice claims.

    Findings:
    •  There is a predictable link between the number of weaknesses identified in an audit firm’s peer-review report and the likelihood of that firm having a malpractice claim filed against it. 
    • The type of weaknesses identified in the report, namely weaknesses related to personnel management and engagement performance, are relevant to predicting audit failure. 
    • There is a predictable link between firm-specific indicators of risk/quality and the likelihood of that firm having a malpractice claim filed against it. 
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Impact of Firm & External Inspection Programs
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  • Jennifer M Mueller-Phillips
    PCAOB Inspections and Large Accounting Firms
    research summary posted September 17, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    PCAOB Inspections and Large Accounting Firms
    Practical Implications:

    Auditors should be interested in the results of this paper because the trends provide information both on emerging issues in accounting, as well as areas that are likely to be flagged by the PCAOB for inspection. For example, issues related to fair value measurement are growing as a percentage of overall issues. This may cause audit firms to examine their fair value accounting practices and training.

    For more information on this study, please contact Bryan K. Church.
     

    Citation:

    Church, B. K., and Shefchik, L. B. 2012. PCAOB Inspections and Large Accounting Firms. Accounting Horizons 26 (1): 43-63.

    Keywords:
    PCAOB inspections; inspection reports; regulation; audit quality.
    Purpose of the Study:

    This article gathers data from PCAOB inspection results and analyzes that data to determine trends in the auditing field. It presents these trends in a way that should be of interest to regulators, academics, practicing accountants, and users of the PCAOB's inspection reports.

    Design/Method/ Approach:

    Using PCAOB inspection reports from 2005 through 2010, the results of each inspection report is manually coded into different categories. Then, using linear regression, the article determines trends of interest in the audit engagements of the big four accounting firms as well as the four other annually inspected accounting firms.

    Findings:

    The article finds a number of trends, but some of the more important ones are:

    • Issues related to fair value measurement are growing as a percentage of overall issues
    • Total issues are declining
    • Revenue recognition is the most common problem area
       
    Category:
    Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of PCAOB
  • The Auditing Section
    PCAOB Inspections of Smaller CPA Firms: Initial Evidence...
    research summary posted April 13, 2012 by The Auditing Section, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    PCAOB Inspections of Smaller CPA Firms: Initial Evidence from Inspection Reports
    Practical Implications:

    This study provides a detailed analysis of the deficiencies identified in the PCAOB inspections of small firms, including an examination of firm-specific characteristics. It also provides insights into the PCAOB’s inspection practices, which is useful for regulators, audit firms, public companies and financial statement users to consider.

     

    Citation:

    Hermanson, D. R., R. W. Houston, and J. C. Rice. 2007. PCAOB Inspections of Smaller CPA Firms: Initial Evidence from Inspection Reports.  Accounting Horizons 21 (2):  137-152. 

    Keywords:
    PCAOB inspections, inspection reports, audit quality, quality control
    Purpose of the Study:

    In accordance with the Sarbanes-Oxley Act (SOX) of 2002, the PCAOB conducts periodic inspections of member firms. Firms with over 100 issuer clients are inspected annually, while firms with 100 or fewer issuers are inspected at least every three years. Inspection results for the large firms have been well-documented and publicized, however very little is known about the PCAOB inspections of the small firms. This study analyzes the PCAOB inspection reports for registered accounting firms with 100 or fewer issuer clients to determine whether: 

    •  There is an association between inspection process characteristics and the identified deficiencies. 
    •  There is an association between audit firm characteristics and the identified deficiencies.
    •  There is an association between audit firm characteristics and the year of the inspection (all inspections were conducted in either 2004 or 2005).
    •  There is an association between client portfolio characteristics and the identified deficiencies.
    •  Certain specific audit deficiencies are cited by the PCAOB more than others.
    Design/Method/ Approach:

    The authors gather data from 316 PCAOB inspections of smaller accounting firms (i.e. firms that audit 100 or fewer issuers annually) through July 13, 2006. All inspection data are gathered from the PCAOB’s website and supplemented with data from Audit Analytics. Descriptive analyses on the 189 inspection reports that have audit deficiencies are compared and contrasted with that of the 127 inspection reports without deficiencies.    

