Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

Posts

  • Jennifer M Mueller-Phillips
    Are Auditors Professionally Skeptical? Evidence from...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Are Auditors Professionally Skeptical? Evidence from Auditors’ Going-Concern Opinions and Management Earnings Forecasts.
    Practical Implications:

    The decision process concerning a firm’s going-concern status is a crucial component of the overall audit. The authors provide new empirical evidence showing how auditors use potentially biased management forecasts in their going-concern decision process. Auditor professional skepticism is an important concept in audit practice as evidenced by its prominence throughout auditing standards. The authors show that auditors do not significantly overweight management forecasts on average, and even underweight management forecasts they perceive as being suspicious, indicating that auditors exercise professional skepticism when using management earnings forecasts. Thus, this paper is informative to regulators who are mainly concerned about auditors relying too heavily on what their clients tell them and failing to sufficiently test or challenge the forecasts, views, or representations of management.

    Citation:

    Feng, M., & Li, C. 2014. Are Auditors Professionally Skeptical? Evidence from Auditors' Going-Concern Opinions and Management Earnings Forecasts. Journal Of Accounting Research 52 (5): 1061-1085.

    Keywords:
    going-concern, management forecast, professional skepticism
    Purpose of the Study:

    This paper investigates whether auditors exercise professional skepticism about management earnings forecasts when assessing a client firm’s going-concern status. Professional skepticism is “an attitude that includes a questioning mind and a critical assessment of audit evidence”. Regulators have long been concerned that auditors rely too much on what their clients tell them rather than applying professional skepticism. For example, a lack of professional skepticism is one primary cause of SEC actions against audit firms.

    This paper sheds light on auditor professional skepticism due to the joint effect of three important factors.

    • Prospective financial information provided by managers is an important input to auditors when they evaluate the client’s going-concern status. Among this information, management earnings forecasts are particularly important because, if a financially distressed firm is expected to continue generating losses, the losses are likely to drain the firm’s limited cash resources and increase the firm’s likelihood of going bankrupt.
    • Financially distressed firms tend to issue optimistically biased forecasts. Because the firms to which auditors consider issuing a going-concern opinion are generally financially distressed, professional skepticism could be especially important in this setting.
    • Auditors could obtain management earnings forecasts through private communication with managers and/or public earnings forecasts.
    Design/Method/ Approach:

    The authors obtain data from financially distressed firms that have auditor reports available on Audit Analytics and are covered by the Compustat and First Call database for fiscal years 2000 through 2010. This results in final sample of 1,054 firm-year observations with 39 observations receiving going-concern opinions, and 33 filing for bankruptcy in the 12 months subsequent to the auditor opinion issuance date.

    Findings:

    The authors find that, when management earnings forecasts are higher, the firms are less likely to receive going-concern opinions and to subsequently go bankrupt. Moreover, the coefficient on management forecasts in the going-concern model is not significantly different from the coefficient in the bankruptcy model. Hence, there is no significant evidence showing that auditors, on average, overweight management earnings forecasts and thus fail to apply professional skepticism when evaluating the firms’ going-concern status.

    The authors find that auditors’ going concern decisions are not associated with management earnings forecasts with lower perceived credibility, but significantly and negatively associated with the other management earnings forecasts. In contrast, the likelihood of bankruptcy is significantly related to management earnings forecasts, regardless of auditor-perceived credibility. More importantly, the weight that auditors assign to management forecasts with low perceived credibility is significantly lower than the weight implied in the bankruptcy model. In other words, auditors’ underweight management earnings forecasts that are issued by managers who previously missed their own forecasts and management forecasts that predict high earnings increases or high earnings.

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Audit Report Restrictions in Debt Covenants
    research summary posted August 30, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Audit Report Restrictions in Debt Covenants
    Practical Implications:

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

    Citation:

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

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

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

    Design/Method/ Approach:

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

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

     

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

     

    • Auditors charge higher audit fees on and are more likely to issue a GCAR to clients who have loan contracts contain a GCAR covenant, holding the degree of financial distress constant. The results are consistent with the argument that the GCAR covenant increases auditors’ perception on litigation risk and the demand on audit effort. 
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Audit Reporting for Going-Concern Uncertainty: A Research...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Audit Reporting for Going-Concern Uncertainty: A Research Synthesis
    Practical Implications:

    This study provides a summary of the literature examining the auditor’s GCO decisions. Determinants of GCOs include client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), auditor factors (e.g. audit firm size), auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and environmental factors (e.g. changes in regulations, auditing standards and audit market structure). Important findings are that auditors will change the likelihood of issuing GCOs in response to changes in the environment (whether due to changes in regulation or changes in the economy) and that the majority of companies that receive GCOs do not subsequently file for bankruptcy.

