Audit Clients Research Articles

Audit Market Competition and Audit Clients’ Use of Accrual-based versus Real Earnings Management

This study investigates how the level of audit market competition influences audit clients’ use of earnings management tools. Specifically, this study examines whether clients use more or less accrual-based earnings management than real earnings management when the competition among auditors intensifies. We use 16,793 firm-year observations collected from Korean stock market for the empirical analyses, and the audit market competition is measured by the number of auditors providing audit service in a specific year and industry. The results are summarized as follows: First, clients use more accrual-based earnings management as audit market competition intensifies, suggesting that auditors allow clients’ aggressive earnings management to overcome intense competition. Because there is a substitutive relation between accrual-based and real earnings management, the magnitude of real earnings management decreases as the competition intensifies. Second, we find that the fierce audit market competition is more likely to decrease real earnings management and increase accrual-based earnings management when the client firms have strong incentive to manipulate earnings. The findings clearly show the detrimental role of intense audit market competition. Based on the findings of this study, regulators should be more careful to set up policies to promote more competition in the audit market.

The Association between Auditor Provided Tax Planning and Tax Compliance Services and Tax Avoidance and Tax Risk

ABSTRACTThis study examines associations between auditor provided tax compliance and tax planning services and tax avoidance and tax risk. Collectively, our results suggest that companies paying their auditors for tax planning advice are more effective tax planners (in terms of higher tax avoidance and lower tax risk) than firms that do not engage their auditor for tax work. Our tax avoidance results are more pronounced for clients of auditors with more tax expertise and longer tenure, as well as for firms with higher tax and operational complexity. We also find that our tax avoidance results hold only when firms also engage their auditors for tax compliance work, which is consistent with auditors seeking to minimize reputation threats. Our study's unique hand-collected panel dataset provides a more precise and nuanced perspective on the role auditors play in tax outcomes.

The Effect of Legal Entity Identifiers on Audit Fee Changes

ABSTRACT This study investigates whether a client's use of a Legal Entity Identifier (LEI) is associated with audit fee changes. An LEI uniquely identifies different legal entities worldwide, making audit clients' transactions and related parties more transparent and traceable, potentially reducing auditors' costs and audit risks, as reflected in audit fee changes. Using a sample of U.S. firms, I find that audit fees increase more for LEI firms than for non-LEI firms within the first few years of LEI registration, but they increase less for LEI firms than for non-LEI firms afterward. The results support a reduction in audit costs due to LEIs, with a learning effect. I also find that audit firms' brand name and industry expertise strengthen this association. This study provides initial empirical evidence of the effects of LEI and policy implications.

Institutional investor inattention and audit quality

We hypothesize and provide empirical evidence that higher institutional investor inattention is associated with lower audit quality. We employ an inattention measure that captures the extent to which institutional investors are distracted by attention-grabbing events irrelevant to the focal firm. Results suggest that a higher degree of institutional investor inattention is associated with a lower propensity of a going-concern opinion, a lower probability of the auditor reporting a material internal control weakness, and a higher likelihood of the audit client misstating the financial statements. Further analyses show that these associations vary by auditor litigation risk, their workload pressure, auditor industry expertise, and analyst coverage. Overall, our findings reveal that while institutional investors play an important monitoring role, the distractions they face undermine the quality of monitoring they provide.

Do goodwill impairments affect audit opinions? Evidence from China

There has been a steady growth of goodwill impairments in the Chinese stock market since the adoption of the impairment approach in accounting. The influence of goodwill impairments on a firm’s financial position and profitability give reason to doubt its current and future performance. We examine whether auditors, as a crucial external monitor, identify the information risks of goodwill impairments and express their concerns about financial reporting quality in their audit opinions. Using a sample of firms listed on China’s A-share market from 2007 to 2017, we test the association between goodwill impairments and the type of audit opinion received in the same financial period. Our findings are as follows. First, the probability of receiving a modified opinion increases with the amount of goodwill impairments. Second, the positive association between goodwill impairments and modified audit opinions is driven primarily by earnings management risks. Third, this positive association is more salient when auditors are industry experts and there is no auditor–client mismatch. Fourth, auditors are more sensitive to the amount of goodwill impairments than to their mere existence. Overall, we document that auditors perceive goodwill impairments as a signal of information risks and communicate their concerns to investors to avoid litigation.

