Audit Adjustments Research Articles

Mandatory Internal Control Audits, Audit Adjustments, and Financial Reporting Quality: Evidence from China

ABSTRACTThis study examines whether audit adjustments are a mechanism that links the effect of mandatory internal control audits (MICAs) on financial reporting quality. We argue that the requirement for auditors to publicly disclose internal control weaknesses exacerbated auditor-client conflicts and that this resulted in auditors being less likely to detect (and correct) misstatements in their clients' pre-audit financial statements. Consistent with this argument, we find significant reductions in audit adjustments following the staggered introduction of MICAs using data from China. We find the reductions in audit adjustments are associated with significant increases in material misstatements following the introduction of MICAs. In contrast, we find that the introduction of MICAs led to a significant reduction in material misstatements among clients that did not experience reductions in audit adjustments. Overall, the two effects offset each other, which explains why financial reporting quality did not improve, on average, following the introduction of MICAs.

Entity Structure and Taxes: An Analysis of Embedded Pass-Through Entities

ABSTRACT We examine the effect of pass-through entities embedded in corporate structures on tax avoidance, tax uncertainty, and tax noncompliance using unique, confidential tax return data that link corporations and pass-through entities together through Schedules K-1. We develop measures of the use of pass-through entities such as the number and “connectedness” of pass-throughs within the structure, the presence of loss pass-throughs or asymmetric allocations of such losses, and connections to entities external to the firm. We predict and find that these features are associated with lower effective tax rates, higher current-year additions to tax reserves, and larger amounts of proposed IRS audit adjustments, controlling for probability of audit selection. This large-sample evidence could help the IRS understand how pass-throughs affect compliance and financial statements users anticipate the tax effects related to entity structure. JEL Classifications: H20; H26; L22; M41.

A Machine Learning Approach of Measuring Audit Quality: Evidence From China

This study develops machine learning models to predict audit quality by using a wide range of data describing detailed characteristics of accounting firms, individual audit partners, and public companies in China. It constructs the surprise score, a new measure of audit quality, calculated as the difference between the predicted probability and the actual value of audit quality proxies (e.g., audit adjustments and non-clean audit opinions). Unlike traditional, observable proxies that measure audit quality indirectly, the proposed measure is driven by unobservable factors directly affecting audit quality. This study also validates the proposed measure by comparing the relative explanatory ability of the surprise score and its corresponding traditional audit quality measure over audit failures proxied by penalties due to accounting violations. Results show that, for the event of non-clean audit opinion, the surprise score is more strongly associated with the occurrence of penalties than traditional audit quality measures. For events of audit adjustments, the surprise score is significantly associated with penalties for the group of companies that received extremely high/low surprise scores, whereas the traditional audit quality measures exhibit no explanatory power for those companies.

External auditors' reliance on management's experts: The effects of an early‐stage conversation and past auditor–client relationship

This study examines the impact of an early‐stage conversation with a management's expert on auditors' decisions within the context of auditor–client relationships. We conducted a 2 × 2 between‐subjects experiment with 69 experienced auditors in Australia. Our results suggest that an early‐stage conversation can adversely affect perceived client flexibility towards proposed audit adjustments, particularly under contentious client conditions. Our results further indicate that an early‐stage conversation results in auditors relaxing, which otherwise might be a more contentious approach towards difficult clients. While we do not find direct evidence that auditors succumb to pressure and accept the work of the management's expert without any changes, our results suggest that auditors are willing to propose an adjustment that meets the interests of both auditor and client.

Relation between Auditors’ Risk-Preparedness and Audit Adjustments: Evidence from Professional Risk Fund and Professional Indemnity Insurance

Using proprietary information about Chinese audit firms’ Professional Risk Fund (PRF) and Professional Indemnity Insurance (PII) and their publicly traded clients’ audit adjustments, we examine whether and how audit firms’ PRF and PII relate to audit adjustments. We find that audit firms’ PRF and PII have opposite effects on the probability of making audit adjustments to clients’ profits and the magnitude of the audit adjustments. In particular, audit firms with larger PRF provisions exhibit a higher probability and magnitude of audit adjustments, whereas audit firms that hold more PII exhibit a lower probability and magnitude of audit adjustments. Our findings are robust to multiple approaches for addressing potential endogeneity, including using a changes model, a fixed-effects model, and a difference-in-differences specification. The results call into question the use of one-size-fits-all regulations regarding specific risk-shielding methods.