    Findings:
    • The length of the inspection (days spent on site) and the report lag (months from completion of the inspection to issuance of the report) are greater for firms with deficiencies.
    • Audit firms with deficiencies are smaller (fewer professionals), have a greater number of issuer clients despite their smaller size, and are growing faster than no-deficiency firms.
    • Audit firms inspected in 2004 are significantly more likely to have deficiencies identified than those inspected in 2005.
    • The PCAOB’s 2004 inspections appear to be focused on smaller, riskier, rapidly growing audit firms.
    • Clients of deficiency firms are smaller, less profitable, and more highly leveraged, suggesting greater risk.
    • Deficiencies are overwhelmingly related to the substantive procedures performed by the audit firms (e.g. failure to perform and document various analyses and procedures)
    • The most commonly cited accounting issues listed in the deficiencies are associated with revenues, receivables, equity, and liabilities

    The authors suggest that their findings provide a caution to smaller audit firms, who have perhaps over-extended themselves, and sacrificed audit quality by serving too many issuer clients. They argue that small firms should carefully consider the costs and benefits of serving multiple issuer clients.  

    Category:
    Standard Setting, Audit Quality & Quality Control
    Sub-category:
    Impact of PCAOB, Impact of Firm & External Inspection Programs
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  • Jennifer M Mueller-Phillips
    PCAOB Quality Control Inspection Reports and Auditor...
    research summary posted February 15, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    PCAOB Quality Control Inspection Reports and Auditor Reputation
    Practical Implications:

    The results of this study are important in considering what should be produced from PCAOB inspections of audit firms. Evidence indicates that clients use the information provided by Part II of the PCAOB inspection reports to choose a high quality audit firm. Perhaps producing a quality control report with every PCAOB inspection report would be helpful to clients in analyzing the audit firm and potentially improving overall audit quality.

    For further information on this study, please contact Albert L. Nagy.

    Citation:

    Nagy, Albert L. 2014. PCAOB Quality Control Inspection Reports and Auditor Reputation. Auditing: A Journal of Practice & Theory 33 (3): 87-104.

    Keywords:
    audit quality signals, PCAOB inspections, quality controls
    Purpose of the Study:

    This study focuses on the informational value of the quality control criticisms disclosed in Part II of PCAOB inspection reports. Part II of the report becomes public only if a firm fails to satisfactorily remediate the quality control deficiencies within a 12-month period. This study examines the change in audit firms' market share following the public disclosure of Part II. The results show that audit firms lose a significant amount of market share following the public disclosure of quality control criticisms, and suggest such a disclosure provides a credible signal of auditor quality to audit clients.

    Design/Method/ Approach:

    Firms analyzed were United States based, non-dark audit firms included in the Audit Analytics database from 2007 to 2012. All firms were inspected by the PCAOB and reports were posted on the PCAOB website. The market share changes for the quality control (QC) report release were measured for the year immediately following the public disclosure of the QC report. The non-QC report observations’ market changes were measured for the calendar years of the sample period.  The sampled observations were used to estimate an OLS regression model to determine whether QC reports have an effect on changes of audit firms’ market share.  

    Findings:

    The regression results of this study show that audit firms associated with publicly disclosed QC reports lose a greater amount of market share in the subsequent year than those firms not associated with a QC report. These results suggest that audit clients associate QC reports as a credible signal of low audit quality and, thus, are less likely to retain and hire audit firms involved with such a report. 