Auditors' Responses to Classification Shifting: Evidence from U.S. Firms

SYNOPSIS This study examines how auditors react to clients' engagement in classification shifting which refers to the intentional misallocation of line items within the income statement. We find that classification shifting is positively associated with audit fees, audit report lags, the issuance of a modified audit opinion, and auditor resignations. Additional analyses show that auditors' responses to multiple-year classification shifting are similar to our main findings. We further find that classification shifting is associated with a higher likelihood of financial misstatements in the classification shifting year, and future announcements of financial restatements. We also find that the probability of future restatements is even higher when audit clients engage in both classification shifting and real earnings management. Overall, our results imply that auditors become more cautious in response to audit clients' classification shifting behavior. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M40; M41; M42.

Did PCAOB rules on ethics, independence, and tax services influence financial reporting for income taxes?

The PCAOB Rules on Ethics, Independence, and Tax Services prohibited accounting firms from providing aggressive tax-position transactions to their audit clients. We exploit this setting to examine whether the scrutiny of the PCAOB affects companies’ financial reporting for income tax accounts. We find robust evidence that the overall quality of the income tax accrual increased after companies significantly reduced auditor-provided tax service (APTS) fees in response to the regulation. We show that this improvement is a function of companies’ pre-regulation tax aggressiveness. In addition, we find evidence that after the fee reductions, tax-aggressive companies increased financial statement reserves for uncertain income tax positions without changing tax-aggressive decisions. Overall, our findings are consistent with an improvement in the financial reporting for income taxes under regulatory scrutiny which is more pronounced for companies that were tax aggressive in the pre-regulation period.

Audit firm operating leverage and pricing strategy: Evidence from lowballing in audit industry

Using a unique set of Korean data for the years 2004–2013, we show that audit firms’ operating leverage is related to lowballing and audit quality. To capture audit firms’ operating leverage, we estimate audit hour elasticity from a regression of changes in logged audit hours on changes in logged audit fees for all audit clients of each audit firm. We find that audit firms with higher audit hour elasticity are more likely to discount fees for new clients (i.e., more lowballing). Further, we find that the relation is more salient when benefits of lowballing is expected to be greater, i.e., in the voluntary auditor rotation regime compared with the mandatory rotation regime. However, we find no evidence suggesting that audit quality of auditors with low operating leverage is compromised due to lowballing. Overall, our findings suggest that audit firms with more flexible production structure have a greater ability to implement pricing strategy even without sacrificing production quality.

Independent oversight of the auditing profession: A review of the literature

This paper reviews the literature on the independent oversight of auditing from 2003 to 2018 and provides several research opportunities for filling the identified gaps in that literature. Our review classifies the literature into three themes: (1) the development of independent audit oversight, (2) the effects of independent audit oversight and (3) the interface between the independent audit oversight authorities and the global audit networks. The paper finds different effects of the independent audit oversight. Positively, it enhances the capital markets by adding more credibility to the published information. Auditors become more conservative about accepting or continuing to work with high‐risk clients. At the same time, while audit fees have increased as a result of the additional requirements of independent audit regulation, non‐audit fees from audit clients have decreased significantly. Negatively, independent oversight has increased audit concentration and resulted in insufficient choice of auditors in most audit markets.

The effect of disclosing audit quality control deficiencies on non-audit tax services: Evidence from Deloitte’s 2007 PCAOB Part II inspection report

We examine whether public disclosure of Deloitte 2007 PCAOB Part II report, which identifies quality control deficiencies related to audits of income tax accounts, affects Deloitte’s auditor-provided tax services (APTS). Using a difference-in-differences model, we document a 17 percent lower likelihood of Deloitte’s audit clients employing APTS relative to clients of other annually inspected firms when the report is made public. We also find that the dampening effect of publicly disclosing the Part II report on Deloitte’s APTS is more evident among audit clients paying higher non-audit fees to auditors and those with more complex tax planning. These results suggest that revealing income tax-specific quality control deficiencies prompts audit clients to revise upward (downward) their expected costs (benefits) of perceived auditor independence impairment (knowledge spillover) stemming from APTS. Overall, our study suggests that public disclosure of audit firm-wide quality control deficiencies pertaining to audits of income tax accounts imposes a collateral damage to the inspected firm’s non-audit tax services, thereby providing a more complete understanding of the consequences of the PCAOB’s communications about quality control deficiencies in Part II reports.

