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    Client-Auditor Supply Chain Relationships, Audit Quality,...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience 
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    Title:
    Client-Auditor Supply Chain Relationships, Audit Quality, and Audit Pricing
    Practical Implications:

    The results of this study provide empirical evidence of an association between supply chain knowledge and improved audit quality, as well as audit efficiency when this knowledge exists at a local level.  Audit firms often attempt to differentiate themselves by a certain level service and audit quality that can be provided based on specialized knowledge, such as industry experience.  Supply chain knowledge can add a new dimension to auditor knowledge and specialization.  By identifying an association between supply chain knowledge and audit quality and fees, this study demonstrates to audit firms an additional value-adding, quality-differentiating audit service. 

    For more information on this study, please contact Karla Johnstone.

    Citation:

    Johnstone, K. M., C. Li, and S. Luo. 2014. Client-Auditor Supply Chain Relationships, Audit Quality, and Audit Pricing. Auditing: A Journal of Practice and Theory 33 (4): 119-166

    Keywords:
    audit pricing; audit quality; supply chain relationships; industry expertise
    Purpose of the Study:

    This study examines the implications of auditor supply chain knowledge on audit quality and audit fee pricing.  The auditor may develop supply chain knowledge when performing the audit of both the supplier and its major customer.  This supply chain knowledge is a specialized understanding of the accounting and auditing issues in the revenue cycle that relates to both the supplier and its major customer.  This study examines the following potential impacts on an audit engagement as a result of supply chain knowledge:

    • As revenue recognition is often a significant audit area, as well as one of the highest areas subject to restatement, an auditor’s level of understanding of the revenue cycle is hypothesized to improve audit quality. 
    • An improved understanding of an audit client’s revenue cycle could also lead to audit efficiencies.  These efficiencies are hypothesized to be reflected in lower audit fees for auditors with supply chain knowledge. 
    • Supply chain knowledge can be developed and transferred at the local office and audit firm level.  The study hypothesizes that this knowledge transfer is stronger when the same office performs the audit of the both the supplier and customer rather than when both the supplier and customer are audited by difference offices in the same firm.  
    Design/Method/ Approach:

    The supply chain relationships for the years 2003 through 2010 were collected using the Compustat customer segment file , which identifies the names of major customers disclosed in the footnotes of the supplier’s 10-K.  Auditor supply chain knowledge was measured as the ratio of the number of supplier and major customer companies employing the same auditor divided by the total number of the supplier companies for the same auditor in the year.  This ratio was measured at both the city-office level and national level.

    Audit quality was measured using three common proxies: absolute discretionary accruals, existence of a restatement, and the propensity to meet or beat analyst’s earnings forecasts.

    Findings:
    • Auditor’s supply chain knowledge at the city level is associated with higher audit quality and lower audit fees for supplier companies compared to companies employing auditors with supply chain knowledge at the national level only, or auditors without supply chain knowledge.
    • This association is present only for suppliers that are highly dependent on their major customer.
    • The association is stronger among a subsample of companies for which the revenue cycle accounts are particularly important (those with high level of accounts receivable balances). 

    The results suggest that knowledge redundancy exists when a supplier and its major customer are audited by audit teams out of the same city level office.  They further suggest that this knowledge redundancy contributes to audit efficiencies, thus reducing audit fees where the city level supply chain knowledge exists.

    Category:
    Audit Quality & Quality Control, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Industry Expertise – Firm and Individual