    For more information on this study, please contact Elizabeth Carson.

    Citation:

    Carson, E., N. L. Fargher, M. A. Geiger, C. S. Lennox, K. Raghunandan, and M. Willekens. 2013. Audit reporting for going-concern uncertainty: A research synthesis. Auditing: A Journal of Practice & Theory 32 (Supp): 353-384.

    Keywords:
    going-concern; audit reporting; bankruptcy
    Purpose of the Study:

    The global financial crisis in 2007 has resulted in an increased incidence of company failures. This led to renewed interest from regulators, standard setters and investors in the auditor’s assessment and reporting on a company’s ability to continue as a going concern. In order to facilitate the understanding of the role and effectiveness of independent audit, this study conducts a comprehensive review to synthesize and discuss the extant academic literature on auditors’ decisions to issue a modified opinion based on going concern uncertainty (hereafter, GCO).

    Design/Method/ Approach:

    This study synthesizes major findings from audit research since the 1970s. Most of the research reviewed is archival; however, a few studies using experimental designs are also cited. A framework is developed to structure the categorization of the extant GCO literature. Three main themes are identified: (1) Determinants of GCOs, (2) Accuracy of GCOs, and (3) Consequences of GCOs. This study also provides a discussion on issues related to research methodology and identifies areas for further research.

    Findings:

    Under the category of “Determinant of GCOs”, the synthesis shows that:

    • Auditors are more likely to issue GCOs after December 2001, which is in response to the accounting and auditing scandals in early 2000s (e.g. collapse of Enron). Also, smaller companies more likely to receive GCOs.
    • In the ten-year period between 2000 and 2010, 60.10% of bankruptcy filings are preceded by GCOs.
    • Determinants of GCOs include: (1) client factors (e.g. size, level of financial stress, financial reporting quality, corporate governance), (2) auditor factors (e.g. audit firm size), (3) auditor-client relationships (e.g. auditor switching and the issue of opinion shopping) and (4) environmental factors (e.g. changes in regulations, auditing standards and audit market structure).

    Under the category of “Accuracy of GCOs”, the synthesis shows that:

    • Since the adoption of SAS No.59, 40-50% of bankruptcy firms did not receive a prior GCO.
    • 80-90% of companies receiving a GCO do not file for bankruptcy in the subsequent year.

    Under the category of “Consequences of GCOs”, the synthesis shows that:

    • Issuance of GCOs is associated with negative excess returns, and the reaction is more negative when problems with obtaining financing are cited.
    • In the U.S., the issuance of GCO can be a “self-fulfilling prophecy” and cause the financial demise of company that would have survived if it had not received a GCO.

    With regards to issues in research methods, this study cautions the use of small samples in analysis and the interpretation of interaction variables in the statistical models. The study also finds general limitations in extant research due to the varying sample selection criteria for identifying financial stressed firms and the exclusion of private companies from samples examined.

    This study suggests further research could (1) examine the relations between auditor independence and GCO decisions, (2) investigate auditor’s GCO decisions and the related issues for financial institutions, non-profit organisations and government entities, (3) replicate research on GCO accuracy in different time periods with different samples, (4) examine the information usefulness of GCOs to a wide set of market participants, and (5) properly distinguish between the roles of management, audit committee and auditor in the disclosure and discussion of going-concern. 

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
  • Jennifer M Mueller-Phillips
    Auditor fees and auditor independence ‒ Evidence from g...
    research summary posted November 12, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Auditor fees and auditor independence ‒ Evidence from going concern reporting decisions in Germany.
    Practical Implications:

    The results of this study show that in general market-based incentives, such as loss of reputation, constitute more important factors with regard to auditor independence than an economic dependence caused by higher non-audit fees. However, those safeguards may not be adequate in all situations given the relatively low litigation risk in Germany. The relatively high importance of consulting services performed in audit engagements by the Big 4 group seems to give Big 4 auditors an incentive to continue the auditor-client relationship, and is therefore to be regarded as an additional economic dependence between auditor and client. The explicit representation of liquidity risks through management appears to influence auditor reporting behavior in relation to going concern risks. This information—even if it is not presented in a separate reporting instrument, such as the Lagebericht—could also determine auditor reporting behavior outside Germany.