Corporate social impact and auditor changes

AbstractCorporate social impact has great influence on companies’ financial and litigation risk. Especially, corporate social irresponsibility raises auditors’ concerns about audit risk. Prior research finds that auditors charge higher audit fees to companies engaging in social irresponsible activities. In this study, we investigate the potential effects of corporate social impact on auditor–client relationship. Our results suggest that the likelihood of auditor changes is greater for the socially irresponsible companies and increases with severity. Additional tests suggest that socially irresponsible companies are more likely to have disagreements with their departing auditors and change to smaller auditors. Our findings are robust under different measures and specifications. Our study contributes to the literature by providing incremental evidence that auditors integrate clients’ social impact into their risk management and client selection. Our findings suggest that corporate social impact has become another determinant of auditor–client relationship and has profound effect on audit market competition.

Big data and data analytics in auditing: in search of legitimacy

PurposeThis study aims to analyze the utilization of big data and data analytics (BDA) in financial auditing, focusing on the process of producing legitimacy around these techniques, the factors fostering or hindering such process and the action auditors take to legitimate BDA inside and outside the audit community.Design/methodology/approachThe analysis bases on semi-structured interviews with partners and senior managers of Italian audit companies.FindingsThe BDA’s legitimation process is more advanced in the audit professional environment than outside the audit community. The Big Four lead the BDA-driven audit innovation process and BDA is used to complement traditional audit procedures. Outside the audit community, the digital maturity of audit clients, the lack of audit standards and the audit oversight authority’s negative view prevent the full legitimation of BDA.Practical implicationsThis research highlights factors influencing the utilization of BDA to enhance audit quality. The results can, thus, be used to enhance the audit strategy and to innovate audit practices by using BDA as a source of adequate audit evidence. Audit regulators and standards setters can also use the results to revise the current auditing standards and guidance.Originality/valueThis study adds to the literature on digital transformation in auditing by analyzing the legitimation process of a new audit technique. The paper answers the call for more empirical studies on the utilization of BDA in financial auditing by analyzing the application of such techniques in an unexplored operational setting in which auditees are mainly medium-sized enterprises and family-run businesses.

Toward an Archival Measure of the Likelihood of Auditor–Client Management Negotiation: An Exploration of the Audit Lag Measures Conjecture*

ABSTRACTSalterio (2012) hypothesized that adaptations of an audit efficiency measure, audit report lag (the length of time between the financial statement year‐end date and the auditor's report date), could provide measures of underlying auditor–client management (ACM) negotiation likelihood. Salterio argued that these measures would enable archival researchers to examine issues that heretofore were the exclusive domain of experimental and field researchers. Using an audit report lag measure and a measure of abnormal audit report lag lags (the residual based on audit report lag determinants model), we show that a larger lag is associated with higher audit fees after controlling for other known determinants of audit fees. We also show that larger lags are associated with higher levels of discretionary accruals—that is, lower accrual quality. Based on our findings, we suggest that there is support for Salterio's hypothesis that audit report lags and abnormal audit report provide valid archival proxies for the differences in year‐end ACM negotiation likelihood. We suggest that this proxy will allow researchers to study issues related to published accounting numbers in light of whether negotiations are likely to have occurred in addition to providing regulators and others the means to determine what clients of audit firms are more likely to have different types of ACM relationships.

The Impact of Client Size and Financial Performance on Audit Opinion: Evidence from a Developing Market

This research investigates the effect of audit client size and its financial performance on audit opinion in the Egyptian audit market. A few studies have investigated the association between these factors in the audit context, especially in African developing countries. Data are manually collected from the annual financial reports of firms registered in the Egyptian Stock Market, focusing on a sample of EGX 70 from 2012 to 2016, and binary logistic regression is used in data analysis. We found that the company size is insignificantly, positively, related to a qualified, rather than an unqualified, type of audit opinion. In contrast, the client's financial performance has a significant but negative relationship with the qualified type of audit opinion. This study provides insights for managers and investors in developing countries to understand and perceive audit opinions in these contexts.
 