Work or Life? Evidence of the Impact of Air Quality on Audit Delay and Audit Quality

We investigate the impact of air quality on audit process and audit outcomes using samples from the Chinese capital market between 2013 and 2018. We find that client firms located in cities with worse air quality have shorter audit delay and lower audit quality, represented by a lower probability of and fewer audit adjustments. Further analyses show that auditors from Big 4 audit firms can mitigate the effect of air quality on audit delay and audit quality. Our study contributes to the emerging literature on behavioral finance by extending the research into ambient air pollution to the auditing context, and provides new insights into the determinants of audit delay and audit quality.

Unintended Consequences from Downward Audit Adjustments: Evidence from China

Unintended Consequences from Downward Audit Adjustments: Evidence from China

Big N Audit Quality Effect: New Evidence on Audit Hours and Audit Adjustments

Using a unique data set on audits of Chinese companies, this paper examines the Big N audit quality effect by comparing the audit processes of Big N and non-Big N auditors. We document that Big N audits involve significantly more audit hours with higher per-hour fees but do not result in more audit adjustments. In fact, Big N audits have a significantly higher percentage of cases with no audit adjustments at all. Big N audits also have fewer subsequent restatements. Collectively, this evidence suggests that Big N firms play a significant disciplinary role by performing more time-consuming and costly audits. Anticipating such stringent audits, clients of the Big N increase the quality of their reports ex ante, resulting in fewer audit adjustments and higher-quality financial reports.

Opening Up the “Black Box” of Audit Firms: The Effects of Audit Partner Ownership on Audit Adjustments

ABSTRACTAudit firms need to provide high‐quality audits but they also need to please their clients. We argue that these conflicting incentives become manifest when comparing the incentive effects of equity ownership on engagement quality (EQ) reviewers and audit engagement partners. We predict that EQ reviewers monitor audit quality more closely when they hold greater ownership. In contrast, we expect that equity ownership has conflicting effects on the incentives of engagement partners because they need to please their clients as well as provide high‐quality audits. Consistent with these predictions, we find that the associations between audit adjustments and partner equity ownership are (1) significantly positive for EQ reviewers, (2) significantly negative or insignificant for audit engagement partners, and (3) significantly more positive for EQ reviewers than engagement partners. Our findings suggest that larger ownership stakes motivate EQ reviewers to monitor audit quality more closely, whereas larger ownership stakes do not motivate engagement partners to deliver higher quality audits.

Accounting Personnel Quality, Audit Risk, and Auditor Responses

Auditing standards and anecdotal evidence suggest that accounting personnel’s lack of financial reporting competencies can increase audit risk. This study draws on human capital theory to measure the quality of accounting personnel based on their education level and obtains evidence of how the quality of accounting personnel affects audit risk through examining audit outcomes. It shows that auditors charge higher fees and are more likely to make audit adjustments to companies whose accounting personnel have a lower level of education. The relationship between accounting personnel’s education and audit fees (audit adjustments) is robust to the propensity score matching approach and stronger in companies with more complex operations. Audit firms strategically assign more experienced partners to audit companies whose accounting personnel have a lower level of education. Taken together, these findings suggest that the quality of accounting personnel affects audit risk and audit outcomes.