    For more information on this study, please contact Nicole Ratzinger-Sakel.

    Citation:

    Ratzinger-Sakel, N. V. S. 2013. Auditor fees and auditor independence ‒ Evidence from going concern reporting decisions in Germany. Auditing: A Journal of Practice and Theory 32 (4): 129-168.

    Keywords:
    Auditor independence, auditor reporting, non-audit fees, audit fees, Germany
    Purpose of the Study:

    On October 13, 2010, the European Commission published a Green Paper entitled “Audit Policy: Lessons from the Crisis”. Against the background of the recent global financial and economic crisis, this Green Paper proposes primarily reforms to improve auditor independence, and therewith audit quality, and to improve the structure of the audit market. One of the main areas of interest in this Green paper is whether the provision of consulting services by statutory auditors endanger the independence of auditors. This paper examines whether this concern can be empirically substantiated by investigating the potential for non-audit services to impair auditor independence using going concern modifications as a proxy for audit quality. While prior research has focused primarily on Anglo-Saxon environments, this study focuses on Germany because of the country’s unique reporting attributes (i.e., Lagebericht, which is a management report, and its associated Risikobericht, which is a risk report) and lower litigation risk when compared to Anglo-Saxon settings.

    Design/Method/ Approach:

    The analysis is based on a sample of financially distressed, capital market-oriented companies from the study period 2005-2009. Companies are defined as financially distressed if they meet one of the following five criteria: (1) negative equity, (2) negative operating cash flow, (3) negative working capital, (4) negative EBIT in the previous year, and (5) net loss in the previous year. These criteria are taken from a survey of German auditors, asking these to estimate the relevance of a number of indicators relating to the going concern assumption. These indicators are very similar to the criteria used in international studies for identifying financially distressed companies. In light of recent research findings on auditor reporting behavior from the United States, which, using strict control samples, report different results compared to previous U.S.-American studies, this study includes a second control sample. In alignment with the U.S.-American literature, this second control sample includes companies showing both a net loss in the previous year and a negative operating cash flow in the previous year. 

    Findings:
    • The results show no evidence of a significant negative relationship between the level of non-audit fees and the likelihood that an auditor issues a going concern opinion (GCO).
    • However, there is some evidence that the potential for non-audit services to impair auditor independence depends on the type of audit firm conducting the audit (Big 4 compared to non-Big 4). If the level of non-audit fees is relatively high, then Big 4 audit firms are less likely to issue a GCO. However, this result holds only for highly financially stressed clients.
    • The results for the examined unique German reporting environment show a positive association between liquidity risks explicitly presented in the Risikobericht and the likelihood that the auditor includes a GCO in the audit report.
    Category:
    Independence & Ethics
    Sub-category:
    Going Concern Decisions, Non-audit Services
  • Jennifer M Mueller-Phillips
    Business Strategy and Auditor Reporting
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 09.04 Going Concern Decisions, 12.01 Going Concern Decisions 
    Title:
    Business Strategy and Auditor Reporting
    Practical Implications:

    This study is informative for stakeholders when they are analyzing financial statements. It provides support that a going concern opinion for a prospector firm may not be as alarming as it appears. It also reveals that many influences are at play when auditors are determining which audit opinion is most appropriate for the situation.

    Citation:

    Chen, Yu, J. D. Eshleman, and J. S. Soileau. 2017. Business Strategy and Auditor Reporting. Auditing, A Journal of Practice and Theory 36 (21): 63-86.

    Keywords:
    business strategy; auditors; going concern; material weakness
    Purpose of the Study:

    This study examines the effects that a firm’s business strategy, whether prospector or defender, has on an auditor’s decision in areas requiring significant professional judgment. Specifically, the authors investigate areas involving material weakness and going concern opinions. Prospector business strategies focus on innovation and invest heavily in marketing and research and development. Alternatively, defender business strategies place a strong emphasis on cost efficiency and instead invest heavily in automated production and distribution processes. It is important to note the focus in the study is on business-level strategy, not corporate strategy. Business level-strategy is the way a firm competes within an industry, not what industries it competes in.

