Audit Effort Research Articles

Financial reporting fraud and CEO pay-performance incentives

Because prior studies find mixed results on the relation between CEOs’ pay performance incentives and a firm’s likelihood of financial reporting fraud, we restudy their relationship using innovative research methods. First, we concentrate on incentives from granting options rather than equity-based incentives. Second, we emphasize vested options, disregarding unvested option holdings, and take the logarithm transformation of option incentives. Third, we analyse the impact of option incentives on future financial reporting irregularities. Using this innovative approach as well as a full sample and a matched sample, we find that an increase in executives’ option incentives raises the likelihood of financial reporting violations. Moreover, the effect of option incentives on financial reporting fraud is moderated by auditor effort. In addition, we find that another proxy for the measurement of executives’ option incentives, namely, the number of vested options by executives, is highly correlated with the CEO’s vested stock option sensitivity.

The Introduction of State Regulation and Auditor Retendering in School Districts: Local Audit Market Structure, Audit Pricing, and Internal Control Reporting

SUMMARYThe impacts of auditor retendering or rotation mandates and auditor selection have been a regulatory concern for some time. However, finding suitable research settings to examine these policies has been a challenge. This paper reports the results of a study (Elder and Yebba 2020) that explores the consequences of implementing a retendering policy in a local governmental audit market. The study finds an association between periodic retendering and auditor concentration, including the growth of fee premium specialization within the market. We also find changes in quality associated with these mandates, including greater auditor effort, evidenced through higher audit fees and longer reporting delays, and improved documentation of internal controls evidenced through increased reporting of control deficiencies. Collectively, we provide evidence that periodic retendering of audit services may provide a suitable level of quality enhancement while not forcing auditees to absorb audit inefficiencies common with a rotation policy.

Archival Evidence on the Audit Process: The Effect of Early Planning and Interim Effort on Audit Hours, Disclosure Timeliness, and Audit Quality

Using proprietary data from a global accounting firm, we investigate the determinants of auditors’ interim effort as well as the impact of interim effort on audit quality, client disclosure timeliness, audit hours, and audit fees. Public statements from accounting firms and regulators suggest various benefits from accelerating auditor effort, but these claims remain largely untested. We find that interim effort is higher for large, complex clients that require integrated audits of both financial statements and internal control over financial reporting. With respect to consequences, we find that allocating relatively more work to the interim period is associated with a reduced likelihood of late 10-K filings, decreased total audit hours, and higher fees. Although increasing interim period effort is not, on average, associated with a reduced likelihood of misstatement, we do find that current period material weaknesses are less likely with greater interim work. Thus, greater interim effort appears to facilitate the remediation of internal control deficiencies before year-end. We also show that the benefits of increased interim period effort allocation are much stronger – including improved audit quality – when manager and partner interim involvement is high. Overall, our study provides important new insights on audit production and highlights benefits of reduced hours for auditors, earlier identification of control deficiencies for clients, and more timely financial reports for investors.

Audit fees and Corporate Innovation

Purpose - Investigates the extent to which a client’s innovative effort affects the level of audit effort and whether the innovative-effort efficiency can attenuate the demand for greater audit effort associated with a client’s risky research-and-development (R&D) investments. Design/methodology/approach - We treat R&D expenditure as an input measure and the patent obtained/cited in a given year as an output measure of a firm’s innovative effort. We estimate innovation efficiency as the number of patents granted to a firm in a given year, scaled by its R&D capital. As a proxy for audit effort, we use audit fees. Combining firm-year observations for fiscal years 2000 to 2010 from Compustat, patent data from the United States Patent and Trademark Office, and Audit Analytics provided a sample of 11,646 observations from 2,051 unique firms. Findings - Results confirm that a client firm’s strategic emphasis on corporate innovations may require greater audit effort. However, we find evidence that the efficiency of a firm’s innovative effort can attenuate the demand for heightened audit effort against risky innovative efforts, implying that the external auditor’s role is not necessarily detrimental to corporate innovation, which suggests that the efficiency of a firm’s innovation effort lowers the client business risk perceived by an auditor related to corporate innovation. Originality/value - Contributes to a stream of literature identifying facilitators and impediments to corporate innovation. Our findings also complement an emerging body of literature on the effect of a firm’s business strategies on the auditor’s decision. Prior studies have not considered the input‒output conversion of a firm’s R&D expenditure as something that the firm values. By using the number of patents obtained and cited as an output measure of a firm’s innovative effort, we extend understanding of the influence of a firm’s business strategies on the level of audit effort.