    Category:
    Audit Quality & Quality Control, Standard Setting
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of PCAOB
  • The Auditing Section
    Risk Monitoring and Control in Audit Firms: A Research...
    research summary posted April 16, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 11.0 Audit Quality and Quality Control, 11.02 Engagement Quality Review – Processes and Effectiveness, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Risk Monitoring and Control in Audit Firms: A Research Synthesis
    Practical Implications:

    While research on “quality-threatening behaviors” by auditors is difficult to perform due to confidentiality constraints, the available findings suggest that audit firms can make a difference in their incidence and severity through careful attention to policies and procedures for assessing, monitoring and controlling risk of violation of professional standards. While there is likely to be greater resistance to higher quality control standards among smaller firms, research shows that audit quality concerns are greater for smaller firms and that larger firms are currently passing smaller and riskier clients to them. The authors suggest that small accounting firms can adopt strategies, like creating alliances or becoming niche providers of certain audit services, to allow them to meet this challenge.

    Citation:

    Bedard, J.C., D.R. Deis, M.B. Curtis, and J.G. Jenkins. 2008. Risk monitoring and control in audit firms: A research synthesis. Auditing: A Journal of Practice & Theory 27 (1): 187-218.

    Keywords:
    Audit firm quality control, risk monitoring, auditing standards, independence risk, whistle-blowing, decision aids
    Purpose of the Study:

    Audit firm quality control is defined as an audit firm’s assessment and control of the risk that auditing standards, professional values or the public interest might be violated. The PCAOB has recently expressed interest in understanding the current status of research related to audit firm quality control as it considers revising the current standards in this area. This paper summarizes the research literature related to audit firm quality control with the following two objectives: (1) to provide information on the current state of knowledge with regard to the ways in which audit firms monitor and control firm-level risk; and (2) to highlight implications for development of new standards and for future research.

    Design/Method/ Approach:

    This paper reviews the literature related to audit firm quality control. Evidence was collected prior to 2006 with much of the data gathered prior to SOX and the founding of the PCAOB.

    Findings:

    Risk Management before the Engagement:

    • Recent research suggests that larger firms are shedding smaller, riskier clients to smaller audit firms as a result of the Andersen demise and Section 404 work. Further, smaller clients often choose smaller firms on the basis of more affordable fees. These findings suggest that client portfolio risk has recently increased among smaller firms.
    • Studies find that audit firms appear to be willing to take on riskier clients if the billing rate allows increased testing and/or assignment of more highly qualified engagement personnel (e.g., specialists). However, smaller audit firms may be less able to price engagement bids to cover increased exposure from riskier clients. 

    Monitoring and Control of Auditor Independence Risk:

    • Audit Firm and Partner Rotation: The archival studies report mixed results on the effect of firm and partner rotation on auditor independence. However, behavioral research provides evidence in support of firm or partner rotation. Behavioral studies generally find that auditors’ tend to make decisions in favor of management’s position and that proposed adjustments are typically smaller when rotation is not required.
    • Employing Former Auditors: Research suggests that the practice of companies employing former auditors is widespread. There is also some evidence of independence impairment and a loss of professional skepticism associated with this practice.
    • Auditor-Provided Nonaudit Services: While results are somewhat mixed, the balance of research does not appear to support the conclusion that auditor independence is compromised by the provision of nonaudit services. 

    Risk Management during the Engagement

    • Electronic Decision Aids: Research shows continuing growth and development of electronic decision aids in audit firms. Potential benefits of auditing decision aids include increased compliance with auditing standards and audit methodology, increased audit efficiency, consistency in audit approaches across clients, easier documentation, and increased control of junior staff.
    • Consultation Units: Accounting firms can control risk by developing specialized internal groups to assist local offices in making decisions. Creating a database of research increases efficiency and improves the consistency of accounting treatments recommended to clients. However, research suggests that the use of consultation units is inconsistent across the profession and declines significantly with firm size.
    • Whistle-Blower Mechanisms: Research suggests that the presence of whistle-blower mechanisms increases the likelihood that reports of wrong-doing will be made. The effectiveness of these programs is enhanced when (1) confidentiality is ensured; (2) employees thoroughly understand the mechanism; and (3) when firms both encourage such reporting and discourage retribution for reporting unethical acts. 