    Design/Method/ Approach:

    All firms in the study were placed into 3 categories: prospectors, analyzers, and defenders. The authors used 6 characteristics to measure strategy in order to categorize the firms. The final sample size was 4,332 firms from 2000-2013. Financial information was obtained about the firms from databases such as Compustat, Audit Analytics, and CRSP.

    Findings:

    The authors find that a firm’s decision to adopt a prospector versus defender strategy significantly increases the likelihood of an auditor issuing an unfavorable opinion.

     

    The authors find the reasoning behind this to be comprised of the following:

    • Prospector business strategies are rooted within innovation and therefore likely to take risks. Often times this leads to past performances being more volatile which reduces the auditor’s ability to accurately predict future outcomes. This results in auditors choosing the most conservative choice, a going of concern opinion.
    • Collectively, prospector strategy characteristics such as decentralized control, frequent product changes, and high executive turnover all lead to a higher probability of material weakness.

     

    Overall, auditors are more prone to Type II errors regarding the issuant of going concern opinions to prospector firms. The evidence suggests that auditors are less successful in predicting bankruptcy for these firms and the going concern opinion is not always warranted. 

    Category:
    Accountants' Reporting, Auditor Judgment
    Sub-category:
    Going Concern Decisions, Going Concern Decisions
    Home:

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

  • The Auditing Section
    Client Importance, Institutional Improvements, and Audit...
    research summary posted May 7, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions, 15.0 International Matters, 15.01 Audit Partner Identification by Name 
    Title:
    Client Importance, Institutional Improvements, and Audit Quality in China: An Office and Individual Auditor Level Analysis
    Practical Implications:

    This study uses engagement-level audit partner data, to analyze whether audit quality is driven by client importance at the office- or partner-level.  Overall, the results contribute to evidence showing that investor protection rules and laws at the country-level are associated with engagement-level audit quality.  This indicates the importance of strong investor protection regulations.  These results may be of interest to shareholders and securities market regulators, especially in developing economies, transitional economies, or economies where such regulations are weak.  Additionally, these results may be of interests to auditors in countries with such economies.  Finally, to the extent that audit firms serve clients with investors that receive varying levels of protection (i.e. public vs. private or a “well-known seasoned issuer”), these results may indicate opportunities for such firms to enhance audit requirements for certain non-public engagements. 

    The results of this study also suggest that audit accountability at the individual level makes auditors more sensitive to the costs of audit failure.  This result may have implications for auditor accountability from a regulatory standpoint, as well as an audit firm policy standpoint.

    Citation:

    Chen, S., S. Y. J. Sun, and D. Wu. 2010. Client Importance, Institutional Improvements, and Audit Quality in China: An Office and Individual Auditor Level Analysis. The Accounting Review 85 (1): 127-158.

    Keywords:
    international matters, audit quality, quality control, client importance, litigation, audit-reporting decision
    Purpose of the Study:

    This study addresses the broad question of whether the economic importance of a client impairs audit quality.  The authors use Chinese data to: 

    • Investigate whether institutional improvements in a country's investor protection environment affect engagement-level audit quality.
    • Examine the relationship between client economic importance to the individual auditor (individual engagement partners) and audit quality in China.
    Design/Method/ Approach:

    The authors use a sample of 8,917 client firm-year observations from 1995 to 2004 where 1995 to 2000 is the low investor protection period and 2001 to 2004 is the high investor protection environment following changes by the Chinese Supreme Court to heighten investor protection rules. Audit quality is measured using the probability of the auditor issuing a modified audit opinion.  Client importance is measured using the ratio of individual client assets to the total client assets audited at both the office level and partner level.