Employee quality and audit fee: evidence from China

AbstractThis study investigates the association between employee quality and audit fee. Using data for firm‐level employee quality (as proxied by employee education) from Chinese listed firms from 2011 to 2018, we find that firms operated by high‐quality employees enjoy lower audit charges. The association between employee quality and audit fee is more pronounced in firms with a culture of high integrity. Our 2SLS estimation helps us establish a causal link between employee quality and audit fee. The final validity tests suggest that high‐quality employees contribute to lower audit fee by reducing audit risk and audit effort.

Discussion of “Audit Firm Assessments of Cyber-Security Risk: Evidence from Audit Fees and SEC Comment Letters”

The study by Rosati, Gogolin, and Lynn (in this issue) examines the impact of cyber-security incidents on audit fees. Using audit fee as a proxy for audit effort and risk, it takes 168 cyber-security incidents during 2005–2014 that are collected by the Privacy Rights Clearinghouse and documents that breached firms are charged higher audit fees. In addition, the authors find that the increase in audit fee is only temporary and exists during the [Formula: see text] to [Formula: see text] window surrounding the breach. Finally, this study also finds that the audit fee increases post SEC comment letters that are related to cyber-security incidents. Overall, my assessment of the paper is that it is well executed and well written. More importantly, it adheres well to its stated research question. The following are my written comments, which are based on my discussion of this paper at the 30th Annual TJIA Conference, regarding this paper’s contribution, framing, and empirical execution.

Shareholder Dissatisfaction and Subsequent Audit Outcomes

SYNOPSIS This study examines the association between shareholder dissatisfaction, as proxied using auditor ratification voting, and subsequent auditor effort and audit quality. We document that increases in shareholder dissatisfaction are associated with (1) higher audit fees and longer audit report lags, and (2) lower abnormal accruals and reduced likelihood of financial statement misstatements, in the subsequent period. These findings inform the debate about auditor ratification voting, as governance activists and some regulators argue to increase the role of shareholders in auditor selection despite opposition from some firms and the staff of the Securities and Exchange Commission. We provide empirical evidence that increases in shareholder dissatisfaction with the auditor are associated with increases in subsequent auditor effort and audit quality. This suggests that shareholder action (even nonbinding) may potentially influence subsequent audit outcomes.

Bank Regulation/Supervision and Bank Auditing

We investigate how overlapping activities of bank regulators and supervisors and bank auditors influence banks’ internal control quality, auditor-client contracting (audit fees and audit effort), and financial statement reliability. Using material weaknesses in internal controls as a proxy for internal control quality, we find that banks exhibit fewer internal control problems than do nonbanks. Using audit fees, earnings announcement lags and audit report lags as alternative proxies for audit effort, we find that auditors expend less effort in audits of banks than in audits of nonbanks. Despite the lower audit effort, we find that banks report fewer and less severe restatements of prior period financial statements than do nonbanks, suggesting that the aggregate efforts of bank regulators/supervisors and bank auditors generate more reliable financial reporting by banks. A notable implication of our study is that bank regulation and supervision alter the auditor-client contracting equilibrium, with a notable benefit being an increase in banks’ financial reporting quality.

Does the Presence of a General Counsel in Top Management Affect Audit Effort and Audit Outcomes?

SYNOPSISThis study examines whether the presence of a general counsel (GC) in top management affects audit effort and audit outcomes. Hopkins, Maydew, and Venkatachalam (2015) find that firms with GCs in top management have lower financial reporting quality and tolerate more aggressive financial reporting practices, which likely influences audit risk. Given the GCs' influence on the financial reporting process, we posit that auditors of firms with GCs in top management increase the amount of effort they expend to provide reasonable assurance that financial statements are stated fairly. We find that the presence of GCs in firms' top management is positively associated with audit effort but does not directly affect the likelihood that these firms will receive unqualified audit opinions that contain explanatory language. Our findings suggest that GCs influence the external audit market by participating in the financial reporting process.JEL Classifications: M42.Data Availability: Data are available from the public sources cited in the text.

Spillover Effects of Clients’ Tax Enforcement on Financial Statement Auditors: Evidence from a Discontinuity Design

We examine the impact of clients’ tax enforcement on financial statement auditors. In a regression discontinuity design, we exploit the firm-registration-date-based application of a new rule that assigns firms to two different tax enforcement regimes. Our analysis implies that auditors exert less effort–evident in lower audit fees and shorter audit report lags–when their clients are monitored by the more stringent tax authority. In results supporting that audit quality improves in this situation despite the fall in auditor effort, we report that clients subject to tougher tax enforcement exhibit a lower incidence of accounting restatements and tax-related restatements. Additionally, we find no evidence of impaired auditor independence evident in the informativeness of auditors’ modified opinions. Finally, we document that clients undergoing stricter tax enforcement are assigned less-experienced partners, suggesting that tax enforcement enables audit firms to optimize client-partner matching. Collectively, our research suggests that tax authority oversight engenders a positive externality by improving external audit efficiency.