 Received: 31 October 2020 / Accepted: 12 December 2020 / Published: 17 January 2021

Audit Partners' Co-Working Experience and Audit Outcomes

SUMMARYWe examine whether increases in co-working experience between the lead and concurring audit partners affect engagement audit quality and audit efficiency. We define co-working experience as the lead and concurring audit partners having worked together in these roles on previous audit engagements for clients other than the focal client. A priori, increases in co-working experience could increase or decrease audit quality, but are expected to increase audit efficiency. Using data from Taiwan, where the identities of lead and concurring audit partners are known, we find that co-working experience is positively associated with audit quality and audit efficiency. Further, the effects of co-working experience on audit quality and audit efficiency are more pronounced when co-working experience is more intensive, the two partners are more accessible to each other, the audit firm is less experienced with the client or less knowledgeable about the client's industry, or client audit risks are higher.Data Availability: Data are available from the sources cited in the text.JEL Classifications: M4; M42.

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.

Killing two birds with one stone? Auditor choice in merger & acquisitions and subsequent auditor assurance quality

ABSTRACT Listed companies commonly appoint their incumbent annual auditors to audit a target company during a merger and acquisition (M&A). However, some companies choose an alternative auditor to perform the M&A audit. To understand the consequences of this apparently unconventional auditor choice, we argue that the acquiring company introduces competition between the M&A auditor and the annual auditor, which makes the M&A auditor incentivised to compete for the annual audit engagement, whereas the annual auditor is motivated to protect her business from rivalry. This game facilitates corporate management to gain favourable treatment from auditors both in the annual audit and in the performance commitment attestation for post-M&A periods. Using data from Chinese M&A market from 2008 to 2017, we find evidence consistent with our hypotheses. Our findings suggest that an audit client is capable of compromising external auditors’ monitoring by employing multiple auditors on various assurance services.

The perceptions of loan officers and auditors of factors affecting auditor independence: Evidence from Palestine

The study investigates the perceptions of external auditors and loan officers regarding external auditor's independence in Palestine. Data were gathered using a questionnaire developed by the author and include 5 main issues related to the perception of external auditor’s independence. The sampling population identified for this study consists of external auditors working in domestic and international audit firms and financial statement users mainly loan officers in Palestine. The sample included 79 auditors and 76 loan officers. The findings revealed that there are significant differences in the perceptions of external auditors and loan officers in relation to provision of non-audit services, auditor’s economic dependence on a single audit client, and long relationship between an auditor and a client. The results revealed mixed results about the effect of presence of active audit committee on independence of the external auditors. Furthermore, acceptance of significant gifts from the client was considered an important factor that may influence auditor independence by loan officers and external auditor and thus significant differences between the two respondent groups were found in relation to acceptance of significant gifts from the client. These findings can be useful to policy makers and professional auditing bodies in Palestine on setting new regulations or strengthening existing ones to enforce auditor’s independence in Palestine.

Agilnost interne revizije

The dynamic changes in the market conditions are increasingly moving away from the reactive audit planning. The increasingly prevalent approach implies agility, i.e. faster adjustment to the external and internal environment, whose result includes the improved operational performance, quality and satisfaction of audit clients. One way to introduce agility in internal audit is to adopt the methodology Scrum, a management approach applied in several project organizations in various industries. By implementing the best experiences of Scrum, a better overview, thinking, learning and adjustment would be achieved. The principles of having to check and adjust, which are inherent in Scrum, enable the teams to work efficiently in the ever-changing conditions, resulting in a high level of sustainable productivity. The paper provides an overview of the agile organizations, specific planning, Scrum principles and concepts for application in audit teams.

Različiti pristupi u komunikaciji u internoj reviziji

In order for the auditor's reports to be adequate, the auditor's communication with the audited entities and its representatives must be adequate. The paper discusses ways how to make internal audit more popular and what communication techniques to use with audit client management. Every aspect of vertical and horizontal communication in internal audit should be approached carefully in order to unify, integrate and focus audit activities on controls, risks and objectives. This includes an introductory and closing meeting, a specific approach to conflicting clients, information on specific objectives and the level of their achievement, using the experience of audit teams in the Telekom Srbija Group.