    Internal and External Inspections and Review

    • Internal Engagement Quality Control Reviews: Research indicates that engagement quality control reviews reduce audit risk by improving audit risk assessments and inducing partners to plan higher levels of audit testing.
    • Peer Reviews: Participation in a quality peer review process represents a commitment to quality by the audit firm. In fact, research provides evidence that audit firms participating in a peer review process conduct higher quality audits, and continued participation leads to continued improvements in audit quality over time.
    • Regulatory Quality Control Reviews and Inspections: Overall, a positive link has been found between quality control reviews and audit quality.
    Category:
    Client Acceptance and Continuance, Audit Quality & Quality Control
    Sub-category:
    Client Risk Assessment, Engagement Quality Review – Processes & Effectiveness, Impact of Firm & External Inspection Programs
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  • Jennifer M Mueller-Phillips
    Spatial Competition in Local Audit Markets and the Fallout...
    research summary posted May 30, 2017 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.06 Impact of PCAOB, 03.0 Auditor Selection and Auditor Changes, 11.0 Audit Quality and Quality Control, 11.11 Impact of Firm and External Inspection Programs 
    Title:
    Spatial Competition in Local Audit Markets and the Fallout on Deloitte from the 2007 PCAOB Censure
    Practical Implications:

    The results from this study demonstrate that product differentiation in the form of market leadership and industry specialization may not provide a firm the power to mitigate the adverse consequences of a PCAOB censure.

    Citation:

    Boone, J. P., I. K. Khurana, and K. K. Raman. 2017. Spatial Competition in Local Audit Markets and the Fallout on Deloitte from the 2007 PCAOB Censure. Auditing, A Journal of Practice and Theory 36 (21): 1-19.

    Keywords:
    PCAOB; Big 4 auditors; local audit markets; spatial competition
    Purpose of the Study:

    The 2007 PCAOB censure on Deloitte regarding a pharmaceutical client in California caused the firm to suffer both audit fee and client losses. The objective of the paper is to determine whether auditor market power in a local area overrides the audit quality issues resulting from a censure. Specifically, authors investigate the effects of the censure on Deloitte’s ability to retain existing clients (or, switching risk) and potential loss of audit fees. The initial assumption is that auditor-client alignment and auditor-closest-competitor distance can help create differentiation among the Big 4 and this would lead to lower audit fee and client losses for a particular metropolitan area. Researchers looked at specific market specialization and geographic areas to analyze the effects on Deloitte. 

    Design/Method/ Approach:

    The research evidence was collected from 2008-2010, the period after the censure. There were 65 local audit markets used within the sample. Each of these markets had a minimum of 6 to a maximum of 1,662 clients observed. Deloitte-client alignment for the individual local audit markets was based on Deloitte’s expertise in the client’s industry, measured according to whether Deloitte is the national leader in the industry (top fee earner), an industry specialist (significant fee earner), or a local audit market leader (top fee earner locally). Deloitte-closest-competitor distance measures Deloitte’s implied differentiation and reputation. It was calculated by comparing the distance between the firm’s fee market share and its closest competitor both at the national level and in the local market.

    Findings:

    The overall finding is that audit quality issues override auditor market power and that differentiation does not provide Big 4 firms market power against adverse regulatory action.

    The authors specifically find that:

    • Deloitte’s audit fee losses were concentrated in the pharmaceutical industry. However, the majority of client losses were not limited to one geographical area or industry.
    • In all cases observed, the results indicate that Deloitte’s leadership or specialty engagements suffered client loss risk odds that were not different from that of its non-leader or non-specialty engagements.
    • Evidence with respect to Deloitte-closest-competitor distance suggests that there was no difference in client loss risk across the local audit market areas.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes, Standard Setting
    Sub-category:
    Impact of Firm & External Inspection Programs, Impact of PCAOB

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