Joint audits and mutual ties of audit firm networks

There has been a lively debate following the 2007 financial crisis regarding the role of joint audits. Prior research argues that joint audits may improve audit quality because of shared audit efforts. However, empirical evidence has been inconclusive. To gain insight into how Big 4 audit firm imprimaturs have become a source of legitimacy in the audit industry, this article investigates how audit networks drive the audit industry in Saudi Arabia. Based on the application of quantitative and qualitative research methods, we conclude that the Big 4 audit firms have strong mutual ties, but ties with other local and international audit firms are weak. We also find the oligopolistic nature of the Big 4 audit firms and international audit firms. Specifically, Ernst & Young, KPMG, PwC, and PKF are controlling over 68% of the audit market. Interviews with accounting professionals suggest that several benefits of joint audits exist, but certain additional costs are also implicated. Our findings are particularly relevant for regulators and local and international policymakers in rethinking and evaluating the appropriateness of either the mandatory or voluntary nature of joint audits in developing countries.

Do Entry Barriers to the Public Company Audit Market Deter Low Quality Audit Firms?

Many legal jurisdictions, including the U.S. and U.K., have passed regulations to address the potential negative impacts of a lack of competition and high concentration in public company audit markets. One consequence of increased regulations, desired or not, is that they have presumably increased barriers to enter the public company audit market. An alternative view is that high barriers prevent the entry of low-quality entrants (von Weizsacker, 1980; Grossman and Horn, 1988). This study investigates the supply of, and demand for, first time public company audit firms in the U.S., firms that presumably overcame these barriers to enter the market. We document that since 2004, 275 unique audit firms have entered the U.S. public company audit market. We find evidence that these first time auditors provide lower quality audits as measured by a higher likelihood of client restatements, PCAOB-identified audit deficiencies, PCAOB enforcement actions, and lower auditor effort as measured by audit engagement hours. We also find evidence that these firms receive lower fees and that clients are significantly more likely to subsequently switch away from first time audit firms. Collectively, our results suggest that existing barriers to entry to the public company audit market do not prevent the entry of low-quality auditors, and clients do not fully infer quality based on first timers’ pre-entry quality signals.

Unintended costs of a dual regulatory environment: Evidence from state-level cannabis legalization and bank audit fees

Since 2014, a number of U.S. states have legalized business activities related to the production, distribution, and use of recreational cannabis. These activities remain illegal at the U.S. federal level, creating a dual regulatory environment. The uncertainty related to the enforcement of federal cannabis laws affects businesses located in legalizing states, particularly federally-insured banks. Applying a difference-in-differences approach to a matched sample of banks in legalizing and non-legalizing states, we document an increase in audit fees incurred by banks located in legalizing states after cannabis legalization. This finding is consistent with increased auditor effort and engagement risk being an unintended consequence of state-level recreational cannabis legalization. In supplemental analysis, we find that the relation between banks’ audit fees and cannabis legalization was greater for banks having larger increases in banking activity, suggesting that audit fees increased primarily for banks that may be engaging in relationships with cannabis-related businesses.

Sustainability reporting quality and post‐audit financial reporting quality: Empirical evidence from the UK

AbstractThis study examines whether firms that appear to exhibit high sustainability reporting quality are less likely to engage in earnings management activities, thereby delivering financial information that is more transparent and reliable than that delivered by firms that do not produce high‐quality sustainability reports. I also investigate whether the association between sustainability reporting quality and post‐audit financial reporting quality is conditional on audit effort. Analysis of data drawn from FTSE 350 companies covering 2007 to 2018 indicates that firms that produce high‐quality sustainability reports are significantly and negatively associated with earnings management metrics. More importantly, this association is moderated by audit effort, measured by audit fees, suggesting that sustainability reporting quality reflects factors considered by auditors in their audit risk assessment practices. These results remain robust after several sensitivity analyses. I conclude that firms that devote more resources to producing high‐quality sustainability reports are likely to demonstrate an overall commitment to quality that alleviates auditors' concerns about the opportunistic use of sustainability reporting and reduces business risk, thereby reducing the effort auditors expend to verify financial reports.

Abnormal Audit Fees and Audit Quality: Evidence from the Korean Audit Market

ABSTRACT Do abnormally high or low audit fees reflect audit quality? In this paper, we re-examine this issue after controlling for the confounding effect of audit hours by using a sample of public firms in the Korean audit market, which publicly discloses both audit fees and audit hour information. While we do not find a significant association between abnormally high audit fees and audit quality, we find that abnormally low audit fees are associated with larger discretionary accruals and a higher likelihood of meeting or beating analyst earnings forecasts. Further, we find that the relationship between abnormally low audit fees and audit quality indicators persists regardless of the level of audit hours. To the extent that audit hours represent audit effort, these findings suggest that greater audit effort alone may not lead to higher audit quality as fee pressure from abnormally low fees may discourage the provision of high-quality audit services. JEL Classifications: M42; M48.