    Findings:
    • Client importance at the partner level impaired audit quality during a period when investor protection was weak (1995-2000).
    • Auditors appear to have become more conservative after improvements were made to investor protection rules and laws.  This is evidenced by a positive correlation between audit quality and client importance at the partner level from 2001-2004.
    • Client importance at the office level is not significantly associated with audit quality in either period (1995-2004).
    • Audits that received a sanction by the Chinese government as an audit failure were more likely to be for clients of high importance to the auditor in the pre 2001 period and were more likely to be for clients of low importance to the auditor in the post 2001 period.
    Category:
    Independence & Ethics, Accountants' Reporting, International Matters
    Sub-category:
    Impact of Fees on Decisions by Auditors & Managmeent, Going Concern Decisions, Going Concern Decisions, Audit Partner Identification by Name
    Home:
    home button
  • Jennifer M Mueller-Phillips
    Debt Covenant Violations, Firm Financial Distress, and...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 02.06 Resignation Decisions, 12.01 Going Concern Decisions 
    Title:
    Debt Covenant Violations, Firm Financial Distress, and Auditor Actions
    Practical Implications:

    The findings from this study impact firms with debt covenant requirements. Violations from debt covenants occur frequently and are often due to tight restrictions rather than signs of financial distress. These types of violations often lead to renegotations or waivers instead of immediate repayment. However, this study shows that auditors will still have negative reactions regardless of whether or not the violation is due to financial difficulty. It is important for firms to not only consider the financial and lending consequences of a violation, but the auditing consequences as well.

    Citation:

    Bhaskar, Lori Shefchik, G. V. Krishnan, and W. Yu.2017. “Debt Covenant Violations, Firm Financial Distress, and Auditor Actions”. Contemporary Accounting Research 34.1 (2017): 186.

    Purpose of the Study:

    This study investigates auditor actions resulting from debt covenant violations for firms. The violations increase business risk and subsequently cause the auditor to respond negatively. The audit actions examined in this paper are:

    • Adjustments in the audit plan causing higher audit fees.
    • The issuance of a going concern opinion.
    • The resignation of the auditor.

    The authors also consider the financial health of the firms before the violation was given. It is hypothesized that auditors are more likely to have a negative reaction to firms that are already financially distressed.

    Design/Method/ Approach:

    The sample includes 4,267 violations occurring from 2000 to 2008. All of the firms were U.S. nonfinancial public companies. The authors gathered the information from databases such as Compustat and Audit Analytics. The analysis was performed by estimating models of the auditor actions based on different client characteristics.

    Findings:

    The authors find the following:

    • Firms with debt covenant violations have significantly higher audit fees.
    • Firms have an increased likelihood of receiving a going-concern opinion after a violation. This is increased even more for firms that are not financially distressed. The authors attribute this to the fact that auditors tend to act more strongly because the information was inconsistent with prior beliefs.
    • Debt covenant violations lead to an increased likelihood of auditor resignation.
    • There is a positive association between the Big 4 auditors and all three auditor actions listed above.
    Category:
    Accountants' Reporting, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Going Concern Decisions, Resignation Decisions
    Home:

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

  • Jennifer M Mueller-Phillips
    Discussion of “Does the Identity of Engagement Partners M...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 01.03 Impact of New Accounting Pronouncements, 05.0 Audit Team Composition, 05.05 Diversity of Skill Sets e.g., Tenure and Experience, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions, 15.0 International Matters, 15.01 Audit Partner Identification by Name 
    Title:
    Discussion of “Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions”.
    Practical Implications:

    This discussion emphasizes significant caution when interpreting the results of the study. Mainly, it is unclear if results of the study can generalize to the broader public company market in the US. Furthermore, if the results are misinterpreted (i.e., individual auditors are not systematically aggressive but, instead, high quality auditors are systematically assigned the riskiest clients) then regulation requiring audit partner identification could actually have overall negative effects on overall audit quality.

    Citation:

    Kinney, W.R. 2015. Discussion of “Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions”. Contemporary Accounting Research 32 (4):1479-1488.

    Keywords:
    auditor attributes, reporting style, auditor identification, audit quality, going concern opinion, Type I error, Type II error, credit risk, insolvency risks, statutory audits
    Purpose of the Study:

    The author reviews the paper's content, analyzes its predictive validity, and discusses its multiple implications. He provides constructive suggestions for improvements. Based on predictive validity analysis, the author concludes that engagement partner assignment strategy is an important and acknowledged omitted variable that affects the study's internal validity via both the independent variable (partner's prior performance measure) and the dependent variable (borrower's cost of debt capital). The omission also affects construct validities and, if audit firms are applying a plausible assignment strategy, then interpretation of the study's main results would be reversed. Finally, the lack of a standards intervention noted by the authors and the extreme size and other differences between audits of Swedish private companies and U.S. public companies impair external validity and generalization to the U.S. intervention.