Weak Incentives for Audit Quality: Evidence from Broker-Dealers

Much of the literature develops theory using audits of publicly owned companies with agency costs that create demand for audit quality. In contrast, I study auditor size and industry specialization in the broker-dealer (BD) industry, where entities have weak incentives to demand and supply high audit quality. Using proprietary data, I test whether larger firms and industry specialists provide better audit quality, as proxied by audit adjustments. Consistent with theory, I find that larger firms provide higher audit quality. In contrast, industry specialists perform worse than non-specialists; industry specialist partners in small firms drive this result. These findings suggest that clients with weak demand for auditing hire low quality auditors, who in turn gain market share in the industry. Overall, my findings illustrate the importance of considering clients’ demand for auditing when evaluating audit quality and industry specialization.

Audit adjustments and corporate financing: evidence from Iran

PurposeIndependent auditors play an important role in increasing the reliability of financial information by giving their professional opinion on the financial statements of business units. Therefore, the purpose of this study is to investigate the relationship between the audit adjustments and financing of companies.Design/methodology/approachThe sample of the study includes 173 Iranian companies listed on the Tehran Stock Exchange (TSE) between 2010 and 2017.FindingsThere is no significant association between the profit incremental audit adjustments (Disagreement) and financing of companies in the current year and the following year through a loan. Furthermore, there is no meaningful relationship between the earnings downward/upward audit adjustments (Disagreement) and the financing of companies in the current year and the following year through ordinary stocks. However, there is a meaningful relationship between the profit downward audit adjustments (Disagreement) and the financing of firms in the current year through a loan. In general, as Iran's economy is facing severe economic sanctions, the existence of a high inflation rate has led to a steady increase in the stock prices of Iranian companies; hence, investors regardless of audit reports prefer to invest their money in the stock market so that it does not lose its purchasing power. Under these disaster economic circumstances, creditors are less willing to lend to companies with lower profits.Originality/valueThe results of the current study extend the knowledge of previous studies as financial pressures from economic sanctions have both positive and negative psychological effects on corporate financing.

Professional liability insurance contracts for auditors: differential pricing and the audit quality effect

ABSTRACT In recent years, the Chinese government and the public accounting profession have advocated the audit practitioners’ use of professional liability insurance (PLI). As a tool to divert audit firms’ business risk, PLI contracts could decrease auditors’ diligence in conducting audits, which might harm audit quality. Insurance companies might perceive the transfer of audit risks, thus having an incentive to monitor risky audit firms to mitigate potential economic losses related to audit failures. We use proprietary PLI contract data and find that insurance companies charge smaller audit firms a significantly higher price and show a lower tendency to offer favourable indemnity clauses. The difference-in-differences analysis reveals that the magnitude of audit adjustments significantly increases after small audit firms purchase PLI and the effect is dominated by income-decreasing audit adjustments. Our evidence supports the notion that insurance contracts play a governance role for audit intermediaries with a higher risk profile.

Beg your pardon? The effect of communication costs on audit quality

We examine how language-induced communication costs affect audit quality by utilising unique data of signing auditors’ native dialects and audit adjustments in China during 2006–2011. The results show that greater language-induced communication costs lead to lower audit quality. We further find that the negative effect of communication costs on audit quality is mitigated by extended audit tenure. Our study introduces linguistics theory into auditing and is the first to investigate the empirical impact of language-related communication costs in the audit context.

How audit effort affects audit quality: An audit process and audit output perspective

Using a unique dataset of audit days in China from 2006 to 2011, this paper examines the relationship between audit effort and audit quality from the perspective of audit process and audit output. The results show that audit effort significantly increases the probability of audit adjustments, which inhibits positive earnings management and improves the quality of audited financial statements. We also find that audit effort does not have a significant effect on the issuance of modified audit opinions overall, but that a modified audit opinion is more likely to be issued in the absence of an audit adjustment. Furthermore, we find that the impact of audit effort on audit quality is attenuated when clients are more complex and when audit firms are larger. Collectively, our evidence suggests that audit effort plays an important role in improving audit quality by influencing audit process and audit output. Our study extends the literature on the impact of audit effort on audit quality in emerging markets, and the conclusions have important implications for the improvement of China’s audit market efficiency.