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.

The consequences of discount rate selection for defined benefit liabilities

This paper provides evidence on the use of discount rates for calculating defined benefit liabilities (DBL), and their impact on value relevance and audit fees for Australian listed companies between 2011 and 2016. We document that the average discount rate is 3.96% but the yearly range across companies is 4.03% (2.76% excluding multinationals with multiple plans), despite the fact that AASB 119 provides guidance to use the yield of high quality corporate bonds or, if there is not a deep market, government bonds. We then find that the DBL or unfunded component (DBL less the fair value of the plan’s assets) is value relevant, but is less so when a higher discount rate is used. Furthermore, we document that audit fees are higher when the DBL is larger, or the discount rate is higher, consistent with greater audit effort and risk. Overall, this paper contributes to the accounting literature by documenting both the discretion available in discount rate selection and its consequences.

Does the severity of a client’s negative environmental, social and governance reputation affect audit effort and audit quality?

In recent years, investors have begun to value companies’ reputations through their environmental, social, and governance (ESG) practices. ESG risk can affect business processes and controls and can heighten financial risk and threaten a firm’s survival. This study examines whether and how the severity of media coverage of a firm’s negative ESG issues (tainted ESG reputation) is associated with audit effort and audit quality. I find that auditors manage the higher expected engagement risk conveyed by tainted ESG reputation by applying higher audit effort. Next, I observe that the increased effort is associated with auditors likely detecting and requiring adjustments for material misstatements and that tainted ESG reputation is associated with fewer misstatements (i.e., reduces poor audit quality). The association between tainted ESG reputation and audit quality is driven primarily by increased audit report lag, not by increased audit fees. Further, I find that tainted ESG reputation is positively associated with audit effort and reduces poor audit quality for up to three years. The results also show that the audit effort and audit quality effect vary across the three components of ESG.

Audit effort, materiality and audit fees: evidence from the adoption of IFRS in Australia

PurposeThis paper aims to investigate the association between International Financial Reporting Standards (IFRS) effort due to higher levels of material adjustments and audit fees. In addition, this paper tests whether these associations differ between industry specialist auditors and non-specialist auditors.Design/methodology/approachThe authors measure IFRS effort by using differences between local GAAP and IFRS. More specifically, they measure the differences in the balances of accounts that are prepared under IFRS as opposed to the previously used Australian Accounting Standards Board (AASB) standards. They posit that higher material adjustments and more risk to fair presentation of financial statements require additional accounting and auditing effort (“IFRS effort”).FindingsThe authors find that audit fees are higher when accounting standards are more material and complex at an aggregate level. Nevertheless, not all standards are equally complex and/or material and not all individual standards contribute to higher audit fees. In addition, the results show that the positive association between IFRS effort and audit fees is more pronounced when firms are audited by city-level industry specialists than by non-industry specialists.Originality/valueOverall, the results are consistent with the prediction of increasing audit fees for firms requiring higher levels of IFRS effort compared to firms requiring lower levels of IFRS effort. The results contribute to the understanding that not all IFRS are equally complex and, thereby, the standards require different levels of auditor effort. Isolating specific standards based on materiality/risk levels is informative to standard setters for standard setting, standard implementation and post-implementation review of standards.

Calidad de la información contable y esfuerzo del auditor: El caso español

El objetivo de este trabajo es analizar si los auditores son capaces de detectar la gestión de resultados en sus empresas auditadas y si ante un incremento en el esfuerzo, el nivel de devengos discrecionales será menor. Como singular contribución, se mide el esfuerzo del auditor mediante las horas efectivamente empleadas, al contrario que trabajos anteriores que se basan en honorarios u horas estimadas o subrogados de estas. Asimismo, la muestra utilizada está compuesta por pequeñas y medianas firmas de auditoría, lo que le aporta un valor añadido por ser este segmento del mercado de auditoría más competitivo. Los resultados evidencian que el cliente reduce los devengos anormales positivos del resultado ante un incremento del esfuerzo del auditor, poniendo así en valor su figura como garante de la información financiera, contribuyendo al debate sobre la calidad de las pequeñas firmas. En lo que respecta a los ajustes por devengo negativos, se puede interpretar una pasividad del auditor ante el conservadurismo contable y un efecto aprendizaje en el cliente, que aumenta la manipulación negativa de resultados conforme se incrementa la duración contractual con el auditor