    Design/Method/ Approach:

    This article is a discussion.

    Findings:

    The discussion emphasizes the following points:

    • KVZ (the reviewed paper’s authors Knechel, Vanstraelen and Zerni) main analyses are for statutory (not financial statement) audits of small, private, Swedish companies. Therefore, these results may have more limited generalizability. 
    • KVZ use publically available data for private companies without considering the significant amount of private information available to private lenders and audit firms.
    • KVZ acknowledge and cannot rule out a potential competing hypothesis whereby audit firms follow a “best partner to riskiest engagements” strategy. In this case, the highest quality partners may appear to have the most aggressive reporting strategy because that partner serves riskier clients with harder to predict bankruptcy risk. To confirm/disconfirm this competing hypothesis occurs, KVZ could ask audit firm management to describe their audit partner assignment strategies and rank a sample of partners accordingly. This information could be correlated with KVZ’s reporting style measures.    
    • Regulators, academics, and popular/business press articles may be similarly over-generalizing KVZ’s results. Furthermore, misinterpretation of results could have the ill-effects of high quality audit partners being assessed as low quality. This false characterization may lead high quality auditors to refuse to audit riskier clients where their skills are most needed. As such, any interpretations of KVZ’s results should proceed with much caution.
    Category:
    Accountants' Reporting, Audit Team Composition, International Matters, Standard Setting
    Sub-category:
    Audit Partner Identification by Name, Changes in Audit Standards, Diversity of Skill Sets (e.g. Tenure & Experience), Going Concern Decisions, Impact of New Accounting Pronouncements
  • Jennifer M Mueller-Phillips
    Do Going Concern Audit Reports Protect Auditors from...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
    Title:
    Do Going Concern Audit Reports Protect Auditors from Litigation? A Simultaneous Equations Approach.
    Practical Implications:

    The results should be of interest to auditing practitioners. Generally, managers of public companies prefer that the audit report does not contain a going concern paragraph. In this regard, researchers have found that issuing a going concern audit report increases the likelihood of management-initiated auditor switches. These results highlight the expected benefits to auditors from issuing a going concern report to their financially stressed clients. Specifically, better controlling for endogeneity, the evidence indicates that issuing a going concern report lowers the likelihood of investors naming the auditor in a class action lawsuit.

    Citation:

    Kaplan, S. E., and D. D. Williams. 2013. Do Going Concern Audit Reports Protect Auditors from Litigation? A Simultaneous Equations Approach. Accounting Review 88 (1): 199-232.

    Keywords:
    audit reports, auditor litigation, auditor litigation settlements
    Purpose of the Study:

    An important aspect of the auditors’ environment is state and federal laws that allow third parties such as investors to sue auditors in an effort to recover damages. Historically, these litigation-related costs have been substantial. Potentially, auditors may be able to reduce their exposure to litigation when auditing a financially stressed client by issuing a going concern report. Under current auditing standards, a going concern audit report is required when an auditor has substantial doubt about the client’s ability to remain a going concern for a reasonable period of time. Whether a going concern report actually protects auditors against lawsuits is an open question.

    The study applies a simultaneous equations approach to examine the relation between auditor going concern reporting and investors’ decisions to sue auditors. Importantly, this approach takes into account the endogeneity between the auditor’s going concern reporting decision and ex ante litigation risk. The authors explicitly recognize two separate aspects of the relation between going concern reporting and auditor litigation.

    Design/Method/ Approach:

    The sample consisted of 1,211 securities class action lawsuits filed against the auditors between 1986 and 2009. 147 firms comprise the final auditor litigation sample. The authors determined whether a securities class action lawsuit had been filed against the auditors by examining the databases constructed by Palmrose (1999), the Stanford Class Action Securities Clearinghouse, Audit Analytics, LexisNexis, Westlaw, CASEmaker, ISS Securities Class Action Services, and the popular press. 

