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    The Contagion Effect of Low-Quality Audits
    research summary posted April 28, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.10 Impact of office size, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
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    Title:
    The Contagion Effect of Low-Quality Audits
    Practical Implications:

    The findings of this study should be of interest to regulators, audit standard-setters, accounting firms, and investors because they provide a method to infer the overall quality of an auditor office location though the use of easily obtainable and publicly available information on restatements. This information can be used to identify offices where audits are more likely to be of lower quality, and to develop standards that emphasize the potential for quality-control problems in the offices of multi-location audit firms. Investors may be able to use it as one piece of additional information with which to infer something about the earnings quality of a particular company based on the history of the auditor office that performs the audit.

    For more information on this study, please contact Jere R. Francis.
     

    Citation:

     Francis, J. R., and P. N. Michas. 2013. The Contagion Effect of Low-Quality Audits. The Accounting Review 88 (2).

    Keywords:
    audit quality; auditor offices; contagion
    Purpose of the Study:

    A low-quality audit is defined as the presence of one or more clients with overstated earnings that were subsequently corrected by a downward restatement. A “contagion” of low quality audits could occur in an auditor office location due to office-specific characteristics including personnel and quality-control procedures. Prior research provides evidence that differences in characteristics across offices of accounting firms are an important determinant of audit quality, and that  differences in audit quality can exist even within the same audit firm, depending on office-level characteristics. The authors of this study investigate if the existence of at least one low-quality audit in an auditor office indicates the presences of a contagion effect on the quality of other audits conducted by the office.
     

    Design/Method/ Approach:

    The authors first developed the following three hypotheses for testing:

    H1: The existence of an audit failure in an auditor office is indicative of a contagion effect that reveals the presence of other concurrent low-quality audits in the office.

    H2: There is lees contagion in large Big4 offices than in small Big 4 offices.

    H3: There is less contagion in a Big 4 office where relatively more audits are conducted in the office’s area of industry expertise, compared to Big 4 offices where relatively fewer audits are conducted in the office’s area of industry expertise. 

    The authors use the Audit Analytics database to identify restatements and the original filing year for which the financial statements were subsequently restated. The Compustat Unrestated U.S. Quarterly Data File was used to obtain originally released and subsequently restated accounting data and cross referenced this sample with the one pulled from the Audit Analytics database. The final sample is comprised of 22,626 firm-year observations for 4,765 unique companies from 2000 through 2008.
     

    Findings:
    • Offices with client restatements in the past are more likely to have new client restatements for up to five years in the future.
    • In auditor offices where an audit failure occurred, the concurrent clients of that office have a higher level of abnormal accrual compared to offices with zero audit failures.
    • The results above hold for all but the largest quartile of office size, indicating that office size is also an important factor in contagion.
    • A relatively high use of industry expertise in a Big 4 office can mitigate the negative effect of small office size.
       
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Impact of Office Size, Restatements