Do Big 4 Auditors Enhance Audit Quality? An Analysis of Client Selection and Audit Adjustments

Recent research challenges the notion that the Big 4 auditors provide a higher quality audit relative to non-Big 4 and suggests that the Big N effect could be due to self-selection. We contribute to this debate by controlling for pre-audit earnings quality, an important omitted variable in prior research. Using proprietary data from the Chinese Institute of CPAs, we first replicate prior studies by documenting lower earnings management and restatement likelihood for clients of Big 4 than those of non-Big 4. However, we find that pre-audit earnings quality is higher for the Big 4 clients. After controlling for pre-audit earnings quality, we do not find a significant difference between the Big 4 and non-Big 4 clients in earnings management and restatement frequencies. We also find that the Big 4 auditors are less likely to make income-decreasing audit adjustments than non-Big 4 auditors and audit adjustments proposed by non-Big 4 auditors enhance earnings quality, while results are mixed for the Big 4 auditors. Collectively, the findings cast doubt that the Big 4 provide better audit quality in China and indicate that besides client size, clients’ pre-audit earnings quality is a significant driver of the Big N effect.

Opening up the ‘Black Box’ of Audit Firms: The Effects of Audit Partner Ownership on Audit Adjustments

Opening up the ‘Black Box’ of Audit Firms: The Effects of Audit Partner Ownership on Audit Adjustments

The Dark Side of Audit Market Competition

This paper examines the relation between audit market competition and audit quality. We use the staggered introduction of bullet trains in China as shocks to travel time between audit clients and prospective audit firms, which increases the threat of competition for incumbent audit firms. Using a generalized difference-in-differences design, we find that the increased threat of competition induced by the opening of a bullet train route in a city leads to a 6.1 percentage point (pp) increase in the probability of GAAP violations and a 2.5 pp decrease in the probability of modified audit opinions for clients headquartered in the city. We also find that bullet train connectivity leads to a 1.7 pp decrease in income-decreasing adjustments to earnings during year-end audits but no change in income-increasing audit adjustments. The negative relation between bullet train connectivity and audit quality is 1) stronger when bullet trains put greater competitive pressure on incumbent auditors and 2) weaker when clients exhibit an ex ante preference for high-quality audits. Our paper contributes to the literature by providing plausibly causal evidence that competition lowers audit quality.

Strategic Interactions Between Tax and Statutory Auditors and Different Information Regimes: Implications for Tax Audit Efficiency

We examine whether tax audit regimes become more efficient if (i) there are audited financial statements and (ii) tax auditors have access to the internal statutory audit report revealing information about statutory audit adjustments. Our analysis is based on a standard tax compliance game that we extend to model the strategic interaction among a firm issuing financial and tax reports, a statutory auditor, and a tax auditor. We find that the efficiency effects of additional information depend on the strength of tax auditor incentives and the weight that firms place on book income. For high-powered tax auditor incentives, we obtain no information effect on our efficiency measures. For low-powered tax auditor incentives, we find an ambiguous effect, and for mediumpowered tax auditor incentives and firms that place a high weight on book income, tax audit efficiency increases if the tax auditor has access to additional information. In the latter case, we find that granting the tax auditor access to the internal statutory audit report increases firms' tax compliance, raises tax revenues, and decreases tax audit frequency.

Capital-Market Liberalization and Asymmetric Auditor Behavior: Evidence from a Quasi-Experiment

Using a shock to the Chinese capital market and unique and detailed audit-adjustment data, this paper investigates the effect of a capital-market liberalization program on auditors’ adjustments to their clients’ financial reports. Employing difference-in-differences tests with propensity-score matching and firm fixed effects, we find that the capital-market liberalization induced by the implementation of the Shanghai - Hong Kong Stock Connect affects auditors’ professional judgment and leads to audit-adjustment changes stimulated by greater reputational and litigation risks for auditors. Specifically, while the liberalization significantly decreases the frequency and magnitude of upward audit adjustments, the probability of downward adjustments remains the same in most cases. Further evidence shows that the effect is more pronounced for companies with high trading volume from Hong Kong investors, audited by the largest audit firms, and with low financial transparency.