    Findings:
    • The evidence indicates that for auditors’ going concern reporting decisions as well as for investors’ decisions to sue auditors, the results differ between the two methods.
    • While the relation between the risk of an auditor lawsuit and going concern reporting decisions is consistently positive, the lawsuit coefficient is larger and significant using simultaneous equations but insignificant using probit analysis.
    • The results also show that the relation between going concern reports and investors’ lawsuit decisions is consistently negative.
    • However, and perhaps more importantly, the going concern coefficient is larger and significant when using simultaneous equations but insignificant when using probit analysis. That is, the simultaneous equations results indicate that going concern reports significantly deter investors from suing auditors.
    • The evidence showing that going concern reports deter investors from filing class action lawsuits against auditors is important, in that it suggests that going concern reports are useful to investors.
    • When investors see a going concern report for financially stressed companies, they are less likely to sue the auditor for their investment losses.
    • Issuing a going concern report offers the auditor protection against claims of negligence due to reporting, but not other claims of auditor negligence.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Going Concern Decisions, Litigation Risk
  • Jennifer M Mueller-Phillips
    Does the Identity of Engagement Partners Matter? An Analysis...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 01.03 Impact of New Accounting Pronouncements, 05.0 Audit Team Composition, 05.05 Diversity of Skill Sets e.g., Tenure and Experience, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions, 15.0 International Matters, 15.01 Audit Partner Identification by Name 
    Title:
    Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions.
    Practical Implications:

    Auditor aggressive/conservative reporting style may be a systematic audit partner attribute and non-randomly distributed across engagements. Particular market participants (in this case, lenders) appear to recognize and price these differences in reporting style. While the particular mechanism through which these different reporting styles occur is not possible to determine, the results suggest the importance of individual audit partners in influencing audit reporting decisions. Therefore, current regulations in both the US and EU to identify the individual partner’s identity could potentially offer valuable information to market participants.

    Citation:

    Knechel, W. R., A. Vanstaelen, and M. Zerni. 2015. Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions. Contemporary Accounting Research 32 (4):1443-1478.

    Keywords:
    auditor attributes, reporting style, auditor identification, audit quality, going concern opinion, Type I error, Type II error, credit risk, insolvency risks, statutory audits
    Purpose of the Study:

    Current debate exists as to whether requiring individual auditor identification would enhance audit quality and, if so, whether investors understand and respond to these differences. This study provides empirical evidence to support the assertions that:

    1. Reporting style (i.e. consistently conservative or aggressive reporting) is an individual partner attribute that systematically differs between partners.  
    2. Investors understand and respond to these differences when assessing a company’s risk.

    This study is especially relevant given both the EU’s decade old requirement to disclosure of audit engagement partner and the recent, similar PCAOB requirement that US audit partners do the same.

    Design/Method/ Approach:

    The authors use archival methods. They acquired panel data between 2001  2008 of the total clienteles of individual Big 4 audit partners of statutory audits for small, private companies in Sweden. This excludes non-Big 4 auditors and joint auditors.

    Findings:

    In general, the frequency of Type I and II reporting errors is correlated over time for an individual partner both (1) across time for the same client and (2) between clients. As such, aggressive or conservative accounting appears to be a systematic partner attribute. Regarding investors, they appear to understand that partner reporting style is systematic across time and between clients and penalize firms audited by partners with a history of aggressive reporting via higher interest rates, lower credit ratings, and higher credit/insolvency risk. These results are, generally, economically significant.

    More specific results include:  

    • Predictive ability of both accruals and cash flows on future OCFs are lower when prior reporting errors of either Type have previously occurred.
    • Prior aggressive reporting results in lower persistence of current accrual estimates.  
    • Type I (Type II) reporting errors are negatively (positively) associated with abnormal accruals.
    • Conservative accrual reporting is positively (negatively) associated with Type I (Type II) reporting errors in all settings. Aggressive accrual reporting is positively (negatively) associated with Type II (Type I) reporting errors in low-risk settings.  
    • Clients of partners with aggressive reporting style have higher implicit interest rates, lower credit ratings, higher assessed insolvency risk, and lower Tobin’s Q. Conservative reporting styles has no effect on these credit measures.  
    • Past partner reporting style differentially affects market reaction to a new Going Concern Opinion.
    • Past partner Type II reporting errors has an economically marginally-significant effect on insolvency risk.
    Category:
    Accountants' Reporting, Audit Team Composition, International Matters, Standard Setting
    Sub-category:
    Audit Partner Identification by Name, Changes in Audit Standards, Diversity of Skill Sets (e.g. Tenure & Experience), Going Concern Decisions, Going Concern Decisions, Impact of New Accounting Pronouncements

Filter by Type

Filter by Tag