A Subsidiary and Parent Level Analysis of Foreign Component Auditor Usage and Audit Quality

Abstract

We hypothesize and find that financial reporting quality at the foreign subsidiaries of U.S. multinational corporations (MNCs) is higher when the MNC’s principal auditor engages a component auditor to audit the foreign subsidiary on its behalf. An important innovation of this study is that we focus on comparing financial reporting quality of equivalent subsidiaries with and without component auditor work. Our approach contrasts with extant studies that examine the consequences of variation in the total amount of component auditor work at the MNC level. Our results are important for two reasons. First, we provide an alternative view on the consequences of component auditor use compared to the emerging literature in this area, which typically finds a negative association between the extent of component auditor use and financial reporting quality at the MNC level. Thus, we show that a different research design, conducted at the level at which component auditors actually perform their work, yields different inferences. Second, we demonstrate that using component auditors on U.S. MNC group audits is an avenue through which U.S. auditing institutions can affect financial reporting quality in foreign locations. We also reconcile our subsidiary-level results to the MNC-level by introducing a new MNC-level component auditor “coverage” variable. Overall, we highlight that the best way to audit a foreign subsidiary is likely to be with a component auditor in the local country, which informs the debate surrounding recently proposed PCAOB guidance.